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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 toleading further 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 do so when vary of real was the secured by (1723-1790) Box 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- 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 enoughmoney 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 thatindeed if 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) B=mGt Second, Thornton argued that the doctrine fails to perceive that monetary expansion raises prices and that rising prices, by expanding 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 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 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 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 Paper Credit, p. 244. RESERVE will be 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 FEDERAL of bills outstanding 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 BANK 14 Thornton, Paper Credit, p. 86. 15 Thornton, Paper Credit, p. 253. 16 Thornton, 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 charges absorb Despite thus “scoring less than the that limit the note issue could of notes. the real bills doctrine 20th 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 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 of money He also denied quantity these criticisms, in 19th and that rise in prices, commerce any conceivable vived extent.“20 stated is no amount 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: money needs in the middle decades notes were mately issued convertible of the there was no and were of over- In the late 19th and early 20th centuries the doc- 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. issue.“23 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
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