Theory of Interest and Prices in Paper Currency Part I (Linearity)

Gold Standard Institute's picture

by Keith Weiner,
President of the Gold Standard Institute, USA


Under gold in a free market, the theory of the formation of the rate of interest is straightforward.[1] The rate varies in the narrow range between the floor at the marginal time preference, and the ceiling at the marginal productivity. There is no positive feedback loop that causes it to skyrocket (as it did up until 1981) and subsequently to spiral into the black hole of zero (as it is doing now). It is stable.

In irredeemable paper currency, it is much more complicated. In this first part of a multipart paper presenting my theory, we consider and discuss some of the key concepts and ideas that are prerequisite to building a theory of interest and prices. We begin by looking at the quantity theory of money. In our dissection, we will identify some key concepts that should be part of any economist’s toolbox.

This theory proposes a causal relationship between the quantity of money and consumer prices. It seems intuitive that if the quantity of money[2] is doubled, then prices will double. I do not think it is hyperbole to say that this premise is one of the cornerstones of the Monetarist School of economics. It is also widely accepted among many who identify themselves as adherents of the Austrian School and who write in critique of the Fed and other central banks today.

The methodology is invalid, the theory is untrue, and what it has predicted has not come to pass. I am offering not an apology for the present regime—which is collapsing under the weight of its debts—but the preamble to the introduction of a new theory.

Economists, investors, traders, and speculators want to understand the course of our monetary disease. As we shall discuss below, the quantity of money in the system is rising, but consumer prices are not rising proportionally. Central bankers assert this as proof that their quackery is actually wise currency management.

Everyone else observing the Fed knows that there is something wrong. However, they often misplace their focus on consumer prices. Or, they obsess about the price of gold, which they insist should be rising in lockstep with the money supply. The fact that the price of gold hasn’t risen in two years must be prima facie proof that there is a conspiracy to suppress it. Gold would have risen, except it’s “manipulated”. I have written many articles to debunk various aspects of the manipulation theory.[3]

The simple linear theory fails to explain what has already occurred, much less predict what will happen next. Faced with the fact that some prices are rising slowly and others have fallen or remained flat, proponents insist, “Well, prices will explode soon.”

Will the price of broccoli rise by the same amount as the price of a building in Manhattan (and the same as a modest home in rural Michigan)? We shall see. In the meantime, let’s look a little closer at the assumptions underlying this model.

Professor Antal Fekete has written that the Quantity Theory of Money (QTM) is false, on grounds that it is a linear theory and also a scalar theory looking only at one variable (i.e. quantity) while ignoring others (e.g. the rate of interest and the rate of change in the rate of interest).[4]  I have also written about other variables (e.g. the change in the burden of a dollar of debt).[5]

It is worth noting that money does not go out of existence when one person pays another.  The recipient of money in one trade could use it to pay someone else in another.  Proponents of the linear QTM would have to explain why prices would rise only if the money supply increases.  This is not a trivial question. Prices rise whenever a buyer takes the offer, so no particular quantity of money is necessary for a given price (or all prices) to rise to any particular level.

In any market, buyers and sellers meet, and the end result is the formation of the bid price and ask price. To a casual observer, it looks like a single “price” has been set for every good. It is important to make the distinction between bid and ask, because different forces operate on each.

These processes and forces are nonlinear. They are also not static, not scalar, not stateless, and not contiguous.


First let’s consider linearity with the simple proposal to increase the tax rate by 2%. It is convenient to think it will increase government tax revenues by 2%. Art Laffer made famous a curve[6] that debunked this assumption. He showed that the maximum tax take is somewhere between 0 and 100% tax rate. The relationship between tax rate and tax take is not linear.

Another presumed linear relationship is between the value of a unit of currency and the quantity of the currency outstanding.  If this were truly linear, then the US dollar would have to be by far the least valuable currency, as it has by far the greatest quantity. Yet the dollar is one of the most valuable currencies.

“M0” money supply has roughly tripled from 2007, “M1” has roughly doubled, and even “M2” has risen by 50%.[7] We don’t want to join the debate about how to measure the money supply, nor do we want to weigh in on how to measure consumer prices. We simply need to acknowledge that by no measure have prices tripled, doubled, or even increased by 50%.[8] It’s worth noting an anomaly: on the Shadowstats inflation[9] chart, the inflation numbers drop to the negative precisely where M0 and M1 rise quite sharply.

Consider another example, the stock price of Bear Stearns. On March 10, 2008 it was $70. Six days later, it was $2 (it had been $170 a year prior). As Bear collapsed, market participants went through a non-linear (and discontiguous) transition from valuing Bear as a going concern to the realization that it was bankrupt.


Some people today argue that if the government changed the tax code back to what it was in the 1950’s then the economy would grow as it did in the. This belief flies in the face of changes that have occurred in the economy in the last 60 years. We are now in the early stages of a massive Bust, following decades of false Boom. Another difference was that they still had an extinguisher of debt in the monetary system back then. I wrote a paper comparing the tax rate during the false Boom the Bust that follows[10]. The economy is not static.

By definition and by nature, when a system is in motion then different results will come from the same input at different times. For example, if a car is on the highway at cruising speed and the driver steps on the accelerator pedal, engine power will increase. The result will be acceleration. Later, if the car is parked with no fuel in the tank, stepping on the pedal will not cause any increase in power. Opening the throttle position does something important when the engine is turning at 3000 RPM, and does nothing when the engine is stopped.

Above, we use the word dynamic as an adjective. There is also a separate but related meaning as a noun. A dynamic is a system that is not only changing, but in a process whereby change drives more change. Think of the internal combustion engine from the car, above. The crankshaft is turning, which forces a piston upwards, which compresses the fuel and air in the cylinder, which detonates at the top, forcing the piston downwards again. The self-perpetuating motion of the engine is a dynamic. This is a very important prerequisite concept for the theory of interest and prices that we are developing.


It is seductive to believe that a single variable, for example “money supply”, can be used to predict the “general price level”. However, it should be obvious that there are many variables that affect pricing, for example, increasing productive efficiency. Think about the capital, labor, time, and waste saved by the use of computers. Is there any price anywhere in the world that has not been reduced as a consequence? The force acting on a price is not a scalar; there are multiple forces.

It should be easy to list some of the factors that go into the price of a commodity such as copper: labor, oil, truck parts, interest, the price of mineral rights, government fees, smelting, and of course mining technology. One or more of these variables could be moving in the opposite direction of the others, and as a group they could be moving in the opposite direction as the money supply.

Perhaps even more importantly, the bid on copper is made by the marginal copper consumer (the one who is most price-sensitive). At the risk of getting ahead of the discussion slightly, I would like to emphasize that today the price of copper is set by the marginal bid more than by the marginal ask. The price of copper has, in fact, been in a falling trend for two years.


Modeling the economy would be much easier if people would respond to the same changes the same way each time—if they didn’t have memories, balance sheets, or any other device that changes state as a result of activity. Even Keynesians admit the existence of human memory (ironically, they call this “animal spirits”[11]), which makes someone more cautious to walk into a pit a second time after he has already learned a lesson from breaking his leg. People are not stateless.

Stateless, and its antonym stateful, is a term from computer software development. It is much simpler to write and understand code that produces its output exclusively from its inputs. When there is storage of the current state of the system, and this state is used to calculate the next state, then the system becomes incalculably more complex.

In the economy, a business that carries no debt will respond to a change in the rate of interest differently from one that is struggling to pay interest every month. A company which does not have cash flow problems but which has liabilities greater than its assets would react differently still.

An individual who has borrowed money to buy a house and then lost the house to foreclosure will look at house price combined with the rate of interest quite differently than one who has never had financial problems.

It is important not to ignore the balance sheet or human memory (especially recent memory) when predicting an outcome.


Markets (and policy outcomes) would be far more predictable, and monetary experiments far less dangerous, if all variables in the economy moved according to a smooth curve.

A run on the bank, as is occurring right now in Cyprus (in slow motion due to capital controls), is a perfect example of a discontiguous phenomenon. One day, people believe the banks are fine. The next day there may not be a measurable change in the quantity of anything, and yet people panic and try to withdraw their money. If the bank is insolvent, they cannot withdraw their money, it was already lost.

A common theme in my economic theories is asymmetry. In the case of a run on the bank, there is no penalty for being a year early, but one takes total losses if one is an hour late. This adds desperate urgency to runs on the bank, and desperate urgency is one simple cause of an abrupt and large change, i.e. discontiguity.

Ernest Hemingway famously quipped that he went bankrupt, “Two ways. Gradually, then suddenly.”[12] It’s not a smooth process.

There are many other examples, for instance a scientific breakthrough may enable a whole new industry because it reduces the cost of something by 1000 times. This new industry in turn enables other new activities and highly unpredictable outcomes occur. As an example, the invention of the transistor eventually led to the Internet. The Internet makes it possible for advocates of the gold standard to organize and coordinate their action into a worldwide movement that demands honest money. The gold standard in this example would be a discontiguous effect caused by the invention of the transistor.

My goal in Part I was to introduce these five key concepts. While not writing directly against the Quantity Theory of Money, I believe that a full grasp of these concepts and related ideas would be sufficient to debunk it.


In Part II, we will discuss the dynamic process whereby the rate of interest puts pressure on prices and vice versa. I promise it will be a non-linear, multivariate, stateful, dynamic, and discontiguous theory.


[2] We do not distinguish herein between money (i.e. gold) and credit (i.e. paper)

[3] Full disclosure: when I am not working for Gold Standard Institute, I am the CEO of Monetary Metals, which publishes a weekly picture and analysis of the gold basis. One can see through the conspiracy theories using the basis:

[9] I don’t define inflation as rising prices, but as an expansion of counterfeit credit: Inflation: an Expansion of Counterfeit Credit

[12] The Sun Also Rises by Ernest Hemingway, 1926

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USGrant's picture

The quantity theory of money is not invalid. It is complicated by the simultaneous creation of a "good" i.e. treasury debt that is bought by the newly created money and so is metabolized slower than a direct injection into the veins of the economy. This is not a new understanding. This was discovered during the Civil War. The theory of gravity is not invalid because the snapping of the stem of the apple inparts forces not directed straight down and for every tested apple fall, simple theory is not matched exactly.

JOYFUL's picture

Keith's latest is most certainly his greatest...not daunted by skeptical questioning of his sanity...our man his bounced back with a blockbuster performance...

if life were so simple as being able to merely dismiss neo-classical doctrines and the Keynesian klaptrap together in one fell swoop...and move into a kind of melded Austrian-Objectivism Ascendancy, having swept all opposition from the field!

Fortunately, there are plenty of other shoals for the SS MonetaryMetals to ground itself that, instead of our usual probity and common sense being bombarded by another broadside of Admiral Wieners' Battleship, we can calmly consider his dilemma from a safe distance.

  • In the economy, a business that carries no debt will respond to a change in the rate of interest differently from one that is struggling to pay interest every month. A company which does not have cash flow problems but which has liabilities greater than its assets would react differently still.
  • An individual who has borrowed money to buy a house and then lost the house to foreclosure will look at house price combined with the rate of interest quite differently than one who has never had financial problems.
  • It is important not to ignore the balance sheet or human memory (especially recent memory) when predicting an outcome.

A doggerel of hyperventilatin verbiage....followed by this deflationary(of patience!) definition of the obvious. Thanks for the insights. Now I will obediently sign on to receive the follow up to this formula in PT 2....where have I seen this kind of unbeatable pitch before????

In the future sir...may I recommend that, as a student of Fekete...who mistaken as he may be about many factors in our current conundrum about the gold market and various other economic indicators...has a way of bringing to life on the page the essence of what needs be considered about inflation\interest\integrated manipulations of money supply -you simply bring a series of quotes of the Prof and like-minded persons to the page...for our consideration...example follows

  • I maintain that the Federal Reserve banks are not creating money out of the thin air. In fact, they must first post collateral with the Federal Reserve Agent (who is not under the jurisdiction of the Fed but under that of the government). Only after the collateral has been posted can they create a commensurate amount of Federal Reserve notes and deposits. Typically, the collateral is U.S. Treasury bills, notes, or bonds, purchased in the open market on behalf of the Fed’s Open Market Committee.
  • On the contrary, it could be an unprecedented deflation with the Federal Reserve notes being hoarded by the people, firms, and institutions as their purchasing power is actually increasing (in fact, they are already being hoarded by foreigners in the second and third world countries in unprecedented amounts). The dollar will not be the first among irredeemable currencies to be annihilated in this latest hecatomb of currencies. It will be last one.
  • The financial and economic collapse of the past two years must be seen as part of the progressive disintegration of Western civilization that started with the sabotaging of the gold standard by governments exactly one hundred years ago when in France and in Germany paper money was made legal tender. The measure was introduced in preparation to the coming war, so that the government could stop paying the military and the civil service in gold coins, starting in 1909. \The Revisionist Theory and History of Depressions, see:

and dispense with the weird and wonderful wienerisms which appear in your mind to stand in for the scholarly summations of your superiors. Then we might be able to have a logical debate about the wisdom of the usury\interest banking system; instead of a regurgitation of it's basic misunderstandings.

postscript...not a bad idea, quoting Hemingway...but take note that for the most part, his best work was already behind him before the war; to study it, and see what is needed to make a statement such as what you clearly aspire to, would be most apropos!

The ground rose, wooded and sandy, to overlook the meadow, the stretch of river and the swamp. Nick dropped his pack and rod case and looked for a level piece of ground. He was very hungry and he wanted to make his camp before he cooked. Between two jack pines, the ground was quite level. He took the ax out of the pack and chopped out two projecting roots. That leveled a piece of ground large enough to sleep on. He smoothed out the sandy soil with his hand and pulled all the sweet fern bushes by their roots. His hands smelled good from the sweet fern. He smoothed the uprooted earth. He did not want anything making lumps under the blankets. When he had the ground smooth, he spread his blankets. One he folded double, next to the ground. The other two he spread on top...Big Two-Hearted River  -EH 

That writing to which both you and I could spend a lifetime trying to get close to!

Yours in solidarity etc; etc;



MrBoompi's picture

Say you double the amount of money in a game of monopoly. If that money stays in the bank, prices will not double. But if you double all the money each player holds, plus the money in the bank, prices would double. The quantity theory of money as it pertains to price inflation is valid only if it is allowed to influence demand in a particular market. Also, if the bank is allowed to participate, or the rules of the game are changed, this will also affect prices. But the quantity theory of money is still valid.

Hayek FA's picture

Monopoly is a socialist game, Hasbro elicits price controls on each property and utility.

The price of Building is even controlled. No amount of extra money will result in higher prices.

Monopoly is the gateway drug to communism 

MrBoompi's picture

Yes, there are price controls in the game, but negotiating for property directly with other players is also a part of the game.  So is luck.  In our crony capitalist system, there isn't much luck involved in economic outcomes.  The reference to monopoly is only an analogy.  And in real life there are more variables than most of us could ever imagine.

Citxmech's picture

I like the Monopoly analogy.  Whats interesting is that cash horded by banks eventually becomes like huge stock holdings where selling (or spending/lending) at too great a rate decreases the value one's holdings.  Of course you maximum benefit for what you buy first. . .  No wonder there's no pysical left!

This article was interesting and a great set-up, but kindof a cock-tease.  Can't wait to read part II.

Boris Alatovkrap's picture

"too great a rate"

Rate is always divide by time. Time is always enemy of bankster. Bankster is like three fishing buddy gather around hole in ice (Boris is like ice fishing, once catch large sturgeon so big cannot extract from hole, but is long story). Bankster is to make bet on thermal endurance of appendage and all is remove footwear and immerse leg in water. First to pull leg is lose! So, winner is not by absolute time, but relative time and is smart pull leg one second after other two. This is story of JPM v Knickerbocker, no? First to flinch is to lose!

(Boris is once make ice hole bet and drink entire vodka flask for body warming. Pass out and win, but is now lose two toe from frost bite.)

tarsubil's picture

Could someone just follow the money with what the Fed prints in QE? Where does it go? Where does it enter the general economy? Does it leak out or is it sealed off completely?

cynicalskeptic's picture

SO far the money created appears to be 'contained' and limited to the banks, financial markets and financial instruments.  Hence you have a rising stock market as banks invest excess funds in equities.  


Pointedly, these funds are NOT being invested in 'Main Street' in the form of loans to small businesses, wages paid to workers, loans for houses and such. People are so loaded with debt that they individually are reluctant to add to that debt by spending unnecessarily.  The few that can afford to spend are doing so cautiously. So the vastly increased amount of money is not really fully 'in circulation' and its velocity is low.   

If confidence in the money supply begins to falter and people believe that there is substantial risk to holding money in savings or the financial markets or in financial instruments, THEN you have a problem.  For now financial institutions seem to believe that government will keep the free money supply flowing - meaning there is little or no risk to them.  They are playing at the casino with other people's money doing the government's biddin gin propping up those markets to provide the illusion of a recovery.  But those funds do NOT 'trickle down' to Main Street in any meaningful amount.  INdeed that money is helping finance overseas operations and pushing up commodity prices - increasing foreign inflation.  So far, individuals, pissed though they may be at the minimal interest earned by their savings, still believe their money is worth more in the dollar than elsewhere (not that ther eare too many choices and not that government makes it east to move savings into non $US accounts).

I suspect people are realizing that they are getting screwed but have yet to take any real action in response. Their options are limited and MOPE seeks to make sure they see the world through an even more limited window.  The US has not seen anything like Argentinian or Brazilian inflation nor has the US seen real efforts to limit capital access or appropriate savings (yet).  But Ibelieve that if you DO see forced conversion of 401Ks to government bonds for 'safety' (in a desperate ploy to keep the Ponzi scheme going) or 'bail-ins' at any major banks, you will see a massive exodus of private funds from the financial system.  People will seek to preserve their wealth through PM purchases or buying anything of tangible value.  Velocity of money will shoot through the roof is this happens - and with that velocity, inflation.    Givne that the $US is likel to be the lsat major western currency to fail, and thereis a lack of sufficiently large 'safe havens' (Swiss Franc, Norwegian Krona, etc) you won't be seeing a situation where the US is grabbing citizens' 'dollar denominated' accounts to increase foreign echange supplies (as in other countries in the past).   There may be a move to grab metals but given that the super wealthy seem to have substantial funds invested there I suspect that will not happen.  Bad form to screw the little guys who prepared while ignoring the billionaires.

We've managed to 'kick the can' down the road for faerther and longer than I ever thought possible.  Never underestimate the power of unlimited funds I guess........  but China and others ARE getting fed up with financiing the US.  They ARE moving out of the $US.  At some point the $US will not be able to buy foreign oil, materials and goods - and the US military will NOT be enough to force the world to do so.  THAT will be 'end-game'.   When it happens and how long it will take.....?       I doubt anyone knows but it won't be pretty.  You may have a continued unrelenting decline in the general standard of living until government can't pay the food stamps, unemployment and welfare for all that need it (Great Britain on steroids fast forwarded) or a crisis driven blow up that gets really messy ('US Spring' - with unemployed and hungry rioting in the streets).  Neither will be good.

Boris Alatovkrap's picture

Boris is have theory. Call "Tinkle Down Economics".

Slut girl is drink wine all night long. Drink, drink, drink. Eventually bladder is constrain and must evacuate. Smallest startle is result in unwanted moisture and ruin party dress.

Fuh Querada's picture

Shit. More "models" and "theories" accompanying intense intellectual masturbation. Just tell me how to make BIG MONEY with the Gold Standard Institute.

Atticus Finch's picture

There is no such word as multivariate. Words develop from the input of thousands of people over multiple years. You can't just make up words. The word Variables accomplishes the same meaning. Stateful might be some skewed use of the meaning "current status" or the "current system" or "baseline system", but stateful? Really?

Fuh Querada's picture

Multivariate has a meaning in certain statistical techniques. God help us when economists get their sticky fingers onto such terms.

tradewithdave's picture

On a long enough Weinerpost the survival rate for ZeroHedge drops to Zero. 

Boris Alatovkrap's picture

Article is mention "if bank is insolvent", but is not fractional reserve banking always insolvent by definition? If lend more than deposit, insolvent is!

Boris Alatovkrap's picture

Boris is curious - is any bank exist of 1:1 Capital Backing? Central Bank cabal is selective for TBTF membership, but outside bank is must run transaction through TBTF, no? This is why Jimmy Stewart sad to commit suicidal end, no?

Boris Alatovkrap's picture

Print more money, prices eventually is doubles.

Key word is "eventually", because if money printing banker class is confident, money is float for long time in bank-o-sphere where bankster is make bet against each other. But when one bankster is utter fail and crash, others is to lose confidence and all money printed is now to seek after hard asset (commodities). Then real goods is more expensive because material to make is more expensive.

This is cause of inflation, no? So Monetary Theory is correct! It just is take time.

But what is Boris know...!?

Boris Alatovkrap's picture

Is not reasonable to shirk inflationary effect of money printing just because scientific advancement to make cheap consumer good. Scientific advancement is happen anyway, no?

tarsubil's picture

Yes, Boris. You are one sharp cookie. I'd rather you had written this article. This article is overly wordy and pointless. The main points could be summed up in about three or four sentences.

It is difficult to measure the money supply and the monetary base does not have a linear relationship with price.

There are always deflationary forces that vary.

People remember the past and that affects their future behavior (although not as much as you'd think since I know people in their 50s who have been scorched twice by stocks and their retirement has stocks today).

Going on about the chain of events that push a car down the road is stupid.

Boris Alatovkrap's picture

However, Boris is intrigue by point in article of "stateful" vs "stateless" and culminating complexity in state transition. Market is long term not have memory, but "rooster is come home to roost" in all case.

Also, must to distinguish "market memory" and "participant memory". Individual is remember bank fail and is lose money, but market is forget after short news cycle. Who here is remember "Long Term Capital Management"? Boris is remember collapse of ruble because must move to apartment for share with cousin, but market is move on - state of system is change or resume and smart investor is ignore past and focus with laser on today and tomorrow.