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Wiener Schule der Ökonomik: Antal Fekete

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Neue Ansätze in der Geldtheorie und aktuelle Streitpunkte innerhalb der Wiener Schule.

ANTAL FEKETE (geb. 1932 in Budapest)

Ausgewählte Werke:

Monetary Economics 101: The Real Bills Doctrine of Adam Smith

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[B]lueprint for a new gold coin standard the features of which can be summed up as follows:

(1) Open the Mint to free and unlimited coinage of gold. The one-ounce Gold Eagle coin should be adopted as a monetary unit minted for the account of anyone tendering the right amount and purity of gold, free of charge.

(2) To get the grass-root circulation of gold coins going, labor organizations (including those of pensioners and retired people) ought to be involved through their Credit Unions offering gold-coin deposit facilities. Banks must be excluded.

(3) Short-term credit to move goods from the producer to the consumer should be provided by the bill market, rather than by the banks, on the pattern of the pre-1914 way to finance world trade with gold.

(4) Long-term credit to the economy should be provided by the gold-bond market. The primary demand for gold bonds comes from financial institutions offering gold life insurance and gold annuity policies to the people. The primary supply is from the government and firms that want to operate on the basis of gold capital. Gold bonds must have a sinking fund protection. Issuers of gold bonds must see the revenues with which to retire the liability.

A real bill is a bill of exchange drawn by the producer (the drawer of the bill) on the distributor (the acceptor of the bill) specifying the kind, quality and quantity of merchandise shipped by the former to the latter, and specifying the sum (the face value of the bill) and the date on which the bill is payable (the maturity date of the bill, in any event, not more than 91 days after the date of billing). In order to be valid, the bill has to be accepted by the acceptor, by writing across its face and over his signature „I accept“.

The Real Bills Doctrine of Adam Smith states that a bill of exchange can, before its maturity date, go into spontaneous circulation as the drawer will use it to pay his suppliers by endorsing the bill on the back. Everybody who receives the bill in payment thereafter can use it in a similar fashion. Endorsement signifies that the owner of the bill has assigned the proceeds to the next one. At maturity, the last owner will mark the bill „paid“ and present it to the acceptor against the payment of the face value in gold coins. Alternatively, anyone who accepts the real bill in payment for goods and services, can discount it at the Discount House at any time. Discounting means selling the bill for cash at a discount, which depends on the discount rate and the number of days the bill has to run to maturity. The Discount House makes a market in real bills and acts as the residual buyer. Indeed, real bills are the most liquid earning asset that a financial institution can have. At maturity the Discount House will collect the face value of the bill from the acceptor.

The point is that as goods in urgent demand emerge in production, the credit needed to finance their move to the consumer also emerges in the form of real bills drawn by the producer on the distributor. The real bill is a non-inflationary purchasing medium which the market has endowed with limited monetary privileges. Non-inflationary because the face value of the bill is matched by the value of the emerging merchandise. Limited because upon maturity the purchasing medium expires as the underlying merchandise is sold to the ultimate cash-paying consumer.

In many ways the circulation of real bills is a miraculous process. Nobody designed the system of credit and clearing that makes goods in demand move along from the producer to the consumer without outside financing. Yet there it is: the real bill will do the miracle of financing production and distribution spontaneously, without taking one penny out of the piggy-banks of the savers, and without legal tender coercion. […]

The consumer’s single gold coin suffices to finance efficiently the journey of bread from the corn-fields to the dinner-table, even in the complete absence of banks. The movement of the „maturing bread“ from the grain farmer to the grocer is matched by the parallel but opposite movement of the real bill from the grocer to the grain farmer. […]

Real bills do work. Prior to the outbreak of World War I in 1914 word trade was financed through real bill circulation with London acting as the discount house. The system worked smoothly and efficiently, showing that there is no limit on the amount of credit that could be built on a given gold basis. World trade was completely self-financing, and producers as well as consumers prospered. The volume of world trade before 1914 was so great that it took more than 75 years before it was surpassed in the 1990’s, in spite of a much faster population-growth. […]

It is unrealistic to expect that the gold coin standard, unaided by real bills circulation, can meet these fluctuations. Indeed, the payments system would seize up during every Christmas shopping season, or whenever division of labor is refined by implementing new inventions, for reasons of dearth in the supply of purchasing media. We should remember that the supply of gold is highly inelastic (which is, paradoxically, the main reasons for gold to have become the monetary metal par excellence ). […]

Why gold? Gold is needed as the essential agent for the litmus test of good faith in financial dealings. Gold needs no endorsement. It can be tested with scales and acids. The recipient of gold does not have to trust the government stamp on it if he does not trust the government that had stamped it. No act of faith is called for when gold is used in payments, and no compulsion is required. […]

the government has, over a period of time involving several generations, successfully indoctrinated people with a most dangerous and vicious doctrine, the Quantity Theory of Money. According to it the value of money is determined, not by its quality, but solely by its quantity. The obvious motivation of the Quantity Theory is the a priori removal of all moral considerations from the debate on debt-based money. Since regulating the quantity of money involves regulating the banking system, it follows that the task can only be entrusted to the government. Only the government can make the ponderous decisions impartially which are involved in the problem of increasing the quantity of money in uniform doses, year in and year out. […]

To tell the truth, the Federal Reserve Act of 1913 was also crafted on the scientific basis of the Real Bills Doctrine. The Federal Reserve was conceived as a commercial-paper based system with the real bill as the only asset category eligible for re-discounting. In more detail, real bills were the only type of paper the Federal Reserve banks were by law allowed to purchase from their member banks. Treasury bills were ineligible. The Federal Reserve banks were not allowed to monetize government debt. The original Act refused to give the Treasury a free ride. The idea was that government debt ought to be exposed to the vicissitudes of the market, without offering it refuge in the portfolio of the Federal Reserve banks. The only way these banks could come into possession of government securities was through a penalty-provision. Whenever gold reserves fell below the legal limit of 40 percent of note and deposit liabilities, the Federal Reserve bank was assessed a tax penalty on a progressive scale. It had to make up the deficiency by putting government securities in the asset portfolio, but there was a tax penalty on the interest income from those securities amounting to several hundred percent. The Act had a built- in disincentive for the banks to hold government securities in their portfolio.

However, the original Act was never put into effect. It was violated on the very day the Federal Reserve banks opened their doors for business in 1914. There was no way for the U.S. government to finance the war effort of the Allied Powers through a commercial- paper based banking system which made the monetization of government debt impossible. […]

Bond speculation is a parasitic activity on the body economic. […] The blame is entirely on the government which is responsible for the institution of this iniquitous system which, rather than promoting social cooperation, pits one citizen against the other. I made it clear that the real culprits are the big banks. Small speculators could never create and feed a $100 trillion derivatives monster. […]

[T]he stock of money must increase at least at the rate marked by the rate of interest. Every year monetary authorities must create at least as much new money as needed to service outstanding debt, in order to keep the game of musical chairs going. […]

Credit is one of the great creative forces of civilization and one of the supporting pillars of human welfare. Next to knowledge and capital, credit is the paramount engine of progress. It can hardly be doubted that most of the prodigious amenities and inventions, technological and therapeutic advances available to modern society owe their origins to credit. To see this we have only to remind ourselves of the role of credit in capital accumulation and in capitalizing income. While capital accumulation would still be possible in the absence of credit, the amounts involved would be reduced to a pittance, subject to the physical limitations of their primitive form: hoarding. Not only would quantity be limited by physical factors, but also the reward would be far removed from effort, giving rise to psychological forces that would militate against saving. One of the great merits of credit is in the manner it works upon the time-element in the means-ends chain, shortening the effort/reward nexus, prompting the individual to work and save harder.

Credit abuse is one of the most difficult problems economics is called upon to study. Exactly the same factors that make credit a great creative force and an engine of human progress will, when abused, render it a most dangerous and obreptitious agent of destruction. […]

It is a mistake to believe that saving is the only source credit. Clearing is a well-recognized second source. The rate of interest is the regulator of lending, grounded in the propensity to save. The discount rate is the regulator of clearing, grounded in the propensity to consume. The relationship in both cases is inverse: the higher the propensity the lower is the rate, and conversely. For example, the higher the propensity to save, the lower is the rate of interest; the lower the propensity to consume, the higher is the discount rate. […]

A certain consumer good is part of the social circulating capital if, and only if, the bill drawn against it will circulate. The prospect of impending consumption of this goods makes it rather special. Its movement through the production and distribution channels is predictable. The uncertainty connected with the ultimate disposal of this goods is reduced to its irreducible minimum. For this reason the credit it generates will circulate Not every consumer good is capable of generating bill circulation, e.g., slow merchandise, goods sold on an installment plan, stores of goods held back in the expectation of speculative profits due to a rise in price. We shall see that certain type of merchandise may at one point start generating bill circulation indicating that they have just become part of the social circulating capital. At other times the same merchandise may drop out of the social circulating capital, the sign of which is that bills drawn on them no longer circulate, e.g., seasonal goods such as heating fuel or seed corn. This highlights the rationale for limiting the term of real bills to 91 days. […]

In reality, the evolution of paper currency takes its origin in the invention of the negotiable bill of exchange, the real bill. This was a wonderful invention. There was nothing sinister about it. The process was perfectly natural. […]

When the weaver draws a bill on the clothier, he is extending credit, yet he is not a lender and the clothier is not a borrower. […] Stated otherwise, prices quoted by the wholesaler to the retailer are discountable prices. The amount of discount depends on the number of days the credit is used, and on the discount rate prevailing at the time of payment. […] it is the consumer’s slacker or brisker buying that makes the discount rate rise or fall. […]

Other tradesmen also found it to their advantage to hold the bills to maturity. They looked at bills as a unique instrument combining two seemingly contradictory features: (1) that of an earning asset, (2) that of a medium of exchange. In fact, bills provided the only way to generate an income on cash holdings. Usually an earning asset is illiquid in that it takes time and, sometimes, monetary losses to liquidate them in a hurry. With the appearance of discounting this has changed. […]

The financing of the movement of cotton could be done through bill-circulation. The financing of the movement of bricks couldn’t: the brickyard-on-bricklayer bills could not fly for lack of momentum in the movement of bricks. The slower movement of bricks had to be financed through lending and borrowing, at the higher interest rate. This involved convincing the lender (saver) that the ultimate consumer of bricks, the buyer of the house, did have the means to retire the mortgage on his new house in time. […]

Economists haven’t paid sufficient attention to the spread and arbitrage, concentrating their efforts on the price and speculation instead. Yet the fact is that arbitrage and speculation are diametrically opposed to one another. The speculator takes large risks in the hope of large profits. The arbitrageur is not interested in increasing risks: he is interested in reducing them. […]

The bill market has made the gold coin extremely efficient, far beyond its physical capability to circulate. The limitation on improvements in production and distribution technology through refining division of labor further has been removed. The bill market has made the monetary system more elastic and more responsive to the needs of the consumer. Any type of good can generate bill circulation, provided that the consumer demands it urgently enough. By the same token, bills representing goods that have just fallen out of the consumers‘ favor are immediately demonetized. […]

The market process promoting the bill of the goldsmith to become the most marketable paper in the bill market was analogous to the market process that had earlier promoted gold to become the most marketable good in the commodity market. […]

We can see that the sale of the house took six months and five exchanges to complete. All five exchanges involved the bank note, the common purchasing medium. The five exchanges were: (1) selling the stocks, (2) buying the 1-month bill with the proceeds from the sale of the stocks, (3) paying for the house with the proceeds from the sale of the 1-month bill, (4) buying the 3-month bill with the proceeds from the sale of the house, (5) paying for the bond with the proceeds from the sale of the 3-month bill. At that point the market agitation caused by the sale of the house came to rest.

We can see that the goldsmith’s bearer sight bill, alias bank note, plays an important role in facilitating the purchase or sale of real estate, stocks, bonds, bills, etc. The goldsmith through his money-changing business has become a banker. His bank notes were considered mature bills (sight bills) which could be exchanged for gold coins on demand at any time. There is no fraud involved. The bank note is not a warehouse receipt for gold on deposit. It is a bill of exchange that the market has promoted to the station of medium of exchange, for being more marketable than any other. People were happy to hold it, especially if they needed ready cash on hand for unexpected purchases, and they willingly paid for its use in the form of foregone discount. They were paying for the convenience to use a paper surrogate of the gold coin, in applications where the direct use of the gold coin would be less convenient.[…]

The bank note is not specific about the asset held against its issue, that could be gold, or real bills, or a blend of the two. The gold certificate, on the other hand, explicitly states that a specified number of gold coins are held on deposit to balance the liability. The legal and economic differences between these two instruments were well-understood by the goldsmith’s creditors. They trusted the goldsmith that he would balance his liability represented by the bank note with a blend of gold coins and maturing real bills drawn against consumer goods in urgent demand. On the average, one-ninetieth of the real bills in his portfolio would mature every single day, bringing in more than enough gold coins to satisfy normal demand for converting bank notes. Holders of the goldsmith’s paper also knew that the marketability of the assets in the goldsmith’s portfolio guaranteed that even abnormal demand for gold coins could be met. The goldsmith could discount his bills with people in need of earning assets, or at the Discount House. Thus real bills could be liquidated at any time, virtually without loss. Bank notes were safe, and their issue did not give rise to credit expansion, as charged by Mises. For each bank note of face value $1,000 issued, the goldsmith had to withdraw $1,000 worth of real bills from circulation. […]

The problem is in the double standard the government has in contract law. It gives special protection to banks, but not to other firms involved in bankruptcy. The government does this in return for the banks‘ cooperation in sheltering illiquid government paper in their portfolio. Unlike the bill of exchange, the government’s treasury bill would not circulate. As part of a sweetheart deal, the banks would discount them along with the commercial bills of exchange. Incidentally, the real cause of bank runs is: illiquid assets such as treasury bills in the bank portfolio. […]

The notion that the bank’s promise, if it is to be honest, forces it to have a store of gold on hand equal to the sum total of its note and deposit liabilities stems from a fundamental confusion between stocks and flows. The promise of a bank, as that of every other business, refers to flows, not stocks. The promise is honest as long as they see to it that everything will be done to keep the flows moving. In the case of the bank, the promise is honest as long as the bank carries only self-liquidating bills, other than gold, in the asset portfolio backing its note and deposit liabilities. […]

Today the concept of legal tender refers to coercion. The government orders its subjects to accept irredeemable promises in payment for the real goods and real services they produce. If people refuse to comply with the order, then they put themselves outside of the law. But the term legal tender hasn’t always meant coercion. It originated in a right, not an obligation, of the people. As recently as in 1933, in the United States ‚legal tender‘ referred to the right of the people to take their worn gold coins still within the established tolerance standards and exchange them free of charge for full-bodied ones. […]

The introduction of bank notes of small denomination was inextricably intertwined with the granting of special privileges by the government to the banks of issue […]. The patent (monopoly) was reward for the favor of banks to monetize government debt. In practice, this meant that the banks were allowed to have a fiduciary issue of bank notes against government paper in addition to (but indistinguishable from) bank notes issued against gold and self-liquidating bills of exchange. The paper backing the fiduciary issue included government bonds and notes that the Treasury was unable to sell to the general public. These bonds and notes were automatically reissued upon expiry. In effect, the bank was carrying a perpetual government debt. This it could do only because the bank was able to pass the burden on to the shoulders of the general public in the form of non-interest-bearing paper: small bank notes. […] The burden was passed on to the public, and the banks pocketed riskless profits in the form of interest payments by the government. Please note that it would not work with the issue of large bank notes. Holders of large notes would hang on to them for as short a period of time as was absolutely necessary, and then would pass them on to others, or would return them to the bank. […]

The wage earner is supposed to be paid in gold or silver coin. This is his Constitutional right. With gold and silver coins jingling in his pocket he was the unquestioned master of the market place. His wishes were sacrosanct to all vendors and producers. He was the proverbial boss who was ‚always right‘. Bereft of his gold and silver coins he was reduced to the station of a serf. Important decisions such as what to produce, when, and how much, are now made without consulting him. He is now inundated with a lot of obnoxious merchandise from unhealthy food through gimmicks with built-in obsolescence, to the lowest quality entertainment including pornography. […]

Bank notes of small denomination get into the hands of the great masses of people who know nothing of the need for protecting their savings through the redemption of idle bank notes. […]

It cannot be emphasized too strongly that longevity of a monetary regime is a matter decided not on the basis of the quantity of money or the rate at which it is increased, but by the quality of assets in the balance sheet of the monetary authority. It is futile to pretend, as the Friedmanites do, that restricting quantity makes for quality. Restricting the quantity of a dishonored promise cannot make it more valuable. […]

As capital was becoming submarginal under a rising interest-rate structure, so were the producers. They were forced to sell their business at a loss, and invest the proceeds in high-yield Treasury bonds. This was a textbook-case how the government can despoil its own taxpayers. In printing high coupon-rates on Treasury bonds, instead of collecting taxes from the productive members of society, the government is now obliged to pay them for holding its debt. A large segment of the producers found themselves unable to compete with the high coupon rates the government so cavalierly printed on its bonds and, from producers of new wealth they became coupon-clippers. The consequences of wholesale destruction of capital are camouflaged by the burgeoning import of consumer goods. Foreigners accept the dollar for the time being, as in their judgment the dollar was depreciating more slowly than their domestic currency. Such a situation cannot continue indefinitely. The most visible sign of the progressive deterioration is the ever-growing trade deficit, the flip-side of the accumulation of U.S. Treasury paper in foreign hands. At one point, the world market will get saturated with the U.S. dollar. When that happens, another convulsion in the world’s commodity and financial markets will follow.

It is not widely understood that the dollar was given a stay of execution by the fortuitous demise of the Soviet Union and its Evil Empire in 1990. This unforeseen historic event turned the dollar-glut into a fresh dollar shortage. All of a sudden a new market, counting some 400 million souls, was thrown wide open to dollar-penetration a market that had earlier been hermetically sealed off by the threat of the firing-squad. Huge though this market for dollars may appear, it is not unlimited. […]

At first, the pendulum was swinging towards infinite interest, threatening the dollar with hyperinflation. Right now the pendulum is swinging to the other extreme, to zero interest, spelling hyper-deflation. This is just as damaging to the producers as the swing towards infinite interest was in the early 1980’s. It is impossible to predict whether one or the other extreme in the swinging of the wrecker’s ball will make the world economy to collapse. Hyperinflation and hyper-deflation are just two different forms of the same phenomenon: credit collapse. Arguing which of the two forms will dominate is futile: it blurs the focus of inquiry and frustrates efforts to avoid disaster. […]

Banking has grown out of two separate roots: the business of the goldsmith, and that of the Acceptance House. The latter is the bad guy. Here is a conspiracy between the borrower and the Acceptance House with ready access to the bill market. Once the fraudulent anticipation and accommodation bills are removed from the bill markets and given shelter in the portfolio of the bank, then whatever possibility for the detection of the fraud had existed before was lost. […] The banks could create something out of nothing only through the fraud of accepting anticipation and accommodation, disregarding the fact that these bills were no longer self-liquidating. The banks could not care less how the borrowers would eventually get the money to repay the loan. In case of a default the bank would liquidate the collateral and satisfy itself from the proceeds. The banks were in fact usurping and monopolizing social circulating capital. They could get away with it by virtue of the government patent exempting banks from the rigors of bank examinations and from the strict application of accounting standards. The banks could carry their assets at arbitrary values. […]

Illicit interest arbitrage in modern setting manifests itself through certain practices of commercial banks. Economists have failed to make a distinction between bank assets representing goods on offer for sale and others representing goods not on offer for sale in the markets. This distinction between the two types of bank assets is fundamental. The value of those of the first category is faithfully reflected in the balance sheet, as the market is continuously testing these values against existing and changing marginal utilities. In case of any discrepancy, correction is instantaneous and automatic. The same, however, is not true of assets of the second category. Here the balance sheet notoriously overstates values. These assets are sheltered from the trials and tribulations of the market place. They are protected against wear and tear due to the ravages of declining marginal utility, brought about by repeated market test.

For example, a house that is being built for the housing market by the contractor is on offer for sale, and a bridge-loan against it is a bank asset of the first category. By contrast, a home equity loan is a bank asset representing an item, your home, which is not on offer for sale (you hope) and, therefore, it is a bank asset of the second category. The seeds of a credit collapse are sowed by the banks themselves in loading their portfolio with assets of the second category. When the crunch comes, these assets are thrown on the market simultaneously and indiscriminately as the banks scramble to regain solvency. The market, which follows the law of declining marginal utility (rather than the wishful thinking of over-confident bankers) refuses to validate the fancy values at which these assets are carried in the balance sheet. […]

The key to preventing the boom-bust cycle is not to allow banks to carry assets of the second category in excess of capital accounts. Bank assets of the first category include gold (as all gold above ground is deemed to be on offer for sale under a gold standard) as well as bills of exchange drawn on goods that will be sold to the ultimate cash-paying consumer in less than 91 days. These bills are the most liquid earning assets that a bank can have. By contrast, assets in the second category are not liquid. They include stocks, bonds, mortgages, finance and treasury bills, or loans collateralized by these. Unlike self- liquidating bills, they are all subject to great fluctuations in value. […]

The positive spread between the interest and the discount rate is not there for the picking. It is there to support social circulating capital. Supplying the consumer with urgently needed goods on the shortest possible notice and in the most efficient manner would become prohibitively expensive, were it not for the presence of the spread. Bread and milk would have to be supplied on the same harsh terms as the surgeon’s knife and the watchmaker’s precision instruments. The publisher of newspapers would have to apply the same mark-up as that of a Sanskrit grammar. Indeed, milk, bread, and newspapers are perishable. Incentives to produce and distribute them for the benefit of society are absolutely essential. Of course, we don’t mean subsidies. We mean the spontaneous incentive embodied in the undistorted spread between the interest and discount rates.

Damages caused by natural disasters, for example, would be far harder to heal (and, hence, far more devastating) in the absence of a positive spread. The productive apparatus of society would be less efficient, more wasteful, and less responsive to changes in the absence of a positive spread between the interest and discount rates. It should be evident that the market needs safeguards against illicit interest arbitrage causing the spread to vanish, much the same as it needs safeguards to prevent any other form of fraud. […]

Capitalism is an economic system that makes the spontaneous capitalization of incomes possible. In more details, capitalism means unobstructed and uninhibited capital formation through the voluntary partnership of the annuitant (typically an elderly man drawing an annuity) and the entrepreneur (who pays the annuity income from the return to capital put at his disposal in the form of wealth of the annuitant). Capitalism means a gold bond market where the residual savings of the people are pooled, parceled, and allocated. In the gold bond market the marginal producer is free to perform his function as arbitrageur between two types of earning assets: capital goods and gold bonds. It is this arbitrage that validates the marginal productivity of capital in fixing the ceiling for the rate of interest. Capitalism means a gold standard without which the marginal bondholder would be unable to perform his function as arbitrageur between present goods (gold) and future goods (the gold bond). It is this arbitrage that validates the marginal time preference of the saving public in fixing the floor for the rate of interest. Capitalism means a bill market where the marginal shopkeeper is free to perform his function as arbitrageur between the two forms of social circulating capital: fast-moving merchandise and bills drawn on them. […]

Monetary Economics 102: Gold and Interest

the nature and the sources of interest could be better grasped if the problem was presented in the form of a different question: What happens when a man with income to spare but who is in need of wealth meets another with wealth to spare but who is in need of an income? Fair exchange is indeed possible in this case. Just why the problem of converting income into wealth and wealth into income is important follows from the fact that man is mortal and he knows it. As he grows old, his former surplus of mental and physical energy will inevitably turn into a deficit. If he has failed to accumulate wealth in his prime years, then his twilight years are likely to be miserable. His needs would overwhelm his resources. […] That wealth is not everything becomes clear as soon as conversion into income is denied to the individual, so vividly portrayed in the comedy of King Midas and in the tragedy of King Lear. […]

Our theory presented in this course will involve a step-by-step refinement of the diagonal model into a square, a pentagonal and finally a hexagonal model of the capital markets. The square model has four participants: the annuitand (the man who is accumulating capital to support his future annuity), the annuitant (the man who is already drawing an annuity), the entrepreneur and, finally, the inventor. They are distinguished by their respective needs that they bring to the capital market to satisfy as follows. The annuitand needs to convert income into future wealth; the annuitant needs to convert wealth into income; the entrepreneur needs wealth in order to convert it into future income; and the inventor needs income in order to convert it into future wealth. […]

Zero interest means the denial of incentives to proceed with the exchange of income and wealth. Given this denial, the providers of credit would abstain from the exchange and fall back on direct conversion. The annuitand would convert his income into wealth through hoarding; the annuitant would convert his wealth into income through dishoarding. It would be absurd for the annuitand to exchange his income for less future wealth than he could himself accumulate through hoarding; and for the annuitant to exchange his wealth for a smaller income than he could himself generate through dishoarding. The same is not true for the entrepreneur and the inventor. In the case of zero interest they are helpless. For them, zero interest is an un-surmountable obstacle to capital formation. The entrepreneur’s potential income could not be generated in the absence of entrepreneurial capital. The inventor’s potential wealth would not be realized in the absence of R&D capital. The square model of the capital market reveals that the exchange of income and wealth is inherently asymmetric. The annuitand and the annuitant could still satisfy their need to convert should the exchange fail; the entrepreneur and the inventor could not. […]

The partnership of the entrepreneur and the inventor is net long of future wealth and net short of present wealth. In order to make the partnership viable we introduce a fifth participant who is net long of present wealth and net short of future wealth. He is none other than the capitalist specializing in the exchange of present wealth for future wealth. […]

A final refinement is the hexagonal model of the capital markets and the introduction of the sixth and last protagonist of the drama of capital accumulation: the investment banker. The refinement is made necessary by the fact that no two annuities are alike. Yet trading them will still be possible if the differences are bridged over by the gold bond. The investment banker’s function is clearing and brokering. He matches the varied demands thrown upon the capital market from its other five corners. He must be prepared to enter into partnership with the annuitand, annuitant, entrepreneur, inventor, or the capitalist, as the case may be, through his specialized instruments of annuity and mortgage contracts. At the same time he will balance his net liability or asset resulting from this activity through the purchase or sale of the standardized instrument, the gold bond.

The hexagonal model of the capital market brings about a great increase in scope for the most successful combination of capitalist production: the triangle of the entrepreneur, the inventor, and the capitalist mentioned earlier. From now on they can form their partnership even if unbeknownst to one another. The inventor need not waste time in seeking out a congenial entrepreneur, nor does the entrepreneur in finding a suitable inventor. Neither of them is at the mercy of the capitalist. If the invention is good and the enterprise is sound, then they could immediately start production on the most favorable terms through the good offices of the match-maker, the investment banker. Nor does the capitalist have to remain wedded to the same inventor and entrepreneur for the entire duration of the project. Through buying and selling gold bonds he can always go after the project that appears most promising to him. The problem of forming optimal triangles can safely be left to the bond market. […]

A bond payable at maturity in irredeemable currency is a promise that is fulfilled by making another irredeemable promise. In effect, it is a promise to defraud in exactly the same way as the promise of Charles Ponzi to pay interest at the rate of 100 percent per annum has been. No serious student of interest can take such bonds for anything but a cruel joke on the public. The Criminal Code calls for severe punishment for deliberately defrauding the public through confidence games and Ponzi-schemes. The issuance of irredeemable promises to pay, be it interest-bearing such as a bond or non-interest bearing such as a bank note, fully exhausts the concept of fraud. Governments have interfered with the justice system by blocking citizens and creditors who wanted to sue it in court. […]

One of the cardinal points about the gold standard as it is remembered today is that it was an attempt to stabilize the price level – an attempt that has failed. But it would be closer to the truth if the gold standard were remembered as an attempt to stabilize the interest rate structure – an attempt that has succeeded. […] Stabilization of prices is neither possible nor desirable. Price changes are part of the signaling mechanism of the economic system that regulates both production and consumption. By contrast, the stabilization of interest rates is both possible and desirable. […]

Carl Menger revolutionized economics by throwing out the equilibrium theory of price formation to replace it with a disequilibrium theory. He observed that the market quotes not one but two prices, a higher asked price and a lower bid price. […] Competition takes the form of arbitrage. Being the combination of a sale and a purchase, arbitrage is the most comprehensive form of human action. The market price is not the result of supply/demand equilibrium, but the outcome of a convergence process whereby it is confined to an ever-narrowing range determined by the vanishing spread. […] the asked price is formed through the horizontal arbitrage of the marginal consumer, and the bid price is formed by the vertical arbitrage of the marginal producer. The marginal consumer is the first to refuse to buy the uptick in price, and horizontal arbitrage means that he is ready to buy a cheaper substitute. The marginal producer is the first to refuse to sell the downtick in price, and vertical arbitrage means that he is ready to buy cheaper substitutes for the producer goods at his input. We see that the asked price is determined by marginal utility. It can be characterized as the lowest price at which consumers can buy as much as they want without haggling – explaining how the asked price earns its name. The bid price is determined by marginal profitability. It can be characterized as the highest price at which producers can sell all they have without haggling – explaining how the bid price earns its name. The spread between the asked and bid prices is closed by the arbitrage of the market makers. […] We have to study two independent market processes: one responsible for the formation of the asked price for bonds (or the floor for the rate of interest), and the other responsible for that of the bid price (or the ceiling for the rate of interest). It turns out that the former is the outcome of the competition of bondholders, while the latter is the outcome of the competition of entrepreneurs. […] Thus the floor for the rate of interest is determined by marginal time preference. It can be characterized as the highest rate of interest which savers still refuse to accept. The ceiling for the rate of interest is determined by the marginal productivity of capital. It can be characterized as the lowest rate of return on capital that entrepreneurs will still accept before they go out of production and invest the proceeds from the sale of their capital goods in bonds. […]

Since gold coins served as bank reserves under the gold standard, by withdrawing their deposits and converting their notes into gold coins savers could force the banks to contract outstanding credit. Moreover, a continuing squeeze on bank reserves could not help but alert legislators that people were unhappy with profligate government spending financed through the banking system. They could amend their ways by eliminating wasteful spending. […]

The initial impetus of credit expansion pushes the market rate of interest below that of marginal time preference, making the propensity to hoard increase. It triggers a first round of purchases of marketable goods for hoarding purposes with the proceeds from the sale of bonds. Marginal savings grow. While selling pressure on bonds increases interest rates, buying pressure on goods increases the price level. The higher price level will increase marginal time preference. When prices are expected to rise, the marginal saver will demand compensation in the form of higher interest rates. The net result is that, once again, the market rate of interest is below the rate of marginal time preference, and the propensity to hoard increases.

This will trigger a second round of purchases of marketable goods for hoarding purposes financed through further liquidation of bond holdings. The inflationary spiral repeats itself at a higher level of prices and interest rates. Thus a ratchet is engaged whereby subsequent rounds of increases in marginal savings pushes commodity prices as well as the rate of interest to ever higher levels. It may take decades for the inflationary spiral run its course. It is not possible to predict when the spiral will turn around. At any rate, high and increasing prices coupled with high and increasing interest rates will eventually lead to panic. People realize that further increases in the rate of interest would threaten the value of their marginal savings. Liquidation of marginal hoards of marketable goods begins. This spells a deflationary spiral, to which the inflationary spiral gives way, featuring ever lower propensity to hoard, or inventory deflation. There is a drawn-out process of dissipating excessive stockpiles. The collapse in demand for newly produced goods causes business lethargy, as reflected by falling interest rates along with falling prices. It may take decades before business confidence can be rebuilt and economic expansion resumed, signaling the end of the deflationary spiral. […]

The long-wave inflation/deflation cycle is aggravated rather than alleviated by central bank intervention. Directly or indirectly, contra-cyclical monetary policy amplifies the oscillating money-flow back-and-forth between the bond market and the commodity market. An accurate reading of the present situation is that after the inflationary spiral lasting for forty years, culminating in the 1980 price explosion, the world economy saw a panic ushering in the deflationary spiral that still continues. Prices and interest rates peaked in 1980 when dishoarding started. It is true that the downward ratchet of the interest-rate structure is more obvious than that of the price level, but you would be well- advised to watch for a very painful erosion of prices and profits as firms keep losing their pricing-power. Central bank intervention is counter-productive. As it tries to ‚reflate‘ by injecting new cash into the economy, the central bank will only pour oil on the fire. Whenever it wants to inject new cash, the central bank goes to the bond market to buy bonds. But in doing so it will only join the crowd of frenzied bond speculators already busy in bidding up bond prices and pushing down interest rates as part of the deflationary process. As a matter of fact, speculators have taken it for granted that the central bank will act that way thereby taking the risk out of bond speculation. The new money injected in the economy, which the government has hoped that it would flow to the commodity market and bid up prices there, does instead flow to the bond market where the fun is. It stokes the fires of the boom there pushing interest rates further down and, due to the linkage, it makes prices fall as well. Far from putting an end to the deflationary spiral, central bank action depresses the economy even more. Unless, of course, the deluge of new money injected in the economy scared bond speculators in causing them to cut and run. As they dumped their bonds, they would make bond prices, and the value of irredeemable currency, collapse. […]

The Principle of Triple-Entry Revenue Accounting is also applicable to corporate governance. In this case the bond department corresponds the Office of the CFO, the managerial department to the Office of the CEO, and the entrepreneurial department to the Board of Directors of the corporation. The order of seniority can be observed in the manner the revenues are distributed among the three accounts: (1) the most senior, the interest account compensates the outside investors, the bondholders; (2) the managerial compensation account pays the salaries and bonuses of the senior managers; (3) the entrepreneurial profit account pays the compensation of the directors of the company, and the dividends of the shareholders.

In modern times we see an unfortunate shift of power away from the entrepreneurial to the managerial department. By issuing class A, class B, etc., shares (some with multiple voting rights), convertible bonds, stock options, etc., the managers have diluted the authority of the shareholders, and inappropriately usurped the power of the entrepreneurial department and its right to dispose of the surplus. The subordinate relationship whereby managers are hired and fired by the entrepreneurial department has been compromised. […]

Notice that the most hoardable commodity is generally not the most saleable one. This is the reason why throughout the ages, up to 1870, there existed two different kinds of money circulating side-by-side. In antiquity cattle became the most saleable commodity, and salt the most hoardable one. Later on these roles were taken over by others till, ultimately, the market has settled on gold as the most saleable, and silver as the most hoardable commodity. […] The dichotomy of space/time explains the dualistic nature of money, explicitly observable throughout the ages –right up to the demise of bimetallism scarcely over six scores of years ago. In its first capacity money transmits value in space, that is, over great distances with the smallest possible losses. In antiquity cattle were particularly well-suited for this purpose and have become money. However, cattle-money was not particularly suitable for transmitting value over time with the smallest possible losses. This explains the emergence of another kind of money, more suitable for hoarding and dishoarding, that is, to facilitate the transmission of value over time. This other kind of money was salt. Not only was it less perishable than other marketable goods; salt was also the most important agent of food preservation. […]

Even though gold and silver which have later replaced cattle and salt were far more similar to one another, the dual nature of money persisted throughout the ages. The main reason for that was the fact that the specific value of gold was high, and parceling it out in molar quantities added substantially to the cost of production. Only towards the end of the 19th century did advances in metallurgy make it possible that one single monetary metal, gold, could answer both monetary needs of man better than any other commodity. […]

A commodity X is said to be more marketable in the large, or more saleable than another Y if the bid/asked spread for X increases more slowly than that for Y, as ever larger quantities of X and Y are offered for sale in the market. For example, perishable or seasonal goods have a lower, while durable goods or goods for all seasons a higher, degree of salability. It is easy to see how cattle have become the most saleable good in antiquity. People had superb confidence that there could never develop a glut in the cattle market. Long before such a turn of events owners would drive their herds of cattle to regions where a shortage prevailed or, at least, there was no glut. […] The term salability refers to the quality whereby a good is capable of being bought or sold in the largest quantities with the smallest possible losses […].

For gold, the bid/asked spread is virtually independent of the quantity for which it is quoted. As we have seen, for non-monetary commodities different spreads are quoted for different quantities, and the larger the quantity the larger is the spread. For gold the spread only depends on the cost of shipping it to the nearest gold center. Under a gold standard the bid/asked spread is actually constant and is equal to the difference between the higher and lower gold points. (The lower gold point is that price at which it becomes profitable to melt down domestic gold coins in order to export the bullion; the higher gold point is that price at which it becomes profitable to import the bullion in order to have it coined at the domestic Mint.) […]

It is common knowledge that, although precious stones have a high degree of marketability in the large, their marketability in the small is poor. […] The precious metals are more hoardable than precious stones, as the losses involved in parceling them out into ever smaller pieces are smaller. […] as ever smaller quantities of a commodity are offered for sale, the bid/asked spread widens. A wider spread compensates the market-maker for the lack of incentives to deal in unusually small quantities. […]

A commodity x is more marketable in the small, or more hoardable than another y if the bid/asked spread for x increases more slowly than that for y, as ever smaller quantities of x and y are offered for sale in the market. For example, non-perishable foodstuff such as grains are more hoardable than perishable ones. Horse meat is more hoardable than live horses. It is easy to see how salt has become the most hoardable commodity in antiquity. People were confident that disturbing surpluses of non-perishable foodstuff would not develop. […] Other examples of highly hoardable commodities are: grain, tobacco, sugar, spirits, silver. It is interesting to note the heavy government involvement, at one time or another, with the production or trade of all these. […]

An historical process similar to the one making gold the most saleable has promoted silver to become the most hoardable commodity. Gold was the money used to pay princely ransoms and to buy vast territories such as Louisiana and Alaska. Silver, by contrast, was the money used by people of small means to buy food, or to accumulate capital […].

In fixing the official bimetallic ratio governments were led by greed. They thought that they could make their vast hoards of silver more valuable by stopping the slide in the relative value of the silky metal. It is not in the power of earthly governments, however powerful economically and militarily, to create value at will. […] The measure to fix the official bimetallic ratio backfired. It signaled to people that time has come to switch from silver-hoarding to gold-hoarding. In response, people started dumping silver at the door of the Treasury while depleting its gold hoards. […]

It is the dishoarding of marketable goods other than gold that is deflationary. Dishoarding gold does, on the contrary, ease the (real or imagined) shortage of purchasing media. To the extent gold is hoarded occasionally, if is offset by occasional dishoarding. The gold standard is far from being contractionist as asserted by the inflationists. Quite to the contrary: gold is the chief prophylactic that protects the economy against deflation. When the banks or the government sabotage the gold standard, they spawn a cycle known as the Kondratieff long-wave cycle. The hoarding instincts of the people are channeled away from gold, a natural conduit (as gold is not essential for human consumption), to other marketable goods, an unnatural conduit and a dangerous agent when hoarded (as they could be indispensable for human consumption). The cycle manifests itself through the destabilization of the price structure as hoarding (dishoarding) marketable commodities results in rising (falling) prices. […]

At the present juncture the world economy is threatened by a treacherous deflationary spiral that could end in the worst depression ever. It is not possible to understand this development without realizing that the removal of the gold standard has destabilized the interest rate structure and, hard on the heels of the Japanese, American interest rates are inexorably plunging to zero. Falling interest rates decimate the balance sheet of the producers, forcing many into bankruptcy. […]

The invention of double-entry book-keeping in Italy of the Trecento was a momentous landmark in economic history. […] The new development released huge amounts of gold from private hoards as people began to accumulate and carry wealth in the form of securities disguised as partnership equity, instead of gold. By contrast in the Orient, where the social and institutional arrangements were far more inimical to the individual and his freedom to choose, the demand for gold and silver for hoarding purposes continued unabated. During the Quattrocento gold disgorged by the Occident flowed to the Orient in payment for exotic goods. Spices, silk, and satin enjoyed exceptional marketability in the Occident where all great banking houses engaged in financing this lucrative trade. The world was treated to a curious spectacle. The Occident was thriving while trading its gold with the Orient for frankincense and myrrh — as it could use more of the latter, and it had learned to get by with less of the former. It was this migration of gold from West to East that gave the edge of industrial power to the Occident, an advantage it still has over the Orient. […]

Capitalism must be seen as the liberator of inventive talent, the creator of wealth and prosperity for the benefit of all. Its creative formula is the troika of the capitalist, entrepreneur and inventor. One cannot assess the merit of capitalism without explicitly recognizing the great and durable reduction in the rate of interest it has brought about. Indeed, the only valid way to bring down the rate of interest is to enhance the bargaining power of the partnership of the entrepreneur and inventor vis-a-vis the annuitand and annuitant, through encouraging the activities of the capitalist. If the latter is hampered in his business, then the partnership of the annuitand and annuitant will enjoy monopoly power and, as a result, the rate of interest will be high. The capitalist is the only actor that can offer competition for the monopoly. As a result of this competition the rate of interest has been reduced from the extremely high levels prevailing in pre-capitalistic times to a low level that puts all bona fide inventors and entrepreneurs in business. Even more remarkable is the fact that capitalism has accomplished the feat of reducing the rate of interest without harming the annuitand and annuitant. Every member of society, regardless of his contribution to the success of capitalism, is a beneficiary of the lower rate of interest brought about by capitalism, through the great increase in the availability of consumer goods at affordable prices, not to mention higher wages due to the increase in the marginal productivity of labor and capital, made possible by countless inventions. […]

A falling rate of interest is even more damaging for the economy than a rising one. […] falling interest rates mean that business has been financed at rates far too high. This fact ought to be registered as a loss in the profit/loss statement, and be compensated for by the injection of new capital (much the same as would losses caused by damage to plant and equipment due to war, for example). Instead, businesses choose to ignore the loss, and they merrily go on paying out phantom profits in the form of dividends, further weakening capital structure. When they plunge into bankruptcy, they wonder what has hit them. […]

The compact between lender and borrower demands that the latter be a superman, uniting in himself the talents of the entrepreneur and the inventor as he wants to meet the terms of his contract in full. How otherwise could he be expected to return a greatly enhanced wealth to the lender at the end of the loan period, and stay in business, without ruining himself? Surely the terms of his contract giving the lender the right to cut out a pound of flesh from any part of his body at the option of the latter was designed with the extinction of his life in mind – according to the socialist’s view. What this view disregards is the fact that the capitalist is not dealing with one individual, but with a partnership combining the talents and skills of two: the entrepreneur and the inventor. Had Aristotle understood the problem of converting income into wealth and wealth into income, and its optimal solution via the agency of exchange, credit, and division of labor, then the wind would have been taken out of the sails of socialist agitation before it had a chance to cause so much mischief in the world. […]

The hierarchy of controls under capitalism runs along the following lines. The annuitant has veto power over the plans of the capitalist; the capitalist in concert with the annuitant has veto power over the plans of the entrepreneur; the entrepreneur in concert with the annuitant and the capitalist has veto power over the plans of the inventor. The inventor has no veto power at all, but in so far as there are more annuitands than annuitants, as obtains under a positive population growth and is therefore a characteristic of a dynamic society, capitalism can employ more inventive than entrepreneurial talent. A dynamic society tends to put a premium on new ideas. It has natural built-in incentives for higher education and advanced studies – even in the absence of compulsory schooling and governmentally sponsored research. It is these dynamic forces, measured by a surplus of R&D over entrepreneurial capital formed by the annuitand and the inventor, which create the educational facilities and equip the laboratories, without any trace of coercion. […]

The cynical phrase “euthanasia of the bondholder” was first used by John Maynard Keynes. He was well aware what the implementation of his schemes to sabotage the gold standard would mean to bondholder. Keynes treated the bondholder with contempt, as a parasitic element of society. He ridiculed coupon-clipping, calling it the only positive contribution the bondholder is capable of making to the commonweal. In the event, euthanasia was turned into a bloodbath, the like of which the world has not seen since the night of St. Bartholomew. In view of the hexagonal model, to disparage the bondholder is tantamount to disparaging the annuitand and the annuitant, that is, one’s father and grandfather who, after a lifetime of faithful and diligent service expect to have a peaceful and secure retirement. The euthanasia of the bondholder means the euthanasia of dear old grandfather. […] The euthanasia of the bondholder was the ill star under which “social security” was born. The latter is a compulsory scheme based on socialistic principles. […]

The yield curve represents the rate of interest as a function of time to maturity. It is considered “normal behavior” for the rate of interest to increase as the time to maturity is increased. […] However, under “abnormal” credit conditions it can and often does happen that, as maturity increases, the yield actually decreases. In this case the yield curve is called “inverted” […]. Abnormal credit conditions mean that, as a result of loose credit policies pursued by the banks and the government, too many short-term credit instruments approach maturity, which depresses their prices. Cash is scarce and the yield on short-term credit is high. […] None of this may happen under a gold standard where the government and the banks are forced to keep their short-term liabilities safely within the limits of their quick assets. In fact, if all the gold bonds issued have sinking fund protection, as they should, then there is no yield curve. More precisely, the yield is the same constant value for all maturities (making the yield curve a horizontal straight line). The rate of interest is stable, both in time and across the maturity spectrum. […] The fact that there is no yield curve under a gold standard does not mean that the rate of interest may not change. What it means is that all the adjustments are so gradual that they present no temptation for the banks to speculate in the bond market. On the other hand, if certain economic shocks (such as a continental crop failure, or pestilence wiping out a sizeable portion of the working force) calls for a big rise in the rate of interest, then it will be made quickly and expeditiously. Issuers of gold bonds will refund their obligation and sell a new issue with a higher coupon rate. In no case would they allow bondholders to suffer a loss. […]

The destruction of the gold standard by the government was thoroughly immoral, but the matter did not end there. It has corrupted the bond market right to its core. Today nobody in his right mind would try to save by holding the bond to maturity. The bond market is the haunt of speculators. It is a casino for gambling. The bond is the chip to be used at the gambling tables. […] the bond market is a casino where speculators risk not their own funds but those of the savers and producers. As a result, the latter are always the losers, even when they haven’t the slightest intention to play. We have an insane arrangement whereby productive activity is penalized and gambling activity is rewarded. As a result, the volume of productive activity constantly shrinks while that of financial activity constantly expands. Moreover, the latter expands at an exponential rate, as the financial markets attract all available funds, gobbling up the capital of the producing sector. Most ominous of all, talent is no longer attracted to production, entrepreneurship, and inventive activity. […]

Pillars of Sound Money and Credit

Gold is the only commodity that can be offered in unlimited quantities in exchange for goods and services across all national boundaries. Without apparently harming its exchange value. Moreover, gold is the only asset that individuals and governments will carry in the balance sheet without any promise of return to capital. Gold is the only asset that can balance a liability without being at the same time a liability of someone else. It is the only financial asset that can survive the consolidation of the balance sheets of any combination of individuals or governments. Economics accounts for this anomalous behavior of gold, not by appealing to psychology or to human weaknesses such as vanity or superstition, but by appealing to logic. Even if we regard the choice of gold as monetary standard as an historical accident, by now gold is so firmly entrenched that its replacement is virtually unthinkable. Almost all the gold that has been produced since the dawn of history is still available in marketable form. The same simply cannot be said of other commodities. They all disappear in consumption. The ratio of stocks of gold to annual production flows is a high multiple, estimated to be between 80 and 100. For other goods, the ratio of stocks to flows is a small fraction, e.g., 1:3 for copper. […]

In these terms, gold is the most abundant commodity known to and produced by man. Gold does not owe its value to its alleged scarcity On the contrary, gold owes its value to the fact that, in spite of its abundance and steady increase of abundance, gold continues to be in universal demand, and it continues to be acceptable in unlimited quantities. No other asset can match the record of gold in this regard. No other commodity can withstand the wear and tear the monetary standard is constantly exposed to. […]

The only way to stop the vicious agitation against the scarcity of money is to put the power of issue where it belongs, namely into the hands of the people. This means free coinage of gold. When this is done, every citizen who believes that there is too little money in circulation can do something about it. He can take his old jewelry or his newly mined gold to the U.S. Mint, and convert it into the gold coins of the realm. […]

As the government creates more money and credit through deficit spending, prices and wages rise. Operating costs tend to rise faster than revenues, thus reducing profits. The result is idle factories and idle men. In short, the effect of deficit spending is more of the same condition that it was supposed to eliminate in the first place. Thus a vicious circle is put into place: deficit spending creates idle capacity and unemployment, which then call for more deficit spending, to create still more idle capacity and more unemployment. […]

Just as wheat ripens into gold by the time the flour is baked into bread, so does every other merchandise, at the time it is offered for sale to the ultimate, cash-paying customer. We may express this ripening process by saying that, as the semi-finished goods become finished goods, they also become ‚liquid.‘

When a commercial bank makes a loan to a producer or distributor, the commercial paper that arises becomes the bank’s asset. Commercial paper is considered liquid, if the underlying merchandise is liquid. Such paper is also called ’self-liquidating‘, because at the time the merchandise ripens into gold, the gold coin of the consumer will liquidate the loan.

By contrast, a loan to finance the construction of a building is not liquid, let alone self- liquidating, because it may take decades before the brick and mortar sunk into the building can amortize the construction costs. Further by contrast, a loan for carrying a speculative storage of goods is not liquid, because the goods are not moving, and they won’t be sold before the bank loan matures. The financing of such slowly maturing projects should not be in the purview of the commercial banks; they should be left to the investment bank which uses actual savings for the purpose […].

The banking system in the United States is not just illiquid, but is in an advanced state of petrification. Only a small part of bank assets could be liquidated on short notice without great losses. The commercial banks rely on the Federal Reserve to replenish their reserves daily, rain or shine. The assets of the Federal Reserve banks are not much better: they consist of government securities. In case of a run, the Federal Reserve would be in no position to meet the demand for cash through honest asset-liquidation, because it would break the bond market. The Fed would have to monetize the bad assets of the commercial banks, which would make its own position even less liquid. Therein lies a great danger. […]

The banks have a double balancing act; they must balance their liabilities with assets not only dollar for dollar, but also maturity for maturity. That is to say the banks must see to it that their assets mature no later than their liabilities. This is known as the Principle of Matching Maturities. […]

If bank liabilities mature faster than bank assets, then two things will happen. (1) Interest rates will rise, as the banks are forced to resort to asset-liquidation, and the public will acquire these assets only at a concession in price. (2) The maturity structure of the debt will shrink, as the banks are forced to issue short-term debt in exchange for long-term debt. In other words, the banking system, led by the central bank, is forced to finance a massive exodus of the savers from long to short term debt. As the banking system has to absorb more and more long-term debt, unwanted by the saving public, and give short- term credit in exchange, it becomes clear that the only cure for the condition caused by that drug abuse is more drug abuse.

The central bank is helpless. Any hesitation on its part to make available the reserves needed to meet the maturing liabilities of banks would bring down the house of cards immediately. The central bank would therefore continue to buy the long-term bonds dumped by a disgruntled public. That is to say the central bank would continue to borrow short and lend long on an ever larger scale. The vicious circle, however, cannot continue indefinitely as the average maturity of the debt cannot shrink to zero. Before that happens the bond market, like a rotten apple, will fall into the lap of the money market. The money supply will explode, the supply of savings will implode, and the new brave world of borrowing short and lending long will come to a sorry end. […]

Debt is not bad per se. Debt embodies the symbiosis between the three progressive classes of people in the economy: the savers, the producers, and the inventors. Debt is the instrument facilitating the exchange of the wealth of the savers for income. Debt is the instrument facilitating the acquisition of state-of-the-art technology by the producers, in order that they may get the highest output per input of labor and capital for the benefit of everybody. Debt is the instrument facilitating the exchange of the future wealth of inventors for present income in support of research and development. Debt alone can make possible the extension of division of labor to generations that are far removed in time. Debt alone makes the emancipation of savings possible: saving is no longer anti- social as it was when the saving of a gold coin perforce meant a contraction of demand, prices, and output. Through debt as catalyst, saving is more beneficial than spending: the present wealth and income of savers find their way to the producers and inventors, and to the socially most beneficial applications. […]

The distinction between good and bad debt is not subjective or arbitrary. The quality of debt can be gauged by its productivity. This is the ratio of the net gain in GNP (gross national product) to the gain in debt. (The net gain in GNP is the excess of additional GNP over additional debt.) If this ratio is positive, then the new debt can be serviced out of current income, and the greater the ratio, the higher is the quality of debt. If the productivity of debt is allowed to decline significantly or, worse still, to become negative, then the debt can no longer be serviced out of income, and new debts have to be incurred to meet the maturing debt. The negative ratio is a clear signal that bad debt is now breeding more bad debt. A feedback is in effect, short-circuiting the economic process. The debt-tower is growing out of control, and in due course it will self-destruct. […] We have long since passed the point when debt had a positive productivity in this country. Before 1960 it took less than one dollar of new debt to produce $1 gain in GNP But in the 1960’s, on average, it took $2. in the 1970’s it took $5, and in the 1980’s so far. It’s taken $3.50 of new debt to produce the same $1 gain in GNP. The growth of bad debt is accelerating. It should be clear that this trend cannot continue indefinitely. The new debt has no economic justification. It does not produce the income to amortize itself, let alone a spendable income. Sooner or later the fantastic debt tower will topple, and bury the economy that prefers debt accumulation to capital accumulation. […]

If the rate of interest goes up, there is an immediate effect of rendering additional labor and capital sub-marginal, regardless of whether or not the productivity of individual laborers has declined. Thus we see that the maximum rate of interest determines the marginal productivity of labor and capital. It arbitrarily decides who can keep his job and who shall lose it, which capital equipment can stay in production, and which shall be doomed to the scrap-yard. The Principle of Productivity of Labor and Capital asserts that the maximum rate of interest must be low enough to allow all those, who are eager to earn wages, to find employment; and also low enough to allow new capital goods to begin their amortization cycle. […]