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Copyright ©2005 by A.
E. Fekete
A Revisionist Theory and History of
Money
Economic Entropy
Antal E. Fekete
Professor Emeritus
Memorial University of Newfoundland
Oct 10, 2005
Abstract
Economists have neglected to
study the phenomenon of vanishing uncertainties and risks in
the production process as maturing goods approach the final consumer
who is eager to buy them at established prices. We fill this
gap in resurrecting Adam Smith's long-forgotten notion of social
circulating capital. Then the propensity to consume appears as
the volume, and the discount rate as the marginal productivity
of social circulating capital. It turns out that the rate of
interest and the discount rate are entirely different concepts
animated by entirely different forces. The fundamental error
of Mises and Rothbard in confusing the two was due to insufficient
research, in particular, ignorance of economic entropy, the measure
of the disappearance of uncertainty and risk. It was also due
to their denial of liquidity, the fruit of maximum entropy.
Social Circulating Capital
When does a river cease to
be a river? At the moment it gets within sight of the sea. As
the river is descending to sea level significant and conspicuous
changes occur. The salinity of the water increases sharply and,
with it, the ecology changes. Water molecules lose their potential
energy and their kinetic energy is converted to entropy.
Similarly, the flow of myriad
goods from producer to market also undergoes a remarkable metamorphosis
when it gets within sight of the consumer. Adam Smith was the
first to notice this interesting phenomenon. He formulated the
concept of social circulating capital. By this he meant
the mass of finished or semi-finished consumer goods which has
reached sufficient proximity and is moving sufficiently fast
to the ultimate cash-paying consumer so that its destiny of being
consumed presently can no longer be in doubt.
The analogy between the flow
of goods to the final consumer and the river emptying into the
ocean can be profitably extended to include economic entropy.
The risks and uncertainties, so characteristic of processing
in the earlier stages of production, all but disappear by the
time the maturing goods become part and parcel of social circulating
capital and sale at the going price can be taken for granted.
Speculation and other forms of risk-taking give way to the highly
predictable automatic processes of distribution. In particular,
established retail prices do not normally change in response
to changes in demand because of the increase in economic entropy,
measuring the reduction of uncertainty and risk.
Liquidity
The vanishing of uncertainty
and risk, the emergence of social circulating capital, and increase
in economic entropy are manifested in a most dramatic fashion
through the appearance of liquidity. To Adam Smith liquidity
was tantamount to the spontaneous circulation of real bills that
he observed in Manchester and Lancashire. It refers to the qualitative
difference between goods carried by the trade at virtually no
risk in anticipation of sale to the final consumer at established
prices, and other goods carried at considerable risk in anticipation
of an eventual appreciation in value.
The importance of the market
phenomenon that stabilizes values as economic entropy is maximized
can hardly be overestimated. It is incumbent on the monetary
economist to study it closely. The process of supplying the consumer
with urgently needed goods cannot be described in terms of a
black-and-white equilibrium model with circulating capital financed
out of savings, as is done in textbooks for dummies. It is a
transition, a metamorphosis, the description of which calls for
the full spectrum of colors involving a wholly new gamut of means
of payment which are legitimate substitutes for the ultimate
extinguisher of debt, gold. Demand does not operate on prices;
it operates on the discount rate. The vanishing of uncertainty
and risk, along with the emergence of social circulating capital
and the increase in economic entropy must be analyzed independently
of any banks or the banking system. It is the disappearance of
uncertainty and risks that gives rise to banking, not the other
way around. We would never understand bank note circulation without
liquidity and spontaneous bill circulation that appear in the
wake of increasing economic entropy.
Liquidity can be measured by
the spread between the ask and bid price. The smaller the spread,
the higher liquidity is. The ultimate in liquidity is epitomized
by the gold coin with zero spread. Next in line is the consumer
good in urgent demand that sits on the shelf of the shopkeeper
waiting to be exchanged for the gold coin of the final consumer.
The bill drawn on the retail merchant inherits liquidity from
the collateralized merchandise on the shelf. Higher-order goods,
while they may also be liquid, are progressively less so as we
move farther away from the ultimate consumer and his gold coin.
The evolution of the bill market
has made the circulating gold coin in the hand of the consumer
extremely efficient, far beyond the limits of its physical mobility.
Henceforth only finished consumer goods would be sold against
gold coins at the retail counter. Semi-finished goods at various
stages of production and distribution would be traded against
bills of exchange. At the end of each quarter all transactions
are cleared, and all outstanding bills paid from the proceeds
of the final sale of first-order goods into which fast-moving
higher-order goods have matured. The gold coins of the final
consumer liquidate all claims that have arisen during the maturation
of goods.
Propensity to consume
The volume of social circulating
capital and changes in its composition are of the highest importance.
They change as a result of arbitrage between the consumer goods
market and the bill market. The arbitrageur is none other than
the shopkeeper who makes the crucial decision which items to
carry on his shelves and which ones to discontinue. In these
decisions he is guided by one consideration alone: the wishes
of the sovereign consumer. For this reason, propensity to
consume can be identified with the volume of social circulating
capital. If the latter is visualized as a great river emptying
into the sea of consumption, then an increase in propensity to
consume appears as the merger of some of the tributaries with
the main river (tide). Conversely, a decrease appears as the
separation of a new tributary from the main flow (ebb).These
changes are not merely quantitative but, on a periodic basis,
become qualitative following the change of seasons. The composition
of social circulating capital is changing along with the change
of volume. Above all, it is a change in the variety of its components.
Interestingly, the mechanism whereby the wishes of the sovereign
consumer are transmuted into changes of stock in the retail store,
to wit, arbitrage of the marginal shopkeeper between the bill
market and the consumer goods market, has escaped the attention
of the economists. A detailed analysis follows.
Marginal Productivity of Social Circulating
Capital
Each merchandise on the shelf
of every retail shopkeeper has a productivity of its own
that can be measured by the ratio of the percentage of the retail
mark-up (with due allowance being made for overhead) to the average
length of its sojourn on the shelf. Thus if the retail mark-up
on $1 worth of sauerkraut is _ cent and the average sojourn on
the shelf of one bottle is three months, then the productivity
of sauerkraut is (1/2)/(3/12) = 2% per annum. The merchandise
on the shelf of the marginal shopkeeper with the lowest productivity
is called the marginal item of social circulating capital.
The marginal shopkeeper is the one who is first to change
the composition of his stock at the first sign of change in the
willingness, buying habits, and taste of the consumer. In other
words, the marginal shopkeeper adjusts the volume of social circulating
capital to the propensity to consume. The marginal item will
disappear from the shelf as propensity to consume declines, because
it will not be re-ordered by the marginal shopkeeper, and no
more bills will be drawn against its movement from producer to
consumer. Another item on the shelf with a higher productivity
will take its place as the new marginal item.
The rate of marginal productivity
of social circulating capital is the productivity of the
marginal item. In more details, it is the rate at which the opportunity
cost of carrying the marginal item on the shelf becomes critical
to the marginal shopkeeper. The reference is to his opportunity
to carry bills drawn on other shopkeepers with faster-moving
merchandise, rather than carrying the marginal item on his shelf.
Indeed, the marginal shopkeeper is doing arbitrage: he is letting
his stock of marginal merchandise run down whenever the rate
of marginal productivity of social circulating capital increases.
This happens precisely when the propensity to consume declines.
The old marginal item with a low productivity gives way to the
new with a higher productivity. Through his arbitrage the marginal
shopkeeper is able to escape a deep cut in his income due to
seasonal and other changes in demand. He can, thanks to his portfolio
of real bills, participate in the higher earnings of his colleagues
operating with higher productivity. Conversely, the marginal
shopkeeper will sell bills from portfolio and re-order some (heretofore
submarginal) merchandise which he is now willing to carry in
stock, provided that the rate of marginal productivity of social
circulating capital decreases. This happens precisely when the
propensity to consume rises. Higher consumer spending will promote
a submarginal item with a lower productivity to become the new
marginal item. Thus we have proved our First Theorem asserting
that the rate of marginal productivity of social circulating
capital varies inversely with the propensity to consume.
Discount rate
The arbitrage of the marginal
shopkeeper between the bill market and the consumer goods market
is the centerpiece of the analysis of the discount rate. We shall
now prove our Second Theorem asserting that
the discount rate is equal to the rate of marginal productivity
of social circulating capital. At every moment the marginal
shopkeeper (who may be impersonated by a different shopkeeper
from one point in time to the next) is guided by two indicators:
(1) the rate of marginal productivity of social circulating capital;
(2) the discount rate. If the former is higher, then he will
sell real bills from portfolio and order a new marginal item
to display on his shelf. As a consequence (1) decreases while
(2) increases (since the fall in the price of real bills makes
the discount rate rise). Conversely, if the latter is higher,
then he will discontinue offering the marginal item and will
purchase real bills to put in portfolio instead. As a consequence
(1) increases while (2) decreases (since the rise in the price
of real bills makes the discount rate fall). In either case the
two rates get equalized.
A higher discount rate heralds
to all shopkeepers a decline in the propensity to consume. Instead
of re-ordering marginal merchandise they will in response buy
real bills in order to benefit from the higher discount rate.
Social circulating capital shrinks. Conversely, a lower discount
rate heralds to all shopkeepers a rise in the propensity to consume.
They can now beat the discount rate by offering a greater variety
of goods to the consumer, so they will reduce their portfolio
of real bills while ordering new merchandise to display on their
shelves. Social circulating capital expands.
This arbitrage of the marginal
shopkeeper between the consumer goods market and the bill market
that regulates the discount rate is analogous to, but conceptually
is very different from, the arbitrage of the marginal producer
between the producer goods market and the bond market that regulates
the (ceiling for the) rate of interest. Comparison of the two
reveal that the discount rate is different from the rate of interest.
The economic forces changing the two rates are different. The
force driving the rate of interest is the propensity to save.
As is well-known, the rate of interest varies inversely with
the propensity to save. The force driving the discount rate is
the propensity to consume. It is immediate from our First and
Second Theorems that the discount rate varies inversely with
the propensity to consume: rising propensity to consume is tantamount
to a falling discount rate and vice versa.
It is important to note that
the two propensities are not complementary. A third one, the
propensity to hoard, is sandwiched between them. Thus it is possible
for the rate of interest and the discount rate to rise together.
It simply means that people are hoarding goods. By the same token
it is also possible for the two rates to fall together. It means
that people are dishoarding previously hoarded goods. The propensity
to hoard plays a pivotal role in the genesis of the Kondratiev
long-wave cycle. This is a topic for a forthcoming article.
There is only one constraint
limiting the relative moves of the two rates. The rate of interest
is not at liberty to fall below the discount rate. Having said
that, we must admit that illicit interest arbitrage, or financing
bond purchases through the sale of bills at the lower discount
rate (a.k.a. borrowing short in order to lend long) could engineer
such a fall. This has been a lucrative if illegitimate source
of profits for banks quick to make a buck by short-changing the
public. Illicit interest arbitrage plays a pivotal role in the
genesis of the business cycle. Again, this is a topic for another
forthcoming article.
Supply/Demand equilibrium
We conclude that the vulgar
supply/demand equilibrium model is inoperative in the consumer
goods market. Supply is not an independent variable: it is closely
regulated by demand through changes in the discount rate. It
is insulated from the "slings and arrows of outrageous fortune"
by the paraphernalia of self-liquidating credit. An increase
in demand lowers the discount rate, which quickly brings out
a greater variety of consumer goods. Conversely, a decrease in
demand raises the discount rate, which quickly eliminates marginal
merchandise from the shelves of retail stores. Consumers who
still want them will have to look for them in specialty shops
where they will be available albeit at a higher price, since
moving them can no longer be financed through real bills, that
is, through self-liquidating credit at the discount rate. It
has to be financed through funds borrowed at the higher interest
rate. Thus we observe the curious but pleasing fact that the
price of goods belonging to the social circulating capital cannot
be upset through supply and demand shocks.
Economists who are unable to
distinguish between the discount rate and the rate of interest
are at a loss to explain why retail prices under the gold standard
were stable even in the face of changing demand. Their denial
of concepts such as liquidity and economic entropy reduces them
to play the role of stooges riding on the coattails of the enemies
of freedom, the protagonists of irredeemable currency. The latter
know full well that they have nothing to fear from a color-blind
gold standard outlawing the bill market as it is doomed to failure
anyway. Only a gold standard recognizing the full spectrum of
colors in the light of liquidity and entropy that rehabilitates
international trade in real bills will scare them.
References
Adam Smith, The
Wealth of Nations, Book 2, Chapters 1-2
Antal E. Fekete, Where Mises Went
Wrong, 321gold, September 16, 2005
October 10, 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.
Copyright ©2005-2010 by A. E. Fekete<
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