A Cure For Austrian Subjectivism II:
The Real Nature of Credit and Cycles
Bid and ask are the two marginal prices I discussed in the first part of this series. The bid is the lowest price in the market, that an individual who needs to sell his goods must take. It is defined by the marginal producer's unwillingness to sell below a certain price. The ask is the highest price in the market, that an individual who needs to buy a certain good must pay. It is defined by the marginal consumer's unwillingness to buy above a certain price.
Ludwig Von Mises gives the first definition in his Theory of Money and Credit, and the second in his Human Action. In both cases, the essential characteristic of money is its common use in indirect exchange, due to multiple individuals' subjective choices, and not an objective factor that makes its use desirable by individuals in the first place.
This is the second article in a two-part series. To fully understand it, I recommend that the reader be comfortable, not only with mainstream Austrian Economics, but also with the ideas presented in the first part of this series.
In the first article of this series, I analyzed how the Austrian School of Economics' epistemology changed over time, and the fundamental differences between the Aristotelian approach of authors like Carl Menger (1840 - 1921) and Murray Rothbard (1926 - 1995), and the subjectivist approach of authors like Ludwig von Mises (1881 - 1973) and Friedrich Hayek (1899 - 1992). I looked at the negative consequences of Mises’ Kantian epistemology in his theories of value and money, while introducing the fundamentals of the New Austrian School Of Economics (NASOE), and its attempt to breathe new life into the original Aristotelian approach.
I detailed how this change in epistemology resulted in a shift from Menger’s volitive theory of value, to entirely subjective theories of value by Mises and Hayek - a change that went unquestioned by Rothbard in his attempt to reintroduce an Aristotelian foundation to Praxeology. We have also seen how the method of imaginary constructs relies on an a priori approach, at the expense of Menger’s original idea of marginalism, and how it conflicts with the idea of the marginal bid and ask prices.
With regards to the Austrian theory of money, we saw how a subjectivist epistemology leads to the conceptualization of marketability as an essentially subjective factor, and to the definition of money as the "universally employed", or "commonly used" means of exchange in a society. I then contrasted that view with the NASOE’s view of marketability as an objective social characteristic related to the spread between the two prices of money, and their focus on its use as the ultimate extinguisher of debt.
I ended the first part of this series with the NASOE’s definition of inflation as "an expansion in counterfeit credit", in contrast to the mainstream Austrian idea of inflation as an increase in the quantity of money. With inflation being essentially a distortion on the credit market, we have yet to look at its particular effects in the market for credit. Before we do that, however, it is a good idea to go over what exactly credit is, and how it originates, according to both the mainstream Austrian Economics and the NASOE.
Throughout this article, I will contrast the mainstream Austrian view of credit as an exchange between present and future value, and of market interest rates as defined by originary interest; with the NASOE’s view of credit as an exchange between wealth and income, both incorporating productivity in the definition of interest rates, and revisiting Adam Smith’s Real Bills Doctrine. We will also be looking at the differences between both schools in their theory of economic cycles, comparing the a priori model that dominates Austrian thought, with the model of ascending and descending positive feedback loops described by Keith Weiner, culminating in the backwardation of monetary metals.
Time Preference: Future vs Present Value
The marginal productivity theory of interest, proposed by classical economists like Alfred Marshal an J.B. Say, was based on the idea that interest rates are defined by the marginal productivity of capital, ignoring factors such as the time-preference of the marginal lender. Contemporary neoclassical economics takes multiple other factors into consideration, yet deals with them in averages and correlations, instead of margins and causal relationships.
Human Action, 1949, Ludwig von Mises, p. 524-525
By that, he means the "myth" that the productivity of borrowers is a factor in the definition of interest rates. As we will see, however, marginal productivity sets the ask price for credit, as no one is willing to borrow at a rate higher than their returns.
Contemporary Positivist models, such as the IS-LM and its derivates, replace causality for correlation, and assume that, since rises in savings often correlate with declines in interest rates, there is a relationship between both - supply of credit is usually taken to be a function of savings. This is wrong however, as an individual with money to save has the alternative to hoard it, or trade for immediately consumable goods. The essential factor in the decision to lend money is not the amount saved by the lender, but the spread between the interest rate and the lender's time preference. The amount saved is irrelevant - if the rate of interest is higher than the individual's time preference, the exchange will take place.
The "final state of rest" is a hypothetical price that a good would be sold for, if every single relevant factor in the market remained
the same for an infinite span of time. It is a tool Mises uses to illustrate the fact that prices tend to reflect real market pressures, and changes in the supply and demand for goods. We covered this idea, its merits and its flaws in the first article of this series.
The mainstream Austrian theory of credit is based on the distinction between a present good and a future good, and considers declining temporal preference to be axiomatic. In other words, it holds the idea that an individual will always attribute a higher value to the satisfaction of a need in the present moment than to that same need at a later time, to be true a priori - a part of the structure of human action itself. Central to the theory is the concept of originary interest, the ratio of the value an individual assigns to want-satisfaction in the immediate future and to want-satisfaction in later periods in the future. In more concrete terms, the mainstream Austrian approach holds that an apple now is more desirable than the same apple tomorrow, which is more desirable than in the day after that - originary interest being the rate at which I'm willing to trade an apple today for more apples in the future.
The price of capital goods derive from the price of goods that it can be used to produce in the future. By that logic alone, the price of a stretch of land would take into account all future production from that land, which is virtually infinite. Originary interest explains market phenomena such as the finite price of land - their prices are finite because the further away in time that land’s production is, the less it is valued, approaching zero for the very distant future. The productivity of a particular stretch of land 10.000 years from now is irrelevant for someone purchasing it now.
Mises makes it clear that originary interest is not defined by the relationship between supply and demand for credit - on the contrary, originary interest is what defines both the supply and demand for credit and capital. In his theory, the multiple interest rates found in the market are defined primarily by the originary interest, coupled with other factors, such as risk and the expectation of change in the prices of goods. In other words, the author did not believe that an increase in savings had an effect on the interest rate, arguing instead that both savings and interest rates were ultimately defined by originary interest. In his view, changes in interest rates tend to reflect changes in the economic agents’ time preference, much like changes in prices reflect changes in production or consumer preference.
Despite making the important distinction between return on capital and the simple ratio of value over different periods of time, Mises completely rejects the influence of productivity in the market interest rates, going so far as to argue against fellow Austrian Eugen von Bohm-Bawerk (1851 - 1914) on the subject:
“Bohm-Bawerk has once for all unmasked the fallacies of the naive productivity explanations of interest, ie., of the idea that interest is the expression of the physical productivity of factors of production. However, Bohm-Bawerk has himself based his own theory to some extent on the productivity approach. In referring in his explanation to the technological superiority of more time-consuming, roundabout processes of production, he avoids the crudity of the naive productivity fallacies. But in fact he returns, although in a subtler form, to the productivity approach. Those later economists who, neglecting the time-preference idea, have stressed exclusively the productivity idea contained in Bohm-Bawerk's theory cannot help concluding that originary interest must disappear if men were one day to reach a state of affairs in which no further lengthening of the period of production could bring about a further increase in productivity. This is, however, utterly wrong. Originary interest cannot disappear as long as there is scarcity and therefore action. ”
Rothbard, despite rejecting the notion of a priori knowledge, shares the same essential aspect of Mises’s theory of credit: the idea that time preference is the essential factor in the definition of the rate of interest. The author dedicates an entire section of Man, Economy and State to what he calls the “myth of the importance of the producers’ loan market” . Both authors reject the idea that productivity is relevant to the definition of interest rates, rooting the phenomena of credit exclusively in time preference.
The mainstream Austrian approach to credit corrects a mistake very commonly made by economists, and core to Positivist economics: the belief in a direct causal relationship between savings and the rate of interest. It also demonstrates how a free credit market achieves uniform interest rates through entrepreneurial activity, and how it is subject, like any other free market, to consumer sovereignty. Just as in the theories of money and value, however, Kantian epistemology takes a toll in the Austrian theory of credit.
Just as the imaginary construct of the state of rest has a purpose, but ignores the marginal prices in the market, the conceptualization of the market rate of interest as a reflection of originary interest properly fulfills the role of introducing the concept of time preference, but ignores the fact that credit, just like any good that is systematically traded, has bid and ask prices. In actuality, an individual that needs to borrow money - be it for investment or, more urgently, to pay off a debt - is subject to a higher interest rate than an individual that wants to lend money. Every transaction happens between the lower marginal price of the credit market, defined by the marginal lender’s refusal to lend money at rates lower than his time preference, and the higher marginal price of credit, defined by the marginal borrower’s refusal to borrow money at rates higher than his marginal productivity.
Time Preference: Income vs Wealth
In contrast to mainstream Austrian economics, the NASOE rejects the very dichotomy of present and future value, as well as the idea of declining time preference as axiomatic, using instead the dichotomy of income and wealth as a foundation for its theory of credit. As Antal Fekete puts it:
Monetary Economics 102: Lecture 2 The Exchange of Income and Wealth, 2003, Antal Fekete.
“The very idea of a dichotomy between present and future goods is false. The future is a closed book to man. He knows not what the future holds for him. He cannot know what his future needs and valuations will be. Even his taste is subject to change, and he is as ignorant about his own preferences in the future as he is of those of another person. "
Consumer sovereignty is the idea that, although the producer is the one who makes decisions regarding the production of a particular good, the consumers are the ones who will determine whether or not a particular good is profitable, ultimately determining whether or not it will remain in production. Creditors are consumers of bonds as much as they are suppliers of credit, and thus ultimately determine what bonds will remain available. Just like consumer sovereignty is conditional to the consumer's ability to choose between all available courses of action, including not making any purchases, so is creditor sovereignty conditional on a lender's ability to choose not to lend.
Rejecting any form of a priori knowledge, the author uses observable facts as a foundation on which to build a theory of credit based on the concepts of hoardability and salability. According to Fekete, the original credit exchange of a present good for a future good put forth by Mises is reducible to two distinct exchanges: the exchange of a good for an income and a second one, later in time, where the income is returned to its original owner in exchange for the same quantity and quality of the original good. In other words, an exchange of wealth for income, and a later exchange of income for wealth. He defines wealth broadly, as property that is held for an extended period of time; and income, more narrowly, as a steady flow of goods and services.
To directly convert income into wealth, or hoard, an individual must abstain from consuming part of his income and exchange it for a marketable good that is not perishable. Conversely, to directly convert wealth into income, or dishoard, an individual must exchange a marketable good for consumable income. Amongst the most marketable goods in the economy, some might be better suited for the purpose of hoarding, because they can be purchased constantly and for a smaller amount of goods, matching the stream nature of income. This particular instance of marketability is what Fekete calls “marketability in the small”, or hoardability. Other marketable goods are more suitable for the purpose of storing value or dishoarding, because they can be exchanged for consumable goods at a much faster rate, with fewer transactions. This particular instance of marketability is what Fekete calls "marketability in the large", or salability.
To be able to purchase small amounts of gold every month, an individual must spend a significant amount of value, as a single ounce costs over $1,500 - an ounce of silver, however, only costs about $15, making it more suitable for the gradual hoarding of smaller amounts over time. Silver is thus more marketable in the small, or hoardable, than gold. The amount of transactions required to dishoard wealth that is made out of silver is likely to be larger, and the whole process to take longer and cost more, than it would to dishoard wealth of the same value made up
of gold. Gold is, thus, more marketable in the large, or more salable, than silver.
With the development of legal and economic institutions, credit emerges as a more productive alternative to the process of direct hoarding and dishoarding. With the advent of credit, an individual can supply his wealth to another in exchange for a steady income, through the purchase of a bond. The individual can later exchange that income for the original wealth once the bond reaches its maturity. Every credit transaction, however, comes with a risk, as its debtor might be unable or unwilling to pay what he owes. It is up to the creditor to assess the situation and make his decision based on the risks and returns involved.
In a free credit market, under an honest monetary system, particular transactions float between the bid price - the lower interest rate defined by the marginal creditor’s refusal to lend money at a rate lower than his time preference - and the ask price, the higher interest rate defined by the marginal debtor’s refusal to borrow money at a rate higher than his marginal productivity. In other words, if the market's interest rate is higher than a producer’s marginal productivity, he can profit by liquidating his capital and buying bonds, causing the available money to flow to more productive enterprises. If, on the other hand, the interest rates are lower than a creditor’s time preference, he is better off liquidating his bonds and keeping his money.
This ability to refuse lending money is what I call creditor sovereignty, and it is a particular instance of the concept of consumer sovereignty put forth by Mises. It is of key importance, because it constitutes a lender’s last resort when facing a credit market out of which he cannot profit. To liquidate one’s bonds and take home an actual good, such as gold, is to say “I have nothing to gain by lending my money at these rates, so I would rather keep the money to myself". The only alternative to being able to liquidate one’s bonds for an actual good is being forced to lend.
Having established that the existence of money with present value is essential to a creditor’s ability to remove himself from the market, we have yet to look into what happens when the government forcefully prohibits the circulation of monetary metals and replaces them with currency backed by government debt. Before exploring the differences between the mainstream and the NASOE’s approach to economic cycles, however, we must explore a second source of credit revisited by Fekete, and neglected by the Austrian mainstream: real bills of exchange.
A Second Source of Credit:
The Real Bills Doctrine
Retailer and supplier, in this context, are not professions, but catallactic functions, i.e. relative market roles. As such, these roles can be "played" by the same individual in different contexts. A producer of bread, for example, is a retailer in so far as he sells bread directly to consumers and, at the same time, a supplier in so far as he sells in bulk to a catering service.
“The dividing line of 91 days between the two is not arbitrary. It is one quarter, the length of the seasons of the year. The difference between the two kinds of credit is fundamental, and goes far beyond the difference in the maturities of credit instruments. Mises denies that sound credit can arise outside of the context of lending and borrowing. For him 'discount rate' is just another name for the rate of interest on short-term loans. Mises denies the validity of the Real Bills Doctrine of Adam Smith. He considers circulating real bills as inflationary as any other form of credit expansion.” - Monetary Economics 101: Lecture 4 The Two Sources of Credit, 2002, Antal E. Fekete
In addition to saving, Fekete identified a second source of credit, that gives rise to a completely independent market than the one based on savings: clearing. Going on the opposite direction of the Austrian mainstream approach, the author revisits Adam Smith’s idea of a source of short-term credit based on the expectation of production.
A real bill of exchange is an instrument of short-term commercial credit that has its origin, not in an individual’s savings, but on the short-term demand for goods. It is written by a retailer to its suppliers, with a maturity of no more than 91 days. Bringing the concept to a perceptual level: a baker might notice an unexpected and urgent demand for bread on the part of his consumers, but not have enough money at hand to buy the flour needed for the production of that bread. His flour supplier can choose to accept a contract drafted by the baker, stating that he will pay for the flour after up to 91 days, once he has sold the bread. Risks aside, both individuals profit from that agreement.
Suppose, however, that the flour supplier wants to liquidate his bill before maturity, because he needs money to pay his employees’ wages. With the increasing complexity of productive chains, and the integration of different markets, the market for real bills emerges - a market in which those bills can be sold to a capitalist at a discount. In that case, all three economic agents involved profit: the baker profits by supplying the unexpected demand, the flour supplier profits by selling to the baker while being able to pay his employees, and the capitalist profits on the spread between the discounted price he payed for the bill and its value at maturity.
The discount rates, i.e the rates that emerge in the market for real bills of exchange, are not directly related to the interest rate on the long-term credit market, as the pressures at work in both markets are different. The market for real bills becomes more essential as productive chains grow longer and more complex, and the process of clearing debt between producers becomes more intricate. In the absence of a market for real bills, for instance, our baker might not have been able borrow money in the bond market, as the risk a banker takes by loaning to a businessman is usually significantly higher than that of a long-term supplier, who has more information available.
Part of the rejection of the Austrian mainstream to the Real Bills Doctrine is due to von Mises’s definition of inflation, while another part is due to ignorance over the content of the theory, as exemplified by Robert Blumen. We shall deal with the later cause first, and than contrast the theory’s actual ideas with those of Mises.
In this article, Blumen cites Nelson Hultberg and Antal Fekete as modern proponents of the Real Bills Doctrine, but goes on to criticize a theory that has no resemblance with the ideas presented by those authors. In the model described by Blumen, real bills are contracts that can be purchased by banks who, in turn, can use them as backing for the emission of currency. Blumen is right in so far as currency that is backed by debt, whether it is a real bill or a treasury bond, is not an actual value and, therefore, cannot extinguish debt. The model criticized by the author, however, does not resemble Fekete’s idea in the slightest.
The market for real bills described by the NASOE is one where a capitalist purchases a bill, paying for it with money. The medium of exchange that goes into circulation is, in fact, money, and the original debt is extinguished once the capitalist receives his payment, also in money. This is the point at which the different definitions of inflation by the NASOE and the Austrian mainstream come into play. According to Mises, Hayek and Rothbard, the increase in the supply of money that comes from the clearing houses for real bills would bring down the value of money. As we have shown in the previous article, however, the value of honest money is virtually immutable, regardless of the amount of money in circulation.
At this point, we can trace a well defined chain of causality between the epistemology and the theories of money and credit of both the mainstream and the NASOE’s approach. The subjectivist epistemology of mainstream Austrian economics leads to a purely subjective theory of value, which leads to a subjective conceptualization of marketability, and a definition of inflation in terms of the quantity of money. In the context of an aprioristic epistemology, the mainstream subjective theory of money and inflation leads to a theory of one source credit, based solely on saving, with a rate defined by time preference. On the other hand, the New Austrian School of Economics adopts an objective epistemology, which leads to a volitive theory of value, which in turn leads to an objective conceptualization of marketability based on the bid-ask spread, and a definition of inflation in terms of government fraud. Building on these premisses, the NASOE arrives at a theory of two sources of credit, one based on saving and the other on clearing, each subject to independent pressures on each of their two marginal prices.
The Mainstream Austrian Theory
As the Austrian School makes abundantly clear, there is no such thing as a "general level of prices". In a free market, prices fluctuate relatively independently from one another, according to changes in the productive process and in people's valuations.
Based on the idea that inflation is the increase in the supply of money, and that deflationary spirals are dangerous situations brought about by the scarcity of money, Friedman proposes his "k-percent rule". The idea is to expand the government's supply fiduciary currency by a fixed amount every year. The goal is to avoid deflation, while minimizing inflation's problems by making it predictable.
"Malinvestment" is the term used by Austrian economists to refer to bad investments that seemed profitable due to an artificially low cost of credit.
The greatest achievement of the Austrian Theory of Economic Cycles was assertively refuting the many theories that attribute the cyclical nature of modern economies to capitalism, “animal spirits”, or any other inherent aspect of a free banking system. By detailing how a free market for credit works, and how fundamental it is to the maintenance and development of productive activities, Austrian economists have shown that destructive economic cycles have only one root: government interference in the credit market.
A second achievement worthy of note is the rejection of the monetarist idea of constant inflation linked to production, proposed by authors like Milton Friedman (1912 - 2006). By clarifying how inflation has effects that go well beyond the rise in a supposed “level of prices”, and that the State’s forceful expansion of credit is harmful to society regardless of its relation to the amount of goods produced, the Austrian School of Economics has contributed to rid liberal and libertarian academia of one of its most pernicious economic beliefs.
According to the mainstream Austrian approach, the phenomena of economic cycles is inextricably connected to the State’s ability to expand credit far beyond what would be possible for a bank in a free market, due to its ability to avoid bankruptcy. In a free banking system, there is always a risk involved for a bank that wishes to grant credit beyond its money reserves.
Suppose that both bank A and bank B have 100 ounces of gold at their disposal, yet, while bank A only lends out redeemable bills worth 100 ounces, bank B decides to lend 150, expecting that people will not try to redeem their money all at the same time. Assuming that people will trade freely amongst themselves, many of bank A's bills will end up in the hands of bank B's clients and, ultimately, in the hands of bank B, and vice versa. Bank B will have no problem redeeming bank A's bills, yet the opposite is not true - bank B has issued more bills than it can redeem, and those bills are now no longer spread out among multiple customers, each representing a small risk, but in the hands of a single agent. The more a bank expands its credit, the more likely it is to be in net debt with other banks, and the higher its risk of bankruptcy.
When the government, which can refrain from declaring bankruptcy on account of its monopoly on violence, distorts the credit market by acting as a lender of last resort, it can essentially manipulate interest rates without being subject to the risk of bankruptcy that regulates the actions of banks operating in a free market. By being able to print money in order to buy treasury bonds from select banks, and by being able to expand its debt at will, the government can essentially manipulate interest rates for a while. This course of action, however, is not innocuous, as the credit market has a role in directing the flow of resources to the most productive activities in the economy.
In the mainstream Austrian approach, an artificial increase in the interest rate, called contraction of credit, causes enterprises that would be profitable in a free market not to be undertaken, leading to sub-utilization of capital. In simple terms, the higher the interest rates, the higher a business’ productivity must be if it its owner is to profit from taking out a loan. A business with a marginal productivity of 6% would be profitable in a market with a 5% interest rate, but not if the rates get artificially increased to 8%.
Artificially reducing the interest rates, called expansion of credit, is what is more commonly done by governments, so that politicians can benefit of an illusion of economic growth. Following the same logic, artificially low interest rates cause enterprises that would not be undertaken in a free market to appear profitable on the short-term, flooding the economy with malinvestments, and creating a false sense of economic development. Inevitably, economic agents eventually adapt, at a high cost, to the reality of the market, readjusting their prices according to the actual factors of production and consumer preference, and causing a big portion of the investments made during the original credit expansion to become fruitless. The original expansion of credit, by its own nature, leads to a costly contraction of credit later on.
Despite all its merits, the strictly deductive and a priori character of the Austrian theory makes it hard for an economist to use it for specific predictions. Understanding the Austrian model, one can easily see how manipulating interest rates of worsens the standards of living in a given society, but is unable to objectively evaluate how close a given society is to its next bust. This particular theoretical deficiency leads many honest and competent economists to the grave methodological mistake of combining the Austrian theory with Positivist tools of analysis.
This article by Ronald-Peter Storfele serves as a perfect example of the negative consequences of the aforementioned theoretical deficiency. In it, Storfele competently presents a compelling and well-written criticism to the actions undertaken by central banks - specifically, to the European Central Bank - that contribute to an environment of negative interest rates. When he attempts to calculate how low those interest rates can get, however, the author adopts a positivist methodology, citing an estimate of how much the savings of an average German individual would be affected based on a generalization of historical data. Despite an Austrian background, the author’s specific predictions are based on averages, instead of margins; strict induction, instead of general principles; and a historical approach, instead of an analysis of fundamentals. By making the appropriate epistemological corrections to the Austrian theory, authors of the NASOE not only give a more detailed description of the processes that cause economic cycles, but also present logically consistent, empirical tools with which to monitor the state of a market.
The New Austrian Theory
For a more detailed explanation of the model, see Keith Weiner's Theory of Interest and Prices in Paper Currency.
For specific data on the markets for monetary metals, see the Supply and Demand Reports at Monetary Metals.
"Time preference" merely refers to the minimum premium an individual is willing to take in return for lending his money. If one expects the same amount of money to buy fewer things in the future than it does now, this minimum premium rises. If an ounce of silver can buy 5 apples now, and 5 apples in the future, the time preference would be the premium one needs to be willing to trade his ability to buy 5 apples now for the ability to buy 5 apples in the future. If one expects that same ounce to buy only 3 apples in the future, then the time preference becomes the premium one needs to be willing to trade 5 apples now for 3 apples in the future - since the value of 3 apples is smaller than that of 5, that premium would need to be higher.
To clarify what I mean by "artificially" high, I must point to the interest rate's role in allocating resources to the more productive enterprises in an economy. The interest rate in a free market is defined by the free interactions between would-be lenders and borrowers and, as such, reflects the lowest level of productivity one must have to compete with other borrowers. High interest rates, in a free market, signal that there are many producers with high rates of return seeking credit, so a producer with a lower rate would do better to lend, allocating his resources to more productive areas, than to invest in his own production. The high interest rates of the falling cycle signal no such thing - they are caused by the actions of central bankers, and signal the urgent need of liquidity by producers.
To put it simply, the mainstream Austrian model of economic cycles essentially consists of a period of artificial expansion of credit, followed by a period in which the economic agents adapt to reality, with the destruction of productive capital as a net result. The model of economic cycles put forth by Keith Weiner, on the other hand, consists of a period of rising prices and interest rates, followed by a period of falling prices and interest rates, leading to in backwardation - a positive spread between the present bid price, and the future ask price for gold - that is already happening in countries like Switzerland and the USA since 2008. A phenomena that, unless remedied by the adoption of an honest monetary system, will lead to monetary collapse.
An individual’s ability to liquidate his bonds, converting them into gold or silver, being essential to the regulation of the bid price for credit, what happens when the government prohibits that specific transaction, adopting a currency based on public debt? What happens when, in that scenario, the government decides to artificially lower the interest rate below the marginal creditor’s time preference? The answer to those questions lie in the concept of volitive, yet objective value. An individual attributes value to a good based on its relation to the satisfaction of a real need or desire. Unable to use honest money, creditors seek the goods that come closer to satisfying the particular needs once satisfied by money: namely, hoarding value.
Money is the commodity with the narrower bid-ask spread in the economy, and its essential function is to maintain its value through transactions. In the absence of honest money to which to liquidate the bonds one no longer wishes to keep, the marginal creditor is forced to purchase other commodities in order to hoard value. The lower the interest rate is in relation to his time preference, the more profitable this transaction is to the individual and, more importantly, to companies. Under those circumstances, a producer can make a profit by stretching his production time through the purchases of commodities and unfinished goods, rather than lending whatever surplus money he might have - the hoarding of value through those commodities is preferable to lending at low rates.
The increase in demand for commodities causes their prices to go up, making it even more profitable for an entrepreneur, expecting a further rise in prices, to act on the spread between credit and commodities, i.e. to borrow money in order to buy commodities. I more concrete terms, if it was already profitable to hoard, commodities instead of lending money, that becomes even more profitable to do so if one expects the price of said commodities to rise - to the point where it becomes profitable to borrow money to buy commodities. This increase in the demand for credit pushes the interest rate up, contrary to the original intentions and expectations of central planners. Simultaneously, the rise in the prices of commodities pushes the time preference of individuals up, which means that, despite the fact that the interest rates are rising, they are still below time preference.
The original attempts of central planners to lower interest rates creates a positive feedback loop of rising prices and interest rates: the rise in the prices of commodities drives the rise in interest rates, which drives the rise in time preference which, in turn, keeps the prices of commodities rising. The most commonly known positive feedback loop is microphone feedback, in which residual noise captured by a microfone is amplified through a speaker and picked up once again by the microphone in a vicious cycle that, if left unchecked, ends up destroying the equipment. So far, the actions of central planners, who try to artificially change interest rates to counteract the consequences of previous artificial changes in interest rates, are the equivalent of trying to stop the noise by screaming into the microphone.
The rising cycle of prices and interest rates necessarily comes to an end only when the decreasing marginal utility of commodities, together with abnormally high interest rates make it impossible for producers to borrow more money in order to buy commodities. In more concrete terms, every additional commodity purchased is less valuable to the producer than the previous one, yet as long as the transaction is profitable, he will borrow money to purchase them, driving up the interest rates. There is a point when interest rates are too high, compared to the value of the next commodity, for the transaction to be profitable.
Interest spikes up as banks take their losses, and companies are left with large amounts of debt, and need liquidity in order to pay for those debts. The decrease in the demand for credit, coupled with the fact that many companies are now forced to liquidate their bonds to remain in business causes the interest rates to fall. Whereas the mainstream approach would deem the cycle to be over when interest rates rise and businesses adjust, however, Weiner demonstrates that there is a second moment of capital destruction.
The saturation of companies’ inventories with hoarded commodities and unfinished goods lowers their marginal productivity. To put it simply, if a producer has already stocked up on an excessive amount of goods, there is not much he can do with extra money - specially if that extra money comes at he cost of very high interest rates. That means that, at the end of the rising cycle, interest rates are now above marginal productivity, which defines the ask price for credit. This spread spans a new cycle of positive feedback: it is now profitable to sell productive capital in order to buy bonds with artificially high interest rates. A producer, whose inventory is full of stocked goods, can now make a profit by selling his machines and unfinished goods in order to invest in bonds.
In addition to the need for liquidity, there is a second market pressure at play as far as the producer is concerned. Operating in a scenario of falling interest rates means competing in a market where every new entrant has access to ever cheaper credit. That means that there is a constant pressure for the lowering of prices, forcing producers to go deeper into debt to stay in business, becoming ever more leveraged and, consequently, fragile. This spans a second positive feedback loop, this time with falling prices and interest rates.
Just like feedback in a microphone, if uninterrupted, destroys the sound system, so the positive feedback cycles caused by the emission of counterfeit credit by the State destroy capital. Left unchecked, the institutionalized fraud of central banks destroys its own currency. That destruction takes the form of permanent gold backwardation.
Empirical Analysis and
The stock-to-flow ratio, that we looked at in the first article is the time it would take to produce the present stock of a given commodity, with the present rate of production. As we saw, gold has between 6 and 8 decades worth of production in stock, while silver has between 2 and 4.
This article by Keith Weiner presents a simple, yet accurate picture of the gold market following the 2008 crash.
For a more thorough look on gold futures, see Monetary Metal's Gold Forward Rates, available for free, and going back to 1996.
Keith Weiner defines basis as the profit rate of a "carry trade", i.e. buying in the present to sell in the future. The cobasis is the profit rate of a "decarry trade", i.e. selling in the present and buying a future. In backwardation, the basis is negative, and the cobasis positive. The opposite is true of contango.
For more information on the subject, see Antal Fekete's lectures on Marginal Productivity of Debt, available for free on youtube.
When dealing with a futures market, one finds that it is in either contango, or in backwardation. Contango is the situation in which the future bid price of a good is higher than its present (or spot) ask price. That signals the abundance of a good in the present, compared to expectations about the future - the market essentially “offers a premium” to the individual who buys that good in the present, stores it, and sells it in the future when it is more scarce. The opposite situation, when the future ask is lower than its present bid, is called backwardation. In this case, it is possible to make a profit by selling a good in the present and buying the same amount of that good in the future. In both cases, profitable arbitrage tends to narrow the spread until it is no longer relevant.
If the present scarcity of a good is what causes backwardation, future markets for monetary metals such as gold and silver, with stocks amounting to decades of production, should never behave like that - and they normally did not, until the financial crisis of 2008. After the crisis’ apex, several instances of temporary backwardation of gold and silver started to occur - instances that lingered, instead of being swiftly resolved through arbitrage. That can be explained by a significant decrease in the marketability of the dollar, to the point where gold and silver entrepreneurs were not willing to part with their goods to buy them again in the future, despite a significant profit margin in terms of dollars. In other words, investors feared that their contracts would not be redeemed at their maturity, and they would be stuck with dollars instead of gold.
Had the phenomenon occurred only immediately after the crisis, it could be attributed to an irrational fear on the side of traders and producers. Temporary backwardation of monetary metals, however, is still happening up to this day, over 10 years after the climax of the financial crisis. If it remains unchecked, that growing tendency will lead to permanent backwardation, in which the dollar bid on gold ceases to exist entirely - in other words, a situation where the market for monetary metals, more sensitive to the declining marketability of currency, stops taking dollars.
The consequence of a permanent gold backwardation is the spreading of this phenomenon to adjacent markets. In a first moment, entrepreneurs that work on sectors closer to the production and commerce of gold would find themselves in need of increasing their gold reserves so that they can deal with businessman that no longer deal in the dollar. In a second moment, that same pressure is now being made by those sectors close to gold on other parts of the economy. In the absence of anything to oppose it, this pressure spreads to the entire market, culminating in sharp rises in the dollar prices of goods and services to a point where the currency is no longer useful. The only alternative to the currency's collapse at this point - and one that can not be ignored - is violent, authoritative government intervention.
In addition to the phenomena of gold backwardation, which brings with it multiple variables to be analyzed, like the gold and silver basis and cobasis, there are two other concepts worthy of note as far as empirical tools for monitoring of the economy are concerned. The first concept is that of marginal productivity of debt, which provides a welcome alternative to traditional GDP and debt-to-GDP analysis, by looking at how much value is created by an additional dollar of debt. Unlike GDP analysis, that shows a worldwide scenario of constant growth punctuated with recessions, the marginal productivity of debt paints a much gloomier picture of gradual capital destruction.
The second concept worthy of note is that of yield purchasing power, which replaces the traditional measure of money in terms of its purchasing power. Purchasing power looks at how a unit of money’s ability to purchase a set of goods varies over time. It is usually used in the context of the Quantity Theory of Money, to measure the effects of inflation, defined as an increase in the supply of the medium of exchange. Consistent to the NASOE approach, yield purchasing power measures how the credit market is distorted by inflation, defined as the expansion counterfeit credit, by looking at how well one can provide for oneself, in terms of real goods and services, with the returns on an investment. Much like productivity of debt, yield purchasing power radically deviates from traditional analysis in its premises and conclusions.
The world is at a clear inflection point as far as culture is concerned. As Positivist and Marxist economic theories become increasingly discredited with each new failed prediction and disastrous public policy, people will look to new theories for answers. It is my hope that this series of articles contributes to steer Austrian thought away from the Kantian epistemology that permeates it today - leading to faulty predictions and fruitless discussions about such things as a "free market for children" - in the direction of objective economic and moral discussion. It is also my hope that it gives Objectivists a new, better way of looking at the economy, and how abstract values translate into production.