Monthly Archives: October 2013



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Let us imagine an economy burdened with a nefarious, covert clique of counterfeiters.  This group (perhaps with the letter “G” painted on the back of their shirts) desires to steal real output from the stolid producers of real output.  They accomplish this by sometimes printing fraudulent paper money (one sub-group of them) and sometimes by issuing debt (another subgroup of them) or fraudulent IOUs promising interest and principal payments during the future in return for “borrowing” real output from naïve lenders.  Of course, since they really are producing nothing of value, themselves, they realize it will actually be impossible for them to pay off the debt they have issued and they have no intention of doing so.  However, they don’t want the gravy train of stolen output to actually come to an abrupt end with a default on their debt—it’s too lucrative and too much fun.  What to do?


Saving the day, a bright member of their gang suddenly realizes that the two cliques can actually cooperate to their joint benefit.  They can buy back the debt they issued by printing yet more worthless currency to repurchase it—so long as the public is naive or stupid enough to accept the entire fraudulent, synergistic scheme.  They go so far as to label these actions “open market purchases”.   Of course, these illicit activities actually result in some artificial “market” rate of interest on their dubious bonds.  That peculiar lending rate is just an accidental result of the cumulative behavior of the issuers of the worthless currency and the fraudulent debt.  To think of this rate as some sort of “risk-free” benchmark seems absurd.  After all, it can easily be manipulated by both the thieves supplying the “bonds” as well as the resultant inflation rate of prices in terms of the counterfeit currency. How could anyone be so silly as to think this interest rate was particularly important or meaningful—that it was some sort of meaningful “benchmark”?  Clearly, no one would be so blind as to think of it as some sort of a “risk-free” rate of return.  In fact, if this nefarious clique of counterfeiters and fraudulent borrowers threatened to desist, pack up, and exit our imaginary economy, the remaining honest producers surely should and would applaud. It would be strange if they could be panicked at the clique’s threatened shutdown of operations and wonder how their economy could go on without them.


Now, in comparison, let us consider the economy we actually live in.  But wait… it appears the two economies are not so different.  If you are a skeptic about the real value to our economy of public goods and government services, then you may agree.  We have a central bank that issues worthless currency at whatever level it chooses and usually issues it by the means of buying back previously issued treasury debt.  The combined scheme is used to finance government spending—either purchasing economic output directly or transferring wealth or claims on output from those who voted against the political incumbents to those who voted for them.  That is the traditional spoils system or “public choice theory” of representative democracy.  In so doing, our economy strongly resembles the hypothetical one that we previously imagined.   Surprisingly, many of us consider the peculiar borrowing rate determined by Fed and Treasury collusion and manipulations to be particularly meaningful.  If it’s not, what should we use for a logical “benchmark” rate of return?


We can think of two candidates.  First, if you live in an economy that enjoys an average rate of growth of say 3% from year to year, then expecting such a future return on wealth or savings that you loan to another is not such a farfetched idea.  In fact, it seems reasonable to expect it as a reward for deferring your own consumption for one year.  Another logical benchmark is the rate of return to a piece of productive capital.  After all, if you choose not consume all the output you produce, then you would likely consider “investing” it.   That is, creating a tool that will make you able to produce more output in the future.  The expected average rate of return to an investment in such a tool or piece of productive capital also seems a logical benchmark rate of return.


Let us suppose that the annual average rate of growth of our real economy is some rate, n.  Secondly, let us define the real average rate of return to a piece of productive capital as r(k).  It may or may not surprise you that there is a strong, logical argument, in a transparent economy in which individuals try to maximize their sustained level of prosperity, these that two rates will tend to converge toward or to equal each other.  That is, r(k) = n.    (Forget about a “risk-free” rate of return.  There isn’t one.  In an uncertain world, you won’t find it anywhere—especially not as a promised rate of return of government bonds or bank accounts.)  To see how and why the real return or marginal product of productive capital should converge to the growth rate of the economy, you may want to read our book (Capital as Money).  Alternatively, you can follow the brief argument sketched out below.  It was first made by originally by an economist named James Tobin and is popularly referred to as Tobin;s “Q.”


Suppose we consider a very simple economy where output can be either immediately consumed or invested in order to create capital or an investment good that helps produce more output in the future.  A simple intuitive example is corn—it can either be eaten as current consumption or dried and planted in order to produce more corn in the future.  In this very simple economy, suppose that the price (in terms of whatever monetary good is being used) of a unit of output steered toward consumption is P.  The price of the same unit of output steered toward the creation of future production or capital is P(k).      Further let us suppose that the real natural rate of return or interest in this economy is, in fact, just its average annual growth rate, n.  For simplicity, suppose there is no inflation of the price of consumption goods and that P is therefore expected to be stable.    Then the equilibrium price of a piece of capital will be nothing more or less than the sum of the expected returns to that piece of capital over future periods discounted to a present value using the real interest rate, n, and stated in terms of the price of a typical piece of output.  Thus, in annual periods,




(1)     P(k) =   P*r(k)/(1+n)+P*r(k)/ (1+n)^2 +P*r(k)/ (1+n)^3… +P*r(k)/(1+n)^i…




P(k) = the price of a unit of output used to create a piece of productive capital


P = the price of a unit of output used for current consumption


r(k)= the real marginal product of a piece of output turned into a capital good (in terms of output)—expected to be constant.


n = the real rate of growth of the economy.


A^b means that A is raised to the power of b.


i = refers to the ith period or year.


It turns out that equation (1) can become, without too much ado (using some re-arrangement and the algebra of the sum of an infinite geometric series);




(2)    P(k)/P = r(k)/n




What is the intuition of equation (2)?  It is surprisingly simple (and hopefully a major reason why James Tobin was awarded the Nobel prize in economics). The ratio P(k)/P, or Tobin’s “Q” provides a clear and elegant behavioral explanation of optimal capital investment.  First, suppose that a unit of output turned into a capital good is currently more valuable to the market than the same piece of output turned into a consumption good.  Then P(k) > P or Tobin’s Q >1.  If this condition is true, it is also true that r(k) > n.  In that case, current output will be steered by the marketplace toward the production of more capital goods.  Until what?  Until the marginal product of capital falls, thereby converging to the growth rate of the economy.  At that point of market equilibrium r(k) = n and Q =1.   This is the same result as the “golden-rule” capital intensity of the Solow neoclassical growth model (for further explanation you should read Capital as Money).  On the other hand, if the current market value of a unit of output invested to create a capital good is less than the value of same unit of output consumed as a consumption good, then P(k) < P or Tobin’s Q <1.  Thus, output will naturally be steered away from investment and toward consumption by the marketplace.  Until what?  Until capital becomes scarce enough in production that its marginal product rises to r(k) = n and Q once again is equal to 1.  Thus, a logical, rational market mechanism exists in a free-market economy that tends to drive us toward the optimal market-determined capital-intensity or aggregate level of investment.  Notice this mechanism has nothing at all to do with government or central bank manipulation of interest rates.  In fact, when such distractions exist, all that can be said for them is that they will tend to thwart or confuse the capital market in realizing the optimal level of productive capital creation.  It is this always present decision of all individuals and all economies of whether to consume or invest at the margin that causes us to recommend that units of broad productive capital should, in fact, be our medium of exchange and natural store of value—that capital should be our money.


This beautiful and elegant picture grows cloudier when we introduce sustained fiat money growth and inflation.  We would like to say that fiat money growth is perfectly neutral in exerting real economic effects upon the real return to capital, investment and the capital-intensity of the economy over the long run.    Unfortunately, the design of our ham-handed tax system, either by accident or intention, allows no such benign result.


To see why, consider the following thought experiment.  Suppose you own a stock during a period where its market price exactly doubles.  Unfortunately, during the same period the average price of all other goods, including the consumer price index, exactly doubles as well.  Realizing that your stock price appreciation has just kept pace with general inflation, you conclude that the real capital gain on your stock is precisely zero.  Carefully noting that fact on your tax return when you sell your shares, you report to the IRS that since there was no real capital gain on your shares, you owe no real tax—especially since the government or central bank’s monetary policy was responsible for the sustained rate of inflation in the first place.   Good luck with that completely reasonable argument!  Since capital taxes are typically not indexed to inflation, this is an important reason why a rise in the interest rate, taken alone, should generally exert a negative effect upon the future returns to a stock (growth or value).  Most rises in market interest rates simply reflect a rise in the actual or expected inflation rate.  In terms of equation (1), above, an increase in expected inflation does not net out in the effect on the numerator (P growing at the inflation rate) and the effect on the denominator (the discount rate becoming (n + Inflation rate)) because r(k) is reduced by taxes that are not inflation-neutral falling upon the real rate of return to capital.  In addition, there is nothing neutral about our witches’ brew of asymmetric tax rates. They will generally exert real distorting effects everywhere, including the split between investment and consumption.


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“Hey Ed how’s it going””

“Not so hot Jill, but I guess you can see that for yourself.”

“Sorry,” Jill replied with concern.  “I wasn’t going to mention it but you do look pretty motley Ed.  Seeing you now reminds of the time you got caught in that rockslide a few years ago.  You look pretty hungry too—your ribs are showing.”

“Yeah, Jill, I’m missing a few chunks.”  Ed regarded himself sadly.  “Even the end of my tail is missing and I doubt that will ever grow back.  They worked me over pretty good, I don’t mind saying.”

“What!?  Who worked you over?  What happened Ed?”

“Well, I was trying to catch rabbits at Red Gulch when a group of the Federal Coyote Police caught me before I even got any.  They found I didn’t have a rabbit permit and said they were going to teach me a lesson—I guess they did.  Nowadays it’s illegal for a coyote to catch rabbits without purchasing a rabbit permit first.”

“That’s nonsense Ed.  I catch rabbits the next valley over and I don’t have a permit—and not just any rabbits, mind you, but plump, tender cottontails.  What does a coyote do, if not catch rabbits Ed?  It’s what we’re about—our ‘raison d’etre,’ if you don’t mind my saying so.”

“Don’t worry Jill, the Feds will get around to you soon enough.  Mark my words.”  Ed sadly replied.

“Well why don’t you just get a rabbit permit then?”

“It’s not so simple Jill.  You need rabbits to buy a rabbit permit, but you can catch rabbits without one.  So here I sit, unemployed.”  Ed sighed.

‘Unemployed!  How can a coyote be unemployed?  We either catch rabbits or we starve.  If you’re self-employed, you cannot be unemployed.  It’s that simple—it always has been.  So you’re ‘unemployed’ just like Ned over there.   I haven’t seen him catch a rabbit in ages, but he’s all plump and glossy.”

“Well, Jill, I’m not exactly like Ned.  I don’t have his connections to the government and I don’t have his mind.  Ned gets a weekly allotment of rabbits from the Feds because he’s performing very valuable R&D that benefits all of us coyotes.  Thank goodness for Ned.”

“What’s R&D?”

“Research and Development Jill.  Ned gets ideas that are supposed to help all of us other coyotes be more productive in catching rabbits, even though I’ve never seen him catch a rabbit himself.  It’s important and valuable stuff he supposedly comes up with.  He says we need more coyotes performing government research.  In fact, his thinking time is so important that the government now officially counts as part of our economy’s total production of final goods per year.  That’s what they call Gross Coyote Product or GCP and Ned’s thinking, alone, actually makes our total value of coyote production larger.  I only wish I had his brain.”  Ed sighed again, sadly.

“What!  Are you for real?  This is the biggest crock of you-know-what I’ve ever heard.  It’s a scam Ed.  If Ned’s R&D, or whatever you call it, is so valuable, then let him prove it the old-fashioned way—by catching more rabbits himself.  That’s how new or better ideas should be rewarded.  If there is such a thing as “total coyote production,” it should be measured by summing up how many rabbits we catch in total.  It should not be measured by adding up rabbits and ideas.  What nonsense!”

“You just don’t get it Jill.  Ned told me you’re a barbarian, not a progressive.  It’s very important for the government to be able to measure the size of our total output in order to know what level of coyote services to provide for all our benefit and how many rabbits to tax and borrow from us in order to finance those services.  Ned says we are lucky to have a coyote government working so diligently to protect the general welfare of all of us.  According to Ned, whatever rabbits we give to them, it’s far less than they deserve.”

“And that’s not all, according to Ned, the coyote government has way underestimated the value of our total production or GCP because it has also failed to include qualitative improvements in output.  Products get better over time as new technology or thinking is embedded in them.  Ned says that’s important because a bigger economy means government borrowing and taxation can be increased to provide yet more government services for all of us.  I just wish I could get some.”

Jill was shaking her head incredulously as she listened to this.  “Qualitative improvement?  How can that be?  The only output we coyotes produce that matters is rabbits, and a rabbit is still a rabbit!  What nonsense!  Have you seen any ‘qualitative improvement’ in the rabbits you eat?  I haven’t.”

“I wouldn’t know, Jill.  It has been such a long time since I have eaten a rabbit, I probably wouldn’t be able to tell.”

Jill looked at him sadly.  “Poor Ed.  You really have had a tough time haven’t you?  What have you been eating to survive?”

“Well at night I started sneaking into the organic farm and scarfing down quinoa, radicchio, edame and acai berries.  I guess I’ve gotten pretty brazen because I’m so hungry—Now, I just eat in broad daylight right in front of the humans that run it.  They’re OK.  Since they don’t have guns, they just shout and run around beating pans.  I ignore them.  I don’t need a permit to eat this stuff because the coyote government doesn’t tax or regulate it.  That’s why more coyotes, like me, are becoming vegan.”

Jill looked at him blankly.  “Quinoa, acai berries, vegan…?”  She echoed.

“Yeah, at least I’m getting my anti-oxidants.  Ned says it’s just as well for me because a vegan diet is healthier anyway.  Still, I can’t help noticing he still eats only rabbits, himself.”

“Ned only says that because he’s part of it!  Government services!  Listen to yourself!  What are you talking about Ed?  We’re coyotes!  The main thing we need is to be able to catch and eat rabbits—and not have them taken away from us by other coyotes who are regulating, taxing, controlling or ‘thinking’ for us.  We should eat meat not vegan.  We can rely on ourselves, Ed.  What we need is freedom—not some coyote clique or cabal that has just cleverly positioned itself to steal production from the rest of us.  It’s the same old story wrapped up in new clothing.  Government working hard to serve the ‘public interest’—the ‘greater good’.  What blather!  At rock bottom, a coyote is still either just catching rabbits or stealing them, no matter how elaborate or dressed up the explanation.  Can’t you see that?”

“I don’t know Jill.  I’ll admit all this stuff just my head spinning.  I don’t have Ned’s mind and apparently I don’t have yours either.   The only thing I know for sure is that I’m still hungry.   Sometimes I just wish that I could get away from all these regulations, rabbit licenses, taxation, and measurement of coyote production.  Wasn’t it better in the old days when we just caught rabbits, ate them at our leisure, let the sun warm our backs as we rested with full bellies, and enjoyed life?  It seems like whenever we get too concerned with measuring stuff, especially somebody else’s stuff, bad things happen.”

“That’s better.  Now you’re sounding more like the old Ed.  There’s hope for you yet.”

“Seriously, Jill, is there still some place we could go and live like that? Like we used to?”

“Well, my cousin Toby says that it’s still possible to live like that in Wyoming.”

“Let’s go to Wyoming.”

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