Fool's Gold

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In his memoirs, in his despair at what he saw as his inability to get the fragile sapling of economic reason to take a firm root, Mises himself was once moved to ask:

"Is the attempt to guide the people on the right road not hopeless, especially when we recognize that men like John Maynard Keynes, Bertrand Russell, Harold Laski and Albert Einstein could not comprehend economic problems?"

Indeed, we have to agree.

In fact, it would provide fertile ground for a doctoral thesis in that Just-So-Story u2018discipline’ of evolutionary psychology to speculate on whether there is something hard-wired into our atavistic, hunter-gatherer brains which does this.

Did all those years — supposedly spent on the sun-baked Savannah — mean we have been stubbornly tuned to the instant gratification of the kill and to the visible apportionment of its spoils among the familiar and ever-present members of our band?

If so, is this what makes it such a struggle to attain a full grasp of the phenomena associated with divided labour, indirect exchange, and u2018roundabout’ methods of production?

We’re sorely tempted to answer in the affirmative, for the idea of Keynes’ own frontal lobes consisting of little more than an economic "barbarous relic" is an irony almost too delicious to resist!

Thus, the job of eradicating economic errors often seems, as Mises’ lament implies, a Sisyphean task.

Picture the poor Austrian, doomed to the eternal task of heaving his rock of enlightenment up the hill of ignorance — only to have it slide from his sweaty grasp, to the diabolical glee of the Inflationist ghoul inevitably supervising his torment.

For example, there is presently a series of polemics rattling around the websites normally frequented by Armageddonist gold bugs and millenary financial doomsters, all emanating from the pen of Antal Fekete — professor emeritus (in Mathematics and Statistics) of the Memorial University of Newfoundland — and his acolytes.

In this, they have been dressing up that ugly sister of the 19th century Banking School — the Real Bills Doctrine (RBD) — in a racy new ball gown, while simultaneously disparaging us Austrian Cinderella’s as "enemies of freedom" for our stubborn adherence to the 100% gold standard in the face of their more sophisticated alternative.

One may acquire a hint of the sheer perversity of the clique’s argument when one knows that among the many enormities Prof. Fekete propounds is one in which he contends that the rate of interest is to be treated separately from the rate of discount, the first being "governed by the propensity to save" and the latter by the purportedly distinct "propensity to consume"!

But, leaving such evident contortions aside, RBD is subject to any number of pernicious flaws, not least that it rests on a u2018reverse engineering’ of one of the ideas — and an extension of yet another — framed by that egregious Scottish gambler, John Law, in his Money and Trade Considered; the first being that:

"…trade depends on money: a greater quantity employs more people than a lesser… nor can more people be set to work without more money to circulate so as to pay the wages of a greater number…"

— and the second on the widely held belief that, so long as money is rooted in u2018the needs of trade’, its increase can occasion no possible harm, thus:

"…the (note-issuing) commission giving out what sums are demanded and taking back what sums are offered to be returned, this paper money will keep its value and there will always be as much money as there is occasion or employment for, and no more…"

Here, Law — like many subsequent inflationists and real bills advocates — has overlooked one crucial flaw; that, absent the physical limitations of the scarcity of a hard specie standard to provide a restraint, this system tangles itself in not so much a Gordian, as a Gödelian knot.

The nature of this hangman’s bootstrap is that, as any California real estate speculator or Nasdaq day-trader will tell you, the u2018needs of trade’ are hardly independent of the quantity of credit available to finance them.

It seems to escape the RBD cultists that the sum one u2018needs’ to borrow in order to buy an asset — with which the loan will be collateralized — is self-referentially dependent upon the quantity of similar credits both already extended and currently competing for similar purposes, thanks to these credits’ crucial role in determining the asset’s prevailing market price.

As Henry Thornton — that giant of the Currency School — succinctly put it, two hundred years since:

"[Law] forgot that there might be no bounds to the demand for paper; that the increasing quantity would contribute to the rise of commodities and the rise of commodities require — and seem to justify — a still further increase"

Thornton’s near contemporary, Joplin, was equally quick to spot the error:

"Bankers, indeed, have the idea that their issues are always called forth by the natural wants of the country, and that it is high prices that cause a demand for their notes, and not their issues which create high prices, and vice versa. The principle is absurd, but it is the natural inference to be deduced from their local experience. They find themselves contracted in their issues, by laws which they do not understand, and are consequently led to attribute the artificial movements of the currency to the hidden operations of nature, which they term the wants of the country"

But, even were we to overlook these fundamental objections and to allow the Feketians their head, they nowhere explain to us how we are to determine the u2018reality’ of a given bill in today’s complex economy.

How are we to gauge the value of, say, the provision of legal services in a patent dispute, rather than that of a VLCC cruising the high seas? Or how might the act of contracting the WPP Group for an advertising campaign differ from laying claim to the very tangible cargo of iron ore nestling in the hold of a 1,000-ft carrier plying the waterways of the Great Lakes?

One might even maliciously wonder whether a margin loan on the NYSE is not at least a cousin to a u2018real’ bill, since it helps finance the purchase of a direct claim upon the net productive assets — the stock — of a private corporation. And what about a repurchase agreement used to finance a holding of that same corporate’s debt and hence to maintain a prior lien on a share of its income stream?

There is also a deafening silence on how the good Prof. Fekete might propose to prohibit the issue of finance (“pig on pork”), or accommodation bills (glorified promissory notes) — and lest the reader thinks we are here arguing about the niceties of some Victorian anachronism, he should be aware that the traditional bill’s latter day equivalents in this area, asset-backed securities, are a quintessential feature of the modern credit landscape, comprising a $1.8 trillion market in the US alone.

In failing to address these points, Prof. Fekete not only overlooks the sporadic bill-”kiting” crises which dogged Industrial Britain throughout what he supposes to be an untarnished golden age, he also fails to recognise that it would be only too trivial to disguise such bastard children as the u2018real’ thing in today’s Andersen-Enron-Money Center Bank, financially-engineered, smoke-and-mirrors economy.

However, erratum longum, vita brevis, so, rather than picking our way through each of the many mistakes which litter Prof. Fekete’s diatribe, there is one matter whose exegesis might furnish us with a more lasting reward than the simple pleasure of puffing air at his inflationist house of cards — namely, that related to the cone of production, to the importance of the concept of gross, not net, product (as Professor Reisman has taken great pains to elucidate), and to the true function of saving.

Here we must allow Professor Fekete the liberty of hoisting himself on his own petard and quote him at some length:

"… it is not possible to finance all of society’s circulating capital out of savings. It would put inordinate demand on savings that simply could not be met. Consider a hypothetical production cycle [of] 91 days, with as many as 90 firms participating, so that the sojourn of the semi-finished product at every one of the 90 stops takes one day. The ultimate consumer is willing to pay $100 for [it] while the producer of the 90th order good has paid $11 for raw materials. We shall also assume that the value added to the maturing product at every stop is $1. Now if you want to finance the movement of one [unit]… through the various stages of production… you have to withdraw savings in the amount of… $4995, almost 50 times retail value"

Put this way, the idea does seem ludicrous — exactly the effect Fekete intends by deploying this clearly exaggerated, 90-stage process as an attempted reductio ad absurdum.

But is this actually as risible as it sounds?

Actually, it’s not — but, rather than going through the argument line-by line here, the sceptical reader is invited to consult the working paper for a full rehearsal of the logic.

The rest of you will just have to take it on trust that what the arithmetic finally shows is that it will require 4,095 units of final goods output selling for $4,095 (at $1 a piece) to equalize the real income of all participating 4,095 u2018workers’ arranged in a 90 step triangle of 1-2-3… …88-89-90 u2018workers’.

The calculations also reveal that $125,580 in revenues will be generated with every complete productive cycle which gives rise to the same $4,095 of consumer goods, in what is a perfect match for the 125,580 units of final and intermediate goods which we shall be transporting down the chain at each turn.

But, though our model shows that this natural correspondence jumps straight out of the simple logic at work, the seemingly large monetary disproportion between $4,095 rattling into the retailers’ tills and the $125,580 circulating throughout the value chain still causes our bill-wielding maths professor to utter howls of derision at the idea of using so much u2018scarce’ money to effect such a low rate of conversion of total effort into final goods.

But, in fact, there is another important truth to be revealed here.

For what Fekete labours under is a GDP-style obsession with the value of these final goods alone to his consequent — and logically fatal — neglect of the importance of all the intermediate products to which each cycle gives rise. This misleads him into scorning matters that are, in fact, critical to the means by which genuine capitalism (not inflationary corporatism) showers us with its bounteous material riches — a sin no true Austrian would knowingly commit.

Now, narrowly, it can be admitted that a clearing instrument (CI), a bill (real or otherwise) could greatly facilitate the movement of the stream of products which emanates from our highly vertically-divided arrangement of labour. However, we must acknowledge that the income — if not necessarily the intermediate revenues — must be settled only in gold dollars — in money — in order to avoid entraining an inflationary outcome from this.

Thus, in our recasting of Fekete, we could get by with $4,095 in gold and supplement its use with roughly 30 times its value, or $121,485 in CI’s.

Alternatively, there is no fundamental reason why we could not use the same physical sum of gold for both tasks (it is highly divisible and completely fungible, after all), dispensing with these CI’s entirely and allowing prices to fall wherever they must so as to reflect the sizeable output of goods taking place across all stages of production (a concept which Fekete totally misses in his characteristic inflationist’s haste to use a putative shortage of money as an argument for his wild schemes).

One key point here, however, is that, even if they should be used for convenience, the clearing instruments are not themselves money in that they cannot automatically be used for final settlement pari passu for final goods, certainly not on demand and not at full face value.

In fact, even this proviso may provide little enough protection against excess, if the issue of bills (or other credit) becomes swollen with regard to the money stock. This most easily occurs under a system where inherently fraudulent, fractional-reserve banks are lulled into the false security of having a lender of last resort behind them or, indeed, in cases where that (typically state-privileged) lender itself is over ready to rediscount their acceptances and to expand credit.

Here, as Law’s sometime confederate, Richard Cantillon, remarked in his marvellous u2018Essai’, the ultimate check was usually imposed when the winners of any ensuing investment mania tried to leave the casino:

"In 1720, the capital of public stock and of Bubbles — which were snares and enterprises of private companies at London — rose to the value of 800 millions sterling, yet the purchases and sales of such pestilential stocks were carried on without difficulty through the quantity of notes of all kinds which were issued, while the same paper money was accepted in payment of interest. But as soon as the idea of great fortunes induced many individuals to increase their expenses, to buy carriages, foreign linen and silk, cash was needed for all that… and this broke up all the systems."

Naturally, today’s South Sea Bubbles and Mississippi Schemes call into play instead what the market argot terms the u2018Greenspan Put’, for they are now watched over by a coterie of central banks, collectively untrammelled in the exercise of their peculiar brand of RBD and ever-ready to abandon even the pretence of sound conduct in a crisis, by invoking the necessity of maintaining the u2018financial stability’ of their multi-trillion dollar Ship of Fools.

But, even setting aside the case of such effusions of wild optimism and their ensuing outbreaks of despair, it remains to emphasize that one of the most insidious dangers of the RBD is precisely that it allows such u2018clearing instruments’ to be converted into — indeed, to form the basis of the issue of — money and thus it begins to disrupt all-important relative price signals, both between factors of production and across time itself which perverts economic activity and so triggers the highly wasteful cycle of repeated Boom-and-Bust.

More important still, however, is that Fekete, in his ambition to be seen as a monetary Messiah, shares the all too common trait of inflationists from Law to Gesell to Keynes, and on to Bernanke; viz., that he has lost sight of the inescapable truth that it decidedly does take genuine net savings to build out our triangle in the first place.

What all such monetary manipulators overlook is that, while physical equipment is being assembled, land cleared, buildings constructed, workers trained and hired, there inevitably arises exactly so much excess of the demand for the sustenance for the workers involved over their ability simultaneously to provide for its supply themselves.

Moreover, there must necessarily be a suitable degree of diversion of scarce physical resources away from the provision of final goods and into the creation of the new, higher order ones, for the whole duration of such an undertaking.

Here, if we think of the Hayekian triangle, not so much as a stylized economy, but as a factory assembly line, it becomes easier to visualize the situation wherein, once a firm decides to revamp its production arrangements, it is highly likely that the existing output of its products will suffer while the re-organisation takes place.

Thus, the company will have to build up an inventory to tide it over if it wishes to keep its customers happy — i.e. it will have to have saved pre-emptively before the revamp of its factory.

If not, then the burden will fall instead upon the consumers of the firm’s products — individuals who, of course, play a dual role as the producers of the other goods which the firm and its workers need in their turn and for which they ultimately aim to exchange their wares.

In the case where the firm has not saved by laying in inventory ahead of time — perhaps because the owners have managed to issue a u2018real’ bill! — the good souls who are its customers will temporarily be compelled to forego the consumption to which they have otherwise earned the right by producing their own marketable goods.

So, assuming they do not simply retire to the beach, while the retooling is being completed, these customers will have to save concurrently with the reorganization’s undertaking.

(Without diverging too far from our theme at this juncture, it is this outcome which, when engendered by producer-centric monetary manipulation, comes under the vexed Keynesian rubric of u2018forced saving’).

But how much saving is needed to accomplish this task? In what proportion to the ongoing division of labour must consumption be foregone?

We can again look at this schematically, using nothing more than straightforward arithmetic, but rather than burden the reader with the details here, it is suggested that he again consults the working paper on the Mises Institute website.

There he will find that to order everyone most efficiently into Fekete’s 90-stage process will require a minimum of 30 2/3 days of savings — or 125,580 units of the goods which were previously being churned out at the rate of 4,095 per day — in order to accomplish his task.

At this stage, the observant reader may have noticed that the requisite quantity of savings of consumer goods needed to divide labour vertically in this manner is arithmetically equivalent to the revenue flow which will comprise one full turn of the completed, triangularized structure!

So much for the laughter with which Professor Fekete greeted the idea that rather than using the wholly insubstantial backing of one of his supposedly u2018real’ pieces of paper, circulating capital must actually take the form of high multiples of the saved output of final goods.

For what we discover is that circulating capital, no less than fixed, must be funded — i.e. it must be built out of a store of saved consumption goods or else accompanied by foregone consumption opportunity — and that no amount of monetary legerdemain can avoid this restriction.

It should also be noted that, even with the simplifications already imposed, we have still only accounted for the maintenance of the human element of what were actually composite capital-plus-labour u2018workers’ and so we have looked only at how many final goods need to be saved.

The reality is that we may well need to divert an over-proportionate amount of scarce physical resources — such as fuel, raw materials, land, and even some of the remaining machinery — away from the reduced, interim production of such goods and into our new building process, as well.

This will especially be the case since our composite u2018workers’ are implicitly assumed to take their capital with them when they move up the order, whereas — in the real world — much of this capital will not be so readily interchangeable in function, but will have to be largely fashioned anew.

Thus, even the seemingly high multiples which our simple heuristics have generated are likely to be seriously understated.

No wonder that while Soviet Russia could routinely announce new pig iron production records, its people were left craving a few ounces of butter and had to queue long hours in the hope of securing a few heads of fresh cabbage!

So, faced with this realisation, are we to conclude that matters are indeed hopeless — that the division of labour cannot be achieved without the whips of Collectivist coercion and the scorpions of inflationary finance?

Not a bit of it!

For what all the forgoing excludes is any consideration of the essential purpose behind all this endeavour to increase u2018roundaboutness’ and to bring about an increasing specialization of function — namely, the very real increase in productivity and efficacy which such an advance almost invariably brings forth (see, for example, The Positive Theory of Capital, Bk II, Ch II.19, n13, Böhm-Bawerk).

As an example, look what the industrial genius of the real Henry Ford managed to achieve and how the principals he laid down have immeasurably enriched our lives ever since.

Yes, we must certainly struggle and scrimp to save and nurture a very great deal of capital, indeed, if we are sustainably to lengthen the structure of production; but the effort to do so usually brings about its own reward!

As the apex of the cone of production is shifted to a more remote location from the store front, as extra tiers of specialists are included on the notional assembly line, so its mouth may also be widened — giving rise to more goods per cycle; it may be improved — giving rise to better goods; and it may be accelerated — giving us more cycles per unit of time.

If we are truly fortunate, all three will occur — though, at first, it may only be available in whatever colour you like, so long as it’s black!

Out of this, of course, comes the possibility of successively generating ever more future savings ever more easily, which all means that the magic of compounding applies not just to monetary interest, but also to real, productive capital.

This means that, on the road to general prosperity, saving, directed by entrepreneurial foresight into a greater division of labour, quickly enlists the "most powerful force in the universe," as Einstein reputedly called it, in what was possibly this proto-socialist’s only correct pronouncement in the field ever.

So, in finally dispensing with the good Professor Fekete’s contumely, we find he has, in fact, rendered us a service, for he has forcefully pointed out what an effort capital accumulation is and so he has implicitly charged us to beware of anything which threatens this act: be they threats to private property; the risk of civil disorder; legal and contractual uncertainty; the clouding of entrepreneurial calculation; or the frustration of the market process.

On this reckoning, his own wild dreams of resurrecting the age-old follies — and his unintended effect of reinforcing the present-day incarnation — of the irretrievably-flawed Real Bills Doctrine poses perhaps the single greatest concentration of all these dangers — in complete contrast to the protections which would be afforded by the institution of a free banking system, securely bound by the ordinary laws of contract and girded tightly about with a 100% gold coin reserve standard.

Sean Corrigan [send him mail] writes from Switzerland.

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