Does Real Bills Doctrine Lead to Excessive Notes in Circulation?
Thomas Allen
Another objection to the real bills doctrine is that if people prefer paper money to coin, an excessive (inflationary) amount of paper money will circulate. People use paper money instead of redeeming it at the issuing bank for coin. Because people are not redeeming notes, banks will issue ever more notes against the same reserves. Banks will use bank notes not only for bills of exchange, but also for treasury bills, anticipation bills, accommodation bills, and other financial and commercial paper. Some will commit an even more egregious banking sin and create bank notes for mortgages. John Law’s monetary experiment in France is commonly used as an example.
In eighteenth-century France, a preference for banknotes over coins may have occurred. However, if such preference exists in a modern economy with decentralized banking with each bank issuing its own notes, it should not result in infrequent redemption. Except for a small quantity of notes that people keep, most are quickly spent. Much of what is spent, the receiving merchant deposits every day or so. If banknotes are cleared like checks, most banknotes would return to the issuing bank within a few weeks. (Larger notes would return more quickly than small notes, which are used as change. This act is an argument for prohibiting small notes.) They would be canceled against other notes and checks or converted to gold. Either way, they are removed from circulation. That excessive circulating notes would or could occur under the real bills doctrine is doubtful.
If people prefer paper money to gold coins, they pay the merchant in paper. The merchant pays his bill of exchange in banknotes. The bank receiving banknotes in payment returns them to the issuing banks for gold. If the bank that owns the bill refuses banknotes of other banks, the merchant redeems them in gold and pays his bill in gold. On average, banknotes will circulate less than a few months. (Under decentralized banking, banknotes are not legal tender, no one is required to accept them unless he has contracted to do so.)
[This article first appeared in The Gold Standard, issue #13, 15 January 2012.]
Copyright © 2011 by Thomas Coley Allen.
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