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Ludwig von Mises erred when he dismissed what is known as the
Fullarton Effect. In 1844 John Fullarton of the Banking School described how
low interest rates were resisted by savers in selling their gold bonds and
hoarding gold instead. Mises ridiculed the idea, calling gold hoards a deus
ex machina in Human Action (3rd revised edition, p 440). My theory of
interest corrects this mistake in giving due recognition to the Fullarton
Effect. I can well understand the frustrations of Robert Blumen, Sean
Corrigan, and other detractors of mine reluctant to read the voluminous
outpourings of this “inflationist monetary crank”. Rather than
finding a weak point in my argument they call me names, stonewall Adam Smith,
conjure up the bogyman of John Law, set up straw men only to knock them down
again, and quarrel bitterly with my ad hoc examples while ignoring my
comprehensive theory of interest. For the benefit of discriminating students
of Carl Menger and Eugene Böhm-Bawerk I restate this novel theory in a
concise form.
The rate of interest is a market phenomenon. It is defined as
the rate at which the coupons of the gold bond amortize its price as quoted
in the secondary bond market. The mathematician has shown us formulas
expressing the rate of interest in terms of the price of the gold bond. They
confirm that the two are inversely related: the higher the bond price, the
lower is the rate of interest and vice versa. As a consequence, the
lower bid price of the gold bond corresponds to the ceiling and the higher
asked price to the floor of the range to which the rate of interest is
confined. The question is what economic factors determine these constraints
and how.
The floor is determined by the time preference of the marginal
bondholder. If the rate of interest falls below it, then he takes profit in
selling the overpriced gold bond and will keep the proceeds in gold coin.
When the rate of interest bounces in response to bondholder resistance, he
will buy back the gold bond at a lower price. The gold hoards are no deus
ex machina: they are the very tool of human action in setting a limit to
falling interest rates.
The ceiling is determined by the marginal productivity of
capital, that is, the rate of productivity of the capital of the marginal
producer. If the rate of interest rises above it, then he sells his plant and
equipment and invests the proceeds in the underpriced gold bond. When the
rate of interest falls back in response to producer resistance, he will sell
the gold bond at a profit and use the proceeds to deploy his capital in
production once more.
There is no valid reason to denigrate the productivity theory of
interest following Mises. The theory of time preference and the productivity
theory are not mutually exclusive. On the contrary, they are complementary.
The fratricidal wars between the two schools have been in vain: they did not
serve the advancement of science. They merely contributed to its retardation.
Only a synthesis of the two theories can adequately explain the formation of
the rate of interest
I submit that my theory of interest brings about such a
synthesis. It is in the spirit of Menger and is in harmony with the insights
of Böhm-Bawerk. It represents a breakthrough that provides solid
foundation for further development of the theory. In Mises, time preference
is no more than a pious wish. It is the gold hoards that lend teeth to those
wishes. Nothing else can. Mises was not alive to the arbitrage of the
marginal bondholder between bonds and gold, the most potent form of arbitrage
between present and future goods. Likewise, Mises failed to explain how
changes in the rate of interest guide production, to wit, through arbitrage
of the marginal producer between bonds and capital goods.
Mises also criticized the Banking School
on the subject of reflux (op.cit., p 444). He charged that banks regularly
short-circuit reflux by putting retired bank notes back into circulation:
“The regular course of affairs is that the bank replaces bills expired
and paid by discounting new bills of exchange. Then to the amount of bank
notes withdrawn from the market through the repayment of the earlier loan
there corresponds an amount of newly issued bank notes.” This ignores
the fact that the credit to which each and every non-fraudulent bill gives
rise is self-liquidating. Moreover, if the Reichsbank of Germany, for
example, had discounted new bills on the same old merchandise, then it would
have violated the law. At any rate, the argument of the Banking School refers
to the transparent case of bill circulation. Slow or fraudulent bills can
take no refuge in the portfolio of conspiring banks. The bill market is fully
capable of ferreting out delinquent bills and will refuse to discount them.
The nexus between drawer and drawee of the bill of exchange is
not the same as that between lender and borrower. The drawer is no lender,
discounting is no lending, and the discount rate is not the same as the rate
of interest. The drawee is the active protagonist in the drama of supplying
the consumer with urgently needed goods; the drawer is passive. It is the
drawee who promptly reacts to changes in the height of the discount rate.
These changes are governed by the consumers. The discount rate is not
regulated by the savers, still less is it set by the banks. The drawee, typically
a retail merchant, has the unconditional privilege of prepaying his bills.
The discount serves as an incentive. If demand is brisk, it will take a lower
discount rate to induce him to prepay; if sluggish, a higher one. Moreover,
in the latter case, the marginal retail merchant will not re-order his usual
quota of consumer goods from his suppliers. Instead, he will carry part of
his circulating capital in the form of bills drawn on more productive
merchants until demand picks up again. Evidently Mises misconstrued the
problem of discounting. Insisting that retail inventory was financed through
loans at the bank, Mises failed to notice that the marginal retail merchant
was doing arbitrage between bills and consumer goods. He would thin out
merchandise on his shelves while beefing up his portfolio of bills in
response to the consumer’s reining back spending, while he would sell
bills from his portfolio and use the proceeds to replace the missing
merchandise on his shelves upon renewed interest of the consumer in buying.
Wrongly, Mises blotted out the important distinction between the discount
rate and the rate of interest which are governed by entirely different
economic factors and move quite independently of one another.
Not until these three most important forms of human action, the
arbitrage of the marginal bondholder, the arbitrage of the marginal producer,
and the arbitrage of the marginal retail merchant are more widely recognized
can further significant progress in the theory of interest be made.
Antal
E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
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Copyright © 2002-2008 by Antal E. Fekete - All rights reserved
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