Full Reserve Banking

CHAPTER 3

Critiques of the Traditional
Real Bills Doctrine

At this point, I would like to turn the focus to the traditional real bills doctrine. Rallo’s approach is not identical with the traditional real bills doctrine, but it relies on its main ideas. Thus, it is worthwhile to investigate why the real bills doctrine is widely rejected, not only by Austrian economists and fractional reserve bankers such as George Selgin but also by the economic mainstream (Selgin 1989). Critiques of the real bills doctrine have a long tradition itself and are worth being reviewed.

Let us briefly restate the real bills doctrine: The real bills doctrine states that credit expansion is never excessive or deficient when the newly created money substitutes arise from granting loans against short-term commercial paper (also called real bills). When bankers only lend for a short term against goods that will be finished and marketed within 30, 60, or 90 days, the stock of money will change with real production. New money will be created only to buy new goods at the existing prices (Humphrey and Timberlake 2019, 1–2).

The real bills doctrine originates from a business norm applied in banking circles. The idea of bankers was to channel new money substitutes into additional real production by discounting short-term commercial bills of exchange. The increase in real output allows for the creation of new money to buy this additional output at old prices, preventing price deflation (Humphrey and Timberlake 2019, 168). The commercial paper (real bills) serves as a reserve against the notes and deposits issued. In the vision of its proponents the commercial paper is paid off quickly and the created money substitutes disappear again (the law of reflux).

Thus, instead of financing 30-year mortgages through the creation of new bank credit, the real bills doctrine prefers the purchase of real bills by banks with newly created money substitutes, thereby monetizing goods closer to market and more liquid than mortgages. According to the real bills doctrine, bankers do not entice entrepreneurs with artificially cheap credit into additional investment projects but passively respond to the demand for additional money and accommodate the needs of business. They fulfill a helpful social need. As Schumpeter (1954, 730) argues, the real bills doctrine makes bankers look good, which in turn explains its attractiveness to bankers.

3.1 The History of the Real Bills Doctrine

The real bills doctrine has a long history. It came into existence 300 years ago as a rule to guide bankers’ loan-making behavior under a gold standard (Humphrey and Timberlake 2019, 5). The idea was to tie the creation of bank credit to real output. The money supply would vary with the needs of trade. While Lloyd Mints (1945) credited Adam Smith for being the first champion of the real bills doctrine in its modern shape, Mints found its basic idea already represented in the works of John Law. Law defended the idea that bank note use should be tied to the market value of land, land value being an indicator or proxy of national production in agricultural societies. Similar to the real bills doctrine, Law’s idea was to tie the production of money to output. However, as critics of John Law have pointed out, more issue of bank notes leads to a higher market value of land, which in turn justifies more note issue, and so on. There is an inflationary spiral. And there is no limit to overissue. The basic idea in both Law’s theory and the real bills doctrine is that the money supply should be tied to a real productive asset (Humphrey and Timberlake 2019, 10).

It was Adam Smith who changed the productive asset that should back the credit created by a fractional reserve bank from land to short-term, self-liquidating bills of exchange (real bills). He argued that the amount of fiduciary media follows the needs of trade when banks “discount[] to a merchant a real bill of exchange drawn by a real creditor upon a real debtor, and which, as soon as it becomes due, is really paid by that debtor” (Smith 1937, 288).

The real bills doctrine was later defended by the antibullionists. They denied that the Bank of England had overissued notes during the Napoleonic Wars when the redemption of specie payment was suspended. They maintained that adherence to the doctrine would prevent overissue even without upholding gold convertibility. Antibullionists argued that as the Bank of England had restricted its note issue to the amount of real bills, it had adjusted the money supply to the real needs of trade and the demand for money.

Thomas Tooke and John Fullarton extended the work of the antibullionists. They combined the real bills doctrine with the requirement to convert bank notes into gold and the theory of reflux (Humphrey and Timberlake 2019, 18–19). Convertibility under an international gold standard implies that if domestic prices rise relative to foreign prices, gold outflow will threaten bank reserves and restrict credit expansion. According to Tooke and Fullarton, not only international gold outflow but also the needs of trade restrict expansion. Ultimately, the reflux mechanism implied that if a bank overissued notes, the notes that money holders do not desire would be returned to the banks and converted into gold, thereby leading to price stability. Finally, to this argument the free banking school added the point that adverse bank clearings also restricted overissue of notes.

3.2 The Traditional Critiques

Several critiques have been raised against the traditional real bills doctrine.

First, the most common critique of the real bills doctrine refers to its linkage of the money supply to a nominal variable—i.e., the market value of goods produced (Humphrey and Timberlake 2019, 5–6). The market value of goods produced is, however, not independent of the money supply. This implies that, without convertibility into gold or some other limited reserve, there is no limit on the money supply and prices.

Imagine that due to supply chain constraints after a pandemic, prices of consumer goods increase disproportionately to their reduction of supply. This means that the market value of consumer goods produced increases. The value of discountable real bills increases. Banks can in this situation create additional money substitutes by purchasing real bills. As the money supply increases, prices tend to increase even more. The market value of produced consumer goods increases further, which allows their producers to get even bigger loans from banks (through discounting real bills), increasing the money supply even more. Prices and money rise together in an inflationary spiral.

The only constraint on such a spiral is (gold) convertibility, and to his credit that is what Rallo defends. In a fractional reserve gold standard there is a reserve ratio that banks wish to uphold which puts a brake on this inflationary spiral. The real bill principle by itself does not limit prices or the money supply (Humphrey and Timberlake 2019, 13). The first to point that out was Henry Thornton (1802). Later David Ricardo also criticized the idea that the needs of trade could limit the amount of money (Humphrey and Timberlake 2019, 18).

Second, and related to the above, critics have argued that the real bills doctrine is procyclical. When production rises, more money is produced. When production falls, less money is produced. In this sense, Humphrey and Timberlake (2019) maintain that the real bills doctrine contributed to the monetary instability of the 1920s and 1930s. I add that before the rise of central banking, real bill discounting was the traditional banking practice in the 19th-century gold standard, yet this period produced numerous banking crises (Huerta de Soto 2014, 231). Thus, to put it mildly, from a historical point of view, real bill practice has failed to provide clear evidence that banking crises are prevented.

Third, there is an objectivist remnant within the real bills doctrine that distinguishes between production, which is considered good, and speculation, which is considered bad (Humphrey and Timberlake 2019). Its proponents claim that a real bill can be used for credit expansion because real bills help to bring real goods that have already been produced to the market. However, a short-term speculative credit that is backed by securities should not be used for credit expansion, because it is used to finance speculation.

However, there is no clear, objective distinction between production and speculation. All production activity is speculative (Humphrey and Timberlake 2019, 169). There is no guarantee that the consumer goods produced will be sold at a certain price. Ineradicable uncertainty and entrepreneurial speculation are always involved in business activity. The proponents claim that real bills are backed by goods that are certain to be sold at a guaranteed price, while there is no such thing as certainty in economic activity but always uncertainty and speculation.

Moreover, stock market speculation, if successful, also creates real value for society by adjusting prices and productive structures. The price information provided by stock market quotations is essential information for the adjustment of the productive structure of the economy. The stock market via its price information facilitates the regrouping of assets, which is a very important and productive endeavor (Lachmann 1978).

Furthermore, bank lending against securities may also be used to finance real production. In addition, not only are real bills backed by real goods, but stocks in the end are also backed by real goods; they are also real. In one case it is consumer goods to be sold soon; in the other case the collaterals are capital goods that produce consumer goods.

In both cases—lending against securities and lending against real bills (commercial paper)—a fractional reserve banking system increases the money supply (by producing fiduciary media). The use of the newly created money substitutes is open to the borrower. The funds may be used for financial-market speculation or improving productive facilities. One may actually make the case that the flow of newly created money to financial markets is—at least in the short term—less distortive. When the newly created money flows to financial markets, asset prices are distorted, while the structure of production is not immediately affected. Malinvestments will occur faster when the money flows into the expansion of real productive activities (Bagus 2007).

Fourth, Henry Thornton in his 1802 classic points out that goods could be sold several times, giving rise to several real bills (Thornton 1978). Let us take the following example: Person A sells goods worth $100 to person B, and person B pays with a real bill that comes due in 30 days. The next day person B sells the goods to person C, and person C pays with a real bill payable in 30 days. In this case, two $100 real bills are in existence for the market value of $100 in real goods. If A and B take their respective real bills to different banks, which purchase them for $99 each, then the money supply increases by $198 (Humphrey and Timberlake 2019, 14–15).

Fifth, there exists the possibility of creating real bills with other companies with the purpose of increasing bank financing. Let us say that company A provides an input to company B for $100, while company B provides an input to company A for $100. Both companies are providing goods or services to the other. The claims cancel out. However, let us imagine that A pays B in the form of a real bill and B also pays A with a real bill. Then both companies hold a real bill drawn on the other company, and they could just cancel them. However, they could also take them and rediscount them at a fractional reserve bank that creates new fiduciary media. Then the money supply increases by the sum of the discounts. Instead of compensating payments, real bills are exchanged. The money supply increases, and new investment projects can be started without any increase in real savings.

A possible rebuttal to this critique is that it is the genuine task of banks to analyze in detail the quality of the real bills and to make sure that there is no creation on purpose as in the example above. However, the quality of real bills is not a variable that is independent of the practice of real bill fractional reserve banking. Once a real bill credit expansion starts, the prices of consumer goods tend to increase, and thereby the value and quality of real bills increases as well. The bills will also become more negotiable if real bill credit expansion is widespread. As there is more money around, and the money supply keeps increasing because of real bill credit expansion, real bills become easier to sell. They become more negotiable and more attractive to use. In other words, the quality of real bills is not independent of the institution of fractional reserve banking.

In addition, the practice of real bill credit expansion may be self-defeating. This is so because the fractional reserve discounting of real bills may trigger an artificial boom, as I will show in section 4. During the artificial boom, there may be overconsumption, which in turn increases the quality of real bills as the price of goods collateralizing them increases. The overconsumption results from lower interest rates and a possible wealth effect, as economic actors feel richer. When the recession hits, many bills will turn bad. After the end of the inflationary process, with widespread malinvestments and during a panic, no bill may be of good quality. Thus, in the same way that banks considered subprime loans during the boom phase to be better quality than they actually were, banks may consider real bills during the boom to be better quality than they are and discount more of them.

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Real bills as such are not a problem and may circulate as secondary media of exchange in specialized circles (i.e., without being generally accepted media of exchange). When a real bill is sold for money formerly spent on consumer goods, someone is saving (reducing consumption). If the real bill is liquid, it may allow one to reduce cash balances somewhat.

The proponents of the real bills doctrine oppose credit expansion through real estate loans, stock market loans, and purchases of government securities. Only credit expansion for the purchase of real bills is considered desirable.

Note that Rallo defends gold convertibility plus real bill fractional reserve banking.

Indeed, Rudolf Havenstein, the president of the Reichsbank during the 1920s German hyperinflation, appealed to the real bills doctrine, arguing that prices increased sharply and that therefore the needs of trade increased. As the quantity of money demanded for transactions increased, there would be a shortage of money, Havenstein argued, and the money supply had to be increased (Humphrey and Timberlake 2019, 21–22).

Unless banks expand credit in unison nationally and internationally.

On the connection between credit expansion, overall liquidity, and maturity mismatching, see (Bagus 2010).

On overconsumption, see Mises (1998, 546–47) and Salerno (2012). On the possible wealth effect, see Bagus (2008b).