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.

[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)
[3] When Gold Backwardation Becomes Permanent
[4] A Free Market for Goods, Services and Money

8 replies
  1. akustas says:

    Great article as usual Keith,

    The one question I have is that the phenomenon of our 10-year bond falling below 80 basis points would require the Fed to be buying massive amounts of bonds counteracting the selling from the rest of the world.

    Could not this occur sooner once people recognize the game is over for the dollar? Already there seems to be greater movement on the yield higher from sellers offsetting the $85B/mo in Fed purchases. A move over 3 or 4% would require a doubling or tripling of the amount of new purchases, and the yield could keep spiraling upward as the masses begin to understand that higher purchasing can’t stop the flow out.

    Curious about your thoughts on that.

    Thanks again Andrew

    • Keith Weiner says:

      akustas: Thank you for your comment and your kind words.

      I don’t think one should assume that the rest of the world will be selling bonds, or dollars ultimately.

      When the Chinese or anyone exports to the US, they get paid in dollars. What are they do to with those dollars? The dilemma is that if they want to be paid in gold, they will have no customers. It is the same dilemma for anyone working for a living in the US. What happens if you go to your boss and say you want 3 ounces of gold per month or else you will quit? No one has that pricing power (especially in the falling cycle!)

      Perhaps more importantly, there are dollars on both sides of every central bank, commercial bank, and other financial player (e.g. insurer) balance sheet. This is not easily changed.

      Finally, what debt-based paper currency is better?

      Gold of course is superior in every way, but I don’t see a move by any country (least of all China) to adopt the gold standard.

  2. akustas says:

    Ok that makes sense, so even if say the Chinese decide not to buy new US bonds at some point and use their dollars to buy other things (Gold, oil, farmland etc…), they will not be net sellers of our bonds, so long as the Fed is buying.

    Still a bit confused as to why they wouldn’t take the capital gain and reinvest in hard assets sooner than later. I realize they rely on the trade surplus they have with us, and they are not in the position to abandon this relationship yet, but at some point it seems they could be large sellers, and then the problem I cited regarding loss of confidence would send yields up….perhaps this is the end game you talk about ?… thanks again

    • Keith Weiner says:

      If one has no use for the metal, fuel, or grain, what will one do with a stockpile of iron, crude oil, or wheat? Oil and wheat both have non-trivial storage requirements. And then what? Sell it? They have wide bid-ask spreads–especially if one needs to dump a lot at once. One of the most important (and not well understood) characteristics of money is its narrow bid-ask spread. One takes little loss to go into and out of money. This is also true for the dollar though I do not consider it to be money. See my discussion of Fekete’s Dilemma in Part IV.

      My radical idea is that it won’t be the conventional players in the system who will decide to abandon the dollar system, in which they are locked. They have a choice: participate in the division-of-labor economy or go on strike (as in Atlas Shrugged) and hoard the most hoardable goods: gold and silver. The conventional players will continue. It is the individual owners of gold and silver who will (are) gradually withdraw(ing) it from the market. This is my permanent backwardation thesis. Most of these individual players won’t necessarily intend to go off the gird, they are just hoarding a little (times millions or hundreds of millions of people). There is an estimated 150,000 tons of gold. Assuming that the reality is double that, it’s 300,000 tons. That is 8.75B ounces. If there are a billion people on the planet who each want gold, it’s just 8.75 each and that’s it. Of course, there are some who accumulate far more than that. But I doubt it is less than a billion people who have gold or think of it and want some.

      We will see this hoarding, when it begins in earnest, in the form of rising backwardation across the entire term structure. Not just the near-month as it gets close to expiry, but all the way out.

  3. Greg Jaxon says:

    Hi Keith,

    I’m trying to grok the differences between this line of analysis written under the assumption of irredeemable fiat money and Fekete’s analysis written under the assumption that gold is money.
    I’m prepared to see some things turned on their head, but I nay need help…

    I stumbled over your claim that “[a]s the interest rate falls, the marginal productivity of labor rises.” This all but contradicts Fekete’s analysis [in AEFPension2x.pdf] where he writes “Indeed, the marginal productivity of both capital and labor automatically rises as a consequence of a rise in the rate of interest.” Admittedly the two statements are not precise opposites, but taken together, workers lose either way rates go. This is part of the point to the destructive power of oscillating rates, but I don’t see that as the basis of your principle, as stated.

    Could you set me straight on why we might find that Fed QE bond buying increases the marginal productivity of labor? If true, it’s devastating indictment of the Fed’s logic. So it’s worth laying out in detail.


    • Keith Weiner says:


      Thanks for your question. I don’t think I can properly answer in a comment here. Throughout this series, I have touched on marginal productivity of labor and of capital, but only tangentially. I spent more time on the marginal productivity of the entrepreneur (which is related), and marginal time preference.

      The reason is that the series was already looking to me from the beginning as likely to be really long (it turned out to be almost exactly 12,000 words in the main bodies). Also, it’s a lot of information for anyone to assimilate, doubly so in a dense topic like monetary science and triply when the whole approach and methodology, not to mention theory, goes against everything they’ve heard or read since grammar school.

      It will be interesting and important work to do the full analysis of what happens at the margin to everything. And how that feeds back into the cycle, either positive or negative. Are you interested in this?

      I want to think about it a lot more. Off the cuff, I don’t see a contradiction to say that when rates rise, marginal productivity of labor rises and when rates fall marginal productivity of labor also rises. In both cases, capital is destroyed by different means in each case. In both cases, capital destruction results in layoffs. Layoffs (assuming labor mobility) render the marginal worker jobless. The higher-productivity workers remain employed while the least-productive worker is unable to find employment. And then the market clicks to the next ratchet position of the cycle, and the bar moves again.

      • Greg Jaxon says:

        OK. Thanks! The two aren’t directly contradictory. Both are consistent with the
        thesis that oscillating interest rates are the great destroyers of the economy.

        I think the best synthesis here is to say that marginal productivity (mainly that of Capital) acts as an upper bound of the interest rates in a healthy free market. What you’re describing is something less than that (Capital “churn”) where the falling rate
        is not properly motivated by the economy’s /willingness/ to take on the extra balance sheet debt to fund /less productive/ labor and capital. Instead that capital is uncontrollably eroding such that for the same wage fund invested (the same propensity to produce), less labor is now affordable.

        Fekete would focus on the breakdown of the time preference (lower bound) on the interest rate. That is the direct effect of iredeemability, and also the clear reason that ZIRP is even doable. The montarist’s hope is that by pulling down the lower bound, that the upper bound must follow: employing more workers at lower average productivity. Instead the spread can just increase setting up the unstable
        resonances you’ve talked about, and reducing the currency’s marketability.

        Perhaps the analysis we’re heading toward here is “market failure”. The damnable thing is that it is so hard to use market principles to describe market failures. Worse when it’s the money market you want to describe, because our terminology is built for the assumption that the price axis has that constant-marginal-utility-property, when in practice it has begun to pick up a slope for the the failing currency.

        Yes, I am interested in rooting this whole inquiry in Menger’s marginality approach. His chapter were about “the Evolution of Money”. Maybe the way to explain things is to write a sequel: “The Devolution of Currency”, in which all pretenders to the throne must wither.

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