In Part I (http://keithweinereconomics.com/2013/04/22/th...rt-i-linearity/),
we looked at the concepts of nonlinearity, dynamics, multivariate, state, and
contiguity. We showed that whatever the relationship may be between prices
and the money supply in irredeemable paper currency, it is not a simple matter
of rising money supply -> rising prices.
In Part II target="_blank"(http://keithweinereconomics.com/2013/05/15...t-ii-mechanics/),
we discussed the mechanics of the formation of the bid price and ask price,
the concepts of stocks and flows, and the central concept of arbitrage. We
showed how arbitrage is the key to the money supply in the gold standard; miners
add to the aboveground stocks of gold when the cost of producing an ounce of
gold is less than the value of one ounce.
In Part I target="_blank"II (http://keithweinereconomics.com/2013/06...art-iii-credit/),
we looked at how credit comes into existence via arbitrage with legitimate
entrepreneur borrowers. We also looked at the counterfeit credit of the central
banks, which is not arbitrage. We introduced the concept of speculation in
markets for government promises, compared to legitimate trading of commodities.
We also discussed the prerequisite concepts of Marginal time preference and marginal
productivity, and resonance.
Part III ended with a question: "What happens if the central bank pushes the
rate of interest below the marginal time preference?"
To my knowledge, Antal Fekete was the first to ask this question¹. It
is now time to explore the answer.
We are dealing with a cycle. It is not a simple or linear relationship between
quantity X and quantity Y, much to the frustration of students of economics
(and central planners).
The cycle begins when the central bank pushes the rate of interest down, below
the rate of marginal time preference. Unlike in the gold standard, under a
paper currency, the disenfranchised savers cannot turn to gold. Perhaps it
has been made illegal as it was in the U.S. from 1933 to 1975. Or it could
merely be taxed and creditors placed under duress to accept repayment in irredeemable
paper. Whatever the reason, the saver cannot perform arbitrage between the
gold coin and the bond², as he could in the gold standard. He is trapped.
The irredeemable paper currency is a closed loop system. The saver is not entirely
without options, however.
He can buy commodities or finished goods.
I can distinctly recall as a boy in the late 1970's, when my parents would
buy cans of tuna fish, they would buy 50 or 100 cans (we ate tuna on Sunday,
two cans). Prices were rising very rapidly, and so it made sense to them to
hold capital in the form of food stocks rather than dollars. Indeed, prices
rose so frequently that grocery stores were going to the expense of manually
applying new price stickers on top of the old ones on inventory on the shelves.
This is extraordinary, because grocers sell through inventory quickly. Some
benighted people began agitating for a law to prohibit this practice (perhaps
descendants of King Canute, reputed to have ordered the tide to recede?).
Consumers are not the only ones to play the game, and they don't have a direct
impact on the rate of interest. Corporations also play. When the rate of interest
is below the rate of marginal time preference, we know that it is also below
the rate of marginal productivity. Corporations can sell bonds in order to
buy commodities. They can also accumulate inventory buffers of each input,
partially completed items at each state of production, and finished products.
What happens if corporations are selling bonds in order to expand holdings
of commodities and goods made from commodities? If this trade occurs at large
enough scale, it will push up the rate of interest as well as prices.
Let the irony sink in. The cycle begins as an attempt to push interest rates down.
The result is the opposite.
Analysts of this phenomenon must be aware that the government or its central
bank cannot change the primary trend. They can exaggerate it and fuel it. In
this case, the trend goes opposite to their intent and there is nothing they
can do about it. King Canute could not do anything about the waves, either.
Wait. The problem was caused when interest was pushed below time preference.
Now interest has risen. Are we out of the woods yet?
No. Unfortunately, marginal time preference rises. Everyone can see that prices
are rising rapidly, and in such an environment, are no longer satisfied with
the rate of interest that they had previously wanted. The time preference to
interest spread remains inverted.
This is a positive feedback loop. Prices and interest move up. And then this
encourages another iteration of the same cycle. Prices and interest move up
again.
Positive feedback is very dangerous, because it runs away very quickly. Think
of holding an electric guitar up to a loudspeaker with the amplifier turned
up to 10. The slightest sound is amplified and fed back and amplified until
there is a horrible squeal. Electrical systems contain circuits to prevent
self-destruction, but alas there is no such thing in the economy.
There are, however, other factors that begin to come into play. The regime
of irredeemable currency forces actors in the economy to make a choice between
two bad alternatives. One option is to earn a lower rate of interest than one's
preference. Meanwhile, prices are rising, perhaps at a rate faster than the
rate of interest. Adding insult to injury, as the interest rate rises, it imposes
capital losses on bondholders. Bonds were once called "certificates of confiscation".
There is but one way to avoid the losses meted out to bondholders.
One can hold commodities and inventory. There is a problem with this alternative
too. The marginal utility of commodities and inventory is rapidly falling.
This means that the more one accumulates, the lower the value of the next unit
of the good. This is negative feedback. Another problem is that it is not an
efficient allocation of capital to lock it up in illiquid inventory. Sooner
or later, errors in capital allocation accumulate to the harm of the enterprise.
There is another problem with commodity hoarding. Unlike gold hoarding, which
harms no one, hoarding of goods that people and businesses depend on hurts
people. As we shall see below, growth in hoarding is not sustainable. What
the economy needed was an increase in the interest rate. An unstable dynamic
that causes prices to rise along with interest rates is no substitute.
The choice between losing money in bonds, vs. buying more goods that one needs
less and less, is a bitter choice. This choice is imposed on people as an "unintended" (like
all the negative effects of central planning) consequence of the central bank's
attempt to drive interest rates lower. I propose that this should be called Fekete's
Dilemma in the vein target="_blank"of the Triffin
Dilemma and Gibson's
Paradox.
Another negative feedback factor is that rising interest rates destroy productive
enterprises. Consider the example of a company that manufactures TVs. When
they built the factory, they borrowed money at 6%. With this cost of capital,
they are profitable. Eventually, the equipment becomes worn out and/or obsolete.
Black and white TVs are no longer in demand by consumers, who want color. Making
color TVs requires new equipment. Unfortunately, at 12% interest, there is
no way to make a profit. Unable to continue making a profit on black and white,
and unable to profitably start making color, the company folds.
The more the interest rate rises, and the longer it remains high, the more
companies go bankrupt. This of course destroys the wealth of shareholders and
bondholders, and causes many workers to be laid off. Its effect on interest
rates is to pull in both directions. When bondholders begin taking losses,
bonds tend to sell off. A falling bond price is the flip side of a rising interest
rate (bond price and yield are inverse). On the other hand, with each bankruptcy
there is now one less bidder pushing up prices. Additionally, the inventories
of the bankrupt company must be liquidated; creditors need to be paid in currency,
not in half-finished goods, or even in stockpiles of iron ingots.
A third factor is that a rising interest rate causes a reduced burden of debt
for those who have previously borrowed at a fixed rate, such as corporations
who have sold bonds. They could buy back their own bonds, and realize a capital
gain. Or, especially if the price of their own product is rising, they have
additional capacity to borrow more to finance further expansion of their inventory
buffers. This will tend to be a positive feedback.
These three phenomena are by no means the only forces set in motion by the
initial suppression of interest rates. The take-away from this discussion should
be that one must begin one's analysis with the individual actors in the economy,
and pay attention to their balance sheets as well as their profit and loss.
The above depiction of a rising cycle, where rising interest rates drive rising
prices, and rising prices drive rising interest rates is not merely hypothetical.
It is a picture of what happened in the U.S. from 1947 to 1981.
Many people predicted that the monetary system was going to collapse in the
1970's. It may have come very close to that point. The Tacoma Narrows Bridge
swung to one side before moving even more violently to the other. The dollar
might have ended with prices and interest rates rising faster and faster, until
it was no longer accepted in trade for goods.
But this is not what, in fact, occurred. Things abruptly turned around. Fed
Chairman Paul Volcker is now credited with "breaking the back of inflation".
Interest rates did indeed spike up briefly to about 16% on the 10-year Treasury
in 1981. After that, they fell, rose once more in 1984, and then settled into
a falling trend (with some volatility) that continues through today. But remember
what we said above, that a central bank can exaggerate the trend but it cannot
reverse it.
Interest rates and prices had peaked. When the marginal utility of each additional
unit of accumulated goods falls without bound, it eventually crosses the threshold
of zero marginal utility. Then it can no longer be justified. Meanwhile, bankruptcies,
with their forced liquidations, increase. A final upwards spike of interest
rates discourages any further borrowing. What company can borrow at such an
extreme interest rate and still make a profit?
At last, the time preference to interest spread is back to normal; interest
is above the time preference. Unfortunately, there is another problem that
causes the cycle to slam into reverse. The cycle continues its dynamic of destroying
wealth, confounding central planners and economists.
The central planning fools think that they can magically gin up some more
credit-money, or extract liquidity somehow to rectify matters. Surely, they
think, they just have to find the right money supply value. Their own theory
acknowledges that there are "leads and lags" so they work their equations to
try to figure out how to get ahead of the cycle.
A blind man would sooner hit the bulls-eye of an archery target.
In Part V, we will examine the mechanics of the cycle reversal,
and the other side of the unstable oscillation. Without spoiling it, let's
just say that a different dynamic occurs which drives both interest and prices
down.
¹ Fekete wrote about the connection between interest rates
and prices at least as early as 2003, in "The Ratchet and the Linkage" and "Between
Scylla and Charybdis". He published Monetary Economics 102: Gold and Inter target="_blank"est
(http://www.professorfekete.com/artic...102Lecture1.pdf).
The idea he proposed in those three pages has been fleshed out and extended
by myself, and incorporated into this series of papers on the theory of interest
and prices, principally in parts IV and V. I would like to note that Fekete
regards the flow of money from the bond market to the commodity market as inflation
and the reverse flow as deflation. I agree with his description of these pathologies,
but prefer to reserve the term inflation to refer to counterfeit credit. I
call it the rising cycle and falling cycle instea target="_blank"d.
²http://keithweinereconomics...rest-rates-set/
