Is the Real Bills Doctrine Inherently Inflationary
Opponents of the real bills doctrine claim that it is inherently inflationary. Mises defines inflation as “an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur [i.e., general prices rise].” Hazlitt gives a more succinct and clearer definition: “an increase in the supply of money that outruns the increase in the supply of goods.” Most economists, very few of whom are supporters of the real bills doctrine, define inflation similarly to Mises and Hazlitt. Thus, inflation occurs when the supply of money increases faster than the supply of goods.
According to these definitions, inflation cannot occur under the real bills doctrine. Money supply grows as new consumer goods enter the markets and contracts as these new goods are removed, consumed, from the markets. Thus, the money supply cannot exceed the supply of new goods.
Opponents also claim that the real bills doctrine leads to an inflationary spiral. When a bank lends money to a holder of a bill of exchange using the bill as collateral, it injects additional new money into the economy. This new money causes a rise in consumer prices. Thus, the monetary denomination of the next round of bills will be higher because of higher prices. As higher prices lead to higher monetary denominated bills, evermore additional new money needs to be injected into the economy. The process continues and causes an unsustainable inflationary boom.
This argument errors in that it confuses lending with clearing. Real bills of exchanges are clearing instruments and do not involve lending or borrowing.
Moreover, this argument overlooks an important function of the gold standard accompanying the real bills doctrine. Gold regulates credit. If prices of consumer goods begin to rise, gold becomes cheap compared to consumer goods. People begin buying fewer goods. They begin converting their credit money, bank notes and checkbook money, into gold. As a result, sellers lower their prices, if they want to move their goods, until supply and demand are again in equilibrium.
Furthermore, banks conserve their gold. They buy fewer bills and by that reduce the issuance of bank notes and checkbook money. Thus, the discount rate rises to encourage banks to buy more bills. (This action shows that the propensity of consumers to spend sets the discount rate. It shows that the discount rate is not an interest rate. The propensity to save sets interest rates.)
Another reason that the real bills doctrine cannot lead to an inflationary spiral is that consumer goods are priced in gold and outside the bills market. The price of goods covered by the bill of exchange are independent of the bills market. With their demand, consumers set the prices of goods. Bills do not generate demand for consumer goods and therefore cannot cause prices to rise.
Another version is that banks create and inject new money into the economy when it buys a bill. However, as bills are money in their own right, banks are merely substituting one form of money for another. They are not adding any new money. If a manmade or natural accident did lead to a rise in prices, gold would prevent an inflationary spiral as described above.
Not only is inflation not likely to occur under the real bills doctrine, but an inflationary spiral is even less likely. Gold regulates credit and prevents an artificial boom from occurring. (Another importance of gold is that a bill needs to mature into that which is no one’s obligation, gold.) Gold keeps everyone honest. Without the gold standard or another commodity standard, the real bills doctrine becomes so dysfunctional that it collapses.
1. Ludwig von Mises, Theory of Money and Credit, new ed., tr. H.E. Batson (Irvington-on-Hudson, New York: The Foundation for Economic Education, Inc., 1971), p. 240.
2. Henry Hazlitt, The ABC of Inflation (Lansing, Michigan: Constitutional Alliance, Inc., 1964), p. 6.
[This article first appeared in The Gold Standard, issue 11, 15 November 2011.]
Copyright © 2011 by Thomas Coley Allen.
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