Theory of Interest and Prices in Paper Currency Part IV (Rising Cycle)

In Part I , we looked at the concepts of nonlinearity, dynamics, multivariate, state, and contiguity. We showed that whatever the relationship may be between prices and the money supply in irredeemable paper currency, it is not a simple matter of rising money supply à rising prices.

In Part II, we discussed the mechanics of the formation of the bid price and ask price, the concepts of stocks and flows, and the central concept of arbitrage. We showed how arbitrage is the key to the money supply in the gold standard; miners add to the aboveground stocks of gold when the cost of producing an ounce of gold is less than the value of one ounce.

In Part III, we looked at how credit comes into existencevia arbitrage with legitimate entrepreneur borrowers. We also looked at the counterfeit credit of the central banks, which is not arbitrage. We introduced the concept of speculation in markets for government promises, compared to legitimate trading of commodities. We also discussed the prerequisite concepts ofMarginal time preference and marginal productivity, and resonance.

Part III ended with a question: “What happens if the central bank pushes the rate of interest below the marginal time preference?”


To my knowledge, Antal Fekete was the first to ask this question[1]. It is now time to explore the answer.

We are dealing with a cycle. It is not a simple or linear relationship between quantity X and quantity Y, much to the frustration of students of economics (and central planners).

The cycle begins when the central bank pushes the rate of interest down, below the rate of marginal time preference. Unlike in the gold standard, under a paper currency, the disenfranchised savers cannot turn to gold. Perhaps it has been made illegal as it was in the U.S. from 1933 to 1975. Or it could merely be taxed and creditors placed under duress to accept repayment in irredeemable paper. Whatever the reason, the saver cannot perform arbitrage between the gold coin and the bond[2], as he could in the gold standard. He is trapped. The irredeemable paper currency is a closed loop system. The saver is not entirely without options, however.

He can buy commodities or finished goods.

I can distinctly recall as a boy in the late 1970’s, when my parents would buy cans of tuna fish, they would buy 50 or 100 cans (we ate tuna on Sunday, two cans). Prices were rising very rapidly, and so it made sense to them to hold capital in the form of food stocks rather than dollars. Indeed, prices rose so frequently that grocery stores were going to the expense of manually applying new price stickers on top of the old ones on inventory on the shelves. This is extraordinary, because grocers sell through inventory quickly. Some benighted people began agitating for a law to prohibit this practice (perhaps descendants of King Canute, reputed to have ordered the tide to recede?).

Consumers are not the only ones to play the game, and they don’t have a direct impact on the rate of interest. Corporations also play. When the rate of interest is below the rate of marginal time preference, we know that it is also below the rate of marginal productivity. Corporations can sell bonds in order to buy commodities. They can also accumulate inventory buffers of each input, partially completed items at each state of production, and finished products.

What happens if corporations are selling bonds in order to expand holdings of commodities and goods made from commodities? If this trade occurs at large enough scale, it will push up the rate of interest as well as prices. Let the irony sink in. The cycle begins as an attempt to push interest rates down. The result is the opposite.

Analysts of this phenomenon must be aware that the government or its central bank cannot change the primary trend. They can exaggerate it and fuel it. In this case, the trend goes opposite to their intent and there is nothing they can do about it. King Canute could not do anything about the waves, either.

Wait. The problem was caused when interest was pushed below time preference. Now interest has risen. Are we out of the woods yet?

No. Unfortunately, marginal time preference rises. Everyone can see that prices are rising rapidly, and in such an environment, are no longer satisfied with the rate of interest that they had previously wanted. The time preference to interest spread remains inverted.

This is a positive feedback loop. Prices and interest move up. And then this encourages another iteration of the same cycle. Prices and interest move up again.

Positive feedback is very dangerous, because it runs away very quickly. Think of holding an electric guitar up to a loudspeaker with the amplifier turned up to 10. The slightest sound is amplified and fed back and amplified until there is a horrible squeal. Electrical systems contain circuits to prevent self-destruction, but alas there is no such thing in the economy.

There are, however, other factors that begin to come into play. The regime of irredeemable currency forces actors in the economy to make a choice between two bad alternatives. One option is to earn a lower rate of interest than one’s preference. Meanwhile, prices are rising, perhaps at a rate faster than the rate of interest. Adding insult to injury, as the interest rate rises, it imposes capital losses on bondholders. Bonds were once called “certificates of confiscation”. There is but one way to avoid the losses meted out to bondholders.

One can hold commodities and inventory. There is a problem with this alternative too. The marginal utility of commodities and inventory is rapidly falling. This means that the more one accumulates, the lower the value of the next unit of the good. This is negative feedback. Another problem is that it is not an efficient allocation of capital to lock it up in illiquid inventory. Sooner or later, errors in capital allocation accumulate to the harm of the enterprise.

There is another problem with commodity hoarding. Unlike gold hoarding,which harms no one, hoarding of goods that people and businesses depend on hurts people. As we shall see below, growth in hoarding is not sustainable. What the economy needed was an increase in the interest rate. An unstable dynamic that causes prices to rise along with interest rates is no substitute.

The choice between losing money in bonds, vs. buying more goods that one needs less and less, is a bitter choice. This choice is imposed on people as an “unintended” (like all the negative effects of central planning) consequence of the central bank’s attempt to drive interest rates lower. I propose that this should be called Fekete’s Dilemma in the vein of the Triffin Dilemma and Gibson’s Paradox.

Another negative feedback factor is that rising interest rates destroy productive enterprises. Consider the example of a company that manufactures TVs. When they built the factory, they borrowed money at 6%. With this cost of capital, they are profitable. Eventually, the equipment becomes worn out and/or obsolete. Black and white TVs are no longer in demand by consumers, who want color. Making color TVs requires new equipment. Unfortunately, at 12% interest, there is no way to make a profit. Unable to continue making a profit on black and white, and unable to profitably start making color, the company folds.

The more the interest rate rises, and the longer it remains high, the more companies go bankrupt. This of course destroysthe wealth of shareholders and bondholders, and causes many workers to be laid off. Its effect on interest rates is to pull in both directions. When bondholders begin taking losses, bonds tend to sell off. A falling bond price is the flip side of a rising interest rate (bond price and yield are inverse). On the other hand, with each bankruptcy there is now one less bidder pushing up prices. Additionally, the inventories of the bankrupt company must be liquidated; creditors need to be paid in currency, not in half-finished goods, or even in stockpiles of iron ingots.

A third factor is that a rising interest rate causes a reduced burden of debt for those who have previously borrowed at a fixed rate, such as corporations who have sold bonds. They could buy back their own bonds, and realize a capital gain. Or, especially if the price of their own product is rising, they have additional capacity to borrow more to finance further expansion of their inventory buffers. This will tend to be a positive feedback.

These three phenomena are by no means the only forces set in motion by the initial suppression of interest rates. The take-away from this discussion should be that one must begin one’s analysis with the individual actors in the economy, and pay attention to their balance sheets as well as their profit and loss.

The above depiction of a rising cycle, where rising interest rates drive rising prices, and rising prices drive rising interest rates is not merely hypothetical. It is a picture of what happened in the U.S. from 1947 to 1981.

Many people predicted that the monetary system was going to collapse in the 1970’s. It may have come very close to that point. The Tacoma Narrows Bridge swung to one side before moving even more violently to the other. The dollar might have ended with prices and interest rates rising faster and faster, until it was no longer accepted in trade for goods.

But this is not what, in fact, occurred. Things abruptly turned around. Fed Chairman Paul Volcker is now credited with “breaking the back of inflation”. Interest rates did indeed spike up briefly to about 16% on the 10-year Treasury in 1981. After that, they fell, rose once more in 1984, and then settled into a falling trend (with some volatility) that continues through today. But remember what we said above, that a central bank can exaggerate the trend but it cannot reverse it.

Interest rates and prices had peaked. When the marginal utility of each additional unit of accumulated goods falls without bound, it eventually crosses the threshold of zero marginal utility. Then it can no longer be justified. Meanwhile, bankruptcies, with their forced liquidations, increase. A finalupwards spike of interest rates discourages any further borrowing. What company can borrow at such an extreme interest rate and still make a profit?

At last, the time preference to interest spread is back to normal; interest is above the time preference. Unfortunately, there is another problem that causes the cycle to slam into reverse. The cycle continues its dynamic of destroying wealth, confounding central planners and economists.

The central planning fools think that they can magically gin up some more credit-money, or extract liquidity somehow to rectify matters. Surely, they think, they just have to find the right money supply value. Their own theory acknowledges that there are “leads and lags” so they work their equations to try to figure out how to get ahead of the cycle.

A blind man would sooner hit the bulls-eye of an archery target.



In Part V, we will examine the mechanics of the cycle reversal, and the other side of the unstable oscillation. Without spoiling it, let’s just say that a different dynamic occurs which drives both interest and prices down.



[1] Fekete wrote about the connection between interest rates and prices at least as early as 2003, in “The Ratchet and the Linkage” and “Between Scylla and Charybdis”. He published Monetary Economics 102: Gold and Interest. The idea he proposed in those three pages has been fleshed out and extended by myself, and incorporated into this series of papers on the theory of interest and prices, principally in parts IV and V. I would like to note that Fekete regards the flow of money from the bond market to the commodity market as inflation and the reverse flow as deflation. I agree with his description of these pathologies, but prefer to reserve the term inflation to refer to counterfeit credit. I call it the rising cycle and falling cycle instead.

[2] How are Interest Rates set in a Gold Standard



Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals.  Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads.  Keith is a sought after speaker and regularly writes on economics.  He is an Objectivist, and has his PhD from the New Austrian School of Economics.  He lives with his wife near Phoenix, Arizona.





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10 Responses to “Theory of Interest and Prices in Paper Currency Part IV (Rising Cycle)”

  • I will tell you what happens when bond financing rates get high. The PV of the debt is shifted forward. Plug it into a calculator.

    • JasonEmery:

      mann–“The PV of the debt is shifted forward.”

      What do you mean by ‘shifted forward’? Are you referring to a situation where a debtor has to roll over some maturing bonds, and prevailing interest rates are higher than the rates on the expiring bonds?

      From the standpoint of the creditor, isn’t the PV declining, unless they can hold the debt to maturity? But even then, there is opportunity cost, unless the date of maturity is close.

  • georgew:

    “georgew-Fekete is in agreement with Mises/Rothbard with respect to the idea that interest rates and the value of the currency move in opposite directions. However, I think Fekete puts a lot of meat on the bones, in terms of explaining the mechanics of the dynamic situation.”

    This is what I tried to say in my last comment, or at least is harmonious with it. I agree.

    I like the way you (JasonEmery) describe the rest of it. I would add the comment that interest rates won’t decline rapidly in a free market situation, but will do so, ceterus paribus, slowly, as a society becomes wealthier; at least in comparison with violent monetary market intervention.

  • georgew:

    In fairness, I want to point out that there is a vast difference between the theory of interest and coercive intervention in the monetary system, which has been accurately described quite well by von Mises & Co. during the 20th century and the details of how these are manifested in the markets, which was not covered by those authors, and may well be contributions attributed to Keith and/or Fekete. I can say I haven’t seen them anywhere else.

    • JasonEmery:

      georgew-Fekete is in agreement with Mises/Rothbard with respect to the idea that interest rates and the value of the currency move in opposite directions. However, I think Fekete puts a lot of meat on the bones, in terms of explaining the mechanics of the dynamic situation.

      As interest rates are falling, by market forces or otherwise, new entrants to a specific industry group have a decided advantage over existing corporations in the same group: their cost of capital is cheaper. Therefore, they can undercut on price, and the result is deflationary, or at least disinflationary, to use Greenspan’s term, and the currency strengthens.

      Obviously, there could be other forces at work in the system to overwhelm this effect.

      Just look around your city, if you are in the USA. They are building new strip malls a block down the street from dingy, but other wise sound, buildings of the same type. Since the cost of capital is so low, it is cheaper to buy than rent, since landlords of existing buildings have a much a higher cost of capital baked into the cake. I believe, in some cases, there are balloon payments not too far down the road. But who is going to hear that when a carnival barker is shouting, “free money, back up your truck”, lol?

  • georgew:

    Rothbard’s Man, Economy and State covers this quite well:

    Chapter 12—The Economics of Violent Intervention in the Market (continued)
    11. Binary Intervention: Inflation and Business Cycles
    A. Inflation and Credit Expansion

  • georgew:

    From “Theory of Money & Credit”, 1912

    “Thus a falling value of money goes hand in hand with a rising rate of interest, and a rising value of money with a falling rate of interest. This lasts as long as the movement of the objective exchange value of money continues. When this ceases, then the rate of interest is reestablished at the level dictated by the general economic situation.”

    An excerpt from Chapter 19, part 4 “The Influence of the Interest Policy of the Credit-issuing Banks on Production”

    “Assuming uniformity of procedure, the credit-issuing banks are able to extend their issues indefinitely. It is within their power to stimulate the demand for capital by reducing the rate of interest on loans, and, except for the limits mentioned above, to go so far in this as the cost of granting the loans permits. In doing this they force their competitors in the loan market, that is all those who do not lend fiduciary media which they have created themselves, to make a corresponding reduction in the rate of interest also. Thus the rate of interest on loans may at first be reduced by the credit-issuing banks almost to zero. This, of course, is true only under the assumption that the fiduciary media enjoy the confidence of the public so that if any requests are made to the banks for liquidation of the promise of prompt cash redemption which constitutes the nature of fiduciary media, it is not because the holders have any doubts as to their soundness.”

  • georgew:

    This is from Human Action, first printed in 1949.

    “We can think of a social system in which there are no prices at all, and we can think of government decrees which aim at fixing prices at a height different from that which the market would determine. It is one of the tasks of economics to study the problems implied.

    In order not to confuse the reader by the introduction of too many new terms, we shall keep to the widespread usage of calling such fiats prices, interest rates, wage rates decreed and enforced by governments or other agencies of compulsion (e.g., labor unions).

    6. The Gross Market Rate of Interest as Affected by Inflation and Credit Expansion

  • georgew:

    While I agree with much of this, and there may be some novel ideas here (not my day job, can’t discern what subtle details may be new), this write-up ignores the important effect of hoarding money. People will not simply consume and hoard in non-money commodities, but will also hoard money itself, which has an ironic counteracting effect. I believe I first read this in Rothbard, but it may have been von Mises. This actually plays into the hands of the central planners for a spell, until people start to realize the (fiat) money itself is a very poor storage of wealth.

  • georgew:

    “What happens if the central bank pushes the rate of interest below the marginal time preference? To my knowledge, Antal Fekete was the first to ask this question”

    Keith, I really like some of your stuff, but when you make statements like this I really wonder. This question has to be asked and answered to derive any properly motivated business cycle theory. Ludwig von Mises and Rothbard, his pupil, both discuss this. I’d wager Hayek does as well.

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