Real bills doctrine

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In monetary economics the real bills doctrine refers to various theories in support of generally unrestricted issuing of 'real bills'. 'Real bills' represent transactions of real goods and services in the economy, or ones soon to be realised. They can be invoices for raw or wholesale goods to be paid to a supplier within a certain time window, i.e. commercial paper. Thus, they allow a manufacturer or retailer time to receive income from the goods without the need for upfront payment (or the need to borrow from a bank). 'Real bills' can also refer to short term bills of exchange, bankers' acceptances, or other short term promissory notes. If the 'real bills' are sold on to a third party it is usually at a discount.[1][2][3]

The theory states that this unrestricted issuing of 'real bills' will not cause excessive inflation from undue increase in the money supply, and that it will not cause bank failure from illiquidity. It is part of debate on whether banks should be involved in controlling the money supply.[4]

Opponents of the theory include supporters of quantity theory of money. The quantity theory states that the money supply has a direct, positive relationship with the price level and therefore the quantity should be stabilized. The British Banking School who were also weary of excessive increases in money supply. It is also criticised by free bankers who believe the even doctrine is not necessary, that competitive forces would best stabilised the money supply.[4][3]

History[edit]

Context[edit]

Before the eighteenth century the system of central banks had not been normalised. Additionally, before the early nineteenth century in many countries before banks could issue their own banknotes. For example, in England and Wales it was not until the Bank Charter Act 1844 that banknote issue was restricted solely to Bank of England. Therefore, the distinction between central and commercial banks and the papers they issued was less defined.

Early commercial banks focused on short term loans. They would purchase 'real bills' (commercial paper etc.) at a discount. As by the doctrine, they believed this activity was without risk of over-extending themselves (bank failure) or causing inflation in the economy.[2]

1700s[edit]

According to Thomas Humphrey the origins of the doctrine can be traced back to John Law's 1705 tract Money and Trade Considered. Law proposed banknote issue be secured by a fixed ratio to the market value of land. This was similar to the doctrine in that it tied issue to a productive asset. It differed in that Law proposed land as the asset, not short term transactions.[5]:5[6]:6 Elements of the real bills doctrine can be found in the 1710 writings of Simon Clement.[citation needed]

In 1776, Adam Smith noted that the supply of banknotes varied 'optimally' when a bank "... discounts to a merchant a real bill of exchange drawn by a real creditor upon a real debtor, and which, as soon as it becomes due, is really paid by that debtor." Thus, Smith had formulated a recognisable form of the doctrine. He also noted the importance that the currency must be convertible for the doctrine to hold true.[7]:288[5]:8

1800s[edit]

In the nineteenth century, Charles Bosanquet (1810), Thomas Tooke (1845) and many others wrote about the doctrine.[citation needed]

In the early nineteenth century it was an underlying issue in the bullionism debates. Antibullionists argued that the real bill doctrine held regardless of the convertibility of the currency.[5]:8

In the 1840s it was part of the British Banking School versus Currency School debate.[citation needed]

The British writer John Fullarton mentioned the doctrine in his 1845 book On the regulation of currencies. He referred to it as the 'doctrine of the old Bank Directors of 1810' and noted it was out of favour in parliament, 'And, much as I fear I am disgracing myself by the avowal, I have no hesitation in professing my own adhesion to the decried doctrine of the old Bank Directors of 1810, "that so long as a bank issues its notes only on the discount of good bills, at not more than sixty days’ date, it cannot go wrong in issuing as many as the public will receive from."'[8]:207

The doctrine formed part of the Greenback debate of the 1870s.[citation needed]

The real bills doctrine was largely discredited by the end of the nineteenth century.[2] Largely because of the writings of Henry Thornton (1801) and David Ricardo (1810).[citation needed] These writers claimed that the real bills doctrine placed no effective limit on the amount of money that banks might create.[citation needed]

1900 - 1944 US Federal Reserve and Great Depression[edit]

The real bills doctrine was a cornerstone of the US Federal Reserve Act of 1913 – which established the Federal Reserve System with the power to discount high-quality self-liquidating bankers' acceptance. The real bills doctrine had been worked into the bill by Henry Parker Willis who was heavily influenced by his mentor James Laurence Laughlin.[9]

It did not become a major policy tool of the Federal Reserve until after Benjamin Strong, governor of the New York Federal Reserve Bank died in October 1928.[citation needed]

Although not the only doctrinal determinant in the early Federal Reserve history, the real bills doctrine found a ready reception within the Federal Reserve System. Members of the Federal Reserve Board such as Adolph Miller and Reserve Bank governors like George Norris and James McDougal initially advanced a relatively pure and unvarnished version of the doctrine. They proposed that the real bills doctrine could be implemented through the central bank's discount window and outright purchases in the open market. The adherents to the real bills doctrine became increasingly influential iduring the 1920s and especially after the death of Benjamin Strong in 1928.[10]

There is a discussion about how influential the real bills doctrine was in causing the Great Depression. Allan H. Meltzer has argued that the false ideology of the real bills doctrine lead to policy errors of the Fed that caused the Great Depression.[11] Others, however, have argued that favoring real bills is not the real bills “doctrine,” and monetary policy did not suggest that the Fed believed it. If it had, there would have been no role for interest rates.[12]

1945 - 1981 mainstream disapproval[edit]

Lloyd Mints was perhaps the originator of the term real-bills doctrine, he used the hyphen in mentioning the term in his Preface to A History of Banking Theory in 1945.[13] He disapproved of the doctrine for similar reasons as Thornton and Ricardo. Mints was willing to admit that money issued in exchange for a given physical amount of assets will not cause inflation; he claimed that money issued for a given money's worth of assets presents the possibility that the new money will cause inflation, thus diminishing the real value of each borrower's debt, and allowing them to borrow still more. The result would be a self-perpetuating cycle of more loans, more money, and more inflation.[citation needed] Mints argued against the doctrine as he thought strict control of the money supply was necessary to stabilise prices. He went as far as supporting full-reserve banking.[14]

According to Frederic Mishkin the real bill doctrine has been regarded as 'thoroughly discredited' by most economists.[15]

1982 - present - a slight revival[edit]

In 1982, Thomas Sargent and Neil Wallace published a notable paper called The Real Bills Doctrine Vs. The Quantity Theory: A Reconsideration. Their paper considered government regulation, central bank open-market operations and discount window, and the definition of money. They asserted that private banks or central banks should not be regulated in issuing 'real bills' or their discounting. They claim the doctrine promotes market forces and competitive banking to prevent excess credit creation.[16]

In 1983, Murray Rothbard noted, Fullarton's support of the doctorine. Fullarton being a supporter of the British Banking School. This could potentially lend weight to Rothbard's support of free banking as both movements reject additional regulation for banks over any over enterprise.[17]:289

In 1984, David Laidler criticised Sargent and Wallace 1982 paper, saying the interpretation of Smith was very loose and the model they used incomplete.[18]

In his 1992 paper, Some Real Evidence on the Real Bills Doctrine versus the Quantity Theory, Thomas Cunningham carried out statistical analysis of Taiwanese economy between 1970 and 1987. He claimed his results showed that a rapid increase in the money, back with assets, did not lead to an inflationary problems. Cunningham concluded that this supports the real bills doctrine and weakens the quantity theory of money.[19]

Maturity mismatching[edit]

Maturity mismatching occurs when, for example, a bank's liabilities come due in 30 days, but the bank's assets will not mature for 1 year. Bank notes and deposit moneys commonly have 30-day suspension clauses, allowing the bank to delay payment for 30 days. A bank that issues its money in exchange for short-term assets that are payable in 30 days will thus match the maturities of its notes (30 days) to those of its assets, and it will avoid illiquidity and possible insolvency.[citation needed][clarification needed]

Speculative bubbles[edit]

It can be inadvisable for banks to lend money to clients engaged in excessively risky speculative bubbles. By issuing its money only in exchange for real bills (bills issued by real businesses engaged in real productive activity), a banker assures that it is lending money to solid, reputable businesses rather than to speculators with inadequate capital. Furthermore, banks that issue money only in exchange for real bills will avoid unwanted reflux of banknotes. In the 18th and 19th centuries, a common complaint of note-issuing bankers was that they would issue bank notes on Monday, only to have the same notes return to the bank on Tuesday. By issuing notes only to firms engaged in productive activity, a bank would automatically match its money-issuance to the needs of business by issuing more money during busy times and retiring money during slack times.[citation needed]

Inflation[edit]

A bank can avoid inflation of its money by always keeping enough assets to back the money it has issued. Thus, a bank that issues $100 must get at least $100 worth of assets in exchange. Failure to get at least $100 worth of assets would leave the bank insolvent and would cause inflation of the bank's money from inadequate backing.[citation needed][clarification needed]

Example[edit]

Define the exchange rate E as the value of the dollar, measured in silver (oz./$). Since assets (100 oz. + IOU's worth 500E oz./$) must equal liabilities ($600 worth E oz./$), it must be true that

100+500E=600E, or E=1 oz./$.

(Here it is assumed that the IOUs are promises to deliver dollars, if necessary by the sale of specified assets, rather than promises to deliver the assets themselves.) If the bank loses some of its assets, then inflation will result. For example, the gambler might default on his loan, and his IOU might therefore fall in value from $300 to $0. The above equation would then become

100+200E=600E, or E=0.25 oz./$

The loss of assets has caused the value of the dollar to fall to one quarter of its original value. (If the bank had more non-dollar assets to call on, such as a claim on the gambler's house, the drop would be less.) Note that the real bills doctrine attributes inflation to inadequate backing, while the quantity theory of money, in contrast, claims that inflation results when the quantity of money outruns the economy's aggregate output of goods.

Example[edit]

The banker's T-account below will clarify the meaning of issuing money "in the discount of good bills".

Bank T-account
Assets Liabilities
100 oz. silver deposited 100 paper dollars
Farmer's IOU worth $200 200 paper dollars lent
Gambler's IOU worth $300 300 paper dollars lent

In line 1, the banker receives 100 ounces of silver on deposit, and issues 100 paper receipts ("dollars") in exchange. Each paper dollar is convertible at the bank into 1 ounce of silver. At this point each paper dollar will be worth 1 ounce of silver in the open market. Note that it is immaterial whether the dollars are issued as printed pieces of paper or as bookkeeping entries transferable by check or other means.

In line (2) we suppose that a farmer requests a loan of 200 paper dollars from the bank. Assuming the farmer offers adequate collateral and pays an adequate interest rate, any profit-seeking banker would agree to print 200 additional paper dollars and lend them to the farmer. The farmer, for his part, might write an IOU to the banker, promising to pay $220 after 1 year. At a 10% interest rate, this IOU or "bill" will be discounted to $200. That is, the banker will pay $200 in paper today for the farmer's $220, 1-year IOU.

Can we say that the 200 paper dollars were issued "in the discount of good bills"? That depends. If the farmer offered only his future production of corn as collateral for the loan, then the farmer's IOU satisfies the traditional idea of a real (i.e., good) bill: "Borrowers and banks agree that these forthcoming productions serve as collateral for the dollar value of the loans." (Timberlake, (b) 2005, p. 3.) But if the farmer offered his farm itself as collateral, then there would be no direct promise of "forthcoming production" and the farmer's IOU would not qualify as a real bill. Furthermore, the farmer's IOU does not meet the condition of being due "at not more than sixty days' date".

The question of whether a bill is "real" or "short-term" would be irrelevant to the banker. The banker is concerned whether the loan will be repaid with interest, and the banker would view the farm as being at least as good collateral as the farmer's future production. The banker might reasonably prefer to lend $300 newly printed dollars to a gambler on his way to a casino (line (3)), as long as the gambler offers his house as collateral, and as long as the house is worth at least $300. In this case there is hardly any chance that the newly printed $300 will result in any forthcoming productions at all, but that is irrelevant to the banker who has received adequate collateral for his loan.

After the bank has completed all the transactions shown in Table 1, having issued a total of $500 newly printed dollars on loan, thus multiplying the original $100 six times, what is the value of a paper dollar? One paper dollar is still worth one ounce of silver. If the bank had issued only $100 against 100 ounces of silver, then each dollar would be worth 1 ounce. If the bank issued the additional $500 without taking any additional assets in return, then the public would hold $600 against only 100 ounces of silver in the bank, and each dollar would be worth only 1/6 ounce of silver. But the banker did receive one dollar's worth of assets for every dollar issued, and each dollar is adequately backed.

Convertibility[edit]

Two kinds of convertibility can be distinguished:

Physical convertibility
A unit of paper or credit money (a "dollar") can be presented to the issuing bank in exchange for a physical amount of gold, silver, or some other commodity.
Financial convertibility
A dollar can be returned to the issuing bank in exchange for a dollar's worth of the bank's assets.

The importance of financial convertibility can be seen by imagining that people in a community one day find themselves with more paper currency than they wish to hold – for example, when the holiday shopping season has ended. If the dollar is physically convertible (ex. for one ounce of silver), people will return the unwanted dollars to the bank in exchange for silver, but the bank could head off this demand for silver by selling some of its own bonds to the public in exchange for its own paper dollars. For example, if the community has $100 of unwanted paper money, and if people intend to redeem the unwanted $100 for silver at the bank, the bank could simply sell $100 worth of bonds or other assets in exchange for $100 of its own paper dollars. This will remove the unwanted paper from circulation and head off peoples' desire to redeem the $100 for silver.

By conducting this type of open market operation – selling bonds when there is excess currency and buying bonds when there is too little – the bank can maintain the value of the dollar at one ounce of silver without ever redeeming any paper dollars for silver. This is currently a process all modern central banks conduct. The lack of physical convertibility of their currencies is made irrelevant by the maintenance of financial convertibility. Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued. The real bills doctrine asserts that it is an illusion that any physically inconvertible currency is necessarily also unbacked.

A related question concerns the timing of convertibility. A dollar that is instantly convertible into one ounce of silver will be worth one ounce on the market. If convertibility is delayed by 1 year, then for some interest rate R, the dollar will be worth 1/(1+R) ounces today, and will grow to 1 ounce next year. When the annual cost of issuing a dollar (cost of printing, periodic redemption, protection against counterfeiting, etc.) is C/year, a dollar that promises 1 ounce of silver in 1 year will be worth 1/(1+R-C) today and grow to 1 oz. after 1 year. (Note-issuing bankers in the nineteenth century generally claimed that these costs made it unprofitable for them to issue paper dollars, and the dollars were issued more as a form of advertising.) If C=R, so that the cost of issue exactly equals the rate of interest, then the dollar will start the year worth 1 ounce and end the year worth 1 ounce. This makes it seem as if the dollar bears no interest, but in truth the interest on the dollar was offset by the cost of issue.

Bank runs[edit]

Suppose that the gambler's IOU falls in value from $300 to $200, so that the market value of the dollar is now given by the equation: 100+400E=600E, or E=0.5 oz/$. If the bank tries to maintain convertibility at the original rate of E=1.0 oz/$, it will face a bank run. Customers see that a dollar will fetch only 0.5 ounces of silver on the market, and so they all rush to the bank for the chance of getting 1 ounce for that dollar. The bank, for its part, loses 0.5 ounces for every dollar redeemed at this rate, and this loss of assets causes the value of the dollar to fall still more. For example, if the bank redeems $40 for 40 ounces, then setting assets equal to liabilities yields 60+400E=560E, implying E=0.375 oz./$. If the bank pays out its last 60 ounces of silver for $60, then the equation becomes 0+400E=500E, or E=0.

At this point the bank will be out of business and the dollar will have lost all value. But the worst problem is that the real value of the community's money supply would have fallen. Originally, the total money supply consisted of $600, with an aggregate real value of 600 ounces. After the gambler's IOU fell in value, the $600 in circulation had an aggregate real value of only 300 ounces. Money would be "tight", and economic activity would be hampered. By the time the bank collapsed, the $500 still in the hands of the public would be worthless, and the only usable money left would be the 100 ounces of silver in the hands of the public. The resulting restriction of the money supply would be recessionary, since people would not have enough money to conduct their business conveniently.

Note that the bank's loss of assets leads to inflation, while the restriction of the money supply leads to recession. There are three solutions to the bank run:

  1. Suspend convertibility and issue additional money. The suspension of convertibility will halt the bank run and stop the loss of assets. This will not reverse the inflation that has occurred, but it will prevent further inflation. The remaining problem is to restore the money supply to its original level. For example, suppose as above that the gambler's IOU has fallen in value from $300 to $200, and the bank has paid out 40 ounces for $40, so that the value of the dollar stands at E=.375 oz./$. The $560 still in circulation would have an aggregate value of $560(.375 oz./$)=210 ounces.
    To return the money supply to its original aggregate real value of 600 ounces, the bank would issue 390/.375=$1040 in new money, in exchange for assets worth 390 ounces of silver. Note that the bank need not force this new money into circulation. If customers require an additional 390 ounces worth of new money in order to conduct their business, then they will voluntarily bring 390 ounces worth of assets to the bank in exchange for $1040 of new money. All that is required of the bank is to accommodate its customers' requests.
  2. Devalue and issue additional money. As before, suppose that the gambler's IOU has fallen in value from $300 to $200, and the bank has paid out 40 ounces for $40, so that the value of the dollar stands at E=.375 oz./$. If the bank devalued its money, so that a dollar would be convertible at the bank for .375 ounces, then the run would stop because a dollar would be worth the same at the bank as in the open market. As in case (1), this would only stop the run. It would not reverse the inflation or the recession. But the bank could then end the recession by issuing another $1040 in exchange for assets worth 390 ounces.
  3. Get a bailout. Given the same conditions as above, with the value of the dollar standing at E=.375 oz./$, suppose that the bank received a bailout equivalent to a gift of 100 ounces of silver. Setting assets equal to liabilities would then yield 160+400E=560E, or E=1 oz/$. The value of the dollar would have been restored to its old level, and all that would remain would be for the bank to restore the money supply to its original level by issuing another $40 in exchange for assets worth 40 ounces.

As a practical matter, bailouts have two main pitfalls:

  1. The bailout might be too small. If the bank had received a bailout of only 40 ounces, instead of the 100 ounces mentioned above, then the value of the dollar would be determined by the equation 100+400E=560E, or E=.62 oz./$. Assuming that the bank mistakenly tries to maintain convertibility at E=1 oz./$, the run will simply continue until the bank collapses in spite of the bailout.
  2. The bailout might have strings attached. For example, in return for its 100 oz. bailout, the agency granting the bailout might insist that the bank pursue tight money policies, in the hope of reducing inflation. This would prevent the bank from issuing the additional 40 ounces worth of money mentioned above, and the tight money conditions would prolong the recession.

Both of these pitfalls appear to have been at work during the Asian currency crises of the late 1990s. Bailouts seem particularly ill-advised from the standpoint of the country or agency granting the bailout. Not only are bailouts expensive, but the recipients would often do better simply by suspending convertibility or devaluing.

Use[edit]

In normal times, the banker will be able to immediately redeem up to $100 for silver at the rate of 1 oz./$. If the banker expects a heavy demand for silver, they can sell the $500 worth of IOU's for 500 oz. of silver and be ready to redeem all $600 at 1 oz/$. Even if the banker faces a run, where customers suddenly and unexpectedly demand silver for their dollars, the banker could survive the run by selling the $500 worth of IOU's for $500 of his own paper dollars, and burning the paper dollars he receives. Then there would be only $100 of paper left in the hands of the public, which the banker could redeem with his 100 oz. of silver. At no point would the value of the dollar fall below 1 oz./$, but note that the banker could not survive the run if he did not have adequate assets backing the dollars he has issued.

Now let us reexamine the traditional view of the real bills doctrine: "that so long as a bank issues its notes only in the discount of good bills, at not more than sixty days' date, it cannot go wrong in issuing as many as the public will receive from it." According to what can be called the "backing view" presented above, it is only necessary that a bank issues its notes for assets of sufficient value. It is irrelevant whether the assets are due in sixty days or sixty years. It is also irrelevant whether the assets in question are "productive" (like a farmer's IOU based on forthcoming productions) or "unproductive" (like a gambler's IOU). It is even irrelevant whether the asset is a "bill" or not. One paper dollar could just as well be issued for a dollar's worth of land as for a commercial bill worth $1.

Once the real bills doctrine is stripped of these irrelevancies, we can restate it as follows:

So long as money is only issued for assets of sufficient value, the money will maintain its value no matter how much is issued.

This statement is clearly true of the paper dollars described in table 1. It is also true of financial securities in general. For example, economists all recognize that if GM stock is currently selling for $60 per share, then GM can issue 1 new share, sell it for $60, and there will be no change in the price of GM shares, since assets will have risen exactly in step with the number of shares issued. One of the weaknesses of the quantity theory of money is that it claims that money is valued for entirely different reasons than any other financial security. One virtue of the backing version of the real bills doctrine is that there is no need for any "special" theory of money. The value of money is determined on exactly the same principles as any other financial security.


See also[edit]

Notes[edit]

  1. ^ "What is a Real Bill? - The Gold Standard Institute International".
  2. ^ a b c "Bank - Commercial banks".
  3. ^ a b "Free Banking Theory versus the Real Bills Doctrine - Alt-M". 16 September 2015.
  4. ^ a b Staff, Investopedia (15 December 2010). "Real Bills Doctrine".
  5. ^ a b c http://www.richmondfed.org/publications/research/economic_review/1982/pdf/er680501.pdf The Real Bill Doctrine, Thomas M. Humphrey, Federal Reserve Bank of Richmond Economic Review, September/October 1982
  6. ^ "Mercantilists and Classicals: Insights from Doctrinal History - Economic Quarterly, Spring 1999 - Federal Reserve Bank of Richmond". www.richmondfed.org.
  7. ^ Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations (1776). Reprinted by Random House, New York: 1937
  8. ^ Fullarton, John (27 October 2018). "On the regulation of currencies :being an examination of the principles on which it is proposed to restrict, within certain limits, the future issues on credit of the Bank of England and of the other banking establishments throughout the country". London :.
  9. ^ Mehrling, Perry. "Retrospectives: economists and the Fed: beginnings." Journal of Economic Perspectives 16.4 (2002): 207-218.
  10. ^ Eichengreen, Barry. "Doctrinal Determinants, Domestic and International, of Federal Reserve Policy 1914-1933." University of California, Berkeley (2014).
  11. ^ Meltzer, Allan H. A History of the Federal Reserve, Volume 1: 1913-1951. University of Chicago Press, 2010.
  12. ^ http://eh.net/book_reviews/a-history-of-the-federal-reserve-vol-i-1913-51/
  13. ^ Mints, Lloyd W. (1945). A History of Banking Theory in Great Britain and the United States (Fourth Impression, 1965 ed.). Chicago & London: University of Chicago Press. p. Preface.
  14. ^ Wood, Elmer (28 October 2018). "Review of A History of Banking Theory in Great Britain and the United States". The Review of Economics and Statistics. 29 (1): 54–56. doi:10.2307/1925653 – via JSTOR.
  15. ^ Mishkin, Frederic S. (1995). The Economics of Money, Banking, and Financial Markets (4th ed.). New York: Harper Collins. p. 503. ISBN 978-0673523785.
  16. ^ Sargent, Thomas J.; Wallace, Neil (27 October 1982). "The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration". Journal of Political Economy. 90 (6): 1212–1236 – via JSTOR.
  17. ^ Rothbard, Murray N. (2008). The Mystery of Banking. Alabama: Ludwig von Mises Institute. ISBN 978-1-933550-28-2.
  18. ^ Laidler, David (28 October 1984). "Misconceptions about the Real-Bills Doctrine: A Comment on Sargent and Wallace". Journal of Political Economy. 92 (1): 149–155 – via JSTOR.
  19. ^ 'Some Real Evidence on the Real Bills Doctrine versus the Quantity Theory' Cunningham, Thomas J. Economic Inquiry; Oxford Vol. 30, Iss. 2, (Apr 1, 1992)

References[edit]

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External links[edit]

Opposing theory[edit]

Supporting theory[edit]