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Copyright ©2005 by A. E. Fekete

Where Mises Went Wrong

Antal E. Fekete
Sep 16, 2005

Ludwig von Mises erred when he dismissed what is known as the Fullarton Effect. In 1844 John Fullarton of the Banking School described how low interest rates were resisted by savers in selling their gold bonds and hoarding gold instead. Mises ridiculed the idea, calling gold hoards a deus ex machina in Human Action (3rd revised edition, p 440). My theory of interest corrects this mistake in giving due recognition to the Fullarton Effect. I can well understand the frustrations of Robert Blumen, Sean Corrigan, and other detractors of mine reluctant to read the voluminous outpourings of this "inflationist monetary crank". Rather than finding a weak point in my argument they call me names, stonewall Adam Smith, conjure up the bogyman of John Law, set up straw men only to knock them down again, and quarrel bitterly with my ad hoc examples while ignoring my comprehensive theory of interest. For the benefit of discriminating students of Carl Menger and Eugene Böhm-Bawerk I restate this novel theory in a concise form.

The rate of interest is a market phenomenon. It is defined as the rate at which the coupons of the gold bond amortize its price as quoted in the secondary bond market. The mathematician has shown us formulas expressing the rate of interest in terms of the price of the gold bond. They confirm that the two are inversely related: the higher the bond price, the lower is the rate of interest and vice versa. As a consequence, the lower bid price of the gold bond corresponds to the ceiling and the higher asked price to the floor of the range to which the rate of interest is confined. The question is what economic factors determine these constraints and how.

The floor is determined by the time preference of the marginal bondholder. If the rate of interest falls below it, then he takes profit in selling the overpriced gold bond and will keep the proceeds in gold coin. When the rate of interest bounces in response to bondholder resistance, he will buy back the gold bond at a lower price. The gold hoards are no deus ex machina: they are the very tool of human action in setting a limit to falling interest rates.

The ceiling is determined by the marginal productivity of capital, that is, the rate of productivity of the capital of the marginal producer. If the rate of interest rises above it, then he sells his plant and equipment and invests the proceeds in the underpriced gold bond. When the rate of interest falls back in response to producer resistance, he will sell the gold bond at a profit and use the proceeds to deploy his capital in production once more.

There is no valid reason to denigrate the productivity theory of interest following Mises. The theory of time preference and the productivity theory are not mutually exclusive. On the contrary, they are complementary. The fratricidal wars between the two schools have been in vain: they did not serve the advancement of science. They merely contributed to its retardation. Only a synthesis of the two theories can adequately explain the formation of the rate of interest.

I submit that my theory of interest brings about such a synthesis. It is in the spirit of Menger and is in harmony with the insights of Böhm-Bawerk. It represents a breakthrough that provides solid foundation for further development of the theory. In Mises, time preference is no more than a pious wish. It is the gold hoards that lend teeth to those wishes. Nothing else can. Mises was not alive to the arbitrage of the marginal bondholder between bonds and gold, the most potent form of arbitrage between present and future goods. Likewise, Mises failed to explain how changes in the rate of interest guide production, to wit, through arbitrage of the marginal producer between bonds and capital goods.

Mises also criticized the Banking School on the subject of reflux (op.cit., p 444). He charged that banks regularly short-circuit reflux by putting retired bank notes back into circulation: "The regular course of affairs is that the bank replaces bills expired and paid by discounting new bills of exchange. Then to the amount of bank notes withdrawn from the market through the repayment of the earlier loan there corresponds an amount of newly issued bank notes." This ignores the fact that the credit to which each and every non-fraudulent bill gives rise is self-liquidating. Moreover, if the Reichsbank of Germany, for example, had discounted new bills on the same old merchandise, then it would have violated the law. At any rate, the argument of the Banking School refers to the transparent case of bill circulation. Slow or fraudulent bills can take no refuge in the portfolio of conspiring banks. The bill market is fully capable of ferreting out delinquent bills and will refuse to discount them.

The nexus between drawer and drawee of the bill of exchange is not the same as that between lender and borrower. The drawer is no lender, discounting is no lending, and the discount rate is not the same as the rate of interest. The drawee is the active protagonist in the drama of supplying the consumer with urgently needed goods; the drawer is passive. It is the drawee who promptly reacts to changes in the height of the discount rate. These changes are governed by the consumers. The discount rate is not regulated by the savers, still less is it set by the banks. The drawee, typically a retail merchant, has the unconditional privilege of prepaying his bills. The discount serves as an incentive. If demand is brisk, it will take a lower discount rate to induce him to prepay; if sluggish, a higher one. Moreover, in the latter case, the marginal retail merchant will not re-order his usual quota of consumer goods from his suppliers. Instead, he will carry part of his circulating capital in the form of bills drawn on more productive merchants until demand picks up again. Evidently Mises misconstrued the problem of discounting. Insisting that retail inventory was financed through loans at the bank, Mises failed to notice that the marginal retail merchant was doing arbitrage between bills and consumer goods. He would thin out merchandise on his shelves while beefing up his portfolio of bills in response to the consumer's reining back spending, while he would sell bills from his portfolio and use the proceeds to replace the missing merchandise on his shelves upon renewed interest of the consumer in buying. Wrongly, Mises blotted out the important distinction between the discount rate and the rate of interest which are governed by entirely different economic factors and move quite independently of one another.

Not until these three most important forms of human action, the arbitrage of the marginal bondholder, the arbitrage of the marginal producer, and the arbitrage of the marginal retail merchant are more widely recognized can further significant progress in the theory of interest be made.


Robert Blumen, Real Bills, Phony Wealth, , July 2005.
Sean Corrigan, Unreal Bills Doctrine, August 8, 2005.
Sean Corrigan, Fool's Gold,, August 9, 2005.
Sean Corrigan, Fool's Gold Redux,, August 12, 2005.
Sean Corrigan, Clearing the Air,, September 8, 2005.
Antal E. Fekete, Gold and Interest, , January, 2003.
Antal E. Fekete, Towards a Dynamic Microeconomics, Laissez-Faire, Revista de la Facultad de Ciencias Económicas, Universidad Francisco Marroquín, No. 5, Sept. 1996.

Note re this piece.

Sep 9, 2005
Antal E. Fekete
Professor Emeritus
Memorial University of Newfoundland

GSULProfessor Antal E. Fekete was born and educated in Hungary. He immigrated to Canada in 1956. In addition to teaching in Canada, he worked in the Washington DC office of Congressman W. E. Dannemeyer for five years on monetary and fiscal reform till 1990. He taught as visiting professor of economics at the Francisco Marroquin University in Guatemala City in 1996. Since 2001 he has been consulting professor at Sapientia University, Cluj-Napoca, Romania. In 1996 Professor Fekete won the first prize in the International Currency Essay contest sponsored by Bank Lips Ltd. of Switzerland. He also runs the Gold Standard University.

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