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- Chapters 1 - 3
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- Origins of the Real Bill -
- The Miracle of One Gold Coin Performing the Job of Three -
- A Small Step for One Man, But a Giant Step for Mankind -
- Clearing at the Great Medieval Fairs -
The Evolution of Paper Currency
Fable has it that paper currency came into being as
warehouse receipts issued by the goldsmith against gold left on deposit for
safe-keeping. The owners found that they could make purchases with these
warehouse receipts as easily as with gold coins. Then the goldsmith went on
lending out at interest his fictitious warehouse receipts. According to this
fable, the fraudulent business of the goldsmith in issuing warehouse receipts
against non-existent gold was the embryonic form of the fractional-reserve
banking of today.
The unsurpassable naivety of this fable raises the
question how serious students of money and credit have found it possible to
treat it with respect. We should credit our ancestors with more intelligence
and acuity than assuming that they fell so easy a
victim to such a crude swindle, or that they meekly continue to be victimized
long after the fraud has been exposed. To be sure, there was fraud aplenty in
the actual process of introducing bank notes but, as we shall see, it was far
more subtle and far more sophisticated than the crude device of issuing
warehouse receipts on non-existing gold.
In reality, the evolution of paper currency takes
its origin in the invention of the negotiable bill of exchange, the real
bill. This was a wonderful invention. There was nothing sinister about it. The
process was perfectly natural. Some authors maintain that the bill of
exchange has been around since time immemorial. Harley Withers in his book (The
Meaning of Money, London, 1910, p 38) quotes an authority as saying that
the bill of exchange was, in its original form, probably nothing more than a
letter of credit from a merchant in one country to his debtor: a merchant in
another, requiring him to pay the debt to a third party, namely, to the
bearer of the letter who happened to be traveling
to the place where the debtor resided. It turned out that the bearer could
with advantage assign his letter of credit to another by endorsing, and there
could be several such endorsements before the letter was finally presented to
the debtor for final settlement.
The only evidence that indeed there might have been
such a circulation of letters of credit is an obscure quotation from Cicero. In a letter to Atticus, Cicero asks
whether he could send money to his son in Athens by exchange operations. This passage
is, of course, not a proof that bills of exchange circulated in Rome and its overseas
possessions. Be that as it may, in view of the voluminous trade between Rome and Athens,
it is possible that the acute and quick-minded Greeks devised some exchange
mechanism to clear the credits arising from the trade of goods between these
two busy cities.
Here we assume that bills of exchange as we know
them from the earliest extant specimens came into use in Florence,
Venice, and Genoa in the 14th century. Either one of
these cities could have been the scene of The Second Greatest Story Ever
Told, an attempt to reconstruct the process whereby the bill of exchange,
or real bill, was invented. The story will be told in twelve chapters. I call
it the 'second' greatest story (the 'first' being the Bible) in order to
emphasize moral philosophy that continues to provide background to the
history of money in the spirit of Adam Smith.
The Second
Greatest Story Ever Told
Chapter
One
in which the gentle reader learns about the miracle of one gold coin
performing the job of three
The cotton dealer shipped cotton to the
spinner and billed him for goods received. The spinner 'accepted' the bill,
that is, he acknowledged receipt of goods by writing across the face of the
bill 'I accept' over his signature. This signified his acceptance of the
responsibility to pay the face value of the obligation at maturity. He then
returned the bill to the cotton dealer pending settlement in coins.
Having spun the cotton, the spinner shipped
the yarn to the weaver and billed him. The weaver accepted the bill and
returned it to the spinner pending settlement in coins.
Having woven the yarn, the weaver shipped the
cloth to the clothier and billed him. The clothier accepted the bill and
returned it to the weaver pending settlement in coins. The journey of the
same cotton on its way to the consumer has spawned three separate bills, each
held by a particular supplier, pending settlement at maturity.
Now the clothier had cash-paying customers,
the ultimate consumers of cloth. After the cloth was sold, he had the gold
coin given up by the consumer. When the bill drawn on him matured, and the
weaver presented it to him for payment, the clothier passed on the gold coin
of the consumer. After adjustment was made in small change for the difference
in the face value of the bill and that of the gold coin, the
weaver-on-clothier bill was marked 'paid'.
Soon afterwards, the spinner presented his
bill to the weaver for payment who paid it by passing along the gold coin of
the consumer. After adjustment in small change, the spinner-on-weaver bill
was marked 'paid' by the spinner.
Finally, the cotton dealer presented his bill
to the spinner for payment, who paid it by passing along the same gold coin
of the consumer. After adjustment in small change, the dealer-on-spinner bill
was marked 'paid' by the dealer. The cycle of supplying the consumer with
cloth was complete. In the end, no one owed anybody anything.
The remarkable feature of this primitive clearing
system is that the use of bills has increased the efficiency of the gold coin
four-fold. In the absence of bills the pool of circulating gold coins would
have had to be invaded and drawn upon four times in order to move cotton to the
ultimate consumer. As it happened, the pool of gold coins wasn't invaded even
once. The single gold coin of the consumer given up in exchange for the
finished cloth was sufficient to extinguish all the claims arising along the
journey of the cotton from the dealer to the consumer. It is also clear that,
regardless how roundabout the journey of the cotton may, due to further
division of labor, become in the future, the single
gold coin of the consumer will always be sufficient to extinguish all the
claims arising along the cotton's journey. To put the matter differently, the
gold standard is no longer a fetter upon technological progress and further
division of labor, as it would be in the absence of
the bill of exchange. The number of hands engaged in the movement of cotton
to the ultimate consumer can increase from four to fourteen, and later to
forty if necessary, without adding any new demand for additional gold coins. The
lengthening of the production and distribution process, of course, represents
specialization, improved technology, better tools, cost
reduction, in one word: greater efficiency. The bill of exchange has opened
up new avenues for progress, leading to great improvements in the condition
of human life on earth. Technological progress will never again be obstructed
by a dearth of gold.
Time is obviously a factor in the cycle of supplying
the consumer with cloth. We may assume that the journey of cotton from the
dealer's warehouse to the consumer takes, on the average, three months to
complete and, accordingly, the dealer-on-spinner bill is drawn to mature in 3
months. The journey of yarn from the spinner to the consumer takes two months
to complete and, accordingly, the spinner-on-weaver bill is drawn to mature
in 2 months. Finally, the journey of cloth from the weaver to the consumer
takes one month to complete and, accordingly, the weaver-on-clothier bill is
drawn to mature in 1 month. In this way, although the three bills have
different life-spans, they will all mature on the same day, facilitating
settlement.
Chapter
Two
in which the gentle reader
learns about an innovation enabling the consumer to choose
from a variety of cloth three times as great as before,
without it costing anybody a penny
One day the clothier told the weaver that he
would be glad to carry an inventory of cloth three times as large, in order
to enable his customers to select from a greater variety of cloth. Naturally,
the weaver was delighted with the proposal, and agreed to draw 3-month bills
on the clothier instead of 1-month bills as before, since an inventory 3
times as large may take 3 times longer to clear. Now the weaver needed
different types of yarn to weave a greater variety of cloth. He figured that
he could use half again as much yarn as before. His new inventory of yarn,
being 1 and 2 times larger, may take 1 and 2 times longer to clear. Accordingly,
the spinner agreed to draw 3-month bills on the weaver, instead of 2-month
bills as before. In his turn, the spinner need not keep a larger inventory of
cotton on hand because all yarn was coming out of the same bale.
Now all three merchants: the cotton dealer,
the spinner, and the weaver were drawing bills not only with the same
maturity date, but also with the same life-span of 3 months. The new system
worked very well indeed. New supplies were ordered, and bills drawn on them
matured monthly, instead of quarterly as before. Consequently, adjustments to
the changing taste of the consumer could be made more readily. The clothier
had no plans to enlarge his inventory of cloth any further, and had no reason
to request the weaver to extend the maturity date of his bills beyond three
months.
At any rate, the weaver would have had solid
grounds to resist such a request. If the cloth moved faster due to brisker
consumer demand, the adjustment would have to be made, not through the size
of inventory, but through that of the monthly shipments. Three months (or 13
weeks, or 91 days) is just the length of the seasons. If the clothier could
not sell a certain kind of cloth in 91 days, then he might not be able to
sell it for 365 days, before the same season of the year came around once
more. However, by that time fashion could change beyond recognition, and the
clothier might not be able to sell the cloth out of vogue except at a loss. For
this reason, there is an unacceptable risk involved in drawing bills of
exchange with maturity 92 days or longer. A slow inventory of cloth that may
take more than 3 months to sell cannot be financed through clearing. Its
journey to the consumer must be financed through borrowing. A bill of
exchange must always represent merchandise that moves, and move it must fast
enough so that the shelves in the retail store can be cleared once every
quarter.
Chapter
Three
in which the gentle reader learns about another invention: that
of making one bill do the job of three.
The drawer of the bill is making his first tentative steps to put the bill
into circulation -
"a small step for one man, but a giant step for mankind".
Some time later our tradesmen met in a pub,
and over a pint of beer discussed the success in financing the production and
distribution of their merchandise through real bills, as well as a new
proposal of the clothier to simplify their billing further. The clothier
pointed out that one bill could in fact do the work of all three, as the
title to the proceeds could easily be transferred to the next holder by
endorsing. "At the end of the first month the weaver will endorse the
bill", the clothier explained, "and pass it on to the spinner in
payment for the yarn, after the necessary adjustment in the outstanding
amounts is made in small change." The weaver got the point and added:
"At the end of the second month the spinner, after endorsing the very
same bill, will pass it on to the cotton dealer in
payment for the cotton, not forgetting to make the adjustment in small change
for the difference in the outstanding amounts." The spinner also chimed
in: "And at the end of the third month the bill will mature. The cotton
dealer can collect his receivables." The spinner raised his glass and,
turning to the clothier continued: "And you, my friend, will have the
gold coin to pay him! By that time the entire inventory of cloth will have
been sold for gold coins. I salute you for your brilliant idea of turning the
bill into currency!"
The tradesmen were enthusiastic. The
experiment came through with the flying colors. This
was a veritable breakthrough. The physical movement of the gold coin was
reduced to its irreducible minimum - without any loss of mobility of goods. The
payment of gold by the clothier to the cotton dealer, as it were,
'telescoped' the three payments occasioned by the movement of cotton from the
producer to the consumer into one. The economy in the movement of gold was
achieved by giving temporary monetary privileges to the bill drawn on the
clothier. The weaver-on-clothier bill could henceforth 'circulate' before its
maturity date. It was readily accepted by the spinner and the cotton dealer
in payment, neither of whom was a party to the deal which formed the basis
for drawing it. The significance of this discovery could hardly be
exaggerated. Credit could now circulate among the tradesmen on the same terms
as gold without a hitch. It was also clear that this circulation owed its existence
to the movement of the underlying merchandise. The emphasis is on the word
'movement'. The clothier experimented with bills representing stalled
merchandise (left unsold from the previous season). He found, to his great
regret, that these bills just would not fly.
Of the three, it was the weaver-on-clothier bill
that was at the head of the line waiting to be exchanged for the gold coin of
the consumer. To use the technical term we say that it was "more
liquid" than the others as it could circulate in lieu of cash. The other
bills, being less liquid, fell by the wayside. There was no need to draw them
any more as the endorsement of the weaver-on-clothier bill was considered
payment in cash.
A finished good ready to be sold to the consumer is
called a first order good. There are also higher order goods.
An n-th order good is a semifinished
good that is n times removed from the consumer, e.g., the cloth is a 1st,
the yarn is a 2nd, and the cotton is a 3rd order good. The
acceptor of the bill (in our example, the clothier) is the retail merchant
selling the first order good to the consumer, to whom the drawer of the bill
(in our example, the weaver) is supplying the second order good. The same
bill, after the n-th endorsement, is used to
pay for the supply of the (n + 1)-st order good. We shall call this primitive circulation of bills vertical.
It is confined to the circle of tradesmen engaged in the production of the
same merchandise, where one is the supplier of the other. But as we shall
soon see, this limitation is not essential. The circulation of the bill
before its maturity date would eventually become universal.
I shall briefly interrupt relating The Second
Greatest Story Ever Told in order to describe another variety of real
bill circulation called horizontal.
The Merchants of
Seville
This is not the title of an opera, nor that of a
drama; it refers to one of those great annual medieval fairs which used to
attract merchants from very great distances to the fair city such as Leipzig
in Germany, Lyon in France, and Seville in Spain, located at the crossroads
of great trading routes. The fair itself could last a month or even six
weeks. Some of the merchants came from as far as a thousand miles away. All
of them came to sell home-produced wares as well as to buy the wares of other
regions that could lie another thousand miles away from the fair city in the
opposite direction. We could imagine that it must have been well worth the
effort of the merchants to travel and spend all this time so far away from
home. This was the way to export and import in those days; there was no
other. While they carried home-made merchandise in their carriages, one thing
they did not carry with them. They did not carry gold. They expected to make
their purchases with the proceeds of their sale. The trouble with that was
that they had to sell first in order to be able to buy afterwards. This was a
fatal limitation. It may have meant missed buying opportunities. This trouble
was eliminated by the clearing house of the fair which made it possible for
the merchants to buy first and sell afterwards, if they so desired, as we
shall now see.
The remarkable thing about these medieval fairs was
their clearing system. An enormous quantity of goods exchanged hands (some
several times) facilitated by a very small pool of gold coins. How did they
do it? Just think for the moment, if you will, about the enormous logistical
problem they were facing. Barter was pretty well out. They quoted gold
prices, but they realized that the buyer they were dealing with, just like
themselves, did not carry gold with him. So how
could they make the sale if a prospective buyer was willing to pay the price
asked?
Well, they developed an ingenious clearing system
using bills of exchange maturing on the last day of the fair. Every merchants registered his merchandise at the clearing house
upon arrival. Registration gave them the right to accept bills payable at the
clearing house where bills would be offset against one another and only the
difference in face values would be paid in gold coins on the last day of the
fair. This afforded an amazing economy in the use of the gold coin. It was
this economy that was responsible for making the fairs so attractive to
merchants coming from far-away places.
We may be certain that without the clearing system
there would have been no fair, and trade would have been limited to that
between next-door neighbors. If merchants traveling those great distances would have had to carry
not only their merchandise for sale, but also the gold coins with which to
make their purchases, they would not have undertaken the trip. For one thing,
they probably would not have had the gold, which was needed for domestic use.
For another, on the long trip they would have offered themselves as easy
targets for highwaymen preying upon the purse of traveling
merchants.
The circulation of bills of exchange generated at
the fair may be described as horizontal. They were all drawn on first-order
goods ready to be sold to the consumer, and they were passed on from hand to
hand between retail merchants (rather than from the producer to his supplier,
as in the case of vertical circulation).
The medieval fairs were a marvelous
institution promoting trade between far-away regions. Not enough research has
been done on this subject, especially on the inner workings of the clearing
and insurance facilities offered at the fairs.
Real Bills Never
Cause Inflation
We have seen that real bills may arise in different
settings and facilitate exchanges of goods that may not otherwise come about
simply because of the limited supply of gold coins available for trade. If
people saw that the goods were in sufficiently urgent demand, and ultimate
payment was guaranteed by the fact that the underlying goods would be soon
(i.e., before the maturity date) removed from the market by the ultimate
consumer paying gold coin for his purchase, then they would take the bill
(provided it has been duly accepted) in payment and then use it themselves in
paying for their own purchases. Thus bills became the preferred currency of
the fair.
Detractors of the Real Bill Doctrine maintain that
the circulating bill was inflationary in that it meant an expansion of the
pool of circulating purchasing media. However, this position is demonstrably
wrong. The bill emerged simultaneously with the emergence of new merchandise
in urgent demand of the same value, and would disappear from circulation at
the same time when the merchandise was sold. The net effect on the stock of
purchasing media was therefore zero.
It is helpful to think of the bill of exchange as an
instrument that automatically adjusts the stock of purchasing media to the
stock of merchandise to be cleared by the markets. During peak season, when
the turnover of merchandise reaches its maximum, the means of payments to
move it is readily available. Once the merchandise has been removed from the
markets, the extra amount of purchasing media disappears. This means that in
low season the pool of purchasing media contracts and there is no excess cash
chasing non-existent goods. The whole process of adjustment is automatic, and
works without direct intervention on the part of the banks or the government.
In fact, the whole system of supplying the consumers with all the goods in
high demand through bill circulation will work even in the complete absence
of banks.
World Trade
Today
Another example of the horizontal circulation is the
pre-1914 financing of world trade by drawing bills on London. In this case London acted as the clearing house of a
non-stop fair. Merchandise was carried by the merchant navy directly from the
exporting to the importing country. The volume of world trade was huge, it
was a two-way street, consequently, the pool of gold
coins to finance the movement of merchandise was tiny. Yet the system worked
beautifully, thanks to the horizontal circulation of self-liquidating
commercial paper. The small and relatively stable pool of gold coins in London could finance
the huge volume of world trade as it flowed and ebbed with the seasons.
Compare that with world trade today, which has been
governed not by commercial, but by political considerations since World War I
and, therefore, has been reduced mostly to one-way flows. The chits of the
world's greatest military power are used, under duress, by all trading
nations of the world. After the chits have done their job of financing trade
they keep piling up, also under duress, in foreign central banks. The nations
of the world are lulled into the false belief that these monetary reserves
are real, usable when the need arises, and earn interest in a meaningful way.
But the cruel truth is that they represent the permanent debt of the United States, the largest debtor of the world
(it used to be the largest creditor before 1972, the year when the U.S.
defaulted on its gold obligations to foreign central banks). It is a
pipedream that the debt of the U.S. plus accrued interest will
ever be repaid - certainly not in dollars of the same purchasing power. Take Japan, for
example. It could use her enormous dollar reserves it has accumulated over a
period of half a century in order to clean up the mess in the Japanese
banking system. But while they are may be available to buy a Coca Cola bottling
franchise, or use it for the purposes of making small payments to third
parties, they are definitely not available for liquidation in larger
quantity. It would wreck the bond market, and ruin the credit of the United States government, if Japan insisted
on using its monetary reserves to solve its banking crisis. There is simply
no way for Japan
to liquidate its monetary reserves accumulated under duress.
The United
States has dismantled its export
industries (with the exception of those of strategic importance) just at the
time when it should have expanded exporting capacity in order to service its
huge and increasing external debt. It has exported industrial jobs to third
world countries in exchange for consumer goods it no longer produces
domestically. This means that the trade deficit is to continue, and increase,
indefinitely.
The costs of this perverse (not to say insane)
system of financing world trade, based as it is on coercion, are enormous. Apart
from it causing relentless currency depreciation, the piling up of U.S.
government debt in foreign central banks makes overseas holders of dollar
balances nervous. For the time being, foreign central banks play the game
according to the rules dictated by the U.S. Treasury. They resist the
temptation to cash their dollar balances, presumably motivated by thieves' solidarity, that "we had better hang together, lest
we hang separately". But when a country breaks ranks and starts liquidating its dollar balances, as is inevitable,
all others will run to the exit. The world's monetary system will crash.
Such a crash could never occur under the
international gold standard with world trade financed by horizontal bill
circulation. Bills of exchange are self-liquidating credit instruments. They
cannot pile up in foreign central banks. Once the goods are sold to the
ultimate cash-paying consumer, the bills of exchange that financed their
trade simply disappears. Why can't the world return
to world-trade to a system of payments using horizontal bill circulation? Because
such a system must be a gold-based system, and gold
is anathema to the United States Treasury.
Yet this system of bill-circulation is well-worth
not only studying but also emulating. The big banks of the world from Japan through Germany
to the United States
are rushing into bankruptcy with break-neck speed. The central banks won't be
in the position to bail them out. Their so-called assets, namely U.S.
government debt, are strictly for window-dressing purposes. They are useless
as a monetary reserve, if you have illusions to liquidate your holdings in
order to pay off your own debts.
We may face an epoch in history without banks, a
world in which people will refuse to trust bankers and their promises.
Be prepared!
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Correction
In Lecture 3 under the caption "The Invisible
Vacuum Cleaner" I referred to the recent accounting scandals and
mentioned Enron and Westcom. The latter should read
"Worldcom".
Bravo for
Monetary Economics 101!
Malik Yusuf of Edith Cowan University,
Perth, Wastern Australia
writes:
Sir,
Bravo for Monetary Economics 101. A standing ovation
for each Lecture. Only the Internet made it possible for me to continue my
education outside of the recognized institutions. I have started my studies
in economics formally at the late age of 38 as a result of my discovery of
your work. If the underlying cause for the excesses of this dark age is as
you have diagnosed, then I feel that this is where I should begin my studies,
even though I must start from scratch. It is a truly fascinating experience
to receive one narrative from the official curriculum, and jostle for high
grades with the current generation of students being groomed and
indoctrinated with the same, and then, after hours, to obtain my real
nourishment and hope for the future from studying your material.
Your most ardent pupil,
Malik Yusuf
We are fortunate indeed that, thanks to the
Internet, we need no longer be forced into the straitjacket of orthodoxy and
subjected to the brain-washing of official indoctrination. In earlier ages
universities were the focal points of intellectual dissent, and resistance to
an ossified science and culture. No more. Virtually all universities in the
world are now in the service pusillanimity, cringing in front of the thought
police that discourages and persecutes independent thinking. Let's hope that
there will be lots of initiatives like ours to break the thought-monopoly of
governments, and let truth be the winner.
July 29, 2002
Antal E. Fekete
Professor Emeritus
Memorial University
of Newfoundland
St.John's, CANADA A1C5S7
e-mail: aefekete@hotmail.com
GOLD UNIVERSITY
SUMMER SEMESTER, 2002
Monetary
Economics 101: The Real Bills Doctrine of Adam Smith
Lecture
1: Ayn Rand's Hymn to Money
Lecture 2: Don't Fix the Dollar Price of Gold
Lecture 3: Credit Unions
Lecture 4: The Two Sources of Credit
Lecture 5: The Second Greatest Story Ever
Told (Chapters 1 - 3)
Lecture 6: The Invention of
Discounting (Chapters 4 - 6)
Lecture 7: The Mystery of the Discount
Rate (Chapters 7 - 8)
Lecture 8: Bills Drawn on the
Goldsmith (Chapter 9)
Lecture 9: Legal Tender. Bank Notes of Small Denomination
Lecture 10: Revolution of
Quality (Chapter 10)
Lecture 11: Acceptance House (Chapter
11)
Lecture 12: Borrowing Short to Lend
Long (Chapter 12)
Lecture 13: Illicit Interest Arbitrage
FALL SEMESTER, 2002
Monetary
Economics 201: Gold and Interest
Lecture
1: The Nature and Sources of Interest
Lecture 2: The Dichotomy of Income versus Wealth
Lecture 3: The Janus-Face of
Marketability
Lecture 4: The Principle of Capitalizing Incomes
Lecture 5: The Pentagonal Structure of the Capital Market
Lecture 6: The Definition of the Rate of Interest
Lecture 7: The Gold Bond
Lecture 8: The Bond Equation
Lecture 9: The Hexagonal Structure of the Capital Market
Lecture 10: Lessons of Bimetallism
Lecture 11: Aristotle and Check-Kiting
Lecture 12: Bond Speculation
Lecture 13: The Blackhole of Zero
Interest
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