Real Bills Doctrine -- Part 12

Does Fractionalization Occur Under the Real Bills Doctrine?

Thomas Allen

    Under the real bills doctrine with sound decentralized banking, fractional reserve banking as such does not exist. Fractional reserve banking exists when a bank creates money out of nothing or allows multiple parties to use the same money simultaneously. The former occurs when banks add to the money supply by creating money out of nothing but computer data entries or the printing press. The latter occurs when banks lend demand deposits (current accounts or checking accounts) or use them as reserves for loans. Neither occurs under the real bills doctrine.

    Specie (gold or silver) or commercial money (real bills) backs all credit money (bank notes and checkbook money) that a bank “creates” (more correctly, converts). The specie and commercial money remains out of circulation. No one has use of it while the bank money representing that specie or commercial money is in circulation or available for use. Thus, if specie or commercial money maturing into specie backs all banknotes and demand deposits, fractional reserve banking as such does not exist.

    The following example illustrates that the real bills doctrine does not require the fractionalization of gold. A retailer accepts a bill of exchange from a wholesaler for 100,000 dwt. (pennyweight) of gold. To pay his supplier, the wholesaler discounts the bill to his supplier for 98,000 dwt. of gold (assuming the quarterly market discount rate is 2 percent). In turn, the supplier pays the manufacturer 98,000 dwt. with this bill. Then the manufacturer pays the 98,000 dwt. that he owes the raw material supplier with this bill. The raw material supplier keeps the bill to maturity. Thus, the retailer pays the 100,000 dwt. due on the bill at maturity to the raw material supplier.

    Has gold been fractionalized? No. As this example shows, 294,000 dwt. of gold are moved, but only 100,000 dwt. of physical gold are moved, which is the final payment that extinguishes the bill. The bill of exchange or commercial money has economized the movement of gold. It enables 100,000 dwt. of physical gold to do the work of 294,000 dwt. of gold, yet it has not fractionalized the gold.

    Now let’s look at the same example, but with banks getting involved. Instead of the wholesaler using the bill to pay his supplier, he sells the bill to a bank. In return, the bank buys the bill with bank money (banknotes or checkbook money). To simplify the example, the wholesaler has the bank credit his checking account with 98,000 dwt. of gold. Has the bank created new money? No, it has converted commercial credit money (the bill of exchange) to bank credit money (checkbook money). Now, the wholesaler writes his supplier a check for 98,000 dwt. to pay his debt to the supplier. That is the wholesaler transfers 98,000 dwt. of gold to the supplier via the check. The supplier deposits the check in his checking account, and the bank credits the supplier’s account with 98,000 dwt. of gold. Has this bank created money? No, it has not. The example continues with the supplier paying the manufacturer with a 98,000-dwt check, who deposits the check in his checking account. Again 98,000 dwt. of gold has been transferred via check; this time it is from the supplier to the manufacturer. In turn, the manufacturer pays the raw material supplier with a 98,000-dwt check who likewise deposits the check. Has 392,000 dwt. of new money been created? No, the checks are merely transferring gold from one account to another. The retailer ends up covering all these checks with the 100,000 dwt. of gold that he pays the wholesaler’s bank when the bill matures. Again, the gold is not fractionalized. The intervening credit money enables a small amount of gold to do the work of a great deal of gold.

    In both examples, the need for gold to change hands has been reduced from four times to one: from the retailer to the raw material supplier in the first instance and to the bank in the second case. Fractionalization has not occurred.

    Has this process created any new money? If this process has created any money, the retailer has created it when he accepted the bill of exchange. If the wholesaler sells the bill of exchange to a bank, the bank does not create any new money. It merely converts commercial credit money (the bill of exchange) to bank credit money (banknotes and checkbook money). The bank has not created any new credit money. It has merely changed the form of credit money. It has sliced the bill of exchange into small and more easily used pieces.

    Moreover, the real bills doctrine does not involve borrowing or lending as Professor Fekete has explained. As no lending is involved, banks are not lending demand deposits or using them as reserves for loans. Since banks are not creating money or lending money under the real bills doctrine, fractional reserve banking as such does not occur under the real bills doctrine.

[This article first appeared in The Gold Standard, issue #15, 15 April 2012.]

Copyright © 2011 by Thomas Coley Allen.

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