Keith Weiner Economics

The official site of the economics work of Keith Weiner, PhD

1. Theory of Interest and Prices in Paper Currency Part I (Linearity)

Under gold in a free market, the theory of the formation of the rate of interest is
straightforward.[1] The rate varies in the narrow range between the floor at the
marginal time preference, and the ceiling at the marginal productivity. There is no
positive feedback loop that causes it to skyrocket (as it did up until 1981) and
subsequently to spiral into the black hole of zero (as it is doing now). It is stable.
In irredeemable paper currency, it is much more complicated. In this first part of a
multipart paper presenting my theory, we consider and discuss some of the key
concepts and ideas that are prerequisite to building a theory of interest and
prices. We begin by looking at the quantity theory of money. In our dissection, we
will identify some key concepts that should be part of any economists toolbox.
This theory proposes a causal relationship between the quantity of money and
consumer prices. It seems intuitive that if the quantity of money[2] is doubled,
then prices will double. I do not think it is hyperbole to say that this premise is
one of the cornerstones of the Monetarist School of economics. It is also widely
accepted among many who identify themselves as adherents of the Austrian
School and who write in critique of the Fed and other central banks today.
The methodology is invalid, the theory is untrue, and what it has predicted has
not come to pass. I am offering not an apology for the present regimewhich is
collapsing under the weight of its debtsbut the preamble to the introduction of a
new theory.
Economists, investors, traders, and speculators want to understand the course of
our monetary disease. As we shall discuss below, the quantity of money in the
system is rising, but consumer prices are not rising proportionally. Central
bankers assert this as proof that their quackery is actually wise currency
management.

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Everyone else observing the Fed knows that there is something wrong. However,
they often misplace their focus on consumer prices. Or, they obsess about the
price of gold, which they insist should be rising in lockstep with the money
supply. The fact that the price of gold hasnt risen in two years must be prima
facie proof that there is a conspiracy to suppress it. Gold would have risen,
except its manipulated. I have written many articles to debunk various aspects
of the manipulation theory.[3]
The simple linear theory fails to explain what has already occurred, much less
predict what will happen next. Faced with the fact that some prices are rising
slowly and others have fallen or remained flat, proponents insist, Well, prices will
explode soon.
Will the price of broccoli rise by the same amount as the price of a building in
Manhattan (and the same as a modest home in rural Michigan)? We shall see. In
the meantime, lets look a little closer at the assumptions underlying this model.
Professor Antal Fekete has written that the Quantity Theory of Money (QTM) is
false, on grounds that it is a linear theory and also a scalar theory looking only at
one variable (i.e. quantity) while ignoring others (e.g. the rate of interest and the
rate of change in the rate of interest).[4] I have also written about other variables
(e.g. the change in the burden of a dollar of debt).[5]
It is worth noting that money does not go out of existence when one person pays
another. The recipient of money in one trade could use it to pay someone else in
another. Proponents of the linear QTM would have to explain why prices woul d
rise only if the money supply increases. This is not a trivial question. Prices rise
whenever a buyer takes the offer, so no particular quantity of money is necessary
for a given price (or all prices) to rise to any particular level.
In any market, buyers and sellers meet, and the end result is the formation of the
bid price and ask price. To a casual observer, it looks like a single price has
been set for every good. It is important to make the distinction between bid and
ask, because different forces operate on each.
These processes and forces are nonlinear. They are also not static, not scalar,
not stateless, and not contiguous.

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Nonlinear
First lets consider linearity with the simple proposal to increase the tax rate by
2%. It is convenient to think it will increase government tax revenues by 2%. Art
Laffer made famous a curve[6] that debunked this assumption. He showed that
the maximum tax take is somewhere between 0 and 100% tax rate. The
relationship between tax rate and tax take is not linear.
Another presumed linear relationship is between the value of a unit of currency
and the quantity of the currency outstanding. If this were truly linear, then the US
dollar would have to be by far the least valuable currency, as it has by far the
greatest quantity. Yet the dollar is one of the most valuable currencies.
M0 money supply has roughly tripled from 2007, M1 has roughly doubled, and
even M2 has risen by 50%.[7] We dont want to join the debate about how to
measure the money supply, nor do we want to weigh in on how to measure
consumer prices. We simply need to acknowledge that by no measure have
prices tripled, doubled, or even increased by 50%.[8] Its worth noting an
anomaly: on the Shadowstats inflation[9] chart, the inflation numbers drop to the
negative precisely where M0 and M1 rise quite sharply.
Consider another example, the stock price of Bear Stearns. On March 10, 2008 it
was $70. Six days later, it was $2 (it had been $170 a year prior). As Bear
collapsed, market participants went through a non-linear (and discontiguous)
transition from valuing Bear as a going concern to the realization that it was
bankrupt.
Dynamic
Some people today argue that if the government changed the tax code back to
what it was in the 1950s then the economy would grow as it did in the. This belief
flies in the face of changes that have occurred in the economy in the last 60
years. We are now in the early stages of a massive Bust, following decades of
false Boom. Another difference was that they still had an extinguisher of debt in
the monetary system back then. I wrote a paper comparing the tax rate during
the false Boom the Bust that follows[10]. The economy is not static.

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By definition and by nature, when a system is in motion then different results will
come from the same input at different times. For example, if a car i s on the
highway at cruising speed and the driver steps on the accelerator pedal, engine
power will increase. The result will be acceleration. Later, if the car is parked with
no fuel in the tank, stepping on the pedal will not cause any increase in power.
Opening the throttle position does something important when the engine is
turning at 3000 RPM, and does nothing when the engine is stopped.
Above, we use the word dynamic as an adjective. There is also a separate but
related meaning as a noun. A dynamic is a system that is not only changing, but
in a process whereby change drives more change. Think of the internal
combustion engine from the car, above. The crankshaft is turning, which forces a
piston upwards, which compresses the fuel and air in the cylinder, which
detonates at the top, forcing the piston downwards again. The self -perpetuating
motion of the engine is a dynamic. This is a very important prerequisite concept
for the theory of interest and prices that we are developing.
Multivariate
It is seductive to believe that a single variable, for example money supply, can
be used to predict the general price level. However, it should be obvious that
there are many variables that affect pricing, for example, increasing productive
efficiency. Think about the capital, labor, time, and waste saved by the use of
computers. Is there any price anywhere in the world that has not been reduced
as a consequence? The force acting on a price is not a scalar; there are multiple
forces.
It should be easy to list some of the factors that go into the price of a commodity
such as copper: labor, oil, truck parts, interest, the price of mineral rights,
government fees, smelting, and of course mining technology. One or more of
these variables could be moving in the opposite direction of the others, and as a
group they could be moving in the opposite direction as the money supply.
Perhaps even more importantly, the bid on copper is made by the marginal
copper consumer (the one who is most price-sensitive). At the risk of getting
ahead of the discussion slightly, I would like to emphasize that today the price of

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copper is set by the marginal bid more than by the marginal ask. The price of
copper has, in fact, been in a falling trend for two years.
Stateful
Modeling the economy would be much easier if people would respond to the
same changes the same way each timeif they didnt have memories, balance
sheets, or any other device that changes state as a result of activity. Even
Keynesians admit the existence of human memory (ironically, they call this
animal spirits[11]), which makes someone more cautious to walk into a pit a
second time after he has already learned a lesson from breaking his leg. People
are not stateless.
Stateless, and its antonym stateful, is a term from computer software
development. It is much simpler to write and understand code that produces its
output exclusively from its inputs. When there is storage of the current state of
the system, and this state is used to calculate the next state, then the system
becomes incalculably more complex.
In the economy, a business that carries no debt will respond to a change in the
rate of interest differently from one that is struggling to pay interest every month.
A company which does not have cash flow problems but whi ch has liabilities
greater than its assets would react differently still.
An individual who has borrowed money to buy a house and then lost the house to
foreclosure will look at house price combined with the rate of interest quite
differently than one who has never had financial problems.
It is important not to ignore the balance sheet or human memory (especially
recent memory) when predicting an outcome.
Discontiguous
Markets (and policy outcomes) would be far more predictable, and monetary
experiments far less dangerous, if all variables in the economy moved according
to a smooth curve.

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A run on the bank, as is occurring right now in Cyprus (in slow motion due to
capital controls), is a perfect example of a discontiguous phenomenon. One day,
people believe the banks are fine. The next day there may not be a measurable
change in the quantity of anything, and yet people panic and try to withdraw their
money. If the bank is insolvent, they cannot withdraw their money, it was already
lost.
A common theme in my economic theories is asymmetry. In the case of a run on
the bank, there is no penalty for being a year early, but one takes total losses if
one is an hour late. This adds desperate urgency to runs on the bank, and
desperate urgency is one simple cause of an abrupt and large change, i.e.
discontiguity.
Ernest Hemingway famously quipped that he went bankrupt, Two ways.
Gradually, then suddenly.[12] Its not a smooth process.
There are many other examples, for instance a scientific breakthrough may
enable a whole new industry because it reduces the cost of something by 1000
times. This new industry in turn enables other new activities and highly
unpredictable outcomes occur. As an example, the invention of the transistor
eventually led to the Internet. The Internet makes it possible for advocates of the
gold standard to organize and coordinate their action into a worldwide movement
that demands honest money. The gold standard in this example would be a
discontiguous effect caused by the invention of the transi stor.
My goal in Part I was to introduce these five key concepts. While not writing
directly against the Quantity Theory of Money, I believe that a full grasp of these
concepts and related ideas would be sufficient to debunk it.
In Part II, we will discuss the dynamic process whereby the rate of interest puts
pressure on prices and vice versa. I promise it will be a non-linear, multivariate,
stateful, dynamic, and discontiguous theory.

[1] In a Gold Standard, How Are Interest Rates Set?

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[2] We do not distinguish herein between money (i.e. gold) and credit (i.e. paper)
[3] Full disclosure: when I am not working for Gold Standard Institute, I am the
CEO of Monetary Metals, which publishes a weekly picture and analysis of the
gold basis. One can see through the conspiracy theories using the basis:
http://monetary-metals.com/basisletter/
[4] http://www.safehaven.com/article/13063/a-critique-of-the-quantity-theory-of-
money
[5] Irredeemable Paper Money, Feature #451
[6] http://en.wikipedia.org/wiki/Laffer_curve
[7] http://www.shadowstats.com/charts/monetary-base-money-supply
[8] http://www.shadowstats.com/alternate_data/inflation-charts
[9] I dont define inflation as rising prices, but as an expansion of counterfeit
credit: Inflation: an Expansion of Counterfeit Credit
[10] The Laffer Curve and Austrian Economics
[11] http://en.wikipedia.org/wiki/Animal_spirits_(Keynes)
[12] The Sun Also Rises by Ernest Hemingway, 1926



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2. Theory of Interest and Prices in Paper Currency Part II (Mechanics)

In Part I, we looked at the concepts of nonlinearity, dynamics, multivariate, state,
and contiguity. We showed that whatever the relationship may be between prices
and the money supply in irredeemable paper currency, it is not a simple matter of
rising money supply > rising prices.
Here is a fitting footnote for Part I. I just bought a pair of Levis jeans at Macys for
$45. I remember buying a pair of Levis Jeans in Macys in 1983 for $50. In 30
years, the price of Levis Jeans has fallen by 10%. By any conventional theory
based on the money supply, the price should have risen by several hundreds of
dollars.
In this part, we look at some mechanics, the understanding of which is a
prerequisite to the theory of interest and prices. To truly understand anything,
you have to know what happens in reality step by step. This is even more
important in an abstract field like monetary science. We discuss stocks vs. flows,
how prices are formed in a market, a broad concept of arbitrage, spreads, and
how money comes into and goes out of existence.
Lets drill down into a point I made in passing in Part I.
It is worth noting that money does not go out of existence when one person pays
another. The recipient of money in one trade could use it to pay someone el se in
another. Proponents of the linear QTM[1] would have to explain why prices would
rise only if the money supply increases. This is not a trivial question. Prices rise
whenever a buyer takes the offer, so no particular quantity of money is necessary
for a given price (or all prices) to rise to any particular level.
It is seductive to respond by way of the common analogy of too much money,
chasing too few goods. But, is that an accurate picture of how markets work?
Money supply is a quantity of stocks. One could theoretically add up all of the
gold in human inventories, or all of the dollars in the financial system, and come
up with a scalar number of ounces or dollars.

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How about goods supply? This is a different meaning of the word supply. Unlike
in money, the supply of goods means the flows of goods. To discuss copper or
wheat, one must measure how much is mined or grown every year. This would
be pounds or bushels per year.
Flows of goods cannot be compared in any meaningful way to the stocks of
money; pounds per year cannot be compared to ounces. Just like in physics,
length cannot be compared to velocity; one cannot compare meters to meters per
second. That is not a proper approach to sciencephysical or monetary.
This brings us to an important fact. The stock of money is not consumed after a
transaction. However, in the normal case, goods are. Other than the monetary
commodities of gold and silver, only small inventories are normally kept as a
buffer in all other goods. To state this in everyday terms, if Joe buys a loaf of
bread from Sally for $1, he will eat the bread (or it will go bad) but Sally has the
money until she spends it. If Acme Pipe buys 1000 pounds of copper, it will
manufacture it into plumbing and sell the plumbing.
Now lets move on to the mechanism of price discovery. In Part I, I stated:
In any market, buyers and sellers meet, and the end result is the formation of the
bid price and ask price.
There is not just one monolithic price, but two prices: the bid, and the ask (also
called the offer). If you come to market and you must buy, then you have to pay
the offer. For example, you own an apartment building and your lease obligates
you to provide heat for your tenants. So you go to the heating oil market. If
heating oil is bid $99 and offered $101, you must pay $101. Note what happens
next. The seller of that oil assuming you just bought all of his oil leaves. He
has exchanged his oil for your dollars and he goes home. The next seller may
ask $102. Now the market is bid $99 and offered $102.
Next, a heating oil distributor comes to market with the days production. He must
sell, because tomorrow he will produce more. What price does he get? Did your
purchase push up the price? You did not push up the bid price, and so the new
heating oil vendor must take the bid of $99. Now this consumer is sated, he has
the oil he wants. The next best bid could be $97.

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There is a counterintuitive process here. The bid is formed by the competition of
producers who keep selling until the marginal seller does not accept the bid. The
ask is formed by the competition of consumers who keep buying until the
marginal buyer does not accept the ask. This is a critical idea in Austrian School
analysis, so I encourage readers to stop and think this through.
Buyers keep coming to market and taking the offer (thus lifting it) until a point is
reached where the next would-be buyer balks. This buyer, the marginal buyer,
may make his own bid, above the best bid but below the best offer. At the same
time, sellers keep coming to market and taking the bid, until the marginal seller
balks. This seller may set his own offer, below the best offer but above the best
bid.
There is one other actor, the market maker. The market maker will act to keep a
consistent bid-ask spread. If the ask is pushed up, then the market maker will
raise his bid. If the bid is pressed down, then he will lower his ask. The market
maker is the only one who can buy at the bid and sell at the offer. His profits
come from the bid-ask spread, the wider the spread the more his profits. Of
course, the next market maker will enter and force the spread to narrow, and so
on until the margin al market maker balks and the spread does not narrow any
further.
From the mechanics described here, we begin to build a picture of how prices are
set where the rubber meets the road in the market. If there are more market
participants who buy at the offer then the end result is that prices move upwards.
If there are more who sell at the bid, then prices move downwards.
This may seem tautological. It is prerequisite material.
We return to my rhetorical question. Why would prices not keep rising in the case
of a fixed quantity of money? After all, when Joe buys the loaf of bread from Sally
for $1 there is no reason why Sue could not buy it from him for $2 and John
couldnt buy it from Sue for $3 and so on.
The observant reader may object on grounds that prices can only go up until
people cannot afford the good. Bread cannot be $300 per loaf if no one has
$300. This is comparing stocks to flows once again. What matters is not whether

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the consumer has $300 in stocks, but whether the consumer has $300 in flows. If
the velocity of money (flows) rises, then the consumer could have $300 of daily
income with which to pay the price of his daily bread.
As we see from the above discussion of price formation, neither the buyer nor the
seller has an intrinsic advantage. Both come to market and must accept the
market price (ask or bid, respectively). Size does not add any power to the seller.
If anything, the seller has a disadvantage in trying to get a price he prefers,
compared to the buyer. He has capital tied up in his productive ent erprise, and
certain fixed costs like payroll that must go on whether he sells or does not sell.
Holding inventory does not normally do him any good. With the exceptions of
food and energy, buyers can afford to be pickier. They do not face the same
problem as sellers; if they go home at the end of the day with money as opposed
to goods, this is not always a problem.
Without delving too deeply into this topic, I want to paint with a broad brush
stroke. There is no force that guarantees a constant price even if the money
supply is fixed. There are many reasons why buyers could lift the offer or sellers
could press down the bid. Not only can prices rise with the same stocks of
money, but they could also rise with the same flows of goods.
Next, lets introduce the concept of arbitrage. People often use this term in a very
narrow sense, to mean buying and selling the same good in different markets to
shave off a small spread. For example, IBM stock is offered at $99.99 in London
and bid at $100.00 in New York, so the arbitrager could simultaneously buy and
sell to pocket a penny. Or, in the gold market, which I write about frequently, one
could buy spot gold and sell December gold for a 0.3% annualized spread.
In this paper, I use the word arbitrage to refer to a much broader concept. I wont
fully explore it herein, but we need to discuss one relevant aspect.[2] Lets go
back to our example of the landlord. What is he doing? He is seeking to make a
profit by renting out apartments to tenants. The rent is his gross revenue. How is
the rent set? If he needs to rent a unit, he must take the bid.
What are his costs? Broadly, he must buy land, construction materials,
construction labor, maintenance labor, heating oil, etc. We will address later that
he must pay the rate of interest on the capital.

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The landlord must buy these things at the offer. We can look at him as doing an
arbitrage between his inputsbought at the offerand his output productsold
on the bid. The landlords spread is Rent(bid) Inputs(ask).
In this light, what should he be the limit of what he is willing to pay for his inputs?
A bit less than the rent he receives, at most.
I give this example to make it clear why we should not think the primary driver of
markets is the consumer with a bank account balance as his budget. One might
think of a consumer who has a total of $10. Lets suppose he would want to pay
$0.01 for a loaf of bread. But if he had $100 total, he would pay $0.10, and so on.
This is the siren song of QTM luring one to think that increased stocks of money
must lead to higher prices. It is often stated, if everyones bank account grew by
10X, then prices will be 10X higher.
Will a middle class consumer buy more food if he has more money?
At any rate, instead of the consumer, we should think of the entrepreneur. He is
an arbitrager who will not normally buy inputs unless the bid on his output affords
him an acceptable margin above the offer on his inputs. What will cause
consumers to raise their bid on his outputs? This is a non-trivial question that will
be addressed in a later part of this paper.
Up until now, we have been using the term money without regard to the
distinction between gold and promises to pay, i.e. between money and credit. It is
now necessary to make this distinction to continue the discussion. In the current
monetary regime, money (gold) has no official role to play at all, though it
assuredly plays a role. My permanent gold backwardation thesis[3] can be
summarized as follows: the withdrawal of the gold bid on the doll ar will bring
about the collapse of the dollar because dollar holders will drive prices up
exponentially by using commodities to get gold.
Money (gold), of course, can only come into existence via a slow and inelastic
process of mining. Money does not go out of existence (though gold coins can be
melted down to produce non-monetary objects). Both of these processes are
themselves driven by arbitrage. When the inputs required to mine one ounce of
gold cost less than one ounce, the gold miners spring into operation. When the

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inputs rise above one ounce, they shut down. When jewelry sells for more than
the cost of its inputs (principally gold, labor, and perhaps gem stones) then
jewelers spring into action. When monetary gold is worth more than jewelry, then
it is melted down and returned to monetary form by arbitragers known as Cash
For Gold.
Credit is an entirely different animal.
In Part III, we will discuss credit including an examination of the borrower, the
borrowers opportunities, and the borrowers considerations.

[1] Quantity Theory of Money
[2] Those interested can read more about arbitrage in Disequilibrium Analysis of
Price Formation by Antal Fekete, January 1, 1999
[3] When Gold Backwardation Becomes Permanent



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3. Theory of Interest and Prices in Paper Currency Part III (Credit)

In Part I, we looked at the concepts of nonlinearity, dynamics, multivariate, state,
and contiguity. We showed that whatever the relationship may be between prices
and the money supply in irredeemable paper currency, it is not a simple matter of
rising money supply > rising prices.
In Part II, we discussed the mechanics of the formation of the bid price and ask
price, the concepts of stocks and flows, and the central concept of arbitrage. We
showed how arbitrage is the key to the money supply in the gold standard;
miners add to the aboveground stocks of gold when the cost of producing an
ounce of gold is less than the value of one ounce.
In this third part, we look at how credit comes into existence (via arbitrage, of
course) with legitimate entrepreneur borrowers. We also look at the counterfeit
credit of the central banks (which is not arbitrage). We introduce the concept of
speculation in markets for government promises, compared to legitimate trading
of commodities. We also discuss the prerequisite concepts. Marginal time
preference and marginal productivity are absolutely essential to the theory of
interest and prices. That leads to the last new concept resonance.
In the gold standard, credit comes into existence when one party lends and
another borrows. The lender is a saver who prefers earning interest to hoarding
his gold. The borrower is an arbitrager who sees an opportunity to earn a net
profit greater than the rate of interest.
As with all markets, there is a bid and an offer (also called the ask) in the bond
market. The bid and the offer are placed by the saver and the entrepreneur,
respectively. The saver prefers a higher rate of interest, which means a lower
bond price (price and interest rate vary inversely). The entrepreneur prefers a
lower rate and a higher bond price.
Increased savings tends to cause the interest rate to fall, whereas increased
entrepreneurial activity tends to cause a rise. These are not symmetrical,
however. If savings fall, then the interest rate must go up. The mechanism that
denies credit to the marginal entrepreneur is the lower bond price. But, if savings
rise, interest does not necessarily go down much. Entrepreneurs can issue

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more bonds. Savings is always finite, but the potential supply of bonds is
unlimited.
What is the bond sellerthe entrepreneurdoing with the money raised by
selling the bond? He is buying real estate, buildings, plant, equipment, trucks,
etc. He is producing something that will make a profit that, net of all costs, is
greater than the interest he must pay. He is doing arbitrage between the rate of
interest and the rate of profit.
It may seem an odd way to think of it, but consider the entrepreneur to be long
the interest rate and short the profit rate. Looking from this perspective will help
illustrate the principle that arbitrage always has the effect of compressing the
spread. The arbitrager lifts the offer on his long leg and presses the bid on his
short leg. The entrepreneur is elevating the rate of interest and depressing the
rate of profit.
Now lets move our focus to the Fed and its irredeemable dollar. The Fed exists
to enable the government and favored cronies to borrow more, at lower interest,
and without responsibility to extinguish their debts.
People often use the shorthand of saying that the Fed prints dollars. It is more
accurate to say that it borrows them into existence, though there is no (knowing)
lender. The Fed has the sole discretion to create these dollars ex nihilo, unlike a
normal bank that must persuade a saver to deposit them. By this reason alone,
the Feds credit is counterfeit. The very purpose of the Fed is to cause inflation,
which I define as an expansion of counterfeit credit[1].
These borrowed dollars are the Feds liability. It uses them to buy assets such as
bonds or to otherwise lend. Those bonds or loans are its assets. While the Fed
can create its own funding, its own liabilities, it still must heed its balance sheet.
If the value of its assets ever falls too far, the market will not accept its liability.
Gold owners will refuse to bid on the dollar. Through a process of arbitrage (of
course), the dollar will collapse.[2]

What does the government get from this game? It diverts resources away from
value-creating activities into the governments welfare programs, graft, regulatory

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agencies, and vast bureaucracy. By suppressing interest rates and enabling
debts to be perpetually rolled, the Fed enables the government to consume much
more than it could in a free market. Politicians are enabled to buy votes without
raising taxes.
Earlier, I said there is no knowing lender. Lets look at this mysterious
unknowing lender. He is industrious and frugal, consuming less than he
produces, keeping the difference as savings. He feeds this savings, the product
of his hard work, into the governments hungry maw. Unfortunately, the credit he
extends is irredeemable. The paper promise he accepts has a warning written in
fine print: it will never be honored. The lender is a self-sacrificial chump. Who is
he?
He is anyone who has demand for dollars.
He is the trader who thinks that gold is going up (in terms of dollars). He is the
businessman who uses the dollar as the unit of account on his income statement.
He is the investor who measures his gains or losses in dol lars. He is every
enabler who does not distinguish between the dollar and money.
People dont think of their savings in this light, that they are freely offering it to
the government to consume. They dont understand that savings is impossible
using counterfeit credit.
Now we have covered the counterfeit credit of th Fed, lets move on to cover
another prerequisite topic: speculation. With arbitrage, I offered in Part II a much
broader definition than the one commonly used. With speculation, I will now
present a narrower concept than the usual definition. Lets build up to it by
looking at some examples.
The first example is the case of agricultural commodities, such as wheat.
Production is subject to unpredictable conditions imposed by nature, like
weather. If early rain reduces the wheat yield by 5%, then there could be a
shortage. Think of the dislocations that would occur if the price of wheat
remained low. Inventories from the prior crop would be consumed too rapidly at
the old price. Then, when the reduced new crop was harvested, it would be too

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late for a small reduction in consumption. Grain consumers would suffer undue
hardship.
Futures traders perform a valuable economic function. Their profit comes from
helping to drive prices up (in this example) as soon as possible, and thus
discourage consumption, encourage more production, and attract wheat to be
shipped in from unaffected regions. Good traders study and anticipate nature-
made risks to valuable goods and earn their profits by providing price signals to
producers and consumers.
Trading commodities futures is a legitimate activity that helps people coordinate
their activities. If such traders were removed, the result would be reduced
coordination (i.e. waste). Therefore my definition of speculation excludes
commodities traders.
There are two elephants in the room of the irredeemable currency regime:
interest and foreign exchange rates. It is the profiteer in these games who earns
the dubious label of speculator.
The price of each currency is constantly changing in terms of all others. To any
business that operates across borders, this creates unbearable risk. They are
forced to hedge. The banks that provide such hedging products must,
themselves, hedge. One result is volatile currency markets.
The rate of interest presents the other big man-made risk. Unlike in gold, interest
in irredeemable paper is always changing and is often quite volatile. For
example, the interest rate on the 10-year Treasury bond has gone from 1.63% to
2.16% just during the month of May. As with currencies, there is a big need to
hedge this risk, and hence, a massive derivatives market.

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Naturally, volatility attracts traders, in this case the speculators. Their gains are
not profits from anticipating natural risks to the production of real commodities.
They are not skilled in responding to nature. They are front-runners of the
artificial risks created by the next move of the government or central bank. Worse
still, they seek to influence the government and central bank to act favorably to
their interests.
Unlike the trader in commodities, the speculator in man-made irredeemable
promises is a parasite. This is not a judgment of any particular speculator, but
rather an indictment of the entire dollar regime. It imposes risks, losses, and
costs on productive businesses, while transferring enormous gains to
speculators.
It is no coincidence that the financial sector (and the derivatives market) has
grown as the productive sector has been shrinking. A good analogy is to call it a
cancer that consumes the economic body, by feeding on its capital. A free market
does not offer gains to those who add no value, much less to parasites who
consume value and destroy wealth. The rise of the speculator is due entirely to
the perverse incentives created by coercive government interference.[3]

In light of the context weve established, we are now ready to start looking at
interest rates. In the gold standard, the mechanism is fairly simple as I wrote in
The Unadulterated Gold Standard Part III (Features):
This trade-off between hoarding the gold coin and depositing it in the bank sets
the floor under the rate of interest. Every depositor has his threshold. If the rate
falls (or credit risk rises) sufficiently, and enough depositors at the margin

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withdraw their gold, then the banking system is deprived of deposits, which drives
down the price of the bond which forces the rate of interest up. This is one half of
the mechanism that acts to keep the rate of interest stable.
The ceiling above the interest rate is set by the marginal business. No business
can borrow at a rate higher than its rate of profit. If the rate ticks above this, the
marginal business is the first to buy back its outstanding bonds and sell capital
stock (or at least not sell a bond to expand). Ultimately, the marginal
businessman may liquidate and put his money into the bonds of a more
productive enterprise.[4]

To state this in more abstract and precise terms, the rate of interest in the gold
standard is always in a narrow range between marginal time preference and
marginal productivity.[5]

The phenomena of time preference and productivity do not go away when there
are legal tender laws. The government attempts to disenfranchise savers, to
remove their influence over the rate of interest and their power to contract
banking system credit.
In the gold standard, when one redeems a bank deposit or sells a bond, one
takes home gold coins. This pushes up the rate of interest and forces a
contraction of banking system credit. The reason to do this is because one does
not like the rate of interest, or one is uncomfortable with the risk. It goes almost
without saying that holding ones savings in gold coins is preferable to lending
with insufficient interest or excessive risk.
By contrast, in irredeemable currency, there is no real choice. A dollar bill is a
zero yield credit. If one is forced to take the credit risk, then one might as well get
some interest. Unlike gold, there is little reason to hoard dollar bills.

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The central planners may impose their will on the market; it is within their power
to distort the bond market. But they cannot repeal the law of gravity, increase the
speed of light, or alter the nature of man. The laws of economics operate even
under bad legislative law. There are horrible consequences to pushing the rate of
interest below the marginal time preference, which we will study later in this
series. The saver is not entirely disenfranchised. He cant avoid harm, but his
attempt to protect himself sets quite a dynamic in motion.
It should also be mentioned that speculators affect and are affected by the
market for government credit. Their behavior is not random, nor scattered.
Speculators often act as a herd, not being driven by arbitrage but by government
policy. They anticipate and respond to volatility. They can often race from one
side of a trade to the other, en masse. This is a good segue to our final
prerequisite concept.
The linear Quantity Theory of Money tempts us to think that when the Fed pumps
more dollars into the economy, this must cause prices to rise. If there were an
analogous linear theory of airplane flight, it would predict that pulling back on the
yoke under any circumstance would cause the plane to climb. Good pilots know
that if the plane is descending in a spiral, pulling back will tighten the spiral. Many
an inexperienced pilot has crashed from making this error.
The Fed adds another confounding factor: its pumping is not steady but pulsed.
Both in the short- and the long-term, their dollar creation is not steady and
smooth. Short term, they buy bonds on some days but not others. Long term,
they sometimes pause to assess the results; they know there are leads and lags.
They also provide verbal and non-verbal signals to attempt to influence the
markets.
In a mechanical or electrical system, a periodic input of energy can cause
oscillation. Antal Fekete first proposed that oscillation occurs in the monetary
system. Here, he compares it to the collapse of an infamous bridge:

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It is hyperdeflation [currently]. The Fed is desperately trying to fight it, but all is in
vain. We are on a roller-coaster ride plunging the world into zero-velocity of
money and into barter. In my lectures at the New Austrian School of Economics I
often point out the similarity with the collapse of the Tacoma Bridge in 1941.[6]

I will end with a few questions. What happens if the central bank pushes the rate
of interest below the marginal time preference? Could this set in motion a non-
linear oscillation? If so, will this oscillation be damped via negative feedback akin
to friction? Or will periodic inputs of credit inject positive feedback into the
system, causing resonance?
In Part IV, we will answer these questions and, at last, dive in to the theory of
prices and interest rates.

[1] http://keithweinereconomics.com/2012/01/06/inflation-an-expansion-of-
counterfeit-credit/
[2] http://keithweinereconomics.com/2012/03/15/when-gold-backwardation-
becomes-permanent/

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[3] See my dissertation for an extensive discussion of government interference: A
Free Market for Goods, Services, and Money
[4] The Unadulterated Gold Standard Part III (Features)
[5] Interested readers are referred to the subsite on Professor Antal Feketes
website where he presents his theory of interest and capital markets.
[6] Antal Fekete: Gold Backwardation and the Collapse of the Tacoma Bridge
with Anthony Wile


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4. Theory of Interest and Prices in Paper Currency Part IV (Rising
Cycle)

In Part I, we looked at the concepts of nonlinearity, dynamics, multi variate, state,
and contiguity. We showed that whatever the relationship may be between prices
and the money supply in irredeemable paper currency, it is not a simple matter of
rising money supply > rising prices.
In Part II, we discussed the mechanics of the formation of the bid price and ask
price, the concepts of stocks and flows, and the central concept of arbitrage. We
showed how arbitrage is the key to the money supply in the gold standard;
miners add to the aboveground stocks of gold when the cost of producing an
ounce of gold is less than the value of one ounce.
In Part III, we looked at how credit comes into existence via arbitrage with
legitimate entrepreneur borrowers. We also looked at the counterfeit credit of the
central banks, which is not arbitrage. We introduced the concept of speculation in
markets for government promises, compared to legitimate trading of
commodities. We also discussed the prerequisite concepts of Marginal time
preference and marginal productivity, and resonance.
Part III ended with a question: What happens if the central bank pushes the rate
of interest below the marginal time preference?
To my knowledge, Antal Fekete was the first to ask this question[1]. It is now time
to explore the answer.
We are dealing with a cycle. It is not a simple or linear relationship between
quantity X and quantity Y, much to the frustration of students of economics (and
central planners).
The cycle begins when the central bank pushes the rate of interest down, below
the rate of marginal time preference. Unlike in the gold standard, under a paper
currency, the disenfranchised savers cannot turn to gold. Perhaps it has been
made illegal as it was in the U.S. from 1933 to 1975. Or it could merely be taxed
and creditors placed under duress to accept repayment in irredeemable paper.
Whatever the reason, the saver cannot perform arbitrage between the gold coin

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and the bond[2], as he could in the gold standard. He is trapped. The
irredeemable paper currency is a closed loop system. The saver is not entirely
without options, however.
He can buy commodities or finished goods.
I can distinctly recall as a boy in the late 1970s, when my parents would buy
cans of tuna fish, they would buy 50 or 100 cans (we ate tuna on Sunday, two
cans). Prices were rising very rapidly, and so it made sense to them to hold
capital in the form of food stocks rather than dollars. Indeed, prices rose so
frequently that grocery stores were going to the expense of manually applying
new price stickers on top of the old ones on inventory on the shelves. This is
extraordinary, because grocers sell through inventory quickly. Some benighted
people began agitating for a law to prohibit this practice (perhaps descendants of
King Canute, reputed to have ordered the tide to recede?).
Consumers are not the only ones to play the game, and they dont have a direct
impact on the rate of interest. Corporations also play. When the rate of interest is
below the rate of marginal time preference, we know that it is also below the rate
of marginal productivity. Corporations can sell bonds in order to buy
commodities. They can also accumulate inventory buffers of each input, partially
completed items at each state of production, and finished products.
What happens if corporations are selling bonds in order to expand holdings of
commodities and goods made from commodities? If this trade occurs at large
enough scale, it will push up the rate of interest as well as prices. Let the irony
sink in. The cycle begins as an attempt to push interest rates down. The result is
the opposite.
Analysts of this phenomenon must be aware that the government or its central
bank cannot change the primary trend. They can exaggerate it and fuel it. In this
case, the trend goes opposite to their intent and there is nothing they can do
about it. King Canute could not do anything about the waves, either.
Wait. The problem was caused when interest was pushed below time preference.
Now interest has risen. Are we out of the woods yet?

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No. Unfortunately, marginal time preference rises. Everyone can see that prices
are rising rapidly, and in such an environment, are no longer satisfied with the
rate of interest that they had previously wanted. The time preference to interest
spread remains inverted.
This is a positive feedback loop. Prices and interest move up. And then this
encourages another iteration of the same cycle. Prices and interest move up
again.
Positive feedback is very dangerous, because it runs away very quickly. Think of
holding an electric guitar up to a loudspeaker with the amplifier turned up to 10.
The slightest sound is amplified and fed back and amplified until there is a
horrible squeal. Electrical systems contain circuits to prevent self -destruction, but
alas there is no such thing in the economy.
There are, however, other factors that begin to come into play. The regime of
irredeemable currency forces actors in the economy to make a choice between
two bad alternatives. One option is to earn a lower rate of interest than ones
preference. Meanwhile, prices are rising, perhaps at a rate faster than the rate of
interest. Adding insult to injury, as the interest rate rises, it imposes capital losses
on bondholders. Bonds were once called certificates of confiscation. There is
but one way to avoid the losses meted out to bondholders.
One can hold commodities and inventory. There is a problem with this alternative
too. The marginal utility of commodities and inventory is rapidly falling. This
means that the more one accumulates, the lower the value of the next unit of the
good. This is negative feedback. Another problem is that it is not an ef ficient
allocation of capital to lock it up in illiquid inventory. Sooner or later, errors in
capital allocation accumulate to the harm of the enterprise.
There is another problem with commodity hoarding. Unlike gold hoarding, which
harms no one, hoarding of goods that people and businesses depend on hurts
people. As we shall see below, growth in hoarding is not sustainable. What the
economy needed was an increase in the interest rate. An unstable dynamic that
causes prices to rise along with interest rates is no substitute.

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The choice between losing money in bonds, vs. buying more goods that one
needs less and less, is a bitter choice. This choice is imposed on people as an
unintended (like all the negative effects of central planning) consequence of the
central banks attempt to drive interest rates lower. I propose that this should be
called Feketes Dilemma in the vein of the Triffin Dilemma and Gibsons Paradox.
Another negative feedback factor is that rising interest rates destroy productive
enterprises. Consider the example of a company that manufactures TVs. When
they built the factory, they borrowed money at 6%. With this cost of capital, they
are profitable. Eventually, the equipment becomes worn out and/or obsolete.
Black and white TVs are no longer in demand by consumers, who want color.
Making color TVs requires new equipment. Unfortunately, at 12% int erest, there
is no way to make a profit. Unable to continue making a profit on black and white,
and unable to profitably start making color, the company folds.
The more the interest rate rises, and the longer it remains high, the more
companies go bankrupt. This of course destroys the wealth of shareholders and
bondholders, and causes many workers to be laid off. Its effect on interest rates
is to pull in both directions. When bondholders begin taking losses, bonds tend to
sell off. A falling bond price is the flip side of a rising interest rate (bond price and
yield are inverse). On the other hand, with each bankruptcy there is now one less
bidder pushing up prices. Additionally, the inventories of the bankrupt company
must be liquidated; creditors need to be paid in currency, not in half-finished
goods, or even in stockpiles of iron ingots.
A third factor is that a rising interest rate causes a reduced burden of debt for
those who have previously borrowed at a fixed rate, such as corporations who
have sold bonds. They could buy back their own bonds, and realize a capital
gain. Or, especially if the price of their own product is rising, they have additional
capacity to borrow more to finance further expansion of their inventory buffers.
This will tend to be a positive feedback.
These three phenomena are by no means the only forces set in motion by the
initial suppression of interest rates. The take-away from this discussion should be
that one must begin ones analysis with the individual actors in the economy, and
pay attention to their balance sheets as well as their profit and loss.

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The above depiction of a rising cycle, where rising interest rates drive rising
prices, and rising prices drive rising interest rates is not merely hypothetical. It is
a picture of what happened in the U.S. from 1947 to 1981.
Many people predicted that the monetary system was going to collapse in the
1970s. It may have come very close to that point. The Tacoma Narrows Bridge
swung to one side before moving even more violently to the other. The dollar
might have ended with prices and interest rates rising faster and faster, until it
was no longer accepted in trade for goods.
But this is not what, in fact, occurred. Things abruptly turned around. Fed
Chairman Paul Volcker is now credited with breaking the back of inflation.
Interest rates did indeed spike up briefly to about 16% on the 10-year Treasury in
1981. After that, they fell, rose once more in 1984, and then settled into a falling
trend (with some volatility) that continues through today. But remember what we
said above, that a central bank can exaggerate the trend but it cannot reverse it.
Interest rates and prices had peaked. When the marginal utility of each additional
unit of accumulated goods falls without bound, it eventually crosses the threshold
of zero marginal utility. Then it can no longer be justified. Meanwhile,
bankruptcies, with their forced liquidations, increase. A final upwards spike of
interest rates discourages any further borrowing. What company can borrow at
such an extreme interest rate and still make a profit?
At last, the time preference to interest spread is back to normal; interest is above
the time preference. Unfortunately, there is another problem that causes the
cycle to slam into reverse. The cycle continues its dynamic of destroying wealth,
confounding central planners and economists.
The central planning fools think that they can magically gin up some more credit -
money, or extract liquidity somehow to rectify matters. Surely, they think, they
just have to find the right money supply value. Their own theory acknowledges
that there are leads and lags so they work their equations to try to figure out
how to get ahead of the cycle.
A blind man would sooner hit the bulls-eye of an archery target.

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In Part V, we will examine the mechanics of the cycle reversal, and the other side
of the unstable oscillation. Without spoiling it, lets just say that a different
dynamic occurs which drives both interest and prices down.

[1] Fekete wrote about the connection between interest rates and prices at least
as early as 2003, in The Ratchet and the Linkage and Between Scylla and
Charybdis. He published Monetary Economics 102: Gold and Interest
(http://www.professorfekete.com/articles/AEFMonEcon102Lecture1.pdf ). The
idea he proposed in those three pages has been fleshed out and extended by
myself, and incorporated into this series of papers on the theory of interest and
prices, principally in parts IV and V. I would like to note that Fekete regards the
flow of money from the bond market to the commodity market as inflation and the
reverse flow as deflation. I agree with his description of these pathologies, but
prefer to reserve the term inflation to refer to counterfeit credit. I call it the rising
cycle and falling cycle instead.
[2] http://keithweinereconomics.com/2012/06/06/in-a-gold-standard-how-are-
interest-rates-set/


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5. Theory of Interest and Prices in Paper Currency Part V (Falling Cycle)

In Part I, we looked at the concepts of nonlinearity, dynamics, multivariate, state,
and contiguity. We showed that whatever the relationship may be between prices
and the money supply in irredeemable paper currency, it is not a simple matter of
rising money supply > rising prices.
In Part II, we discussed the mechanics of the formation of the bid price and ask
price, the concepts of stocks and flows, and the central concept of arbitrage. We
showed how arbitrage is the key to the money supply in the gol d standard;
miners add to the aboveground stocks of gold when the cost of producing an
ounce of gold is less than the value of one ounce.
In Part III, we looked at how credit comes into existence via arbitrage with
legitimate entrepreneur borrowers. We also looked at the counterfeit credit of the
central banks, which is not arbitrage. We introduced the concept of speculation in
markets for government promises, compared to legitimate trading of
commodities. We also discussed the prerequisite concepts of Marginal time
preference and marginal productivity, and resonance.
In Part IV, we discussed the rising cycle. The central planners push the rate of
interest down, below the marginal time preference and unleash a storm whose
ferocious dynamics are more than they bargained for. The hapless subjects of
the regime have little recourse but they do have one seeming way out. They can
buy commodities. The cycle is a positive feedback loop of rising prices and rising
interest rates. Ironically, their clumsy attempt to get lower interest results in rising
interest. Alas, the cycle eventually ends. The interest rate and inventory hoards
have reached the point where no one can issue more bonds or increase their
hoards.
In this Part V, we discuss the end of the rising cycle and the start of the falling
cycle. We examine its dynamics and its mode of capital destruction. Lastly we
look at the response of the central bank.
It is not possible to pay debts with inventories of completed or partially completed
product, nor even with raw commodities. In order to circulate as money, a good
must have an extremely narrow bid-ask spread. Commodities have a wide

30/51



spread, especially in the environment of the late stages of the rising cycle.
Liquidations are pushing the bid down. The ask side is still being pushed up, by
those businesses which are still buying. Work in progress of course could not be
sold, except to another company in the same industry.
Recall that the rising cycle is driven by selling bonds to build inventories. This
creates a conflict: the desire to accumulate more inventories because prices are
rising rapidly vs. the need for cash to service the debt. In any conflict between
want and need, between speculation and leverage, the latter must win in the end.
At the same time that the marginal utility of the unit of hoarded goods is falling,
the amount owed is rising.
The backdrop is layoffs and liquidations, as each time a companys capital and
plant must be renewed, it is harder and harder to make a business case. If it is
profitable to borrow at 7% to buy machines to manufacture cameras, it may not
be profitable at 14%. So factories are closed, resulting in liquidations. People
lose their jobs, resulting in increasing softness in the consumer bid for goods.
Eventually, as it must, the trend comes to its ignominious end. The interest rate
spikes up one final step higher as banks are taking capital losses and become
even more reluctant (or able) to lend. The rate of interest is now, finally, above
marginal time preference. That spread is reverted to normalcy. Unfortunately, the
other spread discussed in Part III inverts.
That other spread is marginal productivity to the rate of interest; the latter is now
above the former. I mentioned in Part IV that many people credit Paul Volcker for
breaking the back of inflation in 1981. The central planners cannot change the
primary trend, and in any case the problem was not caused by the quantity of
money, so the solution could not have been reducing the money supply. At best,
if he pushed up the rate of interest he accentuated the trend and helped get to
the absolute top. The 10-year Treasury bond traded at a yield around 16%.
The rising cycle was driven by rising time preference that caused rising interest
as businesses borrowed to finance inventories which caused time preference to
rise further. During this process, at first one by one and then two by two,
enterprises were forced to close and liquidate their inventori es, as their
businesses could not earn the cost of capital. This force opposed the rising cycle.

31/51



Now it fuels the falling cycle. The only good thing to be said is that interest rates
are not rising and therefore viable companies are not squeezed out due to rising
cost of capital. The wrecking ball of rising rates has finished on that side of the
street. It is done destroying capital by rendering it sub-marginal, when it cannot
produce enough to justify borrowing at the higher rate of interest.
As we shall see, that wrecking ball will not repair the damage it has done when it
swings to the other side. A falling rate destroys capital also, though by a different
mechanism. It causes the Net Present Value (NPV) of every bond to rise. This is
because the NPV of a stream of future payments is calculated by discounting
each future payment by the interest rate. The lower the interest, the lower the
discount for all future payments. This is why the bond price rises.
Falling interest rates benefit one group. The bond speculators get rich. They can
buy bonds, wait a little while, and sell them for a profit. The bond bull market
starts off slowly but becomes ferocious over time. In nature, if a source of readily
usable energy exists then a specialized organism will evolve to exploit it and feed
off it. This is true for plants and animals in every niche on dry land, and it is for
strange sea creatures near volcanic vents on the icy sea floor. Plants convert
sunlight into sugars and animals eat plants, etc. The same is true for free profits
being offered in the bond market. A whole parasitic class develops to feed off the
free capital being offered there.
Savers and pension funds cannot profit from falling rates because they hold until
maturity. The more the interest rate falls, the more they are harmed. The lack of
savings is another blow to the economy, as it is savings that is the prerequisite to
investment and investment is the prerequisite to jobs and rising wages.
By contrast, the speculators are not in the game for the interest payments. They
are in for capital gains.
Where does their free profit come from? It comes from the capital accounts
from the balance sheetsof bond issuers. Anyone who has sold a bond or
borrowed money with a fixed-rate loan should mark up the liability, to market
value. I have written previously on the topic of falling interest rates and the
destruction of capital.[1]


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On the way up, businesses could seemingly dictate whatever prices they felt like
charging. Recall my example of cans of tuna fish in the 1970s; stores were re-
stickering them with higher prices even in the short time they sat on the shelves.
My theory predicts that gross margins must have been rising everywhere,
especially if companies managed their inventory to move from input to final sales
over a long period of time (this would be worth researching in further papers).
But today, they have not this power. Even in industries where prices have been
rising, the consumer is reluctant and sluggish to pay and there are many
competing alternatives. In other industries (recall my example of Levis jeans,
which applies to clothing in general) there seems to be no pricing power. Many
stores in the mall have permanent signs offering big discounts; I regularly see
60% off.
What is it about rising interest rates that allows for aggressively expanding prices
and margins, and falling rates that compresses margins and prices?
We said in Part III:
What is the bond sellerthe entrepreneurdoing with the money raised by
selling the bond? He is buying real estate, buildings, plant, equipment, trucks,
etc. He is producing something that will make a profit that, net of all costs, is
greater than the interest he must pay. He is doing arbitrage between the rate of
interest and the rate of profit.
As the interest rate ticks upwards, every producer in every business must adapt
his business model to the higher cost of capital. They must earn a higher gross
margin, in order to pay the higher interest rate. Higher rates must necessarily
drive higher gross margins. We have discussed two ways to get a higher margin:
(1) a long lag between purchase of inputs and sale of outputs and (2) higher
prices. Strategy #1 is the reaction to the inverted interest to time preference
spread. Strategy #2 is the reaction to higher interest rates and thinning
competition.
The burden of debt is falling when the interest rate is rising, and we can see it in
the reduced competitive pressures on margins. Of course, we are now in the
falling cycle and the opposite applies. If one wants to track the money supply,

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one can think of the money going, not into consumer goods or commodities, but
into productive capacity. I propose that one should think of inflation not in terms
of the money supply but in terms of counterfeit credit.[2] In the rising cycle,
counterfeit credit is going into commodities. In the falling cycle, by contrast, it is
going into bonds that finance government and also productive capacity.
I call it a ferocious bull market in bonds because it is gobbling up the capital of
businesses who borrow (and they have to borrow in order to keep up with their
competitors). The competition is ferocious, because each new business can
borrow at lower rates than incumbent competitors. The new entrant has a
permanent competitive advantage over the old. Then the rate falls further and the
next new entrant enters. The previous new entrant is now squeezed, doubly so
because unemployment is rising. The prior incumbent is wiped out, its workforce
is laid off, and its plant and inventory is sold off. Unemployed workers are not
able to aggressively bid up prices. There is, by the way, another reason why
falling rates cause unemployment. There is always a trade-off between capital
invested to save labor vs. employing labor. At lower cost of borrowing money, the
balance tilts more heavily in favor of investment.
In the falling cycle, a vicious one-two punch is delivered to productive
enterprises. Low margins make it necessary, and low interest makes it possible,
to use big leverage relative to its equity. There is a term for a company with low
and shrinking margins and high leverage.
Brittle.

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If you have ever owned one of those impossibly delicate glass figurines with long
tendrily tails, whiskers, manes, and tongues, you know that the slightest bump
causes it to break. The same is true for many businesses in the falling cycle. In
any case, it is only a matter of a sufficient drop in the interest rate for many to be
wiped out.
Opposite to Feketes Dilemma, the problem now is that the cheaper one finds the
cost of borrowing, the more meager are the opportunities to profit combined with
the higher the price of capital goods.
The falling cycle is a cycle of capital churn. Perfectly good capital is wiped out by
the dropping interest rate, which gives incentive to a new entrepreneur to borrow
to build what is essentially a replacement for the old capital. And then his capital
is replaced by churn, and so on.
So long as the interest rate remains above marginal productivity (and marginal
time preference), people choose to buy the bond over buying commodities. The
burden of debt is rising. As Irving Fisher wrote in 1933, the more debtors pay,
the more they owe. It is better to be a creditor than a debtor (until the debtor
defaults).

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Businesses, struggling under this burden, do everything possible to squeeze
inventory and fixed capital out of their businesses, and buy back some of their
debt. This adds more oil to the fire of rising bond prices and falling interest rates.
It is no coincidence that Lean, the Toyota Way, began to be widely adopted in the
1980s. It was not well suited to the rising cycle of the post WWII era, but it was
demanded by the falling cycle after Volcker.
Meanwhile, the central bank is not idle. What does every central bank in the
world say today? They are fighting the monster of deflation. How? They want to
increase the money supply. How? They buy bonds.
The bond bull market is ferocious indeed.
The last falling cycle ended just after World War II. The situation today is unlike
that of 1947. One key difference is that credit expansion to fuel the falling cycle
was limited by the ties to gold that were still partially in place after FDRs 1933
gold confiscation and kept in place in the Bretton Woods Treaty in 1944. Today,
there is no such constraint and so the end of the falling cycle will be quite
different, as we explore in Part VI.

[1] Falling Interest Rates Destroy Capital
[2] Inflation: An Expansion of Counterfeit Credit


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6. Theory of Interest and Prices in Paper Currency Part VI (The End)

In Part I, we looked at the concepts of nonlinearity, dynamics, multivariate, state,
and contiguity. We showed that whatever the relationship may be between prices
and the money supply in irredeemable paper currency, it is not a simple matter of
rising money supply > rising prices.
In Part II, we discussed the mechanics of the formation of the bid price and ask
price, the concepts of stocks and flows, and the central concept of arbitrage. We
showed how arbitrage is the key to the money supply in the gold standard;
miners add to the aboveground stocks of gold when the cost of producing an
ounce of gold is less than the value of one ounce.
In Part III, we looked at how credit comes into existence via arbitrage with
legitimate entrepreneur borrowers. We also looked at the counterfeit credit of the
central banks, which is not arbitrage. We introduced the concept of speculation in
markets for government promises, compared to legitimate trading of
commodities. We also discussed the prerequisite concepts of Marginal time
preference and marginal productivity, and resonance.
In Part IV, we discussed the rising cycle. The central planners push the rate of
interest down, below the marginal time preference and unleash a storm whose
ferocious dynamics are more than they bargained for. The hapless subjects of
the regime have little recourse but they do have one seeming way out. They can
buy commodities. The cycle is a positive feedback loop of rising prices and rising
interest rates. Ironically, their clumsy attempt to get lower interest results in rising
interest. Alas, the cycle eventually ends. The interest rate and inventory hoards
have reached the point where no one can issue more bonds or increase their
hoards.
In Part V, we discussed the end of the rising cycle. There was a conflict between
commodity speculation and leverage. Leverage won. Liquidations impaired bank
balance sheets, and the result was a spike in the interest rate. It finally rose over
marginal time preference. Unfortunately, it rose over marginal productivity as
well. Slowly at first, the bond market entered a new bull phase. It becomes
ferocious, as it pushes down the interest rate which bleeds borrowers of their
capital. Companies find it harder to make money and easier to borrow. They are
obliged to borrow to get a decent return on equity. In short, they become brittle.

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In this Part VI, we look at The End. At the beginning of Part I, I noted in passing
that we now have a positive feedback loop that is causing us to spiral into the
black hole of zero interest. In astrophysics, the theory says that a black hole is a
singularity with infinite gravity at the center. There is a radius called the event
horizon, and everything including light that gets inside this radius is doomed to
crash into the singularity.

Black Hole
For years, I have been thinking that this is a perfect analogy to the falling rate of
interest. At zero interest on long-term debt, the net present value is infinite. There
is a positive feedback loop that tends to pull the rate ever downward, and the
closer we get to zero the stronger the pull. But an analogy is not a mechanism for
causality.
In the fall of 2012, I attended the Cato Institute Monetary Conference. Many of
the presenters were central bankers past or present, or academics who
specialize in monetary policy. It was fascinating to hear speaker after speaker
discuss the rate of interest. They all share the same playbook, they all follow the
Taylor Rule (and indeed John Taylor himself presented), and they were all
puzzled or disappointed by Fed Chairman Bernanke not raising interest rates.
Their playbook called for this to begin quite a while ago now, based on GDP and
unemployment and the other variables that are the focus of the Monetarists.
Then it clicked for me.
The Chairman is like the Wizard of Oz. He creates a grand illusion that he is all -
powerful. When he bellows, markets jump. But when the curtain is pulled back, it
turns out that he has no magical powers.

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At that conference, after hearing so many speakers, including some of
Bernankes subordinates, discuss when and why and how much the rate should
be higher, I became certain that it is not under his control. It is falling, falling.[1]

One cannot go from analogy to theory. It has to be the other way around. And
yet, the black hole analogy corresponds to the falling rate in several ways. First,
zero interest is like a singularity. I have repeatedly emphasized the fact that debt
cannot be paid off; it cannot go out of existence. It is only shifted around.
Therefore, regardless of whatever nominal duration is attributed to any bond or
loan, it is in effect perpetual. At zero interest, a perpetual debt has an infinite net
present value.
The next part of the analogy is the strong gravitational pull from a very far
distance. The rate of interest has indeed been falling since the high of 16% in
1981, and it was pulled in to a perigee of 1.6% before making an apogee (so far)
of 2.9%. The analogy still holds, objects spiral around and into black holes; they
do not fall in directly.
There is also a causal mechanism for the falling interest rate. As discussed in
Part V, the interest rate is above marginal productivity. So long as it remains
there, the dynamic is given motive power. In Part V, we discussed the fact that
due to the arbitrage between interest and profit, at a lower interest rate one will
see lower profit margins. This is what puts the squeeze on the marginal business,
who borrowed previously at a higher rate. The marginal business is unable to
make a profit when competing against the next competitor who borrowed more
cheaply.
It is worth saying, as an aside, that this process of each new competitor
borrowing money to buy capital that puts older competitors out of business who
borrowed too expensively is a process of capital churn. It may look a lot like the
beneficial process of creative destruction[2], but it is quite different. Churn
replaces good capital with new capital, at great cost and waste.
In falling rates, no one has pricing power, and generally one must borrow to get a
decent return on equity. The combination of soft consumer demand, shrinking
margins, and rising debt makes businesses brittle.

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Consumer demand is softened by the soft labor market. The labor market is soft
because there is always a tradeoff between labor and capital invested. For
example, in India Wal-Mart does not use automation like it does in the US. Labor
is preferred over capital, because it is cheaper. With falling interest rates, capital
equipment upgrades become a more and more attractive relative to labor. Many
attribute the high unemployment to high minimum wages and generous welfare
schemes. This is part of it, but it does not explain unemployment of skilled
workers and professionals.
As the interest rate falls, the marginal productivity of labor rises. This may sound
good, and people may read it as productivity rises or average productivity
rises. No, it means that the bar rises. Each worker must get over a threshold to
be employed; he must produce more than a minimum. This threshold is rising,
and it makes more and more people sub-marginal.
Unemployed people do not make a robust bid on consumer goods.
The next-to-final element of the analogy is the event horizon. In the case of the
black hole, astrophysicists will give their reasons for why everything inside this
radius, including light, must continue down into the singularity. What could force
the interest rate to zero, once it falls below an arbitrary threshold?
Through a gradual process (which occurs when the rate is well above the event
horizon), the central bank evolves. The Fed began as the liquidity provider of last
resort, but incrementally over decades becomes the only provider of credit of any
resort (see my separate article on Rising Interest Rates Spoil the Party).
Savers have been totally demoralized, discouraged, and punished. Borrowers
have become more brazen in borrowing for unproductive purposes. And total
debt continues to rise exponentially. With lower and lower rates offered, and
higher and higher risk, no one would willingly lend. The Fed is obliged to be the
source of all lending.
A proper system is one in which people produce more than they consume, and
lend the surplus, which is called savings. The current system is one in which
institutions borrow from the government or the Fed and lend at a higher rate.
Today, one can even borrow in order to buy bonds. Most in the financial industry

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shrug when I jump up and down and wave my arms about this practice. Other
than a bank borrowing from depositors (with scrupulously matched duration!)
there should not be borrowing to buy bonds. A free market would not offer a
positive spread to engage in this practice, and rational savers would wi thdraw
their savings if they got wind of such a scheme.
Thus, the system devolves. Sound credit extended by savers drives a proper
system. Now, the Fed becomes the ultimate issuer of all credit, and this credit is
taken from unwilling savers (those who hold dollars, thinking it is money) and is
increasingly extended to parties (such as the US government) who havent got
the means or the intent to ever repay it.
The actual event horizon is when the debt passes the point where it can no
longer be amortized. Debtors, especially the ultimate debtors that are the
sovereign governments, and most especially the US government, depend on
deficits. They borrow more than their tax revenues not only to fund welfare
programs, but also to pay the interest on the total accumulated debt.
That singularity at the center beckons. Every big player wants lower rates. The
government can only keep the game going so long as it can refinance its old
debts at ever-lower rates. The Fed can only pretend to be solvent so long as its
bond portfolio is at least flat, if not rising. The banks balance sheets are similarly
stuffed with bonds. Businesses, long since made brittle by three decades of
falling rates, likewise depend on the bond market to roll their old bonds by selling
new ones. No debt is ever repaid, because there is no mechanism for it. An ever-
greater total debt burden must be refinanced periodically. Lower rates are the
enabler.
Recall from Part IV that the dollar system is a closed loop. Dollars can circulate
at whatever velocity, and they can circulate to and from any parties. For interest
rates, what matters is whether net credit is being created to finance net increases
of commodities and inventories, or whether net sales of commodities are used to
finance net purchases of bonds. The spreads of interest to time preference, and
productivity to interest determine the direction of this flow.
So long as the interest rate is higher than marginal productivity and marginal time
preference, the system is latched up. So long as the consumer bid is soft and

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getting softer, marginal productivity is falling. So long as debtors are under a
rising burden of debt, and creditors have the upper hand, then time preference is
falling.
The final element of our analogy to the black hole is that, according to newer
theories that may be controversial (I dont know, I am not a physicist, please bear
with me even if the science isnt quite right) if enough matter and energy crash
into the singularity quickly enough, then it can cause an enormous explosion.

Black Hole Ejecting Matter and Energy
Here is my prediction of the end: permanent gold backwardation[3]. The lower
the rate of interest falls, the more it destabilizes the system because it makes the
debtors more brittle. The dollar system has, to borrow a phrase from Ayn Rand,
blackmailed people not by their vices, but by their virtues. People want to
participate in the economy and benefit from the division of labor. Subsisting on
ones own efforts alone provides a very low quality of life. The government forces
people to choose between using bogus Fed paper vs. dropping out of the
economy. People naturally choose the lesser of these two evils.
But, as the rate of interest falls, as the nominal quantity of debt rises, as the
burden of each dollar of debt rises, and as the debtors incur ever-greater risks,
the marginal saver reaches the point where he prefers gold without a yield and
with price risk too, over bonds even with a yield. We are in the early stages of

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this process now. A small proportion of the population of Western countries is
buying a little gold, typically a small proportion of their savings.
What happens when this process accelerates, as it must inevitably do? What
happens when people will borrow dollars to buy gold, as they had borrowed
dollars to buy commodities in the postwar period?
By then, the bond markets may be so volatile that this could cause a spike in
interest rates. Or it may not. It will pull all the remaining gold out of the bullion
market and into private hoards. At that point, gold will begin to plunge deeper and
deeper into backwardation. As I explained in my dissertation[4], a persistent and
significant backwardation in gold will pull all liquid commodities into the same
degree of backwardation. Desperate, panicky people will buy commodities not to
hoard them or consume them, but as a last resort to get through the side window
into gold after the front door is closed. When they cannot trade dollars for gold,
they can trade dollars for crude oil and then trade crude oil for gold.
Of course, this will very quickly the drive prices of all commodities in dollars to
rapidly skyrocket to arbitrary levels. At that point, there could even be a short -
lived rising cycle where people sell bonds to buy commodities, or this may not
occur (it may be over and done too quickly).
In any case, this is the final death rattle of the dollar. People will no longer be
able to use the dollar in trade, even if they are willing (which is quite a stretch).
Then the interest rate in dollars will not matter to anyone.
My description of this process should not be taken as a prediction that this is
imminent. I think this process will play out within weeks once it gets underway,
but that the starting point is still years away.
The interest rate on the 10-year Japanese government bond fell to 80 basis
points. I think that the rate on the US Treasury can and will likely go below that.
We must continue to watch the gold basis for the earliest possible advance
warning.
This completes the series on interest and prices. There is obviously a lot more to
discuss, including the yield curve and what makes it abruptly flip between normal

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and inverted, and of course mini rising cycles within the major falling cycle such
as the one that is occurring as I write this. I would welcome anyone interested in
doing work in this area to contact me at keith (at) goldstandardinstitute (dot) us.

[1] To briefly address the 80% increase in the 10-year interest rate over the past
few months: it is a correction, nothing more. The rate will resume its ferocious
descent soon enough.
[2] Joseph Schumpeter coined this term in 1942 in his book Capitalism, Socialism
and Democracy (1942)
[3] http://goldstandardinstitute.us/?p=525
[4] http://keithweinereconomics.com/2012/09/05/a-free-market-for-goods-
services-and-money/


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7. The Theory of Interest and Prices in Practice

Medieval thinkers were tempted to believe that if you throw a rock it flies straight
until it runs out of force, and then it falls straight down. Economists are tempted
to think of prices as a linear function of the money supply, and interest rates to
be based on inflation expectations, which is to say expectations of rising prices.
The medieval thinkers, and the economists are not even wrong, to borrow a
phrase often attributed to physicist Wolfgang Pauli. Science has to begin by
going out to reality and observing what happens. Anyone can see that in reality,
these tempting assumptions do not fit what occurs.
In my series of essays on interest rates and prices[1], I argued that the system
has positive feedback and resonance, and cannot be understood in terms of a
linear model. When I began this series of papers, the rate of interest was still
falling to hit a new all-time low. Then on May 5,2013, it began to shoot up. It rose
83% over a period of exactly four months. That may or may not have been the
peak (it has subsided a little since then).
Several readers asked me if I thought this was the beginning of a new rising
cycle, or if I thought this was the End (of the dollar). As I expressed in Part VI,
the End will be driven by the withdrawal of the gold bid on the dollar. Since early
August, gold has become more and more abundant in the market.[2] I think it is
safe to say that this is not the end of the dollar, just yet. The hyperinflationists
stopped clock will have to remain wrong a while longer. I said that the rising rate
was a correction.
I am quite confident of this prediction, for all the reasons I presented in the
discussion of the falling cycle in Part V. But lets look at the question from a
different perspective, to see if we end up with the same conclusion.
In the gold standard, the rate of interest is the spread between the gold coin and
the gold bond. If the rate is higher, that is equivalent to saying that the spread is
wider. If the rate is lower, then this spread is narrower.
A wider spread offers more incentive for people to straddle it, an act that I define
as arbitrage. Another way of saying this is that a higher rate offers more incentive

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for people to dishoard gold and lend it. If the rate falls, which is the same as
saying if the spread narrows, then there is less incentive and people will revert to
hoarding to avoid the risks and capital lock-up of lending. Savers who take the
bid on the interest rate (which is equivalent to taking the ask on the bond) press
the rate lower, which compresses the spread.
It goes almost without saying, that the spread could never be compressed to zero
(by the way, this is true for all arbitrage in all free markets). There are forces
tending to compress the spread, such as the desire to earn interest by savers.
But the lower the rate of interest, the stronger the forces tending to widen the
spread become. These include entrepreneurial demand for credit, and most
importantly the time preference of the saverhis reluctance to delay gratification.
There is no lending at zero interest and nearly zero lending at near-zero interest.
I emphasize that interest is a spread to put the focus on a universal principle of
free markets. As I stated in my dissertation:
All actions of all men in the markets are various forms of arbitrage.
Arbitrage compresses the spread that is being straddled. It lifts up the price of the
long leg, and pushes down the price of the short leg. If one buys eggs in the farm
town, then the price of eggs there will rise. If one sells eggs in the city center,
then the price there will fall.
In the gold standard, hoarding tends to lift the value of the gold coin and depress
the value of the bond. Lending tends to depress the value of the coin and l ift the
value of the bond. The value of gold itself is the closest thing to constant in the
market, so in effect these two arbitrages move the value of the bond. How is the
value of the bond measuredagainst what is it compared? Gold is the unit of
account, the numeraire.
The value of the bond can move much farther than the value of gold. But in this
context it is important to be aware that gold is not fixed, like some kind of intrinsic
value. An analogy would be that if you jump up, you push the Earth in t he
opposite direction. Its mass is so heavy that in most contexts you can safely
ignore the fact that the Earth experiences an equal but opposite force. But this is
not the same thing as saying the Earth is fixed in position in its orbit.

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The regime of irredeemable money behaves quite differently than the gold
standard (notwithstanding frivolous assertions by some economists that the euro
works like the gold standard). The interest rate is still a spread. But what is it a
spread between? Does arbitrage act on this spread? Is there an essential
difference between this and the arbitrage in gold?
Analogous to gold, the rate of interest in paper currency is the spread between
the dollar and the bond. There are a number of differences from gold. Most
notably, there is little reason to hold the dollar in preference to the government
bond. Think about that.
In the gold standard, if you dont like the risk or interest of a bond, you can
happily hold gold coins. But in irredeemable paper currency, the dollar is itself a
credit instrument backed by said government bond. The dollar is the liability side
of the Feds balance sheet, with the bond being the asset. Why would anyone
hold a zero-yield paper credit instrument in preference to a non-zero-yield paper
credit instrument (except as speculationsee below)? And that leads to the key
identification.
The Fed is the arbitrager of this spread!
The Fed is buying bonds, which lifts up the value of the bond and pushes down
the interest rate. Against these new assets, the Fed is issuing more dollars. This
tends to depress the value of the dollar. The dollar has a lot of inertia, like gold. It
has extremely high stocks to flows, like gold. But unlike gold, the dollars value
does fall with its quantity (if not in the way that the quantity theory of money
predicts). Whatever one might say about the marginal utility of gold, the dollars
marginal utility certainly falls.
The Fed is involved in another arbitrage with the bond and the dollar. The Fed
lends dollars to banks, so that they can buy the government bond (and other
bonds). This lifts the value of the bond, just like the Feds own bond purchases.
Astute readers will note that when the Fed lends to banks to buy bonds, this is
equivalent to stating that banks borrow from the Fed to buy bonds. The banks are
borrowing short to lend long, also called duration mismatch.

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This is not precisely an arbitrage between the dollar and the bond. It is an
arbitrage between the short-term lending and long-term bond market. It is the
spread between short- and long-term interest rates that is compressed in this
trade.
One difference between gold and paper is that, in paper, there is a central
planner who sets the short-term rate by diktat. Since 2008, Fed policy has
pegged it to practically zero.
This makes for a lopsided arbitrage, which is not really an arbitrage. One side is
not free to move, even the slight amount of a massive object. It is fixed by law,
which is to say, force. The economy ought to allow free movement of all prices,
and now one point is bolted down. All sorts of distortions will occur around it as
tension builds.
I put arbitrage in scare quotes because it is not really arbitrage. The Fed uses
force to hand money to those cronies who have access to this privilege. It is not
arbitrage in the same way that a fence who sells stolen goods is not a trader.
In any case, the rate on the short end of the yield curve is fixed near zero today,
while there is a pull on the long bond closer to it. Is there any wonder that the
rate on the long bond has a propensity to fall?
Under the gold standard, borrowing short to lend long is certainly not
necessary.[3] However, in our paper system, it is an integral part of the system,
by its very design.
The government offers antiseptic terms for egregious acts. For example, they use
the pseudo-academic term quantitative easing to refer to the dishonest practice
of monetizing the debt. Similarly, they use the dry euphemism maturity
transformation to refer to borrowing short to lend long, i.e. durat ion mismatch.
Perhaps the term transmogrification would be more appropriate, as this is
nothing short of magic.
The saver is the owner of the money being lent out. It is his preference that the
bank must respect, and it is for his benefit that the bank l ends. When the saver
says he may want his money back on demand, and the bank presumes to lend it

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for 30 years, the bank is not transforming anything except its fiduciary duty, its
integrity, and its own soundness. Depositors would not entrust their savings to
such reckless banks, without the soporific of deposit insurance to protect them
from the consequences.
Under the gold standard, this irrational practice would exist on the fringe on the
line between what is legal and what is not (except for the yield curve specialist, a
topic I will treat in another paper), a get-rich-quick schemeif it existed at all (our
jobs as monetary economists are to bellow from the rooftops that this practice is
destructive).
Today, duration mismatch is part of the official means of executing the Feds
monetary policy.
I have already covered how duration mismatch misallocates the savers capital
and when savers eventually pull it back, the result is that the bank fails. I want to
focus here on another facet. Pseudo-arbitrage between short and long bonds
destabilizes the yield curve.
By its very nature, borrowing short to lend long is a brittle business model. One is
committed to a long-term investment, but this is at the mercy of the short-term
funding market. If short-term rates rise, or if borrowing is temporarily not possible,
then the practitioner of this financial voodoo may be forced to sell the long bond.
The original act of borrowing short to lend long causes the interest rate on the
long bond to fall. If the Fed wants to tighten (not their policy post-2008!) and
forces the short-term rate higher, then players of the duration mismatch game
may get caught off guard. They may be reluctant to sell their long bonds at a
loss, and hold on for a while. Or for any number of other proximate causes, the
yield curve can become inverted.
Side note: an inverted yield curve is widely considered a harbinger of recession.
The simple explanation is that the marginal source of credit in the economy is
suddenly more expensive. This causes investment in everything to slow.
At times there is selling of the short bond, at times aggressive buying. Sometimes
there is a steady buying ramp of the long bond. Sometimes there is a slow selling

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slide that turns into an avalanche. The yield curve moves and changes shape. As
with the rate of interest, the economy does best when the curve is stable. Sudden
balance sheet stress, selloffs, and volatility may benefit the speculators of the
world[4], but of course, it can only hurt productive businesses that are financing
factories, farms, mines, and hotels with credit.
Earlier, I referred to the only reason why someone would choose to own the
Feds liabilitythe dollarin preference to its asset. Unlike with gold, hoarding
paper dollar bills serves no real purpose and incurs needless risk of loss by theft.
The holder of dollars is no safer. He avoids no credit risk; he is exposed to the
same risk as is the bondholder is exposed. The sole reason to prefer the dollar is
speculation.
As I described in Theory of Interest and Prices in Paper Currency, the Fed
destabilizes the rate of interest by its very existence, its very nature, and its
purpose. Per the above discussion, the Fed and the speculators induce volatility
in the yield curve, which can easily feed back into volatility in the underlying rate
of interest.
The reason to sell the bond is to avoid losses if interest rates will rise.
Speculators seek to front-run the Fed, duration mismatchers, and other
speculators. If the Fed will taper its purchase of bonds, then that might lead to
higher interest rates. Or at least, it might make other speculators sell. Every
speculator wants to sell first.
Consider the case of large banks borrowing short to lend long. Lets say that you
have some information that their short-term funding is either going to become
much harder to obtain, or at least significantly more expensive. What do you do?
You sell the bond. You, and many other speculators. Everyone sells the bond.
Or, what if you have information that you think will cause other speculat ors to sell
bonds? It may not even be a legitimate factor, either because the rumor is untrue
(e.g. the world is selling Treasury bonds) or because there is no valid economic
reason to sell bonds based on it.
You sell the bond before they do, or you all try to sell first.

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I have been documenting numerous cases in the gold market where traders use
leverage to buy gold futures based on an announcement or non-announcement
by the Fed. These moves reverse themselves quickly. But no one, especially if
they are using leverage, wants to be on the wrong side of a $50 move in gold.
You sell ahead of the crowd, and you buy ahead of the crowd. And they try to do
it to you.
I think it is likely that one of these phenomena, or something similar, has driven
the rate on the 10-year Treasury up by 80%.
I would like to leave you with one take-away from this paper and one from my
series on the theory of interest and prices. In this paper, I want everyone to think
about the difference between the following two statements:
1. The dollar is falling in value
2. The rate of interest in dollars must rise
It is tempting to assume that they are equivalent, but the rate of interest is purely
internal to the closed loop dollar system. Unlike a free market, it does not
operate under the forces of arbitrage. It operates by government diktats, and
hordes of speculators feed on the spoils that fall like rotten food to the floor.
From my entire series, I would like the reader to check and challenge the sacred-
cow premises of macroeconomics, the aggregates, the assumptions, the
equations, and above all else, the linear thinking. I encourage you to think about
what incentives are offered under each scenario to the market participants. No
one even knows the true value of the monetary aggregate and there is endless
debate even among economists. The shopkeeper, miner, farmer, warehouseman,
manufacturer, or banker is not impelled to act based on such abstractions.
They react to the incentives of profit and loss. Even the consumer reacts to
prices being lower in one particular store, or apples being cheaper than pears. If
you can think through how a particular market event or change in government
policy will remove old incentives and offer new incentives, then you can
understand the likely first-order effects in the market. Of course each of these
effects changes still other incentives.
It is not easy, but this is the approach that makes economics a proper science.

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

[1] http://keithweinereconomics.com/2013/09/18/theory-of-interest-and-prices-in-
paper-currency-part-vi-the-end/
[2] See the Monetary Metals Supply and Demand Report
[3] I argue that it always fails in the end in Duration Mismatch Always Fails
[4] Theory of Interest and Prices, Part III