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Summary
for the busy executive
The true story of
de-industrialization in America
has never been told. The boat of American industry has collided with the
iceberg of falling interest-rate structure. The damage to capital is great
and the boat is sinking. Auto manufacturing could go the way of TV and VCR
manufacturing that went down in the 1980’s without the captains knowing
what has hit them. Commentators blamed the demise on Asian sweatshops, on
American consumer preference for services, and on the alleged rigidity of
foreign exchange rates. These explanations reflect warped official thinking
as well as the false teachings of mainstream economics. The true explanation
can be found in the phenomenon of ‘linkage’ that translates
falling interest rates into falling prices. There is a vicious process of
destroying industrial capital under a falling interest-rate structure. This
observation also shows the way out. Remedy is to be found not in more
flexibility of foreign exchange rates but a
return to the system of fixed exchange rates. The only known way to
stabilize interest rates is an immediate return to the gold standard. During
this presidential election year we have, for the first time in
half-a-century, the possibility to debate the merits of the gold standard, thanks
to Dr. Ron Paul’s candidacy
for the Republican nomination. The challenge is enormous. Conventional wisdom
maintains that falling interest rates are good for capital. They are not.
They are lethal. Fiat currency is the destroyer of industrial capital.
Financial
capital: vampire of productive capital
Fiat currency is a
thoroughly toxic agent as it insidiously destroys capital through the
destabilization of the interest rate structure. More precisely, the capital
of industry is surreptitiously siphoned off to enrich bond speculators.
Financial capital has become the vampire sucking the blood of productive
capital. Here is what happens. The rate of interest measures the marginal
productivity of capital. As I shall point out, capricious changes in marginal
productivity, whether up or down, destroy productive capital to no better end
than to prop up and perpetuate a reactionary and unconstitutional monetary
regime that has the effect of exploiting savers, producers, and consumers
alike for the benefit of simonious politicians,
corrupt bankers, and parasitic bond speculators.
A
primer on productivity
There is a great deal of
confusion in the public’s mind about productivity. For example, it is
widely assumed that an increase in the marginal productivity of capital is
beneficial to society. This is wrong. Just the opposite is true. An increase
in the marginal productivity of capital means that a lot of industrial plant
and equipment has become submarginal, is idled, making its labor complement superfluous.
Unemployment is the result. Some people who understand this believe that the
opposite, decreasing marginal productivity, is beneficial to society for the
opposite reason: formerly idled plant and equipment are now pressed into
service, relieving unemployment. Wrong again. Idled capital that has not been
properly maintained is brain dead. It will not be revived by falling interest
rates. Making capital submarginal is an
irreversible process.
Fiat
currency drives capital and jobs abroad
It is a mistake to blame
„Asian sweatshops” for increasing unemployment. America
has coexisted with cheap Asian labor for its entire history. The latter was a
benefit rather than a threat to American prosperity under the gold standard.
It only became a threat under fiat currency, since gyrating interest rates caused the divorce of American capital and labor.
Capital goes abroad to look for a new labor partner. As it migrates,
well-paid American jobs migrate with it never to come back. Notice that the
exportation of American jobs would not have occurred if the interest-rate
structure in America
had been stable, as under the gold standard, bonding the partnership between
labor and capital.
Marginal
productivity
Let’s see what is
meant by marginal productivity and expose the popular misconceptions about
it. Each individual plant and equipment has its own productivity. It can be
calculated as the annualized percentage of increase in value added: output
minus input. We rank all plants and equipment in existence according to
increasing productivity. Those at the low end of the productivity spectrum
will be left idle since the opportunity cost of employing them would be too
high. There is a cut-off point marking the marginal item in the productive apparatus of society. It is that
(variable) piece of equipment or individual plant that is still employed in
productive activity, but all others with a lower productivity are idle. The
productivity of the marginal item is called the rate of marginal productivity of capital (for short, marginal
productivity). If marginal
productivity increases, productive plant and equipment become submarginal and get laid off, resulting in a divorce
between labor and capital. The labor complement of submarginal
capital also gets laid off causing
unemployment. On the other hand, as marginal productivity falls, certain
previously submarginal plants and equipments will
become productive again ― in theory. In practice, however, capital is
looking for new labor partners. Since it is not committed to remarry its
previous partner, under our fiat currency system capital will migrate abroad
in search of cheap labor. In effect, both industrial capital and jobs are
exported.
The
rate of interest
Marginal productivity is
determined by the rate of interest. The latter is that rate at which the stream of income payments from coupons plus the payment of
principal at maturity amortize the (variable) market price of the
bond. This means that the rate of interest is determined by the bond market.
Hence, it is a market phenomenon. Moreover, it varies inversely with the bond
price, since the present value of an income stream varies inversely with the
rate of interest (or, saying it differently, capitalizing the same stream of
payments at a lower rate of interest results in a higher capital value).
Clearly,
bonds compete with industrial capital as an investment outlet to produce
income. Because of this competition
marginal productivity can be identified with the ceiling of the rate of
interest. To see this in more detail look at the arbitrage of the
capitalists. They will not let the two rates deviate from one another. If the
rate of interest is higher, they will sell industrial capital and put the
proceeds into higher-yielding bonds. Even if they can’t sell, at the
very least they stop production and capital maintenance, abolish depreciation
quotas and use the savings to buy the low-priced bond. If consequently the
rate of interest drops, that is, bond prices rise, then capitalists take
profit in selling the bond, buy new industrial plant and equipment and start
production again. Either way, the arbitrage activities of the capitalists
will close the gap between the rate of interest and the rate of marginal
productivity.
Opportunism
of Keynes
Keynesianism is no science.
At best it is (in Ayn Rand’s words) a
“gigolo of science,” forging political capital out of
bad-mouthing the gold standard and the regime of fixed exchange rates. It
advocates the management of the national currency, ostensibly to manage the
national economy for the benefit of society. In fact it is running the
national economy into the ground. Keynesianism is based on the insane but
appealing concept that driving the international value of the national
currency down is beneficial to the export industry. It ignores the fact that
even if you could derive ephemeral advantages through this ploy of
„beggaring thy neighbor”, deteriorating terms of trade could not
be talked out of existence. If America exported x and imported y having
the same value of z dollars, then
after the devaluation of the dollar by, say, 50 percent, America would have
to pay for importing y the sum of 2z dollars. In other words, America has
to export twice as much of x in order to import just the same
amount of y as before devaluation. America’s
terms of trade has deteriorated by
a factor of 2. Worse still, the terms of trade for America’s competitors has improved by a factor of 2. America is
selling its national wealth on the cheap. Far from enriching the country,
devaluation is impoverishing it. No wonder America has been on skid row ever
since it has embarked on a policy of perpetual dollar-devaluation
euphemistically called the floating dollar. Keynesianism is an
unreconstructed mercantilist system. It is hard to see how mainstream
economists and financial journalists have found it possible to treat it with
respect.
The
culprit: destabilization of interest rates
Keynes attributes deflation
and depression to the ’contractionist
tendencies’ of the gold standard. He says the gold standard puts a
squeeze on prices. The government should relieve tightness in the economy by
deficit spending, and the banking system should monetize the resulting
government debt. This is called ’contra-cyclical monetary
policy’. Keynes correctly recognizes the cumulative effect in the
contraction of the economy once prices start falling, but he attributes it to
the wrong cause: the vanishing of
private demand which he wants to compensate with stepped-up public spending.
In reality, the industry’s loss of pricing power and the subsequent
downwards spiral of prices is not due
to vanishing demand. It is due to the weakening of capital structure,
bankrupting producers. To see this we have to provide a more
sophisticated analysis of the effects of destabilizing interest rates than
hitherto given.
The
gold standard is sacrificed in order to make unbridled government spending
possible. In Keynes’ one dimensional world this may have the effect of
increasing prices, but it is all to the good as it is thought to revive the
economy. However, the world is not one-dimensional and abolishing the gold
standard has another effect: increasing interest rates. Bond prices and
interest rates are destabilized.
What
caused the Great Depression?
Keep in mind that there was
no bond speculation under the gold standard. Disingenuously, mainstream economists stone-wall this fact thereby doing great disservice
to the cause of science. They have
blocked research on the detrimental consequences of the removal of the gold
standard. Nobody has exposed the cause:
destabilization of interest rates, and the effect: the Great Depression. The
Keynesian dogma that it was caused
by a deflation-prone gold standard is almost universally accepted.
However,
the very opposite is true: the Great Depression was caused
by sabotaging the gold standard.
When the ownership of and trade in gold was banned by F.D. Roosevelt in 1933,
the biggest competitor of government bonds, gold, was forcibly removed. Bond
prices rose and interest rates fell precipitously. As we shall presently see,
prices are bound to follow interest rates down. Falling prices triggered a
downward spiral. The depression was on. The
root cause was “moral
cannibalism” (again, borrowing a phrase from Ayn
Rand), the confiscation of the gold of
the people. Mainstream economics is stone-walling that fact as well.
Paying
out phantom profits
We shall now show how
falling interest rates translate into falling prices. Contrary to
conventional wisdom, falling interest rates squeeze profits. Mainstream
economists teach that falling rates are salubrious to business. However, they
fail to distinguish between a low and
a falling interest rate structure. Falling interest rates reveal that past
investment in physical capital has been made at too high a rate in view of
lower rates now available. The difference between the two rates hits the
profit margin, and hits it badly. There is no way getting around the fact
that falling interest rates make the cost of servicing debt, contracted
earlier, more onerous. The present value of outstanding debt rises. Firms
with zero debt are not exempt either. The value of industrial capital falls
across the board as new capital could now be financed at lower rates.
Relaxed
accounting standards under fiat currency allow firms to get away without
reporting capital losses in the balance sheet incurred in the wake of
fluctuating interest rates. However, a loss is a loss, reported or
unreported. If the loss is not reported, the firm is paying out phantom
profits in dividends, compounding capital losses and hastening collapse.
Linkage
Critics find the statement
that the present value of outstanding debt rises as
the rate of interest falls counter-intuitive. Yet it is just the flipside of
the statement that the market price of a bond rises
as the rate of interest falls ― a mathematically and empirically
well-established fact of life.
Critics
also object saying that losses in the liability column are offset by gains in
the asset column. Falling interest rates, while increasing the present value
of debt (hence causing capital
losses) also increase the present value of future earnings which, they say,
generate capital gains. The trouble with this argument is that it ignores the
accounting rule that prohibits putting value on assets higher than historic
costs, forcing the accountant to disregard any increase in anticipated future
earnings. He has no choice: the accountant must charge the increased cost of
potential liquidation against assets without making allowance for increased
future earnings due to falling interest rates.
As
profits are squeezed, firms are forced to retrench. They reduce inventory, causing prices to fall. We conclude that falling
interest rates translate into falling prices. This is the missing link that
all the great theorists on interest from Eugene Böhm-Bawerk
to Knut Wicksell have missed. They observed the
operation of linkage as it forced
interest rates to follow ― apart from leads and lags
― the same path upwards or down as do prices. They could even prove
that rising or falling prices caused
interest rates rise or fall, and that rising interest rates caused prices to rise, too. But for all their
efforts they failed to find the missing piece of the jigsaw puzzle: the proof
that falling interest rates caused
prices to fall as well. Our argument above furnishes the missing piece. This,
we believe, is a major break-through in theoretical economics, making
nonsense out of Keynesian prattle to boot.
Why
aren’t airline wreckages investigated?
As linkage is activated,
falling interest rates pull down prices. The deflationary spiral is on.
Falling prices squeeze profits more. Many firms see their capital melt away.
They fold in spite of falling interest rates.
The
same forces that worked in the Great Depression are also at work today. When
interest rates switched from rising to falling mode in the early 1980’s
latter-day Icarus, the airline industry, was flying
high. There was no Daedalus around to warn Icarus that he was flying too high, in view of being one
of most capital-intensive industries. Falling interest rates were considered
an incentive to increase operational altitude. Airlines went into debt to the
hilt in financing spanking new fleets of planes. Then airlines, like Icarus, started falling out of the sky one after another.
Among the victims was the American flagship, Pan American, as well as
Swissair, envy of the industry and widely considered the best-managed airline
that has ever cruised the skies. What caused these and other airlines to nose-dive just
when they were getting ready to enjoy the ‘benefits’ of falling
interest rates? Plenty of ad hoc
reasons were offered, none of them convincing.
Airlines were blown out of the sky because falling interest rates wiped out their
capital. Governments take great pains to investigate the wreckages of airliners meticulously. Experts find
and reassemble even the smallest pieces of the wreckage in a hangar in search
for clues of the cause of the
crash. This effort is praiseworthy. There is much to be learned from each and
every air disaster. Curiously enough, governments never investigate the wreckages of airlines, lest the true causes
of the air disaster be learned. The true causes
are: the regime of fiat currency, and our faulty
accounting system that allows the suppression of capital losses due to
falling interest rates. So much for Keynesianism as a government ideology.
This
example also illustrates that capital gains in the asset column can’t
compensate for capital losses in the liability column. Why did Swissair fall
out of the sky if it could capitalize its higher future earnings due to
falling interest rates? Because it
couldn’t: before it would have been able to collect the expected higher
earnings, it had crashed (financially, anyhow).
Risk-free
profits in bond speculation
Keynes’ recipe makes
the profits of bond speculators risk free. Contra-cyclical monetary policy
calls for open-market purchases of bonds by the central bank. This makes
central bank action predictable. Bond speculators take advantage of it and
they forestall the central bank. They buy the bonds first, only to dump them
at higher prices later, after the central bank has completed the purchase of
its quota. Risk-free profits create an artificial demand for bonds, and a
falling tendency in interest rates. They are responsible for deflation. The
dinosaur of the one-half
quadrillion dollar strong derivatives market is a monument to the folly of
Keynesianism making bond speculation risk-free. Under the gold standard
interest rates and bond prices are stable, and there is no risk-free speculation.
Contra-cyclical
or counter-productive?
As our analysis shows, the
counter-productive central bank monetary policy is responsible for the
falling interest-rate structure, the deflationary spiral, and the depression.
Keynes’ so-called contra-cyclical monetary policy turns out to be an
unmitigated disaster. The central bank wants to combat falling prices through
open-market purchases of bonds. But the new money it creates in the process
does not flow to the commodity market to prop up prices there as hoped for by
the central bank. Instead, it flows to the bond market where speculators,
teased by the lure of risk-free profits, use it for bullish bond speculation.
Interest rates fall; linkage makes prices fall, too. The deflationary spiral
continues one level higher.
Most
analyst take it for granted that the decline in the
value of the dollar will cause
interest rates to rise. However, logic dictates that the value of dollar
bonds should fall before the value
of the dollar. That’s not what has been happening. The dollar has been
falling for the past few years yet bond values, as measured by the 30-year
T-bond, continued their march upwards that had started in the early
1980’s. The explanation is that the allure of risk-free profits sent
the demand for bonds soaring so that it has far surpassed the vanishing
demand for dollars. Paradoxically, there is a rising demand for dollar bonds and a falling demand for dollars. That is Greenspan’s conundrum.
Risk-free profits in the bond market suggest that a continuation of the
regime of falling interest rates, with all its deflationary implications, is
more likely in the future than a new bout of price rises. Be that as it may,
we can be sure that the price for central bank follies will have to be paid
by the sacrificial lamb: the producers, regardless whether interest rates
fall or gyrate.
Confusing
capital and credit deliberately
In the vast literature of
mainstream economics there is not one sentence written about the deleterious
effects of destabilizing interest rates on the value of industrial capital.
This stems from a deliberate confusion between capital and credit. In the
view of mainstream economists any talk about ‘capital decumulation,’ or the destruction of industrial
capital in the wake of destabilizing interest rates, is arrant nonsense.
After all, both credit and capital can be created at will, by a click of the
mouse. The possibility that the dissipation of industrial capital might
figure among the causes of the
Great Depression is not even considered.
Capital
strikes back. The apparition stuns non-believers and capital-deniers. The
admonition to them is: “If
you don’t use your eyes for seeing, then you will use them for
weeping.” (F.W. Foerster.)
Reclaiming
our destiny from the usurpers
The market share of General Motors was 46% in 1980. Today it is 24%
and falling, in spite of great improvements in productivity. Neither Ford nor
Chrysler is doing any better. In 1980 the rate of interest was sixteen
percent; it went as low as four. Having collided with the falling interest
rate structure, the ship of industrial capital is sinking.
Captains
of American industry should issue a Mayday call and rally to Ron Paul’s plank to restore the gold standard in America. The
writing is on the wall: the regime of fiat currency, in the maintenance of
which the Federal Reserve has a vested interest, is going to finish the job
of de-industrializing America
― unless we reclaim our destiny from the usurpers, and return to the
regime of stable interest rates and constitutional money.
References
By the same author:
Kondratieff
Revisited, May, 2001
Deflation
or Runaway Inflation? July, 2001
The
Economic Consequences of Mr. Greenspan, December, 2001
Japan’s
Finest Hour, January, 2002
Revisionist
View of the Great Depression, I-II, March, 2002
The
Black-hole of Zero Interest Revisited, August, 2002
The
Wrecker’s Ball of Swinging Interest Rates, September, 2002
The
Central Banker as the Quartermaster-General
of Deflation, January, 2003
A
Bubble That Broke the World, June, 2003
Stop
Greenspan from Plunging America
into a Depression! June, 2003
Tainted
Research, June, 2003
How
to Protect One’s Pension with Gold, August, 2003
The
Gold-Demonetization Hoax, August, 2003
Gold
Is the Cure for the Job-Drain! September, 2003
The
Decoy of the Falling Dollar, February, 2005
The
Decoy of the Falling Dollar Revisited, May, 2007
The
Shadow Pyramid, November, 2007
Fiat
Currency: Destroyer of Labor, to appear
These and other papers of the same author can be accessed at: www.professorfekete.com
Antal E. Fekete
Gold Standard University
aefekete@hotmail.com
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