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The Mythical Merits of Paper Money

The Mythical Merits of Paper Money.

One economic myth is that paper money is wealth. The proponents of big government oppose honest money for a very specific reason. Inflation, the creation of new money, is used to finance government programs not generally endorsed by the producing members of society. It is a deceptive tool whereby a “tax” is levied without the people as a whole being aware of it. Since the recipients of the newly created money, as well as the politicians, whose only concern is the next election, benefit from this practice, it’s in their interest to perpetuate it.

For this reason, misconceptions are promulgated about the “merits” of paper money and the “demerits” of gold. Some of the myths are promoted deliberately, but many times they are a result of convenient rationalizations and ignorance.

Paper money is not wealth. Wealth comes from production. There’s no other way to create it.

Paper money managers and proponents of government intervention believe that money itself — especially if created out of thin air — is wealth. A close corollary of this myth — which they also believe — is that money supply growth is required for economic growth.

Paper money is not wealth. Wealth comes from production. There’s no other way to create it. Capital comes from production in excess of consumption. This excess is either reinvested, saved, or loaned to others to be used to further produce and invest. Duplicating paper money units creates no wealth whatsoever, it distorts the economy, and it steals wealth from savers. It acts as capital in the early stages of inflation only because it staels real wealth from those who hold dollars or have loaned them to someone.

Instead of economic growth being dependent on money growth as the paper money advocates claim, great economic harm comes from central banks creating new money out of thin air. This leads to the sort of economic stagnation and economic decline that we are experiencing today. Inflation — increasing the supply of paper money — is the cause of malinvestment and the business cycle, and literally destroys the capital needed for economic growth and stability. The formation of capital through savings is discouraged or eliminated by a paper money system. Instead of paper money producing economic growth, it accomplished the opposite. If money growth were necessary for economic growth, the 1970’s would have been a great decade. During this period of time the Federal Reserve nearly tripled the total money supply but the economy grew only 37 percent.

Although the supply under a gold standard would in all probability increase at the rate of two to three percent per year, this growth is not a requirement for gold to function as a sound currency. This natural or market increase in the money supply easily accommodates population growth and economic growth as long as prices are freely adjusting.

If population or economic growth presents a need for “more” purchasing media, prices merely adjust downward if the money supply is not growing. In the latter part of the nineteenth century this occurred. Wholesale prices dropped 47 percent from 1879 to 1900 and economic growth averaged nearly four percent per year. Obviously, although prices were decreasing, there was no depression. While an increase in the supply of money is never needed to produce economic growth, under a gold standard there might be honest money growth (i.e. not money created out of thin air by the politicians and bankers for the benefit of special interests) and this would serve to smooth out price adjustments.

The myth that paper money is wealth has another corollary: the myth that there’s “not enough gold” for reestablishing a gold standard. But this is merely a device used by paper money advocates to confuse the uninformed, and should carry no weight in the debate of gold versus paper. Hans Sennholz explains this clearly in his essay “No Shortage of Gold”:

On the other hand, if the supply of goods increases while that of money remains unchanged, a tendency toward enhancement of the purchasing power of money results. This fact is probably the most popular reason advanced today for policies of monetary expansion. “Our expanding national economy,” economic and monetary authorities proclaim, “requires an ever-growing supply of money and credit in order to assure economic stability.”

No one can seriously maintain that present expansionary policies have brought about economic stability. During the last forty years of almost continuous monetary expansion, whatever else it may have achieved, did not facilitate economic stability. Rather it gave our age it’s economic characteristic — unprecedented instability.

Ludwig von Mises, in his book A Critique of Interventionism (1929), clearly denounces the belief that government can create wealth by printing paper money. He explains:

By its very nature, a government decree that “it be” cannot create anything that has not been created before. Only the naive inflationists could believe that government can create anything; its orders cannot even evict anything from the world of reality, but they can evict from the world of the permissible. Government cannot make man richer, but it can make man poorer.

This is a powerful political and economic message, and yet it seems that so few understand it. Unfortunately, the poorer the people get, the moe economic problems we have, the more inflation we endure, and the higher the interest rates go, since more people demand government intervention. This trend has to be changed if we expect to preserve our freedoms and our standard of living.

Fact: Paper money is not wealth, it steals wealth.

A second myth is that “easy” money causes low interest rates. This myth is based on the erroneous assumption, itself a myth about government, that government officials — the Federal Reserve Board, the Congress, or the Treasury — can actually set interest rates. In reality the market determined interest rates. Governments can dictate rates, but if these rates are contrary to the market, government will not achieve the intended goal. For instance, if a usury law establishes a ten percent interest rate and the market rate if fifteen percent, no funds will be available except those allocated through government force and the creation of new money.

One reason this myth is so persistent is that in the early stages of inflation, an “easy” monetary policy temporarily lowers interest rates below market levels. Before the people are aware of the depreciation of their currency and do not yet anticipate higher prices, the law of supply and demand serves to lower “cost” of money and interest rates fall. But when the people become aware of the depreciation of the dollar’s value and anticipate future loss of purchasing power, this prompts higher interest rates due to inflationary expectations.

This expectation of future inflation and higher risk is determined subjectively by all borrowers and lenders and not by an objective calculation of money supply increases. These increases in the money supply certainly are important and contribute to the setting of the interest rates, but they are not the entire story. Interest rates vary from day to day, week to week, and year to year. There is no close correlation between money supply figures and interest rates.

Crises and panics can occur for political as well as financial reasons; and interest rates can be pushed higher than monetarist theory says they “should be.” In the early stage of inflation, rates may be lower than they “should be,” and in the latter stages frequently are higher than they “should be,” if by “should be” one means commensurate with money supply growth. Nevertheless, wrong ideas die slowly. “Easy” money, that is, inflation of the paper money supply, is still thought of as an absolute method by which the monetary authorities can achieve low interest rates.

This is not to say the Federal Reserve is helpless in manipulating interest rates. If it alters the discount rate and injects new money into the market, the immediate reaction can be that of lowering rates. But a gold-backed dollar, even if only partially backed, is a different sort, and at the time of the ’30s and the ’40s rates were at historic lows.

If the demand for lower interest rates is great enough and not accompanied by a call for sound currency — gold — the politicians will be “forced” to accommodate the demand by means of massive inflation of the money supply with strict credit controls and credit allocation. This would solve nothing, would serve to worsen economic conditions, and real interest rates in the markets would eventually soar. There is no substitute for sound money, and the sooner we realize this the better.

“Easy” money causes hard times.

Regards,

Ron Paul
for The Daily Reckoning

Excerpted with permission from Dr. Paul’s FREE Foundation work

Ed. Note: People blindly trust that “easy money” will bring about growth. They assume that those in power know what they’re doing and that, in the end, the U.S. is simply far to great to fall into the traps that have snared so many other countries throughout history. Of course, you know better. But this is only half the story. The other half is detailed every day in The Daily Reckoning email edition. To get the full analysis, sign up for the FREE Daily Reckoning email edition, right here.

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“Really? There’s no gold in Fort Knox?”

Byron King

Posted Oct 1, 2013.

Stay tuned for a scene right out of the hit TV show, The Walking Dead. Although, instead of human zombies, expect to see a growing army of zombie dollars. Byron King explains…

Ron PaulDr. Ron Paul is a former Republican member of Congress from Texas and perhaps the only voice in Washington still advocating “limited” government in the Jeffersonian tradition. He has delivered several stunning addresses before Congress, including: “Sorry, Mr. Franklin, We Are All Democrats Now” and “We’ve Been Neo-Conned.” Ron Paul is also the author of The Revolution: A Manifesto,End The FedLiberty Defined, and The School Revolution: A New Answer for Our Broken Education System.

Jim Rogers Blasts “Abolish The Fed” Before It Self-Destructs | Zero Hedge

Jim Rogers Blasts “Abolish The Fed” Before It Self-Destructs | Zero Hedge.

“The world has consumed more than it produced for more than a decade,” Jim Rogers explains to BoomBust’s Erin Ade; but his comments to the leather mini-skirted anchor with regard the actions of the world’s central banks bear the most attention. “The world is floating on an artificial ocean of printed money,” he blasts, adding that while it’s going on “everyone’s happy,” but at the first sign of it slowing, he warns, “we will all dry up.”

Rogers sees gold as a crucial holding in this respect but believes there will be a better price to buy more, as he reflects on the suppressive actions of the Indian government.

This excellent far-reaching interview covers everything from gold standards to China’s 3rd Plenum “I much prefer the Chinese system of open markets than the US with the government dictating everything” and from Bitcoin to a barbaric destruction of the Fed and all it stands for, “the Fed will self-destruct, before the polticians realize what is going on.”

 

Erin Ade… (you’re welcome – is it any wonder Maria B quit?) asks every question we need answered…

 

interviews a worried Jim Rogers…

 

4:30 Agriculture/Farmland – bullish sugar and farmland – “The world has consumed more than it produced for more than a decade,” and inventories are near record lows

6:25 Central Banks – “for the first time in history, all central banks are printing money… The world is floating on an artificial ocean of printed money,”

7:15 Gold – “I am not selling any of my gold, but believe there will better prices to buy… the Indian government is actually trying to make its people sell their gold.”

8:45 Gold Standard – “it might work for a while but eventually the politicians will cheat that too”… “people wil be desperate in the next decade to try anything – maybe it will be bitcoins”

9:40 Bitcoin – there are many more important things in the world than worrying about bitcoins

10:15 China’s Plenum – “the Chinese are becoming more and more capitalist”… they are becoming more and more market focused… as opposed to the US where when there is a problem “the government decides how to fix it… look at Obamacare” – “the government says “we will figure out the solution”… “I much prefer the Chinese system of open markets than the US with the government dictating everything”

15:20 The Fed – “The way the world has worked for a few thousand years is – that when people get into trouble, they fail; competent people come along, reorganize the assets and start over…” In America, he chides, “they decided to let incompetent people take over the assets from competent people and compete with the competent people.” – The Japanese tried this in the 90s and it failed for 2 lost decades.

“In America, they are kicking the can down the road, and when the can finally goes over the side, we are all going to go with it.”

“We’ve had 50-60 years of excess in America, you’ve got to pay the price some day whether you like it or not… the longer they delay the day of reckoning the worse it will be.”

17:40 Abolish The Fed – “the world has gotten along very well for most of history without central banks.”

“we would be better of with no central bank, than this central bank”

19:00 Stocks – “we are certainly gonna have a crash some day” – “as long as they keep printing money, and no restraints on congressional spending, this bubble could go on forever”

 

 

What Is A Gold Standard? | Zero Hedge

What Is A Gold Standard? | Zero Hedge.

Given our earlier discussion of Nobel winner Sargent’s comments on Greece and the gold standard, and the ongoingmelt-up in asset markets due to the ‘limitless money-printing’ of central banks around the world, we thought it worth a look at what a gold standard is (and is not). Before 1974, U.S. dollars were backed by gold. This meant that the federal government could not print more money than it could redeem for gold. While this constrained the federal government, it also provided citizens with a relatively stable purchasing power for goods and services. Today’s paper currency has no intrinsic value.

It is not based on the value of gold or anything else. Under a gold standard, inflation was really limited. With floating value, or fiat, currency, however, some countries have seen inflation reach extremely high levels—sometimes enough to lead to economic collapse. Gold standards have historically provided more stable currencies with lower inflation than fiat currency. Professor Larry White asks, should the United States return to a gold standard?

 

 

After “Currency Wars” Comes “The Death of Money” – Truman

After “Currency Wars” Comes “The Death of Money” – Truman. (source)

“The world is getting closer to that end game every day,” says Rickards, who just finished writing the sequel to his bestselling Currency Wars.

James Rickards

James Rickards, bestselling author and partner in Tangent Capital a merchant bank based in New York.

In the winter of 2009, lawyer, investment banker, and advisor on capital markets to the Director of National Intelligence and the Office of the Secretary of Defense, James Rickards took part in a secret war game sponsored by the Pentagon at the Applied Physics Laboratory (APL). The game’s objective was to simulate and explore the potential outcomes and effects of a global financial war. Two years later, Rickards published what would become a national bestseller, Currency Wars: The Making of the Next Global Crisis.

In Currency Wars, Rickards concluded that a dangerous global financial crisis was not only in the making, but that it was inevitable. Based on that financial war game inside a top-secret facility at the APL’s Warfare Analysis Laboratory, a historical analysis of international monetary policy in the twentieth century, as well as his assessment of the events leading to and adopted after the financial debacle of 2008, Rickards laid out the endgame that would result from the global financial chaos of the first currency war of this century; the collapse of the U.S. dollar and the eventual replacement of fiat money with a return to the gold standard.

“The world is getting closer to that end game every day,” warns Rickards, who just finished writing the sequel to Currency Wars, titled The Death of Money, The Coming Collapse of the International Monetary System.

Due out in bookstores next April 2014, The Death of Money picks up on the disturbing predictions outlined in Currency Wars and carries the analysis further into how the international monetary system might collapse and what new system will replace it.

The Death of Money, The Coming Collapse of the International Monetary System (book cover)

The Death of Money, The Coming Collapse of the International Monetary System (Penguin Random House / April 8, 2014).

While Currency Wars “looked at global macroeconomics through the lens for foreign exchange rates including periods when exchange rates were pegged to gold and the more recent floating exchange rate period,”Rickards explains, “The Death of Money looks at the global macro economy more broadly considering not just exchange rates and the dollar, but also fiscal policy and the need for structural change in the U.S., China, Japan and Europe.” In addition, Rickards elaborates,“Currency Wars made extensive use of history to develop its main themes about the dollar and gold, The Death of Money relies less on history and more on dynamic analysis.”

Where some see a seemingly calm climate enveloping the global economy and financial markets eagerly embrace the U.S. Federal Reserve System’s zero interest rates and easing monetary policies, Rickards sees the prevalence of patterns that only confirm his forecast for an impending storm.

Rickards expects the Federal Reserve policies aimed at importing inflation into the United States “to offset the deflation that had arisen because of the ongoing depression and deleveraging” to continue well into 2015 and perhaps beyond. He also points to other developments that are aligning in favor of the increasingly demise of confidence in the dollar as the world’s reserve currency: “U.S. fiscal policy, stockpiling of gold by Russia and China, money printing by Japan and the UK, and the rise of regional groups such as the BRICS.”

According to Rickards, the inexorable character of the next global financial storm is essentially due to the fact that “the world is facing structural problems, but is trying to address them with cyclical solutions. A structural problem can only be solved with structural solutions including changes in fiscal policy, labor policy, regulation and the creation of a positive business climate. Monetary solutions of the kind being pursued are not an answer to the structural problems we face. Meanwhile, monetary solutions threaten to undermine confidence in paper money. The combination of unaddressed structural problems and reckless monetary policy will ultimately produce either extreme deflation, borderline hyperinflation, stagflation or a collapse of confidence in the dollar.”

I expect the Mexican economy to outperform the U.S. economy in the years ahead.

So how does the rest of the world currently fare up in Rickards’ analysis? Asked about Mexico, the United States’ second-largest trading partner, he explains:

“The Mexican and U.S. economies are closely linked because of NAFTA and immigration and that will continue to be the case, however, the U.S. will be less important to Mexico in the future and China will become more important. The U.S. should expect increasing inflation in the years ahead because of its reckless monetary policy. Mexico should be able to avoid the inflation because of its energy exports and relatively inexpensive labor. The result will be a gradual strengthening of the Mexican peso against the U.S. dollar, something that has already appeared. Mexico will be a major magnet for Chinese investment also. In short, I expect the Mexican economy to outperform the U.S. economy in the years ahead. Mexico will begin to delink to some extent from the U.S. and to link more closely with the rest of the world, especially Europe and China.”

The euro is the strongest major currency in the world and will be getting stronger.

Rickards is also bullish on the European Monetary Union, as he underlines that “the euro is the strongest major currency in the world and will be getting stronger.”

Yet some analysts today warn of the euro’s increased appreciation as a dangerous centripetal force to the euro zone’s integrity. Why does Rickards see the opposite?

“Most analysts do not understand the dynamics driving the Euro. They mistakenly assume that if growth is weak, unemployment is high and banks are insolvent that the currency must we weak also. This is not true. The strength of a currency is not driven by the current state of the economy. It is driven by interest rates and capital flows. Right now, Europe has high interest rates compared to the U.S. and Japan and it is receiving huge capital inflows from China.”

Will Germany go all in to preserve the European single currency?

“Germany benefits more from the Euro than any other country because it facilitates the purchase of German exports by its European trading partners. Citizens throughout Europe favor the Euro because it protects them from the devaluations they routinely experienced under their former currencies. No countries will leave the Euro. New members will be added every year. Germany will do whatever it takes to defend the Euro and the European Monetary System. Based on all of these developments, the Euro will get much stronger.”

What about Spain with its increased poverty levels, 2003 per capita income levels, a soon-to-reach 100% debt to GDP ratio and massive unemployment? Isn’t a strong currency the opposite of what the country needs?

“The difficulties Spain has faced for the past five years are part of a necessary structural adjustment to allow Spain to compete more effectively. Most of this adjustment is now complete and Spain is poised for good growth in the years ahead. Unit labor costs have declined more than 20% since 2008, which makes Spanish labor more competitive with the rest of the world. Unemployment is difficult, but it gives Spain a huge pool of untapped labor that is now available as new capital enters the country. Increased labor force participation from among the unemployed will allow the Spanish economy to grow much faster than its overall demographics would suggest. The Euro has given Spain a strong currency, which is extremely attractive to foreign investors. Ford and Peugeot have recently announced major new investments in Spain and more should be expected. Chinese capital is also eager to invest in Spanish infrastructure. Spain has successfully made structural adjustments and put its major problems behind it, unlike the United States where the structural problems have not been addressed and painful economic adjustments are yet to come.”

Agencies such as the Defense Department and the intelligence community are concerned about the future stability of the dollar.

Given the national security aspect to Rickards’ work and the mere threat on the dollar’s future stability, one would expect for the defense and intelligence community in the U.S. to pressure policy makers into taking action. Not the case, says Rickards:

“Various government agencies and private think tanks and corporations have continued to do war game type simulations of financial warfare and attacks on capital markets systems since the Pentagon financial war game in 2009. I have been an advisor to and a participant in many of these subsequent efforts. However, these national security community and private simulations have had very little impact on policy as pursued by the U.S. Treasury and the Federal Reserve. Agencies such as the Defense Department and the intelligence community are concerned about the future stability of the dollar, but the U.S. Treasury is far less concerned. This has created some tension between those who see the danger and cannot do much about it, and those who can affect dollar policy but do not see the danger.”

Ultimately, however, Rickards argues that if his predictions come true (and in his opinion it is only a matter of time), the collapse of the dollar would lead to a reset in the world’s monetary system whereby gold would regain its historic role as the standard unit of value. What happens after the end of fiat money would then depend on how each country is positioned in terms of its gold reserves.

Can the point of no return in the path to the death of money be averted?

“The point of no return may already have passed,” says Rickards, “but the consequences have not yet played out.”

In Rickards’ view, it’s a catch-22 situation from this point forward: “the Fed has painted itself into a corner. If they withdraw policy and reduce asset purchases, the economy will go into a recession with deflationary consequences. If the Fed does not withdraw policy, they will eventually undermine confidence in the dollar. Both outcomes are bad, but there are no good choices. This is the fruit of fifteen years of market manipulation by the Fed beginning with the Russian – LTCM crisis in 1998. The Fed will cause either deflation or inflation, but it cannot produce stable real economic growth.”

Theory of Interest and Prices in Practice | Zero Hedge

Theory of Interest and Prices in Practice | Zero Hedge. (source)

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 let’s 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 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 saver—his 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 lift 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 measured—against 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 the 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.

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 don’t 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 Fed’s 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 speculation—see 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 dollar’s 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 dollar’s 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 Fed’s 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.

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. duration 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 lends. When the saver says he may want his money back on demand, and the bank presumes to lend it 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 scheme—if 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 Fed’s 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 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 Fed’s liability—the dollar—in 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. Let’s 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 speculators 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.

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.

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 bank’s liability. The bank will not be able to honor this liability if its asset—the US Treasury bond—defaults. 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.

 

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