Whither Gold? Part 2
Antal E. Fekete

A short course on demonetization

Quantity theorists widely predicted that the demonetization of gold would seriously
undermine gold's exchange value. (A representative of this view is the first quotation
from Mises on p 3 above.) They argued that the removal of the lion's share of the
demand could not help but make gold cheaper. As a reinforcement of this argument,
quantity theorists were fond of recalling the episode of silver demonetization in the
last century. They claimed that demonetization had caused the prolonged decline in
the price of silver that has been continuing ever since.

It is not known whether these views had any influence on the thinking of the
decision-makers who `demonetized' gold in 1971. Be that as it may, the idea that
dishonoring promises to pay gold would somehow cause the dishonored paper to go
to a premium in gold is preposterous. It is true that insolvent bankers have in the past
often tried to promote their discredited paper (sometimes using such extreme
measures as the threat of the death penalty, as did John Law of Lauriston in France)
-- to no avail. Logic and history prove that dishonored promises to pay always and
everywhere go to a discount -- never to a premium. Indeed, this is exactly what
happened after gold was `demonetized' word-wide in 1971.

In less than a decade the U.S. dollar went to a 90 per cent discount in terms of gold.
The discount is fully commensurate with the 90 per cent loss in purchasing power
that the dollar has suffered during the same period. Even though the discount on the
dollar fluctuates, the hope that it would ever disappear is a forlorn one. The disarray
in the nation's budgetary and trade accounts suggest that currency depreciation is
likely to continue, if not to accelerate. The only way to stop the rot would be to adopt
a credible plan to resume gold redeemability of the dollar -- but no party has so far
mustered the political courage to propose it.

The comparison between the demonetization of silver in 1873 and the so-called
demonetization of gold a century later is disingenuous. In fact, the use of the word
`demonetization' in connection with the latter is quite inappropriate: it is but a
euphemism for debt-abatement or partial debt-repudiation inflicted upon the foreign
creditors of the United States of America. In 1971 these creditors were deprived of a
valuable property right to a fixed amount of gold, or to the dollar equivalent thereof.

This unilateral and capricious act has done nothing to benefit the citizens or the
government of the U.S. On the contrary, the debt abatement had one predictable
consequence: harsher terms on future borrowings, as measured by the higher and
unpredictable rate of interest at which the government and the people of the U.S. can
borrow at home and abroad.

It is true that the burden of the debtors who had contracted debt prior to the
abatement was lightened. But insofar as they were the same people and the same
government on whom the burden of the harsher terms on further borrowings fell for
the indefinite future, there were no beneficiaries -- only losers. In particular, the big
loser was the American taxpayer. The international credit of the United States
government, which had been the envy of the world for over a century, was grievously
damaged -- as manifested by the unprecedented interest rates the Treasury was
forced to pay upon its obligations after the debt abatement.

The stubborn insistence the credit of the U.S. has not been damaged in the
demonetization exercise of 1971 is the centerpiece of mainstream economic
orthodoxy. Yet this is a world of crime and punishment and no one, not even the
government of the mightiest nation on earth can exempt itself from the consequences,
which are numerous. America's industry has lost its international competitiveness.
Due to the high rates of interest a large segment of America's park of capital goods
has become submarginal, as producers were either unwilling or unable to maintain it
or to replace it by more up-to-date equipment.

As capital became submarginal, so did the producers using it. They were forced to
sell their businesses at a loss, and to invest the remnants of their former wealth in
high-yield Treasury bonds. This is a textbook-case showing that a government can
only harm itself by harming its own taxpayers. Printing high coupon-rates on its
bonds the U.S. government turned former producers of wealth into coupon-clippers.
The world is witnessing the progressive de-industrialization of America, as a large
segment of the producers find themselves unable to compete with those capricious
coupon-rates the government high-handedly prints on its bonds. At the same time,
the main competitors of American industry in Japan and Germany are the
beneficiaries of a low interest-rate structure, made possible by those countries' more
stable currencies.

While the so-called demonetization of gold was a farce staged by the U.S.
government in order to cover up its own insolvency, the demonetization of silver a
hundred years earlier was a genuine market-phenomenon. Government action in
demonetizing silver amounted to little more than a belated acknowledgement of a
fait accompli.

There was no dishonoring of promises to pay. There was no deterioration in the
public credit, no destruction of private capital. On the contrary, by virtue of its
cooperating with market forces, the government greatly enhanced its credit. The
United States was well on its way to become the world's greatest creditor nation. One
hundred years later the government, in demonetizing gold, was moving against
market forces, and the credit of the U.S. government suffered its greatest setback in
the history of the nation.

The deterioration of the credit of the United States still continues, with unforeseeable
consequences. This is not generally acknowledged by financial writers at home and
abroad. But one palpable and indisputable consequence of the `demonetization' of
gold was that, in a few short years, the U.S. has turned itself from the world's
greatest creditor into the world's greatest debtor nation. The United States was forced
to borrow enormous sums abroad at exorbitant rates of interest. The gross
mismanagement of credit has created enormous problems for which there are no
painless solutions.

The dual nature of money

The evolution of a dual monetary standard involving both silver and gold was no
accident. In every treatise on money, in one form or another the proposition is
advanced that money (whatever else it may be) is a transmitter of value through space
and time. Thus the concept of money is directly linked to these two absolute
categories of human thought. The space/time dichotomy explains the dualistic nature
of money -- explicitly observable throughout the ages, right up to the demise of

In its first capacity money must be able to transfer value through space, over great
distances, with the smallest possible loss. In antiquity, cattle were especially suitable
for this purpose, and became money. In its second capacity money must be able to
transfer value through time with the smallest possible loss. Cattle-money was
scarcely suitable for this second task.

This explains the emergence of another kind of money, suitable for hoarding and
dishoarding with the greatest ease, in order to facilitate the transfer of value over time.
Originally this other kind of money was salt. Not only was it less perishable than
other marketable goods, but salt was also the most important agent of food
preservation. As the threat of periodic food shortages loomed large in antiquity, the
agent of food preservation was destined to have a monetary role.

To people of the antique world it appeared natural that two vastly different
commodities answered their money-needs, and they took the coexistence of
cattle-money and salt-money for granted. Our linguistic heritage clearly reflects this
fact. The English adjective pecuniary and noun salary were derived from the Latin
words pecus (cattle) and sal (salt). Even though gold and silver which later
replaced cattle and salt were far more similar to one another, the dual nature of
money persisted throughout the ages.

Only towards the end of the 19th century did advances in metallurgy make it
possible that one monetary metal, gold, could answer both money-needs of man
better than any other commodity. This was the development that made it possible to
produce or recover gold in molar quantities economically. The practical outcome was
the recognition that the best monetary system was gold monometallism.

As Bruno Moll put it in his book La Moneda, "gold is that form of possession
which is of the highest elevation above time and space". The dualism of monetary
systems is the central theme of this essay, as we explore the two sources of man's
need for money. The first, man's need to transfer value over space, was used by Carl
Menger to build his theory of value on it. The second, man's need to transfer value
over time (or as we shall more specifically describe it, man's need to convert income
into wealth and wealth into income) is used here to build a new theory of interest on

The Janus-face of marketability

In developing his theory of value, Menger described the origin of money in terms of
the evolution marketability. But as the ancient Italian god Janus (in whose honor the
first month of the year is named) marketability has two faces. The first is
marketability in the small -- or hoardability. The second is marketability in the large
-- or salability. The latter is synonymous with Menger's term Absatzfähigkeit, the
cornerstone of his theory of value. Hoardability has not been independently analyzed
before. In isolating this concept I propose to lay a new cornerstone for the theory of

A commodity is more marketable in the large (or more salable) than another if
the bid/asked spread increases more slowly for the former than for the latter, as each
is brought to the market in ever larger quantities. For example, perishable or seasonal
goods show the lowest, durable goods or goods for all seasons show the highest
degree of salability. It is easy to see how cattle became the most salable commodity
in antiquity. People had superb confidence that there could never develop a situation
in which there was a disturbing surplus of cattle.

Long before anything like that could happen, owners would drive their herds to
regions where there was a shortage of cattle. The cost of transporting the unit of
value represented by cattle over great distances was lower than that of transporting
the same value represented by anything else, due to the self-mobility of cattle. This
fact, too, is preserved in our linguistic heritage. A herd is also known as a drove of
cattle, and a herdsman as a drover (both are derived from the verb to drive). Thus
mobility or, better still, portability is an important aspect of salability. The more
portable a commodity is, the more easily it can seek out havens where it is in greater

The term salability refers to the quality of a good which allows very large quantities
of it to be sold during the shortest period of time with minimal losses -- which
explains how the term earns its name. Among the most salable goods we find the
precious stones and metals. A long historical process promoted gold to become the
most salable of all goods. For gold, the spread between the asked and bid prices is
virtually independent of the quantity for which it is quoted. It only depends on the
cost of shipping gold to the nearest gold center. Under the gold standard the spread
is constant, and is equal to the difference between the gold points. By contrast, for all
other goods, different spreads are quoted for different quantities, and the larger the
quantity, the wider the spread.

Thus the gold standard is seen as the product of a market process in search for the
most salable commodity. Some authors deliberately confuse the issue insisting that
the constant spread of gold is due to institutional factors, i.e., the statutory
requirement that the central bank should stand ready to buy at the lower, and to sell at
the upper gold point unlimited quantities of gold. Once again, this is a confusion of
cause and effect. In reality, institutional constraints would sooner or later break
down, and the commodity with less than perfect salability would be demonetized by
the market, if the authorities tried to promote it to be the monetary standard -- as
indeed happened to silver in the 19th century, to copper in medieval times, and to iron
in antiquity.

It is common knowledge that, although they have a high degree of marketability in
the large, precious stones have poor marketability in the small. The process of cutting
up a large stone into a number of smaller pieces often results in a permanent loss of
value. (This is just another illustration of the paradox that the value of a parcel is not
necessarily the same as the sum total of the values forming part of that parcel.) Even
for precious metals whose subdivision into smaller parts is fully reversible,
marketability in the small cannot be taken for granted. A penetrating example due to
a 19th century traveller is cited by Menger in the Grundsätze:

When a person goes to the market in Burma, he must take along a piece of silver, a
hammer, a chisel, a balance, and the necessary weights. `How much are those pots?'
he asks. `Show me your money', answers the merchant and after inspecting it, he
quotes a price at this or that weight. The buyer then asks the merchant for a small
anvil and belabors his piece of silver with his hammer until he thinks he has found
the correct weight. Then he weighs it on his own balance, since that of the merchant
is not to be trusted, and adds or takes away silver until the weight is right. Of course,
a good deal of silver is lost in the process as chips fall to the ground. Therefore the
buyer prefers not to buy the exact quantity he desires, but one equivalent to the piece
of silver he has just broken off. (Principles of Economics, op. cit., p281.)

A commodity is more marketable in the small (or more hoardable) than another if
the bid/asked spread increases more slowly for the former than for the latter, as each
is brought to the market in ever smaller quantity. The term `hoardability' refers to the
quality of goods which allows large stores to be built up piecemeal through hoarding,
or to be drawn down through dishoarding, with minimal exchange losses. It is this
property that matters most when individuals are trying to convert income into wealth,
or wealth into income. They succeed best if they employ the most hoardable

It is easy to see how salt became the most hoardable commodity in antiquity. People
were confident that exorbitant surpluses of hoardable foodstuff would never develop.
Everybody who could afford it would hoard it. People would recall the Biblical
teaching that the seven fat years would always be followed by seven lean ones.

For the stronger reason, people were supremely confident that their hoards of salt --
this foremost agent of food preservation -- would not lose its value, whatever the
fortune may hold in store. In antiquity it was not possible to transfer value over time
with smaller losses than those involved in hoarding salt.

Other examples of commodities that have been highly hoardable at one time or
another throughout history are: grains, tobacco, sugar, spirits. It is interesting to note
that there has been heavy government involvement in the production and trade of all
these. Thus we see that an historical process, similar to the one making gold most
salable, has promoted silver to become most hoardable. Gold was the money used
for paying princely ransoms and for buying territories (such as Louisiana and
Alaska), and silver was the money used by people of small means for accumulating
capital (Maundy money).

Why bimetallism failed

As long as the necessary technology was lacking, gold could not challenge silver's
position as the most hoardable commodity. The cost of producing or recovering a
small fraction of the unit of value represented by gold could involve expensive molar
processes. The recovery of the same small fraction of the unit of value represented
by silver incurred no such extra cost as the amounts involved were not molar, thanks
to the lower specific value of silver. However, by the second half of the 19th century,
with the progress of metallurgy, the cost of molar processes was lowered and
commercial dealings in gold on the molar scale became economically feasible.
Thereafter gold could effectively challenge and ultimately displace silver as the most
hoardable commodity. The demonetization of silver by the market was a logical

To see clearly why it was gold, and not silver, that was destined to win the race for
hegemony we have to consider the specific values of the monetary metals, and their
relation to the spreads between the export/import points. Gold has a high and silver a
low specific value, implying that the unit of value as represented by gold is lighter
than the same as represented by silver (in fact, 15 times lighter if we assume that the
gold/silver bimetallic ratio is 15).

We have seen that the gold export (import) point is the melted value of the standard
coin above (below) which it becomes profitable to export (import) gold. The meaning
of the silver export (import) point is analogous. Clearly, the spread between the gold
export/import points depends on the cost of shipping the unit of value as represented
by gold to the nearest gold center abroad. The same is true, mutatis mutandis, for
the spread between the silver export/import points. But shipping costs depend on the
weight of the shipment. As the weight of the unit of value as represented by gold is
relatively small, the spread between the gold export/import points will be relatively
small. (It was approximately 1 percent of value between New York and London in
the heyday of bimetallism, while the spread between the silver export/import points
was 15 percent of value.)

For example, assume that the statutory gold price is $20 per Troy ounce, and the
upper and lower gold points are at $20.20 and $19.80, respectively. Assuming
further that the official bimetallic ratio is 15, the statutory silver price will be
approximately $1.33 per Troy ounce (20 divided by 15). Let us calculate the gold
and silver export/import spreads. The cost of shipping the unit of value, $1, as
represented by gold is 1 cent (because the cost of shipping 1 ounce of gold is $20 --
$19.80 = twenty cents; this we have to divide by 20 as the standard gold dollar
weighs 1/20 of one ounce).

The melted value of the standard gold dollar may therefore fluctuate between 99
cents and $1.01 before it will induce a corrective movement of gold. The gold
export/import spread is 2 cents. But the same unit of value, $1, as represented by
silver, is 15 times heavier, so the cost of its shipping will be 15 cents, or 15 times the
cost of shipping the standard gold dollar. The melted value of the standard silver
dollar may therefore fluctuate between 85 cents and $1.15 before it will induce a
corrective movement of silver. It follows that the silver export/import spread is 30
cents, or 15 times wider than the gold spread. We see that under bimetallism the
export/import spread for the monetary metal of the higher specific value is narrower
by a factor equal to the bimetallic ratio.

It is certainly true that under a monometallic monetary regime most large transactions
will not involve shipment of the metal as long as the price of gold stays within the
range between the gold points. Clearing is effected through the exchange of
warehouse receipts. However, the case under bimetallism is different. Here the
arbitrageur profits by actually shipping the undervalued metal out of, and the
overvalued metal into, the country maintaining a rigid bimetallic ratio.

What this shows is that silver is inferior to gold as a standard of value. Those who
park their wealth in silver stand to lose 15 times more than those who use gold for
that purpose, due to variations in the market ratio between the silver and gold prices.
The upshot is that people will gradually move out of silver and into gold. In due
course the market will demonetize the metal with the lower specific value, in this case,
silver. Gold monometallism was no accident: it was brought about by inexorable
market forces. For the first time ever in human history one commodity, gold, became
the undisputed monetary metal, combining the characteristics of the most salable and
the most hoardable assets.

Mene Tekel

But the distinctive property of gold, that it is the only remaining monetary metal
around in the closing decade of the 20th century, should not blot out entirely the
dualistic nature of money. In fact, it is monetary dualism that provides the only
rational explanation for the occasional breakdown of the monetary system. During
periods of great monetary disturbance, such as a hyperinflation, the distinction
between the two kinds of marketability is most dramatically revived by the market.

For shorter or longer periods, the government may succeed in forcing the circulation
of irredeemable bank notes, which may retain the characteristics of the most salable
asset. Yet, at the same time, the government is patently unable to make these credit
instruments the most hoardable asset. Although the fast-depreciating bank note is
still usable in transmitting value through space, it suffers from a fatal paralysis when
trying to transmit value through time. It is inevitable that, ultimately, gold should
assert its position as the most hoardable asset. Nor is there anything governments
can do to save their irredeemable paper from monetary destruction. Even if they
succeed in banning the ownership of and trading in gold, a number of other
commodities stand ready to step into the golden slippers to assume the role of the
most hoardable asset.

The most conspicuous defect of the quantity theory of money is its utter failure in
explaining the hyperinflationary episodes of history. Over-issue of the fiat currency
certainly cannot be the cause of the malady. It has been convincingly demonstrated
that (especially in the final phases) there was always a desperate shortage of the
doomed currency. Hyperinflation has nothing to do with quantity it has everything to
do with quality of money. The true cause of hyperinflation is the inexorable human
need for a most hoardable asset. It is the relentless search for a reliable transmitter
of value through time. Those who believe that the millennium of irredeemable
currency has arrived must believe that governments have found a way to change
human nature by legislative fiat.

Under the regime of irredeemable currency hyperinflation is inevitable -- unless gold
is once more allowed to play its historical role that has been taken away from it
through government coercion: the role of the most hoardable asset. The full
implications of the inevitability of a breakdown in the regime of irredeemable
currency are not yet clear to most people. Purveyors of goods and services are still
willing to give up real value in exchange for irredeemable promises. This ignorance
may, of course, help postpone the moment of truth. In the meantime, Lincoln's
dictum should be remembered, according to which it may be possible to fool some
people all the time, even to fool all the people some of the time; but it is not possible
to fool all the people all of the time.

Certain monetary economists can see the writing on the wall mene tekel: your days
are numbered -- you have been weighed in the balance and found wanting (Daniel
v:26-28) announcing the verdict on the regime of irredeemable currencies. They
propose a solution that would `tie' the value of the currency to that of a basket of
commodities. Some go as far as suggesting that -- horrible dictu -- even gold may
be put into the basket. There is nothing new in these proposals. F.A. Hayek
suggested it in 1943 in a paper entitled Commodity Reserve Currency. It is
extremely doubtful that Hayek's scheme would work.

Let us disregard the utter naivete of the scheme in ignoring the cost of warehousing
perishable goods, and ignoring the problem of quality-control. Let us consider the
scheme in its simplest form known as symmetalism (originally proposed by the
British economist Alfred Marshall a hundred years ago, but never tried in practice)
whose unit of value is a basket consisting of a fixed amount of gold and a fixed
amount of silver. Unlike bimetallism, this arrangement would let the prices of the
monetary metals vary.

We now show that symmetalism, no less than bimetallism (which Milton Friedman
called preferable to gold monometallism in his book Money Mischief) would be
shipwrecked on the rock of gold's constant marginal utility. The market would stamp
out symmetalism even faster than bimetallism, precisely because of the price
flexibility the former affords. The gold/silver ratio would widen further for reasons
already discussed. The profit opportunities offered by symmetalism would result in a
relentless arbitrage out of silver and into gold. The arbitrageur would redeem his
currency in gold and silver; then he would sell the silver and keep the gold. When the
anticipated rise in the price of gold materialized, he would buy back his silver for
less, and unwind his arbitrage by surrendering the same amount of gold and silver in
exchange for symmetallic currency, showing a net profit in gold.

Let us note in passing that the scheme concocted at Maastricht (introducing yet
another irredeemable monetary unit, the Euro, defined as a basket of irredeemable
currencies) is doomed for the same reason. The currency that depreciates at the
lowest rate, in this case the German mark, far from imparting strength to other
currencies in the basket, would make them even weaker. Arbitrage would act as a
centrifuge, separating the components of the basket, throwing away the soft and
keeping only the hardest of hard currencies. (If marks, liras, etc. were no longer
available for trading, then the object of arbitrage would be the central bank assets that
had been used to balance liabilities in marks, liras, etc.) The authors of the Maastricht
scheme turned the ancient wisdom -- that no chain can be stronger than its weakest
link -- upside down. They have invented a chain that is as strong as its strongest

2. Towards a New Theory of Interest

The nature of interest is one of the great problems of humankind, as old as money
itself. It has engaged the greatest minds, from Aristotle through the church fathers to
Menger. The lack of a satisfactory solution to the problem has rocked empires,
contributing to their destruction. This author hopes that his essay can make a modest
contribution to the ultimate disposal of this great and vexed problem.

Part of the difficulty is in the way the question has traditionally been presented,
namely: what happens when a man with a need to borrow meets another with
money to lend? It has always been in this context that usury was condemned by
both criminal and canon law. It has not occurred to the philosophers and moralists --
or, for that matter, to most economists -- that the nature of interest could be better
grasped if the question was reformulated thus: what happens when a man with
income to spare but who is in need of wealth meets another with wealth to spare
but who is in need of an income?

The resulting exchanges provide a passage from direct to indirect conversion of
wealth and income. Indirect conversion represents a great improvement in efficiency
over direct conversion, interest being the manifestation of the market value of this
improvement. Thus the proper setting for the study of interest is the indirect
conversion of income into wealth (just as the proper setting for the study of price is
the indirect exchange of goods). It now appears that condemnation of usury is akin
to condemning a man for charging or paying the going price for bread.

Traditionally, interest is conceived as a steady income in perpetuity which is
exchanged for the unit of wealth. It can be measured as a percentage of the unit of
wealth accruing as income to its owner after the exchange. If the unit of wealth is one
gold dollar, and it is exchanged for an income in perpetuity amounting to one gold
cent per quarter, then the rate of interest is four percent per annum. Of course, an
income in perpetuity is an abstraction, but it has great theoretical importance as the
standard measuring interest. The mathematician has shown us exact formulas
expressing the rate of interest involved in exchanges of wealth for income for a set
period of time, as well as formulas expressing the rate of interest involved in
exchanging present for future wealth, in terms of this standard -- making arbitrage
between various credit markets possible.

I shall not pause here to give an iron-clad definition between "wealth" and "income'.
Suffice it to say that an inexorable need exists, second only to the need for food and
shelter, urging man to convert income into wealth in order that later, when past his
prime, he may convert his wealth back into income. As the comedy of King Midas
and the tragedy of King Lear show, a most important difference exits between
controlling wealth and controlling income, and the possibility of converting one into
the other must not be taken for granted. Income is an ultimate end for man, insofar as
without it he may have no other ultimate ends on earth. (If denied an income he, as
King Midas, is in danger of starving to death.) Since wealth is an indispensable
means to that end in the twilight years of his life, man's need for a reliable conversion
mechanism is beyond doubt. (Without such he may, as King Lear, end up losing
both his wealth and income.)

The theory of private property ought to take full account of the fact that conversion
of income into wealth is the rational and characteristically human manifestation of the
law of the biosphere whereby all living things can only survive and prosper by
hoarding their substance. In the case of man this substance, as we have seen, is the
most marketable commodity, gold, which is always in demand, whether it is offered
in the largest or in the smallest practically realizable quantity -- since it can always be
traded with the smallest possible exchange losses.

The chimaera of hoarding

Here we come to a paradox which utilitarian philosophy has failed to solve. An
apparent contradiction exists between the needs of the individual and his society.
There is a time in the life of every man when he wishes to draw on his savings
accumulated earlier. Yet hoarding and dishoarding are widely considered as
anti-social. They are unsettling as the former affects demand and the latter affects
supply unfavorably, possibly at a time that is inopportune from the point of view of
society. The utilitarian philosophers could not clarify how the market provides for
the conflicting demands of society and its ageing members. Utilitarian philosophy
has failed to solve the problem of hoarding and dishoarding.

In particular, it has failed to explode the arguments of Silvio Gesell, John Maynard
Keynes and other inflationists, according to which the contractionist and deflationary
pressures inherent in a metallic monetary system are the source of poverty and
chronic economic distress, as they invite hoarding. At the same time these authors
described the promised land of the inflationist paradise in glowing terms. There, the
miracle of "turning the stone into bread" would be routinely performed by monetary
technicians in the service of the government for the benefit of the people. In what
follows I refute the inflationist argument in the spirit of utilitarian philosophy, hoping
to remove an obstacle which has blocked the advancement of monetary science for a
hundred years.

The invention of double-entry book-keeping in Italy of the Trecento was a
momentous landmark in economic history. Göthe called it "one of the finest
inventions of the human mind" (Wilhelm Meister's Apprenticeship). Double-entry
book-keeping is of utmost economic importance, second only to the appearance of
indirect exchange much earlier that had made direct exchange of goods obsolete. The
new invention made the indirect accumulation of capital via the instrument of contract
possible, thus making the direct accumulation of capital via hoarding obsolete.
Previously, there was only one way for people to convert income into wealth or
wealth into income outside of family bonds: hoarding and dishoarding. (For much of
the Orient, which was slower in developing the institutional framework to protect
contractual rights, it is still the only way.)

This immobilized large amounts of gold, and made capital accumulation an arduous
and protracted process in which reward was far removed from effort, dampening
incentive. The invention of double-entry book-keeping made possible a heretofore
unprecedented increase in the efficiency of gold as the catalyst of capital
accumulation. Gold's physical presence was no longer necessary in every
conversion. From then on gold could act by proxy, as its role in the conversion has
become residual.

Thanks to this breakthrough, partnerships could now be formed representing an
exchange of income (of the junior partner) for wealth (of the senior partner). Later,
with the gradual acceptance of `sleeping' partners in the firm, it became possible to
buy and sell shares in the enterprise as if they were fixed-income securities. Indeed,
this they were in all but name, in order to avoid censure by canonical and secular
authorities under the usury laws. It is clear that without double-entry book-keeping,
balance sheets and income statements, trade in shares would not have been possible,
nor could a departing partner have been bought out. There would have been no
precise and objective way of attaching value to the assets and liabilities of the firm
short of liquidation.

The new development released huge amounts of gold from private hoards as people
began to accumulate and carry wealth in the form of securities disguised as
partnership equity. (By contrast, in the Orient, where the social and institutional
arrangements were far more inimical to the individual and his freedom to choose, the
demand for gold and silver for hoarding purposes continued unabated.) During the
Quattrocento gold disgorged by the Occident flowed to the Orient to finance the
trade in exotic goods. Myrrh, spices, silk and satin enjoyed exceptionally high
marketability in the Occident where all the great banking houses engaged in
financing this lucrative trade. The world was treated to the curious spectacle that the
Occident was thriving while losing gold to the Orient, because it had learned how to
get by with less. It had learned to exchange wealth and income.

This shows that gold is merely the whipping boy at the hand of the inflationists.
Gold is not scarce (in fact, as measured by the stocks-to-flows ratio mentioned
above, the monetary metal is more abundant than any other economic good) but it
quickly goes into hiding at the moment inflationists gain the upper hand. There is no
contradiction between the interests of society and its ageing members. Very little if
any gold is needed to complete all the exchanges of income and wealth in the course
of normal business, provided that the free choice of individuals is allowed to prevail.
Only when government interference is feared or expected does the demand for gold
become disturbing. The correct policy is `hands off' -- let the market decide what is
best for its participants.

Squaring the diagonal

The next advance came with the Reformation, during which the canonical and secular
strictures on interest were eased, the definition of usury narrowed and, later, the
prohibition against both repealed. Whereas the partnership contract had originally
been designed with the concealment of interest in mind, then it became possible, for
the first time in history, to openly engage in the exchange of income and wealth, with
the payment of interest freely admitted, and the rate of interest explicitly quoted. The
bond market was born as a result of these historical changes. The right to income
reserved by the bondholder could now enjoy the same legal protection as the right to
rent-charges enjoyed during the prohibition era. Thus, it remained for the
Reformation to crown the great economic advances of the Renaissance, to free the
exchange of income and wealth from its former fetters. For the first time in history,
the rate of interest could manifest itself as a market phenomenon.

The analysis of the formation of interest rates is usually given in terms of a diagonal
model featuring just two participants in the market: the supplier and the user of
`loanable funds'. This model is woefully inadequate, as it blots out the time element
and the crucial process of capital formation, it ignores the principle of capitalizing
income, and it confuses saving and investment. The present analysis will replace the
diagonal model first with a square, then a pentagonal and, finally, with a hexagonal
model, in order to gain a more penetrating insight into the process of capital
formation. First we take a look at the square model which has the merit of identifying
the supply of and demand for wealth and income.

In considering the problem of converting income into wealth and wealth into income,
we may isolate two fundamental needs: (1) the annuitand's need to convert income
into future wealth; and (2) the annuitant's need to convert wealth into income.
Typically, the annuitand is a young man who is looking forward to getting married.
He tries to provide for the future needs of his family: for the education of his
children, and for his and his wife's old age. By contrast, the annuitant is a man in his
harvest years, looking forward to his twilight years with equanimity.

He has by now accumulated the wealth which he is ready to convert into a suitable
income. If the annuitand (or the annuitant) is restricted to direct conversion, due to
institutional restraints on the exchange of income for wealth (or wealth for income)
then the optimum conversion is provided by gold hoarding (dishoarding). By
definition of marketability in the small, no further improvement in efficiency is
possible. However, if the institutional constraints on exchange are removed, then a
whole new game comes into play and, indeed, further improvements become
possible, for the benefit of all participants.

On the one hand, the annuitant's need is answered directly by the entrepreneur who
is anxious to give up income in exchange for present wealth. The latter could
profitably invest the former's wealth in his business which would then generate a
greater income that he could afford to share. On the other hand, the annuitand's need
is answered directly by the inventor ready to give up future wealth in exchange for
an income. The latter is working on a new production process that may take several
years to perfect before it can be put into place. In the meantime he has to maintain
himself and has to defray the cost of his research and development (R&D).

The new tool or process the inventor is perfecting represents future wealth which he
is willing to share with his partner, the annuitand, who puts the necessary income at
his disposal in the interim. Both the entrepreneur and the inventor are engaged in the
business of capital formation; the difference is seen in the method of amortization.
The capital formed by the entrepreneur is scheduled to begin its amortization cycle
immediately. There is a more-or-less prolonged waiting period before the capital
formed by the inventor can start its amortization cycle.

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