There are two broad approaches to the world of science; the traditional way, the way of Natural Philosophers is one. Galileo, Newton, Darwin, Adam Smith and many other greats of the past were considered ‘Natural Philosophers’. Natural Philosophers observe Nature, and formulate hypotheses and theories based on their observations. They may use mathematics to describe and clarify their observations and hypotheses, but for Natural Philosophers mathematics is simply a tool used to describe Nature.
A second approach, quite different, was first popularized by Einstein. He called this approach the ‘gedanken’ experiment… in other words, a ‘mental’ experiment. The hypotheses came first, followed by the experiment. The equations… the math… came first, then came the observation; Natural Philosophy was turned on its head.
Einstein was a good enough scientist to understand that experiment would prove or disprove his hypothesis and his theory and his math; unfortunately, many of Einstein’s followers have lost this important nuance. Today, there is a widespread belief that mathematics is science, that numbers are physics. Experimental evidence that does not support the prevailing paradigm is discarded, ignored, and vilified… all to the detriment of scientific progress.
This distortion of the scientific method has invaded economics; most main stream economists believe that economics is mathematics… and the only issue is to discover the right equations. This is wrong headed thinking, in economics no less than in physics… if not more so. People’s behavior, unlike the behavior of subatomic particles, cannot be described by equations; there are no equations to quantify free will.
So what has this to do with ‘interest vs. discount’? Plenty… it is easy to mathematically convert the discount on a Real Bill to a percentage; to annualize the discount, making it easy to compare the discount with interest paid by bonds or mortgages; but the math is not the economics. Converting the numbers does not change economic reality or the meaning behind the numbers.
Bonds carry an interest rate… and the forces that determine interest rates are completely divorced from the forces that determine the discount rate of Real Bills. Interest rates reflect the cost of borrowing… the cost of debt. Real Bills represent commercial credit, and have nothing to do with borrowing… or debt.
Interest rates are determined by two sets of forces; one sets the floor of interest rates and the other sets the ceiling. The floor is set by arbitrage between the bond and cash Gold markets… if rates are too low, the marginal bond holder will sell his now overpriced bonds and hold cash Gold instead. Bonds are overpriced because the price of a long bond varies inversely with current interest rates; low interest rates=high bond prices, and vice-versa.
This is the Austrian formula for interest rates; it is a reflection of time preference, expressed in technical terms. More simply, a person with wealth (money to lend) will not lend it… except perhaps to family… unless he is compensated (by sufficient interest payments) for giving up the immediate use of his Gold. This is time preference, and the floor is absolute; as interest rates approach zero, lending will approach zero.
Conversely, as interest rates climb, more and more Gold holders will choose to buy bonds; that is, lend their cash Gold in order to capture income. In fact, if rates go high enough… not likely under a proper Gold standard but theoretically possible… then all cash Gold available (disposable income) will be invested. If interest rates somehow still climb, there will be no more Gold available to buy bonds… Bonds are a paper instrument, with no definite limit… unlike a very definite limit to the amount of Gold in existence. This is where the other force that sets the interest rate ceiling kicks in.
This force is arbitrage between the equity markets and the bond markets. As interest rates climb, the marginal entrepreneur will sell his equity and buy risk free bonds at low prices. Once this arbitrage kicks in, bond buying picks up, forcing bond prices up and pushing interest rates down. Moreover, if entrepreneurs abandon productive enterprise for bonds, the demand for bonds also drops. In a real economy, vs a Fiat economy, entrepreneurs use borrowed funds to finance productive enterprise… there is no demand for new loans if enterprise is being shut down.
To clarify this, imagine an investor with 100,000 monetary units to invest. If bonds yield 5% and an enterprise can earn 10% net returns, the odds are that the investor will take the higher risk investment for the much higher returns. On the other hand, if interest rates climb to 9%, and enterprise cannot earn more than 10%, odds are he will choose the low risk bond… never mind if interest rates actually go higher than what enterprise can earn.
This ceiling is absolute, just as the floor is; the drop in the supply of bonds (less demand for borrowing) along with increased demand (buying by investors) will inevitably lower interest rates by raising bond prices. Notice that there are two sets of forces here, time preference as the floor and marginal productivity of capital as the ceiling; this diversity of forces sets up the spread… that is, the gap between floor and ceiling… as between bid and ask.
By contrast, Real Bills are in a different world. There is no borrowing, no ‘floor’ or ‘ceiling’, no spread, no buying or selling of Bills. There are only physical goods on their way to the consumer, and credit granted to the retailer. Bills arise from consumption; they are not offered to the market, nor issued like shares, nor ‘floated’ like bonds; real goods arriving at the retailer are the genesis of the Bill.
Real Bills enter circulation, assuming a monetary role, because they mature into Gold; consumers buy the urgently needed goods, paying Gold coin, and this buying allows the retailer to pay his bill. If the product against which a particular bill was drawn becomes less urgently wanted, then this particular bill will no longer circulate, and will lose its monetary role. It will be removed from the Social Circulating Capital, and revert to being an ordinary invoice, no longer considered a Real Bill.
So what is the exact mechanism that sets the discount rate? Remember, as the Real Bill circulates, the recipient of payment on maturity changes. The Bill is endorsed to the new holder, as a means of payment… but the ultimate payer, the retailer who accepted the goods and signed the Bill does not change. He will have to pay the Bill on maturity, come heck or high water… to the holder of the Bill, to whoever it was last endorsed to.
So, exactly why is there a discount? Well, the retailer will have to pay the bill on maturity, at full face value, without question… but does he have to pay it early? Will he be willing to Pre-Pay his bill? This is the heart of the matter… and the answer is a big maybe! Sure, he may pre-pay, before the due date… if he has the cash on hand… and if the discount being offered to him is attractive enough. Will he have the cash? Why, this depends on the propensity of consumers to spend. If the propensity to spend is high, if his products fly off the shelves, the retailer will be rolling in cash… and will be happy to pay his bills early, for a modest consideration… a ‘small’ discount.
On the other hand, if consumers are more reluctant to spend, the retailer’s cash position will be weaker; he will not be so eager to pay his bill early, and will demand a bigger discount to pre-pay. The concept of pre-payment is the driving force behind the discount rate; indeed, under the Classical Gold Standard of the nineteenth century, discount houses claimed they could ‘pull Gold from the Moon’ if they but offered a discount large enough.
Clearly this claim is true; with a big enough discount, the retailer will indeed redeem his bill, paying it early; why not… it is possible the discount being offered is higher than his net profit from sales… he may use cash other than what is in his till if he gets a good enough offer. Gold from the Moon indeed… if there is a retailer on the Moon, he has bills that are coming due… and the discount house (holder of his Bills) makes an offer too good to refuse.
Now we see why there is no spread on Bills; Bills are not bought or sold… there is no bid or offer. They are simply re-discounted. To see how this works in practice, suppose there is a particular Bill drawn against Christmas turkeys… a product the flies off the shelves. A Bill drawn against Christmas turkeys will certainly circulate. Suppose this Bill has a face value of 1,000 Silver ounces, a maturity of 90 days, and the discount is 3 Oz for ninety days.
Now if the turkey wholesaler who holds the bill decides to pay one of his creditors with this Bill, the question is what will the market value of the Bill be… how much is it worth? This depends on three factors; the Bill’s face value, it’s time to maturity, and the discount rate. If the wholesaler decides to endorse the Bill to the turkey slaughterhouse, and the day it changes hands is 60 days from maturity, the market value will be 998 Oz.; 3 Oz for 90 days is the same discount rate as 2 Oz. for 60 days.
If the slaughter house operator then uses the very same bill to pay the turkey farmer, and the day it changes hands again is 30 days from maturity, the bill will now be worth 999 Oz… the day the Bill is paid by the retailer, it will command its face value, 1,000 Oz… and expire.
Indeed Real Bills are an almost magical creation of human ingenuity; there is little doubt that as the Fiat money regime collapses, Real Bills circulation will emerge spontaneously as it did historically. We can only hope that this time it will take but a few years, not centuries. Once Gold money and Real Bills circulation resume their vital roles in the world economy, capital destruction will turn to capital accumulation, and the standard of living of all inhabitants of Planet Earth will begin to climb.
Rudy J. Fritsch
Editor in Chief
The Gold Standard Institute