Apology of I , pencil...
Demand for pencils in the Stone Age
I related my family tree to Leonard E. Read back in 1958 (transcript appended at the end of this update). I offer my belated apology to gold miners and the makers of their mining equipment for not mentioning them in my genealogy. I proudly acknowledge that in this genealogy, just as in that of every economic good, gold inevitably enters, directly or indirectly, through the exchange of semi-finished goods as they are being handed over by the producer of the higher to that of the lower-order goods for further processing.
There is some controversy about the question whether the gold miners and makers of their mining equipment have since dropped out of the circle of people in my genealogy after 1973, when gold was demonetized by all the governments of the world, or whether they still play a role in providing financing for the production and distribution of consumer goods. I must confess that I was fearing for my life that year. I believed that world trade would collapse in short order and civilization would be rolled back to the Stone Age where need existed neither for writing nor for pencils.
As we all know, that did not happen. Governments and bankers hijacked the gold belonging to the people, and they sequestered the social circulating capital. They took over the responsibility for financing the flow of maturing goods from the primary producer all the way to the ultimate consumer. That take-over made things worse, not better. It was the root cause of a seemingly endless series of currency crises. In spite of this, the millennium of fiat money, exiling gold from the monetary system forever, was declared and hailed.
That did not diminish my worries; it increased them. I knew that paper is paper and gold is gold. Banking without gold is like production without capital (or maintenance of capital). When the original producer’s goods wear out, producing activity ceases and civilizations fall back to the Stone Age, unawares of what had hit them. This process of wearing out capital is of course not instantaneous. It could take decades. But when capital erosion is complete, collapse of civilizations occurs as surely as night follows the day. The nexus between cause and effect may well be obscured, but can never be over-ruled.
Falling interest rates, the destroyer of capital
It seems to me that the final stage of erosion of capital is occurring right now. A synopsis of what has taken place during the past four decades is as follows. First, interest rates were destabilized and rising rates destroyed the major part of productive capital of the producers as well as the financial capital of the banks. To understand this you don’t have to know more than the bare fact that rising rates decimate the market value of bonds and that of all other sources of fixed income.
In 1980 the Fed reacted by pushing the rate of interest all the way down from 22 percent to virtually 0. It took three decades to accomplish this feat. In doing so the Fed destroyed the remaining capital of producers as well as that of the banks. The truth of this has not been recognized, however. In fact, the thesis that a falling interest-rate structure is lethal to the economy has been dismissed out of hand. The argument goes that if rising interest rates decimate bond values, then falling ones enhance them, thus enhancing wealth. There is no need to argue the point that falling interest rates raise the present value of a future income stream. The trouble is that the firm must be around to benefit from it.
Most of them won’t be. They will be wiped out for reasons of insufficient capital. Accounting rules do not admit the treatment of cash receivable as cash in the till. The fact is that as long as the regime of falling of interest rates was continuing, no one in his right mind would add to his investments, otherwise they were doomed by the further fall.
Most observers fail to see the danger in either the upswing or the downswing in the rate of interest and think that, in fact, the downswing is beneficial. Yet a falling interest rate structure inevitably destroys capital, whether seen by the observers or not.
Although we cannot be certain about it, the rate of interest has been effectively killed by “monetary policy” and is not likely to rise from the dead, ready for another run. Even if it is, and another devastating swing of the wrecker’s ball is coming, that will administer the coup de grâce to productive and financial capital.
Real Bills Doctrine
My forgetfulness in ignoring gold miners and the makers of gold mining equipments in my family tree was due to the extremely low cost per unit of product of financing production and movement. Since I am in very high consumer demand, second only to food and clothes, my production and distribution is not financed through savings. It is financed through drawing or endorsing real bills against the shipments of my ingredients by the higher to the lower-order producer.
The difference in the method of financing is a most important distinction. My distant cousin the typewriter is not in such a high consumer demand (in fact, right now it is in danger of going the way of the dodo bird). Its production is financed through savings as real bills drawn on the typewriter and the movement of its ingredients ‘could not fly’. The movement of those ingredients as they change hands between the producers of higher and lower-order goods was financed directly by paying cash, not by drawing bills. For this reason, gold miners were much more prominently represented in the family tree of the typewriter. The contribution to the demand for gold attributable to the cost of financing production and distribution of typewriters was sizeable.
In my case, cash entered the chain of production and distribution but once: when the ultimate consumer bought his pencil from the retail merchant. All other exchanges between producers and distributors of higher and lower order goods were financed through billing or discounting real bills. The claims arising out of all these bills were settled from the cash payment for the pencil at the end of the supply chain. We may visualize this as the single gold coin released by the consumer extinguishing all claims arising during the long journey of my ingredients from the primary producer to the shelf of the retail merchant. Indeed, the bill market was the clearing house of the gold standard. The contribution to the demand for gold attributable to the cost of financing my production and distribution, and that of billions of my brothers, was negligible. (Of course, this is no excuse for my oversight in ignoring the gold miners in my family-tree).
“I have told you so: gold is deflationary”
I was flabbergasted at hearing the proposal, promoted by the Mises Institute, that after the present banking collapse they should introduce the so-called 100 percent gold standard. This means a gold standard without real bills circulation. A gold standard bereft of its clearing house, the bill market, is brain dead. It would be a walking zombie — just as it was after Britain had returned to it in 1925.
People at the Mises Institute should be careful about what they wish for, because they might just get it. If they had understood what I had to say in my genealogy published in 1958, they would have never proposed such a harebrained scheme as the 100-percent gold standard. As I have explained to Leonard, I am a simple and humble product, and neither myself, nor any of my ingredients represent high value. Yet there are millions of transactions whereby my ingredients are passed along the supply chain from one hand to the next. If you multiply the modest value of my ingredients with the number of transactions which is in the millions, and you have to pay gold to complete every one of those transactions, then you make such inroads into the stock of gold that trade and production will soon seize up and, to end insult to injury, you have to face the enemies of gold standard gleefully teasing you: “See, I have told you so: gold is deflationary.”
The payments system would become inelastic. The peak season to buy pencils is late August and early September. It is highly questionable that the 100 percent gold standard (so-called) could meet the extra demand for purchasing media to buy school supplies, including pencils. Furthermore, such an imaginary monetary system would be a fetter upon any further refinement of division of labor, as it would require more gold, even without an increase in pencil consumption, to finance the entry of extra producers the chain of semi-finished products. The 100 percent gold standard (so called) would be the end of all further improvement of production equipments and methods.
Adam Smith was no fool
If Adam Smith has done nothing else but contributing the “invisible hand” metaphor to our language, his place in the history of economics would be secure. But Adam Smith has contributed another metaphor as well, perhaps less well-known: that of the “waggon way in the sky”.
It is the mental image of financing production and distribution of consumer goods in most urgent demand through real bill circulation. This image is not fanciful. It has been tried in practice and was found to be working beautifully — long before jet cargo planes were put into service. The idea is simple: just as air transport could free up land presently used as wagon ways, that could be put back into agricultural production, the same way real bills circulation would free up gold and make it available for long-term credit and investments that could not be financed through the bill market.
Real bills should have been allowed to make a come-back at the end of World War I. But the victors were not interested in multilateral trade. They felt more secure under the regime of bilateral trade offering, as it was, a ready shelter for the slow paper of the inefficient producers. We should remember that it took more than half a century for world trade to outstrip its own record chalked up in 1913, because the ban on real bills circulation and multilateral trade was an insurmountable setback.
Banning real bills and multilateral trade is coercion. What kind of free market is that which cannot stand the competition of spontaneous real bills circulation? The free market aspect of real bills should shake up politicians and economist from their lethargy. It is all very well to overthrow the tyranny of legal tender paper money that outlawed gold. But it would be preposterous to replace it with a new tyranny outlawing the circulation of real bills.
I told Leonard in 1958 that if you contemplate the miraculous nature of my existence and the fact that knowledge and know-how cannot reside in one single individual to make my creation possible, then you can help save the freedom mankind is so unhappily losing. The bill market also represents knowledge and know-how that cannot reside in one single individual for the stronger reason. Nor can it reside in a computer or a network of computers.
The bill market flows and ebbs with consumer demand under the signaling system of the discount rate, sending an urgent message to all producers about the state of mind of the sovereign consumer and his propensity to consume. The price system is far too sluggish for that purpose. Change in the taste and preferences of the consumer requires immediate action.
But there is a second reason, too, why the bill market is all-important. The retail merchant is the arbitrageur between social circulating capital and the bill market. He keeps not only an inventory of consumer goods on his shelves; but also a portfolio of real bills drawn on other retail merchants who work with a higher productivity. If the discount rate rises, he sells out marginal merchandise without restocking and buys bills on others. That way he will participate in their earnings whenever his own business slackens. At the first sign of a reversal he will sell bills from portfolio at a profit and restock his inventory from the proceeds.
Preserving freedom, preserving free markets means, among other things, the preservation of real bills and the regime of multilateral trade that they represent. Gold is what makes the world go round — but it must be used with the greatest care, sparing it from frivolous uses by pig-headed and ham-handed “experts”.