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""The
masses are misled by the assertions of the pseudo-experts,” wrote
Mises, “that cheap money can make them prosperous at no expense
whatever.” The damage that this inflationary fallacy has done to
our monetary institutions cannot be over-estimated. In spite of efforts by
classical and Austrian economists to refute it, it refuses to die. It has  been resurrected
under many guises, but all with the same error at its core: that printing
money can create real wealth.[1]
An article (by a libertarian writer on a gold site no less)
proposing a revival of the Real Bills Doctrine is a recent addition to this
literature.
The Real Bills
Doctrine (RBD) has a long and controversial history. Many of the key concepts
originated with the monetary crank John Law. There are men who are commonly
stigmatized as monetary cranks.[2] Two rivals schools
of monetary thought, the Currency
School and the Banking School existed. In England, immense debate over the doctrine raged between them during the 19th century. In
the United States, the RBD was a key plank in the platform of the first
generation of US Federal Reserve bankers.[3],[4]
The Doctrine of Real
Bills concerns debts formed by transactions between business firms. When a
firm purchases raw materials or partially finished goods on credit, a debt is
created. The goods might be for use in the purchasing firm’s own manufacturing
processes, or they may be finished goods advanced to a downstream producer on
credit. In such a loan, the receiver promises to pay the supplier in cash
plus interest at some future date. The negotiable document setting down the
terms of credit is the so-called bill of exchange.[5]
As an example, a
manufacturer of chairs purchases wood from his supplier with a bill of exchange
due in 30 days. Two weeks later, finding himself short on cash to make
payroll, the wood supplier takes the bill to his local bank, which purchases
the note from him for 98% of its face value. The discount rate (here 2% for
14 days) annualized, would be the bank rate of interest on the transaction.
No special banking
doctrine is required to justify an ordinary loan transaction. Nor is any new
monetary theory required when firms wish to resell their paper assets to
buyers for cashon a commercial paper market.
The RBD comes into
play when the loan is sold to a bank. Suppose that the holder of a real bill
needs cash before the bill falls due. (Perhaps he needs to pay off his own
bills to his own suppliers further down the line before their bills fall
due). He would then present the bill to a bank. The bank, having been
persuaded by some clever monetary theorist to adopt the RBD,
“discounts” the bill, that is, purchases the bill from the
supplier at a discount to the present value of the loan.
It is crucial to
understand that, in the workings of RBD, bills are to be funded not with the
bank’s own equity capital, nor with savings loaned to the bank by its
creditors. Bills are not funded at all in the economic sense of the
term.
According to the RBD,
banks would monetize short-term business debt. Monetization of debt means to
create paper credit out of nothing and loan this credit into being as money. The
money exists either in the form of either bank notes or checking account
balances. The purchase of the bill is therefore a of loan from the bank, but
a curious sort of loan in which the funds for the credit were not previously
loaned to the bank by anyone. This is the mechanism by which the banking
system generates paper money inflation. The Real Bills Doctrine is in essence
a complex rationalization for paper money inflation.
Hultberg and Fekete
present a series of arguments for the adoption of the discounting mechanism. In
the interest of space, this essay will address some but not all of them:
credit intermediation without expansions is not “elastic”; credit
by itself is “too rigid”; the limitation of borrowing to previous
savings will reduce economic growth (the term “contractionist”
means essentially the same thing); or, equivalently, expanding credit beyond
savings enable more goods to be produced ; in the absence of paper credit,
business firms will not be able to obtain a sufficient amount of short-term
credit; similarly a “a liquidity shortage” will prevail without
money printing.
The “monetary
crank”, wrote Mises, is one who “suggests a method for making
everybody prosperous by monetary measures.”[6] All
variants of monetary crankism suffer from the same error: the printing press
cannot create actual goods. To understand why this is so, the difference
between transfer-of-savings-credit and credit expansion must be explained. Transfer
credit is extended when a borrower borrows money that someone saved. When a
bank is involved in this type of transaction, the bank is only brokers the
exchange. The bank locates borrowers and savers who wish to participate but
might not otherwise know each other. The bank first borrows from the saver
and then loans the money to the creditor.
Credit expansion is
an entirely different type of transaction. When banks expand credit there is
no saver anywhere involved. For a bank to expand credit, it creates new paper
claims to money -- bank notes or fractional reserve checking deposits -- out
of nothing at all and loans them as if they were money. These paper money
substitutes “give to somebody the means of purchasing goods without at
the same time diminishing the money spending power of somebody else,”
explained Hayek. He adds, “This is most obviously the case when the
creditor receives a bill of exchange which he may pass on in payment for
other goods.”[7] Paper claims of this type
were named fiduciary media [8] by Mises, meaning media of
exchange that circulated at parity with real money, but came into existence
as the result of credit expansion.[9]
Bullionist writer and
opponent of fiduciary media Charles Holt Carroll clarifies the distinction
between cash -– either gold or fully redeemable paper -- and fiduciary
media. Carroll aptly termed the latter “debt organized into
currency”:
Some writers have
placed promissory notes and bills of exchange in the category of currency,
but it is altogether a mistake; their affinity is with circulating property,
not with money… They are, however, neither money, nor currency, nor
property, but more records of an unfinished bargain; the purchase money is
not paid, and these are memoranda or written evidences of what the debtor is
to do to complete the contract. One species of property exchanges for
another; this is barter, the fundamental principle of trade; and when
promissory notes and bills of exchange are exchanged for money, they take the
position of property as essentially different from money as the goods that
were delivered for them, or for the fund upon which they are drawn.[10]
Opponents of RBD are
not attacking debt as such (either businesses-to-business or between
banks and bank customers). Lending transactions are a crucial mechanism for
the allocation of savings within a monetary economy. It is the distinction
between debt via credit and debt as money via credit expansion that makes all
the difference. Credit expansion is problematic, and the RBD is problematic
because it relies on credit expansion.
Cash is the commodity
that can be most readily exchanged for any other good on the market. Rent,
raw materials, payroll, or office supplies are often needed on short notice. Without
credit expansion, liquidity could only be supplied by someone who is willing
to reduce their own consumption.
Advocates of credit
expansion say that requiring someone to save before someone else can borrow is
too onerous a condition. Without the magic elixir of paper money, borrowers
would face insufficient liquidity, an excessively rigid credit system, and an
inelastic monetary system. Banks they say solve this problem “creating
liquidity” and “providing elasticity”.
There is always
insufficient quantity of any good to meet all possible uses of a good at
that time. The quality of scarcity defines what it is for something
to be an economic good. Liquidity is no different. Hülsmann writes,
“one has always to remember that money is a present good. It can be
used now. No present good is available in a quantity that would satisfy all
demands. This is precisely why it is a good. Hence, there is always demand
for some more money to secure hitherto less important (submarginal)
satisfactions.”[11]
A motivated borrower
in search of liquidity could always obtain a loan at some rate of
interest, as there would always be someone holding cash that would part with
it at a sufficiently high rate of interest. As in all markets, a price
for bank loans will emerge in credit markets through supply and demand. Even
without adding to the supply through credit expansion, firms that need funds
could attempt to borrow at the market rate of interest.
Prices ration
resources. Prices by their nature exclude. The market rate of interest is
always higher than the some of the potential borrowers are willing to
pay. The interest rate is a price that is formed in credit markets. But
to call this state of affairs “insufficient liquidity” is to say
that amount of supplied and demanded at the market price is the wrong amount
and rate of interest determined on the market is too high. If the quantity of
a good supplied by the market is said to be the wrong quantity, one must have
some other criteria for evaluating what is enough of the good,
outside of the ability of market participants themselves supply it and demand
it. But what other criteria could there be? Modern economics calls this
situation “market failure”, a term that substitutes the learned
judgment of expert economists for the preferences of market participants.
A business that pays
expenses by issuing bills to its supplier instead of cash is taking on credit
risk. Suppose that the cash receivable does not arrive at the time that it
was promised, or that the firm’s goods may not be sold as expected. Even
if the time structure of assets and liabilities match on the firm’s
balance sheet, a credit crunch is always a real possibility. Faced with such
a situation, if the firm could not raise cash by obtaining more credit
immediately, it would be insolvent.
Yet this is a problem
for that firm, not a problem with the monetary system as a whole. A
firm cannot obtain employees and office space because some other firm already
is hiring the employees and leasing office space that it wants. Owners
of business firms must evaluate the supply of things that they need to buy,
the marketability of their goods, and the credit-worthiness of their
customers.
“What may hurt
the interests of the producer of a definite commodity,” Mises observed,
“is his failure to anticipate correctly the state of the market. He has
overrated the public’s demand for his commodity and underrated its
demand for other commodities. Consumers have no use for such a bungling
entrepreneur; they buy his products only at prices which make him incur
losses, and they force him, if he does not in time correct his mistakes, to
go out of business.”[12]
It might be objected
here that the problem is really liquidity, not insolvency: a firm that cannot
obtain credit is not really insolvent, it only has a teeny-weeny liquidity
problem, and if the banks were allowed to discount the bills in its
possession that would solve the liquidity problem. The pain of bankruptcy is
not necessary.[13]
The distinction is
bogus: the inability of a business to pay its creditors on time
is the definition of insolvency. To this it might be objected that firms only
need a bit more time, such as is provided to them when a bank is willing to
discount their bills. However, to say so would be to ignore the role of time
in production. Present goods are scarce in the present as
Hülsmann clearly explains:
If we always disposed
of just a little bit more time we could be sure to have reached nirvana. With
always just a little bit more time one could provide all the money in the
world. Unfortunately, every means in the mundane life of the human race is
limited. Time, therefore, plays a crucial role for the success of action. In
every place outside nirvana one has to pay for the time-saving means called
goods. There is no possibility of providing “liquidity to the market
only.” One cannot pay with liquidity; one can only pay with goods.[14]
A market, as Mises
argued in his seminal critique of economic
calculation under socialism, can only bring about a
rational allocation of productive factors under the clear light of
profit-and-loss accounting. The definition of an making a loss to consume
more scarce factors of production (labor, real estate, machinery, energy,
etc.) than are produced. Bankruptcy redistributes factors of production away
from wasteful uses toward productive ones. It is a critical part of the
market process. Having a “liquidity problem” is the definition
of insolvency. Insolvent businesses should be taken over by their
creditors, not allowed to stay on life support with phony paper credit. Firms
are not insolvent because of some general shortage of money but because their
judgments about supply and demand were incorrect.
What is falsely
called insufficient quantity of credit is in reality the scarcity of goods in
the world. Credit expansion is an attempt to paper over this problem. Loss-making
firms sustained through the issue of fiduciary media are artificial forms of life, consume accumulated
savings, and impoverish society. Credit per se does not fund productive
activity.
Businesses usually do
not borrow solely to increase their cash holdings without the intention of
spending the borrowed money. The demand for credit by businesses is a demand
for office space, computers, machinery, employees, and raw materials. They
need to earn a return that will be sufficient to eventually repay the loan. They
can only do this by producing something at a profit. The scarcity of the real
things that business firms need in order to produce goods for consumption is
what limits the their ability to produce more. Mises explains this clearly:
An entrepreneur who
wishes to acquire command over capital goods and labor in order to begin a
process of production must first of all have money with which to purchase
them. For a long time now it has not been usual to transfer capital goods by
way of direct exchange. The capitalists advance money to the producers, who
then use it for buying means of production and for paying wages. Those
entrepreneurs who have not enough of their own capital at their disposal do
not demand production goods, but money. The demand for capital takes on the
form of a demand for money. But this must not deceive us as to the nature of
the phenomenon. What is usually called plentifulness of money and scarcity of
money is really plentifulness of capital and scarcity of capital.[15]
Only goods fund the
production of goods, not credit. Issuing more paper claims to the existing
stock of goods is not the same as producing more goods. Credit expansion can
alleviate scarcity only for those under the influence of the falsehood that
production is funded by credit. Bank credit expansion does not fund
production because it does not transfer savings, it only creates new claims
to the same amount of savings. In order for goods to be used in production,
they must be transferred by others who have produced them but not consumed
them.
“Not
consuming” is the definition of saving. As Frank Shostak explains only savings can fund
investment. To deny this, as Antal Fekete does (cited by Hultberg) here:
“the real bill will do the miracle of financing production and
distribution spontaneously, without taking one penny out of the piggy-banks
of the savers” is to claim that production can be financed without
any goods, by the creation of credit.
What, one wonders,
will the employees of manufacturing firms eat? Goods that are consumed
are gone and thus not available for use in production. Notes Carroll,
“It is the most preposterous nonsense in the world to suppose that
money and the promise to pay it can both be kept in circulation together and
made available as capital, and that we can thus eat our cake and have it too.”[16]
Printing more paper
does not create more productive workers, more office space, or build
manufacturing plants – it only enables more paper to chase the existing
base of assets. If credit could fund real productive activity, why have
savings at all? Why not fund all production through credit expansion, not
just short term goods in process? As Mises explains,
[the masses does] not
realize that investment can be expanded only to the extent that more capital
is accumulated by saving. They are deceived by the fairy tales of monetary
cranks. Yet what counts in reality is not fairy tales, but people’s
conduct. If men are not prepared to save more by cutting down their current
consumption, the means for a substantial expansion of investment are lacking.
Those means cannot be provided by printing banknotes and by credit on the
bank books.[17]
Economists have used
the somewhat obscure term “forced savings” to describe the shift
in the expenditure of savings set in motion by credit expansion. This term
can be explained as follows. In the market, purchasing power comes from
the ability to supply goods to others who demand them. When fiduciary media
are created, new purchasing power is obtained not by supplying but by
diluting the purchasing power of existing money. While the immediate
recipients of the new credit have more purchasing power, they have only
obtained this power at the expense of other money holders.
The business
firms that have borrowed fiduciary media obtain the ability to outbid other
holders of money. By shifting those goods from others who might have consumed
them to toward production, they exclude others who might have purchased them
for consumption. That is, they save-and-invest the goods. The savings is
“forced” in the sense that the loss off purchasing power by the
rest of the community is not made willingly, as would be the case if the
others had chosen to save and invest by loaning their funds.
Mises was overly
optimistic when he wrote, “The absurdity of [inflationists’]
arguments is so manifest that their refutation and exposure is easy
indeed.” Inflationism has been the most enduring and harmful fallacy
of monetary economics. The progress of sound economics against this doctrine
has not been without setbacks. The fantasy of wealth creation through paper
inflation never loses its appeal, as the continuing popularity of the
Real Bills Doctrine suggests.
Each new generation
of monetary cranks has rekindled hope for the long-awaited Christmas Day when
the Santa Claus of money creation arrives. Only when the distinction
between real savings and empty paper promises is understood will economics
drive a stake through the heart of this fallacy for all time.
[1] Mises:
“There are men who are commonly stigmatized as monetary cranks. The
monetary crank suggests a method for making everybody prosperous by monetary
measures.” Mises, Ludwig von, Human Action, Auburn, Alabama: Ludwig von
Mises Institute, 1998, 186.).
[2] Law was the
second greatest inflationist of all time after Alan “two bubbles”
Greenspan. See: Makin, John H., Greenspan's Second Bubble, 2005.
[3] Interview with Allan H. Meltzer, September, 2003.
[4]Noland, Doug, Henry Calvert Simons, August 24, 2001.
[5] From Mises Made Easier: Bill of exchange. A negotiable
document drawn up and signed by one party (usually, but not necessarily, a
seller) on a second party (usually a buyer) providing that the second party
unconditionally promises to pay to the order of bearer or a third party, but
which may be the drawer or first party, a specified sum on sight (upon
acceptance by the second party) or upon a specified or determinable date. The
bill becomes valid only upon the signed acceptance by the second party. A
bill payable at a future date is a credit instrument discountable at banks in
advance of maturity, depending upon the credit of the parties signing the
bill. At certain times and places in history, bills of exchange have been
used as media of exchange.
[6] Mises, Ludwig
von, Human Action, Auburn, Alabama: Ludwig von Mises Institute, 1998, 186.
[7] Hayek,
Friederich A. von, Prices and Production, Augustus Kelley, 1931, 114.
[8] Mises, Ludwig
von, Human Action, Auburn, Alabama: Ludwig von Mises Institute, 1998, 430.
[9] Hultberg raises the
issue of whether this sort of transaction is inherently fraudulent, and
concludes that it is not if the bank fully informs its customers. To address
the legal-theoretic issue fully would take the discussion too far afield for
the current article. Note however that the resolution of the juridical issues
has no bearing whatever on the economics of the problem, the focus of the
current article.
I agree with Hultberg
that legal powers given to banks, such as the option to suspend
convertibility of bank notes when they are bankrupt, are a form of special
privilege and should be abolished. However, I believe Hultberg’s
view is mistaken that fractional reserves per se are not a
problem if they are fully disclosed. Even if a bank had a large sign stating
“this bank does not have sufficient gold coins to redeem all of the
bank notes and deposits” this system would still pose legal problems.
For a full explanation of this view, the interested reader might wish
to read the following articles: Hans Hoppe and Jörg Guido Hülsmann,
Against
Fiduciary Media; Jesús Huerta de Soto, A
Critical Note on Fractional-Reserve Banking and A
Critical Analysis of Central Banks and Fractional-Reserve Free Banking; Jörg
Guido Hülsmann: Free
Banking and the Free Bankers, Free
Banking and Fractional Reserves: Response to Pascal Salin, Has Fractional-Reserve Banking Really Passed the Market Test?, and Banks Cannot Create Money.
[10] Carroll,
Charles Holt, 1860, in Hunt's Merchants' Magazine and Commercial Review,
XLIII, "Currency of the United States,"; reprinted in Edward C.
Simmons, ed., Organization of Debt Into Currency and Other Papers,
William Volker Fund Series in the Humane Studies, Princeton, New Jersey:
William Volker Fund, 1964, 234.
[11] Hülsmann,
Jörg Guido, Free
Banking and the Free Bankers, Review of Austrian
Economics, 9(1), 1996, 39-40.
[12] Mises, Ludwig
von, Lord Keynes and
Say's Law, Ludwig von Mises Institute, April 25, 2005.
[13] Hülsmann,
Jörg Guido, Free
Banking and the Free Bankers, Review of Austrian
Economics, 9(1), 1996, 32-33.
[14] Hülsmann,
Jörg Guido, Free
Banking and the Free Bankers,, Review of Austrian
Economics, 9(1), 1996, 32-43.
[15]Mises, Ludwig von, The
Theory of Money and Credit, Indianapolis, Indiana: Liberty Fund, 05/04/10, 1980, 378.
[16] Carroll,
Charles Holt, Organization of Debt Into Currency and Other Papers, Princeton, New Jersey: William Volker Fund, 1964, 258.
[17] Mises, Ludwig
von, Human Action, Auburn, Alabama: Ludwig von Mises Institute, 1998, 186.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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