Discounting Accommodation Bills
Some proponents of the real bills doctrine and many opponents of the real bills doctrine present accommodation bills as legitimate bills for discounting. Some do so out of ignorance. Others do so to disparage the real bills doctrine.
An accommodation bill is essentially a promissory note where the borrower secures accommodation from a bank on his own note, single name paper, or on an endorsed note of his customer, double name paper. Whereas real bills of exchange represent past transactions, accommodation bills represent future transactions. With a real bill of exchange, goods are in the process of being purchased or have been purchased. With an accommodation bill, the goods are not in the process of being purchased; they are to be purchased in the future.
A real bill of exchange provides for its own payment; it is self-liquidating. When the retailer sells the merchandise represented by the bill of exchange, the retailer receives the gold necessary to pay the bill. Thus, a real bill of exchange is self-liquidating.
An accommodation bill is not self-liquidating. As it represents goods not yet produced, whatever the accommodation bill represents does not provide the gold necessary to pay it.
Discounting accommodation bills leads to inflation, i.e., more bank credit money (bank notes and checkbook money) enters the community than new goods. This inflation is eventually followed by an economic contraction.
Discounting a real bill of exchange leads to a smooth operating economy. Credit money represents goods in the process of being sold, i.e., the goods represented by the bill of exchange, and provides the money to purchase the new merchandise. It also provides the funds to pay workers before the goods are sold without resorting to borrowing. As this credit money is removed when the merchandise is sold, it does not lead to inflation or economic contraction.
The following example illustrates the difference between discounting a bill of exchange and an accommodation bill. New products of a community are being produced and consumed at the rate of £100,000,000. The value of these products is represented by bank notes and checkbook money via the discounting of bills of exchange. As far as currency is concerned, business would remain in a normal healthy condition.
To this example, let’s add the assumption that banks want to maintain a 20 percent reserve in gold coins. That is, bank reserves equal £20,000,000. Furthermore, let’s assume that some smooth-talking pettifoggers convince bankers to discount their accommodation bills equal to £10,000,000. Now the community has £110,000,000 of credit money with which to buy £100,000,000 of goods. We also assume no lost in confidence.
The result is inflation and a rise in prices. As the community was producing only £100,000,000 in products, much of the new demand will be met by increasing imports to absorb the additional £10,000,000. Gold would be used to pay for the imports as the foreign sellers have no need of the community’s credit money. The remainder of new demand would cause additional unsustainable domestic production.
Having consumed the money for the accommodation bills, the drafters, the pettifoggers, would have nothing with which to pay the bills when they mature. Thus, the holders of the bank credit money created by the accommodation bills become creditors of the banks of the amount of £10,000,000 when the bills mature. Thus, the outstanding credit money would be presented to the banks for gold.
If the banks had maintained their 20 percent reserve ratio, they would have £22,000,000 in gold backing their outstanding credit money issued to buy bills of exchanges and accommodation bills. If the excess credit money created by discounting the accommodation bills were redeemed, bank reserves would fall to £12,000,000. Thus, banks have to reduce new discounting to £60,000,000 to maintain a 20-percent ratio. Instead of being able to discount £100,000,000 in bills of exchange as the community requires, they could only discount £60,000,000.
As a result of discounting accommodation bills, the quantity of credit money drops from £110,000,000 to £60,000,000. Economic stagnation quickly follows and bank runs become highly likely. As the banks lack the means, gold, to pay all their outstanding notes and checking account moneys, bankruptcy and suspension of payment results — all from discounting non-self-liquidating bills.
As the above overly simplified example shows, banks should only discount self-liquidating bills, real bills of exchange, with bank credit money. Otherwise, economic disaster can, and often does, occurs.
Copyright © 2015, 2017 by Thomas Coley Allen.