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In
the first article of my
two-part series on the Real Bills Doctrine (RBD), in commenting on the Daily
Bell’s interview with Professor Lawrence H. White on October 10, 2010,
I made the central point that the source of commercial credit is not saving
but consumption. The following example will dramatize this point.
Assume for the sake of argument that all banks in the whole wide world
succumb to the sudden death syndrome simultaneously. What does this mean in terms
of the production and distribution of consumer goods? Would we have to go
back and start from scratch to save in order to replenish society’s
circulating capital? Saving is a time-consuming process and people have to
get fed, clad, shod, and sheltered in the meantime. We could not restore
circulating capital through saving for the simple reason that before we could
we would die of starvation.
Luckily,
there is no need to go through such a regimen to satisfy the dogma that the
only source of capital is saving. Consumption per se is a ready and
instantaneous source of commercial credit. Real bills drawn on merchandise in
most urgent demand will supply all the credit society needs so that
consumption can continue without interruption — and the banks be damned.
It does not matter if very little gold is available to pay the bills upon
maturity. My detractors’ 100 percent reserve banking would be
confronted with sky-high prices on account of the scarcity of gold. Under the
RBD prices need not be high: the burden of adjustment will not fall on
prices, as the quantity theory of money falsely teaches; it will fall upon
the discount rate. There is only one interdiction,
namely, real bills must not mature in mere promises to pay gold
— the proviso of Ludwig von Mises
notwithstanding that “claims to gold are a complete substitute
for gold in markets where their security and maturity of those claims is
recognized.” (The Theory of Money and Credit, Chapter 15.)
Claims to gold are useless. Bills at maturity must be paid in gold
coins, not in claims thereto. Claims to gold coin are inferior to
bills that must mature into something superior. The only thing
superior to a real bill drawn on consumer goods in most urgent demand is the
gold coin. A bill maturing in a mere claim on gold will not circulate.
In
commenting on the first part of this paper several of my correspondents asked
why the discount rate is getting lower when the bill price is getting higher.
Here is the relevant arithmetic. Suppose a bill of $1000 maturing in 91 days
(or 0.25 years) circulates at $990. This corresponds to a discount rate of 4
percent per annum, because 1000(1 – 4(0.25)/100) =
10(99) = 990.
If next day the bill market quotes the same bill at a higher price, say at
$995, then there is a corresponding decrease in the discount to $5,
half of the earlier discount of $10. Thus the discount rate has fallen from 4
to 2 percent.
Let
us return to the Daily Bell’s interview with Professor White. Observing
that the RBD has been important in the history of monetary theory, he goes on
to say: It is a mistaken idea that if the banking system lends only by
discounting real bills, then it cannot over-expand. It is also a dangerous
idea … because rather than letting interest rates rise to reach their
new equilibrium level whenever the business demand for credit rises, the
banks will actually make money over-expand.
This
is tantamount to blaming the loot, rather than the thief, for the thievery.
Why did it allow itself to be stolen? There are uses
and abuses of credit. Over-extension of credit is an abuse. For
example, drawing two or more bills on the same merchandise is an
abuse, and so is rolling over a bill at maturity rather than paying it,
regardless whether or not the underlying merchandise has been sold. Such
abuses should be dealt with by the Criminal Code in the same breath as
dealing with the forgery of bank notes.
Professor
White’s remark assumes that the discount rate is the same as the short
term rate of interest. I shall not pause here to repeat the arguments of my
previous article refuting this misconception. Instead, I shall describe what
has actually happened when banks first put in an appearance to take a piece
of the action in the already flourishing bill market.
Banks
have arisen because they had a legitimate and useful role to play: (1) Their
credit has a high name-recognition; (2) Bank credit in the form of bank notes
come in standard denomination which is easy to count
and make payments with.
The
banks in discounting real bills paid with bank notes of their own issue. Thus
they substituted their own credit, enjoying high name-recognition, for the
sometimes obscure credit of traders in the periphery. Also, they offered
standard-denomination bank notes to replace bills with odd amounts as face
value that circulated more easily. Because of this, bank notes were welcome:
you did not have to scrutinize the credit standing of the drawer and the drawee of the bill. People were glad to pay for this
service in the form of foregone discount which accrued to the bank for
facilitating the circulation of real bills further.
The
good banks strictly followed the market rate of discount. Upon the
expiry of the underlying bill they punctiliously withdrew a corresponding
amount of bank notes from circulation. There is no sense in which the
reserves of these banks could be called “fractional.” Bank
liabilities were backed 100 percent by reserves, either in the form of gold,
or the next best thing to gold: real bills maturing into gold in 91 days or
less. Such banks were not exposed to the nemesis of poorly managed banks: the
bank run. Every business day on the average as much 1⅔ percent their
portfolio of real bills matured into gold coins. That was sufficient to meet
normal demand for gold coins. If the demand for the gold coin was abnormally
high, then the banks had to go to the bill market and sell unexpired bills
from portfolio for gold, in order to meet the extra demand. There was no
problem involved in selling real bills for gold. Some other banks
experiencing an overflow of gold coins would be scrambling to get earning
assets and would buy the extra supply of real bills eagerly. To call these
“fractional reserve banks” is to bark up on the wrong tree.
However,
inevitably, there were bad banks as well that did not bother
withdrawing their bank notes from circulation when the underlying bills
expired but made fresh loans with them on which they collected interest. This
was very profitable business for them. Nevertheless, their profits were illegitimate
and their loans were fraudulent. In effect, the bad banks were borrowing
short in order to lend long. I call such a transaction illegitimate
arbitrage between the bill market and the loan market, to take advantage
of the spread between the higher interest rate and the lower discount rate.
Illegitimate arbitrage is unsound because the short leg of the arbitrage has
to be moved forward every quarter and it may not be possible to do at the old
rate. The new discount rate may well be higher, and if it is higher than the
interest rate on the long leg, then the bank ends up with a loss rather than
a profit. In addition, the bank is guilty of false pretenses. It pretends
that its bank notes are covered by real bills drawn on fast moving
merchandise demanded most urgently by the consumers — which could
circulate on their own in the bill market. In reality, however, its notes
were covered by anticipation bills and accommodation bills or
notes of debtors — that could not so circulate. Illiquid and
dubious paper: expired real bills on unsold or unsalable merchandise;
accommodation bills drawn on the dreams of lunatics, notes of speculators was
being aided and abetted by the fraudulent bank that gave shelter to them in
its portfolio that was not open for public inspection. Note the difference:
bills circulating in the bill market are completely transparent making fraud
and conspiracy easy to detect. The common earmark of bad banks is that their
assets cannot be readily sold except maybe at a loss.
I
have mentioned the notes of speculators that are ineligible to figure among
the assets of banks. This is no condemnation of speculation per se.
Speculators in agricultural commodities render a great service to society.
Trouble starts when they speculate with other people’s money without
their knowledge and concurrence. The best example of this is the conspiracy
committed by Dick the Grain Merchant and Bob the Miller who anticipate an
increase in grain prices from which they want to benefit. Lacking money of their
own to buy grain, they decide to put Dick-on-Bob bills into circulation drawn
on grain the movement of which has been arrested.
This
conspiracy is criminal. The bill market must not be used for the
purpose of financing speculation. The market for real bills must be
recognized as a social institution that has evolved spontaneously for the
benefit of everybody, to facilitate the most expeditious movement of consumer
goods in the greatest demand. Sabotaging the bill market, whether by
speculators, or the banks, or by the government itself, is a crime against
society.
The
low discount rate is there to benefit the consumer,
and the consumer only. Luckily, by virtue of its openness, the bill market
exposes such conspiracies. Trouble starts when the bank is participating in
the conspiracy and gives shelter to fraudulent Dick-on-Bob bills.
It
is possible to brand the bad banks “fractional reserve banks“ to
reflect the fact that a portion of their credit outstanding is not covered by
gold coins or real bills maturing into gold coins. The existence of such
delinquent banks, however, does not justify disparaging the entire banking
system calling it “fractional reserve banking system.” The
suggestion that there are no “good” banks and that, in
discounting real bills all banks create money out of thin air, is fanciful
and untrue.
The
Daily Bell concludes the interview by commending Professor White for
“simplifying the Real Bills debate.” It adds that “the real
bills debate has raged for some time and Professor White’s perspective
has clarified matters.” With all due respect to Professor White
perspectives, I demur. Far more careful analysis of real bills and
clarification of the difference between the discount rate and the rate of
interest is needed than Professor White is willing
to offer. Just as my detractors, Professor White has declined to debate the
issues on the premise that the merit or demerit of real bills must be decided
in the context of complete absence of banks, since real bills can and do
circulate on their own wings and under their own steam. Such refusal is
especially regrettable at the present juncture, in view of the unprecedented
world banking crisis. There is a real danger that all the banks may
simultaneously succumb to the sudden death syndrome. I imagine that Professor
White would not dismiss this assumption of mine as outlandish.
Professor
White is one of the important and respected protagonists of the hard money
movement. In the interest of success, and also to save the world from
unnecessary ordeal and much suffering, we should admit that further study of
the RBD is needed, including an impartial inquiry about the circumstances
under which governments forcibly blocked real bill circulation at the end of
hostilities in World War I, and enforced the ban until the gold standard,
such as it was, collapsed. It had to collapse because it could not
survive the destruction of its clearing house, the bill market: its most
vital organ.
It
is a fallacy to assume that real bills, thankfully, faded away into oblivion
for reasons of being obsolete. It is wrong to conclude that the RDB is a
stale, “mistaken” and even “dangerous” idea.
The
RBD, in making a comeback, may protect lives.
It
may also save
our Western civilization.
Antal E. Fekete
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT
IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY
SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND SOURCES
BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS
COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE
TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
Copyright © 2002-2008 by Antal
E. Fekete - All rights reserved
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