Fed’s open market purchases of securities (always net) affect only the
short end of the yield curve directly, through the transmission of
risk-free bond speculation they will affect the rest of the yield curve indirectly.
Thus the entire spectrum of interest rates will keep falling in consequence
of the Fed’s open market purchases of Treasury bills (or equivalent).
This is a powerful if unrecognized force in the economy causing a
chain-reaction as follows:
bond speculation causes interest rates to fall,
interest rates cause a severe erosion of capital throughout the
(3) erosion of
capital causes a falling trend in prices,
(4) falling prices further increase the downward pressure on
Thus a vicious
spiral of falling interest rates and falling prices is engaged, threatening
to push the economy into the abyss of deflation. Mainstream economics lacks a
valid theory of speculation. Hence it has a blind spot, failing to see the
destructive nature of open market operations.
speculators carry on interest arbitrage along the entire (normal) yield-curve.
They sell the short maturity and buy the long, hoping to capture the difference
between the higher long rate and the lower short rate of interest (borrowing
short and lending long). This arbitrage is not risk-free per se as it
has the effect of flattening, and possibly inverting, the yield curve. As a
result of inversion it is turned from a rising curve into a falling one,
while turning the speculators’ profits into losses.
However, as a
direct result of the open market operations of the Fed (introduced
clandestinely and illegally in the 1920’s through the conspiracy of the
US Treasury and the Fed, long before the practice was legalized ex post facto
in the 1930’s), interest arbitrage has been made risk-free. Astute
bond speculators with their long leg in the bond market can profitably mimic
Fed action in the bill market with their short leg. This never fails.
Speculators know that, sooner or later, the Fed has to answer nature’s
call and will go to the bill market as a buyer in order to replenish the
money supply. This is their signal to sell. On rare occasions the Fed would
be a seller. This is their signal to buy. This copycat action is an
inexhaustible source of unearned profits for the speculators. Thanks to the
Fed’s open market purchases, they are always able to spread. The more
aggressive the Fed is in increasing the monetary base, the wider the spread
and the greater the bond speculators’ profits will be.
After the F.R.
Act of 1913 was quietly overthrown when Congress was not looking, the Fed has
been revolutionized. According to the original Act the earning assets of the
F.R. banks were to be restricted to real bills, that is, short term
commercial paper originating in the production and distribution of consumer
goods. Treasury paper was not listed in the Act as an eligible asset. This
was not an oversight. No part of F.R. credit outstanding was supposed to be backed
by government debt. If a F.R. bank was found short of eligible paper in balancing
its note and deposit liabilities, it did not matter how much the overflow of
Treasury bills was in its portfolio, it had to pay stiff and progressive penalties.
between the U.S. Treasury and the Fed is to be seen in the fact that the
former has ‘forgotten’ to collect the penalty from the latter.
Indeed, why should the Treasury penalize its best customers for buying its
staple product? By 1920 you could not find a real bill in F.R. portfolios
with a magnifying glass. Nor was a serious effort made to return to the norms
of the original Act after the end of the hostilities in starting
rediscounting bills once more.
has gone right to the heart of the U.S. monetary system. In 1913 legislators
were assured that they were voting for a commercial paper system that could
never become an engine of monetizing government debt. Should it try, it would
be confronted with unacceptable losses. Later, when time came to legalize the
illegal practice, the introduction of open market operations was presented as
an innocent house-keeping change, a technical matter relating to banking
practice. The fundamental issue, the wisdom of allowing the Fed to monetize
government debt, was hushed up. Congress, let alone the general public, was
never given a chance to scrutinize or debate it. Monetization of government
debt was legalized through the back door, through chicanery, and through
absolute bad faith. It was made the centerpiece of the money-creating process,
in a complete reversal of the intention of the original Act. Is it any wonder,
then, that the new monetary system born in sin has brought disaster to the
nation in due course?
their criticism on the way the Fed creates money through sleight of hand. But
there is a much larger issue here that goes unnoticed and has escaped attention.
Open market purchases have made it possible for the Fed to usurp unlimited
power in suppressing the rate of interest on all maturities through
the transmission mechanism of risk-free bond speculation, while maintaining
the illusion that it had only a very limited power of influencing the
overnight rate of interest. The impression created is that the world can rest
assured that all other rates are true market rates. Nobody took the trouble
dispelling this illusion.
investigated the consequences of bond speculation in the wake of open market
operations. The ‘innocent house-keeping change’ opened up a bottomless
pit for the national economy, as it has granted unlimited power to the Fed to
suppress all interest rates along the yield curve, all the way to zero. Just
as nature abhors vacuum, it also ‘abhors’ risk-free speculation.
It exacts an exceedingly high price from violators, sometimes after a long
delay, when retribution is least expected.
for opening Pandora’s box of risk-free speculation was devastating, as
demonstrated by the Great Depression of the 1930’s. In that episode
risk-free speculation made bond prices rise and
interest rates fall beyond any reasonable limits. Speculators abandoned the
commodity market as too risky, and flocked to the bond market where all bets
were on the house. Commodity prices fell, along with interest rates, through
the whole spectrum. The consequences were apocalyptic.
interest rates as a destroyer of capital
My thesis that
falling interest rates destroy capital across the board is admittedly controversial.
I would welcome its examination ‘without fear and favor’ by a competent
and unbiased panel. We must look at two related effects of falling (as opposed to
low but stable) interest rates: (i) the
increase in the liquidation value of debt, (ii) the fading of
that the bond price varies inversely with the rate of interest is uncontroversial
and universally accepted. It describes the effect from the point of view of
the creditor. Yet people find it hard to comprehend the equivalent proposition
describing the very same effect from the point of view of the debtor, namely,
that the liquidation value of debt varies inversely with the rate of interest,
in particular, lowering the rate of interest will increase the liquidation value
of debt. There is no difference between the meanings of the two statements.
The bond price is just the liquidation value of debt evidenced by the bond. Falling
interest rates make the burden of debt increase.
depreciation quota of a producer good is an accounting tool revealing how
much of its value is being ‘used up’, and needs to be replaced
through amortization, in any particular year. It is comparable to the annual
yield of capital invested in a bond. When looked at in this way, it becomes
clear that falling interest rates should make the revision of depreciation
quotas upwards mandatory. If this rule is ignored, there will be a shortfall
in amortization. Sufficient funds will not have been set aside to pay for the
purchase of the replacement at the end of the useful life of producer goods.
accounting standards ignore both effects (i) and
(ii). This is the cause of concealed capital erosion acting
insidiously. Losses are masked as profits, and phantom profits are paid out
as dividends and managerial compensation. The process of capital erosion is
accelerated. Inevitably, the result is deflation, depression, or worse.
We have seen
that open market operations of the Fed serve as a powerful deflationary force
in the economy causing interest rates to fall and capital to erode. We shall
now see that falling interest rates cause prices to fall as well. It engages
a vicious spiral pulling the economy into the abyss.
capital causes a falling trend in prices
The erosion of
capital affects all producers, some of whom will succumb while others will
fight for survival by trying to get out of debt. They will aggressively cut
prices in the face of weakening demand.
Herein we have
a classic example of central bank action being counterproductive. The central
bank wants to snatch the economy from the jaws of deflation by increasing the
money supply. Its preferred method is the open market purchases of short-term
government securities. But through the transmission of risk-free bond
speculation interest rates keep falling for all maturities. Capital invested
in production is eroding faster as a result. The burden of debt is
increasing. Producers are squeezed. They try to get out of debt by selling
more of their product. In desperation they cut prices, but to no avail.
circle is complete.
theory of the boom-bust cycle
of the rate of interest through monetary policy and the resulting malinvestments made by entrepreneurs is a central theme
of the Austrian School of economics. Our analysis is in the same tradition.
In exposing the actual transmission mechanism that converts the suppression
of short term rates into the suppression of the longer term rates, it carries
the analysis further. It points out that open market purchases of the Fed
make bond speculation risk-free with the result that all interest rates will
It turns out
that it is not necessary to bring in the malinvestment
argument. After all, entrepreneurs could learn from past experience and
fine-tune their investments taking the distortion in the rate of interest
into account. Could the bust be avoided if they did? Our explanation of
deflation and depression in terms of destruction of capital, brought about by
the falling interest rate structure, avoids any reference to possible malinvestments and is, therefore, superior.
heel of Keynesianism
of capital argument also has the advantage that it reveals the Achilles heel
of Keynesianism preaching, as it is, the dangers of ‘oversaving’ and ‘underconsumption’.
These concepts are vacuous. There is no reason why a society should not be
able to satisfy the needs of those of its members who must be net savers
(typically the juniors), and those who must be net consumers (typically the
seniors). The Achilles heel of Keynesianism can be found in its treatment of
capital, in particular, in ignoring the danger of capital erosion. Keynesianism
is oblivious to the fact that, if capital consumption occurs for any reason,
then the resulting deficiency must be compensated for by the accumulation of
new capital. Without it society cannot continue living at the same level of
comfort and security. If it tries, it makes the crisis of undercapitalization
even more critical.
mistake of Keynesianism is to teach that the cause of the Great Depression
was falling prices due to oversaving. But
falling prices were not the cause: they were the effect. The cause was
falling interest rates, for which the fiscal and monetary policies
advocated by Keynes were directly responsible: the unbalancing of the budget,
inordinate increases in debt, and the monetization of government debt by the
central bank. The Keynesian idea that open market operations will not and
cannot have devastating side effects has become a dogma. This dogma must be
discarded. Open market operations do have consequences.
asked question is whether the international monetary system based on
irredeemable currency is facing a deflation similar to that of the
1930’s, or whether it is facing a Zimbabwe-type hyperinflation. A
relentlessly increasing money supply is not the only prerequisite for hyperinflation.
There is another: the lack of suitable outlets for the bloated purchasing
power. As risk-free bond speculation made possible by open market operations
shows, no matter how much purchasing power is being created by the world’s
central banks, speculators will always find rising bond values safer to bet
on than on rising commodity values. In the absence of wars, or civil wars, destroying
stores of consumer goods as well as the park of capital goods to produce, the
forecast is deflation, not hyperinflation.
It follows that
in combating deflation the Obama administration is resorting to measures that
are ineffective, if not outright counter-productive. In particular, more
government debt is poison for the economy. Its monetization by the Fed will
only feed bullish bond speculation (and possibly bearish commodity speculation)
while doing nothing to rebuild the impaired capital base of industry and
finance. Bullish bond speculation is responsible for the falling interest-rate
structure and destruction of capital. The economy needs to be stimulated,
yes, but increased government spending is the wrong way to that goal. The
right way is through stable interest rates, more savings, and the accumulation
of more capital. If it were not so tragic, one could rub in the irony that
Keynesianism, in trying to push the world into the pit of inflation, has only
succeeded in pushing it into that of deflation — the very same pit it
was so anxious to avoid.
Antal E. Fekete
San Francisco School
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