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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Real Bills Doctrine -- Part 11

Do Real Bills Eliminate the Need for Savings?

Thomas Allen

    Real bills of exchange do not eliminate the need for savings as some opponents assert that proponents claim. They are not intended to do so. The function of savings and the function of real bills are entirely two different things.

    Savings are necessary to provide resources for the expansion of farms, mines, and factories. As productivity precedes real bills, savings must come before any real bills are generated.

    Once items are produced and on their way to the final consumer, then real bills come into being. Their purpose is to facilitate the movement of goods from their origin to their final destination.

    Real bills free up savings so that more savings are available for production. They do this by eliminating the need for borrowing savings to distribute goods.

    Real bills cannot and do not replace savings. They are not a substitute for savings. Since real bills make the distribution of goods more efficient and less costly, they are not a form of savings.

    When an economy operates on the real bills doctrine, it expands and prospers. Without the real bills doctrine, it stagnates because savings must be withdrawn from production to fund distribution. Because it frees up savings for production, the real bills doctrine leads to an increasing standard of living. It eliminates the need for savings to fund the distribution of goods. Thus, it makes more savings available for the production of wealth, which leads to a higher standard of living. Moreover, the real bills doctrine may actually increase savings. As more wealth is created, more resources become available for savings.

    When the real bills doctrine is abandoned, the standard of living suffers. It is lower because the production of wealth is lower. The production of wealth is lower because savings that would have gone into production must be diverted to the distribution of consumer goods.

    Real bills do not eliminate the need for savings. On the contrary, they lead to an increase in savings.

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

Copyright © 2011 by Thomas Coley Allen.

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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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