Who the Heck Consumes His Capital?!

by | Aug 25, 2015

To make people eat their seed corn, we need to add the essential element: a perverse incentive. Let’s look at monetary policy in this light.

I have been writing about consumption of capital, using the example of a farmer who sells off his farm to buy groceries. It’s a striking story, because people don’t normally act like this. Of course, there are self-destructive people in every society, but, not many. Most people know not to spend themselves into poverty.

To make people hurt themselves, we need to add the essential element: a perverse incentive. Consider a parlor game called Shubik’s Dollar Auction. You auction off a dollar bill, but there’s one extra rule. The second highest bidder has to pay his bid, getting nothing in return. This game works best with a large crowd, so that several people bid before they think too much about it. Then the participants become ensnared. There is always an incentive to raise the bid by a penny. Would you rather pay $1.01 to buy a dollar, or lose $1.00 and get nothing? The same incentive works at $2.01, $3.01, and so on. There is no limit to how high the bidding will go, until someone gives up in disgust (and anger at whoever ran the game).

This game can make people overpay to win a dollar. How perverse is that?

It’s easy to see through this simple game, and many people will refuse to play. There’s only one way to push everyone into such a scheme: force. Let’s look at monetary policy in this light. When the Federal Reserve dictates interest near zero, everyone has to play under that rule. It causes some perverse outcomes.

Those with access to the Fed’s dirt-cheap credit can borrow to buy bonds, mortgages, or other assets. The result is rising assets and falling yields. With every increase in bond prices, there is falling yield purchasing power. This makes it impossible to live on the interest, forcing retirees to liquidate capital to buy groceries.

Let’s consider this from a different angle. Suppose you own a home. If you mortgage it, does that make you richer? Would you spend the borrowed funds like you would spend income? Of course not. What if someone else borrows money to buy the house from you, at a higher price than you originally paid? “Aha,” you say, “that’s different!”

Is it? At first, it may look like a capital gain. However, your gain is possible only because the next guy borrows more. Why is he doing that? With a lower interest rate, the same monthly payment covers a larger loan.

Suppose the rate keeps falling. One person after another buys the house, handing a profit to each seller. Each seller is given the incentive to spend some of his gain. However, nothing has been produced though this entire series of transactions. If nothing is produced, then what are these successive sellers consuming? They consume something that was previously produced. It’s otherwise known as capital.

This is a perverse incentive in action. Outside Shubik’s game, a dollar does not sell for $5. Outside central banking, capital is not destroyed en masse. While any fool can dissipate his inheritance and any farmer can sell his farm to fund his drug habit, farms are not destroyed. They are transferred intact, to more rational neighbors. Once back in responsible hands, they quickly return to productive use. A free market has no mechanism to cause all capital to be destroyed simultaneously.

The Fed does. We should call its game Shubik’s Wealth Effect.

 

This article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog SNBCHF.com.

Keither Weiner is the founder of the Gold Standard Institute USA in Phoenix, Arizona, and CEO of precious metals fund manager Monetary Metals. He created DiamondWare, a technology company which he sold to Nortel Networks in 2008. He writes about money, credit and gold. Visit his site at monetary-metals.com

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

4 Comments

  1. Now I understand your last column. Lol.

  2. A free mkt. has no way to destroy capitol, but lots of ways to produce wealth, some of the wealth being consumed (we all need our next meal.), with the rest saved or invested (all of it, ultimately, invested, productively).

    Mr. Weiner, your key word is: force. Low interest rates, accorded by ‘gvt.’, meaning by force, meaning by crooks under cover of the guise of gvt. by law, funds consumption and defunds production. Such funding of consumption is funding of crime and the defunding of the law abiding. Of necessity, this, in principle, stops production and renders inevitable the consumption of all wealth (saving and investments) because all people, even the richest, need their next meal.

    Is there ANY circumstance under which we must LET crooks take over gvt. by law, render it a criminal organization outside law, and make animals out of the rest of us? Mike Kevitt

  3. “But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.”

  4. So the answer to my question is, No. And CROOKS ARE rendering gvt. by law a criminal organization outside law, and making animals out of the rest of us. We must decide what to do about it, and how, while it can be done peacefully. The crooks are still amenable to being marginalized peacefully, but that must be done as soon as possible, before they get to the point where they’re not amenable. They’ll get there if they’re not stopped. Mike Kevitt

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