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 , 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 (http://www.professorfekete.com/articles/AEFMonEcon102Lecture1.pdf). The idea he proposed in those three pages has been fleshed out and extended by myself, and incorporated into this series of papers on the theory of interest and prices, principally in parts IV and V. I would like to note that Fekete regards the flow of money from the bond market to the commodity market as inflation and the reverse flow as deflation. I agree with his description of these pathologies, but prefer to reserve the term inflation to refer to counterfeit credit. I call it the rising cycle and falling cycle instead.