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 money² 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.

Nonlinear

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 curve⁶ 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 inflation⁹ 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.

Dynamic

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 follows¹⁰. 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.

Multivariate

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.

Stateful

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.

Discontiguous

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.

¹ http://monetary-metals.com/in-a-gold-standard-how-are-interest-rates-set-3/

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: http://monetary-metals.com/basisletter/

⁴ http://www.safehaven.com/article/13063/a-critique-of-the-quantity-theory-of-money

⁵ http://monetary-metals.com/irredeemable-paper-money-feature-451-3/

⁶ http://en.wikipedia.org/wiki/Laffer_curve

⁷ http://www.shadowstats.com/charts/monetary-base-money-supply

⁸ http://www.shadowstats.com/alternate_data/inflation-charts

⁹ I don't define inflation as rising prices, but as an expansion of counterfeit credit: http://monetary-metals.com/inflation-an-expansion-of-counterfeit-credit/

¹⁰ http://monetary-metals.com/the-laffer-curve-and-austrian-school-economics/

¹¹11 http://en.wikipedia.org/wiki/Animal_spirits_(Keynes)

¹² The Sun Also Rises by Ernest Hemingway, 1926