SNB sign

The Swiss Franc Will Collapse

I have worked to keep this piece readable, and as brief as possible. My grave diagnosis demands the evidence and reasoning to support it. One cannot explain the collapse of this currency with the conventional view. “They will print money to infinity,” may be popular but it’s not accurate. The coming destruction has nothing to do with the quantity of money. It is a story of what happens when interest rates fall into a black hole.


Yields Have Fallen Beyond Zero

The Swiss yield curve looks like nothing so much as a sinking ship. All but the 20- and 30-year bonds are now below the water line.

Swiss Yield Curve Jan23

Look at how much it’s submerged in just one week. The top line (yellow) is January 16, and the one below it was taken just a week later on January 23. It’s terrifying how fast the whole interest rate structure sank. Here is a graph of the 10-year bond since September. For comparison, the 10-year Treasury bond would not fit on this chart. The US bond currently pays 1.8%.

Swiss 10-year history

The Swiss 10-year yield was as high as 37 basis points on Friday January 2. By the next Monday, it had plunged to 28, or -25%. By January 15—the day the Swiss National Bank (SNB) announced it was removing the peg to the euro—the yield had plunged to just 7 basis points. It has been nonstop freefall since then, currently to -26 basis points.

What can explain this epic collapse? Why is the entire Swiss bond market drowning?

Drowning is a fitting metaphor. In my dissertation, I describe several harbingers of financial and monetary collapse. The first is when the interest interest rate on the long bond goes to zero. I discuss the fact that a falling rate destroys capital, and that lower rates mean a higher burden of debt. If the long bond rate is zero then the net present value of all debt (which is effectively perpetual) is infinite. Debtors cannot carry an infinite burden. As we’ll see, any monetary system that depends on debtors servicing their debt must collapse when the rate goes to zero.

I think the franc has reached the end. With negative rates out to 15 years, and a scant 33 basis points on the 30-year, it is all over but the shouting.

Not Printing, Borrowing

Let’s take a step back for a moment, and look at how the recent chapter unfolded. It began with the SNB borrowing mass quantities of francs. Most people say printed, but it’s impossible to understand this unprecedented disaster with such an approximate understanding. It’s not printing, but borrowing.

Think of a homebuyer borrowing $100,000 to buy a house. He never gets the cash in his bank account. He signs a bunch of paperwork, and then at the end of the day he has a debt obligation to repay, plus the title to the house. The former owner has the cash.

It works the same with any central bank that wants to buy an asset. At the end of the day, the bank owns the asset, and the former owner of the asset now holds the cash. This cash is the debt of the central bank. It is on the bank’s balance sheet as a liability. The bank owes it.

This is vitally important to understand, and it can be quite counterintuitive. If one thinks of the franc (or dollar, euro, etc.) as money, and if one thinks that the central banks print money, then one will come to precisely the wrong conclusion: that there is nothing owed, and indeed there is no debtor. In this view, the holder of francs has cash, which is a current asset. End of story.

This conclusion could not be more wrong.

Certainly, the idea of the central bank repaying its debt is absurd. By law, payment is deemed made when the debtor pays in currency—i.e. francs in Switzerland. However, the franc is the very liability of the SNB that we’re discussing. How can the SNB pay off its franc liabilities using its own franc liabilities as means of payment?

It can’t. This is a contradiction in terms. Thus it’s critical to understand that there is no extinguisher of debt in the regime of irredeemable paper currency. You may get yourself out of the debt loop by paying in currency, but that merely shifts the debt. The debt does not go out of existence, because paying a debt with an IOU cannot extinguish it. Unlike you, the central bank cannot get itself out of debt.

However, it can service its debt. For example, the Federal Reserve in the U.S. pays interest on reserves. Indeed, the bank must service its debts. It would be a calamity if a payment is missed, if the central bank ever defaulted.

The central bank must also maintain its liabilities, which is what it uses to fund its assets. If the commercial banks withdraw their deposits—and they do generally have a choice—the central bank would be forced to sell its assets. That would be contrary to its policy intent, not to mention quite a shock to brittle economies.

Make no mistake, a central bank can go bankrupt. This may seem tricky to understand, as the law makes its liability legal tender for all debts public and private. A central bank is also allowed to commit acts of accounting (and leverage) that would not be tolerated in a private company. Regardless, it can present misleading financial statements, but even if the law lets it get away with that, reality will have its revenge in the end. The emperor may claim to be wearing magnificent royal robes, but he’s still naked.

If liabilities exceed assets, then a bank—even a central bank—is insolvent and the consequences will come soon enough. The cash flow from the assets will sooner or later become insufficient to pay the interest on the liabilities. No central bank wants to be in a position where it is obliged to borrow, not to purchase asset but to service a negative cash flow. That is a rapid death spiral. It must somehow push down the interest rate on its liabilities (which are typically short term) to keep the cost of financing its portfolio below the revenue generated on the assets.

This becomes increasingly tricky when two things happen. One, the yield on the asset goes negative. Thus, the even-more-negative (and even more absurd) one-day rate of -400 basis points in Switzerland. Two, the issuance of more currency drives down yields even further (described in detail, below).

Events force the hand of the central bank. It goes down a path where it has fewer and fewer choices. That brings us back to negative interest rates out to the 15-year bond so far.

The Visible Hand of the Swiss National Bank

So the SNB issued francs to fund its purchase of euros. Next, it spent the euros on whatever Eurozone assets it wished to buy, such as German bunds.

It’s well known that the SNB put on a lot of this trade to keep the franc down to €0.83 (the inverse of keeping the euro down to CHF1.2) l. It also helped push down interest rates in Europe. The SNB was a relentless buyer of European bonds.

That leads to the question of what it did in Switzerland. The SNB was trading new francs for euros. That means the former owner of those euros then owned francs. These francs have to stay in the franc-denominated domain. What asset will this new franc owner buy?

I frame the question this way deliberately. If you have a 100-franc note, you can put it in your pocket. If you have CHF100,000, you can deposit it in a bank. If you have CHF100,000,000 (or billions) then you are going to buy a bond or other asset (depositing cash in a bank just pushes it to the bank, who buys the asset).

The seller of the asset is selling on an uptick. He gives up the bond, because at its higher price (and hence lower yield) he now finds another asset more attractive on a risk-adjusted basis. Risk includes his own liquidity risk (which of course rises as his leverage increases).

As the SNB (and many others) relentlessly push up the bond price, and hence push down the yield, the sellers of the ever-lower yielding bonds have fresh new franc cash balances.

The Quantity Theory of Money holds that the demand for money falls as the quantity rises. If demand for money falls, then by this definition the prices of all other things—including consumer goods—rises. It is commonly held that people tradeoff between saving money vs. spending money (i.e. consumption). The prediction is rising consumer prices.

I emphatically disagree. A wealthy investor does unload his assets to go on an extra vacation if he doesn’t like the bond yield. A bank with a trillion dollar balance sheet does not dole out bigger salaries if its margins are compressed.

So what does trade off with government bonds? If an investor doesn’t want to own a government bond, what else might he want to own? He buys corporate bonds, stocks, or rental real estate, thus pushing up their prices and yields down.

And then, in a dysfunctional monetary system, you can add antique cars, paintings, a second and third home, etc. These things serve as surrogates for investment. When investing cannot produce an adequate yield, people turn to non-yielding non-investment assets.

The addition of a new franc at the margin perturbs the previous equilibrium of risk-adjusted yields across all asset classes. Every time the bond price goes up, every owner of every franc-denominated asset must recalculate his preferences.

The problem is that the SNB does not create any more productive investment opportunities when it spills more francs into the Swiss financial system. Those new francs have to chase after the existing assets.

Yields are falling. They necessarily had to fall.

An Increasing Money Supply and Decreasing Interest Rate

The above discussion describes the picture in every developed economy. Interest rates have been falling for 34 years in the U.S., for example.

In a free market, the expansion of credit would be driven by a market spread: available yield – cost of borrowing. If that spread is too small (or negative) there will be no more borrowing to buy assets. If it gets wider, then banks can spring into action.

However, central banks distort this. Instead of the cost of borrowing being a market-determined price, it is fixed by the central bank. This perverts the business model of a bank into what is euphemistically known as maturity transformation—borrowing short to lend long. It’s not possible for a bank to borrow money from depositors with 5-year time deposit accounts in order to buy 5-year bonds. The bank has to borrow a shorter duration and buy a longer, in order to make a reasonable profit margin.

If the central bank sets the borrowing cost lower and lower, then the banks can bid up the price of government bonds higher and higher (which causes a lower and lower yield on the long bond). This is not capitalism at all, but a centrally planned kabuki theater. All of the rules are set by a non-market actor, who can change them for political expediency.

The net result is issuance of credit far beyond what could ever happen in a free market. This problem is compounded by the fact that the central bank cannot control what assets get bought when it buys bonds. It hands the cash over to the former bond holders. It’s trying to accomplish something—such as keeping the franc down in the case of the SNB, or preventing bankruptcies, in the case of the Fed—and it has no choice but to keep flooding the market until it achieves its goal. In the US, the rising tide eventually lifted all ships, even the leaky old tubs. The result is a steeper credit gradient, and the bank can eventually force liquidity out to its target debtors.

The situation in Switzerland makes the Fed’s problems look small by comparison. Unlike the Fed, which had a relatively well-defined goal, the SNB put itself at the mercy of the currency market. It had no particular goal, and therefore no particular budget or cost. The SNB was fighting to hold a line against the world. While it kept the franc peg, the SNB put pressure on both Swiss and European interest rates.

Something changed with the start of the year. We can understand it in light of the arbitrage between the Swiss bond, and other Swiss assets. The risk-adjusted rate of return on other assets always has to be greater than that of the Swiss government bond (except perhaps at the peak of a bubble). Otherwise why would anyone own the higher-risk and lower-yield asset?

Therefore, there are three possible causes for the utter collapse in interest rates in Switzerland beginning 10 days prior to the abandonment of the peg:

1. the rate of return of other assets has been leading the drop in yields
2. buying pressure on the franc obliged the SNB to borrow more francs into existence, fueling more bond buying
3. the risk of other assets has been rising (including liquidity risk to their leveraged owners)

#1 is doubtful. It’s surely the other way around. It’s not falling yields on real estate driving falling yields on bonds. Bond holders are induced to part with their bonds on a SNB-subsidized uptick. Then they use the proceeds to buy something else, and drive its yield down.

One fact supports conclusion #2. Something forced the SNB to remove the peg. Buying pressure is the only thing that makes any sense. The SNB hit its stop-loss.

The rate of interest continued to fall even after the SNB abandoned its peg. Why? Reason #3, rising risks. Think of a bank which borrowed in Swiss francs to buy Eurozone assets. This trade seemed safe with the franc pegged to the euro. When the peg was lifted, suddenly the firm was faced with a staggering loss incurred in a very short time.

The overreaction of the franc in the minutes following the SNB’s policy change had to be the urgent closing of Eurozone positions by many of these players. The franc went from €0.83 to €1.15 in 10 minutes, before settling down near €0.96. For those balance sheets denominated in francs, this looked like the euro moved from CHF1.20 to CHF0.87, a loss of 28%. What would you do, if your positions instantly lost so much? Most people would try to close their positions.

Closing means selling Eurozone assets to get francs. Then you need to buy a franc-denominated asset, such as the Swiss government bond. That clearly happened big-time, as we see in the incredible drop in the interest rate in Switzerland. Francs which had formerly been used to fund Eurozone assets must now be used to fund assets exclusively in the much-smaller Swiss realm.

In other words, a great deal of franc credit was used to finance Eurozone assets. This is a big world, and hence the franc carry trade didn’t dominate it. When those francs had to go home and finance Swiss assets only, it capsized the market.

And the entire yield curve is now sinking into a sea of negative rates.

The Consequences of Falling Interest

Meanwhile, unnaturally low interest is offering perverse incentives to corporations who can issue franc-denominated liabilities. They are being forced-fed with credit, like ducks being fatted for foie gras. This surely must be fueling all manner of malinvestment, including overbuilding of unnecessary capacity. The hurdle to build a business case has never been lower, because the cost of borrowing has never been lower. The consequence is to push down the rate of profit, as competitors expand production to chase smaller returns. All thanks to ever-cheaper credit.

Artificially low interest in Switzerland is causing rising risk and, at the same time, falling returns.

The Swiss situation is truly amazing. One has to go out to 20 years to see a positive number for yield—if one can call 21 basis points much of a yield.

It’s not only pathological, but terminal. This is the end.

In Switzerland, there is hardly any incentive remaining to do the right things, such as save and invest for the long term. However, there’s no lack of perverse incentives to borrow more and speculate on asset prices detaching even further from reality.

Speculation is in its own class of perversity. Speculation is a process that converts one man’s capital into another man’s income. The owner of capital, as I noted earlier, does not want to squander it. The recipient of income, on the other hand, is happy to spend some of it.

We should think of a falling interest rate (i.e. rising bond market and hence rising asset markets) as sucking the juice (capital) out of the system. While the juice is flowing, asset owners can spend, and lots of people are employed (especially in the service sector).

For example, picture a homeowner in a housing bubble. Every year, the market price of his house is up 20%. Many homeowners might consider borrowing money against their houses. They spend this money freely. Suppose a house goes up in price from $100,000 to $1,000,000 in a little over a decade. Unfortunately, the debt owed on the house goes up proportionally.

With financial assets, they typically change hands many times on the way up. In each case, the sellers may spend some of their gains. Certainly, the brokers, advisors, custodians, and other professionals all get a cut—and the tax man too. At the end of the day, you have higher prices but not higher equity. In other words, the capital ratio in the market collapses.

To understand the devastating significance of this, consider two business owners. Both have small print shops. Both have $1,000,000 worth of presses, cutters, binding machines, etc. One owns everything outright; he paid cash when he bought it. The other used every penny of financing he could get, and has a monthly payment of about $18,000. Both shops have the same cost of doing business, say $6,000. If sales revenues are $27,000 then both owners may feel they are doing well. What happens if revenues drop by $3,500? The all-equity owner is fine. He can reduce the dividend a bit. The leveraged owner is forced to default. The more your leverage, the more vulnerable you are to a drop in revenues or asset values.

Falling interest, and its attendant rising asset prices, juices up the economy. People feel richer (especially if their estimation of their wealth is portfolio value divided by consumer prices) and spend freely. Unfortunately, it becomes harder and harder to extract smaller and smaller drops of juice. The marginal productivity of debt falls.

Think about it from the other side, the borrower. The very capacity to pay interest has been falling for decades. A declining rate of profit goes hand-in-hand with a falling rate of interest. Lower profit is both caused by lower interest, and also the cause of it. A business with less profit is less able to pay interest expense. Who could afford to pay rates that were considered to be normal just a few decades ago? It is capital that makes profit, and hence capacity to pay interest, possible. And it is capital that’s eroded by falling rates.

The stream of endless bubbles is just the flip side of the endless consumption of capital. Except, there is an end. There is no way of avoiding it now, for Switzerland.

How About Just Shrinking the Money Supply?

Monetarists often tell us that the central bank can shrink the money supply as well as grow it, and the reason why it’s never happened is, well… the wrong people were in charge.

I disagree.

To see why, let’s look at the mechanism for how a central bank expands the money supply. It issues cash to an asset owner, and the asset changes hands. Now the bank owns the asset and the seller owns the cash (which he will promptly use to buy the next best asset). A relentlessly rising bond price is lots of fun. It’s called a bull market, and everyone is making profits as they reckon them (actually consuming capital, as we said above).

How would a contraction of the money supply work? It seems simple, at first. The central bank just sells an asset and gets back the cash. The cash is actually its own liability, so it can just retire it. And voila. The money supply shrinks.

Not so fast.

There is an old saying among traders. Markets take the escalator up, but the elevator down. Central bank buying slowly but relentlessly bid up the price of bonds. Tick by tick, the bank forced it up. What would central bank selling do? What would even a rumor of massive central bank selling do?

Bond prices would fall sharply.

The problem is that few can tolerate falling bond prices, because everyone is leveraged. Think about what it means for everyone to borrow and buy assets, for sellers to consume some profits and reinvest the proceeds into other assets. There is increasingly scant capital base supporting an increasingly inflated—as in puffed-up with air, without much substance—asset market. A small decline in prices across all asset classes would wipe out the financial system.

Market participants have to be leveraged. Dirt cheap credit not only makes leverage possible, but also necessary. How else to keep the doors open, without using leverage? Spreads are too thin to support anyone, unlevered.

Banks are also maturity mismatched, borrowing short to lend long. The consequences of a rate hike will be devastating, crushing banks on both sides of the balance sheet. On the liabilities side, the cost of funding rises with each uptick in the interest rate. On the asset side, long bonds fall in value at the same time. If short-term rates rise enough, banks will have a negative cash flow.

For example, imagine owning a 10-year bond that pays 250 basis points. To finance it, you borrow at 25 basis points. Well, now imagine your financing cost rises to 400 basis points. For every dollar worth of bonds you own, you lose 1.5 cents per year. This problem can also afflict the central bank itself.

You have a cash flow problem. You are also bust.

The Bottom Line

The problem of falling rates is crushing everyone, but raising the rate cannot fix the problem. It should not be surprising that, after decades of capital destruction—caused by falling rates—the ruins of a once-great accumulation of wealth cannot be repaired by raising the interest rate.

I do not see any way out for the Swiss National Bank and the franc, within the system of irredeemable paper money. However, unless the SNB can get out of this jam, the franc is doomed. I can’t predict the timing, but I believe the fuse is lit and the powder keg could go off at any time.

One day, a bankruptcy will happen. Soothing voices will assure us it was unexpected. Then another will happen, perhaps triggered by the first or perhaps not. Then the cascading begins. One party’s liabilities are another’s assets. ABC’s bankruptcy wipes out DEF’s asset. Since DEF is leveraged, it cannot absorb much loss until it, too, is dragged under.

Somewhere in the midst of this, people will turn against the franc. Today, it’s arguably the most loved paper currency. However, I don’t think it will take too many capital losses in Switzerland, before there is a selling stampede. The currency will fall to zero, in a repeat of a pattern that the world has seen many times before.

People will call it hyperinflation (I don’t prefer that term). Call it what you will, it will be the death of the franc. It will have nothing to do with the quantity of money.

Two factors can delay the inevitable. One, the SNB may unwind its euro position. As this will involve selling euros to buy francs, the result will be to put a firm bid under the franc. Two, speculators will of course know this is happening and eagerly front-run the SNB. After all, the SNB is not an arbitrager buying when it can make a spread. It is a buyer by mandate (in this scenario) and must pay the ask price. Even if the SNB does not unwind, speculators may buy the franc and wait for it to happen. And of course, they could also buy based on a poor understanding of what’s happening, or due to other perverse incentives in their own countries.

Bankruptcies aside, the franc is already set on a hair-trigger. Something else could trip it and begin the process of collapse. There is little reason for holding Swiss francs in preference to dollars. The interest rate differential is huge. The 10-year US Treasury pays 1.8%. Compare that to the Swiss bond which charges you 26 basis points, and the difference is over 208 points in favor of the US Treasury. Once the risk of a rising franc is taken out of the market (by time or price action) this trade will commence. A falling franc against the dollar will add further kick to this trade. A trickle could become a torrent very quickly.

I would not be surprised if the process of collapse of the franc began next week, nor if it lingered all year. This kind of event is not susceptible to a precise prediction of when.

What is clear is that, once the process begins in earnest, it will be explosive, highly non-linear, and over quickly (I would guess a matter weeks).


I plan to publish a separate paper revisiting my Gold Bonds to Avert Financial Armageddon thesis in light of the Swiss crisis. I will save for that paper my assessment of whether or how gold bonds can provide a way out for the Swiss people trapped in the terminal phase of irredeemable paper money.

The Credit Gradient

The United States, and every country, is subject to a monetary authority and legal tender laws. Here in the U.S. we have the Federal Reserve, a central bank that plans money and credit. The Fed thought they had perfected their planning (but of course it cannot be perfected). They thought they had ended the boom and bust cycle, and brought us into a brave new era, their so-called great moderation that ended in 2008. All they really did was manage the banking system to the brink of insolvency.

Let’s try a thought experiment. Suppose the monetary central planner attempts to fix the problem of insolvency by massive injections of liquidity. The central bank buys bonds. It dictates rates near zero on the short end of the yield curve, and promises not to raise rates for years to come. What perverse outcome would we expect?

Arbitrageurs see a green light, telling them that they can safely borrow short to buy long bonds. As the price of a bond goes up, the rate of interest goes down—it’s a rigid mathematical inverse. This is how suppression of short-term rates causes suppression of long-term rates.

This poses a problem for investors. Every investor has a minimum yield he must earn in order to meet his goals, such as retirement. When the yield available in government bonds falls, this gives the investor a strong push to other bonds with higher yields. Some Treasury bond owners sell, and go into AAA corporate bonds. This, of course, pushes up bond prices and pushes down the yield. This pushes some AAA corporate investors into AA bonds. And so on.

The net yield earned by every investor is pushed lower. However, at each step in the process, the effect is diminished. The wave of credit does not quite make it all the way to the other side of the pool, where the small businesses are trying to get wet.

In a free or semi-free market, credit is generally plentiful and inexpensive for mature, large enterprises. When well managed, these companies offer a low credit risk. Conversely, it has always been difficult for startups to obtain credit. When they can get it, they have to pay dearly. In other words, there is a credit gradient.

A gradient describes a change in concentration of something as you move through a range of coordinates. For example, this is a color gradient.

color gradient

Of course, there is always a credit gradient. Only now, the Federal Reserve has exaggerated it to an extreme. They have made the gradient steeper.

The biggest players are drunk, chugging as much as they want. At the same time, the scrappy disruptors with the greatest opportunities to improve our world are more dehydrated than ever. Worse yet, the innovators have to try to compete for resources with the large corporations.

The credit gradient is artificially enhanced. The end result is not surprising.

I came across this paper, by the Brookings Institute. Authors Ian Hathaway and Robert Litan found that “Like the population, the business sector of the U.S. economy is aging. … The share of firms aged 16 years or more was 23 percent in 1992, but leaped to 34 percent by 2011—an increase of 50 percent in two decades.”

Entrepreneurial young companies are not hiring, or in many cases, surviving. The older, larger ones are all that remain. Their hiring is anemic compared to that of younger companies. The proof is in the labor force participation rate, which shows the percentage of working age people who are employed or seeking employment. It is now down to a level last seen during the Carter Administration in the late 1970’s.

labor part

Although there are other factors that contribute to this dismal reality including minimum wage and labor law, taxes, environmentalism, subsidies for crony companies, and regulations, the artificially enhanced credit gradient deserves the lion’s share of the blame.

Legal Tender Renders Planning Impossible

There is much confusion over what the legal tender law does. I have read articles, written by people who are otherwise knowledgeable about economics, claiming that legal tender forces merchants to accept dollars under threat of imprisonment. Recently, I wrote a short article for Forbes clarifying how legal tender law works in the US.

Legal tender law has nothing to do with merchants. If you want to sell steak dinners in your restaurant for silver, you may legally have at it. Unfortunately, the tax code discourages your would-be customers as I wrote in another article.

The legal tender law targets the lender. It grants to debtors a right to repay a debt in dollars. In practice, this means that if you lend gold, the debtor gets a free put option at your expense. If the gold price rises, he can repay in dollars. If it falls, of course he will be happy to repay in gold. It’s a rotten deal for the lender.

The relationship between lender and borrower is mutually beneficial, or else it would not exist. The parties are exchanging wealth and income, creating new wealth and new income in the process. The government is displeased by this happy marriage, and busts it up by sticking a gun in the lender’s face. His right to expect his partner to honor a signed agreement is violated.

Because no lender will lend gold under such circumstances, gold is relegated to hoarding and speculation only. This strikes a blow to savers, because the best way to save is to lend and earn interest. Savers are forced to choose between hoarding gold, getting no yield, or holding dollars and getting whatever yield crumbs are dropped by the Fed.

If there’s no lending in gold, what takes its place? The Fed force-feeds credit in ever-larger amounts, and at ever-falling interest rates.

The Fed is supposed to make its credit decisions in order to optimize two variables. First, employment shouldn’t be too high or too low. Second, consumer prices shouldn’t rise too quickly or too slowly. The Fed has little ability to predict employment and prices, and even less control over them.

Most Fed critics focus on the quantity of money. Is there too much, or too little? Is the rate of increase too fast or too slow? Is monetary policy too tight or too loose? Lost in this noise is any discussion of who the lender is.

If you buy Treasury bonds, then you know you are lending to the government. You are enabling welfare spending, and a few cases of lending to such worthy activities as housing speculation.

What if you don’t? Well if you deposit dollars in a bank, you are funding the bank’s purchase of Treasury and other bonds. You know, or reasonably ought to know, that this money is being lent.

But suppose you don’t even do that. Suppose you keep a wad of dollar bills under the mattress. You are still lending. The dollar is the Fed’s credit paper. You are financing the Fed’s activities, which consist of buying Treasury bonds and various other bonds.

You’re the patsy. You are the lender.

Anybody who wants to earn dollars is bringing demand for dollars to the market—in other words, making a bid on dollars. With what do they bid? They bid with their labor, with tangible goods, and with land. All assets today are bidding on the dollar, though most people look at it inside out. They think that all assets are offered for sale at the right price.

In any case, this universal bid on the dollar provides credit to the Fed. By placing wealth in the Fed’s hands, everyone gives it their savings to lend out.

Forget about what this does to consumer prices. There are much more serious implications. In place of the delicate, mutually beneficial relationships involved in lending, the Fed sucks the savings from the people, and pumps it out at high pressure. The Fed’s indiscriminate deluge of credit is not a substitute for individual thinking, planning, acting, and lending.

The consequence is incalculable destruction.

The legal tender law does not attack the ability to do a trade here and now, “cash on the barrel head.” It attacks something subtler but just as important. It destroys your ability to plan long range, to prepare for the passage of time. Time is a universal in the human experience. We all work during our adulthood with urgency, because some day we will grow old and be unable to work. To plan for that day, we save while we work and lend our savings to earn interest.

The motivation to borrow also comes from planning for the passage of time. The entrepreneur wants to start or grow a business now, while he has the opportunity, and energy. That’s why he is willing to pay interest out of part of his profits.

In a loan, the borrower gets money immediately, but the lender gets paid later. Time is an integral part of the deal, as one party prefers to be paid later.

In the free market, nothing comes between the saver and the entrepreneur. In central banking, by contrast, the legal tender law attacks the very heart of the free market, like an insidious poison. It disenfranchises the saver, enabling the Fed to plunder his nest egg and undermine his retirement plans.

At the same time, the Fed abuses the hapless entrepreneur too. It lures him to borrow with the promise of low rates, and then like Lucy pulling the football out from under Charlie Brown, cuts the interest rate again. This drives down his profit margin and plunders his capital.

Legal tender law takes away your ability to plan for the future. It replaces a hundred million individual decisions whether or not to have tea, with a giant high-pressure fire hose that blasts hot wastewater indiscriminately. No matter whether they open the spigot further, or close it slightly, the scalding deluge of Fed credit is not in any way equivalent to the individual planning, saving, and borrowing that would go on if we had a free market.

The Lazy 1970’s vs. the Frenetic 2000’s

Many people today see the Fed’s Quantitative Easing as money printing. They remember what happened in the 1970’s, and they instantly jump to conclusions. However, we live in a different world. To illustrate this, consider the following story about Joe, a promising and eager young manager in a struggling manufacturing company.

Joe excitedly walks into the boardroom and pitches his idea. “Let’s borrow a billion dollars. We can use it to build a massive warehouse and to buy massive quantities of our raw materials!”

The senior management team stares at him. The CEO demands, “Why?”

“We need to have a stockpile at every level. We should start with 3 months of raw materials, and a three-month buffer of work-in-progress in between every one of the 27 steps of our manufacturing line. And even better, we need to warehouse finished product. We shouldn’t ship anything that hasn’t been sitting for at least 4 months. Ideally six, but we can start with four.” Joe has the bit in his teeth now.

He rushes on. “Bernanke has printed so much money, and Yellen is going to continue. We already have massive inflation and it’s going to get worse! By borrowing to buy stuff that is only going up in price, we can make extra profits and protect ourselves from supply shocks as the cost of commodities rises out of sight!”

The CFO leans over to whisper in the ear of a young assistant, Bill. Bill does a quick Google search and finds the price of copper, which is one of the most important raw materials the company buys. Bill puts the copper chart up on the screen. It has fallen a third over the past few years.

Joe will be lucky to remain employed when he leaves the room. To be fair to him, his mistake is simply to try to implement a business strategy around what most casual observers and many economists believe.

Sometimes, the best way to debunk an idea is to take it seriously.

Though it makes no sense today, holding inventory was not the crazy idea of a young fool back in the 1970’s. It was how many businesses conducted business. In that era, the game was to accumulate inventories. The more, the better. First people were trading excess cash for inventories. I can recall my parents stockpiling things like canned tuna fish. It was better to keep one’s wealth stored in a durable food product than in a bank account. Consumer prices were rising about 20 percent per year.

Next, companies began selling bonds to finance inventory growth. This pushes down the bond price, which is the same thing as pushing up the interest rate. And of course it pushes up prices.

In the 1970’s, cash was trash. Inventories rose relentlessly in value, at least as measured in terms of the dollar. This, by the way, is a great example of how irredeemable money distorts the economy. You aren’t producing any more, or creating any kind of new wealth, and yet, you are rewarded with a profit.

Now we have the opposite condition. Since the interest rate began falling in the early 1980’s, companies have been finding ways to reduce inventory accumulation. The Lean manufacturing movement began to gain acceptance at this time. Lean, also known as the Toyota Way, defines inventory—such as work-in-progress sitting on a shelf—as waste. Lean is all about eliminating waste.

Today, cash is king. Excess inventory quickly become obsolete.

Companies are not borrowing to hold inventory, but to expand production when they can make a profit above the cost of capital. Since the interest rate keeps falling, the hurdle to get over for minimum acceptable profit keeps going lower.

Think of it this way, if you manufactured handheld electronic devices, would you want to keep inventory a minute longer than you had to? Of course not, because your competitor is about to release a new model that will make your product less desirable, or even unsalable. How about clothing? Cars?

In the 1970’s, the interest rate was rising. When a worn-out plant needed replacing, it may not have been feasible to borrow to replace it. That’s because the new interest rate was much higher than at the time when the plant was first acquired, a decade or more earlier.

This is the connection between the rate of interest and the rate of profit. It’s impossible to borrow at a higher rate than the profit one hopes to earn. A rising rate will therefore lead to rising margins, and a falling rate to falling margins.

Other than the problem of financing plant replacement, business was easy. Sleepy conglomerates had travel policies that allowed managers and executives to fly first class, even for domestic travel. With the cost of borrowing rising all the time, profit margins were expanding. And there was the kicker, holding inventory before selling it fattened margins further.

Business had a lazy pace to it, as I look at it today (though business managers at the time might not have agreed with that characterization).

In comparison, today it is the opposite. Limitless oceans of dirt-cheap credit issue forth, like effluent from the world’s central banks. The problem is not replacing worn-out plant when the cost of capital is higher. The problem is that every competitor has ever-cheaper cost of capital. The challenge is that rapid product cycles are driving rapid obsolescence. It is harder and harder to recoup design and tooling expenses. Inventory that sits for a week may have to be liquidated at a massive discount. Profit margins are under constant pressure.

Business executives routinely fly coach, even for international travel.

If the word for the 1970’s business environment was lazy, the word for today’s climate is frenetic.

Neither is the ideal behavior for a rational enterprise. They are the direct fault of the regime of irredeemable paper money.

Everyone’s attention is misdirected towards prices. Is the Consumer Price Index rising? Is it rising more than expected? How about the producer price index? Is that dropping into the dread D-word—deflation?

It’s the greatest economic sleight of hand ever perpetrated.

Instead of zeroing in on prices, we should be looking at the enormous distortions of our centrally banked irredeemable currency. We have bubbles, malinvestment, insolvencies, volatility, with exponentially rising debt and derivatives outstanding.

The Theory of Interest and Prices in Practice

Medieval thinkers were tempted to believe that if you throw a rock it flies straight until it runs out of force, and then it falls straight down. Economists are tempted to think of prices as a linear function of the “money supply”, and interest rates to be based on “inflation expectations”, which is to say expectations of rising prices.

The medieval thinkers, and the economists are “not even wrong”, to borrow a phrase often attributed to physicist Wolfgang Pauli. Science has to begin by going out to reality and observing what happens. Anyone can see that in reality, these tempting assumptions do not fit what occurs.

In my series of essays on interest rates and prices, I argued that the system has positive feedback and resonance, and cannot be understood in terms of a linear model. When I began this series of papers, the rate of interest was still falling to hit a new all-time low. Then on May 5,2013, it began to shoot up. It rose 83% over a period of exactly four months. That may or may not have been the peak (it has subsided a little since then).

Several readers asked me if I thought this was the beginning of a new rising cycle, or if I thought this was the End (of the dollar). As I expressed in Part VI, the End will be driven by the withdrawal of the gold bid on the dollar. Since early August, gold has become more and more abundant in the market. I think it is safe to say that this is not the end of the dollar, just yet. The hyperinflationists’ stopped clock will have to remain wrong a while longer. I said that the rising rate was a correction.

I am quite confident of this prediction, for all the reasons I presented in the discussion of the falling cycle in Part V. But let’s look at the question from a different perspective, to see if we end up with the same conclusion.

In the gold standard, the rate of interest is the spread between the gold coin and the gold bond. If the rate is higher, that is equivalent to saying that the spread is wider. If the rate is lower, then this spread is narrower.

A wider spread offers more incentive for people to straddle it, an act that I define as arbitrage. Another way of saying this is that a higher rate offers more incentive for people to dishoard gold and lend it. If the rate falls, which is the same as saying if the spread narrows, then there is less incentive and people will revert to hoarding to avoid the risks and capital lock-up of lending. Savers who take the bid on the interest rate (which is equivalent to taking the ask on the bond) press the rate lower, which compresses the spread.

It goes almost without saying, that the spread could never be compressed to zero (by the way, this is true for all arbitrage in all free markets). There are forces tending to compress the spread, such as the desire to earn interest by savers. But the lower the rate of interest, the stronger the forces tending to widen the spread become. These include entrepreneurial demand for credit, and most importantly the time preference of the saver—his reluctance to delay gratification. There is no lending at zero interest and nearly zero lending at near-zero interest.

I emphasize that interest is a spread to put the focus on a universal principle of free markets. As I stated in my dissertation:

“All actions of all men in the markets are various forms of arbitrage.”

Arbitrage compresses the spread that is being straddled. It lifts up the price of the long leg, and pushes down the price of the short leg. If one buys eggs in the farm town, then the price of eggs there will rise. If one sells eggs in the city center, then the price there will fall.

In the gold standard, hoarding tends to lift the value of the gold coin and depress the value of the bond. Lending tends to depress the value of the coin and lift the value of the bond. The value of gold itself is the closest thing to constant in the market, so in effect these two arbitrages move the value of the bond. How is the value of the bond measured—against what is it compared? Gold is the unit of account, the numeraire.

The value of the bond can move much farther than the value of gold. But in this context it is important to be aware that gold is not fixed, like some kind of intrinsic value. An analogy would be that if you jump up, you push the Earth in the opposite direction. Its mass is so heavy that in most contexts you can safely ignore the fact that the Earth experiences an equal but opposite force. But this is not the same thing as saying the Earth is fixed in position in its orbit.

The regime of irredeemable money behaves quite differently than the gold standard (notwithstanding frivolous assertions by some economists that the euro “works like” the gold standard). The interest rate is still a spread. But what is it a spread between? Does arbitrage act on this spread? Is there an essential difference between this and the arbitrage in gold?

Analogous to gold, the rate of interest in paper currency is the spread between the dollar and the bond. There are a number of differences from gold. Most notably, there is little reason to hold the dollar in preference to the government bond. Think about that.

In the gold standard, if you don’t like the risk or interest of a bond, you can happily hold gold coins. But in irredeemable paper currency, the dollar is itself a credit instrument backed by said government bond. The dollar is the liability side of the Fed’s balance sheet, with the bond being the asset. Why would anyone hold a zero-yield paper credit instrument in preference to a non-zero-yield paper credit instrument (except as speculation—see below)? And that leads to the key identification.

The Fed is the arbitrager of this spread!

The Fed is buying bonds, which lifts up the value of the bond and pushes down the interest rate. Against these new assets, the Fed is issuing more dollars. This tends to depress the value of the dollar. The dollar has a lot of inertia, like gold. It has extremely high stocks to flows, like gold. But unlike gold, the dollar’s value does fall with its quantity (if not in the way that the quantity theory of money predicts). Whatever one might say about the marginal utility of gold, the dollar’s marginal utility certainly falls.

The Fed is involved in another arbitrage with the bond and the dollar. The Fed lends dollars to banks, so that they can buy the government bond (and other bonds). This lifts the value of the bond, just like the Fed’s own bond purchases.

Astute readers will note that when the Fed lends to banks to buy bonds, this is equivalent to stating that banks borrow from the Fed to buy bonds. The banks are borrowing short to lend long, also called duration mismatch.

This is not precisely an arbitrage between the dollar and the bond. It is an arbitrage between the short-term lending and long-term bond market. It is the spread between short- and long-term interest rates that is compressed in this trade.

One difference between gold and paper is that, in paper, there is a central planner who sets the short-term rate by diktat. Since 2008, Fed policy has pegged it to practically zero.

This makes for a lopsided “arbitrage”, which is not really an arbitrage. One side is not free to move, even the slight amount of a massive object. It is fixed by law, which is to say, force. The economy ought to allow free movement of all prices, and now one point is bolted down. All sorts of distortions will occur around it as tension builds.

I put “arbitrage” in scare quotes because it is not really arbitrage. The Fed uses force to hand money to those cronies who have access to this privilege. It is not arbitrage in the same way that a fence who sells stolen goods is not a trader.

In any case, the rate on the short end of the yield curve is fixed near zero today, while there is a pull on the long bond closer to it. Is there any wonder that the rate on the long bond has a propensity to fall?

Under the gold standard, borrowing short to lend long is certainly not necessary. However, in our paper system, it is an integral part of the system, by its very design.

The government offers antiseptic terms for egregious acts. For example, they use the pseudo-academic term “quantitative easing” to refer to the dishonest practice of monetizing the debt. Similarly, they use the dry euphemism “maturity transformation” to refer to borrowing short to lend long, i.e. duration mismatch. Perhaps the term “transmogrification” would be more appropriate, as this is nothing short of magic.

The saver is the owner of the money being lent out. It is his preference that the bank must respect, and it is for his benefit that the bank lends. When the saver says he may want his money back on demand, and the bank presumes to lend it for 30 years, the bank is not “transforming” anything except its fiduciary duty, its integrity, and its own soundness. Depositors would not entrust their savings to such reckless banks, without the soporific of deposit insurance to protect them from the consequences.

Under the gold standard, this irrational practice would exist on the fringe on the line between what is legal and what is not (except for the yield curve specialist, a topic I will treat in another paper), a get-rich-quick scheme—if it existed at all (our jobs as monetary economists are to bellow from the rooftops that this practice is destructive).

Today, duration mismatch is part of the official means of executing the Fed’s monetary policy.

I have already covered how duration mismatch misallocates the savers’ capital and when savers eventually pull it back, the result is that the bank fails. I want to focus here on another facet. Pseudo-arbitrage between short and long bonds destabilizes the yield curve.

By its very nature, borrowing short to lend long is a brittle business model. One is committed to a long-term investment, but this is at the mercy of the short-term funding market. If short-term rates rise, or if borrowing is temporarily not possible, then the practitioner of this financial voodoo may be forced to sell the long bond.

The original act of borrowing short to lend long causes the interest rate on the long bond to fall. If the Fed wants to tighten (not their policy post-2008!) and forces the short-term rate higher, then players of the duration mismatch game may get caught off guard. They may be reluctant to sell their long bonds at a loss, and hold on for a while. Or for any number of other proximate causes, the yield curve can become inverted.

Side note: an inverted yield curve is widely considered a harbinger of recession. The simple explanation is that the marginal source of credit in the economy is suddenly more expensive. This causes investment in everything to slow.

At times there is selling of the short bond, at times aggressive buying. Sometimes there is a steady buying ramp of the long bond. Sometimes there is a slow selling slide that turns into an avalanche. The yield curve moves and changes shape. As with the rate of interest, the economy does best when the curve is stable. Sudden balance sheet stress, selloffs, and volatility may benefit the speculators of the world, but of course, it can only hurt productive businesses that are financing factories, farms, mines, and hotels with credit.

Earlier, I referred to the only reason why someone would choose to own the Fed’s liability—the dollar—in preference to its asset. Unlike with gold, hoarding paper dollar bills serves no real purpose and incurs needless risk of loss by theft. The holder of dollars is no safer. He avoids no credit risk; he is exposed to the same risk as is the bondholder is exposed. The sole reason to prefer the dollar is speculation.

As I described in Theory of Interest and Prices in Paper Currency, the Fed destabilizes the rate of interest by its very existence, its very nature, and its purpose. Per the above discussion, the Fed and the speculators induce volatility in the yield curve, which can easily feed back into volatility in the underlying rate of interest.

The reason to sell the bond is to avoid losses if interest rates will rise. Speculators seek to front-run the Fed, duration mismatchers, and other speculators. If the Fed will “taper” its purchase of bonds, then that might lead to higher interest rates. Or at least, it might make other speculators sell. Every speculator wants to sell first.

Consider the case of large banks borrowing short to lend long. Let’s say that you have some information that their short-term funding is either going to become much harder to obtain, or at least significantly more expensive. What do you do?

You sell the bond. You, and many other speculators. Everyone sells the bond.

Or, what if you have information that you think will cause other speculators to sell bonds? It may not even be a legitimate factor, either because the rumor is untrue (e.g. “the world is selling Treasury bonds”) or because there is no valid economic reason to sell bonds based on it.

You sell the bond before they do, or you all try to sell first.

I have been documenting numerous cases in the gold market where traders use leverage to buy gold futures based on an announcement or non-announcement by the Fed. These moves reverse themselves quickly. But no one, especially if they are using leverage, wants to be on the wrong side of a $50 move in gold. You sell ahead of the crowd, and you buy ahead of the crowd. And they try to do it to you.

I think it is likely that one of these phenomena, or something similar, has driven the rate on the 10-year Treasury up by 80%.

I would like to leave you with one take-away from this paper and one from my series on the theory of interest and prices. In this paper, I want everyone to think about the difference between the following two statements:

  1. The dollar is falling in value
  2. The rate of interest in dollars must rise

It is tempting to assume that they are equivalent, but the rate of interest is purely internal to the “closed loop” dollar system. Unlike a free market, it does not operate under the forces of arbitrage. It operates by government diktats, and hordes of speculators feed on the spoils that fall like rotten food to the floor.

From my entire series, I would like the reader to check and challenge the sacred-cow premises of macroeconomics, the aggregates, the assumptions, the equations, and above all else, the linear thinking. I encourage you to think about what incentives are offered under each scenario to the market participants. No one even knows the true value of the monetary aggregate and there is endless debate even among economists. The shopkeeper, miner, farmer, warehouseman, manufacturer, or banker is not impelled to act based on such abstractions.

They react to the incentives of profit and loss. Even the consumer reacts to prices being lower in one particular store, or apples being cheaper than pears. If you can think through how a particular market event or change in government policy will remove old incentives and offer new incentives, then you can understand the likely first-order effects in the market. Of course each of these effects changes still other incentives.

It is not easy, but this is the approach that makes economics a proper science.

P.S. As I do my final edits on this paper (October 4, 2013), there is a selloff in short US T-Bills, leading to an inversion at the short end of the yield curve. This is due, of course, to the possible effect of the partial government shutdown. The government is not going to default. If this danger were real, then there would be much greater turmoil in every market (and much more buying of gold as the only way to avoid catastrophic losses). The selloff has two drivers. First, some holders of T-Bills need the cash on the maturity date. They would prefer to liquidate now and hold “cash” rather than incur the risk that they will not be paid on the maturity date. Second, of course speculators want to front-run this trade. I put “cash” in scare quotes because dollars in a bank account are the bank’s liability. The bank will not be able to honor this liability if its asset—the US Treasury bond—defaults. The “cash” will be worthless in the very scenario that bond sellers are hoping to avoid by their very sales. When the scare and the shutdown end, then the 30-day T-Bill will snap back to its typical rate near zero. Some clever speculators will make a killing on this move.

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 à 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 above ground 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


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 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)

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 à 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 à 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. 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.

2. In a Gold Standard, How Are Interest Rates Set?, Keith Weiner

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 past. 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:






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





The Unadulterated Gold Standard Part IV (Intro to Real Bills)

In Part I, we looked at the period prior to and during the time of what we now call the Classical Gold Standard.  It should be underscored that it worked pretty darned well.  Under this standard, the United States produced more wealth at a faster pace than any other country before, or since.  There were problems; such as laws to fix prices, and regulations to force banks to buy government bonds, but they were not an essential property of the gold standard.

In Part II, we went through the era of heavy-handed intrusion by governments all over the world, central planning by central banks, and some of the destructive consequences of their actions including the destabilized interest rate, foreign exchange rates, the Triffin dilemma with an irredeemable paper reserve currency, and the inevitable gold default by the US government which occurred in 1971.

In Part III we looked at the key features of the gold standard, emphasized the distinction between money (gold) and credit (everything else), and looked at bonds and the banking system including fractional reserves.

In this Part IV, we consider another kind of credit: the Real Bill.  We must acknowledge that this topic is controversial because of the belief that Real Bills are inflationary.  This author proposes that inflation should not be defined as an increase in the money supply per se, but of counterfeit credit.

Let’s start by looking at the function served by the Real Bill: clearing.  This is an age-old problem and a modern one as well.  The early Medieval Fairs were large gatherings of merchants.  Each would come with goods from his local area to trade for goods from other lands.  None carried gold to make the purchases for two reasons.  First, they didn’t have enough gold to buy the local goods plus the gross price of the foreign goods.  Second, carrying gold was risky and dangerous.

The merchants could have attempted some sort of direct barter.  But they would encounter the very problem that led to the discovery and use of money originally.  It is called the “coincidence of wants”.  One merchant may have had furs to sell and wants to buy silks.  But the silk merchant does not want furs.  He wants spices.  The spice merchant may not want silks or furs, and so on.  It would waste everyone’s time to run around and put together a three-way deal, much less a four-way or a 7-way deal so that every merchant got the goods he wanted to bring to his home market.  They developed a system of “chits” to enable them to clear their various and complex trades.  In the end, all merchants had to settle up only the net difference in gold or silver.

Clearing is necessary when merchants deal in large gross amounts with small net differences.

The same challenge occurs in the supply chain of consumer goods.  Each business along the way adds some value to the product and passes it to the next business.  For example the farmer starts the chain by selling wheat.  The miller turns wheat into flour and sells it to the baker.  The baker turns flour into bread and sells it to the consumer.  These businesses run on thin margins, and this is a good thing for everyone (though the baker, the miller and the farmer might disagree!)  The question is: on thin margins, how are they to pay for the gross price of their ingredients before selling their products?

This is an intractable problem and it only gets worse if they attempt to grow their businesses.  Further, it would be impossible to add a new business into the supply chain.  For example, a processor to bleach the flour might be a separate company.  And then it may turn out that when the bakery grows and grows, that it is more efficient to operate a small number of very large regional bakeries and then the distributor enters the supply chain to buy the bread from the baker and sell it to another new entrant in the chain, the grocer.

With each new entrant into each supply chain, the supply of gold coins would have to grow proportionally.  This is not possible.  Fortunately, it is not necessary.   If there were a means of clearing the market, then only the net differences would have to be settled in gold.  If consumers buy 10,000 grams of gold worth of bread from the grocer, the grocer could keep his 5% profit of 500g and pass 9,500g to the distributor.  The distributor would keep his 2% profit of 190g and pay 9310g to the baker.  The baker would keep his 10%, 931g and pay 8379 to the flour bleacher, and so on up the chain.

The obvious challenge is that the payments move in the opposite direction compared to the goods.  Whereas the wheat is eventually turned into bread as it moves from the farmer to the consumer, the gold moves from consumer to farmer.  The Real Bill is the clearing mechanism that makes this possible.

Without the Real Bill, the enterprises in the supply chain would have to borrow using conventional loans and bonds, which is less efficient and more expensive.  Or else the division of labor along with highly optimized specialty businesses would not be possible.

As we discussed in Part III of this series, everyone benefits if it is possible to efficiently exchange wealth in the form of savings for income in the form of interest on a bond.  The saver’s money can work for him his whole life, and he can live on the interest in retirement without fear of outliving his money.  The entrepreneur can start or grow a new business without having to spend his career saving a fraction of his wages, working a job in which he is underemployed.  Everyone else gets the use of the entrepreneur’s new products, and thereby improve their lives.

The same analogy applies to the efficient clearing of the supply chain for every kind of consumer good.  This is especially true as new entrants come in to the chain and make the process more efficient (i.e. less expensive to the consumer).  And it is also necessary for seasonal demand, such as prior to Christmas.  Clearly, there is an increase in the production of all kinds of consumer goods around September or October.  Everything from chocolates to wrapping paper must be produced in larger quantities than at other times of the year.  Without a clearing mechanism, without the Real Bill, the manufacturers would be forced to limit production based on their gold on hand.  There would be shortages.

In practice, the Real Bill is nothing more than the invoice of the wholesaler on the retailer.   In our example, the distributor delivers bread to the grocer and presents him with a bill.  The grocer signs it, agreeing to pay 9500g of gold in 90 days (probably less for bread).  It is an important criterion that Real Bills must be paid in less than 90 days, for a number of reasons.  First, the Real Bill is for consumer goods with known demand.  If the good does not sell through in 90 days, that indicates a problem has occurred or someone has misestimated the demand.  The sooner this is realized, the better.

Second, 90 days represents the change of the season in most countries.  What had been in demand last season may not be in demand in the next.

Third, the Real Bill is a short-term credit instrument that is not debt.  At the Medieval Fair, there was no borrowing and no lending.  The same is true for the Real Bill.  The wholesaler does not lend money to the retailer.  He delivers the goods and accepts that he will be paid when the goods sell through to the consumer.  The retailer agrees to pay for the goods when they sell through, but he does not borrow money.

Finally, if a business transaction requires longer-term credit, then it is appropriate to borrow money via a loan or a bond.  The Real Bill is not suitable for the risk or the duration.  Longer-term credit means that it is not simply being used to clear a transaction, but that there is some element of speculation, storage, and uncertainty.

What has happened in different times and in different countries is that Real Bills circulate.  Spontaneously.  No law is required to force anyone to accept them.  No banking system is necessary to make them liquid.  Real Bills “circulate on their own wings and under their own steam” in the words of Antal Fekete[1].  The Real Bill is the highest quality earning asset, and the highest quality asset aside from gold itself (incidentally, this is why Real Bills don’t work under irredeemable paper—it would be a contradiction for a Real Bill to mature into a lower-quality paper instrument).

Opponents of Real Bills have a dilemma.  They can either oppose them by means of enacting a coercive law, or they can allow them because they will spring into existence and circulate in a free market under the gold standard.  We can hope that the principle of freedom and free markets leads everyone to the latter.

It is not the job of government to outlaw everything that experts in every field believe will lead to calamity.  And those experts should be cautious before prejudging free actors in a free market and presuming that they will hurt themselves if left alone.

In Part V, we will take a deeper look at the Real Bills market, including the arbitrages and the players…