Whither Gold? Part 2 | |||||||||||||||
By: | Antal E. Fekete | ||||||||||||||
Date: | 10/29/1996 | ||||||||||||||
A short course on demonetization Quantity theorists widely predicted that the demonetization of gold would seriously undermine gold's exchange value. (A representative of this view is the first quotation from Mises on p 3 above.) They argued that the removal of the lion's share of the demand could not help but make gold cheaper. As a reinforcement of this argument, quantity theorists were fond of recalling the episode of silver demonetization in the last century. They claimed that demonetization had caused the prolonged decline in the price of silver that has been continuing ever since. It is not known whether these views had any influence on the thinking of the decision-makers who `demonetized' gold in 1971. Be that as it may, the idea that dishonoring promises to pay gold would somehow cause the dishonored paper to go to a premium in gold is preposterous. It is true that insolvent bankers have in the past often tried to promote their discredited paper (sometimes using such extreme measures as the threat of the death penalty, as did John Law of Lauriston in France) -- to no avail. Logic and history prove that dishonored promises to pay always and everywhere go to a discount -- never to a premium. Indeed, this is exactly what happened after gold was `demonetized' word-wide in 1971. In less than a decade the U.S. dollar went to a 90 per cent discount in terms of gold. The discount is fully commensurate with the 90 per cent loss in purchasing power that the dollar has suffered during the same period. Even though the discount on the dollar fluctuates, the hope that it would ever disappear is a forlorn one. The disarray in the nation's budgetary and trade accounts suggest that currency depreciation is likely to continue, if not to accelerate. The only way to stop the rot would be to adopt a credible plan to resume gold redeemability of the dollar -- but no party has so far mustered the political courage to propose it. The comparison between the demonetization of silver in 1873 and the so-called demonetization of gold a century later is disingenuous. In fact, the use of the word `demonetization' in connection with the latter is quite inappropriate: it is but a euphemism for debt-abatement or partial debt-repudiation inflicted upon the foreign creditors of the United States of America. In 1971 these creditors were deprived of a valuable property right to a fixed amount of gold, or to the dollar equivalent thereof. This unilateral and capricious act has done nothing to benefit the citizens or the government of the U.S. On the contrary, the debt abatement had one predictable consequence: harsher terms on future borrowings, as measured by the higher and unpredictable rate of interest at which the government and the people of the U.S. can borrow at home and abroad. It is true that the burden of the debtors who had contracted debt prior to the abatement was lightened. But insofar as they were the same people and the same government on whom the burden of the harsher terms on further borrowings fell for the indefinite future, there were no beneficiaries -- only losers. In particular, the big loser was the American taxpayer. The international credit of the United States government, which had been the envy of the world for over a century, was grievously damaged -- as manifested by the unprecedented interest rates the Treasury was forced to pay upon its obligations after the debt abatement. The stubborn insistence the credit of the U.S. has not been damaged in the demonetization exercise of 1971 is the centerpiece of mainstream economic orthodoxy. Yet this is a world of crime and punishment and no one, not even the government of the mightiest nation on earth can exempt itself from the consequences, which are numerous. America's industry has lost its international competitiveness. Due to the high rates of interest a large segment of America's park of capital goods has become submarginal, as producers were either unwilling or unable to maintain it or to replace it by more up-to-date equipment. As capital became submarginal, so did the producers using it. They were forced to sell their businesses at a loss, and to invest the remnants of their former wealth in high-yield Treasury bonds. This is a textbook-case showing that a government can only harm itself by harming its own taxpayers. Printing high coupon-rates on its bonds the U.S. government turned former producers of wealth into coupon-clippers. The world is witnessing the progressive de-industrialization of America, as a large segment of the producers find themselves unable to compete with those capricious coupon-rates the government high-handedly prints on its bonds. At the same time, the main competitors of American industry in Japan and Germany are the beneficiaries of a low interest-rate structure, made possible by those countries' more stable currencies. While the so-called demonetization of gold was a farce staged by the U.S. government in order to cover up its own insolvency, the demonetization of silver a hundred years earlier was a genuine market-phenomenon. Government action in demonetizing silver amounted to little more than a belated acknowledgement of a fait accompli. There was no dishonoring of promises to pay. There was no deterioration in the public credit, no destruction of private capital. On the contrary, by virtue of its cooperating with market forces, the government greatly enhanced its credit. The United States was well on its way to become the world's greatest creditor nation. One hundred years later the government, in demonetizing gold, was moving against market forces, and the credit of the U.S. government suffered its greatest setback in the history of the nation. The deterioration of the credit of the United States still continues, with unforeseeable consequences. This is not generally acknowledged by financial writers at home and abroad. But one palpable and indisputable consequence of the `demonetization' of gold was that, in a few short years, the U.S. has turned itself from the world's greatest creditor into the world's greatest debtor nation. The United States was forced to borrow enormous sums abroad at exorbitant rates of interest. The gross mismanagement of credit has created enormous problems for which there are no painless solutions. The dual nature of money The evolution of a dual monetary standard involving both silver and gold was no accident. In every treatise on money, in one form or another the proposition is advanced that money (whatever else it may be) is a transmitter of value through space and time. Thus the concept of money is directly linked to these two absolute categories of human thought. The space/time dichotomy explains the dualistic nature of money -- explicitly observable throughout the ages, right up to the demise of bimetallism. In its first capacity money must be able to transfer value through space, over great distances, with the smallest possible loss. In antiquity, cattle were especially suitable for this purpose, and became money. In its second capacity money must be able to transfer value through time with the smallest possible loss. Cattle-money was scarcely suitable for this second task. This explains the emergence of another kind of money, suitable for hoarding and dishoarding with the greatest ease, in order to facilitate the transfer of value over time. Originally this other kind of money was salt. Not only was it less perishable than other marketable goods, but salt was also the most important agent of food preservation. As the threat of periodic food shortages loomed large in antiquity, the agent of food preservation was destined to have a monetary role. To people of the antique world it appeared natural that two vastly different commodities answered their money-needs, and they took the coexistence of cattle-money and salt-money for granted. Our linguistic heritage clearly reflects this fact. The English adjective pecuniary and noun salary were derived from the Latin words pecus (cattle) and sal (salt). Even though gold and silver which later replaced cattle and salt were far more similar to one another, the dual nature of money persisted throughout the ages. Only towards the end of the 19th century did advances in metallurgy make it possible that one monetary metal, gold, could answer both money-needs of man better than any other commodity. This was the development that made it possible to produce or recover gold in molar quantities economically. The practical outcome was the recognition that the best monetary system was gold monometallism. As Bruno Moll put it in his book La Moneda, "gold is that form of possession which is of the highest elevation above time and space". The dualism of monetary systems is the central theme of this essay, as we explore the two sources of man's need for money. The first, man's need to transfer value over space, was used by Carl Menger to build his theory of value on it. The second, man's need to transfer value over time (or as we shall more specifically describe it, man's need to convert income into wealth and wealth into income) is used here to build a new theory of interest on it. The Janus-face of marketability In developing his theory of value, Menger described the origin of money in terms of the evolution marketability. But as the ancient Italian god Janus (in whose honor the first month of the year is named) marketability has two faces. The first is marketability in the small -- or hoardability. The second is marketability in the large -- or salability. The latter is synonymous with Menger's term Absatzfähigkeit, the cornerstone of his theory of value. Hoardability has not been independently analyzed before. In isolating this concept I propose to lay a new cornerstone for the theory of interest. A commodity is more marketable in the large (or more salable) than another if the bid/asked spread increases more slowly for the former than for the latter, as each is brought to the market in ever larger quantities. For example, perishable or seasonal goods show the lowest, durable goods or goods for all seasons show the highest degree of salability. It is easy to see how cattle became the most salable commodity in antiquity. People had superb confidence that there could never develop a situation in which there was a disturbing surplus of cattle. Long before anything like that could happen, owners would drive their herds to regions where there was a shortage of cattle. The cost of transporting the unit of value represented by cattle over great distances was lower than that of transporting the same value represented by anything else, due to the self-mobility of cattle. This fact, too, is preserved in our linguistic heritage. A herd is also known as a drove of cattle, and a herdsman as a drover (both are derived from the verb to drive). Thus mobility or, better still, portability is an important aspect of salability. The more portable a commodity is, the more easily it can seek out havens where it is in greater demand. The term salability refers to the quality of a good which allows very large quantities of it to be sold during the shortest period of time with minimal losses -- which explains how the term earns its name. Among the most salable goods we find the precious stones and metals. A long historical process promoted gold to become the most salable of all goods. For gold, the spread between the asked and bid prices is virtually independent of the quantity for which it is quoted. It only depends on the cost of shipping gold to the nearest gold center. Under the gold standard the spread is constant, and is equal to the difference between the gold points. By contrast, for all other goods, different spreads are quoted for different quantities, and the larger the quantity, the wider the spread. Thus the gold standard is seen as the product of a market process in search for the most salable commodity. Some authors deliberately confuse the issue insisting that the constant spread of gold is due to institutional factors, i.e., the statutory requirement that the central bank should stand ready to buy at the lower, and to sell at the upper gold point unlimited quantities of gold. Once again, this is a confusion of cause and effect. In reality, institutional constraints would sooner or later break down, and the commodity with less than perfect salability would be demonetized by the market, if the authorities tried to promote it to be the monetary standard -- as indeed happened to silver in the 19th century, to copper in medieval times, and to iron in antiquity. It is common knowledge that, although they have a high degree of marketability in the large, precious stones have poor marketability in the small. The process of cutting up a large stone into a number of smaller pieces often results in a permanent loss of value. (This is just another illustration of the paradox that the value of a parcel is not necessarily the same as the sum total of the values forming part of that parcel.) Even for precious metals whose subdivision into smaller parts is fully reversible, marketability in the small cannot be taken for granted. A penetrating example due to a 19th century traveller is cited by Menger in the Grundsätze: When a person goes to the market in Burma, he must take along a piece of silver, a hammer, a chisel, a balance, and the necessary weights. `How much are those pots?' he asks. `Show me your money', answers the merchant and after inspecting it, he quotes a price at this or that weight. The buyer then asks the merchant for a small anvil and belabors his piece of silver with his hammer until he thinks he has found the correct weight. Then he weighs it on his own balance, since that of the merchant is not to be trusted, and adds or takes away silver until the weight is right. Of course, a good deal of silver is lost in the process as chips fall to the ground. Therefore the buyer prefers not to buy the exact quantity he desires, but one equivalent to the piece of silver he has just broken off. (Principles of Economics, op. cit., p281.) A commodity is more marketable in the small (or more hoardable) than another if the bid/asked spread increases more slowly for the former than for the latter, as each is brought to the market in ever smaller quantity. The term `hoardability' refers to the quality of goods which allows large stores to be built up piecemeal through hoarding, or to be drawn down through dishoarding, with minimal exchange losses. It is this property that matters most when individuals are trying to convert income into wealth, or wealth into income. They succeed best if they employ the most hoardable commodity. It is easy to see how salt became the most hoardable commodity in antiquity. People were confident that exorbitant surpluses of hoardable foodstuff would never develop. Everybody who could afford it would hoard it. People would recall the Biblical teaching that the seven fat years would always be followed by seven lean ones. For the stronger reason, people were supremely confident that their hoards of salt -- this foremost agent of food preservation -- would not lose its value, whatever the fortune may hold in store. In antiquity it was not possible to transfer value over time with smaller losses than those involved in hoarding salt. Other examples of commodities that have been highly hoardable at one time or another throughout history are: grains, tobacco, sugar, spirits. It is interesting to note that there has been heavy government involvement in the production and trade of all these. Thus we see that an historical process, similar to the one making gold most salable, has promoted silver to become most hoardable. Gold was the money used for paying princely ransoms and for buying territories (such as Louisiana and Alaska), and silver was the money used by people of small means for accumulating capital (Maundy money). Why bimetallism failed As long as the necessary technology was lacking, gold could not challenge silver's position as the most hoardable commodity. The cost of producing or recovering a small fraction of the unit of value represented by gold could involve expensive molar processes. The recovery of the same small fraction of the unit of value represented by silver incurred no such extra cost as the amounts involved were not molar, thanks to the lower specific value of silver. However, by the second half of the 19th century, with the progress of metallurgy, the cost of molar processes was lowered and commercial dealings in gold on the molar scale became economically feasible. Thereafter gold could effectively challenge and ultimately displace silver as the most hoardable commodity. The demonetization of silver by the market was a logical consequence. To see clearly why it was gold, and not silver, that was destined to win the race for hegemony we have to consider the specific values of the monetary metals, and their relation to the spreads between the export/import points. Gold has a high and silver a low specific value, implying that the unit of value as represented by gold is lighter than the same as represented by silver (in fact, 15 times lighter if we assume that the gold/silver bimetallic ratio is 15). We have seen that the gold export (import) point is the melted value of the standard coin above (below) which it becomes profitable to export (import) gold. The meaning of the silver export (import) point is analogous. Clearly, the spread between the gold export/import points depends on the cost of shipping the unit of value as represented by gold to the nearest gold center abroad. The same is true, mutatis mutandis, for the spread between the silver export/import points. But shipping costs depend on the weight of the shipment. As the weight of the unit of value as represented by gold is relatively small, the spread between the gold export/import points will be relatively small. (It was approximately 1 percent of value between New York and London in the heyday of bimetallism, while the spread between the silver export/import points was 15 percent of value.) For example, assume that the statutory gold price is $20 per Troy ounce, and the upper and lower gold points are at $20.20 and $19.80, respectively. Assuming further that the official bimetallic ratio is 15, the statutory silver price will be approximately $1.33 per Troy ounce (20 divided by 15). Let us calculate the gold and silver export/import spreads. The cost of shipping the unit of value, $1, as represented by gold is 1 cent (because the cost of shipping 1 ounce of gold is $20 -- $19.80 = twenty cents; this we have to divide by 20 as the standard gold dollar weighs 1/20 of one ounce). The melted value of the standard gold dollar may therefore fluctuate between 99 cents and $1.01 before it will induce a corrective movement of gold. The gold export/import spread is 2 cents. But the same unit of value, $1, as represented by silver, is 15 times heavier, so the cost of its shipping will be 15 cents, or 15 times the cost of shipping the standard gold dollar. The melted value of the standard silver dollar may therefore fluctuate between 85 cents and $1.15 before it will induce a corrective movement of silver. It follows that the silver export/import spread is 30 cents, or 15 times wider than the gold spread. We see that under bimetallism the export/import spread for the monetary metal of the higher specific value is narrower by a factor equal to the bimetallic ratio. It is certainly true that under a monometallic monetary regime most large transactions will not involve shipment of the metal as long as the price of gold stays within the range between the gold points. Clearing is effected through the exchange of warehouse receipts. However, the case under bimetallism is different. Here the arbitrageur profits by actually shipping the undervalued metal out of, and the overvalued metal into, the country maintaining a rigid bimetallic ratio. What this shows is that silver is inferior to gold as a standard of value. Those who park their wealth in silver stand to lose 15 times more than those who use gold for that purpose, due to variations in the market ratio between the silver and gold prices. The upshot is that people will gradually move out of silver and into gold. In due course the market will demonetize the metal with the lower specific value, in this case, silver. Gold monometallism was no accident: it was brought about by inexorable market forces. For the first time ever in human history one commodity, gold, became the undisputed monetary metal, combining the characteristics of the most salable and the most hoardable assets. Mene Tekel But the distinctive property of gold, that it is the only remaining monetary metal around in the closing decade of the 20th century, should not blot out entirely the dualistic nature of money. In fact, it is monetary dualism that provides the only rational explanation for the occasional breakdown of the monetary system. During periods of great monetary disturbance, such as a hyperinflation, the distinction between the two kinds of marketability is most dramatically revived by the market. For shorter or longer periods, the government may succeed in forcing the circulation of irredeemable bank notes, which may retain the characteristics of the most salable asset. Yet, at the same time, the government is patently unable to make these credit instruments the most hoardable asset. Although the fast-depreciating bank note is still usable in transmitting value through space, it suffers from a fatal paralysis when trying to transmit value through time. It is inevitable that, ultimately, gold should assert its position as the most hoardable asset. Nor is there anything governments can do to save their irredeemable paper from monetary destruction. Even if they succeed in banning the ownership of and trading in gold, a number of other commodities stand ready to step into the golden slippers to assume the role of the most hoardable asset. The most conspicuous defect of the quantity theory of money is its utter failure in explaining the hyperinflationary episodes of history. Over-issue of the fiat currency certainly cannot be the cause of the malady. It has been convincingly demonstrated that (especially in the final phases) there was always a desperate shortage of the doomed currency. Hyperinflation has nothing to do with quantity it has everything to do with quality of money. The true cause of hyperinflation is the inexorable human need for a most hoardable asset. It is the relentless search for a reliable transmitter of value through time. Those who believe that the millennium of irredeemable currency has arrived must believe that governments have found a way to change human nature by legislative fiat. Under the regime of irredeemable currency hyperinflation is inevitable -- unless gold is once more allowed to play its historical role that has been taken away from it through government coercion: the role of the most hoardable asset. The full implications of the inevitability of a breakdown in the regime of irredeemable currency are not yet clear to most people. Purveyors of goods and services are still willing to give up real value in exchange for irredeemable promises. This ignorance may, of course, help postpone the moment of truth. In the meantime, Lincoln's dictum should be remembered, according to which it may be possible to fool some people all the time, even to fool all the people some of the time; but it is not possible to fool all the people all of the time. Certain monetary economists can see the writing on the wall mene tekel: your days are numbered -- you have been weighed in the balance and found wanting (Daniel v:26-28) announcing the verdict on the regime of irredeemable currencies. They propose a solution that would `tie' the value of the currency to that of a basket of commodities. Some go as far as suggesting that -- horrible dictu -- even gold may be put into the basket. There is nothing new in these proposals. F.A. Hayek suggested it in 1943 in a paper entitled Commodity Reserve Currency. It is extremely doubtful that Hayek's scheme would work. Let us disregard the utter naivete of the scheme in ignoring the cost of warehousing perishable goods, and ignoring the problem of quality-control. Let us consider the scheme in its simplest form known as symmetalism (originally proposed by the British economist Alfred Marshall a hundred years ago, but never tried in practice) whose unit of value is a basket consisting of a fixed amount of gold and a fixed amount of silver. Unlike bimetallism, this arrangement would let the prices of the monetary metals vary. We now show that symmetalism, no less than bimetallism (which Milton Friedman called preferable to gold monometallism in his book Money Mischief) would be shipwrecked on the rock of gold's constant marginal utility. The market would stamp out symmetalism even faster than bimetallism, precisely because of the price flexibility the former affords. The gold/silver ratio would widen further for reasons already discussed. The profit opportunities offered by symmetalism would result in a relentless arbitrage out of silver and into gold. The arbitrageur would redeem his currency in gold and silver; then he would sell the silver and keep the gold. When the anticipated rise in the price of gold materialized, he would buy back his silver for less, and unwind his arbitrage by surrendering the same amount of gold and silver in exchange for symmetallic currency, showing a net profit in gold. Let us note in passing that the scheme concocted at Maastricht (introducing yet another irredeemable monetary unit, the Euro, defined as a basket of irredeemable currencies) is doomed for the same reason. The currency that depreciates at the lowest rate, in this case the German mark, far from imparting strength to other currencies in the basket, would make them even weaker. Arbitrage would act as a centrifuge, separating the components of the basket, throwing away the soft and keeping only the hardest of hard currencies. (If marks, liras, etc. were no longer available for trading, then the object of arbitrage would be the central bank assets that had been used to balance liabilities in marks, liras, etc.) The authors of the Maastricht scheme turned the ancient wisdom -- that no chain can be stronger than its weakest link -- upside down. They have invented a chain that is as strong as its strongest link. 2. Towards a New Theory of Interest The nature of interest is one of the great problems of humankind, as old as money itself. It has engaged the greatest minds, from Aristotle through the church fathers to Menger. The lack of a satisfactory solution to the problem has rocked empires, contributing to their destruction. This author hopes that his essay can make a modest contribution to the ultimate disposal of this great and vexed problem. Part of the difficulty is in the way the question has traditionally been presented, namely: what happens when a man with a need to borrow meets another with money to lend? It has always been in this context that usury was condemned by both criminal and canon law. It has not occurred to the philosophers and moralists -- or, for that matter, to most economists -- that the nature of interest could be better grasped if the question was reformulated thus: what happens when a man with income to spare but who is in need of wealth meets another with wealth to spare but who is in need of an income? The resulting exchanges provide a passage from direct to indirect conversion of wealth and income. Indirect conversion represents a great improvement in efficiency over direct conversion, interest being the manifestation of the market value of this improvement. Thus the proper setting for the study of interest is the indirect conversion of income into wealth (just as the proper setting for the study of price is the indirect exchange of goods). It now appears that condemnation of usury is akin to condemning a man for charging or paying the going price for bread. Traditionally, interest is conceived as a steady income in perpetuity which is exchanged for the unit of wealth. It can be measured as a percentage of the unit of wealth accruing as income to its owner after the exchange. If the unit of wealth is one gold dollar, and it is exchanged for an income in perpetuity amounting to one gold cent per quarter, then the rate of interest is four percent per annum. Of course, an income in perpetuity is an abstraction, but it has great theoretical importance as the standard measuring interest. The mathematician has shown us exact formulas expressing the rate of interest involved in exchanges of wealth for income for a set period of time, as well as formulas expressing the rate of interest involved in exchanging present for future wealth, in terms of this standard -- making arbitrage between various credit markets possible. I shall not pause here to give an iron-clad definition between "wealth" and "income'. Suffice it to say that an inexorable need exists, second only to the need for food and shelter, urging man to convert income into wealth in order that later, when past his prime, he may convert his wealth back into income. As the comedy of King Midas and the tragedy of King Lear show, a most important difference exits between controlling wealth and controlling income, and the possibility of converting one into the other must not be taken for granted. Income is an ultimate end for man, insofar as without it he may have no other ultimate ends on earth. (If denied an income he, as King Midas, is in danger of starving to death.) Since wealth is an indispensable means to that end in the twilight years of his life, man's need for a reliable conversion mechanism is beyond doubt. (Without such he may, as King Lear, end up losing both his wealth and income.) The theory of private property ought to take full account of the fact that conversion of income into wealth is the rational and characteristically human manifestation of the law of the biosphere whereby all living things can only survive and prosper by hoarding their substance. In the case of man this substance, as we have seen, is the most marketable commodity, gold, which is always in demand, whether it is offered in the largest or in the smallest practically realizable quantity -- since it can always be traded with the smallest possible exchange losses. The chimaera of hoarding Here we come to a paradox which utilitarian philosophy has failed to solve. An apparent contradiction exists between the needs of the individual and his society. There is a time in the life of every man when he wishes to draw on his savings accumulated earlier. Yet hoarding and dishoarding are widely considered as anti-social. They are unsettling as the former affects demand and the latter affects supply unfavorably, possibly at a time that is inopportune from the point of view of society. The utilitarian philosophers could not clarify how the market provides for the conflicting demands of society and its ageing members. Utilitarian philosophy has failed to solve the problem of hoarding and dishoarding. In particular, it has failed to explode the arguments of Silvio Gesell, John Maynard Keynes and other inflationists, according to which the contractionist and deflationary pressures inherent in a metallic monetary system are the source of poverty and chronic economic distress, as they invite hoarding. At the same time these authors described the promised land of the inflationist paradise in glowing terms. There, the miracle of "turning the stone into bread" would be routinely performed by monetary technicians in the service of the government for the benefit of the people. In what follows I refute the inflationist argument in the spirit of utilitarian philosophy, hoping to remove an obstacle which has blocked the advancement of monetary science for a hundred years. The invention of double-entry book-keeping in Italy of the Trecento was a momentous landmark in economic history. Göthe called it "one of the finest inventions of the human mind" (Wilhelm Meister's Apprenticeship). Double-entry book-keeping is of utmost economic importance, second only to the appearance of indirect exchange much earlier that had made direct exchange of goods obsolete. The new invention made the indirect accumulation of capital via the instrument of contract possible, thus making the direct accumulation of capital via hoarding obsolete. Previously, there was only one way for people to convert income into wealth or wealth into income outside of family bonds: hoarding and dishoarding. (For much of the Orient, which was slower in developing the institutional framework to protect contractual rights, it is still the only way.) This immobilized large amounts of gold, and made capital accumulation an arduous and protracted process in which reward was far removed from effort, dampening incentive. The invention of double-entry book-keeping made possible a heretofore unprecedented increase in the efficiency of gold as the catalyst of capital accumulation. Gold's physical presence was no longer necessary in every conversion. From then on gold could act by proxy, as its role in the conversion has become residual. Thanks to this breakthrough, partnerships could now be formed representing an exchange of income (of the junior partner) for wealth (of the senior partner). Later, with the gradual acceptance of `sleeping' partners in the firm, it became possible to buy and sell shares in the enterprise as if they were fixed-income securities. Indeed, this they were in all but name, in order to avoid censure by canonical and secular authorities under the usury laws. It is clear that without double-entry book-keeping, balance sheets and income statements, trade in shares would not have been possible, nor could a departing partner have been bought out. There would have been no precise and objective way of attaching value to the assets and liabilities of the firm short of liquidation. The new development released huge amounts of gold from private hoards as people began to accumulate and carry wealth in the form of securities disguised as partnership equity. (By contrast, in the Orient, where the social and institutional arrangements were far more inimical to the individual and his freedom to choose, the demand for gold and silver for hoarding purposes continued unabated.) During the Quattrocento gold disgorged by the Occident flowed to the Orient to finance the trade in exotic goods. Myrrh, spices, silk and satin enjoyed exceptionally high marketability in the Occident where all the great banking houses engaged in financing this lucrative trade. The world was treated to the curious spectacle that the Occident was thriving while losing gold to the Orient, because it had learned how to get by with less. It had learned to exchange wealth and income. This shows that gold is merely the whipping boy at the hand of the inflationists. Gold is not scarce (in fact, as measured by the stocks-to-flows ratio mentioned above, the monetary metal is more abundant than any other economic good) but it quickly goes into hiding at the moment inflationists gain the upper hand. There is no contradiction between the interests of society and its ageing members. Very little if any gold is needed to complete all the exchanges of income and wealth in the course of normal business, provided that the free choice of individuals is allowed to prevail. Only when government interference is feared or expected does the demand for gold become disturbing. The correct policy is `hands off' -- let the market decide what is best for its participants. Squaring the diagonal The next advance came with the Reformation, during which the canonical and secular strictures on interest were eased, the definition of usury narrowed and, later, the prohibition against both repealed. Whereas the partnership contract had originally been designed with the concealment of interest in mind, then it became possible, for the first time in history, to openly engage in the exchange of income and wealth, with the payment of interest freely admitted, and the rate of interest explicitly quoted. The bond market was born as a result of these historical changes. The right to income reserved by the bondholder could now enjoy the same legal protection as the right to rent-charges enjoyed during the prohibition era. Thus, it remained for the Reformation to crown the great economic advances of the Renaissance, to free the exchange of income and wealth from its former fetters. For the first time in history, the rate of interest could manifest itself as a market phenomenon. The analysis of the formation of interest rates is usually given in terms of a diagonal model featuring just two participants in the market: the supplier and the user of `loanable funds'. This model is woefully inadequate, as it blots out the time element and the crucial process of capital formation, it ignores the principle of capitalizing income, and it confuses saving and investment. The present analysis will replace the diagonal model first with a square, then a pentagonal and, finally, with a hexagonal model, in order to gain a more penetrating insight into the process of capital formation. First we take a look at the square model which has the merit of identifying the supply of and demand for wealth and income. In considering the problem of converting income into wealth and wealth into income, we may isolate two fundamental needs: (1) the annuitand's need to convert income into future wealth; and (2) the annuitant's need to convert wealth into income. Typically, the annuitand is a young man who is looking forward to getting married. He tries to provide for the future needs of his family: for the education of his children, and for his and his wife's old age. By contrast, the annuitant is a man in his harvest years, looking forward to his twilight years with equanimity. He has by now accumulated the wealth which he is ready to convert into a suitable income. If the annuitand (or the annuitant) is restricted to direct conversion, due to institutional restraints on the exchange of income for wealth (or wealth for income) then the optimum conversion is provided by gold hoarding (dishoarding). By definition of marketability in the small, no further improvement in efficiency is possible. However, if the institutional constraints on exchange are removed, then a whole new game comes into play and, indeed, further improvements become possible, for the benefit of all participants. On the one hand, the annuitant's need is answered directly by the entrepreneur who is anxious to give up income in exchange for present wealth. The latter could profitably invest the former's wealth in his business which would then generate a greater income that he could afford to share. On the other hand, the annuitand's need is answered directly by the inventor ready to give up future wealth in exchange for an income. The latter is working on a new production process that may take several years to perfect before it can be put into place. In the meantime he has to maintain himself and has to defray the cost of his research and development (R&D). The new tool or process the inventor is perfecting represents future wealth which he is willing to share with his partner, the annuitand, who puts the necessary income at his disposal in the interim. Both the entrepreneur and the inventor are engaged in the business of capital formation; the difference is seen in the method of amortization. The capital formed by the entrepreneur is scheduled to begin its amortization cycle immediately. There is a more-or-less prolonged waiting period before the capital formed by the inventor can start its amortization cycle. | ||||||||||||||||
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