Category Archives: Monetary Science

Theory of Interest and Prices in Paper Currency Part VI (The End)

In Part I, 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, 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 III, 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.

In Part IV, we discussed the rising cycle. The central planners push the rate of interest down, below the marginal time preference and unleash a storm whose ferocious dynamics are more than they bargained for. The hapless subjects of the regime have little recourse but they do have one seeming way out. They can buy commodities. The cycle is a positive feedback loop of rising prices and rising interest rates. Ironically, their clumsy attempt to get lower interest results in rising interest. Alas, the cycle eventually ends. The interest rate and inventory hoards have reached the point where no one can issue more bonds or increase their hoards.

In Part V, we discussed the end of the rising cycle. There was a conflict between commodity speculation and leverage. Leverage won.  Liquidations impaired bank balance sheets, and the result was a spike in the interest rate. It finally rose over marginal time preference. Unfortunately, it rose over marginal productivity as well. Slowly at first, the bond market entered a new bull phase. It becomes ferocious, as it pushes down the interest rate which bleeds borrowers of their capital. Companies find it harder to make money and easier to borrow. They are obliged to borrow to get a decent return on equity. In short, they become brittle.

In this Part VI, we look at The End. At the beginning of Part I, I noted in passing that we now have a positive feedback loop that is causing us to spiral into the black hole of zero interest. In astrophysics, the theory says that a black hole is a singularity with infinite gravity at the center. There is a radius called the event horizon, and everything including light that gets inside this radius is doomed to crash into the singularity.

black hole
Black Hole

For years, I have been thinking that this is a perfect analogy to the falling rate of interest. At zero interest on long-term debt, the net present value is infinite. There is a positive feedback loop that tends to pull the rate ever downward, and the closer we get to zero the stronger the pull. But an analogy is not a mechanism for causality.

In the fall of 2012, I attended the Cato Institute Monetary Conference. Many of the presenters were central bankers past or present, or academics who specialize in monetary policy. It was fascinating to hear speaker after speaker discuss the rate of interest. They all share the same playbook, they all follow the Taylor Rule (and indeed John Taylor himself presented), and they were all puzzled or disappointed by Fed Chairman Bernanke not raising interest rates. Their playbook called for this to begin quite a while ago now, based on GDP and unemployment and the other variables that are the focus of the Monetarists.

Then it clicked for me.

The Chairman is like the Wizard of Oz. He creates a grand illusion that he is all-powerful. When he bellows, markets jump. But when the curtain is pulled back, it turns out that he has no magical powers.

At that conference, after hearing so many speakers, including some of Bernanke’s subordinates, discuss when and why and how much the rate should be higher, I became certain that it is not under his control. It is falling, falling.[1]

One cannot go from analogy to theory. It has to be the other way around. And yet, the black hole analogy corresponds to the falling rate in several ways. First, zero interest is like a singularity. I have repeatedly emphasized the fact that debt cannot be paid off; it cannot go out of existence. It is only shifted around. Therefore, regardless of whatever nominal duration is attributed to any bond or loan, it is in effect perpetual. At zero interest, a perpetual debt has an infinite net present value.

The next part of the analogy is the strong gravitational pull from a very far distance. The rate of interest has indeed been falling since the high of 16% in 1981, and it was pulled in to a perigee of 1.6% before making an apogee (so far) of 2.9%. The analogy still holds, objects spiral around and into black holes; they do not fall in directly.

There is also a causal mechanism for the falling interest rate. As discussed in Part V, the interest rate is above marginal productivity. So long as it remains there, the dynamic is given motive power. In Part V, we discussed the fact that due to the arbitrage between interest and profit, at a lower interest rate one will see lower profit margins. This is what puts the squeeze on the marginal business, who borrowed previously at a higher rate. The marginal business is unable to make a profit when competing against the next competitor who borrowed more cheaply.

It is worth saying, as an aside, that this process of each new competitor borrowing money to buy capital that puts older competitors out of business who borrowed too expensively is a process of capital churn. It may look a lot like the beneficial process of creative destruction[2], but it is quite different. Churn replaces good capital with new capital, at great cost and waste.

In falling rates, no one has pricing power, and generally one must borrow to get a decent return on equity. The combination of soft consumer demand, shrinking margins, and rising debt makes businesses brittle.

Consumer demand is softened by the soft labor market. The labor market is soft because there is always a tradeoff between labor and capital invested. For example, in India Wal-Mart does not use automation like it does in the US. Labor is preferred over capital, because it is cheaper. With falling interest rates, capital equipment upgrades become a more and more attractive relative to labor. Many attribute the high unemployment to high minimum wages and generous welfare schemes. This is part of it, but it does not explain unemployment of skilled workers and professionals.

As the interest rate falls, the marginal productivity of labor rises. This may sound good, and people may read it as “productivity rises” or “average productivity rises”. No, it means that the bar rises. Each worker must get over a threshold to be employed; he must produce more than a minimum. This threshold is rising, and it makes more and more people sub-marginal.

Unemployed people do not make a robust bid on consumer goods.

The next-to-final element of the analogy is the event horizon. In the case of the black hole, astrophysicists will give their reasons for why everything inside this radius, including light, must continue down into the singularity. What could force the interest rate to zero, once it falls below an arbitrary threshold?

Through a gradual process (which occurs when the rate is well above the event horizon), the central bank evolves. The Fed began as the liquidity provider of last resort, but incrementally over decades becomes the only provider of credit of any resort (see my separate article on Rising Interest Rates Spoil the Party).

Savers have been totally demoralized, discouraged, and punished. Borrowers have become more brazen in borrowing for unproductive purposes. And total debt continues to rise exponentially. With lower and lower rates offered, and higher and higher risk, no one would willingly lend. The Fed is obliged to be the source of all lending.

A proper system is one in which people produce more than they consume, and lend the surplus, which is called “savings”. The current system is one in which institutions borrow from the government or the Fed and lend at a higher rate. Today, one can even borrow in order to buy bonds. Most in the financial industry shrug when I jump up and down and wave my arms about this practice. Other than a bank borrowing from depositors (with scrupulously matched duration!) there should not be borrowing to buy bonds. A free market would not offer a positive spread to engage in this practice, and rational savers would withdraw their savings if they got wind of such a scheme.

Thus, the system devolves. Sound credit extended by savers drives a proper system. Now, the Fed becomes the ultimate issuer of all credit, and this credit is taken from unwilling savers (those who hold dollars, thinking it is “money”) and is increasingly extended to parties (such as the US government) who haven’t got the means or the intent to ever repay it.

The actual event horizon is when the debt passes the point where it can no longer be amortized. Debtors, especially the ultimate debtors that are the sovereign governments, and most especially the US government, depend on deficits. They borrow more than their tax revenues not only to fund welfare programs, but also to pay the interest on the total accumulated debt.

That singularity at the center beckons. Every big player wants lower rates. The government can only keep the game going so long as it can refinance its old debts at ever-lower rates. The Fed can only pretend to be solvent so long as its bond portfolio is at least flat, if not rising. The banks’ balance sheets are similarly stuffed with bonds. Businesses, long since made brittle by three decades of falling rates, likewise depend on the bond market to roll their old bonds by selling new ones. No debt is ever repaid, because there is no mechanism for it. An ever-greater total debt burden must be refinanced periodically. Lower rates are the enabler.

Recall from Part IV that the dollar system is a closed loop. Dollars can circulate at whatever velocity, and they can circulate to and from any parties. For interest rates, what matters is whether net credit is being created to finance net increases of commodities and inventories, or whether net sales of commodities are used to finance net purchases of bonds. The spreads of interest to time preference, and productivity to interest determine the direction of this flow.

So long as the interest rate is higher than marginal productivity and marginal time preference, the system is latched up. So long as the consumer bid is soft and getting softer, marginal productivity is falling. So long as debtors are under a rising burden of debt, and creditors have the upper hand, then time preference is falling.

The final element of our analogy to the black hole is that, according to newer theories that may be controversial (I don’t know, I am not a physicist, please bear with me even if the science isn’t quite right) if enough matter and energy crash into the singularity quickly enough, then it can cause an enormous explosion.

black hole bubble
Black Hole Ejecting Matter and Energy

Here is my prediction of the end: permanent gold backwardation[3]. The lower the rate of interest falls, the more it destabilizes the system because it makes the debtors more brittle. The dollar system has, to borrow a phrase from Ayn Rand, blackmailed people not by their vices, but by their virtues. People want to participate in the economy and benefit from the division of labor. Subsisting on one’s own efforts alone provides a very low quality of life. The government forces people to choose between using bogus Fed paper vs. dropping out of the economy. People naturally choose the lesser of these two evils.

But, as the rate of interest falls, as the nominal quantity of debt rises, as the burden of each dollar of debt rises, and as the debtors incur ever-greater risks, the marginal saver reaches the point where he prefers gold without a yield and with price risk too, over bonds even with a yield. We are in the early stages of this process now. A small proportion of the population of Western countries is buying a little gold, typically a small proportion of their savings.

What happens when this process accelerates, as it must inevitably do? What happens when people will borrow dollars to buy gold, as they had borrowed dollars to buy commodities in the postwar period?

By then, the bond markets may be so volatile that this could cause a spike in interest rates. Or it may not. It will pull all the remaining gold out of the bullion market and into private hoards. At that point, gold will begin to plunge deeper and deeper into backwardation. As I explained in my dissertation[4], a persistent and significant backwardation in gold will pull all liquid commodities into the same degree of backwardation. Desperate, panicky people will buy commodities not to hoard them or consume them, but as a last resort to get through the side window into gold after the front door is closed. When they cannot trade dollars for gold, they can trade dollars for crude oil and then trade crude oil for gold.

Of course, this will very quickly the drive prices of all commodities in dollars to rapidly skyrocket to arbitrary levels. At that point, there could even be a short-lived rising cycle where people sell bonds to buy commodities, or this may not occur (it may be over and done too quickly).

In any case, this is the final death rattle of the dollar. People will no longer be able to use the dollar in trade, even if they are willing (which is quite a stretch). Then the interest rate in dollars will not matter to anyone.

My description of this process should not be taken as a prediction that this is imminent. I think this process will play out within weeks once it gets underway, but that the starting point is still years away.

The interest rate on the 10-year Japanese government bond fell to 80 basis points. I think that the rate on the US Treasury can and will likely go below that. We must continue to watch the gold basis for the earliest possible advance warning.

This completes the series on interest and prices. There is obviously a lot more to discuss, including the yield curve and what makes it abruptly flip between normal and inverted, and of course mini rising cycles within the major falling cycle such as the one that is occurring as I write this. I would welcome anyone interested in doing work in this area to contact me at keith (at) goldstandardinstitute (dot) us.

[1] To briefly address the 80% increase in the 10-year interest rate over the past few months: it is a correction, nothing more. The rate will resume its ferocious descent soon enough.

[2] Joseph Schumpeter coined this term in 1942 in his book Capitalism, Socialism and Democracy (1942)

Oscillation, Feedback, and Resonance

I just saw this fascinating video of a bunch of metronomes that begin ticking out of sync with one another, but slowly line up until they all beat in unison. I really love the title slide where it says “NONLINEAR DYNAMICAL SYSTEMS”, how apropos! Watch the video, the outcome is counterintuitive.

The metronomes show some principles of a non-linear, dynamic system including periodic inputs of energy, oscillation, resonance, and positive feedback. These are key concepts in my series on the Theory of Interest and Prices in Paper Currency. In Part I, I discuss the assumption that the monetary system is linear and static. Later in Part III, I discuss periodic input of energy, oscillation, and resonance. In Part IV, I discuss feedback, both negative which damps a system and positive which runs away.

Our monetary system cannot be understood in terms of the quantity of money. It is convenient, tempting, and easy to assume that if the money supply doubles*, then prices should eventually double sooner or later. It was convenient for the Medievals to assume that if you throw a rock then it first flies straight until it sooner or later runs out of force and falls straight down. Both are errors of rationalism, of sitting in an armchair imagining how the world ought to be, how it should fit with preconceived notions.

But neither rocks nor money work that way. Science must begin by observation, and only then is one entitled to try to generalize and form a theory. What would the simplistic linear quantity theory of metronomes predict? One would assume that the more metronomes one had ticking away (assuming they were not synchronized manually), the more that the sound would approach white noise. The average interval between ticks would be 1/N where N is the number of metronomes. As N became sufficiently large the ticks would blur into a continual sound.

As the video shows, it just does not happen that way. Instead, there is periodic input of energy from each metronome to the shelf on which they sit, and periodic input of energy from the shelf to each metronome. This creates both positive feedback and negative feedback. A metronome that is slightly “behind” the average is given more energy to accelerate, and one that is “ahead” is drained.

With the harmless experiment of a bunch of ticking pendulums, the end result is that they all end up in tight sync with one another. There is negative feedback to ensure this. Without negative feedback, the oscillations would grow and grow until either the devices began to leap off the shelf, or the shelf fell out of its brackets, or maybe the shelf broke (as in the Tacoma Narrows Bridge).

With the current monetary experiment, the result is cycles of rising and falling interest rates and booms and busts, with increasing amplitude. The positive feedbacks in the system are overwhelming the negative feedbacks, which have been removed or suppressed by deliberate government policy.

If there is one take-away that I hope every reader gets from this article and my series on interest and prices, it is that the monetary system is non-linear, dynamic, stateful, discontiguous, and multivariate. It is time we stop obsessing over the quantity of money (and boldly issuing predictions about prices that never come true). We must start thinking about the system dynamics and the unstable interest rate before it collapses into the black hole of zero.



* Ignoring that we don’t have money in our system today, we have only credit.

Magical Thinking Drags on Economics

Many economists often attempt to set arbitrary thresholds. For example, if debt hits X% of GDP (or whatever measure) then it is “too” large and “impedes economic growth”.  This article on Acting Man blog cites Carmen Reinhart attempting to do just this.

It is the wrong approach entirely.

To understand why, let’s look at productive debt and contrast with government debt. If Joe borrows money to build a factory to produce Supersmart phones, then paying the interest and principle on this bond does not impede anything. His revenues would not exist without borrowing the money, and so we can say with certainty that this debt is good for Joe, it is good for Joe’s customers, and it is good for everyone else including Joe’s employees, Joe’s vendors, etc.

By contrast, what if John borrows to live a lavish lifestyle that his income would not otherwise support? EVERY PENNY spent to service this debt is a drag on John. At first, he was seemingly able to buy things without real cost. But when the first credit card bill comes due, then he incurs cost without being able to buy things. There is no magic number, no arbitrary threshold, no line in the sand. This debt is bad for John, and for everyone else that John touches. (I don’t think that there would be much, if any, consumer lending in a world where savers had to lend their hard-earned gold, a world in which the Fed was not the ultimate source of credit, but that is a different discussion).

Government debt is not like Joe’s debt; it is like John’s. The government borrows so that it can buy more than its tax revenues. Initially, this creates an illusion of prosperity. But soon, the government must begin paying to service the debt (it can never actually pay the principle because there is no extinguisher of debt). EVERY PENNY of this debt service is a drag on the economy. The government is buying fewer goods than what could be paid for by its tax revenues.

Contrary to the threshold idea, the drag really begins with the first dollar of debt and it is proportional to the debt.

Two factors obscure this and makes it harder to see. One is that the government can borrow more. So long as the government has access to unlimited credit, it can borrow to pay the interest and borrow to consume. A major theme of my writing is that this can only go on while people are willing to feed perfectly good capital to the government so that the government may consume it. When they are no longer willing, or when their capital is depleted, then the game ends. It ended in Greece and it will end in the US at some point.

The other is that it can force down the rate of interest. This makes it cheaper to “roll” its debt, to pay off old bonds as they mature by selling new bonds. If the new bonds have a lower rate, then the government can service more debt for the same payment. Another major theme of my writing is that a falling interest rate destroys capital.

It is no accident that both factors masking the drag of debt have to do with capital destruction. Nevertheless, the drag of the nearly-$17T of debt that the government acknowledges plus the far larger liability that they carry off the balance sheet is very real. One can see it almost everywhere one looks, from the weak labor market to the increasing reliance on the Fed as the only source of credit.

Rising Interest Rates

Interest rates have risen since May of this year, from under 1.7% to over 2.7%. By any measure, that is an enormous move.


I have mostly written about how falling interest rates cause capital destruction, because that is the environment we have been in since 1981. There are, however, occasional corrections when interest rates rise. Rising rates means bond prices fall (the relationship between interest rate and bond price is a rigid mathematical inverse, like a teeter totter).

Here is a picture from Zero Hedge worth 1000 words in explaining the consequences on this side of unstable rates. Banks are taking big (unrealized, so far) losses.

Unrealized Losses on AFS

If you buy a bond, and then the interest rate rises, you suffer a capital loss. If you borrowed money to buy bonds with leverage, you could be in big trouble very quickly.

On the other side of the trade, some bond issuers are breathing a little easier as the burden of their debt has fallen. Unfortunately, most of them have a different problem. They generally must “roll” liabilities, which means selling new bonds to pay old bonds. They are forced to replace lower-interest borrowing with higher-interest borrowing. This is pinching their cash flow.

Whether the wrecking ball swings to one side of the street when rates fall, or to the other side when rates rise, destruction is the result either way. We need the monetary system that provides a stable interest rate.

Theory of Interest and Prices in Paper Currency Part V (Falling Cycle)

In Part I, 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, 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 III, 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.

In Part IV, we discussed the rising cycle. The central planners push the rate of interest down, below the marginal time preference and unleash a storm whose ferocious dynamics are more than they bargained for. The hapless subjects of the regime have little recourse but they do have one seeming way out. They can buy commodities. The cycle is a positive feedback loop of rising prices and rising interest rates. Ironically, their clumsy attempt to get lower interest results in rising interest. Alas, the cycle eventually ends. The interest rate and inventory hoards have reached the point where no one can issue more bonds or increase their hoards.

In this Part V, we discuss the end of the rising cycle and the start of the falling cycle. We examine its dynamics and its mode of capital destruction. Lastly we look at the response of the central bank.

It is not possible to pay debts with inventories of completed or partially completed product, nor even with raw commodities. In order to circulate as money, a good must have an extremely narrow bid-ask spread. Commodities have a wide spread, especially in the environment of the late stages of the rising cycle. Liquidations are pushing the bid down. The ask side is still being pushed up, by those businesses which are still buying. Work in progress of course could not be sold, except to another company in the same industry.

Recall that the rising cycle is driven by selling bonds to build inventories. This creates a conflict: the desire to accumulate more inventories because prices are rising rapidly vs. the need for cash to service the debt. In any conflict between want and need, between speculation and leverage, the latter must win in the end. At the same time that the marginal utility of the unit of hoarded goods is falling, the amount owed is rising.

The backdrop is layoffs and liquidations, as each time a company’s capital and plant must be renewed, it is harder and harder to make a business case. If it is profitable to borrow at 7% to buy machines to manufacture cameras, it may not be profitable at 14%. So factories are closed, resulting in liquidations. People lose their jobs, resulting in increasing softness in the consumer bid for goods.

Eventually, as it must, the trend comes to its ignominious end.  The interest rate spikes up one final step higher as banks are taking capital losses and become even more reluctant (or able) to lend. The rate of interest is now, finally, above marginal time preference. That spread is reverted to normalcy. Unfortunately, the other spread discussed in Part III inverts.

That other spread is marginal productivity to the rate of interest; the latter is now above the former. I mentioned in Part IV that many people credit Paul Volcker for “breaking the back of inflation” in 1981. The central planners cannot change the primary trend, and in any case the problem was not caused by the quantity of money, so the solution could not have been reducing the money supply. At best, if he pushed up the rate of interest he accentuated the trend and helped get to the absolute top. The 10-year Treasury bond traded at a yield around 16%.

The rising cycle was driven by rising time preference that caused rising interest as businesses borrowed to finance inventories which caused time preference to rise further. During this process, at first one by one and then two by two, enterprises were forced to close and liquidate their inventories, as their businesses could not earn the cost of capital. This force opposed the rising cycle.

Now it fuels the falling cycle.  The only good thing to be said is that interest rates are not rising and therefore viable companies are not squeezed out due to rising cost of capital. The wrecking ball of rising rates has finished on that side of the street. It is done destroying capital by rendering it sub-marginal, when it cannot produce enough to justify borrowing at the higher rate of interest.

As we shall see, that wrecking ball will not repair the damage it has done when it swings to the other side. A falling rate destroys capital also, though by a different mechanism. It causes the Net Present Value (NPV) of every bond to rise.  This is because the NPV of a stream of future payments is calculated by discounting each future payment by the interest rate. The lower the interest, the lower the discount for all future payments. This is why the bond price rises.

Falling interest rates benefit one group. The bond speculators get rich. They can buy bonds, wait a little while, and sell them for a profit. The bond bull market starts off slowly but becomes ferocious over time. In nature, if a source of readily usable energy exists then a specialized organism will evolve to exploit it and feed off it. This is true for plants and animals in every niche on dry land, and it is for strange sea creatures near volcanic vents on the icy sea floor. Plants convert sunlight into sugars and animals eat plants, etc. The same is true for free profits being offered in the bond market. A whole parasitic class develops to feed off the free capital being offered there.

Savers and pension funds cannot profit from falling rates because they hold until maturity. The more the interest rate falls, the more they are harmed. The lack of savings is another blow to the economy, as it is savings that is the prerequisite to investment and investment is the prerequisite to jobs and rising wages.

By contrast, the speculators are not in the game for the interest payments. They are in for capital gains.

Where does their free profit come from? It comes from the capital accounts—from the balance sheets—of bond issuers. Anyone who has sold a bond or borrowed money with a fixed-rate loan should mark up the liability, to market value. I have written previously on the topic of falling interest rates and the destruction of capital.[1]

On the way up, businesses could seemingly dictate whatever prices they felt like charging. Recall my example of cans of tuna fish in the 1970’s; stores were re-stickering them with higher prices even in the short time they sat on the shelves. My theory predicts that gross margins must have been rising everywhere, especially if companies managed their inventory to move from input to final sales over a long period of time (this would be worth researching in further papers).

But today, they have not this power. Even in industries where prices have been rising, the consumer is reluctant and sluggish to pay and there are many competing alternatives. In other industries (recall my example of Levis jeans, which applies to clothing in general) there seems to be no pricing power. Many stores in the mall have permanent signs offering big discounts; I regularly see 60% off.

What is it about rising interest rates that allows for aggressively expanding prices and margins, and falling rates that compresses margins and prices?

We said in Part III:

What is the bond seller—the entrepreneur—doing with the money raised by selling the bond? He is buying real estate, buildings, plant, equipment, trucks, etc. He is producing something that will make a profit that, net of all costs, is greater than the interest he must pay. He is doing arbitrage between the rate of interest and the rate of profit.

As the interest rate ticks upwards, every producer in every business must adapt his business model to the higher cost of capital. They must earn a higher gross margin, in order to pay the higher interest rate. Higher rates must necessarily drive higher gross margins. We have discussed two ways to get a higher margin: (1) a long lag between purchase of inputs and sale of outputs and (2) higher prices. Strategy #1 is the reaction to the inverted interest to time preference spread. Strategy #2 is the reaction to higher interest rates and thinning competition.

The burden of debt is falling when the interest rate is rising, and we can see it in the reduced competitive pressures on margins. Of course, we are now in the falling cycle and the opposite applies. If one wants to track the “money supply”, one can think of the money going, not into consumer goods or commodities, but into productive capacity. I propose that one should think of inflation not in terms of the “money supply” but in terms of counterfeit credit.[2] In the rising cycle, counterfeit credit is going into commodities. In the falling cycle, by contrast, it is going into bonds that finance government and also productive capacity.

I call it a “ferocious” bull market in bonds because it is gobbling up the capital of businesses who borrow (and they have to borrow in order to keep up with their competitors). The competition is ferocious, because each new business can borrow at lower rates than incumbent competitors. The new entrant has a permanent competitive advantage over the old. Then the rate falls further and the next new entrant enters. The previous new entrant is now squeezed, doubly so because unemployment is rising. The prior incumbent is wiped out, its workforce is laid off, and its plant and inventory is sold off. Unemployed workers are not able to aggressively bid up prices. There is, by the way, another reason why falling rates cause unemployment. There is always a trade-off between capital invested to save labor vs. employing labor. At lower cost of borrowing money, the balance tilts more heavily in favor of investment.

In the falling cycle, a vicious one-two punch is delivered to productive enterprises. Low margins make it necessary, and low interest makes it possible, to use big leverage relative to its equity. There is a term for a company with low and shrinking margins and high leverage.



If you have ever owned one of those impossibly delicate glass figurines with long tendrily tails, whiskers, manes, and tongues, you know that the slightest bump causes it to break. The same is true for many businesses in the falling cycle. In any case, it is only a matter of a sufficient drop in the interest rate for many to be wiped out.

Opposite to Fekete’s Dilemma, the problem now is that the cheaper one finds the cost of borrowing, the more meager are the opportunities to profit combined with the higher the price of capital goods.

The falling cycle is a cycle of capital churn. Perfectly good capital is wiped out by the dropping interest rate, which gives incentive to a new entrepreneur to borrow to build what is essentially a replacement for the old capital. And then his capital is replaced by churn, and so on.

So long as the interest rate remains above marginal productivity (and marginal time preference), people choose to buy the bond over buying commodities. The burden of debt is rising. As Irving Fisher wrote in 1933, “…the more debtors pay, the more they owe.” It is better to be a creditor than a debtor (until the debtor defaults).

Businesses, struggling under this burden, do everything possible to squeeze inventory and fixed capital out of their businesses, and buy back some of their debt. This adds more oil to the fire of rising bond prices and falling interest rates. It is no coincidence that Lean, the Toyota Way, began to be widely adopted in the 1980’s. It was not well suited to the rising cycle of the post WWII era, but it was demanded by the falling cycle after Volcker.

Meanwhile, the central bank is not idle. What does every central bank in the world say today? They are fighting the monster of “deflation”. How? They want to increase the money supply. How? They buy bonds.

The bond bull market is ferocious indeed.

The last falling cycle ended just after World War II. The situation today is unlike that of 1947. One key difference is that credit expansion to fuel the falling cycle was limited by the ties to gold that were still partially in place after FDR’s 1933 gold confiscation and kept in place in the Bretton Woods Treaty in 1944. Today, there is no such constraint and so the end of the falling cycle will be quite different, as we explore in Part VI.

Theory of Interest and Prices in Paper Currency Part IV (Rising Cycle)

In Part I, 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, 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 III, 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 question[1]. 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 bond[2], 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 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 Interest ( 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 instead.


Theory of Interest and Prices in Paper Currency Part III (Credit)

In Part I, 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, 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 this third part, we look at how credit comes into existence (via arbitrage, of course) with legitimate entrepreneur borrowers. We also look at the counterfeit credit of the central banks (which is not arbitrage). We introduce the concept of speculation in markets for government promises, compared to legitimate trading of commodities. We also discuss the prerequisite concepts. Marginal time preference and marginal productivity are absolutely essential to the theory of interest and prices. That leads to the last new concept resonance.

In the gold standard, credit comes into existence when one party lends and another borrows. The lender is a saver who prefers earning interest to hoarding his gold. The borrower is an arbitrager who sees an opportunity to earn a net profit greater than the rate of interest.

As with all markets, there is a bid and an offer (also called the “ask”) in the bond market. The bid and the offer are placed by the saver and the entrepreneur, respectively. The saver prefers a higher rate of interest, which means a lower bond price (price and interest rate vary inversely). The entrepreneur prefers a lower rate and a higher bond price.

Increased savings tends to cause the interest rate to fall, whereas increased entrepreneurial activity tends to cause a rise. These are not symmetrical, however. If savings fall, then the interest rate must go up. The mechanism that denies credit to the marginal entrepreneur is the lower bond price. But, if savings rise, interest does not necessarily go down much. Entrepreneurs can issue more bonds. Savings is always finite, but the potential supply of bonds is unlimited.

What is the bond seller—the entrepreneur—doing with the money raised by selling the bond? He is buying real estate, buildings, plant, equipment, trucks, etc. He is producing something that will make a profit that, net of all costs, is greater than the interest he must pay. He is doing arbitrage between the rate of interest and the rate of profit.

It may seem an odd way to think of it, but consider the entrepreneur to be long the interest rate and short the profit rate. Looking from this perspective will help illustrate the principle that arbitrage always has the effect of compressing the spread. The arbitrager lifts the offer on his long leg and presses the bid on his short leg. The entrepreneur is elevating the rate of interest and depressing the rate of profit.

Now let’s move our focus to the Fed and its irredeemable dollar. The Fed exists to enable the government and favored cronies to borrow more, at lower interest, and without responsibility to extinguish their debts.

People often use the shorthand of saying that the Fed “prints” dollars. It is more accurate to say that it borrows them into existence, though there is no (knowing) lender. The Fed has the sole discretion to create these dollars ex nihilo, unlike a normal bank that must persuade a saver to deposit them. By this reason alone, the Fed’s credit is counterfeit. The very purpose of the Fed is to cause inflation, which I define as an expansion of counterfeit credit[1].

These borrowed dollars are the Fed’s liability. It uses them to buy assets such as bonds or to otherwise lend. Those bonds or loans are its assets. While the Fed can create its own funding, its own liabilities, it still must heed its balance sheet. If the value of its assets ever falls too far, the market will not accept its liability. Gold owners will refuse to bid on the dollar. Through a process of arbitrage (of course), the dollar will collapse.[2]

What does the government get from this game? It diverts resources away from value-creating activities into the government’s welfare programs, graft, regulatory agencies, and vast bureaucracy. By suppressing interest rates and enabling debts to be perpetually rolled, the Fed enables the government to consume much more than it could in a free market. Politicians are enabled to buy votes without raising taxes.

Earlier, I said there is no knowing lender. Let’s look at this mysterious unknowing lender. He is industrious and frugal, consuming less than he produces, keeping the difference as savings. He feeds this savings, the product of his hard work, into the government’s hungry maw. Unfortunately, the credit he extends is irredeemable. The paper promise he accepts has a warning written in fine print: it will never be honored. The lender is a self-sacrificial chump. Who is he?

He is anyone who has demand for dollars.

He is the trader who thinks that gold is “going up” (in terms of dollars). He is the businessman who uses the dollar as the unit of account on his income statement. He is the investor who measures his gains or losses in dollars. He is every enabler who does not distinguish between the dollar and money.

People don’t think of their savings in this light, that they are freely offering it to the government to consume. They don’t understand that savings is impossible using counterfeit credit.

Now we have covered the counterfeit credit of th Fed, let’s move on to cover another prerequisite topic: speculation. With arbitrage, I offered in Part II a much broader definition than the one commonly used. With speculation, I will now present a narrower concept than the usual definition. Let’s build up to it by looking at some examples.

The first example is the case of agricultural commodities, such as wheat. Production is subject to unpredictable conditions imposed by nature, like weather. If early rain reduces the wheat yield by 5%, then there could be a shortage. Think of the dislocations that would occur if the price of wheat remained low. Inventories from the prior crop would be consumed too rapidly at the old price. Then, when the reduced new crop was harvested, it would be too late for a small reduction in consumption. Grain consumers would suffer undue hardship.

Futures traders perform a valuable economic function. Their profit comes from helping to drive prices up (in this example) as soon as possible, and thus discourage consumption, encourage more production, and attract wheat to be shipped in from unaffected regions. Good traders study and anticipate nature-made risks to valuable goods and earn their profits by providing price signals to producers and consumers.

Trading commodities futures is a legitimate activity that helps people coordinate their activities. If such traders were removed, the result would be reduced coordination (i.e. waste). Therefore my definition of speculation excludes commodities traders.

There are two elephants in the room of the irredeemable currency regime: interest and foreign exchange rates. It is the profiteer in these games who earns the dubious label of speculator.

The price of each currency is constantly changing in terms of all others. To any business that operates across borders, this creates unbearable risk. They are forced to hedge. The banks that provide such hedging products must, themselves, hedge. One result is volatile currency markets.

The rate of interest presents the other big man-made risk. Unlike in gold, interest in irredeemable paper is always changing and is often quite volatile. For example, the interest rate on the 10-year Treasury bond has gone from 1.63% to 2.16% just during the month of May. As with currencies, there is a big need to hedge this risk, and hence, a massive derivatives market.


Naturally, volatility attracts traders, in this case the speculators. Their gains are not profits from anticipating natural risks to the production of real commodities. They are not skilled in responding to nature. They are front-runners of the artificial risks created by the next move of the government or central bank. Worse still, they seek to influence the government and central bank to act favorably to their interests.

Unlike the trader in commodities, the speculator in man-made irredeemable promises is a parasite. This is not a judgment of any particular speculator, but rather an indictment of the entire dollar regime. It imposes risks, losses, and costs on productive businesses, while transferring enormous gains to speculators.

It is no coincidence that the financial sector (and the derivatives market) has grown as the productive sector has been shrinking. A good analogy is to call it a cancer that consumes the economic body, by feeding on its capital. A free market does not offer gains to those who add no value, much less to parasites who consume value and destroy wealth. The rise of the speculator is due entirely to the perverse incentives created by coercive government interference.[3]

In light of the context we’ve established, we are now ready to start looking at interest rates. In the gold standard, the mechanism is fairly simple as I wrote in “The Unadulterated Gold Standard Part III (Features)”:

This trade-off between hoarding the gold coin and depositing it in the bank sets the floor under the rate of interest.  Every depositor has his threshold.  If the rate falls (or credit risk rises) sufficiently, and enough depositors at the margin withdraw their gold, then the banking system is deprived of deposits, which drives down the price of the bond which forces the rate of interest up.  This is one half of the mechanism that acts to keep the rate of interest stable.

The ceiling above the interest rate is set by the marginal business.  No business can borrow at a rate higher than its rate of profit.  If the rate ticks above this, the marginal business is the first to buy back its outstanding bonds and sell capital stock (or at least not sell a bond to expand).  Ultimately, the marginal businessman may liquidate and put his money into the bonds of a more productive enterprise.[4]

 interest spread

To state this in more abstract and precise terms, the rate of interest in the gold standard is always in a narrow range between marginal time preference and marginal productivity.[5]

The phenomena of time preference and productivity do not go away when there are legal tender laws. The government attempts to disenfranchise savers, to remove their influence over the rate of interest and their power to contract banking system credit.

In the gold standard, when one redeems a bank deposit or sells a bond, one takes home gold coins. This pushes up the rate of interest and forces a contraction of banking system credit. The reason to do this is because one does not like the rate of interest, or one is uncomfortable with the risk. It goes almost without saying that holding one’s savings in gold coins is preferable to lending with insufficient interest or excessive risk.

By contrast, in irredeemable currency, there is no real choice. A dollar bill is a zero yield credit. If one is forced to take the credit risk, then one might as well get some interest. Unlike gold, there is little reason to hoard dollar bills.

The central planners may impose their will on the market; it is within their power to distort the bond market. But they cannot repeal the law of gravity, increase the speed of light, or alter the nature of man. The laws of economics operate even under bad legislative law. There are horrible consequences to pushing the rate of interest below the marginal time preference, which we will study later in this series. The saver is not entirely disenfranchised. He can’t avoid harm, but his attempt to protect himself sets quite a dynamic in motion.

It should also be mentioned that speculators affect and are affected by the market for government credit. Their behavior is not random, nor scattered. Speculators often act as a herd, not being driven by arbitrage but by government policy. They anticipate and respond to volatility. They can often race from one side of a trade to the other, en masse. This is a good segue to our final prerequisite concept.

The linear Quantity Theory of Money tempts us to think that when the Fed pumps more dollars into the economy, this must cause prices to rise. If there were an analogous linear theory of airplane flight, it would predict that pulling back on the yoke under any circumstance would cause the plane to climb. Good pilots know that if the plane is descending in a spiral, pulling back will tighten the spiral. Many an inexperienced pilot has crashed from making this error.

The Fed adds another confounding factor: its pumping is not steady but pulsed. Both in the short- and the long-term, their dollar creation is not steady and smooth. Short term, they buy bonds on some days but not others. Long term, they sometimes pause to assess the results; they know there are leads and lags. They also provide verbal and non-verbal signals to attempt to influence the markets.

In a mechanical or electrical system, a periodic input of energy can cause oscillation. Antal Fekete first proposed that oscillation occurs in the monetary system. Here, he compares it to the collapse of an infamous bridge:


It is hyperdeflation [currently]. The Fed is desperately trying to fight it, but all is in vain. We are on a roller-coaster ride plunging the world into zero-velocity of money and into barter. In my lectures at the New Austrian School of Economics I often point out the similarity with the collapse of the Tacoma Bridge in 1941.[6]

I will end with a few questions. What happens if the central bank pushes the rate of interest below the marginal time preference? Could this set in motion a non-linear oscillation? If so, will this oscillation be damped via negative feedback akin to friction? Or will periodic inputs of credit inject positive feedback into the system, causing resonance?

In Part IV, we will answer these questions and, at last, dive in to the theory of prices and interest rates.

[3] See my dissertation for an extensive discussion of government interference: A Free Market for Goods, Services, and Money

[5] Interested readers are referred to the subsite on Professor Antal Fekete’s website where he presents his theory of interest and capital markets.

Theory of Interest and Prices in Paper Currency Part II (Mechanics)

In Part I, 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.

Here is a fitting footnote for Part I. I just bought a pair of Levis jeans at Macy’s for $45. I remember buying a pair of Levis Jeans in Macy’s in 1983 for $50. In 30 years, the price of Levis Jeans has fallen by 10%. By any conventional theory based on the money supply, the price should have risen by several hundreds of dollars.

In this part, we look at some mechanics, the understanding of which is a prerequisite to the theory of interest and prices. To truly understand anything, you have to know what happens in reality step by step. This is even more important in an abstract field like monetary science. We discuss stocks vs. flows, how prices are formed in a market, a broad concept of arbitrage, spreads, and how money comes into and goes out of existence.

Let’s drill down into a point I made in passing in Part I.

It is worth noting that money does not go out of existence when one person pays another.  The recipient of money in one trade could use it to pay someone else in another.  Proponents of the linear QTM[1] would have to explain why prices would rise only if the money supply increases.  This is not a trivial question. Prices rise whenever a buyer takes the offer, so no particular quantity of money is necessary for a given price (or all prices) to rise to any particular level.

It is seductive to respond by way of the common analogy of “too much money, chasing too few goods”. But, is that an accurate picture of how markets work?

Money supply is a quantity of stocks. One could theoretically add up all of the gold in human inventories, or all of the dollars in the financial system, and come up with a scalar number of ounces or dollars.

How about goods supply? This is a different meaning of the word supply. Unlike in money, the supply of goods means the flows of goods. To discuss copper or wheat, one must measure how much is mined or grown every year. This would be pounds or bushels per year.

Flows of goods cannot be compared in any meaningful way to the stocks of money; pounds per year cannot be compared to ounces. Just like in physics, length cannot be compared to velocity; one cannot compare meters to meters per second. That is not a proper approach to science—physical or monetary.

This brings us to an important fact. The stock of money is not consumed after a transaction. However, in the normal case, goods are. Other than the monetary commodities of gold and silver, only small inventories are normally kept as a buffer in all other goods. To state this in everyday terms, if Joe buys a loaf of bread from Sally for $1, he will eat the bread (or it will go bad) but Sally has the money until she spends it. If Acme Pipe buys 1000 pounds of copper, it will manufacture it into plumbing and sell the plumbing.

Now let’s move on to the mechanism of price discovery. In Part I, I stated:

In any market, buyers and sellers meet, and the end result is the formation of the bid price and ask price.

There is not just one monolithic price, but two prices: the bid, and the ask (also called the “offer”). If you come to market and you must buy, then you have to pay the offer. For example, you own an apartment building and your lease obligates you to provide heat for your tenants. So you go to the heating oil market. If heating oil is bid $99 and offered $101, you must pay $101. Note what happens next. The seller of that oil – assuming you just bought all of his oil – leaves. He has exchanged his oil for your dollars and he goes home. The next seller may ask $102. Now the market is bid $99 and offered $102.

Next, a heating oil distributor comes to market with the day’s production. He must sell, because tomorrow he will produce more. What price does he get? Did your purchase push up the price? You did not push up the bid price, and so the new heating oil vendor must take the bid of $99. Now this consumer is sated, he has the oil he wants. The next best bid could be $97.

There is a counterintuitive process here. The bid is formed by the competition of producers who keep selling until the marginal seller does not accept the bid. The ask is formed by the competition of consumers who keep buying until the marginal buyer does not accept the ask. This is a critical idea in Austrian School analysis, so I encourage readers to stop and think this through.

Buyers keep coming to market and taking the offer (thus lifting it) until a point is reached where the next would-be buyer balks. This buyer, the marginal buyer, may make his own bid, above the best bid but below the best offer. At the same time, sellers keep coming to market and taking the bid, until the marginal seller balks. This seller may set his own offer, below the best offer but above the best bid.

There is one other actor, the market maker. The market maker will act to keep a consistent bid-ask spread. If the ask is pushed up, then the market maker will raise his bid. If the bid is pressed down, then he will lower his ask. The market maker is the only one who can buy at the bid and sell at the offer. His profits come from the bid-ask spread, the wider the spread the more his profits. Of course, the next market maker will enter and force the spread to narrow, and so on until the margin al market maker balks and the spread does not narrow any further.

From the mechanics described here, we begin to build a picture of how prices are set where the “rubber meets the road” in the market. If there are more market participants who buy at the offer then the end result is that prices move upwards. If there are more who sell at the bid, then prices move downwards.

This may seem tautological. It is prerequisite material.

We return to my rhetorical question. Why would prices not keep rising in the case of a fixed quantity of money? After all, when Joe buys the loaf of bread from Sally for $1 there is no reason why Sue could not buy it from him for $2 and John couldn’t buy it from Sue for $3 and so on.

The observant reader may object on grounds that prices can only go up until people cannot afford the good. Bread cannot be $300 per loaf if no one has $300. This is comparing stocks to flows once again. What matters is not whether the consumer has $300 in stocks, but whether the consumer has $300 in flows. If the velocity of money (flows) rises, then the consumer could have $300 of daily income with which to pay the price of his daily bread.

As we see from the above discussion of price formation, neither the buyer nor the seller has an intrinsic advantage. Both come to market and must accept the market price (ask or bid, respectively). Size does not add any power to the seller. If anything, the seller has a disadvantage in trying to get a price he prefers, compared to the buyer. He has capital tied up in his productive enterprise, and certain fixed costs like payroll that must go on whether he sells or does not sell. Holding inventory does not normally do him any good. With the exceptions of food and energy, buyers can afford to be pickier. They do not face the same problem as sellers; if they go home at the end of the day with money as opposed to goods, this is not always a problem.

Without delving too deeply into this topic, I want to paint with a broad brush stroke. There is no force that guarantees a constant price even if the money supply is fixed. There are many reasons why buyers could lift the offer or sellers could press down the bid. Not only can prices rise with the same stocks of money, but they could also rise with the same flows of goods.

Next, let’s introduce the concept of arbitrage. People often use this term in a very narrow sense, to mean buying and selling the same good in different markets to shave off a small spread. For example, IBM stock is offered at $99.99 in London and bid at $100.00 in New York, so the arbitrager could simultaneously buy and sell to pocket a penny. Or, in the gold market, which I write about frequently, one could buy spot gold and sell December gold for a 0.3% annualized spread.

In this paper, I use the word arbitrage to refer to a much broader concept. I won’t fully explore it herein, but we need to discuss one relevant aspect.[2] Let’s go back to our example of the landlord. What is he doing? He is seeking to make a profit by renting out apartments to tenants. The rent is his gross revenue. How is the rent set? If he needs to rent a unit, he must take the bid.

What are his costs? Broadly, he must buy land, construction materials, construction labor, maintenance labor, heating oil, etc. We will address later that he must pay the rate of interest on the capital.

The landlord must buy these things at the offer. We can look at him as doing an arbitrage between his inputs—bought at the offer—and his output product—sold on the bid. The landlord’s spread is Rent(bid) – Inputs(ask).

In this light, what should he be the limit of what he is willing to pay for his inputs? A bit less than the rent he receives, at most.

I give this example to make it clear why we should not think the primary driver of markets is the consumer with a bank account balance as his budget. One might think of a consumer who has a total of $10. Let’s suppose he would want to pay $0.01 for a loaf of bread. But if he had $100 total, he would pay $0.10, and so on. This is the siren song of QTM luring one to think that increased stocks of money must lead to higher prices. It is often stated, “if everyone’s bank account grew by 10X, then prices will be 10X higher.”

Will a middle class consumer buy more food if he has more money?

At any rate, instead of the consumer, we should think of the entrepreneur. He is an arbitrager who will not normally buy inputs unless the bid on his output affords him an acceptable margin above the offer on his inputs. What will cause consumers to raise their bid on his outputs? This is a non-trivial question that will be addressed in a later part of this paper.

Up until now, we have been using the term “money” without regard to the distinction between gold and promises to pay, i.e. between money and credit. It is now necessary to make this distinction to continue the discussion. In the current monetary regime, money (gold) has no official role to play at all, though it assuredly plays a role. My permanent gold backwardation thesis[3] can be summarized as follows: the withdrawal of the gold bid on the dollar will bring about the collapse of the dollar because dollar holders will drive prices up exponentially by using commodities to get gold.

Money (gold), of course, can only come into existence via a slow and inelastic process of mining. Money does not go out of existence (though gold coins can be melted down to produce non-monetary objects). Both of these processes are themselves driven by arbitrage. When the inputs required to mine one ounce of gold cost less than one ounce, the gold miners spring into operation. When the inputs rise above one ounce, they shut down. When jewelry sells for more than the cost of its inputs (principally gold, labor, and perhaps gem stones) then jewelers spring into action. When monetary gold is worth more than jewelry, then it is melted down and returned to monetary form by arbitragers known as “Cash For Gold”.

Credit is an entirely different animal.

In Part III, we will discuss credit including an examination of the borrower, the borrower’s opportunities, and the borrower’s considerations.

[1] Quantity Theory of Money

[2] Those interested can read more about arbitrage in Disequilibrium Analysis of Price Formation by Antal Fekete, January 1, 1999

Theory of Interest and Prices in Paper Currency Part I (Linearity)

Under gold in a free market, the theory of the formation of the rate of interest is straightforward.[1] The rate varies in the narrow range between the floor at the marginal time preference, and the ceiling at the marginal productivity. There is no positive feedback loop that causes it to skyrocket (as it did up until 1981) and subsequently to spiral into the black hole of zero (as it is doing now). It is stable.

In irredeemable paper currency, it is much more complicated. In this first part of a multipart paper presenting my theory, we consider and discuss some of the key concepts and ideas that are prerequisite to building a theory of interest and prices. We begin by looking at the quantity theory of money. In our dissection, we will identify some key concepts that should be part of any economist’s toolbox.

This theory proposes a causal relationship between the quantity of money and consumer prices. It seems intuitive that if the quantity of money[2] is doubled, then prices will double. I do not think it is hyperbole to say that this premise is one of the cornerstones of the Monetarist School of economics. It is also widely accepted among many who identify themselves as adherents of the Austrian School and who write in critique of the Fed and other central banks today.

The methodology is invalid, the theory is untrue, and what it has predicted has not come to pass. I am offering not an apology for the present regime—which is collapsing under the weight of its debts—but the preamble to the introduction of a new theory.

Economists, investors, traders, and speculators want to understand the course of our monetary disease. As we shall discuss below, the quantity of money in the system is rising, but consumer prices are not rising proportionally. Central bankers assert this as proof that their quackery is actually wise currency management.

Everyone else observing the Fed knows that there is something wrong. However, they often misplace their focus on consumer prices. Or, they obsess about the price of gold, which they insist should be rising in lockstep with the money supply. The fact that the price of gold hasn’t risen in two years must be prima facie proof that there is a conspiracy to suppress it. Gold would have risen, except it’s “manipulated”. I have written many articles to debunk various aspects of the manipulation theory.[3]

The simple linear theory fails to explain what has already occurred, much less predict what will happen next. Faced with the fact that some prices are rising slowly and others have fallen or remained flat, proponents insist, “Well, prices will explode soon.”

Will the price of broccoli rise by the same amount as the price of a building in Manhattan (and the same as a modest home in rural Michigan)? We shall see. In the meantime, let’s look a little closer at the assumptions underlying this model.

Professor Antal Fekete has written that the Quantity Theory of Money (QTM) is false, on grounds that it is a linear theory and also a scalar theory looking only at one variable (i.e. quantity) while ignoring others (e.g. the rate of interest and the rate of change in the rate of interest).[4]  I have also written about other variables (e.g. the change in the burden of a dollar of debt).[5]

It is worth noting that money does not go out of existence when one person pays another.  The recipient of money in one trade could use it to pay someone else in another.  Proponents of the linear QTM would have to explain why prices would rise only if the money supply increases.  This is not a trivial question. Prices rise whenever a buyer takes the offer, so no particular quantity of money is necessary for a given price (or all prices) to rise to any particular level.

In any market, buyers and sellers meet, and the end result is the formation of the bid price and ask price. To a casual observer, it looks like a single “price” has been set for every good. It is important to make the distinction between bid and ask, because different forces operate on each.

These processes and forces are nonlinear. They are also not static, not scalar, not stateless, and not contiguous.


First let’s consider linearity with the simple proposal to increase the tax rate by 2%. It is convenient to think it will increase government tax revenues by 2%. Art Laffer made famous a curve[6] that debunked this assumption. He showed that the maximum tax take is somewhere between 0 and 100% tax rate. The relationship between tax rate and tax take is not linear.

Another presumed linear relationship is between the value of a unit of currency and the quantity of the currency outstanding.  If this were truly linear, then the US dollar would have to be by far the least valuable currency, as it has by far the greatest quantity. Yet the dollar is one of the most valuable currencies.

“M0” money supply has roughly tripled from 2007, “M1” has roughly doubled, and even “M2” has risen by 50%.[7] We don’t want to join the debate about how to measure the money supply, nor do we want to weigh in on how to measure consumer prices. We simply need to acknowledge that by no measure have prices tripled, doubled, or even increased by 50%.[8] It’s worth noting an anomaly: on the Shadowstats inflation[9] chart, the inflation numbers drop to the negative precisely where M0 and M1 rise quite sharply.

Consider another example, the stock price of Bear Stearns. On March 10, 2008 it was $70. Six days later, it was $2 (it had been $170 a year prior). As Bear collapsed, market participants went through a non-linear (and discontiguous) transition from valuing Bear as a going concern to the realization that it was bankrupt.


Some people today argue that if the government changed the tax code back to what it was in the 1950’s then the economy would grow as it did in the. This belief flies in the face of changes that have occurred in the economy in the last 60 years. We are now in the early stages of a massive Bust, following decades of false Boom. Another difference was that they still had an extinguisher of debt in the monetary system back then. I wrote a paper comparing the tax rate during the false Boom the Bust that follows[10]. The economy is not static.

By definition and by nature, when a system is in motion then different results will come from the same input at different times. For example, if a car is on the highway at cruising speed and the driver steps on the accelerator pedal, engine power will increase. The result will be acceleration. Later, if the car is parked with no fuel in the tank, stepping on the pedal will not cause any increase in power. Opening the throttle position does something important when the engine is turning at 3000 RPM, and does nothing when the engine is stopped.

Above, we use the word dynamic as an adjective. There is also a separate but related meaning as a noun. A dynamic is a system that is not only changing, but in a process whereby change drives more change. Think of the internal combustion engine from the car, above. The crankshaft is turning, which forces a piston upwards, which compresses the fuel and air in the cylinder, which detonates at the top, forcing the piston downwards again. The self-perpetuating motion of the engine is a dynamic. This is a very important prerequisite concept for the theory of interest and prices that we are developing.


It is seductive to believe that a single variable, for example “money supply”, can be used to predict the “general price level”. However, it should be obvious that there are many variables that affect pricing, for example, increasing productive efficiency. Think about the capital, labor, time, and waste saved by the use of computers. Is there any price anywhere in the world that has not been reduced as a consequence? The force acting on a price is not a scalar; there are multiple forces.

It should be easy to list some of the factors that go into the price of a commodity such as copper: labor, oil, truck parts, interest, the price of mineral rights, government fees, smelting, and of course mining technology. One or more of these variables could be moving in the opposite direction of the others, and as a group they could be moving in the opposite direction as the money supply.

Perhaps even more importantly, the bid on copper is made by the marginal copper consumer (the one who is most price-sensitive). At the risk of getting ahead of the discussion slightly, I would like to emphasize that today the price of copper is set by the marginal bid more than by the marginal ask. The price of copper has, in fact, been in a falling trend for two years.


Modeling the economy would be much easier if people would respond to the same changes the same way each time—if they didn’t have memories, balance sheets, or any other device that changes state as a result of activity. Even Keynesians admit the existence of human memory (ironically, they call this “animal spirits”[11]), which makes someone more cautious to walk into a pit a second time after he has already learned a lesson from breaking his leg. People are not stateless.

Stateless, and its antonym stateful, is a term from computer software development. It is much simpler to write and understand code that produces its output exclusively from its inputs. When there is storage of the current state of the system, and this state is used to calculate the next state, then the system becomes incalculably more complex.

In the economy, a business that carries no debt will respond to a change in the rate of interest differently from one that is struggling to pay interest every month. A company which does not have cash flow problems but which has liabilities greater than its assets would react differently still.

An individual who has borrowed money to buy a house and then lost the house to foreclosure will look at house price combined with the rate of interest quite differently than one who has never had financial problems.

It is important not to ignore the balance sheet or human memory (especially recent memory) when predicting an outcome.


Markets (and policy outcomes) would be far more predictable, and monetary experiments far less dangerous, if all variables in the economy moved according to a smooth curve.

A run on the bank, as is occurring right now in Cyprus (in slow motion due to capital controls), is a perfect example of a discontiguous phenomenon. One day, people believe the banks are fine. The next day there may not be a measurable change in the quantity of anything, and yet people panic and try to withdraw their money. If the bank is insolvent, they cannot withdraw their money, it was already lost.

A common theme in my economic theories is asymmetry. In the case of a run on the bank, there is no penalty for being a year early, but one takes total losses if one is an hour late. This adds desperate urgency to runs on the bank, and desperate urgency is one simple cause of an abrupt and large change, i.e. discontiguity.

Ernest Hemingway famously quipped that he went bankrupt, “Two ways. Gradually, then suddenly.”[12] It’s not a smooth process.

There are many other examples, for instance a scientific breakthrough may enable a whole new industry because it reduces the cost of something by 1000 times. This new industry in turn enables other new activities and highly unpredictable outcomes occur. As an example, the invention of the transistor eventually led to the Internet. The Internet makes it possible for advocates of the gold standard to organize and coordinate their action into a worldwide movement that demands honest money. The gold standard in this example would be a discontiguous effect caused by the invention of the transistor.

My goal in Part I was to introduce these five key concepts. While not writing directly against the Quantity Theory of Money, I believe that a full grasp of these concepts and related ideas would be sufficient to debunk it.

In Part II, we will discuss the dynamic process whereby the rate of interest puts pressure on prices and vice versa. I promise it will be a non-linear, multivariate, stateful, dynamic, and discontiguous theory.

[2] We do not distinguish herein between money (i.e. gold) and credit (i.e. paper)

[3] Full disclosure: when I am not working for Gold Standard Institute, I am the CEO of Monetary Metals, which publishes a weekly picture and analysis of the gold basis. One can see through the conspiracy theories using the basis:

[9] I don’t define inflation as rising prices, but as an expansion of counterfeit credit: Inflation: an Expansion of Counterfeit Credit

[12] The Sun Also Rises by Ernest Hemingway, 1926

Gold Bonds to Avert Financial Armageddon

This paper has been published in a number of places, notably including the Gold Standard Institute.  I submitted it to the Wolfson Economics Prize.  Now it can live here permanently on my own blog site.


After the near-collapse of the financial system in 2008, a growing number of people have come to realize that our monetary disease is terminal.  It is that group to whom I address this paper.  I sincerely hope that this group includes leaders in business, finance, and government.

I do not believe that my proposal herein is necessarily “realistic” (i.e. pragmatic).  There are many interest groups that may oppose it for various reasons, based on their short-sighted desire to try to continue the status quo yet a while longer.  Nevertheless, I feel that I must write and publish this paper.  To say nothing in the face of the greatest financial calamity would go against everything I believe.


It seems self-evident.  The government can debase the currency and thereby be able to pay off its astronomical debt in cheaper dollars.  But as I will explain below, things don’t work that way.  In order to use the debasement of paper currencies to repay the debt more easily, governments will need to issue and use the gold bond[1].

I give credit for the basic idea of using gold bonds to solve the debt problem to Professor Antal Fekete, as proposed in his paper: “Cut the Gordian Knot: Resurrect the Latin Monetary Union”.  My paper covers different ground than Fekete’s, and my proposal is different as well.  I encourage readers to read both papers.

The paper currencies will not survive too much longer.  Most governments now owe as much or more than the annual GDPs of their nations (typically far more, under GAAP accounting).  But the total liabilities in the system are much larger.

Even worse, in the formal and shadow banking system, derivative exposure is estimated to be more than 700 trillion dollars.  Many are quick to insist that this is the “gross” exposure, and the “net” is much smaller as these positions are typically hedged.  But the real exposure is close to the “gross” exposure in a crisis.  While each party may be “hedged” by having a long leg and a balancing short leg, these will not “net out”.  This is because in times of stress the bid (but not the offer) is withdrawn.  To close the long leg of an arbitrage, one must sell on the bid (which could be zero).  To close the short leg, one must buy at the offer (which will still be high).  When the bid-ask spread widens that way, it will be for good reason and it does not do to be an armchair philosopher and argue that it “should not” occur.  Lots of things will occur that should not occur.

For example, gold should not go into backwardation.  This is another big (if not widely appreciated) piece of evidence that confidence in the ability of debtors to pay is waning.  Gold and silver went into backwardation in 2008 and have been flitting in and out of backwardation since then.  Backwardation develops when traders refuse to take a “risk free” profit.  That is, the trade is free from all risks except the risk of default and losing one’s metal in exchange for a defaulted futures contract.  See my paper on When Gold Backwardation Becomes Permanent for a full treatment of this topic.

The root cause of our monetary disease has its origins in the creation of the Fed and other central banks prior to World War I, and in the insane treaty signed in 1944 at Bretton Woods in which many nations agreed for their central banks to use the US dollar as if it were gold, and this paved the way for President Nixon to pound in the final nail in the coffin.  He repudiated the gold obligations of the US government in 1971, thereby plunging the whole world into the regime of irredeemable paper.

The US dollar game is a check-kiting scheme.  The Fed issues the dollar, which is its liability.  The Fed buys the US Treasury bond, which is the asset to balance the liability.  The only problem is that the bonds are payable only in the central bank’s paper scrip!  Meanwhile, per Bretton Woods, the rest of the world’s central banks use the dollar as if it were gold.  It is their reserve asset, and they pyramid credit in their local currencies on top of it.

It is not a bug, but a feature, that debt in this system must grow exponentially.  There is no ultimate extinguisher of debt.  In my paper on Inflation, I define inflation as an expansion of counterfeit credit.  I define deflation as a forcible contraction of counterfeit credit, and the inevitable consequence of inflation.  Well, we have had many decades of rampant expansion of counterfeit credit.  Now we will have deflation, and the harder the central banks try to fight it by forcing yet more expansion of counterfeit credit, the worse the problem becomes.  With leverage everywhere in the system, it would not take many defaults to wipe out every financial institution.  And there will be many defaults.   One default will beget another and once it really begins in earnest there will be no stopping the cascade.

Another key problem is duration mismatch.  Today, every bank and financial institution borrows short to lend long, many corporations borrow short to finance long-term projects, and every government is borrowing short to fund perpetual debts.  Duration mismatch can cause runs on the banks and market crashes, because when depositors demand their money, banks must desperately sell any asset they can into a market that is suddenly “no bid”.  In two papers (Fractional Reserve is Not the Problem and Falling Interest Rates and Duration Mismatch), I cover duration mismatch in banks and corporations in more depth.

Most banks and economists have supported a policy of falling interest rates since they began to fall in 1981.  But falling interest rates destroy capital, as I explain in that last paper, linked above.  As the rate of interest falls, the real burden of the debt, incurred at higher rates, increases.

Related to this phenomenon is the fact that the average duration of bonds at every level has been falling for a long time (US Treasury duration began increasing post 2008, but I think this is an artifact of the Fed’s purchases in their so-called “Quantitative Easing”).  Declining duration is an inevitable consequence of the need to constantly “roll” debts.  Debts are never repaid, the debtor merely pays the interest and rolls the principal when due.  As the duration gets shorter and shorter, the noose gets tighter and tighter.  If there is to be a real payback of debt, even in nominal terms, we need to buy more time.  At the US Treasury level, average duration is about 5 years.  I doubt that’s long enough.

And of course the motivation for building this broken system in the first place is the desire by nearly everyone to have a welfare state, without the corresponding crippling taxation.  It has been long believed by most people a central bank is just the right kind of magic to let one have this cake and eat it too, without consequences.  Well, the consequences are now becoming visible.  See my papers The Laffer Curve and Austrian Economics and A Politically Incorrect Look at Marginal Tax Rates) discussing what raising taxes will do, especially in the bust phase like we have now.

In reality, stripped of the fancy nomenclature and the abstraction of a monetary system, the picture is as simple as it is bleak.  Normally, people produce more than they consume.  They save.  A frontier farmer in the 19th century, for example, would dedicate some work to clearing a new field, or building a smokehouse, or putting a wall around a pasture so he could add to his herd.  But for the past several decades, people have been tricked by distorted price signals (including bond prices, i.e. interest rates) into consuming more than they produce.

In any case, it is not possible to save in an irredeemable paper currency.  Depositing money in a bank will just result in more buying of government bonds.  Capital accumulation has long since turned to capital decumulation.

This would be bad enough, as capital is the leverage on human effort that allows us to have the present standard of living.  We don’t work any harder than early people did 10,000 years ago, and yet we are vastly more productive due to our accumulated capital.

Now much of the capital is gone, and it cannot be brought back.  It will soon be impossible to continue to paper over the losses.  The purpose of this piece is not to propose how to save the dollar or the other paper currencies.  They are past the point where saving them is possible.  This paper is directed to avoiding the collapse of our civilization.

If we stay on the present course, I think the outcome will look more like 472 AD than 1929.  We must solve three problems to avoid that kind of collapse:

  1. Repayment of all debts in nominal terms
  2. Keep bank accounts, pensions, annuities, corporate payrolls, annuities, etc. solvent, in nominal terms
  3. Begin circulation of a proper currency before the collapse of the paper currencies, so that people have something they can use when paper no longer works

I propose a few simple steps first, and then a simple solution.  All of this is designed to get gold to circulate once again as money.  Today, we have gold “souvenir coins”.  They are readily available, and have been for many years, but they do not circulate.

A gold standard is like a living organism.  While having the right elements present and arranged in the right way is necessary, it is not sufficient.  It must also be in constant motion.  Gold, under the gold standard, was always flowing.  Once the motion is stopped, restarting it is not easy.  This applies to a corpse of a man as well as of a gold standard.

The first steps are:

  1. Eliminate all capital “gains” taxes on gold and silver
  2. Repeal all legal tender laws that force creditors to accept paper
  3. Also repeal laws that nullify gold clauses in contracts
  4. Open the mint to the (seigniorage) free coinage of gold and silver; let people bring in their metal and receive back an equal amount in coin form.  These coins should not be denominated in paper currency units, but merely ounces or grams

Each of these items removes one obstacle for gold to circulate as money, along side the paper currencies.  The capital “gains” tax will do its worst damage precisely when people need gold the most.  At that point, the nominal price of gold in the paper currencies will be rising very rapidly.  Any sale of bullion will result in a tax of virtually the entire amount, as the cost basis from even a few weeks prior will be much lower than the current price.  This amounts, in the US, to a 28% confiscation of gold.  This tax will force people to keep gold underground and not bring it to market.  It will contribute to the acceleration of permanent backwardation.

It is important to realize that gold is not “going up”.  Paper is going down.  There is no gain for the holder of gold; he has simply not lost wealth due to the debasement of paper.

Current law forces creditors to accept paper as payment in full for all debts, and there are also laws that nullify gold clauses in contracts.  Repeal them, and let creditors and borrowers negotiate something mutually agreeable.

Finally, the bid-ask spread on gold bullion coins such as the US gold eagle or the South African krugerrand is too wide.  If the mint provided seigniorage-free coinage service, then people would bring in gold bars and other forms of bullion until the bid-ask spread narrowed appropriately.  One of the attributes that gives gold its “moneyness” is its tight spread (even today, it is 10 to 30 cents per $1600 ounce!)  But currently, this tight spread only applies to large bullion bars traded by the bullion banks and other sophisticated traders.  This spread must be available to the average person.

As I said earlier, these steps are necessary.  Gold certainly will not circulate under the current leftover regime from Roosevelt and Nixon.  But it is not sufficient to address the debt problem.

Accordingly, I propose a simple additional step.  The government should sell gold bonds.  By this, I do not mean gold “backed” paper bonds.  I mean bonds denominated in ounces of gold, which pay their coupon in ounces of gold and pay the principal amount in ounces of gold.  Below, I explain how this will solve the three problems I described above.

Mechanically, it is straightforward.  The government should set a rule that, to buy a gold bond, one does not bid dollars.  One bids paper bonds!  So to buy a 100-ounce gold bond, then one could bid for example $160,000 worth of paper bonds (assuming the price of gold is $1600 per ounce).  The government retires the paper bond and in exchange replaces it with a newly-issued gold bond.

The government should start with a small tender, to ensure a high bid to cover ratio.  And a series of small auctions will give the market time to accept the idea.  It will also allow the development of gold bond market makers.

With gold bonds, it would be possible to sell long durations.  With paper, there is no good reason to buy a 30-year bond (except to speculate on the next move by the central bank).  The dollar is expected to fall considerably over a 30-year period.  But with gold, there is no such debasement.  The government could therefore exchange short-duration debt for long-duration debt.

At first, the price of the gold bonds would likely be set as a straight conversion of the gold price, perhaps adjusted for differing durations.  For example, a 100 ounce gold bond of 30 years duration might be bid at $160,000 worth of 30-year paper bond.

But I think that the bid on gold bonds will rise far above “par”, for several reasons I will discuss below.

The nature of the dynamic will become clear to more and more people in due course.  In the present regime, there is a common misconception that the yield on a bond is set by the market’s expectation of how much consumer prices will rise (the crude proxy for the loss of value for the dollar).  But this is not true.  Unlike in a gold standard, in an irredeemable paper standard, people are disenfranchised.  They have no say over the rate of interest.  The dollar system is a closed loop, and if you sell a bond then you either hold cash in a bank, which means the bank will buy a bond.  Or you buy another asset.  In which case the seller of that asset holds cash in a bank or buys a bond.  This is one of the reasons why the rate of interest has been falling for 30 years despite huge debasement.  All dollars eventually go into the Treasury bond.

The price of the paper bond today is set by a combination of central bank buying, and structural distortions in the system.  But it is a self-referential price, in a game between the Treasury and the Fed.  The price of the bond does not really come from the market.  And this impacts every other bond in the universe, which all trade at varying spreads to the Treasury.

An alternative to paper bonds would be very attractive to those who want to save and earn income for the long term, pension funds, annuities, etc.  Not only will the price of gold continue to rise (i.e. the value of the paper currency will continue to fall towards zero), but also a premium for gold bonds would develop and grow.  The quality asset will be recognized to be worth more, and at the least people would price in whatever rate of the price of gold they expect to occur over the duration of the bond.

This dynamic—a rising price of gold, and a rising exchange value of gold bonds for paper bonds—will allow governments and other debtors to use the devaluation of paper as a means to repay their debts in nominal terms, but affordably in real terms.

This is impossible under paper bonds!  This is because the process of debasement is a process of the Treasury borrowing more money.  Debt goes up to debase the dollar.  This path leads not to repayment of the debt cheaply, but to exponentially growing debt until a total default.

So we have solved problem number one.  With a rising gold price, and a rising exchange rate of gold bonds for paper bonds, we have set up a dynamic whereby every paper obligation can be met in nominal terms.  Of course, the value of that paper will be vastly lower than it is today.  This is the only way that the immense amounts of debt outstanding can possibly be honored.

This also solves problem number two.  If every financial institution is repaid every nominal dollar it is owed, then they will remain solvent.  To be sure, pension payments, bank accounts, corporate payroll, and annuities etc. will be of much lower real value.  But there is a critical difference between smoothly losing value vs. abruptly losing everything, along with catastrophic failure of the financial system.

I want to address what could be a misconception at this point.  Does this work only for governments that have gold reserves in the vaults?  No, this is not about gold reserves.  While that may help accelerate a gold bond program, the essential is not gold stocks but gold flows.  The government issuer of gold bonds must have a gold income (or a credible plan to develop one quickly). 

And this leads to problem number three.  Gold does not circulate today.  Who has a gold income?  That is where we must look to begin the loop.  There is one kind of participant today who has a gold income: the gold miner.  Beset by environmentalist lawsuits, regulations, permits, impact studies, fees, labor law, confiscatory taxes, and other obstacles created by government, these companies still manage to extract gold out of the ground.

The gold miners are the group to which we must turn to help solve the catch-22 of getting gold to circulate from the current state where it does not.  I think there is a simple win-win proposition to offer them.  In exchange for exemptions from the various taxes, regulations, environmentalism, etc. they have a choice to pay a tax in gold bullion.

There are other kinds of entities to consider taxing, but the problem is that they all would need to buy gold in the open market in order to pay the tax.  As the price begins to rise exponentially, this will be certain bankruptcy for anyone but a gold miner.

And now, look at the progress we’ve made on the problem of getting gold to circulate.  We have gold miners paying tax in gold to governments who are making bond coupon payments in gold to investors who now have a gold income.  We can see how gold bond market makers will enter the scene, and earn a gold income to provide liquidity for bonds that are not “on the run”.  These bond market makers could pay a tax in gold also.

And we have released other creditors from any restriction in lending and demanding repayment in gold.  And anyone else in a position to sign a long-term agreement involving a stream of payments over a long period of time, such as landlords, can incorporate gold clauses in their contracts.  And if the tenant has a gold income, perhaps from owning a gold bond, he can manage his cash flows and confidently sign such a lease.

Note that the lender, unlike the employee, the restaurant, or most other economic actors, is in a position to demand gold.  While everyone else would like to be paid in gold, they haven’t got the pricing power to demand it.  The lender can say: “if you want my capital, you must repay it in gold!”

If enough gold bonds are issued soon enough, we may reverse the one-way flow of gold from the markets into private hiding, that is inexorably leading to inevitable permanent backwardation and the withdrawal of all gold from the system.

One of the key points in my backwardation paper is that the value of the dollar collapses to zero not as a consequence of the quantity of dollars rising to infinity, but because of the desire of some dollar holders to get gold.  If they cannot trade paper for gold, then they will trade paper for commodities without regard to price and trade those commodities for gold.  This will cause the price of the commodities in dollar terms to rise to levels that make the dollar useless in trade (and collapse the price of commodities in gold terms).

If we reverse the flow of gold out of the markets, we may be able to prevent this disaster from occurring.  The dollar will then continue to lose value in a continuous (if accelerating) manner, as people migrate to gold.

This is the best outcome that could possibly be hoped for.  If it occurs along with a reduction in spending so that spending does not exceed (tax) revenues, we will avert Armageddon and be on the path to a proper and real recovery.  To be clear, times will be hard and the average standard of living will decline precipitously.

But this is infinitely preferable to total collapse.

It is now up to farsighted leaders, especially in government, to take the first concrete steps towards saving Western Civilization.

[1] Wherever I refer to gold, I also mean silver.  For the sake of brevity and readability I will only say gold in most cases.