The ZIRP Boomerang, Conceptual Blindness, and the Way Out
An interview with Keith Weiner (April 2015)
"There is no limit to how low rates can go and how large foreign currency reserves can grow… The message is that if it’s not enough, we will do even more… Either we can expand our balance sheet or we can go deeper into negative territory with the interest rates. That is a possibility and no one should try to outguess us here… We can go on forever." — Lars Rohde, chairman, Board of Governors of Denmark’s Nationalbank (4 Feb 2015)
Keith Weiner is founder of the Gold Standard Institute USA in Phoenix, Arizona, and CEO of precious metals fund manager Monetary Metals. He created DiamondWare, a technology company which he sold to Nortel Networks in 2008. I was recently introduced to his work when someone sent me a link to his article, The Swiss Franc Will Collapse. His fresh approach to monetary science made me dig deeper. From there I went to Falling Interest Rates Destroy Capital, and best of all, Gold Bonds to Avert Financial Armageddon. I list all these because I strongly recommend you read them. Keith Weiner kindly gave me an interview on 10 March 2015. In the references below to “gold,” please understand “gold and silver.”
Moneychanger: Re-reading your articles today, I was again impressed by your fresh perspective.
Weiner: Thank you.
Moneychanger: Some things had not occurred to me before, and I've been thinking about monetary issues since 1968, so I've had time. Let’s begin with your article, “The Swiss Franc Will Collapse.” You say there that the first harbinger of monetary and financial collapse is the long bond interest rate falling to zero. Why?
Weiner: Even without any monetary theory, it should be evident that there's something really wrong when borrowing money costs zero—not on an overnight bill but on a ten-year bond.
As you drill deeper, a company or government typically issues that bond. It's their liability. Every time the interest rate drops, the net present value of the outstanding liability rises, and a net present value increase flows to the bond buyers. Every time the interest rate falls, they get free capital gains.
If you ask people where that free capital gain comes from, they might suppose the Fed or the Swiss National Bank is printing it. But the dollar amounts of the free capital gains accruing to people are vastly greater than the actual amount the Fed injects. The free capital gains accrue to the bond speculators. I say “speculators” because nobody would actually buy one of these bonds to live on the coupons.
So you’re buying the bond hoping for capital gains. Those capital gains are coming from the bond issuer’s balance sheet. If the bond price rises, the interest rate must fall; that’s simply their mathematical relationship, the price moves opposite to the yield. The bond buyer, who is long bonds, wins and the bond seller (the issuer), who is short bonds, loses.
Moneychanger: Stop one moment. That's perfectly clear to you, but I don't think it's even clear to the accounting profession.
Weiner: No, it's not.
CONCEPTUAL BLINDNESS: WHY MARK ASSETS TO MARKET BUT NOT LIABILITIES?
Moneychanger: Because they do not handle balance sheets according to that mathematical principle. That is, although they mark balance sheet assets to markets, they do not mark liabilities to market. You just demonstrated that when a bond price rises, a gain—capital—moves from the bond issuer’s balance sheet to the bond owner’s balance sheet.
Weiner: Go back to the discoverer of double entry accounting, 15th century Italian mathematician Luca Pacioli (1447-1517). He laid out the “law of assets.” That says that an accountant should rate an asset’s value at the lower of acquisition price or current market value.
Why the lower? The accountant’s aim is to be conservative. At that time neither Pacioli nor anyone else envisioned a period of persistently falling interest rates. We’ve never had an era like that until the end of the 20th century: since 1981 interest rates have fallen persistently. That means that liabilities’ values have also risen persistently. I argue there should be a corresponding “law of liabilities” that marks the liability to the higher of acquisition value or current market, just as you mark asset values to the lower of current market or acquisition price.
The logic here is fairly simple. Aside from what the law says, you can write on your books whatever you want, but it doesn't make it so. You could be a naked emperor and brag loudly about your wonderful purple velvet robes, but it only takes one naïve and honest little boy to say, “You're naked.” So you can report that your liabilities are fine at their book values, and then therefore you have a perfectly adequate capital ratio. However, then you're subject to sudden capital death because those liabilities are not valued accurately.
Moneychanger: On first reading your article I wanted to object, “Wait, that's not so, because the burden of the interest payment does not rise.” Let’s say I issue a $1,000 one-year bond with a ten percent rate. All I will do is wait out the year and pay the principal bond principal and my $100 coupon. But that's not true, is it? Over time, low and falling interest rates erode capital.
Weiner: Right. Falling rates erode your ability to make a profit on your capital. Let's use the example of a ten-year bond.
Suppose your business borrows $1 million to install widget manufacturing machines. You borrow $1 million. The interest rate is ten percent. Now, suppose the central bank comes along and lowers the interest rate shortly after you borrow. Now the interest rate is five percent.
Your competitor could borrow more money at the same monthly payment. That's what a lower interest rate means. Now your situation is exactly equivalent to his, except you have ten widget manufacturing machines in your plant and he has twelve. With exactly the same debt payment, he has two more machines.
Suppose a fire in his plant destroys two of those machines and he had no insurance to cover them. Surely he would have to write down the value of his assets, and then he'd be in exactly the same position as you. Now he's in the same boat as you but he must write off the loss while you can't.
So the interest rate is a key component of business cost that the finance and accounting profession simply aren’t taking into consideration.
Moneychanger: Because the interest rate affects the value of all capital, not assets alone?
Weiner: That's right.
Moneychanger: Yet they are only applying interest rate change to one side of the balance sheet, the asset side?
Weiner: Right. And that's what makes the boom so much fun.
Another way of thinking about this is “liquidation value.” Think about retiring the debt.
Suppose you have issued a bond and, later, you need to refinance for a merger or acquisition. You must first buy back those bonds. You will have to pay their current liquidation value, which is the price of the bond marked to market at the current interest rate. If rates have fallen since you issued the bond, then the bond’s current price is much higher than your original sale price. Think of this as an overhang, a ceiling that's creeping over your head. The more the interest rate falls, the more the overhang grows.
A naive interpretation says, “Well, I just won't pay it off.” You'll just keep making the payments and you know what the payments will be because they don't change. That's true, but naïve because there are times in business when you need to re-capitalize.
Maybe clearest would be to suppose that a firm’s best return to the shareholders is to get acquired. Say Google is on the acquisition path and your business is strategic to their plan. They will pay an attractive multiple.
Wait—now you have this gigantic overhang of the bonds you sold earlier that may kill the whole transaction. Now you must turn down the best possible path and instead put yourself in Google's crosshairs: they will acquire your competitor and now the steamroller's headed right at you.
That overhang may not only deny you the opportunity to get acquired, but may actually turn you into roadkill. Google will finally ramp up after they've bought your competitor and go for your sector. As sort of a mid-size firm you may be viable, but the overhang of that bond you sold ties your hands. You're at a disadvantage because of cost of your earlier bond issue has risen.
ZIRP BOOMERANG: FALLING INTEREST RATES ERODE PROFIT MARGINS
Moneychanger: You also argue that falling interest rates erode profit margins over time.
Weiner: That's right. Suppose in a free market the cost of borrowing is two percent and you can make a ten percent return by opening a hamburger stand. Well, let's see: borrow at two, make ten. I don't really need too much of a calculator to say that an eight point spread sounds like a pretty good deal.
In a free market, the interest rate is not pinned. The very act of my taking that two percent, of selling that bond onto the bid price, pushes down the market bond price. (Remember that the bond price and the interest rate are a strict inverse, a teeter-totter. When one rises the other must fall.)
When you sell bonds onto that bid, you push down the bond price, which means pushing up the interest rate. Your hamburger stand is also dumping hamburgers into your local market on the bid price. The profit margin in hamburgers drops from 10% to 9%, and the interest rates rises from 2% to 3%.
The next guy says, “Three percent to nine still sounds like a pretty good deal.” He enters as competition and the interest rate rises to 4% and the hamburger profit falls to 8%, until the marginal hamburger operator walks away and says, “It's no longer attractive. There's too little spread here for the headaches.”
What happens, however, when the central bank wrests control of interest rates from the market? A central bank is an outside force that has nothing to do with entrepreneurs and market realities. I don't think the Fed has as much control over interest rates as people assume, but they've certainly set in force something very powerful and very destructive, so that now that hamburger entrepreneur’s action doesn't push up the interest rate the same as it would in a free market.
However, a lower interest rate certainly does pull down the profit rate (margin) in hamburger stands, so the profit rate will tend to be pulled down over time towards the interest rate. That's another way that the falling interest rate will get you.
Back to the widget manufacturing business: suppose you borrow money to build your widget manufacturing plant and buy certain tools. If the interest rate falls enough, the next guy can buy more sophisticated tools that produce widgets much faster. These tools are more expensive, but at the new, lower interest rate the math works out just fine.
Now your competitor can manufacture widgets at a much lower cost than you can, and you can do nothing to remove his competitive edge. He can borrow the same amount of money but he, coming later to market, has a lower interest rate than you and a lower payment. He can borrow more money with the same payment, and use that extra money in a variety of ways.
Each succeeding generation—whether it's restaurant, hotel, or casino—is bigger and more glorious than the previous because the interest rate is falling. Twenty or 30 years ago, the cost of borrowing was pretty high by today’s standards. You had to build a pretty modest restaurant or store. Then the interest rate keeps falling and falling and the new guy can build a much nicer place with higher end materials and better finishes, six layers of lighting and a newer brass bar with LEDs.
Where do the customers want to go? They’ll say your place is beat and the other place is hip. What can you do to correct that? Not much.
There are, then, several ways that this falling interest rate will manifest in terms of making it more and more and more difficult for you to service your debt, borrowed at the older, higher rate. Does that make sense?
ZIRP BOOMERANG: INTEREST RATES MOVE LIKE A SNOWBALL...
Moneychanger: One thing I don't want to miss that it is not normal, it is not natural, it is not a thing found in creation that interest rates go down for 34 years. This can't possibly happen naturally because crops fail, floods occur, strikes break out, technology emerges, and the world continually changes. Changing conditions should change the interest rates the same way the change the price of oranges.
What is an interest rate? The cost or price of money. Unless you assume that economic conditions never change, it's not possible that interest rates would not fluctuate over time. Yet I'm looking at the 10 year Treasury note chart out of your “Falling Interest Rate Destroys Capital” article, and it's a line steadily descending from about 16% down to today's rates below two percent. That doesn't happen in nature.
Weiner: People continue to believe that the interest rate is cyclical, so every time there's the slightest tick upwards, people feel upset: “It's turning. It's the amount of money they're printing. It's blah-blah-blah.” Look, this chart is out there, right? The ticker is ^TNX, the interest rate on a ten-year Treasury. Take a look at that. There's a 34-year trend.
Before you say that trend is magically changing, you might want to ask yourself what you think caused it to drop for 34 years? What do you think happened or yesterday or last month to turn that cause off? In one of my articles I did two pictures of that interest rate graph, one without labeling Quantitative Easing (QE) we have had since 2009. On the other I put in little arrows to point out QE episodes. Basically, without my helpful little arrows, you wouldn't even know when QE happened. QE has had no visible effect on this graph.
Moneychanger: That 34 year graph says that Bernanke did not invent zero interest rates. Rather, somewhere in that subculture of the Federal Reserve and federal government lurk people who long ago decided to drive interest rates down long term.
Weiner: I don't even necessarily think that. Here's what I think. Do you have snow in your area?
Moneychanger: Occasionally, yes.
Weiner: I grew up in New York with plenty of hills and plenty of snow. Typically this time of year, the snow gets wet and sticky. Sometimes you get a 12 or 15 inch snowfall, those big, soggy, giant flakes. Every boy around a certain age must have this same experience. You climb to the top of the hill, make a snowball, and push it down the hill.
Usually the hilltop’s not the steep part, and the snow is heavy and sticky and very frictional; you really have to push to make the snowball move. But it's accumulating mass really rapidly because the snow is thick and the snowball's growing.
You get to the steeper part of the hill, and there's this moment—and maybe I shouldn't use a four-letter word, but it’s the uh-oh moment—when you suddenly realize that that snowball is no longer under your control and only two forces are governing its speed: gravity and whatever happens to be at the bottom of the hill: your parents' house, plate glass window in the living room, or a car.
Even at that point, it's usually moving slowly enough that you can keep your hands over the snowball and continue to run with it for quite a while, but you know you’ve lost control. There's a moment, and you can feel it, and you know you've lost it.
I was working on my theory of interest and prices, and I happened to be at the Cato Institute Annual monetary conference during the first week of November. That particular year they had loads of monetarists who all say the solution is to constrain the Fed by certain rules. I don't think we should have socialized money and central planning, rules or no rules. We should have a free market.
But it's fascinating to listen to these fellows, five or six back to back. First I realized they all have same playbook, same set of rules. Typical is the Taylor rule that says the central bank should change the interest rate based on changes in CPI, GDP, unemployment, etc. Then they talked about GDP and unemployment, CPI and all these factors, and when the central bank should raise rates.
Number one, all acknowledged that this is the playbook. Bernanke, the Fed chair at the time, belongs to the same camp and uses that same playbook.
Number two, their playbook says the interest rate should have been raised a year to a year and a half previous to this conference according to their metrics of CPI and GDP and unemployment. All expressed various degrees of surprise and astonishment: “Why hasn’t Chairman Bernanke been raising rates?”
At that time I was working on my theory that the interest rate is like an object falling into a black hole. There's a certain radius around the black hole that physicists call the “event horizon.” Once you're inside the event horizon on the black hole, you can't escape. More than that, it's mathematically certain that you will crash into the black hole.
I'd been thinking that once the interest rate reaches a certain point, it's going to crash in. The most fascinating thing for me was hearing all these men astonished that Bernanke wasn't raising the interest rate. One more light bulb went off in my head: “That's because he cannot.” Sure, he would like to raise the interest rate. All these people are on the same playbook. The rule says you're supposed to raise the rate. He would have if he could.
INTEREST RATES IN A FREE MARKET
Let me tie this all together with the comment you made that, in a free market you wouldn't have this 34 year trend, which is absolutely correct. In a free market, the interest rate obviously can move: every price moves in a free market and no price is fixed politically by government or central bank. The interest rate cannot fall below what we call marginal time preference, the saver’s time preference.
In a free market, if people don't like the rate of interest offered they withdraw their gold coin and stick it under the mattress at home. This forces the selling of bonds, which pushes the bond price down and the interest rate up. The saver's time preference has real teeth. The interest rate cannot go below the floor of marginal time preference.
The saver’s preference works the same way on interest rates as it does with meat. If you don't like the sirloin steak price, your not buying will force the grocery store to lower the price, and so the price of steak cannot rise. Every price in every market is controlled this way. On one side there's a buyer who walks away when he doesn't like the price.
The interest rate cannot fall below marginal time preference. Marginal time preference is not zero. It can never be zero. If you're offering me zero to take the risk and lock up with you my money for a year, I'll just take my gold coin home. Thank you very much. There's absolutely a floor under the interest rate in the gold standard.
There's also a ceiling, namely, the entrepreneur’s marginal productivity. You cannot borrow money at ten percent in order to make two percent in your hamburger stand. It doesn't work. Obviously, you have to borrow money cheaper and make more profits in order to be able to service your debt.
So there's a floor and a ceiling in a free market, and the interest rate can freely move around between the two but not outside. I found a graph that depicts the ten-year Treasury bond from 1790 to today. It’s amazing how stable the interest rate was up until 1913, when congress created the Fed.
Moneychanger: That doesn’t surprise me.
Weiner: There was a disruption for the War of 1812 and in the early 1860s. Events did change the interest rate but, basically, it was pretty stable.
Moneychanger: Does that have something to do with a natural growth rate in the economy?
Weiner: That's part of it. The growth rate is part of what creates the profit of the marginal entrepreneur, but you can't borrow money at more than your rate of profit—you can’t borrow at 8% to make 5%. That's just an ironclad law because otherwise you're losing money, paying your investors more in interest than the free cash flow of the operation.
CENTRAL BANK CONCEPTUAL BLINDNESS
Moneychanger: Let's assume that this chart with this 34-year dropping rate is the product of nature in the sense that Federal Reserve policies produce it. Do you know what I mean by conceptual blindness?
Weiner: I think so.
Moneychanger: Conceptual blindness means the matrix of your mind does not have a pigeonhole to put some fact in, not because the fact doesn’t exist, but because the matrix is wrong. The way you've constructed that matrix, the way you conceive of the world, doesn't allow for a certain possibility.
Moneychanger: You already told me that accountants have conceptual blindness: they mark the balance sheet’s asset side to market but not the liability side.
Is it possible central banks and governments are conceptually blind? They just don’t get it? This raises government and central bank stupidity to a whole new level: they have never realized that trying to keep interest rates down engages all these other mechanisms that terribly drag on the economy and waste capital?
Weiner: Oh, yeah, and that's exactly where I'm going. It's even worse than that. I don't think our monetary masters get it.
Moneychanger: Remember that Lars Rohde quotation about keeping the Danish kroner’s exchange rate pegged to the euro? He says there's no limit how low they can push interest rates and no limit how large foreign currency reserves can grow. His message is, “If that's not enough, we will do even more. Nobody should try to outguess us here. We can go on forever.” That sounds like acute conceptual blindness to me. He seems to think they could take interest rates down to negative five, negative ten, negative 20 percent, and the economy would keep rolling along.
Weiner: To me, it sounds like the former Luxembourgish prime minister and finance minister and current president of the European Commission, Jean-Claude Juncker. He said, “When it becomes serious, you have to lie.”
It's also sounds like the president of the Swiss National Bank, Thomas Jordan. As recently as December, he protested the bank was absolutely dedicated to maintaining the Swiss franc’s peg to the euro. Now Denmark is saying they can do what Switzerland could not. And right up until the moment when they broke the peg the Swiss National Bank was absolutely swearing that they could hold the peg forever—then it busted. I think they hit their stop-loss, where they realized they were risking bankruptcy for the central bank.
They're borrowing in francs, or in Danish kroner, and borrowing is a liability. And the asset they're buying is eurozone bonds. As the market continues to want to put more and more capital into Danish kroner, the market is going against them. This balance sheet is expanding, which means more and more liabilities in Danish kroner, and more and more assets in euros.
Eventually the market overruns them in the reverse direction and inflicts upon them instantaneously a 20-30 percent loss on a highly leveraged portfolio. I think that's why the Swiss had to cry uncle and why the Danish, will eventually scream uncle, too.
Moneychanger: I shouldn't laugh, because it's so tragic. But they actually fancy themselves Masters of the Universe. They believe that they can contradict economic laws of nature and they’re dragging the rest of us down with them. I can't get off this boat because they're the pilots.
Weiner: They think in terms of quantity of money. The theory says if you double the quantity of money, you double the price level, and yet [consumer] prices aren't really skyrocketing. Maybe in Europe they're even falling right now and people feel that gives them a license to increase money supply. It is conceptual blindness: their theory about how it works totally blinds them to what's happening in fact.
One analogy I like to use is a famous bridge collapse 1940, the Tacoma Narrows Bridge in Washington State. Somebody captured it with an 8 millimeter camera.
The engineers who built it weren't stupid but they missed one thing: the canyon the bridge crossed drew wind in a certain way. Those gusts of wind were hitting the bridge at a certain sequence at or very close to the resonant frequency of the bridge.
Each burst of wind that hit the bridge contributed to the twisting or torsional force on the bridge. The bridge twisted clockwise and then counterclockwise, and then clockwise, and then counterclockwise, with the magnitude of twist increasing.
The bridge has a natural resonant frequency. Then you add positive feedback from the wind, not subtracting, not cancelling out, but adding to the natural resonance.
It twists left and then right, each twist getting bigger until, eventually, the whole thing dumps into the drink.
This is an interesting way to picture the monetary system. It has a natural resonance, and the inputs of the central bank act as a positive feedback with that.
In contrast to the gold standard where the mechanism for setting the interest rate is pretty simple—marginal time preferences at the floor and marginal productivity at the ceiling—fiat money is a complicated dynamic system that is driven by positive feedback loops. The cycle starts with the central bank pushing down the interest rate, which is a central bank’s real purpose, to make it cheaper for the government to borrow more.
Forget unemployment and CPI, the whole point of any central bank is to enable the government to borrow more. It does this buy pushing down the rate of interest. Lower interest = lower monthly payments = good for government. That's the elephant in the room that needs to be named.
INTEREST RATES 1947-1980—UNINTENDED CONSEQUENCES: RATES RISE, INVENTORIES EXPAND
The central bank says, “Fine, we're gonna push down the interest rate.” People aren't stupid. They're aware of what's happening, and suddenly their time preference is violated, and now the interest rate is below time preference, so people don't want to own bonds or own credit, so they start buying and hoarding commodities. And businesses do this, too.
The central bank sets something in motion: a dynamic system with positive feedback and resonance. Think of the Tacoma Narrows Bridge that collapsed. Positive feedback occurs when inputs to the system do not correct imbalances, but add to them. In the case of the bridge, there were constant gusts of wind coming down the gorge. Those gusts were periodic, every X seconds. It turns out the resonant frequency of the bridge matched the rate of the gusts. So each gust added energy. As the bridge twisted, each new gust made it twist more, until the steel failed and it dropped into the drink.
What does this have to do with the monetary system? The Fed thinks to push the rate down, but people react to that. Their reactions create a dynamic much bigger than the Fed itself.
Thus begins the cycle with ever more borrowing to load up on commodities and expanding inventories. From 1947 to 1980 this rising cycle existed: rising interest rates, rising prices, and expanding inventories. It resulted in a positive feedback that feeds on itself. The interest rate is going higher and higher and higher. It's not what the central bank wanted, but it's what they got. With each step up of the interest rate, the burden of debt, of course, is decreasing and those businesses that are fortunate to survive in that environment are basically increasing their inventories, and so decreasing the burden of debts.
I was born around the time you started studying money, so I was 12 years old in 1979. My family would typically have chopped tuna fish salad on Sunday, one or two cans for a family of four. When my parents bought tuna fish, they bought 50 or 100 cans. We’d fill a whole grocery cart, nothing but tuna. It would last a year, but you'd rather have your money in tuna in the pantry than in a bank where it's losing value so fast.
People see this. They're not stupid. They get it.
Moneychanger: They open a Nicaraguan savings account. In 1989 I went to Nicaragua when the Sandinistas were inflating the currency, and every house’s front yard contained a pile of concrete blocks in the front yard. I asked the guide. “Why the concrete blocks?”
“Oh, that's a Nicaraguan savings account.” Knowing the price of concrete blocks would soar, they bought blocks now to build in the future, just like your parents investing in tuna fish.
Weiner: The bottom line is that the asset that people would choose to own in a free market would be gold, of course.
Moneychanger: Sure, or silver.
Weiner: It doesn't have all the disadvantages of tuna: it doesn't spoil. It doesn't have all the disadvantage of concrete blocks. But the government takes that option off the table, so people are forced into the next best thing and the next, next, next best thing, and ends up in a feedback loop of rising interest rates and rising prices. Eventually, you hit an end where that cycle is exhausted.
That happened in 1981 in the United States. People give Volcker and Reagan credit for “breaking the back of inflation” but the cycle was already long in the tooth, and all sorts of things were inverting. Interest rates spiked in 1981 [prime rose from 6.25% in December 1976 to 20% or higher in April 1980 and into May 1981] and then began going in the other direction.
Yeah, sure, the interest rate goes above time preference, so that's good. It also goes above marginal productivity and begins this process of capital destruction and capital churn, which at first looks like a boom and everybody thought the 1980s were good. It was a boom in the Austrian business cycle sense.
INTEREST RATES 1981-2015—UNINTENDED CONSEQUENCES: RATES FALL, SEED CORN EATEN, INCENTIVES PERVERTED
Today at the end of the boom it's not really fun anymore because it takes more and more central bank action to squeeze out less and less juice. As long as the interest rate stays above marginal productivity, then the economy is anemic, labor is perpetually idled, people get hurt. The only people happy are those speculating with leverage on assets. Of course, you must use leverage because the difference between the interest rate and the yield on assets is tiny, so you must leverage up in order to do it. As long as asset prices are rising, it feels like a lot of fun but it's really a process of capital consumption akin to a farmer eating his seed corn. Till that runs out, you can have a party feast bigger than you can afford without worrying about next year. That's the state that we're in right now.
THE CHICKENS FLY HOME
Moneychanger: Where does this end? As the interest rate falls lower and lower it squeezes profit margins lower and lower. Who does it squeeze out? The entrepreneurs who enter at the edge and disrupt things. You are not stabilizing the economy, you’re putting it into a coma.
Weiner: Sure. Absolutely.
Moneychanger: That means the economy will stultify and stagnate.
Weiner: Yes. Capital consumption is accelerating. We don't work any harder today than pre-civilized tribes worked 10,000 years ago to keep starvation at bay. In fact, we probably work a lot less hard and certainly in much safer conditions for a lot more pay. The difference is accumulated capital that leverages our effort, so we that we can work less and produce more.
That is the capital we're consuming to continue this present phase and pretend that we're not busted. If something doesn't change—and there's no monetary incentive for it to change—we continue to consume the capital that our civilization rests upon until something gives.
First, we are destroying real capital in the real world.
Second, if you think of this as a giant machine, we keep tightening all the springs, the monetary system and specifically credit. Eventually, credit busts in a big way. People won't accept bank credit because the banks aren't good for it anymore because they are insolvent.
But wait: everything from food production to energy production today depends totally on credit, and is all “just in time.”
There's no such thing as an inventory anywhere in the system. Thirty-four years of falling interest rates have liquidated and squeezed out every drop of inventory, and so the economy seizes up partly because the capital needed for mass production and distribution is destroyed, and partly because there’s no credit to finance it anymore.
If we let it run all the way to the very end, where we can no longer produce energy and food on an industrial scale, three days later people begin starving. The consequences of this destructive policy are horrible, and people sense this. That explains “preppers.” That's why people are stashing gold coins. It’s not 1929 approaching, it's 476 a.d., the fall of Rome.
Moneychanger: Sometimes when one speaks abstractly, one forgets the real world. We are not talking about a notional or abstract loss of capital when we're talking about marking-to-market but a real loss of capital caused by lower interest rates
Weiner: That's right. Think about the current boom starting to bust, oil production. The previous boom was real estate. To build a real estate project you consume X amount of bulldozers and other construction equipment and tools, and you pay an army of people to work for a couple of years, during which time those people have to eat, and be clothed and housed and everything else.
If there's no real utility for what they're building, if the only reason why another 1,500 homes subdivision is being built is because speculators are looking for a way to get a return in a falling interest rate environment although there are no actual people who want to live in those houses, then all of those resources—from the bulldozers, to the cars, to the workers, to the farm equipment that produces the food that the workers ate—all of that is being consumed without anything being produced to replenish it.
Today speculation consists of front-running the central bank and understanding how, when the central bank pushes up the bond price that ripples across all the asset classes.
This is a process that converts—and I use that word “conversion” because in a legal context, conversion connotes an illicit taking—one man's wealth is converted to another man's income.
Suppose I buy copper at $2.50/lb., $100,000 worth or 40,000 pounds and the price doubles to $5 a pound. I've doubled my money. I had $100,000, now I have $200,000.
People are happy to spend their income, but normal people do not want to spend their life savings. It's the story of the Prodigal Son, right? No one wants spend his life savings or nest egg, but everybody’s happy to spend some of the interest. So I bought $100,000 worth of copper and now it's $200,000. I could sell $90,000 worth of copper and buy myself a BMW, and I'll still feel as if I have my original capital plus ten percent more. That's one way of looking at it.
What actually happens is somebody else came along and handed me his wealth. When he passed it to my hands, it came as income. It also comes in the form of income to my broker, to my commodity newsletter writer, to the IRS, to CME that runs the exchange. Lots of people get income off of this trade besides me. Everybody spends the majority of his income but not his capital.
Somebody just handed over his capital, fooled into thinking that he's making an investment, but actually he's just forking over his capital.
Look at it in dollar terms: I had $100,000, now I have $200,000. That's a big gain. In copper terms, I still have 40,000 pounds of copper, only now I sell half of my copper. I consume 20,000 pounds of copper in order to barter it or trade it for a BMW. You want to talk about the conceptual blind spot? The biggest blind spot of all is the one that says, “If I have more dollars, I have more wealth and, therefore I have income, and if I have income, I can spend it.” That is what's eroding and killing us.
Imagine that every productive capital asset is being consumed as that copper is being consumed. That process has a finite end. That’s occurring all over the economy because of this perverse incentive. In the free market, the natural incentives are all good incentives, not perverse.
When government distorts things, it creates perverse incentives: unintended consequences. Regardless of the intention, the incentive is perverse and, therefore, the outcome is perverse. Capital consumption is the perverse outcome caused by the perverse incentive of the falling interest rate.
Moneychanger: That helps explain why, the labor force participation rate shows about the same number of people working now as in 1973. There's not enough capital around to employ all those people.
Weiner: That's right. It takes capital to employ people.
Imagine you are shipwrecked on a little tropical island. To get water, you have to climb up the volcano where there's some fresh water, and to get food you have to stand in the lagoon with your hands and patiently catch fish. Somebody else washes up on shore. You'd like to hire him to help you, but you have no capital and, therefore, no way of paying him a wage that pays him any more than standing on the other side of the lagoon and catching his own fish.
It takes capital to employ labor, and we're destroying capital and replacing it with credit. Do you remember a commercial around 1980 when they introduced Sanka? The commercials said, “We secretly replaced his coffee with Sanka. Let's see if he notices.” Well, we've secretly replaced their capital with credit. Let's see if they notice.
A WAY OUT: GOLD BONDS & CIRCULATING GOLD & SILVER
Moneychanger: Let me just touch briefly on your article, “Gold Bonds to Avert Financial Armageddon.” As a gold dealer for nearly 35 years it has always bothered me that my customers are tying up their capital. They do it for safety and a capital gain, but they are still tying up capital, reducing the capita available to them and to the economy.
In your gold bond suggestion I saw a means to recover from today’s colossal debt where we are eaten up by credit and paper money and move back to gold and silver money, a way to soaking up the unpayable debt.
Weiner: When the price of gold goes up, it's not a gain. It's simply the loss on the dollar.
Moneychanger: Yes, but the government and the IRS calls it a capital gain even while they don’t allow you a capital loss on your paper dollars their inflation caused. It's ridiculous.
Weiner: That's right. Although the dollar gold price is higher, it's simply the inverse of the falling dollar. In 1913 the dollar was 1,505 milligrams of gold, over 1.5 grams. Today it's 27 milligrams because of the falling dollar.
Today gold and silver do not circulate. They cannot because of the legal tender laws and the capital gains tax. So you can only hoard gold and silver, which is, as you point out, does nothing productive with it. It turns it into a dry asset, with all the inconveniences and hassles. If you want to spend it, you have to take it to a gold coin dealer, keep a record of when you bought it at what price, what you sold it for, and pay capital gains tax at a higher rate than other gains are taxed. Dealing in gold is inconvenient, to put it mildly.
People believe the national debt could be paid off with inflation because they define inflation as rising prices. If a toothbrush costs $1 trillion, then paying off $18 trillion worth of debt would be relatively easy, 18 toothbrushes worth. I define inflation differently. I define it as counterfeit borrowing. In that view, digging a hole deeper will never get you out of the hole.
How are we going to escape this debt? We must solve three critical problems if we don't want a collapse: preserve the financial system, repay the debt nominally, and get gold and silver to circulate.
PRESERVE FINANCIAL SYSTEM SOLVENCY
First is preserving the solvency of the financial system: not just banks but also employers, insurance companies, pension funds, annuities. The whole world depends on them. Anybody with parents in retirement homes or continuing care facilities, knows they all depend on annuities, and as the interest rate falls, those annuities are getting crushed.
PAY ALL THE DEBT NOMINALLY
Second, to preserve the financial system, every dollar of debt has to be repaid in nominal terms. If Party A owes $1 trillion to Party B, there must be a way to pay that. Currently in the dollar system, no mechanism exists to pay the debt.
I'm not simply arguing that the notional amount is ludicrously high although at $18 trillion that’s true. Then you have unfunded government liabilities of $1 million a person, on top of everyone's pro rata burden at the state, county, city, and municipal water district levels. All that's on top of business debt, corporate debt, car debt, student loans, mortgages. The sheer amount of the debt is insane, and no case can be made that it could actually be paid.
But I'm arguing something even more fundamental than that. There isn't a mechanism for repayment because there is no “money”. The dollar is just a small slice of a government bond, a little piece of government debt. You cannot “extinguish” a debt by paying it with another debt. That only shifts the debt. If I pay you $100 in Federal Reserve notes, I've only shifted the debt. Now the Fed owes you the money instead of my owing it, but the debt doesn't actually die.
That’s why debt has been rising exponentially in our system today since Nixon's 1971 gold default. It must rise every year by at least the total amount of accrued interest and more if we want what passes for growth today. That is mathematically baked into the cake.
I come from a computer software background and in that world they say, “It's not a bug, it's a feature.” It's not simply a matter of saying, “Well, what if we elected Rand Paul as President and take over congress? They can't fix it. The debt must grow to pay the interest.
So second, to reach a stable footing we must somehow repay all the debt, at least in nominal terms, recognizing that it won't be paid back with dollars of the same value as those borrowed. That’s impossible.
CIRCULATE GOLD & SILVER
Third, how do we get gold and silver to circulate? It's all well and good to say, “If the dollar collapses, everybody would use gold and silver.” But virtually nobody in the United States has any gold or silver. What can you do if you have no money and it takes money to buy food? You starve. That's not really a workable formula for the people that don't own gold and silver.
It won’t work for the people who do own it, either. After Rome collapsed and all government inflation ceased, gold was accepted and recognized as money but it was so valuable that it was worth your life to show anybody that you had it. So gold went into hiding. The gold didn't evaporate, but it didn’t circulate for hundreds of years.
We want to make it actually circulate. How do you kick start life into that body? Gold and silver used to circulate and now they don't. It's a dead body and we want to kick start life into it again. How?
First you repeal the legal tender law that favors paper money. Next you repeal the punishing capital gains tax, but even then it won’t necessarily circulate.
The key is the interest rate. If you own an ounce of gold, you can do one of two things with it: either stick it under the mattress or loan it out at interest. The interest rate governs your choice.
Today the interest rate on gold is zero, so at zero you won't lend it. During an early 20th century banking panic when there wasn't enough gold in New York and the banking system suffered a liquidity crisis J.P. Morgan said, “Four percent interest will pull the gold off the Continent. Five percent will pull it off the moon.” That puts gold standard interest rates into perspective. The key to gold circulation is an interest rate in gold.
What if we had the opposite of a perverse incentive? What if set up positive incentives, unwind the debt of the dollar, and return ourselves to the gold standard? This supposes that politicians actually want that, which today they don't.
Moneychanger: Tomorrow they might.
Weiner: Right. If voters demand it, the politicians will want it. What would you do?
Suppose the U.S. Treasury auctioned off gold bonds—not gold backed bonds, not using gold as collateral somewhere—actual bonds denominated in ounces, not in dollars, with a coupon payable in gold and the principal paid in gold, but with a twist.
When they auction off the bond, they don’t sell it for gold. Normally if it's a 100 ounce gold bond and interest is X I’ll buy it for 89 ounces of gold.” In this case, however, you don’t buy it for gold or dollars, you buy by bidding on it in Treasury Bonds.
At first this sets up a dynamic to leverage the gold price. As gold rises, it takes less and less gold bond to pay off the outstanding Treasury bond debt. When gold reaches $12,000 an ounce, then you will need to issue one tenth as many gold bonds to redeem the same Treasury bond debt as you would at $1,200 gold. One ounce of gold will pay off 10 times as Treasury debt much as it will today.
That will buy the Treasury time. Today, to borrow what they want to borrow the Treasury has to sell shorter and shorter maturity bonds. That noose is getting tighter and tighter. No one knows what the dollar will be worth in decades, so nobody wants to lend long term. There’s no question what gold will be worth: an ounce will still be an ounce.
Gold bonds will allow the Treasury to trade shorter-term paper bonds and issue longer-term gold bonds. If you are going to amortize and actually pay the debt, even nominally, you must buy yourself time to do it.
So the first dynamic is that as gold rises, it becomes cheaper and cheaper in gold terms to redeem the debt.
Second, the market now has a dollar to gold exchange rate. We call it the gold price. Today they are asking $1161.00.
There will also be a gold bond to paper bond exchange rate. So, initially, $1 million worth of paper bonds will trade for $1 million worth of gold bonds. This is due to arbitrage. People are looking for profits, so they'll bid gold bonds up to their gold value price. However, over time, as people realize that gold’s value is not falling and the dollar’s value is, a gold bond to paper bond exchange ratio will develop that that will also be rising.
That means that it will become exponentially cheaper to retire the debt and replace it with gold bonds. This accomplishes even more: by putting gold bonds out there and paying their coupon in gold every quarter, people start to receive a gold income.
Also the government has to develop a gold income. I propose they repeal all the taxes and regulations that impose costs on gold mining. Then levy just one tax on mines, payable in gold. That gives the government a gold income. They're developing a gold income to amortize their gold liability. That’s how debt really works. When you borrow money to buy a house, you don’t store the money to pay off the mortgage locked up in the basement. You have income, and the income amortizes the debt. That's the position the government needs to get into.
Then the government is paying coupons in gold, and that is starting to put gold income into investors’ hands. Other virtuous dynamics will develop around that: gold investment banking, gold investments into other enterprises. Gold miners will recapitalize themselves in gold. For full disclosure’s sake, this is my business model at Monetary Metals, thinking about offering a yield to gold investors on their gold in gold.
So this is not about buying gold so that when the price goes up you can sell it. It's about investing in gold so you can earn a yield on your gold in gold. If that happens, then the gold standard will come about because people will naturally prefer gold to dollars.
Moneychanger: You'll engage the positive side of Gresham's Law in your behalf, good money will drive out bad.
Weiner: That's right.
Moneychanger: Under today's electronic circumstances, that could happen very, very rapidly.
Weiner: Right. Here’s how I would define the gold standard, by the way. When anybody who chooses to do so can make a gold deposit and get a gold interest rate on his gold deposit. That is the gold standard, and then gold will circulate.
Moneychanger: Right. But so many people in the gold and silver business and gold and silver investors think only of collapse and catastrophe. That may be rational, but they are not thinking about how we will rebuild a just and prosperous economy on the other side. Your proposal offers a way we could get there.
Thank you most kindly for your time.
Weiner: You’re welcome.
Originally published April 2015