Real Bils Doctine -- Part 10

Is the Real Bills Doctrine Another John Law Scheme?

Thomas Allen

    Opponents of the real bills doctrine cite John Law’s monetary scheme and claim that it is what the supporters of the real bills doctrine seek. Law wrote “. . . trade depends on money: a greater quantity employs more people than a lesser . . . nor can more people be set to work without money to circulate so as to pay wages of a greater number. . . .” Law sought to increase trade, production, and employment by increasing the money supply. Under Law’s system, money growth precedes production growth. New money enters the economy before new goods do.

    Under the real bills doctrine, the opposite is true. Production growth precedes money growth. Real bills can come into existence only after newly produced goods are being shipped to be sold. Only after production has occurred does commercial money, real bills of exchange, come into existence. Bills can only be converted into bank money after they exist. Consequently, new goods enter the economy before new money does.

    Law’s system rests on the premise that increasing the quantity of money makes a country wealthy. Furthermore, to make a country wealthy, increasing the quantity of money is necessary.

    The real bills doctrine rejects this premise. Under the real bills doctrine, increasing productivity, not money, leads to increase wealth. Real bills merely facilitate the movement of goods produced. It allows more goods to be produced because it paves the way for the movement of goods without tying up savings needed for production. Production creates wealth.

    With Law’s system, bank money comes first. Thus, it can become a highly inflationary system. Bank money under his system had no direct relationship with production.

    With the real bills doctrine, the opposite is true. Production growth precedes money growth. A direct relationship exists between production and the growth of money. Bank money can never grow faster than new goods entering the markets.

    Moreover, under the real bills doctrine, credit money is continuously being converted into gold. With Law’s system, conversion was infrequent.

    Real bills are self-liquidating within 91 days. Therefore, bank money into which they have been converted liquidates at the same time. Any bank money that is not canceled is now representing the gold used to pay the bill. That is, any bank notes or checkbook money not used to pay a bill becomes fully backed by gold when the bill is paid. Law’s system lacked this feature. His credit money was not self-liquidating.

[This article first appeared in The Gold Standard, issue #14, 15 February 2012.]

Copyright © 2011 by Thomas Coley Allen.

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The Real Bills Doctrine --- Part 8

Does Discount Rate Control Money Supply?

Thomas Allen

    One criticism of the real bills doctrine is that supporters claim that the state of business determines the number of bills, and, therefore, the number of bills is independent of bank policies. On the contrary, according to these opponents, the amount lent depends on the discount rate. Banks decide how many bills to discount by the discount rate that they set. A lower discount rate results in banks discounting more bills.

    First, banks do not discount bills by lending; they buy bills at a discount. The two actions are entirely different. Second, banks may propose a discount rate, but markets decide the discount rate. A bank that sets a below-market rate would not earn an adequate return. If it sets a rate too high, it would not do any business.

    True, a lower discount rate normally results in more bills being sold to banks and thus more banknotes and checkbook money being placed in circulation. However, a higher discount rate does not reduce money in circulation. A real bill is commercial money. It can and does, or did, circulate and function as money until it matures. The quantity of commercial money available for discounting determines the discount rate. More commercial money leads to lower discount rates. More productivity results in more commercial money. More consumption causes more productivity. Thus, the discount rate depends on consumption and not banks and savings.

    With commercial money in circulation, the economy can function without banks. Banks merely improve the efficiency of the monetary system. With banknotes, they divide commercial money into small uniform pieces that are more easily spent. Also, more people will accept banknotes in payment than bills of exchange because the creditworthiness of a bank is easier to judge.

    Under the real bills doctrine, banks do not decide the amount of credit money in circulation. Productivity and consumption decide. Whenever a merchant signs a bill of exchange accepting it, credit money as commercial money is created. Thus, as more goods are produced, commercial money increases. As fewer goods are produced, commercial money decreases. All banks decide is how much commercial money to convert to bank credit, banknotes and checkbook money. (In today’s economy, most would be converted to checkbook money.)

    In summary, the discount rate depends on the supply of commercial money, real bills of exchange. However, it does not control the supply. Quite the contrary, the supply of commercial money controls the discount rate. Productivity and consumption control the quantity of commercial money. Therefore, productivity and consumption instead of banks fix the discount rate.

[This article first appeared in The Gold Standard, issue #12, 15 December 2011.]

Copyright © 2011 by Thomas Coley Allen.

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Real Bills Doctrine -- Part 9

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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Real Bills Doctrine --- Part 7

Is the Real Bills Doctrine Inherently Inflationary

Thomas Allen

    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].”[1] Hazlitt gives a more succinct and clearer definition: “an increase in the supply of money that outruns the increase in the supply of goods.”[2] 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, ever more additional new money needs to be injected into the economy. The process continues and causes an unsustainable inflationary boom.

    This argument errs in that it confuses lending with clearing. Real bills of exchange 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, banknotes, 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 banknotes 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 is 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 they buy bills. 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.

End Notes
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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Real Bills Doctrine -- Part 6

How Will Bills of Exchange Be Paid?

Thomas Allen

    Normally merchants will pay their bills of exchanges with checks, either paper or electronic. When customers buy goods covered by a bill of exchange, they will pay with gold coins, bank notes, gold certificates, or checks. (Credit cards are not a final payment since the customer still has to pay the credit card bill with a check or some other form of money.) Merchants deposit all these moneys in their checking accounts. All paper moneys deposited will be returned to the bank that issued them or on which they are drawn through clearing houses. All paper moneys not canceled with other paper moneys are redeemed in gold.

    When the bill comes due, the merchant most likely uses a check to pay the bill. If the owner of the bill is the bank holding the merchant’s checking account, the bank transfers gold from the merchant’s account to itself. If the bill is owned by another bank, that bank will send the check to the merchant’s bank for cancellation. If the merchant’s bank does not hold enough liabilities of the bank receiving the merchant’s check, the merchant’s bank sends the bank owning the bill gold to make up the difference. Gold in the amount of the bill canceled is transferred from the merchant’s account to his bank. If the owner of the bill is not a bank, the owner receives the merchant’s check and deposits it in his (the bill owner’s) bank, and the process just described is followed.

    The above description shows the importance of the gold-coin standard accompanying the real bills doctrine. All paper moneys (banknotes, checkbook money, and gold certificates) connected with the bill and the bill itself convert into gold and are extinguished with the maturity of the bill. Gold regulates the whole process and prevents excessive paper money from being produced.

[This article first appeared in The Gold Standard, issue #10, 15 October 2011.]

Copyright © 2011 by Thomas Coley Allen.

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Real Bills Doctrine -- Part 5

Do Banks Create Money Under the Real Bills Doctrine?

Thomas Allen

    One reason that proponents of a 100-percent gold standard give for rejecting the real bills doctrine is that it creates money out of nothing via fractional reserve banking. Fractional reserve banking is a fraudulent activity. Therefore, when a bank creates money to lend using a real bill of exchange as collateral, it is practicing fraud. (This statement is incorrect. The real bills doctrine deals with clearing and not lending. If one starts with a false premise, he most likely will arrive at a wrong conclusion.)

    When a bank buys a bill of exchange, it converts commercial money into bank money. It does not create any additional money. This conversion of commercial money into bank money removes the commercial money from circulation and places it in the bank’s vault until it matures into gold and is canceled or until the bank sells it for gold.

    This process is analogous to a person depositing a gold coin in a checking account. When a gold coin is deposited, the bank removes the coin from circulation by placing it in its vault. It creates checkbook money to exchange for, or buy, the gold coin. As with commercial money, the bank has converted one form of money into another form. In both cases, it has created bank credit money to substitute for another type of money. In both cases, the bank has converted market-created money into bank money. For both situations, market-created money backs the money created by the bank. Either commercial money or gold coins are backing the banknotes and checkbook money that the bank issues.

    The major difference between the two is that the checkbook money into which gold coins are converted represents gold directly. The money into which the bill is converted is in the process of becoming gold as the goods represented by the bill are sold. It becomes gold as the bill is paid in gold or bank money that almost immediately becomes gold.

    Moreover, these opponents of the real bills doctrine confuse discount rates with interest rates. They are not the same as Professor Fekete has explained. Also, they confuse lending instruments with clearing instruments.

    Like an investor, a bank buys a bill. It becomes the owner of the bill and receives the payment when the bill is paid. It does not lend money to the drawer of the bill with the bill as collateral for a loan. Again, a bill is like a check. The final recipient collects directly from the signer without the money having to pass through all the intermediaries.

    Rist notes, “. . . bills are an addition to metallic money; they are a commercial money spontaneously created to supplement the circulation of coin.”[1] Thus, when a bank buys a bill, it does not monetize it. The bill is already money. A bank is no more monetizing a bill than it monetizes gold when it buys gold with notes.

    If the opponents of the real bills doctrine want to prevent money in addition to gold, they need to suppress bills of exchange. They need to direct their opposition away from banks buying bills with bank money instead of gold. As shown above, banks do not create any additional money when they buy a bill. They convert one form of money (commercial money) to another form (bank money, i.e., banknotes and checkbook money). These opponents need to direct their opposition to the creation of the bill of exchange, which is the heart of the real bills doctrine. They must prohibit either its creation or its use as money, i.e., prohibit its use to pay debt or purchase goods and services. (The recipient of a bill in payment receives it at the same discount as a bank does.) Either choice causes them to oppose a spontaneous market activity.

End Note
1. Charles Rist, History of Monetary and Credit Theory from John Law to the Present Day, trans. Jane Degras (New York, New York: Augustus M. Kelley, 1966), p. 96.

[This article first appeared in The Gold Standard, issue #9, 15 September 2011.]

Copyright © 2011 by Thomas Coley Allen.

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Real Bills Doctrine -- Part 4

Should Bills of Exchange Be Allowed as Money?

Thomas Allen

    One argument against the real bills doctrine is that a bill of exchange is credit, and such credit should not be used as money. Most people presenting this argument do not object to all types of credit being used as money. They accept some types of credit money, but object to other types of credit money.

    Under the true gold standard, only full-bodied coins are true money. All other purchasing media are types of credit money.

    Most who present this argument against the real bills doctrine seem to accept the use of token coins. Token coins are needed to buy low-valued items like a box of matches, which is worth less than a speck of gold. Token coins are a form of credit that functions as money.

    Most seem to allow the use of checks and gold certificates. Checks and gold certificates are forms of credit that function as money. A check is an order to a bank to transfer gold from one account to another or to transfer gold from an account to cash in gold coins. A gold certificate is essentially a warehouse receipt for gold and can be converted to gold at any time.

    However, they object to using bills of exchange as money. A bill of exchange is a spontaneously market-generated form of credit money that some call commercial money. So why discriminate against this type of credit money? Commercial money is more like gold than other forms of credit money in that it is a spontaneous market creation. To prevent the use of bills of exchange as money requires using political forces to overrule a natural market function.


[This article first appeared in The Gold Standard, issue #8, 15 August 2011.]

Copyright © 2011 by Thomas Coley Allen.

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