In Interest vs. Discount, we saw that the formation of the discount rate is radically different from the formation of the interest rate. To clarify this, and to examine the importance of this difference, we first follow a very simple, indeed embryonic example of a Real Bill used to clear credit; an example first given by Professor Fekete.
Consider the sequence of production of a highly marketable and desirable consumer good… bread. The production sequence involves four ‘protagonists’… or human ‘actors’; the grain farmer produces wheat, the miller turns wheat into flour, the baker makes bread from the flour… and the consumer buys bread… and consumes it.
In a C.O.D. or ‘100% Gold’ economy, money (Gold) has to change hands three times; once when the miller buys wheat, once when the baker buys flour… and one more time when the consumer buys bread. Thus, as Professor Fekete puts it, the Gold supply has to be ‘invaded’ three times, or to put it another way, the velocity of Gold… how many times Gold must change hands… increases as consumption picks up. Gold needs to be kept on hand to fund three transactions.
By contrast, once Real Bills are in use, only the baker-to-consumer transaction commands Gold; the other two transactions involve commercial credit, and are cleared by the Real Bill drawn on the baker. Instead of the miller having to use Gold to buy wheat, and the baker having to use Gold to buy flour, the Real Bill is used to make payment. The Baker’s bill pays both the miller and the farmer… only small change is used to account for mark up. On maturity of the Bill, the credit granted to the miller by the farmer, and the credit granted to the baker by the miller… are extinguished by the consumer’s Gold coins.
The Gold supply is only ‘invaded’ once instead of three times… a great increase in the efficient, economical use of a scarce and valuable resource, Gold. The velocity of money is reduced… whereas without Bills, the velocity of money must increase as consumption increases, unless there is an increase in the quantity of Gold available for consumption and production purposes.
The discount rate in this scenario is set by the desire of the baker to pre-pay his Bill… if offered a sufficient incentive; a sufficient discount… balanced by the desire of the Bill holder for cash Gold rather than Gold in the future. This is a question of liquidity preference; with booming sales, the baker has plenty of liquidity and will accept a small discount. With slower sales, he is less liquid, and will demand a larger discount before agreeing to pre-pay his Bill.
Notice this scenario assumes that the baker has no choices other than to hold cash Gold, or to pre-pay his Bill. Once there is a fully developed Bill market in existence, this assumption is no longer valid. Instead of having to hold cash Gold, the baker will be able to hold Bills… Bills of other trades, Bills of various maturities and denomination; whatever Bills he deems best suited to his purposes.
Under this new scenario, if consumers have an increasing propensity to spend, the baker… and retailers in general… will buy Bills with the incoming cash. This buying will tend to drive up the price of Bills… which is the same as driving the discount rate lower… just as in the bond market, buying pushes up prices and pushes interest rates down. If consumers spend less, retail merchants will buy fewer Bills, pushing Bill prices down… and the discount rate up. This is the same result as in the simple, embryonic state without a fully developed Bill market.
So, where does all this take us? So what if the discount rate is driven by spending? How does the economy benefit? To see the magic of the Bill market in operation, let’s take a typical market scenario and compare how it plays out under Bill circulation, vs. how it plays out today, with the Bill market moribund. Let’s take a scenario where local conditions, such as a drought or other natural disaster destroys grain crops in one region, while there is a bountiful harvest in other regions.
Today, the imbalances of supply and demand can only be met by the price mechanism… and the tendency will be for prices in the devastated region to rise vs. prices in the areas of bountiful supply. This affects the consumer, and soon enough cries of ‘price gouging’ fill the air… perhaps leading to government interference, price controls, quotas, corruption, inefficiencies, shortages… on and on.
By contrast, under a fully functional Bill market, prices are not affected at all. Rather, the discount rate mechanism kicks in to automatically, rapidly resolve the imbalances. Consider that in the area with shortages, there are consumers with plenty of cash… but no goods to purchase. This is ‘pent up demand’ waiting to be fulfilled.
Merchants compete to be the first to take advantage of this, knowing full well that the discount rates in the shortage region will be lower… as there is plenty of liquidity, leading to early payback of bills at a modest discount… or to increasing Bill buying, which gives the same result… lower discount rates. In the meantime, the discount rates in the areas of bounty are higher, as there is relatively less consumption… and less consumption leads to higher discount rates.
Suppose a wagon load of wheat is priced at 100 Silver units; and further, let’s suppose that the discount rate in areas of plenty is 2 units. Now, let’s further suppose that in the area of shortage, the discount rate drops to 1 unit… and see how a sharp wheat merchant can profit by this discrepancy… this ‘spread’.
By rushing to be the first to deliver his wheat to the shortage area, he will be able to acquire a wheat Bill with a face value of 100 units for a wagon load of wheat. However, the discounted value of this Bill is 99 units; remember the discount in the drought area is 1 unit.
SO, what can our eager merchant do with this Bill? Well, he can hold it to maturity, and collect the full 100 unit face value of the Bill; this is given. On the other hand, he can very well turn around, and sell (rediscount) the brand new Bill; he will sell it at its discounted value, that is for 99 Silver units. Turning around again, he will buy a bill from the bounty area… and these Bills are discounted by 2 units… so he gets a 100 unit face value bill, at the market price of 98 units… and ends up with the bill and a unit of silver.
Then, he simply waits till the bill he just bought matures. At maturity he will collect the face value… 100 units… plus he gets to keep the silver unit he earned by selling the draught area bill for 99 units, and buying the plenty area bill for 98 units! He just earned an extra silver unit on his wagon load of wheat, not by increasing the price… but by being first to deliver. As more and more wheat is delivered into the drought area, the difference in discount disappears…it is ‘arbitraged’ away… and the opportunity for extra profit disappears as well.
How magical is this? The natural, emergent phenomenon of Real Bill circulation allows ideal allocation of resources, matching supply and demand, without any response from the price mechanism. This is a wonderful example of the power of free, voluntary markets… and another grievous flaw of the current system of centralized control. The current monetary crisis will not resolve until the monopoly on money and credit creation held by banks and governments is broken, and power is returned to free markets… to the citizens of the world.
Rudy J. Fritsch