Institute for Science and Applied Mathematics, Missoula, Montana, U.S.A.
Director of Education and
Research, Lips Institute, Zurich, Switzerland
Dear Mr. Princeton:
Thank you for writing.
You ask me to comment on the article Real Bills, Phony Wealth--Financing
Is not Funding (www.lewrockwell.com), May 31, 2006. You also want
to know how I would respond to the author's remark to you in a private
communication that "one of the problems with Fekete's
writing is that he does not distinguish between real bills--which are quite
benign--and the Real Bills Doctrine (RBD), which is false and
pernicious". I comply with your request with some reluctance as I am not
in the habit of returning the ball to the mudslinger's court.
paper by the noted monetary economist Richard Timberlake also makes the same
point as your correspondent:
". . . the twist . . . that makes the ordinarily harmless real
bills into the RBD [is] an advised policy for gearing the creation of new
money to the money-value of new goods and services. What could be cooler? . .
. As a principle for a commercial bank's lending operations, [the RBD is just
as] harmless; but as a theory for central bank monetary policy, it is
disastrous." I hope that you will read my rejoinder to Timberlake's
paper which moved me to answer to your kind letter.
The common earmark of
latter-day detractors of the RBD is that they treat Adam Smith as a
'non-person'. They just don't want to acknowledge that he is the father of
the RBD. I can well understand their hesitation. It is a forbidding task to
get into an argument with this giant of economic thought. I am happy to
interpret The Wealth of Nations for their benefit. What they call
'false', 'pernicious', and 'disastrous', comes straight from this
fountainhead. In explaining the operation of the bill market, Adam Smith
calls the circulation of real bills a "waggon-way in the air". In
comparison, the circulation of gold coins in moving merchandise in urgent
demand to the final consumer is just an earthly waggon-way, winding through
agricultural land, as it were. Land that had to be taken out of production;
land that cannot be turned "into good pastures and corn fields . . . to
increase very considerably the annual produce of land and labor".
Moreover, since the road from producer to consumer is getting ever more
roundabout (as the productivity of labor and
capital is increasing), the amount of agricultural land taken out of
production is also increasing by leaps and bounds, with no end in sight.
Therein we have a problem. We may end up with more land dedicated to
waggon-ways, than the land dedicated to growing produce. Either there is a
limit to further increases in productivity, or the fruits of higher
productivity must be gobbled up by the doctrinaire insistence on a "100
percent gold standard".
solution? As Adam Smith suggests, the "invisible hand" of the
market has constructed a "waggon-way in the air". It has let
circulating capital be financed through real bills, thus freeing up a large
part of agricultural land which could then be put back into production. It
has also stopped further incursions of productive land. The meaning of Adam
Smith's simile is that gold can be put to better use in financing fixed
rather than circulating capital. Bills drawn on merchandise in urgent demand
have "Daedalian wings" (the reference is
to the Athenian inventor Daedalus who, according to mythology, fashioned
feathers, reeds, wax, and twine into wings for himself and for his son
Icarus, in order to escape from the island of Crete where they were held
against their wish). With those wings bills can fly under their own steam. It
is true that bills arising out of the financing of new fixed capital, for
example, capital needed for further refinement in the division of labor, or for further perfecting the roundabout ways of
production processes, won't fly (read: will refuse to circulate). Only bills
financing circulating capital (that is, the movement of finished or
semi-finished goods moving to the consumer from the producers of higher-order
goods through those of lower order) can. It is true that every new division
of labor, and every new extension in the
roundaboutness of production, brings with it new demands for additional
circulating capital. The point is that this new demand will not take gold
coins out of circulation as it would in the absence of the waggon-way in the
observing that real bills do fly, we must add that fly they must sufficiently
fast so that the goods will reach the ultimate gold-paying customer in less
than 91 days. This number, 13x7, is not taken from cabal for the reason of
being lucky (or unlucky). It is just the length of the seasons of the year.
Clearly, the type of merchandise demanded most urgently by the consumers changes with the seasons.
Adam Smith makes an apology to his readers of 1776 for having recourse to
"such a violent metaphor" as the "waggon-way in the air"
and the "Daedalian wings of paper money
[secured by real bills]". No apology is needed to readers of The
Wealth of Nations 230 years later. New-Yorkers and dwellers of other
North-American cities are well used to enjoying seedless grapes picked on the
sunny slopes of the Andes the day before, brought to them via a waggon-way in
the air, this time in the strict meaning of the word: in air cargo jets through
several thousands of miles. This
is something that even Adam Smith's vivid imagination could not fathom. If
latter-day detractors of the RBD in the 21st century are unable to follow the
reasoning in The Wealth of Nations, it cannot be blamed on Adam
Smith's use of 'violent metaphors'. Could it, perhaps, be due to the
obtuseness of the reader?
Adventures of Robinson Crusoe on Manhattan Island
The ocean liner Titanic
hit an iceberg off the coast of Newfoundland and went down in April, 1912.
The handful of survivors were picked up and taken by the freighter Carpathia to New York. Among them was one Robinson
Crusoe, himself no stranger to shipwrecks. He was determined to put his
survivalist experience to good use in telling the natives, apparently waiting
to be rescued from the overcrowded Manhattan Island, how savings in the form
of a subsistence fund would help them survive better. He saw a lot of
paper-pushing on the island, but he encountered not one person who would eat
paper, or even use it as fuel in wintertime. People's face went blank when he
started telling them about the virtues of a renewal fund. He picked up
a can of sardines in the grocery store, and showed the people listening to
him his torn clothes, saying that he would eat the fish he bought with his
savings while he was mending his garment.
that point a kindly economist pulled Crusoe away from the curious crowd and
patiently explained it to him that on this island the distinction to
be made was not between a subsistence and a renewal fund, but between
circulating capital and fixed capital. In particular, the circulating capital
of the whole world is what the paper-pushing, that could be seen, is all
about. Paper moved in the opposite direction to the movement of the
underlying goods, which could not be seen because they were in the bottoms of
vessels moored in the harbor.
survivalist instinct in Crusoe made him to accept the explanation of the
economist, and he settled down to learn the new paradigm. He realized that
there are islands and islands, and the economics applicable to one may not be
applicable to the other.
Spinner-on-weaver and weaver-on-clothier bills
Let's turn to an example
of Ludwig von Mises to demonstrate that the distinction
between financing and funding production and distribution is vacuous,
provided that there is no fraud involved in financing. The spinner is
spinning cotton or wool into yarn that he delivers to the weaver who, in
turn, weaves the yarn into cloth to be delivered to the clothier. The latter
runs a store selling the cloth to the ultimate cash-paying consumer.
Following merchant custom, the weaver does not expect to be paid in cash at
the time of the delivery of cloth (good of the first order). Nor does, for
that matter, the spinner. He expects to be paid for the yarn (good of the
second order), as does the weaver for the cloth, but only after the
first-order good has been sold to the final consumer. So the spinner bills
the weaver, making him endorse the bill in writing across its face "I
accept". The weaver in his turn bills the clothier, making him endorse
the bill and write across its face "I accept". They keep the bills
pending settlement in less than 91 days, by which time the consumer will have
bought the first-order good. The proceeds from the sale will liquidate all
the claims that have arisen against the journey of the 'maturing' good
through the various stages of production. Note the saving: the pool of
circulating gold coins did not have to be invaded twice to make
payments for the maturing good. It did not have to be invaded even once.
The gold coin of the consumer was given up voluntarily. Of course, the saving
is even greater if the production process is more roundabout. It is still the
single gold coin given up by the ultimate consumer that liquidates all the
claims, whether the production process has four, fourteen, or forty stages.
"Neither a lender nor a borrower be" (Shakespeare)
It is important to see
that neither the spinner nor the weaver are lenders.
There are no borrowers either. No funding and no financing is involved. In consequence the distinction between
the two disappears. The bill is not an evidence of debt, nor is it a
collateral security for a loan. It is simply a receipt for goods of a stated
quantity and quality that has been delivered. The face value of the bill is
payable on settlement day. The usual term of the bill is "3 months
net". That is all. These tradesmen follow a long-established merchant
custom in allowing for the time it may take to sell the underlying
merchandise to the ultimate consumer. Producers of semi-finished goods never
(let's say hardly ever) quote or charge cash prices for their product. They
quote and charge discounted prices.
day a commercial banker calls on the spinner and the weaver. He offers to
purchase (as he says, to "discount") the maturing bills in their
possession. He explains that he will shoulder the cost and the burden of
collection at maturity and, in the meantime, his clients can put the cash to
immediate use. The spinner and the weaver cannot resist the temptation. They
endorse the bills on the back thereby transferring their rights to the
banker. Again, it is important to see that there is no lending and borrowing
involved, nor financing and funding. In fact, none of the previously existing
arrangements has been disturbed by the transfer. Nor is it correct to say
that the banker has "monetized" the bills. If anything, it is the
market, or the "invisible hand" of which Adam Smith spoke that has
given ephemeral monetary privileges to the bill. These privileges lapse at
the moment the bill matures. The tradesmen could have discovered this themselves, without the banker presence as a midwife.
In fact, the weaver could have used the bill endorsed by the clothier in
paying the spinner for the next shipment of yarn. For that matter, even
tradesmen who do not know the clothier in person would accept the bill drawn
on him, or on any other merchant selling first-order goods in payment for
semi-finished goods. They need not worry that the clothier might default.
Even in the unlikely event that the clothier has taken a loss, he would pay
the face value of the rather than be denied discounting privileges in the
then, did the saga of real bill circulation to replace gold coin circulation,
begin. There was no government coercion, no bank intrigues. Everything was
perfectly voluntary all round. The system worked perfectly and without a
hitch for hundreds of years, before central banks were imposed on the people
by spendthrift governments. They were anxious to "discount" but
found their "anticipation bills" just wouldn't fly. They needed the
assistance of a central bank to shelter their bills, along with "accommodation
bills", "pig-on-pork bills" or any other phony bills in their
portfolio from the scrutiny and ravages of the bill market. It was at this
point, it may be noted, that periodic runs on banks (not excluding central
banks) have started.
Discount rate versus interest rate
The banker applied a
"discount" to the face value of the maturing bill when he purchased
it from the producer. The discount was equal to the number of days left to
maturity times the "discount rate". It is of utmost importance to
distinguish the discount rate from the rate of interest. The former is always
lower than the latter. Moreover, the discount rate tends to be low if
consumer confidence is high, and vice versa. In other words, the discount
rate varies inversely with the propensity to consume. By contrast, the
interest rate varies inversely with the propensity to save. It is most
unfortunate that Mises failed to recognize this
difference and, therefore, his theory of interest is faulty. Several other
errors followed from this fundamental mistake. For example, Mises said that a promise to pay gold on demand can
substitute gold in every market where the maturity and security of the
promise is recognized. Not so. The marginal bondholder would be foolish to
accept the promise in exchange when he sells his gold bond in protest against
low interest rates. Mises also held that paper
currency, whether redeemable or not, is a present good and not a
future good. As far as it is known he never commented on the question how
this can be reconciled with the fact that governments can print (and
helicopter-drop) any amount of it ad
discount rate makes the real bill an appreciating asset. This is why
the real bill is in constant demand by the commercial bankers. In fact, real
bills are the most liquid earning asset that a bank can have, second
only to gold (not considered an earning asset). To discount a real bill is
not a lending function of the bank. It is a clearing function.
The bank could never get into hot water on account its
clearing, although it can on account of its lending activities. This has
important consequences at maturity. The borrower must invade the pool of
circulating gold coins and withdraw an equivalent amount to repay the bank
loan. If too many loans mature at the same time, then there may be trouble
with the lending. Some borrowers may find it difficult or impossible to
withdraw the gold, and defaults may cascade. As far
as the clearing function of the bank is concerned, such a thing would be
unthinkable. The real bill is a self-liquidating paper, that is, the
underlying obligation is liquidated with the gold coin of the final consumer
who releases it when he buys the underlying consumer good.
is a constant source of amazement for me why detractors of the RBD are
incapable to understand such a simple yet fundamental distinction, one that
was so clearly explained by Adam Smith 230 years ago.
The death of Icarus
Detractors of the RBD gleefully point out that Icarus was so thrilled
with their flight that, ignoring his father's admonitions, he was flying ever
closer to the Sun. The heat eventually melted the wax, the wings came
unstuck, and Icarus plunged to his death in the Aegean Sea. They say that
this is exactly what happened to the U.S. economy suspended, as it was, on
the Daedalian wings of the RBD -- due to the
misguided monetary policies of the Federal Reserve in 1928.
these detractors forget is that it was not the imperfection of Daedalian wings but the disobedience of Icarus that led
to his death. Making the RDB non-operational was in violation of the law. The
practice of "open market operations", euphemism for organizing the
public debt into currency, was a further incursion of the law. Note carefully
that it was not the ownership of the government bond that was made illegal by
the Federal Reserve Act of 1913, but the monetization of it, that is to say,
the practice of paying for it in Federal reserve notes or deposits created
out of nothing. The Federal Reserve banks were free to acquire it in any
other way, e.g., through repayment of Federal Reserve credit by a member
bank. Furthermore, the Federal Reserve Acy of 1913
did not outlaw the monetization of government bonds by member banks--a
serious loophole that was exploited by corrupt Federal Reserve officials.
When the unlawful inflationary regime caused the Florida real estate bubble
and, a few years later, the stock market bubble, the Federal Reserve made an
"about-face", returning to guidelines of the RBD as required by the
law, as it then was. However, it was too late: the Great Contraction of
1929-1933 could not be averted.
the Great Depression of 1933-1941 could have. However, when the economy made
the first tentative steps to recovery in 1932, something terrible happened.
The gold standard, and with it the RBD, fell victim to sabotage. On March 4,
1933, the day that "shall live in infamy",
the newly inaugurated president took the law, and the Constitution of the
United States, into his hands. He called in the gold coin of the realm so
that later, after the citizenry has complied with his passionate appeal to
their patriotic feelings, he could cry down the value of paper money that had
been paid out "in compensation" for the confiscated gold. As gold
coin circulation was an absolute prerequisite for the RBD, no wonder that the
Daedalian wings came unstuck, and the U.S. economy
plunged, taking the world economy with it. It was no coincidence that the
beginning of the Great Depression coincided with the sequestration of gold.
that is the true story of the death of Icarus.
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of
Nations, first published in 1776; Oxford University Press: New York,
Bills, Phony Wealth--Financing Is not Founding,
www.lewrockwell.com, May 31,
Antal E. Fekete, Federal Reserve Follies: What
Really Started the Great Depression -- View from the other side of the brink,
www.financialsense.com, July 26, 2006
July 29, 2006.
Antal E. Fekete is Director of Research and Education at the Ferdinand
Lips Institute, Zurich, Switzerland. . Born and educated in Hungary, he emigrated to Canada after the Hungarian Revolution in 1956
and taught for 35 years in the field of mathematics. Over the years, he has
been a visiting professor or Fellow at Columbia University, Princeton
University, and Trinity College of Dublin. He worked in the Washington office
of Congressman W.E. Dannemeyer on monetary and
fiscal reform for five years in the nineties; and in 1996, he won first prize
in the prestigious International Currency Essay contest sponsored by Bank
Lips Ltd. of Switzerland. He is the author of Gold and Interest and Monetary
Economics 101. In addition, his scholarly articles have appeared on
numerous Internet sites throughout America.