The Real Bills Doctrine
The Real Bills Doctrine is best known as "the decried doctrine of the old Bank Directors of 1810: 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.'" (Fullarton, 1845) The Real Bills Doctrine is opposed to the Quantity Theory of money. Traces of the real bills doctrine can be found in the writings of John Law (1705), Simon Clement (1710), Adam Smith (1776), Charles Bosanquet (1810), Thomas Tooke (1845) and many others. It was at the heart of the Bullionist debates of 1810, the Banking School/Currency School debates of the 1840s, the Greenback debates of the 1870s, etc. It was a guiding principle for the establishment of the Federal Reserve in 1913, and throughout its history it has been controversial. Since 1945, it has been regarded as "thoroughly discredited" (Mishkin, 2000) among mainstream economists.
Issuing money "in the discount of good bills" is a strange concept to the modern reader. The banker's T-account below will clarify the concept.
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 hair-splitting question of whether a bill is “real” or “short-term” would be irrelevant to the banker, and with good reason. The banker only cares that his 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. In fact, 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.
The key question is this: 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? The answer is the same as it always was: one paper dollar is worth one ounce of silver. It is obvious that if the bank had issued only $100 against 100 ounces of silver, then each dollar would be worth 1 ounce. It is also obvious that 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.
Two kinds of convertibility must be distinguished:
A unit of paper or credit money (a “dollar”) can be returned to the issuing bank in exchange for a physical amount of gold, silver, or some other commodity.
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 Christmas shopping season has ended. If the dollar is physically convertible (for one ounce of silver, let us suppose), 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 soak up the unwanted paper 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. In fact, this is essentially what all modern central banks do, and the fact that their currencies might be physically inconvertible 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. Thus, 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. The annual cost of issuing a dollar must also be considered. These costs would include the cost of printing, periodic redemption, protection against counterfeiting, etc. (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.) When the annual cost of issuing a dollar is C oz./year, a dollar that promises 1 ounce of silver in 1 year will be worth 1/(1+R-C) today and will grow to 1 oz. after 1 year. 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. Note also that if convertibility is suspended in the middle of the year, the dollar will remain worth 1 oz., in anticipation of convertibility being restored at year-end. This is why suspension of convertibility seldom affects the value of money, and it has contributed to the illusion that currencies were never backed to begin with. The truth is that the value of money is determined by its backing, whether or not the money is convertible.
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
(a) 100+500E=600E, or E=1 oz./$.
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 $200. The above equation would then become
(b) 100+400E=600E, or E=0.5 oz./$
The loss of assets has caused the value of the dollar to fall to half its original value. 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.
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, he 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.
The real bills doctrine was discredited largely because of the writings of
Henry Thornton (1801), David Ricardo (1810) and Lloyd Mints (1945). Each of
these writers claimed that the real bills doctrine placed no effective limit on
the amount of money that banks might create. While Mints, for example, was
willing to admit that money issued in exchange for a given physical amount of
assets will not cause inflation, he claimed that money that is 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. Mints,
Thomas Cunningham in 1992 did an empirical survey which concluded: "The results provide clear evidence supporting the Real Bills doctrine, that the value of assets backing money determines its value, over the Quantity Theory."