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- Chapters 1 - 3 -
- 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!
* * *
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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