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DEDICATED TO THE MEMORY OF FERDINAND LIPS WHO ARDENTLY ADVOCATED THE
PRESERVATION OF KNOWLEDGE HOW TO RUN A GOLD STANDARD SO THAT IT CAN BE PASSED
ON TO FUTURE GENERATIONS
Abstract
Economists have
neglected to study the phenomenon of vanishing uncertainties and risks in the
production process as maturing goods approach the final consumer who is eager
to buy them at established prices. We fill this gap in resurrecting Adam
Smith’s long-forgotten notion of social circulating capital. Then the
propensity to consume appears as the volume, and the discount rate as the
marginal productivity of social circulating capital. It turns out that the
rate of interest and the discount rate are entirely different concepts
animated by entirely different forces. The fundamental error of Mises and Rothbard in confusing
the two was due to insufficient research, in particular, ignorance of
economic entropy, the measure of the disappearance of uncertainty and risk.
It was also due to their denial of liquidity, the fruit of maximum entropy.
Social Circulating Capital
When does a river cease to be a river? At the
moment it gets within sight of the sea. As the river is descending to sea
level significant and conspicuous changes occur. The salinity of the water
increases sharply and, with it, the ecology changes. Water molecules lose
their potential energy and their kinetic energy is converted to entropy.
Similarly, the flow of myriad goods from
producer to market also undergoes a remarkable metamorphosis when it gets
within sight of the consumer. Adam Smith was the first to notice this
interesting phenomenon. He formulated the concept of social circulating
capital. By this he meant the mass of finished or semi-finished consumer
goods which has reached sufficient proximity and is moving sufficiently fast
to the ultimate cash-paying consumer so that its destiny of being consumed
presently can no longer be in doubt.
The analogy between the flow of goods to the
final consumer and the river emptying into the ocean can be profitably extended
to include economic entropy. The risks and uncertainties, so
characteristic of processing in the earlier stages of production, all but
disappear by the time the maturing goods become part and parcel of social
circulating capital and sale at the going price can be taken for granted.
Speculation and other forms of risk-taking give way to the highly predictable
automatic processes of distribution. In particular, established retail prices
do not normally change in response to changes in demand because of the
increase in economic entropy, measuring the reduction of uncertainty and
risk.
Liquidity
The vanishing of uncertainty and risk, the
emergence of social circulating capital, and increase in economic entropy are
manifested in a most dramatic fashion through the appearance of liquidity. To
Adam Smith liquidity was tantamount to the spontaneous circulation of real
bills that he observed in Manchester and Lancashire. It refers to the qualitative difference
between goods carried by the trade at virtually no risk in anticipation of
sale to the final consumer at established prices, and other goods carried at
considerable risk in anticipation of an eventual appreciation in value.
The importance of the market phenomenon that
stabilizes values as economic entropy is maximized can hardly be
overestimated. It is incumbent on the monetary economist to study it closely.
The process of supplying the consumer with urgently needed goods cannot be
described in terms of a black-and-white equilibrium model with circulating
capital financed out of savings, as is done in textbooks for dummies. It is a
transition, a metamorphosis, the description of which calls for the full
spectrum of colors involving a wholly new gamut of
means of payment which are legitimate substitutes for the ultimate
extinguisher of debt, gold. Demand does not operate on prices; it operates on
the discount rate. The vanishing of uncertainty and risk, along with the
emergence of social circulating capital and the increase in economic entropy
must be analyzed independently of any banks or the banking system. It is the
disappearance of uncertainty and risks that gives rise to banking, not the
other way around. We would never understand bank note circulation without
liquidity and spontaneous bill circulation that appear in the wake of
increasing economic entropy.
Liquidity can be measured by the spread
between the ask and bid price. The smaller the
spread, the higher liquidity is. The ultimate in liquidity is epitomized by the
gold coin with zero spread. Next in line is the consumer good in urgent
demand that sits on the shelf of the shopkeeper waiting to be exchanged for
the gold coin of the final consumer. The bill drawn on the retail merchant
inherits liquidity from the collateralized merchandise on the shelf.
Higher-order goods, while they may also be liquid, are progressively less so
as we move farther away from the ultimate consumer and his gold coin.
The evolution of the bill market has made the
circulating gold coin in the hand of the consumer extremely efficient, far
beyond the limits of its physical mobility. Henceforth only finished consumer
goods would be sold against gold coins at the retail counter. Semi-finished
goods at various stages of production and distribution would be traded
against bills of exchange. At the end of each quarter all transactions are
cleared, and all outstanding bills paid from the proceeds of the final sale
of first-order goods into which fast-moving higher-order goods have matured.
The gold coins of the final consumer liquidate all claims that have arisen
during the maturation of goods.
Propensity to consume
The volume of social circulating capital and
changes in its composition are of the highest importance. They change as a result
of arbitrage between the consumer goods market and the bill market.
The arbitrageur is none other than the shopkeeper who makes the crucial
decision which items to carry on his shelves and which ones to discontinue.
In these decisions he is guided by one consideration alone: the wishes of the sovereign consumer. For this
reason, propensity to consume can be identified with the volume of
social circulating capital. If the latter is visualized as a great river
emptying into the sea of consumption, then an increase in propensity to
consume appears as the merger of some of the tributaries with the main river
(tide). Conversely, a decrease appears as the separation of a new tributary
from the main flow (ebb).These changes are not merely quantitative but, on a
periodic basis, become qualitative following the change of seasons. The
composition of social circulating capital is changing along with the change
of volume. Above all, it is a change in the variety of its components.
Interestingly, the mechanism whereby the wishes of the sovereign consumer are
transmuted into changes of stock in the retail store, to wit, arbitrage of
the marginal shopkeeper between the bill market and the consumer goods
market, has escaped the attention of the economists. A detailed analysis
follows.
Marginal Productivity of Social Circulating
Capital
Each merchandise on the shelf of every retail
shopkeeper has a productivity of its own that can be measured by the
ratio of the percentage of the retail mark-up (with due allowance being made
for overhead) to the average length of its sojourn on the shelf. Thus if the
retail mark-up on $1 worth of sauerkraut is ½ cent and the average
sojourn on the shelf of one bottle is three months, then the productivity of
sauerkraut is (1/2)/(3/12) =
2% per annum. The
merchandise on the shelf of the marginal shopkeeper with the lowest
productivity is called the marginal item of social circulating
capital. The marginal shopkeeper is the one who is first to change the
composition of his stock at the first sign of change in the willingness,
buying habits, and taste of the consumer. In other words, the marginal
shopkeeper adjusts the volume of social circulating capital to the propensity
to consume. The marginal item will disappear from the shelf as propensity to
consume declines, because it will not be re-ordered by the marginal
shopkeeper, and no more bills will be drawn against its movement from
producer to consumer. Another item on the shelf with a higher productivity
will take its place as the new marginal item.
The rate of marginal productivity of
social circulating capital is the productivity of the marginal item. In
more details, it is the rate at which the opportunity cost of carrying the
marginal item on the shelf becomes critical to the marginal shopkeeper. The
reference is to his opportunity to carry bills drawn on other shopkeepers
with faster-moving merchandise, rather than carrying the marginal item on his
shelf. Indeed, the marginal shopkeeper is doing arbitrage: he is letting his stock of marginal merchandise
run down whenever the rate of marginal productivity of social circulating
capital increases. This happens precisely when the propensity to consume
declines. The old marginal item with a low productivity gives way to the new
with a higher productivity. Through his arbitrage the marginal shopkeeper is
able to escape a deep cut in his income due to seasonal and other changes in
demand. He can, thanks to his portfolio of real bills, participate in the
higher earnings of his colleagues operating with higher productivity.
Conversely, the marginal shopkeeper will sell bills from portfolio and
re-order some (heretofore submarginal) merchandise
which he is now willing to carry in stock, provided that the rate of marginal
productivity of social circulating capital decreases. This happens precisely
when the propensity to consume rises. Higher consumer spending will promote a
submarginal item with a lower productivity to
become the new marginal item. Thus we have proved our First Theorem
asserting that the rate of marginal productivity of social circulating
capital varies inversely with the propensity to consume.
Discount rate
The arbitrage of the marginal shopkeeper
between the bill market and the consumer goods market is the centerpiece of the analysis of the discount rate. We
shall now prove our Second Therorem asserting
that the discount rate is equal to the rate of marginal productivity of
social circulating capital. At every moment the marginal shopkeeper (who
may be impersonated by a different shopkeeper from one point in time to the
next) is guided by two indicators:
(1) the rate of marginal productivity of social circulating capital; (2) the
discount rate. If the former is higher, then he will sell real bills from
portfolio and order a new marginal item to display on his shelf. As a
consequence (1) decreases while (2) increases (since the fall in the price of
real bills makes the discount rate rise). Conversely, if the latter is
higher, then he will discontinue offering the marginal item and will purchase
real bills to put in portfolio instead. As a consequence (1) increases while
(2) decreases (since the rise in the price of real bills makes the discount
rate fall). In either case the two rates get equalized.
A higher discount rate heralds to all
shopkeepers a decline in the propensity to consume. Instead of re-ordering
marginal merchandise they will in response buy real bills in order to benefit
from the higher discount rate. Social circulating capital shrinks.
Conversely, a lower discount rate heralds to all shopkeepers a rise in the
propensity to consume. They can now beat the discount rate by offering a
greater variety of goods to the consumer, so they will reduce their portfolio
of real bills while ordering new merchandise to display on their shelves.
Social circulating capital expands.
This arbitrage of the marginal shopkeeper
between the consumer goods market and the bill market that regulates the
discount rate is analogous to, but conceptually is very different from, the
arbitrage of the marginal producer between the producer goods market and the
bond market that regulates the (ceiling for the) rate of interest. Comparison
of the two reveal that the discount rate is different from the rate of interest. The
economic forces changing the two rates are different. The force driving the
rate of interest is the propensity to save. As is well-known, the rate of
interest varies inversely with the propensity to save. The force driving the
discount rate is the propensity to consume. It is immediate from our First
and Second Theorems that the discount rate varies inversely with the
propensity to consume: rising
propensity to consume is tantamount to a falling discount rate and vice
versa.
It is important to note that the two
propensities are not complementary. A third one, the propensity to hoard, is
sandwiched between them. Thus it is possible for the rate of interest and the
discount rate to rise together. It simply means that people are hoarding
goods. By the same token it is also possible for the two rates to fall
together. It means that people are dishoarding
previously hoarded goods. The propensity to hoard plays a pivotal role in the
genesis of the Kondratiev long-wave cycle. This is
a topic for a forthcoming article.
There is only one constraint limiting the
relative moves of the two rates. The rate of interest is not at liberty to
fall below the discount rate. Having said that, we must admit that illicit
interest arbitrage, or financing bond purchases through the sale of bills at
the lower discount rate (a.k.a. borrowing short in order to lend long) could
engineer such a fall. This has been a lucrative if illegitimate source of
profits for banks quick to make a buck by short-changing the public. Illicit
interest arbitrage plays a pivotal role in the genesis of the business cycle.
Again, this is a topic for another forthcoming article.
Supply/Demand equilibrium
We conclude that the vulgar supply/demand
equilibrium model is inoperative in the consumer goods market. Supply is not
an independent variable: it is
closely regulated by demand through changes in the discount rate. It is
insulated from the “slings and arrows of outrageous fortune” by
the paraphernalia of self-liquidating credit. An increase in demand lowers
the discount rate, which quickly brings out a greater variety of consumer
goods. Conversely, a decrease in demand raises the discount rate, which
quickly eliminates marginal merchandise from the shelves of retail stores.
Consumers who still want them will have to look for them in specialty shops
where they will be available albeit at a higher price, since moving them can
no longer be financed through real bills, that is, through self-liquidating
credit at the discount rate. It has to be financed through funds borrowed at
the higher interest rate. Thus we observe the curious but pleasing fact that
the price of goods belonging to the social circulating capital cannot be
upset through supply and demand shocks.
Economists who are unable to distinguish
between the discount rate and the rate of interest are at a loss to explain
why retail prices under the gold standard were stable even in the face of
changing demand. Their denial of concepts such as liquidity and economic
entropy reduces them to play the role of stooges riding on the coattails of
the enemies of freedom, the protagonists of irredeemable currency. The latter
know full well that they have nothing to fear from a color-blind
gold standard outlawing the bill market as it is doomed to failure anyway.
Only a gold standard recognizing the full spectrum of colors
in the light of liquidity and entropy that rehabilitates international trade
in real bills will scare them.
References
Adam Smith, The Wealth of Nations, Book 2, Chapters 1-2
Antal E.
Fekete, Where Mises
Went Wrong, Financial Sense Online, September 16, 2005
Copyright © 2005 by A. E. Fekete
.
Antal E. Fekete is Professor Emeritus at Memorial University
in St. Johns, Newfoundland. Born and educated in Hungary, he emigrated to Canada after the Hungarian
Revolution in 1956 and taught for 35 years in the field of mathematics. Over
the years, he has been a visiting professor or Fellow at Columbia University,
Princeton University,
and Trinity College
of Dublin. He
worked in the Washington office of Congressman W.E. Dannemeyer
on monetary and fiscal reform for five years in the nineties; and in 1996, he
won first prize in the prestigious International Currency Essay contest
sponsored by Bank Lips Ltd. of Switzerland. He is the author of Gold and
Interest and Monetary Economics 101. In addition, his scholarly articles have appeared on
numerous Internet sites throughout America.
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