If you have read my last three articles, you are starting to understand the true value of Honest Money to society and to you and ME… and the crucial importance of ‘trust based credit’, that is Real Bill circulation… but we have only scratched the surface. The well hidden ‘magic’ of Gold money emerges only once Gold is in free circulation, and a mature Bill market with free circulation of Bills of Exchange is established.
In Entrepreneurial Magic, we saw how trust based credit lets entrepreneurs start and run business without capital and without borrowing… business that serves the best interest of society. In Trust Your Neighbor-Tie Your Camel, we saw just as the rate of interest is driven by the consumer’s propensity to save, the discount rate is driven by the consumer’s propensity to consume. The discount rate is determined by the willingness of the bill acceptor to pre-pay his bill, and his willingness to pre-pay depends on the consumer’s spending.
In Breakthrough of Trust Based Credit, we saw how a reduction in the marginal productivity of labor… that is, a lower cost of doing business… will eliminate unemployment, and allow a virtuous circle of general prosperity to replace the current rat race of trying to keep ahead of monetary inflation. With a fully developed Bill market, and international trade based on the unhampered circulation of Bills of Exchange, multilateral magic emerges.
With a mature, fully developed Bill market in existence, the previously necessary one-on-one agreement between merchant (Bill acceptor) and wholesaler (Bill holder) is replaced by the action of the market. It is no longer necessary for each merchant to negotiate the pre-payment of his bill, just as with a fully developed Bond market, it is not necessary for each borrower to negotiate terms with a lender.
As a mature bond market consolidates the rate of interest by the ongoing market process of bid and ask for bonds, so a mature Bill market consolidates the discount rate by the ongoing process of Bill sales and purchases. The merchant need no longer negotiate with the bill holder to obtain a discount; if he has cash Gold on hand, he simply buys Bills as desired from the discount house.
In other words, if his till is filling with cash due to consumers spending taking an uptick, he will buy Bills, and hold them (earning the discount) till his own Bills come due. The Bill market, just like the bond market, will consolidate all buy/hold decisions made by merchants… and thus develop the discount rate. More Bill buying tends to increase the price of Bills, which is the same as reducing the discount rate. Exactly the same principle as in bonds; more bond buying leads to higher bond prices… and to lower interest rates.
The Bill market is a wonderful mechanism; not only do Bills improve profitability by reducing the cost of doing business, but they help to even out seasonality. An ice cream shop need not hold inventory over the winter season, but rather will hold bills; and as Bills are an appreciating asset, the ice cream merchant profits. When the ice cream season begins, the ice cream merchant will sell the bills, and buy new inventory… if the profit of selling ice cream is greater than the profit of holding bills.
So, from marginal ‘umbrella entrepreneur’, to all business, to full employment and improving standard of living, the Real Bills Doctrine of Adam Smith is shown to be a wonderful artifact of the free market, embodying the concept of nature’s principle of Least Action… but still… where is the Magic? How –really- did the pre WWI Gold Standard run on 150-200 Tons of Gold in the vault of the Bank of England?
I have studied the Gold Standard and Real Bills for years… but my understanding of Real Magic, the ‘Earth Moving’ effect, only kicked in a few months ago. Strangely enough, what inspired my ‘Aha” experience was some Internet rumor about India buying Iranian oil with Gold.
At first, this sounded intriguing; but then, knowing how much Indians love their Gold, I kind of dismissed this as mere rumor. Then, came another rumor; that Iranians were buying Indian grain and tractor parts… with Gold. With the American pressure on Iran, and the desperate situation the Iranians were in… I had to take this rumor more seriously. Trade Gold for Food? Yes… in extremis, for sure.
Then, thinking further, I thought; hmmm, if Iran sends Gold to India, would the Indians consider trading this new Gold for oil? After all, they did not have to give up any of their own precious Gold, simply return some of the Iranian’s Gold… so I could see this trade happening. Indian food for Iranian Gold, and Iranian oil for Indian Gold.
The scene is set; negotiations are done, the ships full of Indian grains and stuff leave harbor, on their way to Iran… while the oil laden tankers from Iran head off towards India. The ships unload, the trade is complete, and the due dates for the bills arrive; Iran needs to send Gold to India to make payment, and vice versa.
Say the trade was for a ton of Gold; a pallet full. Now visualize the armored cars and escorts arriving at the Indian airport, loading Gold into the waiting jet… and the same scenario in Iran. The planes take off, carrying their precious cargo to their destinations; from India to Iran, and from Iran to India… one Ton of Gold heading both ways.
And suddenly, the truth struck me; if those bullion laden airplanes simply turned around and went back to their departure points, instead of completing their journeys, it would make no difference! India would still get a ton of Gold, and so would Iran. Gold is Gold, whether of Iranian or Indian origin. There is no actual need for the Gold to change hands.
Wow. We see a big chunk of magic here; shiploads of stuff changing hands, paid for by Gold… but Gold need not ever leave the vault. Only the Bills must leave… traveling from India to Iran, and from Iran to India… and net out the transaction. A glimpse into the true magic of Bills circulation.
Well, I took this glimpse and ran with it. If the transaction, from signing the agreements to netting out the Bills takes three months, then a ton of Gold’s worth of trade can be carried out every month, as long as the Gold value of the goods being traded is equal… no? Hmmm…
Is it necessary for the ton of Gold to sit in the vault for ninety days, while guaranteeing the transaction? What if in thirty days, a new trade agreement is made? Could the same Gold guarantee this transaction as well? Without any fraud?
Suppose the partners want to trade a ton’s worth of stuff every thirty days? Well, yes… if the first transaction closes (is netted out) on January 1 2014, then there is no problem using the very same Gold to guarantee another transaction that comes due February 1 2014… and another one March 1 2014… and so on and so forth.
The very same Ton of gold, committed for ninety days, is available for trade every thirty days… as long as the trades balance, and Gold does not actually have to move to make payment. The volume of international trade supported by the same quantity of Gold just tripled. But wait; why wait a month? Why not net out the trades every week? Then, the volume of trade supported by the same Gold is increased by a factor of twelve.
Better yet, net the trades out every day… as trades in the future markets are netted out every day… and now, that single ton of Gold in Iran, and that single ton of Gold in India, can support ninety Gold tons worth of transactions. One Ton of Gold in each vault, used to guarantee Real Bills, does the work of ninety tons of Cash Gold. The magic of Bill circulation grows.
Still, we are talking bilateral trade; between two countries… and disadvantages are clear. Each transaction must balance, or ‘net out’… else Gold would need to flow. Each participant has to have sufficient Gold on hand… and if there is not enough trust, the Gold must actually be transported; those airplanes will have to make the seemingly silly trips to their destination, to prove that the promise of Gold is kept… till real ‘trust based credit’ kicks in, and the netting out of Bills is accepted.
The final steps to Multilateral Magic are now in sight; Instead of a ton of Gold in India and a ton of Gold in Iran, there is a single Ton of Gold at the trading house… and the Bill netting takes place at the trading house, or ‘discount house’ as it used to be called. Under the Classical Gold Standard, the discount houses were in London… the hub of world trade.
Now, true multilateral trade becomes easy; India need not keep a perfect trade balance with Iran… and Iran need not keep a perfect trade balance with India. With multiple participants, each country need only keep an over-all balance of trade; imbalances between trade partners are not detrimental… Gold will not flow unless the sum of all trades is out of balance… i.e. unless trade deficits or surpluses are run. Only then will Gold end up moving… and the very threat of losing their precious, print-proof Gold is incentive for all nations to keep their trade in balance.
Better yet, less total Gold is needed; a Ton of Gold at the discount house will substitute for a Ton of Gold in each participant’s vault. Best of all, the final excuse to dodge Gold is gone; no longer is it legitimate to whine, “We have no Gold, a Gold based system would not be fair to us”.
With the Gold in the vault of the discount house, there is no need for a trade participant to actually own a single ounce of Gold; all they have to do is avoid running a deficit, so no actual claim for Gold is served on them. And, if they want to actually own and hold Gold, but have none to start with, all they have to do is run a trade surplus, netting out more and more Gold; and at some point, ship some of this honestly earned Gold to their own vaults.
Simple, but not easy; spend less than you earn.