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ILudwig 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.
References
Robert
Blumen, Real Bills, Phony Wealth, , July 2005.
Sean
Corrigan, Unreal Bills Doctrine, August 8, 2005.
Sean
Corrigan, Fool’s Gold, August 9, 2005.
Sean
Corrigan, Fool’s Gold Redux, August 12,
2005.
Sean
Corrigan, Clearing the Air, September 8,
2005.
Antal
E. Fekete, Gold and Interest, , January,
2003.
Antal E. Fekete,
Towards a Dynamic Microeconomics, Laissez-Faire, Revista de la Facultad de Ciencias Económicas,
Universidad Francisco Marroquín, No. 5, Sept. 1996.
Note
The foregoing piece was
written as a rejoinder to Sean Corrigan’s series of papers criticizing
me by name, posted on the website LewRockwell.com. I sent it to Lew whom I have known for over twenty
years and with whom I thought I have had a cordial relation. I asked him to
post my rejoinder so that his readership could see both sides of the
argument. Lew refused.
The late Percy Greaves, the
author of the pamphlet “Mises Made Easier”, used to be upset
whenever economic research was mentioned in his presence: “Research?
What research? All the research has already been done by Mises. All that is
left is to explain Mises to the public.”
I am also an admirer of
Mises. I have acknowledged my intellectual indebtedness to him many times. I
have made a conscious effort to use his terminology in preference to others.
I have approached the criticism of Mises carefully and modestly. I have not
rushed into print with it. I even withheld the publication of my own theory
of interest for several years because it was in conflict with that of Mises
on several points.
Bettina Bien, the widow of
Percy Greaves, is a good friend of mine. She used to invite me to her home in
Irvington-on-Hudson
for dinner. We discussed Mises and economics a great deal. She had attended
the Mises seminar at New York
University for 18
years. She is a serious, devoted, and honorable student of Mises. She
painstakingly put together the most complete bibliography of Mises. Years ago
I asked her if she could explain some inconsistencies that I thought I have
discovered in Mises’ work. While she agreed that they appeared to be
inconsistencies, she couldn’t offer an explanation.
I welcomed Lew’s
founding of the Mises Institute because I believed that it was dedicated to
the search for and the dissemination of scientific truth, as was Mises
himself. I am sadly disappointed to see that Lew is outdoing Percy. Not only
does he think that all the research has been done and all we need to do is to
regurgitate it again and again; he also thinks that Mises needs an
“intellectual bodyguard”.
Science has nothing to fear
from an open debate. Feeling of insecurity is characteristic of a cult. Mises
would have abhorred the idea that his scientific heritage has fallen to the
care of a self-appointed “thought police” that would censor and
suppress all dissent.
The style and approach of
Corrigan and Blumen fall short of the high ideals of Mises. These gentlemen
cannot for a moment assume that their selected targets may write and act in
good faith. They do not want to dispute. They want to discredit. In refusing
to publish my rejoinder Rockwell has stooped to their level. I am sorry for
him. He prefers sycophants to thinkers.
Antal E. Fekete
September 9th,
2005
Professor Emeritus
Memorial University of Newfoundland
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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