Copyright ©2005
by A. E. Fekete
Where Mises Went Wrong
Antal E. Fekete
Sep 16, 2005
Ludwig von Mises erred when
he dismissed what is known as the Fullarton Effect. In 1844 John
Fullarton of the Banking School described how low interest rates
were resisted by savers in selling their gold bonds and hoarding
gold instead. Mises ridiculed the idea, calling gold hoards a
deus ex machina in Human Action (3rd revised edition,
p 440). My theory of interest corrects this mistake in giving
due recognition to the Fullarton Effect. I can well understand
the frustrations of Robert Blumen, Sean Corrigan, and other detractors
of mine reluctant to read the voluminous outpourings of this
"inflationist monetary crank". Rather than finding
a weak point in my argument they call me names, stonewall Adam
Smith, conjure up the bogyman of John Law, set up straw men only
to knock them down again, and quarrel bitterly with my ad
hoc examples while ignoring my comprehensive theory of interest.
For the benefit of discriminating students of Carl Menger and
Eugene Böhm-Bawerk I restate this novel theory in a concise
form.
The rate of interest is a market phenomenon. It is defined as
the rate at which the coupons of the gold bond amortize its price
as quoted in the secondary bond market. The mathematician has
shown us formulas expressing the rate of interest in terms of
the price of the gold bond. They confirm that the two are inversely
related: the higher the bond price, the lower is the rate of
interest and vice versa. As a consequence, the lower bid
price of the gold bond corresponds to the ceiling and the higher
asked price to the floor of the range to which the rate of interest
is confined. The question is what economic factors determine
these constraints and how.
The floor is determined by the time preference of the marginal
bondholder. If the rate of interest falls below it, then he takes
profit in selling the overpriced gold bond and will keep the
proceeds in gold coin. When the rate of interest bounces in response
to bondholder resistance, he will buy back the gold bond at a
lower price. The gold hoards are no deus ex machina: they
are the very tool of human action in setting a limit to falling
interest rates.
The ceiling is determined by the marginal productivity of capital,
that is, the rate of productivity of the capital of the marginal
producer. If the rate of interest rises above it, then he sells
his plant and equipment and invests the proceeds in the underpriced
gold bond. When the rate of interest falls back in response to
producer resistance, he will sell the gold bond at a profit and
use the proceeds to deploy his capital in production once more.
There is no valid reason to denigrate the productivity theory
of interest following Mises. The theory of time preference and
the productivity theory are not mutually exclusive. On the contrary,
they are complementary. The fratricidal wars between the two
schools have been in vain: they did not serve the advancement
of science. They merely contributed to its retardation. Only
a synthesis of the two theories can adequately explain the formation
of the rate of interest.
I submit that my theory of interest brings about such a synthesis.
It is in the spirit of Menger and is in harmony with the insights
of Böhm-Bawerk. It represents a breakthrough that provides
solid foundation for further development of the theory. In Mises,
time preference is no more than a pious wish. It is the gold
hoards that lend teeth to those wishes. Nothing else can. Mises
was not alive to the arbitrage of the marginal bondholder between
bonds and gold, the most potent form of arbitrage between present
and future goods. Likewise, Mises failed to explain how changes
in the rate of interest guide production, to wit, through arbitrage
of the marginal producer between bonds and capital goods.
Mises also criticized the Banking School on the subject of reflux
(op.cit., p 444). He charged that banks regularly short-circuit
reflux by putting retired bank notes back into circulation: "The
regular course of affairs is that the bank replaces bills expired
and paid by discounting new bills of exchange. Then to the amount
of bank notes withdrawn from the market through the repayment
of the earlier loan there corresponds an amount of newly issued
bank notes." This ignores the fact that the credit to which
each and every non-fraudulent bill gives rise is self-liquidating.
Moreover, if the Reichsbank of Germany, for example, had discounted
new bills on the same old merchandise, then it would have violated
the law. At any rate, the argument of the Banking School refers
to the transparent case of bill circulation. Slow or fraudulent
bills can take no refuge in the portfolio of conspiring banks.
The bill market is fully capable of ferreting out delinquent
bills and will refuse to discount them.
The nexus between drawer and drawee of the bill of exchange is
not the same as that between lender and borrower. The drawer
is no lender, discounting is no lending, and the discount rate
is not the same as the rate of interest. The drawee is the active
protagonist in the drama of supplying the consumer with urgently
needed goods; the drawer is passive. It is the drawee who promptly
reacts to changes in the height of the discount rate. These changes
are governed by the consumers. The discount rate is not regulated
by the savers, still less is it set by the banks. The drawee,
typically a retail merchant, has the unconditional privilege
of prepaying his bills. The discount serves as an incentive.
If demand is brisk, it will take a lower discount rate to induce
him to prepay; if sluggish, a higher one. Moreover, in the latter
case, the marginal retail merchant will not re-order his usual
quota of consumer goods from his suppliers. Instead, he will
carry part of his circulating capital in the form of bills drawn
on more productive merchants until demand picks up again. Evidently
Mises misconstrued the problem of discounting. Insisting that
retail inventory was financed through loans at the bank, Mises
failed to notice that the marginal retail merchant was doing
arbitrage between bills and consumer goods. He would thin out
merchandise on his shelves while beefing up his portfolio of
bills in response to the consumer's reining back spending, while
he would sell bills from his portfolio and use the proceeds to
replace the missing merchandise on his shelves upon renewed interest
of the consumer in buying. Wrongly, Mises blotted out the important
distinction between the discount rate and the rate of interest
which are governed by entirely different economic factors and
move quite independently of one another.
Not until these three most important forms of human action, the
arbitrage of the marginal bondholder, the arbitrage of the marginal
producer, and the arbitrage of the marginal retail merchant are
more widely recognized can further significant progress in the
theory of interest be made.
References
Robert Blumen, Real Bills,
Phony Wealth, www.financialsense.com , July 2005.
Sean Corrigan, Unreal Bills Doctrine, August 8, 2005.
Sean Corrigan, Fool's Gold, http://lewrockwell.com, August 9,
2005.
Sean Corrigan, Fool's Gold Redux, http://lewrockwell.com, August
12, 2005.
Sean Corrigan, Clearing the Air, http://lewrockwell.com, September
8, 2005.
Antal E. Fekete, Gold and Interest, www.goldisfreedom.com , January,
2003.
Antal E. Fekete, Towards a Dynamic Microeconomics, Laissez-Faire,
Revista de la Facultad de Ciencias Económicas, Universidad
Francisco Marroquín, No. 5, Sept. 1996.
Note re this piece.
Sep 9, 2005
Antal E. Fekete
Professor
Emeritus
Memorial University of Newfoundland
email: aefekete@hotmail.com
Professor Antal E. Fekete was born and educated
in Hungary. He immigrated to Canada in 1956. In addition to teaching
in Canada, he worked in the Washington DC office of Congressman
W. E. Dannemeyer for five years on monetary and fiscal reform
till 1990. He taught as visiting professor of economics at the
Francisco Marroquin University in Guatemala City in 1996. Since
2001 he has been consulting professor at Sapientia University,
Cluj-Napoca, Romania. In 1996 Professor Fekete won the first prize
in the International Currency Essay contest sponsored by Bank
Lips Ltd. of Switzerland. He also runs the Gold Standard
University.
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