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THE REAL BILLS DOCTRINE
Thomas M. Humphrey

. . . the real bills criterion sets no effective limit to the quantity of money.
Milton

With recession lingering and interest rates remaining high, one hears increasingly
that the Fed should

these respects, at least, the interest-pegging
proposal
may be viewed as a recent variant of the old real bills
doctrine.1

abandon its money growth targets and move to a
policy of lowering interest rates to full employment

The purpose of this article is to trace the origin
and historical evolution of the real bills doctrine and
to show how that doctrine survives
today in the
interest-targeting
scheme. Before doing so, however,
it is necessary to spell out the essential features of
the doctrine and to identify its underlying
error.

levels.
All would be well, we are told, if only the
Fed would set a fixed low interest rate target consistent with full employment and then let the money
stock adjust to money demand to achieve that desired
target rate. In effect, this means that the Fed would
relinquish
control over the money stock, letting it
expand as required in a vain effort to eliminate discrepancies between the market rate and the predetermined target rate.

What is the Real Bills Doctrine?
Essentially,
the real bills doctrine is a rule purporting to gear money to production
via the shortterm commercial bill of exchange, thereby ensuring
that output generates its own means of purchase and
money adapts passively to the legitimate needs of
trade. The doctrine states that money can never be
excessive when issued against short-term commercial
bills arising from real transactions
in goods and

This low target interest rate proposal has much in
common with the long-discredited
real bills doctrine,
according to which the money supply should expand
passively
trade.

to accommodate
Both views contend

(or should be) essentially
see causality as running
money rather

the

legitimate

that the money

needs

of

supply

is

demand determined.
Both
from economic activity to

than vice versa.

And, in their simplest

1 Thomas
Sargent
for one recognizes
the essential
similarity between the interest-pegging
view and the real bills
doctrine.
Says he:

versions at least, both treat the price level and its
rate of change as predetermined
exogenous variables
and deny that inflation originates in the central bank.

. . . it has often been argued that the proper function
of the monetary
authorities
is to set the interest rate
at some reasonable
level, allowing the money supply
to be whatever it must be to ensure that the demand
for money at that interest
rate is satisfied.
Such a
rule was actually
written
into the original
act that
established
the Federal Reserve
System in the U.S.
The rule was known as the “real bills” doctrine.
It
was alleged that the quantity of money would automatically
be properly
regulated
if the monetary
authorities
ensured
that banks
always
had enough
reserves
to meet the demand for loans intended to
finance “real” (as opposed to “speculative”)
investments at an interest-rate
set “with a view of accommodating commerce
and business.”

In fact, both views prescribe positive monetary ‘expansion even in the face of inflation, the one to allow
real transactions
to take place at ever-rising
prices,
the other in an attempt to lower interest rates to
target levels. In essence, both tie the money supply
directly to an uncontrolled
nominal
variable
that
reflects inflationary
pressures-the
volume of eligible
bills offered for discount
doctrine

and

differential
Finally,

the

nominal

in the case of the real bills
market

rate-target

in the case of the interest-pegging

because

they link the money

rate

Thomas J. Sargent,
Macroeconomic
Theory (New York:
Academic
Press,
1979), p. 92.
See also Lance Girton,
who states that cheap-money,
low-interest
rate. policies
are “a close substitute
for a real-bills
money
supply
mechanism,
and subject
to the same defect.”
Lance
Girton,
“SDR
Creation
And The Real-Bills
Doctrine,”
Southern Economic
Journal, 41 (July 1974), 58, footnote
6.

scheme.

stock to vari-

ables that tend to rise in step with prices, both generate inflationary

feedback mechanisms

and money chase each other upward

in which prices
indefinitely.
FEDERAL

In
RESERVE

Friedman
and Anna J. Schwartz
A Monetary History of the
United States, 1867-1960

BANK

OF

RICHMOND

3

services.
More precisely, the doctrine contends that
so long as banks lend only against sound, short-term
commercial
paper the money stock will be secured
by and will automatically
vary equiproportionally
with real output such that the latter will be matched
by just enough money to purchase
it at existing
prices.2

In

impossible
to finance

other

words,

provided money
real transactions.

inflationary

overissue

is issued

on loans made

is

2 This conclusion-that
a real-bills-based
money
stock
will be just sufficient
to purchase
the economy’s
real
output at. existing
prices-is
derived as follows:
First,
define the needs of trade T as the value of inventories
of
working capital or goods-in-process
G, the production
of
which must be financed by bank loans.
Symbolically
(1)

T =

G.

Second,
assume
that each dollar’s
worth of goods-inprocess
G generates
an equivalent
quantity
of paper
claims in the form of commercial
bills B which business
borrowers
offer as collateral
behind their loan demands
Ld. That is, assume that
(2)

G =

B and

(3)

B = Ld.

Third, observe that these loan demands Ld pass the real
bills test (i.e., they are secured by claims to real goods)
and therefore are accommodated
by a matching
supply of
bank loans LS as indicated by the expression
(4) Ld = Ls.
Fourth,
note that since banks supply loans in the form
of banknotes
and/or demand deposits the sum of which
comprises
the money stock, the supply of loans Ls must
equal the stock of money MS,
(5)

Ls =

Substituting
money stock
(6)

Ms =

Ms =

equations
yields

1-4 into

5 and solving

for

the

T

G

which states that the money supply is ultimately
secured
by goods-in-process
such that when those goods reach
the market they will be matched by just enough money
to purchase them at existing prices.
This can be shown
by -defining the value of go&-in-process
G as the multiplicative product of the price P and quantity Q of those
goods, i.e.,
(8)

G =

Substituting
(9)

Ms =

The doctrine overlooks that the demand for loans
depends not only upon the quantity
of real transactions but also upon the level of prices at which
those real transactions
are effected. And rising prices
would require an ever-growing
volume of loans just
to finance the same level of real transactions.
Under
the real bills criterion these loans would be granted
and the stock of money would therefore
expand.
This monetary expansion would raise prices thereby
requiring further monetary expansion leading to still
higher prices and so on in a never-ending
inflationary
sequence.
In this way, price inflation would induce
the very monetary expansion necessary to perpetuate
it and the real bills criterion would provide no effective limit to the quantity of money in existence. Here
is the error of the real bills doctrine, namely the
tendency to treat prices as given when in fact they
vary directly with the money stock. Associated with
this is the failure to perceive the two-way inflationary
interaction
between money and prices that results
once money is allowed to be governed by the needs
of trade.
Dynamic Instability
The preceding has identified the flaw in the doctrine as its failure to take account of the price-moneyprice feedback loop that renders the real bills mechanism dynamically
unstable.3
As early as 1802

equation

3 This dynamic instability
can be illustrated
by introducing a one-period
time lag into the real bills money supply
function
(equation
9 of the preceding
footnote)
and
adding
the quantity
theory
equation
of exchange
to
determine
the current
price level.
Specifically,
let the
current period’s money supply M be tied to last period’s
nominal national product QP-1
via the real bills money
supply relationship
(1)

M =

aQP-1

where a is the fixed ratio of money to lagged nominal
national product and real output Q is assumed to be fixed
at its constant
full capacity level.
Given real output this
equation says that last period’s price level P-1 determines
this period’s
money stock.
Next, assume
that money
determines
prices contemporaneously
via the equation of
exchange
(2)

P =

(V/Q)M

where V is the constant
circulation
velocity
or rate of
turnover of money.
Lagging
equation
2 one period, substituting
it into
equation 1, and solving the resulting first order difference
equation for the time path of the money stock yields

PQ.
8 into 7 yields

PQ

which says that
assuming
prices
P given, the money
stock Ms-varies
in step with real
production
Q. This is
the essence of the real bills doctrine.
Its error lies in
treating prices as exogenous
when in fact they are determined by the money stock itself.
4

Inflation

Ms.

which says that as long as banks lend only against shortterm commercial
bills arising out of transactions
in real
goods and services, the money stock will conform to the
needs of trade.
Since the needs of trade T and the value
of goods-in-process
G are identically
equal one can also
write
(7)

Underwriting

ECONOMIC

REVIEW,

(3)

M =

Mo(aV)t

where t is time
stock.
Similarly,
by the expression
SEPTEMBER/OCTOBER

1982

and M0 is the arbitrary
initial money
the time path of the price level is given

nominal variable (the money value of real transactions)
to regulate
another
nominal
variable
(the
money stock).
This is the fundamental
fallacy of the
real bills doctrine.

Henry Thornton had already recognized this inherent
instability.
Real bills proponents,
said he, “forgot
that there might be no bounds to the demand for
paper; that the increasing quantity would contribute
to the rise [in the prices] of commodities : and the
rise of commodities
require, and seem to justify, a
still further increase.“4
More recently, Don Patinkin,
referring
to “the vicious cycle of inflation
(or deflation) generated by a policy based on the real bills
doctrine,” identified the source of this instability:

Historical Origins:

Having
spelled out the real bills doctrine
and
identified
its underlying
error, the next step is to
trace the evolution of the doctrine in the history of
The concept
of an outputmonetary
thought.
governed currency secured by claims to real property
and responding to the needs of trade has a long history dating back almost 280 years.
The basic idea
originated
with John Law (1671-1729)
who in his
Money and Trade Considered (1705) proposed that
the banknote issue be secured by and bear a fixed
ratio to the market value of land. In arguing for a
land-collateralized
note issue, Law contended
( 1)
that money’s purchasing
power ought to be stable,
(2) that such purchasing
power stability requires
limiting the note issue to the real needs of trade, (3)
that this limitation can be achieved by tying notes to
the value of land (a proxy for the level of economic
activity),
and (4) that doing so provides an automatic check to overissue since notes cannot exceed
the value of their collateral.6
Here is the origin of
the idea that money cannot be inflationary
if backed
by sound productive assets.

For the essence of this doctrine
[Patinkin
says] is
that the banking
system
should expand
credit
in
accordance
with the “legitimate
needs of business”
-where
these
“needs”
are measured
in money
terms, and thus increase
proportionately
with the
price level. [The result is] that any (say) upward
price movement
. . . will-in
accordance
with the
“real bills doctrine”-generate
an increased
supply
of money which will enable the movement
to continue indefinitely.6

In other words, the doctrine ignores the fact that
the needs of trade are measured in nominal terms
that rise in step with prices. Since monetary expansion raises prices and rising prices, by expanding the
needs of trade, are allowed to generate further increases in the money stock, the result is a vicious
circle of inflation in which money and prices chase
each other upward indefinitely.
In short, because it
ties the money supply to a nominal magnitude
that
moves in step with prices, the real bills doctrine
provides no effective constraint
on money or prices,
both of which can rise without limit (see Box, pp.
6-7).
Here is the fallacy of using one uncontrolled

(4)

P =

Law’s Error
To summarize, Law sought a criterion that would
limit money expansion and ensure price stability.
He
thought that land’s value provided such a criterion.
Collateralized
by land, money could never be overissued since it would always be constrained
by the
value of the real property backing it. What he overlooked was that the market value of property contains a price component and that this price component
Since
is determined
by the money supply itself.
money determines
the level of prices and the latter,
through its influence on the value of land, is allowed
to determine the size of the money stock, the result
is a two-way inflationary
interaction between money
and prices in which both can rise without limit. That
is, he failed to see that monetary expansion
raises
prices and that rising prices, by augmenting
the
nominal
value of land, justifies further monetary

Po(aV)t

where Po is the arbitrary
initial price level.
Far from
limiting prices and the money supply, equations
3 and 4
state that money and prices will either rise without limit
or fall to zero with the passage of time depending upon
whether the term enclosed by parentheses
is greater than
or less than unity.
Only in the singular case in which
the coefficient
a is precisely
equal to the reciprocal
(inverse)
of velocity will the money supply and the price
level stabilize.
But this case is unlikely to happen since
a and V are determined
by different factors.
Specifically,
a is determined
by businessmen’s
desired
inventory/
output ratios, by the proportion
of working capital financed by bank loans, and by the proportion
of total bank
loans made for working capital versus nonworking
capital
purposes.
By contrast,
velocity
is determined
by cash
holders decisions
regarding
the fraction
of income they
wish to hold in the form of money balances.
Because of
this it is unlikely
that the product
aV will assume its
money-stabilizing
value of unity.
Thornton,
Two Speeches of Henry Thornton,
Esq. on the Bullion Report, May 1811. Reprinted in An
Enquiry into the Nature and Effects of the Paper Credit
of Great Britain (1802), ed. by F. A. v. Hayek (New
4 Henry

York:

Rinehart

& Company,

Inc.,

1939),

6 On Law see Lloyd W. Mints, A History
of Banking
Theory
(Chicago:
University
of Chicago
Press,
1945),
pp. 15-16, 18, 20, 30-32 and Frank W. Fetter,
Development of British Monetary
Orthodoxy
1797-1875
(Cambridge:
Harvard University
Press, 1965), pp. 7-9.

p. 342.

5 Don Patinkin,
Money, Interest, and Prices,
(New York:
Harper and Row, 1965), p. 309.

FEDERAL

2nd

ed.

RESERVE

John Law

BANK

OF

RICHMOND

5

expansion to further
leading

price increases

and

sequence.

In short,

on in a cumulative
inflationary
he erred in ignoring that

so

Money and Price Level Instability
in a Real Bills Regime

whereas
convertibility
into a given physical amount
of specie
(or any other economic good) will limit
the quantity
of notes that can be issued . . . the
basing
of notes on a given money’s worth
of any
form of wealth-be
it land or merchants’
stockspresents
the possibility
of an unlimited
expansion
of loans . . .7

Because of this, he failed to see that the money value
of land provides no effective limit to the money stock
or prices, both of which can expand indefinitely.8
Here is the origin of the basic fallacy of the real bills
doctrine, namely the notion that one nominal variable
(the money value of land) can be used to control the
nominal money stock.
Adam Smith
If

Law

was

the

optimally

when

property,

then

first

to

contend

7 Mints,

History,

first

to state

collateralized
Adam
that

Smith
they

that
by

banknotes

the

value

so

when

vary
of

the

secured

The following
charts illustrate
the inherent
dynamic
instability
of the real bills money supply mechanism
discussed in the text.
Assuming
real output constant,
the
charts plot money supply and money demand (equations
1 and 2 of footnote 3) as increasing
linear functions of the
price level. Money supply rises with prices because rising
prices raise the nominal value of economic
activity
and
thereby
justify,
via the real bills criterion,
further
increases
in the money stock.
Likewise,
money demand
also rises with prices because people need to hold more
cash to purchase the constant
quantity of real output at
higher prices.
The slopes of the two curves
show the
sensitivity
or responsiveness
of money supply and demand to price level changes.
Since these sensitivities
are
determined
by different sets of factors, it is unlikely that
both curves will possess identical
slopes.
In particular,
the price responsiveness
of money supply is determined
by such conditions
as (1) businessmen’s
desired inventory/output
ratios, (2) by the fraction of working capital
financed by bank loans, and (3) by the proportion
of total
bank loans made for working capital purposes.
By con-

real

was

by

(1723-1790)
do

Box

p. 30.

8 Law’s error is easily demonstrated.
Following
him, let
the note issue N be rigidly tied to the value of land V by
the formula (rule)
(1)

N =

kV

where k is the fixed ratio of notes to the value of land.
By definition,
the total value of land is the multiplicative
product of the fixed quantity
of land L times the price
per acre P,, i.e.,
(2)

v

=

LPL

Now the price of land PL is linked to the general
level P via the relative price relationship
(3)

PL =

price

aP

where a is the relative
price of land in terms of the
general price level, as can be seen by rewriting
the equation as a = PL/P.
Finally, assume that the price level P
is a lagged function
of the note issue N-1, i.e., money
determines
prices with a one-period lag. Symbolically,
(4)

P =

bN-1

where
b is the constant
coefficient
linking
money
to
prices.
Substituting
equations 2-4 into 1 and solving the
resulting
difference
equation for the time path of the note
issue yields
(5)

N =

No[kLab]t

where t is time and No is the initial quantity of notes.
Far from limiting the note issue, equation 5 says that the
stock of notes will either rise without limit or fall to zero
with the passage
of time depending
upon whether
the
bracketed
term is greater than or less than unity.
Note
that since each component
of the bracketed term is determined by different
factors it is unlikely that the product
of these components
will assume its money-stabilizing
value of unity.

6

ECONOMIC

REVIEW,

SEPTEMBER/OCTOBER

1982

trast, the slope or price responsiveness
of the money
demand function is determined by the fraction of nominal
income that people desire to hold in the form of cash
balances-this
fraction being the inverse of the circulation
velocity of money.
Only by accident would the slopes of
the two curves be the same.
Chart 1 depicts the inflationary
case in which money
supply is more responsive
to price level changes than is
money demand, as indicated by the steeper slope of the
money supply function.
This case is characterized
by a
persistent
(and growing)
excess
supply of money that
continually
bids up prices.
Starting
with an arbitrary
initial money stock M0 the chart traces out a monotonic
explosive sequence of ever-rising
money and prices showing that the real bills mechanism
is incapable of limiting
either variable.
Chart 2 depicts the opposite case in which the real bills
money supply function
is less sensitive
to price level
changes than is money demand.
This case is characterized by a persistent
excess demand for money that causes

FEDERAL

RESERVE

Here is the potential
money and prices to fall to zero.
for severe deflation inherent in the real bills mechanism.
Finally,
Chart 3 depicts
the special
case in which
money supply coincides with money demand at all price
levels.
In this particular
case the real bills mechanism
is
said to be indeterminate,
i.e., incapable
of yielding
a
unique equilibrium
solution
for money and prices.
It
cannot yield a determinate
solution because all points on
the money supply/money
demand curve represent
equilibrium points.
In this case, the mechanism
determines
only
the ratio of money to prices but not those variables
separately.
To be sure, one can fix either money or
prices from outside
the mechanism,
i.e., one can arbitrarily set money at M0 or prices at PO. Doing so results
in stability
for both.
But the mechanism
itself is incapable of determining
this solution.
In short, Charts
l-3
indicate that the money stock and price level in a real
bills regime are either dynamically
unstable
or indeterminate.
Either way, the real bills criterion
is incapable
of limiting
the money stock and for that reason alone
constitutes
a disastrous
guide to policy.

BANK

OF

RICHMOND

7

short-term,
self-liquidating
bills of exchange.
In so
doing, he shifted the emphasis from land to commercial paper as the basis of the currency.
Paper money,
he wrote, varies optimally with the needs of trade

bills doctrine and renders
to the problem of dynamic

when each bank “discounts
to a merchant a real bill
of exchange drawn by a real creditor upon a real

As previously mentioned, Adam Smith was astute
enough to present the real bills doctrine within the
context of a convertible
currency regime in which
specie convertibility
limits the note issue and pricelevel exogeneity prevents it from generating inflation.
Later, less astute writers incautiously
extended the
doctrine to the case of currency inconvertibility
in
Chief among
which those safeguards
are absent.
these writers were the antibullionists
who employed
the doctrine to defend the Bank of England against
the charge that it had taken advantage of the suspension of specie convertibility
during the Napoleonic
wars to overissue the currency.
The antibullionists
adhered to the doctrine in its
They argued
crudest, most uncompromising
form.
that it provided a sufficient safeguard to overissue
even under inconvertibility.
That is, they argued
that even an inconvertible
paper currency could not
be issued to excess as long as it was advanced only
upon the’ discount of sound, short-term
commercial
bills. Two considerations,
they said, ensured that a
currency backed by real bills could never be oversupplied. First, being geared to real transactions,
the quantity of currency could never exceed the real
demand for it. More precisely,

debtor, and which, as soon as it becomes due, is really
Here is the origin of the
paid by that debtor.“9
phrase “real bill” to denote short-term
commercial
paper arising from real transactions
in goods and
services.
Smith’s statement of it marks him as “the
first thoroughgoing
exponent
of the real bills doctrine”

in its modern

form.10

While endorsing
the doctrine,
however,
Smith
managed to avoid some of its shortcomings.
He
realized, for example, that the real bills criterion by
itself is not sufficient to prevent overissue.
For that
reason he advocated specie (i.e., gold) convertibility
as the ultimate constraint
on the quantity of paper
money.
That is, he held that banks should be required by law to convert their paper notes into specie
at a fixed price upon demand.
Constrained
by the
convertibility
obligation, banks, he felt, would rarely
overissue.
In short, he viewed specie convertibility
as the overriding check to overissue.
In so doing, he
avoided the error of supposing
that the real bills
criterion per se provides a sufficient limitation to the
note issue regardless of the monetary regime.
He also avoided the dynamic instability or vicious
circle problem that results from the two-way interaction between money and prices in the real bills
mechanism.
His version of the doctrine excludes the
possibility of such inflationary
interaction
by explicitly breaking the transmission
linkage running from
money to prices.
He severed that link by treating
the price level as a predetermined
exogenous variable
that is invariant with respect to the note issue. More
precisely, Smith argued that under specie convertibility the commodity
price level is determined
in
world markets by the relative cost of producing gold
and goods and then given exogenously
to the open
national

economy.

And

with

prices

thus predeter-

mined, it follows that they must be invariant
with
respect to the domestic note issue, i.e., paper money
cannot affect prices in the small open economy. This
breaks the vicious circle of inflation
and money
growth inherent in conventional
versions of the real
9 Adam Smith, An Inquiry into the Nature and Causes of
the Wealth
of Nations
(1776),
(New York:
Random
House, 1937), p. 288.
10 Mints,

8

History,

p. 25.

ECONOMIC

REVIEW,

The Antibullionists

Smith’s version
instability.11

immune

(Early 1800s)

bank paper
issued against
the genuine
‘needs of
trade’-that
is against
real security-could
never
become ‘excessive.’
Such issues could never be the
active factor in any price rise because if they were
the equivalent
of real security
they would only be
meeting
a demand for credit which was already in
to this
view-bank
existence
: hence-according
credit met the needs of trade and did nothing
to
create those needs.12

In other words the supply of real product generates
just enough
money to purchase it at existing prices.
Second, since no one would borrow at interest money
not needed, banks could not force an excess issue on
the market.
Associated with this was the argument
that if
indeed the currency was temporarily excessive,
the excess would immediately return to the banks to
pay off costly loans.
In short, interest-minimization
considerations
would ensure that any excess notes
would quickly be retired from circulation.
11 On this point see David Laidler,
“Adam Smith as a
Monetary
Economist,”
Canadian Journal of Economics
14, no. 2, (May 1981) 196-97.
12 B. A. Corry, Money,
Economics
1800-1850
1962), p. 75.

SEPTEMBER/OCTOBER

1982

Saving and Investment
in English
(New York:
St. Martin’s
Press,

The antibullionists
used these arguments to defend
the Bank of England against the charge that it had
caused inflation.
The Bank, they said, was blameless
since it had restricted its issues to real bills of exchange and therefore had merely responded to the
real needs of trade.
That is, the Bank could not
possibly be the source of inflation because, by limiting
its advances to commercial paper representing
actual
output, it had merely responded
to a demand for
money already in existence and had done nothing to
create that demand.
Here is the origin of the notion
that central banks cannot cause inflation since they
merely supply money passively in response to a prior
real demand for it. Besides this there was the argument that since no one would borrow at interest
money not needed, the Bank could not force an excess
issue on the market. Overlooked was the fact that the
demand for loans depends not upon the loan interest
rate itself but rather upon that rate relative to the
expected rate of return on the use of the borrowed
If the latter rate exceeds the former, the
funds.
demand for loans becomes insatiable and the real bills
criterion presents no bar to overissue.
This was a
key point in Henry Thornton’s
criticism of the real
bills doctrine.
Henry Thornton’s

given bill is customarily
drawn may exceed the turnover period of goods.
Thus, depending
upon the
number of transactions
between merchants in bringing goods to market and the period of credit, any
number of bills can be generated
upon the alleged
security of the same goods. For example,
Suppose that A sells one [dollar’s] worth of goods
to B at six months credit, and takes a bill at six
months for it; and that B, within a month after,
sells the same goods, at a like credit, to C, taking a
like bill; and again, that C, after another month,
sells them to D, taking a like bill, and so on.14
At the end of six months, $6 of bills, all eligible for
discount, would be outstanding
even though only $1
worth of goods had been produced.

of credit (maturity
of each bill) were 12 rather than
6 months, then $12 of bills could be issued on the
security of the original $1 worth of goods. In general,
the volume
(1)

of bills outstanding

B=mGt

either of the maturity of bills
over rate. Extension
or of the turnover
rate of goods would, Thornton
claimed, result in “the greatest imaginable multiplication” of bills on the basis of a given quantum of
Because of this, the quantity
of money
goods.15
issued against real bills would far exceed the needs
of trade.

Criticisms

Second, Thornton
argued that the doctrine fails to
perceive that monetary
expansion
raises prices and
that rising

prices,

by expanding

indefinitely.

Because

it links the money

supply to a

nominal magnitude
that moves in step with prices,
the real bills doctrine provides no constraint on prices
or the quantity
of money, both of which can rise
without limit. The fallacy of the real bills doctrine,
said Thornton, is that it “considered security as every
thing and quantity as nothing.”
Its proponents
forgot that there might be no bounds to the demand
for paper; that the increasing
quantity would
contribute to the rise of commodities: and the rise
of commodities require, and seem to justify, a still
further increase.16

14 Thornton,

BANK

Paper Credit, p. 253.

16 Thornton,

Paper Credit, p. 244.

Paper Credit, p. 86.

15 Thornton,

RESERVE

the needs of trade,

generate further inflationary
increases in the quantity
of money.
The result is a vicious circle of inflation
in which money and prices chase each other upward

First, he contended that the volume of eligible bills
coming forward for discount depends not only upon
the quantity of goods produced, but also upon the rate
of turnover of those goods and the period of credit
Goods, he
or length of time that bills have to run.
pointed out, may be sold a number of times, each sale
giving rise to a real bill. Also, the period for which a

FEDERAL

will be

where B is the volume of bills, m their maturity, G
the nominal stock of goods, and t its annual turn-

If the antibullionists
were the strongest proponents
of the real bills doctrine then Henry Thornton
(17601815), the British banker, monetary
theorist, and
long-time
member
of Parliament,
was by far its
ablest and most penetrating
critic.
His devastating
critique of the doctrine remains unsurpassed
to this
In his parliamentary
speeches and his
very day.
classic An Enquiry into the Nature and Effects of the
Paper Credit of Great Britain (1802) he flatly denied
that the real bills criterion can effectively limit the
note issue.
Indeed, he went out of his way to dethat a proper
nounce “the error . . . of imagining
limitation of bank notes may be sufficiently secured
by attending merely to the nature of the security for
which they are given.“13 He then proceeded to attack
the doctrine on at least three grounds.

13 Thornton,

And if the length

Paper Credit, p. 342.

OF

RICHMOND

9

Here is the classic statement of the inherent dynamic
instability
of the real bills mechanism.
Finally, Thornton argued that the supply of eligible
bills becomes inexhaustible
and the corresponding
demand for loans insatiable when the loan rate of
interest is pegged below the expected rate of profit
on new capital investment.
He explained in great
detail how such a rate differential,
by making borrowing profitable, would set in motion a process of
cumulative
expansion
of bills, loans, money, and
This expansion,
he said, would persist as
prices.
long as the loan rate remained below the expected
profit rate. Given the interest rate differential, money
and prices would rise without limit and the real bills
criterion would fail to provide the needed constraint.
He reached this conclusion via the following route.
He argued, first, that the demand for new loans
depends primarily
upon the profit rate-loan
rate
differential.17
Secondly,
assuming
that new loan
demands are accommodated
via corresponding
increases in the note issue, and that the increased note
issue is spent on the fixed full capacity level of real
output thereby raising prices equiproportionally
with
the money stock, it follows that money and prices
also rise in proportion to the interest rate differential,
growing without limit as that differential persists.18

In this connection, Thornton stressed that the interest
differential,
if maintained
indefinitely,
produces
a
continuous and not merely a one-time rise in money
and prices. This is so, he said, because as long as the
differential
persists, borrowing
will continue
to be
profitable

even

The result will be more
more monetary expansion,

18 To demonstrate
how Thornton
reached this conclusion,
consider the simplest possible version of his model.
First,
suppose that business loan demands Ld expand in proprotion to the profit rate-loan
rate differential
(R-R)
according to the expression

where the dot over the loan demand variable denotes the
rate of change (time derivative)
of that variable and a is
the coefficient
linking new loan demands to the profit
rate-interest
rate differential.
Second, assume that the
new loan demands are backed by a corresponding
expansion in the volume of eligible bills B offered for discount.
Because
these bills pass the real bills test. the new loan
demands are accommodated
via an equivalent
expansion
in the money stock MS. In symbols,

where Ld denotes loan demand, B the volume of bills,
MS the money stock, and the dots denote the rates of
change (time derivative)
of the attached variables.
Third,
suppose that prices P rise in proportion
to rises in the
money stock according to the equation

10

ECONOMIC

REVIEW,

higher

price

levels.

borrowing,
more lending,
still higher prices and so

on ad infinitum
in a cumulative
inflationary
Here, almost 100 years before Knut Wicksell
expressed it, is the essence of the Wicksellian
lative process.

spiral.
himself
cumu-

On the basis of the foregoing analysis, Thornton
drew several conclusions regarding the validity of the
real bills doctrine.
First, the real bills constraint
is
ineffective in the face of a positive profit rate-loan
rate differential.
For as long as the differential persists and credit rationing
is not applied, money,
prices,

and the volume

of eligible

bills will expand

without limit on the basis of a fixed amount of real
property.
In short, given the rate differential,
the
Secreal bills doctrine provides no bar to overissue.
ond, the ineffectiveness
of the real bills constraint
renders invalid the notion that it is safe to allow the
money supply to adapt itself automatically
to the
needs of trade.

17 “In order to ascertain
how far the desire of obtaining
loans at the bank may be expected
at any time to be
carried [he writes],
we must enquire into the subject of
the quantum of profit likely to be derived from borrowing
there under the existing
circumstances.
This is to be
judged of by considering
two points:
the amount, first of
interest
to be paid on the sum borrowed;
and, secondly,
of the mercantile
or other gain to be obtained by the employment
of the borrowed
capital . . . . We may, therefore, consider
this question
as turning principally
on a
comparison
of the rate of interest taken at the bank with
the current rate of mercantile
profit.”
Thornton,
Paper
Credit, pp. 253-54.

at successively

Said Thornton,

Any supposition
that it would be safe to permit the
bank paper to limit itself, because this would be to
take
the more natural
course,
is, therefore,
alIt implies
that there
is no
together
erroneous.
occasion
to advert to the rate of interest
in consideration
of which the bank paper is furnished,
or
to change that rate according
to the varying
circumstances
of the country.19

To summarize, in Thornton’s view the real bills constraint offered no effective limit on the money supply.
To achieve monetary stability, other constraints
(e.g.,
convertibility,
a loan rate equal to the profit rate or,
alternatively,
direct credit rationing)
were required.

where P denotes prices, MS denotes the money stock, the
dots denote the rates of rise (time derivatives)
of those
variables,
and k denotes
the proportional
relationship
between inflation and money growth.
Substituting
equation 1 into equations 2 and 3 yields

These equations
identify the profit rate-loan
rate differential as the ultimate
cause of the rise in loan demand.
loan supply, eligible bills, money stock, and price levelall of which expand without limit as long as the differential persists.
19 Thornton,
SEPTEMBER/OCTOBER

Paper
1982

Credit,

p. 254.

The Doctrine After Thornton
Thornton
bills

was not alone

doctrine.

Among

King, for example,
cial profit
demand
bills

in condemning

his

be carried

that when the commer-

to any

David

Ricardo

(1772-1823)

when

the Bank

of England

going

rate of profit

which they might

“there

assignable

absorb

Despite

these criticisms,

in 19th and

thus “scoring

the

is no amount

of money

He also denied

quantity

that

limit the note issue
could

of notes.

the real bills doctrine

20th

every new extension
of credit, though based upon
the money value of goods, would tend to raise the
price level, and each elevation
of the price level in
its turn would justify
a further
extension
of credit.
The two movements
might continue
pursuing
each
other until eternity
and yet the aggregate
value
of the means
of payment
would not become coextensive
with the money value of all property.
The alleged limitation
of bank credit by ‘the value
of goods and property
owned by borrowers’
is from
every point of view delusive.
It is not only untrue;
it is impossible.25

that

rise in prices, commerce

any conceivable

vived

extent.“20
stated

less than

charges

the needs of trade could effectively

the

offer of eligible

likewise

not lend.“21

since, via the resulting

Lord

the loan rate of interest

for loans and corresponding

“may

the real

contemporaries,

contended

rate exceeds

commercial
paper arising from real transactions.24
The doctrine
was attacked
in 1905 by A. Piatt
Andrew
who pointed to the two-way inflationary
interaction between money and prices inherent in the
real bills mechanism.
Said Andrew of this inflationary feedback loop running from money to prices
and prices to money:

century

banking

sur-

tradition

high on the list of ‘longest-lived

In other

eco-

nomic fallacies of all times’.“22 Renamed

the Principle

of Reflux

to which overissue

is impossible

since any excess notes will be returned

immediately

(according

money
needs

in the middle

decades

notes

were

mately

issued

convertible

of the

there

was

no

and were

In the late 19th and early 20th centuries

the doc-

issue.“23
in the United

States where it formed

the theoretical mainstay of such proponents
of banking reform as Charles A. Conant, A. Barton Hepburn,

J.

Laurence

Horace

White,

believed

that

Laughlin,

William

and H. Parker

Willis-all

the

currency

should

A.

Scott,

of whom

be based

upon

20 Lord King,
Thoughts
on the Effects
of the Bank
Restrictions,
2nd ed., 1804, p. 22. Quoted in Jacob Viner,
Studies in the Theory of International
Trade (New York:
Augustus
Kelley,
1965), p. 149.
21 David
Taxation,

Ricardo,
Principles
of Political
3rd ed. [1821], quoted in Viner,

22 Mark Blaug, Economic
(Cambridge:
Cambridge

Economy
and
Studies, p. 150.

Theory in Retrospect,
University
Press), p.

3rd ed.,
56.

RESERVE

activity
that

or

rises in

no bar

the price and output com-

activity,

the real bills criterion

to the inflationary

overissue

of

24 Mints, History,
pp. 206-7, footnote 33. See also Robert
Craig West, Banking
Reform
and the Federal
Reserve,
1863-1923 (Ithaca,
N. Y., Cornell University
Press, 1977),
Chap. 7.

23 Lord Robbins,
The Theory of Economic
Development
in the History
of Economic
Thought
(New York:
St.
Martin’s
Press, 1968), p. 141.

FEDERAL

magnitude

an
from

Andrew’s criticism notwithstanding,
the doctrine
was enshrined
as a key concept in the Federal Reserve Act of 1913. The Act provided for the extension of reserve bank credit (chiefly loans to member
banks) via the Federal Reserve’s rediscounting
of
eligible
(short-term,
self-liquidating)
commercial
paper presented to it by member banks.
As if to
underscore its allegiance to the doctrine, the Federal
Reserve Board in its famous Tenth Annual Report
for 1923 stated that “It is the belief of the Board that
there is little danger that the credit created and
distributed
by the Federal Reserve Banks will be in
excessive volume if restricted to productive
uses.”
And in its ruling as to the kinds of eligible paper that
member
banks could present
for rediscount,
the
Board showed that by “productive
uses” it meant
loans to finance the production
and marketing
of
actual goods.

of over-

trine reappeared

between

of economic

constitutes
money.

ulti-

danger

(a nominal

distinguish

ponents

that so long as

on good security

embodies
running

and back again to money in a neverIn short, because it
explosive sequence.

ending,

the alleged necessity of any regulation
of the note
issue other than the obligation of convertibility;
and
to establish

mechanism

to prices to the level of economic
of trade

cannot

19th century.
In particular, Banking School writers
Thomas Tooke and John Fullerton used it “to refute

to this end they sought

the real bills doctrine

transmission

step with prices)

to the banks to repay loans), it reappeared
in the
Currency
School-Banking
School controversy
that
took place in England

words,

inflationary

25 “Credit
American
111.

BANK

OF

and the Value of Money.”
Publications
Economic
Association,
VI
(3d. ser.,

RICHMOND

of the
1905),

11

Finally,

the real bills doctrine

Reichsbank’s

policy of issuing

money

to satisfy

prices

during

the needs

the

German

was the basis of the
astronomical

of trade

sums of

at ever-rising

hyperinflation

of 1922-

1923.
Oblivious of Thornton’s
demonstration
that
the real bills criterion is no bar to inflationary
overissue when the borrowing
rate is pegged below the
going profit rate, the Reichsbank

insisted

on pegging

its discount rate at a level no higher than 90 percent
at a time when the going market rate of interest was
This huge
in excess of 7000 percent per annum.
interest differential of course made it extremely profitable for banks to rediscount
bills with the Reichsbank and to loan out the proceeds, thereby producing
additional
inflationary
expansions
supply and further upward pressure
If the authorities

recognized

of the money
on interest rates,

this, however,

they did

nothing to stop it. On the contrary, throughout
the
hyperinflation
episode the Reichsbank’s
president,
Rudolf Havenstein,
considered it his duty to supply
the growing sums of money required to conduct real
transactions

at skyrocketing

prices.

Citing

the real

bills doctrine, he refused to believe that issuing money
in favor of businessmen
against genuine commercial
bills could

have an inflationary

effect.

He simply

failed to understand
that linking the money supply
to a nominal variable that moves in step with prices
is tantamount
to creating an engine of inflation.
That
is, he succumbed to the fallacy of using one uncontrolled nominal variable
(the money value of economic activity)
(the money

12

to regulate

another

nominal

variable

ECONOMIC

REVIEW,

stock).

Survival of the Real Bills Fallacy in the
Interest-Pegging Scheme
The foregoing fallacy survives today in the notion
that the Federal Reserve should use easy monetary
policy to lower interest rates to target levels consistent with full employment.
For just as the real
bills doctrine calls for expanding
the money stock
with rises in the needs of trade, so does the interesttargeting
proposal
call for increasing
the money
supply when the market rate of interest rises above its
target
level-this
monetary
expansion
continuing
until the rate disparity is eliminated.
Here again is
the fallacy of using one uncontrolled
nominal variable
(the market rate-target
rate differential)
as a guide
to regulating
the nominal money stock.
Moreover,
tying the money stock to the market
rate-target
rate differential produces the same inflationary feedback of prices to money and money to
prices that characterizes
the real bills mechanism.
For the more the Fed expands the money supply in a
vain effort to get interest rates down, the greater the
inflationary
pressure it puts on those rates. And the
more those rates rise, the greater the monetary expansion required to temporarily
lower them.
Thus
the attempt to peg interest rates generates a dynamically unstable process in which money and prices
chase each other upward ad infinitum in a cumulative
inflationary
spiral.
Like the real bills criterion, the
interest-pegging
scheme provides no effective constraint on money or prices, both of which rise without
limit. Because of this the interest-targeting
proposal
may be viewed as merely the latest reincarnation
of
the discredited real bills fallacy.

SEPTEMBER/OCTOBER

1982

References
Patinkin, Don.
New York:

Andrew, A. Piatt. “Credit and the Value of Money.”
Publications of the American Economic Association
VI (3d. ser., 1905).

Money, Interest, and Prices.
Harper and Row, 1965.

2nd ed.

Blaug, Mark. Economic Theory in Retrospect. 3rd ed.
Cambridge : Cambridge University Press. 1978.

Ricardo, David. Principles of Political Economy and
Taxation, 3rd ed., [1821] in The Works of David
Ricardo, edited by J. R. McCulloch, 1852.

Corry, B. A. Money, Saving and Investment in English
Economics 1800-1850.
New York:
St. Martin’s
Press, 1962.

Robbins, Lionel Charles.
The Theory of Economic
Development in the History of Economic Thought.
New York: St. Martin’s Press, 1968.

Fetter, Frank W. Development of British Monetary
Orthodoxy 1797-1875. Cambridge : Harvard University Press, 1965.

Sargent, Thomas J.
Macroeconomic
York: Academic Press, 1979.

Thornton, Henry.
An Enquiry Into the Nature and
Effects
of the Paper- Credit of Great Britain
(1802): and Speeches on the Bullion Report, May
1811. Edited with an introduction by F. A. von
Hayek.
New York: Rinehart & Company, Inc.,
1939.

Girton, Lance. “SDR Creation and the Real-Bills Doctrine.” Southern Economic Journal 41 (July 1974).
of the Bank Re-

Viner, Jacob. Studies in the Theory of International
Trade (1937). New York: Augustus Kelley, 1965.

Laidler, David. “Adam Smith as a Monetary Economist.”
Canadian Journal of Economics 14, no. 2
(May 1981).
Mints, Lloyd W. A History of Banking Theory.
cago: University of Chicago Press, 1945.

FEDERAL

West, Robert Craig. Banking Reform and the Federal
Reserve, 1863-1923. Ithaca, N. Y., Cornell University Press, 1977.

Chi-

RESERVE

New

Smith, Adam. An Inquiry Into the Nature and Causes
of the Wealth of Nations (1776).
New York:
Random House, 1937.

Friedman, Milton, and Anna J. Schwartz. A Monetary
History of the United States, 1867-1960. Princeton,
New Jersey: Princeton University Press, 1963.

King, Lord. Thoughts on the Effects
strictions. 2nd ed., 1804.

Theory.

BANK

OF

RICHMOND

13