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- The Second Greatest Story Ever Told, Chapters 4 - 6 -
- The Origin of Discount -
- The Discount Rate and the Rate of Interest -
Why Is This
Story Important?
I got several comments from my audience to the
effect that the story on the invention of real bills and discounting has only
historical interest, and hardly any relevance to contemporary affairs. Actually,
if the world is ever to return to a gold standard, we have to understand how
it worked in the past. My researches show that economists have not succeeded
in explaining its operation. They approached the issue from the position of
mercantilism and from that of the Quantity Theory of Money. For example, they
explained the adjustment mechanism governing foreign trade in terms of the
international gold standard as follows. A country running a trade surplus is
gaining gold while another running a deficit is losing it. The money supply
of the surplus country grows, and that of the deficit country contracts. Other
things being the same, there will be an increase in the price level in the
surplus and a decrease in the deficit country. In the absence of trade
barriers the surplus country will export less and import more, while the
deficit country will export more and import less. This process will continue
until the trade surplus/deficit disappears. International gold flows tend to reestablish equilibrium in the foreign trade accounts of
gold standard countries, through their effect on the price level. So goes the
argument. However, the available trade statistics show that this was not at
all what was happening. International gold flows were negligible, and they
were moved by other factors than payment for net imports. In fact, the
adjustment mechanism worked not on the relative price levels, but on the
discount rates of the trading countries. We must have a new theory of foreign
trade, purged from the influence of mercantilism and the Quantity Theory of
Money. In these Lectures I intend to develop this new theory of the gold
standard in terms of the Real Bills Doctrine. Let us now return to The Second
Greatest Story Ever Told.
Chapter Four
in which the gentle reader
learns how discounting was invented
The weaver-on-clothier bill was singularly
well-suited to play the role of means of exchange. The clothier came into
daily contact with the gold coin in the course of his business (by contrast,
the weaver and the spinner didn't see much gold in the pursuit of their
trade). Often the clothier found himself in the position that he could prepay
the bills he has accepted, sometimes well before maturity. But our clothier
was a very shrewd man, with a perfect grasp of the reality that moved
merchandise in one while moving bills in the opposite direction. The clothier
would prepay the bills he has accepted only for a consideration. In
more details, whenever people asked him to prepay a bill before maturity, as
the weaver often did, he would offer to discount it, that is, to apply
a reduction to the face value of the bill proportional to the number of days
left to maturity. The weaver didn't object to receiving less than the face
value of the bill. He needed ready cash, and he could not get it on any
better terms than discounting his bills with the clothier. For his part, the
clothier wanted the custom of the weaver as an obvious supplier of bills for
his budding discount business, so he would offer the best terms to him he
could. The discount was an income for him that the gold coins in his till
could not otherwise generate. Clearly, both parties benefited from
discounting. After this latest innovation people no longer talked about paying
a bill; they talked about discounting it.
The origin of discount is merchant custom. The
sale of cloth by the weaver to the clothier is not final until the bill is
marked 'paid'. The cloth is on consignment. Payment at maturity is subject to
the sale of cloth to the ultimate, cash-paying customer. Payment before
maturity is certainly not a matter of right; it is a matter for negotiation. The
height of discount depends on the intensity of consumer demand as
observed by the acceptor of the bill. If the demand is brisk, he will be
satisfied with a smaller discount. But if the demand is slack, then the
acceptor who still has an unsold inventory on hand to worry about - which he
will, after discounting, carry entirely at his own risk - must insist on a
larger discount. He wants to be compensated for the increased risk of
carrying inventory that he may not be able to sell except at a loss.
Soon enough the clothier started posting his discount
rate, that is, the amount of discount in cents, per $100 face value per
day. For example, if the discount rate is 4 ¢, then a bill of face value
$1,500 maturing in 50 days will be discounted to $1,500 -15x50x4¢ =
$1,500 - $30 = $1,470 since $1,500 = 15x$100. The clothier reserved the right
to adjust his posted discount rate, every day if need be, to reflect the
changing mood of the consumer.
No Lending Is
Involved in Discounting
It was a later development that an annualized discount
rate became the norm of quoting it (even though the credit involved would
never ever exceed 91 days). For example, if the bill with $100 face value had
91 days to run to maturity, and was discounted to $99.50, then the discount
rate was 2% per annum. Indeed, 4x91 days = 1 year, therefore, on an
annualized basis, the discount is 4x(100 - 99.50) =
4x½ = 2 percent.
The fact that the discount rate is quoted on an
annualized basis, the same as the rate of interest (in spite of the fact that
the bill will mature long before a year would go by) has led to a curious
mistake that was not free from its more ominous consequences. It has been
suggested that discounting a bill is just another way of making a short-term
loan, and the discount is nothing more or less than interest on the sum to be
loaned, taken out of the loan in advance. In this (erroneous) view the
discount rate is just another name for the short-term rate of interest. It
would follow that there are no new problems here to study: in this
(erroneous) view the source of discount rate is the same as that of the rate
of interest, namely time preference (or its reciprocal, the propensity
to save).
This was one of the most damaging mistakes ever made
by economic theoreticians. In fact, there is no lending and borrowing
involved in the act of discounting. The clothier is not lending and the
weaver is not borrowing (nor is the clothier retiring a loan owed to the
weaver) when the former discounts the bill before maturity for the latter. The
discount rate has nothing to do with time preference (or its reciprocal, the
propensity to save). It has everything to do with the propensity to consume
(or its reciprocal, the productivity of the Social Circulating Capital, a
concept I plan to introduce in a later course).
All participants of the bill market take to heart
the admonition of Polonius to his son, Laertes:
Neither a borrower, nor a
lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
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(Shakespeare, Hamlet, Act I.,
Scene 3.)
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Shakespeare may sound hopelessly outmoded to our
ears in the 21st century. Yet it is quite possible that he saw
something that most others have failed to see. The advice of Polonius is not
meant for everybody. If there is a lesson to be learned from the endless
disputes about usury, usurers, and about the advantages or disadvantages of
lending or borrowing, then it must be this. To make or take a loan is an art
that cannot be profitably cultivated just by anybody. This art, no less than
any other, has to be learned, practiced, refined, and rehearsed by both the
lender and the borrower, each on his own turf. Implicit in Shakespeare's line
is the fact that not every form of credit may involve a loan, lending and
borrowing. It is precisely that form of credit we are studying here, that
arises through clearing, epitomized by bill circulation and discounting, that
ought to be available to everyone - whether one is artistically inclined or
not.
Indeed, credit can and does arise independently of
lending and borrowing. When the weaver draws a bill on the clothier, he is
extending credit, yet he is not a lender and the clothier is not
a borrower. Nor should the transaction consummated be regarded as a loan. The
perception that the drawer grants a loan to the acceptor when he delivers
goods against payment in the form of the bill accepted, or the perception
that the acceptor repays the loan to the drawer when he discounts the same
bill before it matures, is entirely fallacious and must be resisted by all
means. The credit is an integral part of the deal, by virtue of the
momentum of the underlying merchandise moving apace. By standard merchant
custom, the terms "91 days net" are part of every such commercial
deal. Stated otherwise, prices quoted by the wholesaler to the retailer are discountable
prices. The amount of discount depends on the number of days the credit is
used, and on the discount rate prevailing at the time of payment.
The Discount
Rate Is Independent of the Interest Rate
Time preference, that determines the rate of
interest, has nothing to do with the discount rate. Discounting is not
governed by the sovereign saver. It is governed by the sovereign
consumer. As we have seen, it is the consumer's slacker or brisker buying
that makes the discount rate rise or fall. We express this by saying that the
discount rate varies inversely with the propensity to consume. (By
contrast, the rate of interest varies inversely with the propensity to save.)
The conceptual difference between the two rates was observed by John Fullarton writing in his book On the Regulation of
Currencies as follows:
"It is a great error indeed to imagine that the
demand for . . . the loan of capital is identical with a demand for
additional means of circulation, or even that the
two are frequently associated. Each demand originates in circumstances
peculiarly affecting itself, and very distinct from the other. It is when
everything looks prosperous, when wages are high, prices are on the rise, and
factories are busy, that an additional supply of currency is usually required
. . . whereas it is chiefly in a more advanced stage of the commercial cycle,
when difficulties begin to present themselves, when markets are overstocked,
and returns delayed, that interest rises, and pressure comes on the bank for
advances of capital" (op. cit., p 97).
The confusion between the discount rate and the rate
of interest has also been noted by Charles Rist in
his History of Money and Credit Theory from John Law to the Present Day:
"Identification of the discount rate with the
interest rate, which is frequent among English writers, is an unfortunate
source of confusion" (op. cit., p 315).
Achillean Heel of the
Quantity Theory
The idea that the bill of exchange can circulate on
its own wings and under its own power is often ridiculed by advocates of the
Quantity Theory of Money, as I have pointed out in Lecture 3. The vicious
attacks of monetarists, including those of their high priest Milton Friedman,
on the Real Bills Doctrine mark the Achillean heel
of the Quantity Theory of Money. It shows that an increase in the quantity of
purchasing media need not cause a rise in prices. If the new purchasing media
emerges simultaneously with the new merchandise, and the two disappear
together as the latter is removed from the market by the ultimate cash-paying
consumer, as in the case of financing the production and distribution of
consumer goods by bills of exchange, there will be no price rises on
account of the increase in bill circulation.
Detractors of the Real Bill Doctrine argue that
several bills can be drawn on the same merchandise on its way to the market. So
they can. But as I have pointed out in the previous Lecture, only the most
liquid one, the bill drawn by the supplier on the seller of first order
goods will be put into circulation. Just what the order of the underlying
good is should be clear from the information provided on the face of the
bill. If an additional bill on the same good is put into circulation,
then, clearly, fraud is involved. It is disingenuous to attack a theory
arguing that it fails whenever fraud is present. On that basis, every theory
can be dismissed as worthless.
Demand for Real
Bills
We have seen that the spinner and the cotton dealer
were happy to hold the weaver-on-clothier bill to maturity. As soon as
discounting became a universal practice, the demand for these bills has
greatly increased. Other tradesmen also found it to their advantage to hold
the bills to maturity. They looked at bills as a unique instrument combining
two seemingly contradictory features: (1) that of an earning asset, (2) that
of a medium of exchange. In fact, bills provided the only way to generate an
income on cash holdings. Usually an earning asset is illiquid in that it
takes time and, sometimes, monetary losses to liquidate them in a hurry. With
the appearance of discounting this has changed. Now tradesmen could earn an
income on that part of their circulating capital which they had to carry in
the form of cash. As most businesses were cyclical in nature, they had to
face a fluctuation in their cash needs. It was a most welcome development
that they could generate an income on their cash holdings especially at the
time they were entering their slow season.
In the next Chapter of The Second Greatest Story
Ever Told we shall see how the demand for real bills snowballed as people
discovered their great versatility.
Chapter Five
in which the gentle reader
learns how the wily clothier shifted
his cross of gold onto the shoulders of the miller
One day the weaver's loom broke down and was
found beyond repair. The weaver had to get a new loom in a hurry. He did not
have the ready cash, but he had a pile of maturing bills drawn on and
accepted by the clothier. He visited his colleague and offered him the bills
at a good discount. The clothier was anxious to help. An interruption in the
supply of cloth would hurt his business, too. But he could not come up with
the necessary sum in gold. However, as we have said, the clothier was a very
smart man, and his advice was worth gold. "Why don't you offer these
bills to the loom-maker in payment for the new loom?" the clothier
suggested. "If the spinner found them attractive to carry to maturity,
so should the loom-maker."
As predicted, the loom-maker was happy to take
the weaver-on-clothier bills. He looked at these bills as a liquid earning
asset which could be passed on easily if the need arose. The weaver found the
discount rate offered by the loom-maker acceptable. He endorsed the bills,
thus transferring the title to the proceeds to the loom-maker. Once more,
there was no interruption in the business of satisfying consumer demand due
to a shortage of gold coins. The versatility of the bill of exchange drawn on
consumer goods in demand, and its potential for circulation, was proved
again. The weaver-on-clothier bill could circulate even outside the small
circle of tradesmen engaged in the production of cloth.
As it happened, next morning the clothier had
a field day selling out his entire inventory of cloth. As his till was now
flush with gold coins, he thought that his cash could with advantage be put
to some use. He recalled that the previous day the weaver was offering his
bills for discounting. So he emptied the contents of his till into a large
purse, and walked over to the weaver's. There to his chagrin he found that
his earlier advice to the weaver was 'too good'. The weaver told him that he
had passed on all the weaver-on-clothier bills to the loom-maker. Since the
clothier felt uneasy with that much gold on hand, he decided to walk over to
the loom-maker and offered to discount the bills he had come into the
possession of earlier. But the loom-maker had disappointing news, too. He had
in the meantime passed on those bills to the bricklayer in payment for work
on the extension to his loom-factory. "If you hurry you might catch him,
he left the premises scarcely an hour ago".
The clothier was annoyed. He wasn't going to
run after the bricklayer. He saw that he could only blame himself. Here he
was, foolishly chasing his own bills. "And they call this division of labor", he fumed, looking at the heavy purse of gold
he grew tired of carrying. "Someone ought to do something about it, and
let me mind my own business!"
Luckily, the flour mill was next door to the
loom factory. The clothier got an idea. "I shall be damned if I ever go
on wild goose chase again", he said to himself. "They will surely
come home to roost, on their own wings, in their own good time - and so will
my bills!" He dropped in to see the miller, asking him whether he wanted
to get rid of some of the miller-on-baker bills in his possession. "I
just thought you need a few extra gold coins. You must be buying grain to
fill up your bins. It's harvest time."
As far as the miller was concerned, it was a
deal. They didn't quibble long about the discount rate. The clothier let out
a sigh of relief as he exchanged his gold coins for the bills endorsed by the
miller. "It is high time, too", he said to
the miller and added, jokingly: "I got tired of carrying my heavy cross
of gold. It is your turn now, to take up the burden."
The clothier was pleased with himself. He was
the type of man who would always turn adversity into advantage, by looking
for a moral. Just as he thought: he had no trouble, after all, unloading his
'cross of gold'. There were always willing takers around.
The fact that the loom-maker and the
bricklayer were happy to take the weaver-on-clothier bills in payment was a
very significant discovery indeed. It proved that maturing bills of exchange
on merchandise in great demand were perfectly acceptable as purchasing
medium. Whoever got the bills had no doubts that he could also pass them on
without difficulty, should he have to make an unexpected payment before the
bills have matured. And if he kept the bills, he would earn a welcome return
on his cash holdings.
While the bill of exchange was a good
substitute for the gold coin, it was not a 'perfect' substitute, as the baker
found out when he offered weaver-on-clothier bills in his possession to the
grain merchant when the miller-on-baker bills came up for payment. "Don't
take me for a fool!" the grain merchant told the baker angrily. This
paper clearly calls for payment in gold, and not in another piece of paper! If
you haven't got gold, then you are in violation of your contract!
The grain-merchant was right. At maturity the
miller-on-baker bill must be settled in gold. The idea of settling paper with
more paper suggests fraud. A bill that at maturity can only be paid by
drawing another stinks. The bill of exchange must be settled in specie
at maturity. How otherwise could the holder of the bill be sure that he
wasn't being taken for a ride? This reveals a function of the gold coin in
which no other means of payment can deputize for it: gold is the
philosopher's stone, the only one with which the quality of outstanding
credit can be gaged. (In future Lectures we shall
see other instances where the gold coin cannot be substituted by paper
currency.)
Social
Circulating Capital
In Lecture 4 I introduced Adam Smith's concept of
the Social Circulating Capital. It can be visualized as that mass of goods
that society is appropriating strictly for the purpose of imminent
consumption during the next 91 day period. This mass of goods is far from
being static. It is dynamic in the sense that its size and composition is
changing constantly, following the proverbially fickle demand of the
consuming public. I also proved the theorem that an item belongs to the
Social Circulating Capital if the bill drawn on it will circulate - or, using
our new term just introduced, if the bill can be discounted; if not, then the
underlying item does not belong to the Social Circulating Capital. In the
next Chapter we shall see that the unique quality of a good to belong to the
Social Circulating Capital has to do with the drastic reduction in
uncertainty concerning the path that good will follow as it is moved closer
to the ultimate consumer. The risks of tradesmen in moving that good have
been reduced to their irreducible minimum.
Chapter Six
in
which the gentle reader learns why cloth can, but bricks cannot, fly
It was the beginning of winter when somebody
was knocking at the weaver's door. It was the bricklayer. He recalled that in
the summer he had held some weaver-on-clothier bills the loom-maker gave him
in payment for work done. This time he wanted to get it right from the
source. He has brought the gold coins along to save the weaver the trouble of
carrying them himself.
The bricklayer was trying hard to please the
weaver. His business was rather slow in the winter, and he wanted to earn an
income on his idle cash. He looked at the bill of exchange as an appreciating
asset: every day it was worth more, right up to the day of maturity. By its
very nature, the bricklayer's own trade did not generate any bills of
exchange. His bills could never hope to circulate. Money sunk into brick and
mortar was not the same as money put into fast-moving goods such as cotton,
or wheat, within earshot of the cash-paying consumer.
The bricklayer was not jealous. He understood
perfectly well that the preferential treatment given to the
weaver-on-clothier and miller-on-baker bills, but not to the
brickyard-on-bricklayer bills, was bestowed by the market for a good reason. The
discrimination had to do with the nature of the underlying merchandise, and
had nothing to do with character or personal honor.
Brick is not consumed in the same way as cloth. It is used in building houses
which are not bought and sold against cash payments representing the full
purchase price. Therefore the production and distribution of bricks is
financed quite differently from that of cloth. The fast movement of cloth to
the consumer can generate bill circulation; the much slower movement of brick
cannot. The movement of bricks to the consumer must be financed through
lending and borrowing.
The weaver was pleased to comply with the
request of the bricklayer. He even took a standing order for
weaver-on-clothier bills to cover the winter months when the construction
business was slow and the bricklayer needed a safe and profitable place to
park his circulating capital idled temporarily.
It is crucial to understand the economic difference
between cotton and brick. Cotton had the momentum which brick lacked. The
financing of the movement of cotton could be done through bill-circulation. The
financing of the movement of bricks couldn't: the brickyard-on-bricklayer
bills could not fly for lack of momentum in the movement of bricks. The slower
movement of bricks had to be financed through lending and borrowing, at the
higher interest rate. This involved convincing the lender (saver) that the
ultimate consumer of bricks, the buyer of the house, did have the means to
retire the mortgage on his new house in time. As the proverb says,
"there is many a slip between cup and lip". In case of the cloth
(or any other item belonging to the Social Circulating Capital) the lip is
already touching the cup and, accordingly, the chance of a slip is reduced
next to naught.
A bill acknowledging receipt by the retailer of
fast-moving merchandise can circulate in lieu of cash. The market extends
limited and ephemeral monetary privileges to bills representing certain
transactions while denying the same privileges to others. The decision
whether to extend or deny it depends on objective criteria, having to do with
the briskness of consumer demand, as well as the time-frame within which
'maturing' goods can be moved to the cash-paying consumer. Goods that are
disqualified (as bills drawn on them would not circulate) are not left out in
the cold. Their movement to the consumer is financed through lending and
borrowing, at the higher interest rate. For example, the bill drawn on bricks
being moved to the construction site will not circulate. Nobody who wants to
park his liquid funds in quick earning assets would discount them for lack of
liquidity. On the other hand, there are a lot of mortgage brokers who will be
happy to arrange the financing for the purchase of bricks connected with the
construction of a house. Other lenders would be happy to finance the
construction and the operation of the brickyard at the going rate of
interest.
In the 18th century there was a saying
(long since forgotten) in Lombard
Street in the financial district of London:
"Nothing is easier than a banker's job, provided that the banker
is able to tell a bill and a mortgage apart".
* * *
Rothbard on the Origin
of the Bank Note
My correspondent Robert writes:
"I have enjoyed your articles on GOLD-EAGLE.com. Good job! Keep up the
good work! For the last three years I have been teaching economics myself. I
started out by reading about the various schools of economics and finally
happened upon one that resonated with what I understood intuitively which
was, of course, the Austrian
School. So for a few
years now, in my spare time, I have been reading all I can absorb from the
great authors of that tradition. So, as I was reading your instalment of
Monetary Economics 101 I noticed that you criticized Murry
Rothbard's explanation (I don't know who he derived
it from) of the evolution of paper currency from warehouse receipts. I
actually questioned this as well when first reading his explanations, so I am
wondering if you have a list of books you might recommend for learning more
on the history of real bills. Also I'm curious what other criticism you have
of Rothbard's work or on the Austrian School's
in general."
Here is my reply: Stay tuned, Robert, there is lots
more criticism to come whence this has come from. Although the Austrians are
not monolithic, neither are they sufficiently hospitable to authors who are
unable to reduce themselves to sycophancy and to tone down criticism of
Austrian idols. Austrian journals never published my contributions,
presumably for this very reason.
In addition to my criticism of Rothbard's
diagnosis of the fraud in the origin of the bank note and of fractional
reserve banking, I shall also criticize his proposed therapy of the malady,
100 percent gold reserve banking. It would never work. It would be unable to
supply the elastic currency that the economy needs. It would open the gold
standard to even more violent attacks for being 'contractionist'
and anti-labor. It is based on a serious
misunderstanding of the operation of the gold standard. At any rate, the
issue cannot be decided until one has studied the Real Bills Doctrine in
depth.
An Austrian by birth although not by affiliation,
Joseph A. Schumpeter wrote a concise History of Economic Analysis. Chapter 7
on Money, Credit, and Cycles will give you reference to authors who wrote on
the bill of exchange. See in particular the debate preceding Peel's Act of 1844 in Britain, p
695 and 725, and his discussion of the Real Bills Doctrine starting on p 729.
References
John Fullarton, On the Regulation of Currencies
(originally published in 1844), New
York: A.M. Kelley, 1969.
Ch. Rist, History of Money and Credit Theory from John Law
to the Present Day, 1940.
Joseph
A. Schumpeter, History of Economic Analysis, New York, 1954.
August 5, 2002
Antal E. Fekete
Professor Emeritus
Memorial University
of Newfoundland
St.John's, CANADA A1C5S7
e-mail: aefekete@hotmail.com
GOLD UNIVERSITY
SUMMER SEMESTER, 2002
Monetary
Economics 101: The Real Bills Doctrine of Adam Smith
Lecture
1: Ayn Rand's Hymn to Money
Lecture 2: Don't Fix the Dollar Price of Gold
Lecture 3: Credit Unions
Lecture 4: The Two Sources of Credit
Lecture 5: The Second Greatest Story Ever
Told (Chapters 1 - 3)
Lecture 6: The Invention of
Discounting (Chapters 4 - 6)
Lecture 7: The Mystery of the Discount
Rate (Chapters 7 - 8)
Lecture 8: Bills Drawn on the
Goldsmith (Chapter 9)
Lecture 9: Legal Tender. Bank Notes of Small Denomination
Lecture 10: Revolution of
Quality (Chapter 10)
Lecture 11: Acceptance House (Chapter
11)
Lecture 12: Borrowing Short to Lend
Long (Chapter 12)
Lecture 13: Illicit Interest Arbitrage
FALL SEMESTER, 2002
Monetary
Economics 201: Gold and Interest
Lecture
1: The Nature and Sources of Interest
Lecture 2: The Dichotomy of Income versus Wealth
Lecture 3: The Janus-Face of
Marketability
Lecture 4: The Principle of Capitalizing Incomes
Lecture 5: The Pentagonal Structure of the Capital Market
Lecture 6: The Definition of the Rate of Interest
Lecture 7: The Gold Bond
Lecture 8: The Bond Equation
Lecture 9: The Hexagonal Structure of the Capital Market
Lecture 10: Lessons of Bimetallism
Lecture 11: Aristotle and Check-Kiting
Lecture 12: Bond Speculation
Lecture 13: The Blackhole of Zero
Interest
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