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The Great Depression of the 1930s bringing unprecedented world-wide
unemployment in its wake was not caused by the “contractionist
nature” of the gold standard as alleged by John M. Keynes. Nor was it
caused by “fractional reserve banking” as alleged by Murray N. Rothbard. It was caused by national governments
sabotaging the clearing system of the international gold standard, the bill
market, thereby destroying the wage fund of workers employed in the
production and distribution of consumer goods. In throwing out the bath-water
of real bills governments have thrown out the baby of full employment.
Unemployment is the modern version of the earlier religious practice of
making human sacrifice on the altar of Mammon
The tale of the cuckoo’s egg
1909 was a milestone in
the history of money. That year, in preparation for the coming war, the note
issues of the Bank of France and of the Reichsbank
of Germany were made legal tender. Most people did not even notice the subtle
change. Gold coins stayed in circulation for another five years. It was not
the disappearance of gold coins from circulation that heralded the
destruction of the world’s monetary and payments system. There was an
early warning: the German and French government’s decision to make bank
notes legal tender that would effectively sabotage the clearing system of the
international gold standard, the bill market.
Real bills drawn on
consumer goods in urgent demand circulated world-wide without let or
hindrance before 1909. As goods were moving to the ultimate gold-paying
consumer, bills drawn on them matured, as it were, into gold coins, that is
to say, into a present good. It is readily seen that the notion of a bill
maturing into a legal tender bank note is preposterous. The bank note is not
a present good but, like the bill itself, a future good. Furthermore, legal
tender means coercion enforced within a given jurisdiction but unenforceable
outside. At any rate, legal tender bank notes were incompatible with the
voluntary system based on the bill of exchange payable in gold coin at
maturity. They were bound to paralyze the market in real bills. The monkey
wrench has been thrown into the clearing system of the international gold
standard.
The bank of issue
continued to use the bill of exchange as an earning asset to back the legal
tender bank note issue. But other subtle changes would alter the character of
the world’s monetary system beyond recognition. The cuckoo has invaded
the neighboring nest to lay her egg
surreptitiously. In addition to bank notes originating in bills of exchange
bank notes originating in financial bills have made their appearance for the
first time. In due course the cuckoo chick would hatch and push the native
chick out of the nest. In five years the entire portfolio of the bank of
issue consisting of real bills exclusively would be replaced by one
consisting of financial bills, including treasury bills. The real bill has
become an endangered species. In another five years it would become extinct.
Bank notes as self-liquidating credit
Previous to 1909
circulating capital for the production of consumer goods in urgent demand had
been financed, not out of savings, but through discounting real bills at a commercial
bank which would then rediscount them at the bank of issue that supplied the
country with bank notes. To be sure, these bank notes represented
self-liquidating credit. They were merely a more convenient form of the bill
of exchange from which they derived their strength. They came in standard
denomination round figures. Unlike the bill of exchange they could without
hassle and loss be broken up into smaller units. The great convenience they
offered was valued by the public so much that people were willing to pay for
it in the form of forgone discount.
When the bill matured and
was paid, the bank note was retired. For this very reason it was not
inflationary, not any more than the real bill itself. The bank of issue would
under no circumstances prolong credit beyond the maturity date of the
rediscounted bill. If the underlying merchandise could not be sold in 91 days
then, for the stronger reason, it would not be sold in 365 days, certainly
not before the same season of the year came around once more. But by that
time the merchandise would be stale and could only be sold at a loss.
Prolonging credit on a mature bill would violate the letter and spirit of the
law governing central banking in Germany prior to 1909.
Could a commercial bank,
nevertheless, roll over a real bill at maturity? On strictly economic grounds
it wouldn’t. First of all, it would forfeit its rediscounting
privileges at the bank of issue if it did. Secondly, it would make its
portfolio less liquid and so it could no longer compete successfully with
more liquid banks. Having said this, we must admit that in practice some
banks may have been guilty of rolling over mature real bills for various
reasons. At the benign end of the spectrum the reason could be a false sense
of loyalty to clients; at the malignant, conspiracy with them in speculative
ventures. It was this latter practice that could be properly condemned as
“credit expansion”. However, the unethical behavior
of some banks should be no grounds for issuing a blanket condemnation of all
banks and calling the legitimate practice of discounting real bills
“credit expansion” with a disapproving connotation.
Real bills versus financial bills
The changeover from bank
notes backed by real bills to bank notes backed by financial bills was the
last nail in the coffin of the clearing system of the international gold
standard. Monetary scientists and others with intellectual power to grasp the
intricacies of bank note circulation raised their voice condemning the new
paradigm making financial bills eligible for rediscount, a practice that had
previously been prohibited by law with severe penalties for non-compliance.
Most people could not understand what the fuss was about. But there was a
world of a difference between rediscounting real bills as opposed to
financial bills. It was the difference between self-liquidating credit and
non-self-liquidating credit. Real bills were backed by a huge international
bill market with its practically inexhaustible demand for liquid earning
assets. Financial bills were backed by the odds that speculative inventory of
goods and equities or investment in brick and mortar may be unwound without a
loss. If the odds did not play out in time, then at maturity the financial
bills would have to be rolled over. This was borrowing short and lending long
through the back door, carrier of the seeds of self-destruction.
The chimera of “fractional reserve banking”
Financial bills made the
asset portfolio of the bank of issue illiquid. The bank could no longer satisfy
potential demand for gold coins, should holders of bank notes decide to
exercise their legal right to redeem them. To take away this right was the
reason for making bank notes legal tender in the first place. Redemption
wouldn’t be a problem as long as the asset portfolio consisted of real
bills exclusively. Every single day one-ninetieth of the outstanding bank
notes matured into gold coins which were available for redemption. This would
normally suffice to satisfy daily demand. But what about abnormal demand for
gold coins?
A real bill is the most
liquid earning asset in existence. At any time somewhere in the world there
is demand for it. In particular, banks that have a temporary overflow of gold
would be more than anxious to exchange it for real bills. The bank of issue
would not have the slightest difficulty to get gold in exchange for real
bills in the international bill market. Once upon a time the Bank of England
boasted that “it could draw gold from the moon by raising the
rediscount rate to 5%.” The assumption that there will always be takers
for real bills offered is just as safe as the assumption that people will
want to eat, get clad, keep themselves warm and
sheltered tomorrow and every day thereafter.
This explodes the blanket
condemnation of “fractional reserve banking”,
a stand so popular nowadays in some circles. Detractors of fractional reserve
banking are barking up the wrong tree. They should condemn the practice of
rediscounting financial bills on the same terms as real bills. The latter
were self-liquidating, while the former had impaired liquidity: under certain
circumstances they might become unsaleable even in
peacetime. They were simply unsuitable to serve as bank reserves.
Prior to 1909 the charter
of every bank of issue explicitly made financial bills ineligible for
rediscounting. The laws governing central banking prohibited the use of these
bills for the purposes of backing the note issue, and prescribed heavy
penalties for non-compliance. This was not a controversial issue. Informed
people could distinguish between safe banking that utilized real bills and
unsafe banking that utilized financial bills to back the note issue. That
judgment is epitomized by the old saying that “the easiest profession
in the world is that of the banker, provided that he can tell a bill and a
mortgage apart”.
Reflux
The process of retiring
the bank note after the merchandise serving as the basis for its issue has
been removed from the market by the ultimate gold-paying consumer is called
“reflux”. Some authors ridiculed the concept calling it a deus ex machina.
They argued that the banks were only interested in credit expansion, not in
reflux. They would not for one moment think of withdrawing a corresponding
amount of bank notes from circulation when the real bill matured. Instead,
they would lend them out at interest to enrich themselves at the expense of
the public. For
the stronger reason, you could also ridicule the entire legal system asking
the rhetorical question: “what is the point in making laws when they
will be broken anyhow?” This is not a valid argument. You can’t
judge the merit of an institution by the behavior
of those who are set upon destroying it.
Let us follow the trail
of gold coins through the path of reflux. Our description is necessarily
schematic. For the sake of simplicity we assume that only
distributor-on-retailer bills are discounted. This is reasonable as these
bills are more liquid than producer-on-distributor bills, or
higher-order-producer-on-lower-order-producer bills. We also assume that the
retailer is expected to pay his bill with gold coins flowing to him from the
consumers. The gold is considered proof that the merchandise underlying the
bill has been sold to the ultimate consumer and is not held, contrary to the
purpose of bill circulation, in speculative stores in anticipation of a price
rise. Finally, our description follows the practice of the German banking
system as it was before 1909. The practice elsewhere may have been different,
but the essential idea was the same: with the sale of merchandise the gold
coin was recycled from the consumer through the retail merchant to the
commercial bank, from where it would be withdrawn by producers in order to
pay wages, thus putting the gold coin back into the hand of the consumers.
Then the cycle of supplying the consumer with urgently demanded merchandise
could start all over again.
In more details, as gold
coins flowed from the consumer to the retail merchant, they were deposited at
the commercial bank. When he was ready to replenish his depleted inventory,
the retailer ordered a fresh supply and, after endorsing the bill he returned
it to the distributor. The latter would discount it at the commercial bank
taking the proceeds in the form of bank notes which the commercial bank
obtained from the bank of issue through rediscounting.
The distributor would use
the bank notes to pay the producer of first order goods for supplies. The
latter would use them to pay the producer of second order goods for supplies,
and so on. But when it came to paying wages, all these producers had to draw
out gold coins from the commercial bank against bank notes. Upon maturity the
commercial bank paid the rediscounted bill with bank notes which the bank of
issue was under obligation to retire. It could not lend them out at interest.
If it did, it would violate the law, and would have to pay heavy penalties.
The only purpose the retired bank notes could be used for was to rediscount
fresh bills drawn on new consumer goods moving to the ultimate gold-paying
consumer. This was not the same as lending them out at interest, since
lending and discounting were two entirely different banking functions.
Now the gold coin was in
the hands of the wage-earner. As he spent it in buying consumer goods he
enabled the retail merchant to make payments on his discounted bill at the
commercial bank with gold. When paid in full, it was returned to the retail
merchant and the bill’s ephemeral life as a means of payment has come
to an end. But the march of gold coins would continue. They would be
withdrawn by the producers to pay wages, and the cycle of supplying
wage-earners with consumer goods against payment in gold coin could start all
over again.
Mistaking the back-seat
driver for the boss in the driver seat
The havoc that the silent
monetary revolution of 1909 would wreak upon society had not been foreseen.
Nor was the causal relation between the expulsion of real bills and massive
unemployment recognized in retrospect after the worst happened and almost 50%
of trade union members, or 8 million people, lost their jobs in Germany
alone.
Real bills finance the
movement of consumer goods, including wages paid to people handling the
maturing merchandise through the various stages of production and
distribution. The size of circulating capital needed to move the mass of
consumer goods through these stages, if financed out of savings, would be
staggering. Quite simply, it could not be done. No conceivable economy would
produce savings so generously as to be able to finance all circulating
capital that society needed in order to flourish at present levels of comfort
and security. To move a $100 item all the way to the consumer may, in an
extreme case, require savings in the order of $5000, or 50 times retail
value!
Fortunately, there is no
need to employ savings in such a wasteful manner. It is true that fixed
capital must be financed out of savings. As a result, creation of fixed
capital depends on the propensity to save. Not so circulating capital,
provided that the merchandise moves fast enough to the ultimate gold-paying
consumer. It can be financed through self-liquidating credit which depends on
the propensity to consume, but is independent from the propensity to save.
The discovery of this fact
is one of the great achievements of the human spirit and intellect, on a par
with the discovery of indirect exchange. The impact on human life of the
invention of the circulating bill of exchange is fully commensurate with that
of the invention of the wheel. The detractors of the Real Bills Doctrine have
missed one of the most exciting developments of our civilization: the
discovery of self-liquidating credit in the wake of the disappearance of
risks in the production process as the maturing good gets within earshot of
the final gold-paying consumer.
Pari passu with the emergence of the need for consumer goods
the means to finance their production and distribution emerges as well. It is
in the form of the bill of exchange. Retailers and distributors hardly ever
pay cash for supplies of consumer goods. “91 days net” is
invariably part of the deal, to give ample time for the merchandise to reach
the ultimate gold-paying consumer. Producers of higher-order goods could fold
tent and go out of business if they insisted on cash payment for the supplies
they provide. Producers of lower-order goods were the boss by virtue of being
that much closer to the ultimate consumer and his gold coin. They would laugh
you out of court if you told them that they have just been granted a loan and
the discount is just interest taken out of the proceeds in advance. They know
better. They know that self-liquidating credit is theirs for the taking. They
know that the discount rate has nothing to do with the rate of interest. For
a consideration they may be willing to prepay their bill before maturity. The
privilege is theirs. The discount is just the consideration to tempt them.
Those who insist that the producer of the higher-order good is the lender and
that of the lower-order good is the borrower are mistaking the back-seat
driver for the boss in the driver seat.
The biggest
job-destruction ever
Let us now see how the
governments destroyed the wage fund of workers employed in the sector
providing goods and services to the consumer. These workers’ wages were
financed through the trade in real bills. The emerging consumer good they
handled would not be sold to the ultimate consumer for 91 days at the latest.
Yet in the meantime these workers had to eat, get clad, keep
themselves warm and sheltered. If they could, it was only because real bills
trading would keep replenishing their wage fund.
In order to create a job
capital must be accumulated through savings. This applies to the fixed
capital deployed in making both producer goods and consumer goods. In case of
the former it applies to circulating capital as well. But if circulating
capital had to be accumulated through savings in the latter case, too, then
jobs in the consumer goods sector would be few and far in between. In the
event jobs were plentiful in that sector because of the fact that circulating
capital supporting them could be financed through self-liquidating credit
that did not tie up savings. By contrast, jobs in the producers
good sector could not be financed in this way, explaining why they were not
nearly as plentiful nor as easily available.
When governments locked
out real bills from the payments system, they inadvertently destroyed the
wage fund of workers employed in the sector providing goods and services for
the consumer. Unless they were prepared to assume responsibility for paying
wages, there would be unemployment on a massive scale that would spill over
to all other sectors as well. Eventually the governments, to avoid
undermining social peace, decided to do just that. They invented the
so-called “welfare state” paying so-called “unemployment
insurance” to people who could have easily found employment had the clearing
system of the gold standard, the bill market, been allowed to make a
come-back after World War I. What has been hailed as a heroic job-creation
program appears, in the present light, as a miserable effort at damage
control by the same government that has destroyed those jobs in the first
place. Economists share responsibility for the disaster. They have never
examined the 1909 decision to make bank notes legal tender from the point of
view of its effect on employment. They should have demanded that, instead of
treating the symptoms, the government remove the cause in reinstating the
international gold standard and its clearing system,
the bill market. They should have demanded that the government abolish the
legal tender privilege of bank notes forthwith.
It took 20 years for the
chickens of 1909 to come home to roost. But come home they did with a
vengeance. However, by 1929 the memory of the 1909 coercive manipulation of
bank notes faded, and virtually no one realized that a causal relationship
existed between the two events: making bank notes legal tender and the
wholesale destruction of jobs twenty years later.
The father of revisionist theory and history of money
One man who did, and whom
we salute as the father of revisionist theory and history of money, was
Professor Heinrich Rittershausen of Germany. In his
1930 book Arbeitslosigkeit und Kapitalbildung (Unemployment and Capital Formation)
he predicted not only the imminent collapse of the gold standard but also the
wholesale destruction of jobs world-wide as a result of the explosion of the
time bomb planted in 1909, wrecking the clearing system of the international
gold standard, the bill market. The horrible unemployment Rittershausen
predicted would continue to haunt the world for the rest of the 20th
century and beyond.
If we want to exorcise
the world of the incubus of unemployment with which it has been saddled by
greedy governments making bank notes legal tender in their worship of Mammon,
not only must we return to the international gold standard, but we must also
rehabilitate its clearing system, the bill market. In this way the fund, out
of which wages to all those eager to earn them for work in providing the
consumer with goods and services can be paid, will be resurrected. Then, and
only then, can the so-called welfare state paying workers for not working and
farmers for not farming be dismantled.
References
Heinrich Rittershausen, Arbeitslosigkeit
und Kapitalbildung, Jena: Fischer, 1930.
A Spanish translation of
this volume including an essay of von Beckerath was
published in Barcelona in 1934.
Heinrich Rittershausen, Zahlungsverkehr,
Einkaufsscheine und Arbeitsbeschaffung,
published in the Annalen der
Gemeinwirtschaft, vol. 10, p 153-207, Jan.-July,
1934.
This paper is also available
in English translation (by G. Spiller) under the title Unemployment as a
Problem of Turnover Credits and the Supply of Means of Payment, in the
volume: Ending the Unemployment and Trade Crisis, p 137-187, London: William
and Northgate, 1935. See the website.
A French translation
(apparently of a better quality) under the title Organisation des echange et creation de travail can be found in the volume
Le chomage, probleme de
credit commercial et d’approvisionnement en moyens de paiement, p 154-214,
Paris: Recueil Sirey,
1934.
Antal E. Fekete, Adam
Smith’s Real Bills Doctrine, Monetary Economics 101, Gold Standard
University, 2002, see the website.
Antal E. Fekete,
Detractors of Adam Smith’s Real Bills Doctrine, July 2005, see the website.
Acknowledgement
The author is grateful to
Dr. Theo Megalli of Plattling,
Germany, for bringing the work of Heinrich Rittershausen
to his attention. The biography of H. Rittershausen
(1898-1984) by Dr. Megalli can be found on the website.
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