In this paper I argue that the Real Bills Doctrine
has been wrongly discredited, and that it ought to displace the
Quantity Theory as the dominant theory of money. The discussion
begins with the observation that the issue of backed money
will not be inflationary as long as central banks follow the Real-Bills
rule of only issuing money to those customers who offer
good security in exchange. I then contend that modern paper currencies,
which we normally think of as unbacked fiat money, may in fact
be (and probably are) backed. If correct, this would imply that
the Real Bills Doctrine, and not the Quantity Theory, is a correct
model of the value of modern money. The paper concludes
by discussing a few controversies in the history of the Real Bills
Doctrine, and shows that the major arguments responsible for the
defeat of the Real Bills Doctrine contain obvious and serious
When the Directors of the old Bank of England were accused
of having allowed the pound to depreciate between 1797 and 1810,
their defense was based on the Real Bills Doctrine. They stated
that they had only issued money to those customers who offered
good security in exchange for the money. Therefore, they claimed,
the Bank had only issued as much money as the legitimate needs
of business required. The Bullion Committee appointed by the House
of Commons in 1810 denounced this defense as "wholly erroneous
in principle" (Gilbart, 1882, p. 53). Sixty-three years later,
the bankers' answers were still derided as "almost classical
by their nonsense." (Bagehot, 1873, p. 86) It would be difficult
to count the number of times that similar debates over the Real
Bills Doctrine have flared over the centuries. A few episodes
are summarized by Mints (1945, p. 9.):
The real-bills doctrine has been a most persistent one. Given
its most elegant statement in all its history by Adam Smith in
the Wealth of Nations, it has since served as the defense
for the directors of the Bank of England during the period of
the Restriction. With some changes it re-appeared as the banking
principle; it was the main reliance of the agitators for banking
reform in the United States before 1913; it was as comforting
to the Federal Reserve Board following the depression of 1921
as it had been a century earlier to the directors of the Bank
of England; more recently it has re-emerged as the doctrine of
"qualitative" control of bank credit; and, quite aside
from these special uses to which it has been put, it has been
consistently defended throughout all these years by a large proportion
of bankers and economists.
Since Mints' time, a dissident tradition opposed to the Quantity
Theory (and sometimes favorable to Real-Bills principles) has
been evident in the writings of Tobin (1963), Black (1970), Samuelson
(1971), Wallace (1982), and Sargent and Wallace (1982). Still,
most economists' attitudes toward the Real Bills Doctrine have
remained far from charitable. G. A. Selgin (1989, p. 489.), for
example, comments that
The dead horses of economic theory have a habit of suddenly
springing back to life again, which is why it is necessary to
beat them even when they appear lifeless.
In what follows I hope to revive this dead horse.
Empirical studies by Sargent (1982), Smith (1985), Calomiris (1988), Siklos (1990), Bomberger and Makinen (91), and Cunningham (1992) have found that the value of money is more accurately predicted by a Real-Bills type "Backing Theory" than by the Quantity Theory. Cunningham (1992) in particular, notes that his study of Taiwan provides "clear support for the Real Bills doctrine over the Quantity Theory." These results deserve serious attention, but the Real Bills Doctrine is still widely regarded as "thoroughly discredited" (Mishkin, 1994, p. 503). One reason for this inattention is that most economists' understanding of the Real Bills Doctrine does not go beyond the simple (and inadequate) statement that "Money issued in exchange for real bills will not be inflationary." This paper attempts to fill a clear need for an explanation of the elements of the Real Bills Doctrine, while correcting errors that have crippled past discussions.
This paper examines backed money from a Real-Bills perspective.
I contend that economists have been too quick to accept the idea
that what we call fiat money is actually unbacked, since it is
possible for money to be inconvertible but still backed.
A. THE REAL BILLS VIEW OF BACKED MONEY
The Real Bills Doctrine holds that money issued in exchange
for sufficient security (usually short-term commercial bills)
will not cause inflation. For example, Figure 1 represents a bank
which has taken in 100 ounces of gold on deposit and issued 100
'credits' (either bank notes or deposits), each of which is a
claim to one ounce of gold.
100 credits Bank Liabilities
100 oz. of
gold Bank Assets
The value of these credits depends only upon the bank's ratio of assets to liabilities, just like any other financial security. The interesting thing about this money is that its value does not depend on any of the following factors:
(1) the quantity of money,
(2) the convertibility of the money,
(3) money demand,
(4) the quantity of derivative moneys,
(5) fiscal policy.
I will discuss each of these in turn.
1. THE QUANTITY OF MONEY
Suppose that the public wants 100 additional credits, but instead
of offering gold in exchange they offer IOU's with a current market
value 100 ounces of gold. The banker would have no reason to refuse
this offer, and so he would issue 100 more credits, thus doubling
the money supply.
_____________ _ _ _ _ _ _ _ _ _ _
100 credits +100 credits
_____________ _ _ _ _ _ _ _ _ _ _
100 oz. of +IOU's worth
gold 100 oz. of gold _____________ _ _ _ _ _ _ _ _ _ _
There are now 200 credits laying claim to assets worth 200 ounces of gold, so each credit must still be worth one ounce. The banker can safely issue any amount of money the public desires, provided that he only issues credits to those customers who offer 'sufficient security' (i.e., resources worth one ounce of gold). This rule is nothing but the Real Bills Doctrine, except that the security need not be "short-term commercial bills". Anything worth 100 ounces of gold would serve equally well.
While it is true that money-creation will not affect the credits'
value relative to gold, it is still possible that the
issue of credits might reduce the monetary demand for gold and
thus reduce its value. This may seem to support the Quantity Theory
proposition that money-creation, even on sufficient security,
will cause inflation. However, if gold's value drops because of
competition from the bank's credits, the drop would reflect increased
economic efficiency, as monetary gold is released for other uses.
But this is the effect of an improvement in monetary technology--not
of an increase in the quantity of money.
2. THE CONVERTIBILITY OF THE MONEY
Suppose that the bank in Figure 2 closes over the weekend, thus making its notes temporarily inconvertible. Then, while the bank is closed, the value of the IOU's drops to 50 ounces of gold. The credits would then trade for 150/200=.75 ounces for the rest of the weekend. If the bank restored convertibility at one ounce per credit on Monday morning, it would face a run. The first 150 depositors would get their gold (or something of equivalent value) and the last 50 would get nothing. As the run progressed the expected value of the credits would fall, so that, for example, after 80 credits had been redeemed at one ounce each the value of each remaining credit would be 70/120=.58 ounces. If the bank continued to offer one ounce per note, customers would see it as an empty promise, and they would value the notes at only .58 ounces. Clearly, it is backing that matters, not convertibility. Put another way, convertibility requires backing, but backing does not require convertibility.
If banks can suspend convertibility for a weekend, they can suspend it for a hundred years. For example, a banker might make this offer to his depositors: "Give me resources worth one ounce of gold today, and in 100 years I will return your deposit plus a competitive interest yield." Each credit issued on these terms would initially be worth one ounce of gold, and its value would grow at the rate of interest. If customers preferred the credits to have roughly constant value, then the banker could make periodic interest payments, say by adding .05 credits per year to the account of each credit-holder. Note that the banker need not specify the exact date of redemption, or even that he will pay in gold. All that matters to the customers is that the credits are a claim to something of value.
We are now in a position to make an important observation:
It is possible that what we think of as unbacked fiat money is
in fact money that is backed but inconvertible. Consider the usual
justification for asserting that the dollar is fiat money:
You cannot convert a Federal Reserve Note into gold, silver, or
anything else. The truth is that a Federal Reserve Note has no
inherent value other than its value as money, as a medium of exchange.
(Tresch, 1994, p. 996.)
Observing that the dollar is inconvertible, economists conclude
that it is unbacked. The most remarkable thing about this simple
non-sequitur is that it has survived virtually unquestioned for
centuries. If we want to show that the dollar is not just inconvertible,
but unbacked, it is not enough to say that the Federal
Reserve does not pay out gold on demand. Yet economists' belief
in fiat money, and in fact the better part of monetary theory,
is founded on nothing but this obviously flawed premise. Add to
this the facts that the Federal Reserve (like all central banks)
does in fact hold assets against the money it issues, that no
dollar is ever issued except in exchange for valuable assets,
and that the Federal Reserve's balance sheet plainly identifies
those assets as "Collateral Held Against Federal Reserve
Notes", and we have good reason to wonder if fiat money is
no more real than the phlogiston, ether, and caloric of early
3. MONEY DEMAND
If our banker has resources worth 100 ounces of gold backing 100 credits, then those credits will be worth one ounce each regardless of the public's demand for them. If their value exceeded one ounce by (say) 2 percent, then rival bankers could earn easy profits by issuing credits for 1.02 ounces of gold, keeping 1 ounce as backing, and spending the seignorage of .02 ounces on their own consumption. This profit opportunity will exist as long as there is any seignorage, so the only stable solution is for the seignorage to be driven to zero. The same reasoning implies that there can be no such thing as fiat money, since fiat money is money whose whole value is seignorage.
Depending on who is talking, we hear that fiat money has value because other people value it (Samuelson, 1980, p. 261), because the government accepts it for taxes (Wicksteed, 1910, p. 619), because it is useful for making exchanges and limited in supply (Marshall, 1922, p. 49), because the government requires banks to hold it (Fama, 1980, p. 56), or because it allows us to transfer wealth to our children (Wallace, 1980, p. 50). The trouble with these theories is that they fail to consider rival monies. Each theory begins by asserting that there is some force (e.g., liquidity services) that creates a demand for intrinsically worthless pieces of paper. They then assert that it would only be necessary to limit the supply of these pieces of paper in order to give them value. Of course, no one believes that such a thing would be possible for private, competitive banks. Furthermore, if a private bank could issue notes on which it paid no interest, while investing the proceeds at 5%, then competitors would issue rival notes until the interest spread just covered costs of printing, periodic redemption, controlling counterfeiting, etc. Given this, it is strange to see how easily economists accept the proposition that central banks earn seignorage on their note issue, and that note issue therefore gives a free lunch to the Federal Reserve, especially if the dollars go to foreign countries. Since most of us are trained to be suspicious of free lunches, this idea deserves some skepticism.
The only reason to believe that the Federal Reserve earns seignorage is that it has the power to suppress rival bank notes. But governments cannot suppress commodity money, credit, foreign bank notes, or barter. There are also traveller's checks, gift certificates, and scrip, all of which are bank notes issued by non-bank institutions. (In point of fact the only entities barred from issuing bank notes are banks themselves.) Given this rivalry, it is hard to believe that note issue could yield abnormal profits, even to government banks. Where countries are small, weak, and close together, it seems impossible.
But assume for the sake of argument that a country is strong enough to erect significant barriers to rival bank notes. The government notes will still face rivalry from derivative monies. (By 'derivative money', I mean money that is a claim to some other money, in the sense that a dollar in a checking account is a claim to a Federal Reserve note.) For example, a farmer might pledge $10,000 of wheat to a banker, and the banker in turn will lend the farmer $10,000 by crediting that amount to his checking account. By this exchange the banker will have effectively coined wheat into dollars. If we accept the assertion that the dollar has value because of the liquidity services it provides, then the creation of the new wheat-backed derivative dollars would reduce the demand for Federal Reserve dollars, and thus would reduce their value. If there were no constraint on the issue of derivative dollars, the value of Federal Reserve dollars would be driven to zero.
One might argue that banks are constrained by reserve requirements, but these only apply to conventional bank accounts, not to credit cards, eurodollars, scrip, and so on. In light of this limitless potential for the issue of rival monies, fiat money seems implausible. In contrast, the view that the dollar is backed but inconvertible only requires us to believe that money is valued for the same reason that any other financial security is valued.
A stock market analogy may help explain the role of reserve requirements. Just as bankers issue checking accounts that are claims to Federal Reserve dollars, stock market traders routinely issue derivative securities which are claims to GM stock. Suppose that those traders were required to hold "reserves" of genuine GM stock against the derivative shares that they issue. Would this requirement increase the value of GM stock? The answer is no, since this requirement does not affect GM's ratio of assets to liabilities. If one accepts the idea that the dollar is backed, then the same reasoning implies that reserve requirements are irrelevant to the value of the dollar.
A reasonably skeptical reader could still argue that a constraint on rival monies could cause the dollar to sell for a few points above its backing. However, one could also argue that GM stock could be raised a few points (or lowered!) by a constraint on the issue of rival stocks. But I doubt that this argument would persuade economists to abandon the theory that stocks are valued according to their backing. When applied to money, the same argument is clearly an inadequate reason for believing that the dollar is a pure fiat money.
Why does the Federal Reserve (and every other central bank)
bother to hold gold and financial securities if the dollar does
not get its value from backing? How could fiat money ever come
into circulation in the first place? Why issue dollars through
an expensive central bank instead of just printing them and spending
them? Why do even the weakest countries seem to be able to maintain
"fiat" money in circulation? These questions and many
more have inspired a mountain of convoluted monetary theories.
But if fiat money is in fact an illusion--if it is actually backed
but inconvertible, then these questions do not even arise.
4. THE QUANTITY OF DERIVATIVE MONIES
Checking accounts issued by private banks entitle depositors to claim Federal Reserve notes on demand. Thus we could call the accounts 'derivative money' (a term I prefer to 'inside money') since they are claims to genuine dollars. The dollar, in turn, is an inconvertible claim to the assets of the Federal Reserve, and is itself a derivative money, even though we commonly think of it as base money. By analogy, there are derivative financial securities (options, warrants, etc.) that are claims to GM stock. The GM shares, in turn, are a claim (generally inconvertible) against GM's assets. Thus the base stock is itself a derivative security.
The issue of derivative shares of GM stock does not change GM's ratio of assets to liabilities, and therefore does not depreciate GM stock. Similarly, if the dollar has value because of its backing, then the issue of derivative dollars will not reduce the value of the dollar. The Quantity Theory, however, implies that derivative dollars reduce the demand for base dollars and thus cause inflation. On this view, a legitimate banker is no different from a counterfeiter: Both increase the quantity of money, so both cause inflation! This belief has led to a number of proposals to require all banks, public and private, to maintain 100% reserves against the money they issue (e.g., Friedman, 1948, p. 372.). This idea, besides being out of character for libertarian economists, ignores the fact that banks recognize their money as their liability, while counterfeiters do not.
Derivative monies raise the question of what is 'money' and what is not. Should we include only gold? Notes issued by the central bank? Private bank notes? What about checking accounts, credit cards, traveller's checks, eurodollars, overdrafts, and gift certificates?
These questions could only matter to someone who believes that
the value of money depends on its quantity. No one bothers to
wonder whether derivative shares of stock (options, hypothecated
shares, etc.) should be counted along with genuine shares. We
simply recognize that derivative shares can take many forms, and
that each share will be valued in accordance with the resources
backing it. If economists understood money as well as they understand
stock, they would recognize that derivative monies also take many
forms, but that their quantity is irrelevant to the value of the
dollar. Misunderstandings of this point are widespread. For example,
Salin (1984, p. 13.) worries that eurodollars reduce the Federal
Reserve's control over the world supply of dollars. On this view,
the issuer of a eurodollar is violating the 'brand name' of the
dollar. The Real Bills view, however, is that a foreign bank which
issues a eurodollar is analogous to a foreign brokerage house
which issues a derivative share of GM stock. Viewed in this way,
we see that eurodollars are no cause for concern to Americans,
and in fact are likely to improve the efficiency of the market
5. FISCAL POLICY
Sargent and Wallace (1981, p. 176) observe that a government
deficit can be financed either by borrowing or by printing money.
They conclude that
...once the limit on the federal debt per capita that can be marketed
with the public has been reached, the Fed has no choice: It must
increase base money. That is, it must "monetize" all
of the additional government borrowing by purchasing all real
additions to the stock of interest-bearing debt that the treasury
issues. More generally, given the time path of fiscal policy and
given that government interest-bearing debt can only be sold at
a real interest rate exceeding the growth rate n, the tighter
is current monetary policy, the higher must the inflation rate
That "the Fed has no choice" is incorrect. The Federal Reserve, like most central banks, has the right to buy as much or as little government debt as it chooses. Furthermore, the competitive auction process assures that it pays market value for that debt. So suppose that the Treasury, having spent itself into bankruptcy, tries to raise some cash by offering a bond that promises to pay one million ounces of gold next year. Since nobody trusts that promise, that bond will sell today for (say) 100 ounces. If the Federal Reserve buys that bond with cash worth 100 ounces, then its assets will rise as much as its liabilities, and the value of the dollar will not change.
If the central bank is not independent, fiscal policy could affect the value of the dollar, but not for the reasons given by Sargent and Wallace. If the government orders the bank in Figure 2 to hand over 100 credits in exchange for bonds that are really worth only 40 ounces, then the value of the credits will drop to 240/300=.8 ounces. The inflation is not caused by the increase in the supply of money, but by the reduction in the bank's ratio of assets to liabilities. This, in turn, can only happen when the bank is subservient to the Treasury. Sargent (1981) has observed that inflation abates when a subservient central bank becomes independent, but his interpretation is that independence allows the central bank to restrain the growth of the money supply. The Real Bills interpretation is that independence frees the central bank from government policies that would reduce the bank's ratio of assets to liabilities.
A money-issuing bank located in Mexico might own nothing but
U.S. government bonds, even though its money circulates in Mexico.
Thus, no matter what happens in Mexican fiscal affairs, the bank's
money will be stable. Conversely, if U.S. bonds drop in value,
the Mexican bank's money will depreciate even when Mexican finances
are in order. Note, however, that the U.S. Treasury cannot force
a Mexican bank to buy U.S. bonds, and therefore the Mexican bank
will never monetize U.S. debt. If the Mexican bank's money becomes
widely-used in the U.S., then the U.S. would have a completely
independent central bank which would never monetize U.S. debt,
regardless of U.S. fiscal policy.
Return to the case of a bank that holds miscellaneous goods worth 100 ounces of gold as backing for 100 outstanding credits. Now suppose that the bank follows an 'easy money' policy and begins issuing credits in exchange for securities worth only .95 ounces of gold. If the banker issues 50 new credits on these terms, then the value of each credit will drop to (100+(50x.95))/150=.983 ounces. We get the familiar result that easy money leads to inflation. Note that the inflation results from a drop in the bank's ratio of assets to liabilities, not from an increase in the quantity of money relative to aggregate output of goods.
When depositors see the bank handing out credits worth one ounce of gold in exchange for securities worth only .95 ounces, they will rush to buy these credits. Thus the quantity of bank money will expand as long as the bank follows its easy money policy. At the same time, the value of the bank money will fall because of the drop in the ratio of assets to liabilities. This point has confused economists for centuries. The true cause of inflation is that the bank issues money for insufficient security. The apparent cause of inflation--the increase in the quantity of money--is really just a side effect of the bank's easy money policy.
This analysis provides an interesting view of credit rationing.
In discussing an English credit rationing episode, Friedrich Hayek
This recourse to a rationing of credit caused renewed stringency in the money market in the spring of 1796 and evoked loud protests from the City (London).
It is not easy to reconcile these complaints about the continued
scarcity of money during this period with the no less insistent
complaints about high prices, and with the continued unfavorable
course of the exchanges." (Hayek, 1933, p. 40)
From a Real Bills perspective, it is easy to reconcile the two sets of complaints. If the Bank of England were issuing notes on insufficient security, then each issue would cause the Bank's ratio of assets to liabilities to fall and thereby reduce the value of the pound. Meanwhile, since the Bank was issuing pounds in exchange for security worth (say) .98 pounds, customers would eagerly buy any pounds the Bank offered. Assuming the Bank dealt with the resulting surge in demand by rationing credit, we would naturally expect people to complain of a shortage of credit.
A problem arises when the bank's assets are denominated in
the bank's own credits. (e.g., The Federal Reserve's bondholdings
are denominated in dollars.) If the bank's credits were to depreciate
for any reason, then the bank's assets would also depreciate.
The credits would then fall still further, and so on. Let P represent
the price, in gold, of a bank's credits. Assume that the bank
initially has 100 outstanding credits, each worth one ounce of
gold, and that its assets consist of 30 ounces of gold plus bonds,
denominated in the bank's own credits, which have a market value
of 70 credits. Now suppose that the bank follows an easy money
policy and issues 10 new credits in exchange for bonds with a
true value of only 6 credits. If assets (30 ounces of gold plus
bonds worth 76 credits) are to equal liabilities (110 credits),
the following must hold:
Solving, we find that P=.888 ounces of gold. If the bank had
instead started with 20 ounces of gold and bonds worth 80 credits,
the same easy money policy would have reduced the value of the
bank's credits to P=.833 ounces. Thus, the bank's holdings of
gold or other 'real' assets would limit the force of inflationary
feedback. The smaller are real reserves, the more volatile the
C. THE FAULTS ON BOTH SIDES
Debates between Quantity Theorists and Real Bills adherents
have flared repeatedly over the last three centuries. As a rule
the Quantity Theory has come out on top, but often the controversies
"have slumbered, rather from the exhaustion of the combatants
than from the acknowledged defeat of either party." (Farrer,
1898, p. 78.) When a debate becomes as protracted as this, there
is good reason to think that both sides are asking the wrong questions.
I contend that two key errors lie at the root of the problem.
First, both sides accepted the existence of fiat money, without
exploring the possibility that paper money could be backed but
inconvertible. Second, both sides held that stable prices would
be achieved if the money supply rose and fell with the "needs
of business" (i.e., real output). They ignored the role of
the issuing bank's ratio of assets to liabilities. In what follows
I discuss some key episodes in the history of the Real Bills Doctrine
in order to show the effects of these and other errors.
1. ADAM SMITH
What a bank can with propriety advance to a merchant or undertaker of any kind, is not either the whole capital with which he trades, or even any considerable part of that capital; but that part of it only, which he would otherwise be obliged to keep by him unemployed, and in ready money for answering occasional demands. If the paper money which the bank advances never exceeds this value, it can never exceed the value of the gold and silver, which would necessarily circulate in the country if there was no paper money; it can never exceed the quantity which the circulation of the country can easily absorb and employ.
When a bank discounts to a merchant a real bill of exchange
drawn by a real creditor on a real debtor, and which, as soon
as it becomes due, is really paid by that debtor; it only advances
to him a part of the value which he would otherwise be obliged
to keep by him unemployed and in ready money for answering occasional
demands. (Smith, 1776, p. 322)
The idea that a bank should only lend as much money as its
customers would otherwise have kept in their tills is nonsense.
We all know that a bank can, with propriety, lend to a merchant
any amount reasonably short of the merchant's net worth. Such
a bank will always have assets sufficient for its liabilities,
and thus its money will maintain its value. Smith's proposition
that the amount of bank money should correspond to the amount
of gold and silver it replaces implicitly assumes that money's
value will be maintained by a limitation of its quantity, and
not by a matching of bank assets to liabilities. Having no clear
idea of this distinction, Smith made a dangerous misinterpretation
of central bank policies:
By issuing too great a quantity of paper, of which the excess
was continually returning, in order to be exchanged for gold and
silver, the bank of England was for many years together obliged
to coin gold...at an average (of) about eight hundred and fifty
thousand pounds. For this great coinage the bank (in consequence
of the worn and degraded state into which the coin had fallen
a few years ago) was frequently obliged to purchase gold bullion
at the high price of four pounds an ounce, which it soon after
issued in coin at 3 l. 17 s. 10 1/2 d. an ounce, losing
in this manner between two and a half and three per cent. on the
coinage of so very large a sum. (Smith, 1776, p. 286.)
By attributing the bank's loss upon the coinage to excessive note issue, Smith got the chain of causation precisely backwards. Note issue expanded because the bank issued money on insufficient security. But on Smith's interpretation, it was excessive note issue that forced the bank to accept insufficient security for its notes. When the bank pays out four one-pound notes for an ounce of gold that it reissues as coins worth 3 l. 17 s. 10 1/2 d., (about 3.9 pounds) then customers will eagerly bring one ounce of gold to the bank to exchange for 4 pound notes. They will then return 3.9 of those notes to the bank in exchange for a coin containing one full ounce. With the bank losing 2.5% on each exchange, the bank would soon exhaust its treasure.
What would get the bank started on such a ruinous course? Smith himself gave the answer: "the worn and degraded state into which the coin had fallen". When a new one pound coin was issued, it would have contained gold worth one pound. Because of wear and clipping, that same coin might soon contain gold worth 0.975 pounds. The heavy coins would disappear from the circulation and the value of the pound would drop by 2.5%. Thus, as Smith states, it would require four one-pound notes to buy the same amount of gold that it previously bought for 3.9 notes. But the effort to restore the pound to its old value will be hopeless. If the bank recoined the newly-purchased gold and sold it for 3.9 pounds per ounce, it would be buying its own notes on the market for 2.5% more gold than the notes were worth. The bank's ratio of assets to liabilities would fall, and the value of the pound would drop.
Modern central banks make the same mistake when they attempt
to support their currency in world markets. Suppose, for example,
that the pound trades for $1.60, but that the Bank of England
wants the pound to trade for $1.80. The Quantity Theory prescription
would be for the Bank of England to use its dollar reserves to
buy pounds in the open market for $1.80. But by paying $1.80 for
a British pound that is only worth $1.60, the Bank would lose
$.20 on each purchase. Its ratio of assets to currency would drop,
and the value of the pound would fall. Small wonder then, that
efforts to support various currencies are so often followed by
devaluation (Taylor, 1982, pp. 356-68). This empirical result
is exactly what the Real Bills Doctrine implies, and exactly opposite
to the implications of the Quantity Theory.
2. HENRY THORNTON
Henry Thornton (1802) is largely responsible for a popular
misconception that bank credit will not be adequately limited
by the requirement that loans only be granted on the basis of
"Real notes," it is sometimes said, "represent actual property. There are actual goods in existence, which are the counterpart to every real note. Notes which are not drawn, in consequence of a sale of goods, are a species of false wealth, by which a nation is deceived. These supply only an imaginary capital; the others indicate one that is real."
In answer to this statement it may be observed, first, that
the notes given in consequence of a real sale of goods cannot
be considered as, on that account, certainly representing
any actual property. Suppose that A sells one hundred pounds 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 bill; and again, that C, after
another month, sells them to D, taking a like bill, and so on.
There may then, at the end of six months, be six bills of 100
pounds each existing at the same time; and every one of these
may possibly have been discounted. Of all these bills, then, only
one represents any actual property. (Thornton, 1802, p. 86.)
Thornton's mistake was in failing to realize that no matter
how we look at it, 600 pounds of debt will not be created unless
security worth 600 pounds is offered in exchange. Suppose A sells
wheat worth 100 pounds to B, and receives B's IOU in exchange.
B then sells the wheat to C, in exchange for C's IOU. It is important
to realize that A would only accept B's IOU if it were backed
by something worth 100 pounds. For example, B might own property
that A could take from him in court. Thus B's IOU is backed by
B's property (not necessarily by the wheat). Every additional
sale of the wheat would create new IOU's backed by new goods,
and no matter how far the process went, the self interest of the
parties involved would assure that every new IOU would be backed
by goods of commensurate value. Thus Thornton's "false wealth"
argument collapses, and with it goes his refutation of the Real
3. THE BULLIONIST DEBATES
a. The Quantity Theory Position
The most extensively debated inflationary episode in history
occurred during the suspension of convertibility by the Bank of
England from 1797-1819. (For a history of the period, see Ashton
& Sayers (1953)). The controversy centered on the question
of why the pound had depreciated during the suspension period.
The 'Bullionist' (Quantity Theory) explanation was championed
by Ricardo, who held that money-issuing banks had increased the
quantity of money:
Let us suppose all the countries of Europe to carry on their circulation
by means of the precious metals, and that each were at the same
moment to establish a Bank on the same principles as the Bank
of England--Could they, or could they not, each add to the metallic
circulation a certain portion of paper? and could they not permanently
maintain that paper in circulation? If they could, the question
is at an end, an addition might then be made to a circulation
already sufficient, without occasioning the notes to return to
the Bank in payment of bills due. If it is said they could not,
then I appeal to experience, and ask for some explanation of the
manner in which bank notes were originally called into existence,
and how they are permanently kept in circulation. (Ricardo, 1811,
In this statement, Ricardo convincingly shows that banks are
able to increase the quantity of money. Being imbued with the
Quantity Theory, he considered this as satisfactory proof that
banks cause inflation. But the connection between money and inflation
should have been the very point under examination. On Real Bills
principles, an increase in the money supply, accompanied by
an equal increase in bank assets, will have no effect on prices.
But Ricardo, like Quantity Theorists ever since, ignored bank
assets, and did not consider the reasonable proposition that the
pound had fallen because the Bank of England's assets (mainly
British government bonds) had fallen in value.
b. The Real Bills Position
The Anti-Bullionist position, as stated by Charles Bosanquet,
relied on Real Bills principles:
...(inflation will result whether) the issue be gold from a mine or paper from a government bank. All this I distinctly admit, but in all this statement, there is not a single point of analogy to the issues of the Bank of England.
The principle on which the Bank issues its notes is that of loan. Every note is issued at the requisition of some party, who becomes indebted to the Bank for its amount, and gives security to return this note, or another of equal value... (bosanquet, 1810, pp. 52-53.)
First, note that Bosanquet admitted the existence of fiat money ("paper from a government bank"), and that an increase in the quantity of fiat money will cause inflation. He then denied that the creation of derivative money will cause inflation, since every issue of derivative money is matched by an equal increase in bank assets. But once the existence of fiat money is admitted, it cannot be denied that the issue of derivative money will reduce the demand for the fiat money and thus reduce its value. This was a weakness that Ricardo was quick to exploit, though neither man considered that fiat money might not exist at all.
Ricardo's errors in this case were more serious than Bosanquet's.
(Nevertheless, his "Reply to Mr. Bosanquet" is described
in the Dictionary of National Biography (1917, p. 874.) as "perhaps
the best controversial essay that has ever appeared on any disputed
question of political economy.") Ricardo held to the strict
Quantity Theory view that the pound had depreciated from an increase
in quantity, and not from a loss of backing.
...depreciation may arise from the abundance of the notes alone, however great might be the funds of those who were the issuers of them. (Ricardo, 1811, p. 114.)
Ricardo held that during the Restriction period the pound was
a true fiat money, whose value was determined by its quantity.
His mistake was in confusing backing with convertibility.
On February 27, the day after suspension of convertibility, the
Bank of England's ratio of outstanding notes to assets cannot
have been much different from the day before. Thus the Real Bills
Doctrine implies that the pound would be stable, as for a time
it was. Ricardo, however, asserted that all that was necessary
for an inconvertible currency to have value was a limitation of
its quantity. This leads to the doubtful proposition that the
forces determining the value of the pound changed completely on
February 26. Before that date, convertibility would have forced
the pound to be worth its backing. Afterwards, the value of the
pound was supposedly determined by the number in circulation.
Ricardo made this assertion in spite of the fact that the suspension
of convertibility was temporary, and in spite of the fact that
the Bank of England continued to hold backing for the pound throughout
the Restriction period (just as the Federal Reserve does with
dollars). On these grounds it is easy to sympathize with Nassau
Senior, who called Ricardo "the most incorrect writer who
ever attained philosophical eminence." (Bell, 1953, p. 205.)
5. LLOYD MINTS
In the few textbooks that still discuss the Real Bills Doctrine,
Lloyd Mints' criticism is still standard:
The fundamental error of all three men (Law, Steuart, and Smith)...
lay in the fact that they failed to see that, whereas convertibility
into a given physical amount of specie (or any other economic
good) will limit the amount of notes that can be issued, although
not to any precise and foreseeable extent (and therefore not acceptably),
the basing of notes on a given money's worth of any form
of wealth--be it land or merchants' stocks--presents the possibility
of unlimited expansion of loans, provided only that the eligible
goods are not unduly limited in aggregate value. (Mints, 1945,
Mints supposed that a bank issued new credits based on security
that was initially sufficient, but which was denominated in the
bank's own credits. He then asserted that the increase in the
quantity of credits would cause inflation, thus reducing the real
value of borrowers' debts and allowing them to borrow still more.
This in turn would lead to a vicious circle of more inflation
and more borrowing. He implicitly assumed, however, that the initial
issue of credits on sufficient security would cause an
initial round of inflation. But on Real Bills principles this
initial inflation would not occur. The value of the bank's credits
would be determined by their backing, and an issue of new credits
in exchange for sufficient security would automatically increase
backing in step with the new credits. Thus the 'unlimited expansion
of loans' would be cut off before it started. Mint's refutation
of the Real Bills Doctrine implicitly assumed the correctness
of the Quantity Theory--the very point in dispute!
6. SMITH VS. MCCALLUM
A recent clash between the Real Bills Doctrine and the Quantity
Theory concerns money and inflation in the American Colonies.
In a series of articles, Bruce Smith (1985a, 1985b, 1988), found
evidence from the colonial period in support of the theory that
price levels are determined more by the backing of money than
by its quantity.
When colonial currencies were carefully backed by future governmental
surpluses, they held their value remarkably well. When such backing
was not carefully provided, depreciation was the rule. The quantity
of notes issued, on the other hand, bears little relation to currency
values, or to colonial price levels. (Smith, 1985a, p. 156.)
Smith's conclusions were refuted by McCallum (1992)
A basic point is that the dispute between classical and anticlassical writers is not principally about the response of prices to money changes, but instead about the size of money stock changes associated with measures that pertain to paper currency alone. For a few cases there is widespread agreement, but the present discussion has featured nine episodes put forth by Smith as examples of the failure of classical monetary analysis. In each of these cases, large percentage increases in the stock of paper currency were followed by little or no response in price levels. Since the anticlassical position contends that specie supplies were minimal, it implies that large increases in real money balances occurred. The classical hypothesis, by contrast, is that outflows of specie (or commodity claims) occurred, with total real money balances remaining unchanged. The crucial implication is that, even at the episodes' peak years, colonies would be left with deflated levels of paper currency not significantly in excess of normal real money balances. (McCallum, 1992, p. 158.)
On Real Bills principles, the price level is not affected by either the size of the money stock or the quantity of specie or commodity claims. So by focusing on these two factors, McCallum tests only the Quantity Theory without testing the Real Bills Doctrine. For example, if a colony issued 100 notes backed by resources worth 100 ounces of gold, and then doubled the supply of notes while it also doubled assets, then the value of the notes would not change. This is consistent with Smith's position. McCallum's argument is that the 100 new notes would drive out an equivalent amount of specie (or other monies) from the circulation, leaving the total money stock unchanged. But one could not conclude from this that the stability of the overall money stock caused stability of prices, because a Real Bills adherent could reply that stable prices resulted from stability of the asset-to-liability ratio of the money-issuing colony.
A proper test of the two theories would ask whether the value of the money issued by a specific entity was more accurately predicted by the assets and liabilities of that entity, or by some money demand function based on the Quantity Theory. In view of the limitations of colonial data, as well as McCallum's observation that new colonial money probably drove out comparable amounts of existing monies, we are left without persuasive evidence for one theory over the other.
Given the extensive data available on the assets and liabilities of modern central banks, as well as on various measures of the money supply, it is clear that a persuasive study would have to use modern data to discover whether the value of money is more accurately predicted by the quantity of money or by the backing held by the central bank. Furthermore, modern central banks back their money with bonds whose value can be precisely estimated. The advantage over Smith's use of "future government surpluses" as an estimate of backing is obvious.
Smith incorrectly claims that studies of modern central banks
would be stymied by the abundance of fractional reserve intermediaties.
This similarity between theoretical specifications and colonial monetary arrangements reflects a simplicity of the colonial economy deriving from an absence of fractional reserve intermediaries. The absence of such intermediaries implies that it is unnecessary to decide whether private bank liabilities were money, and if so, to attempt to disentangle changes in this stock of high-powered money from changes in bank behaviour that might affect the 'money supply.' An attempt to conduct a study such as this one for any more recent period would certainly encounter problems of this sort. (Smith, 1985b, p. 535.)
The trouble with this argument is that on Real Bills principles, the value of the dollar is determined only by the assets and liabilities of the Federal Reserve, and is unaffected by what I have called the 'derivative monies' issued in the private sector. Thus, a test of the Real Bills Doctrine need only look at the quantity of money issued by the Federal Reserve. A test of the Quantity Theory would have to examine derivative monies as well, but once this was done, the accuracy of the Quantity Theory could be directly compared to that of the Real Bills Doctrine.
The Real Bills Doctrine holds that money issued on sufficient security will not cause inflation. In the 19th century this view was rejected on the grounds that private banks following a Real Bills rule would in fact increase the supply of money, thus reducing the demand for base money and thereby causing inflation. This argument cannot be true when the base money is backed, since money backed by resources worth an ounce of gold will be worth an ounce of gold no matter what happens to money demand. Furthermore, we have no reason to believe that the dollar (or any other currency) is unbacked, since it is possible that all so-called fiat monies are actually backed but inconvertible. Thus we cannot reject the Real Bills proposition that money creation does not cause inflation.
In the 20th century, the Real Bills Doctrine has been rejected largely on the grounds of the "money's worth" theory, which states that loans secured by a given "money's worth" of assets will create a self-perpetuating cycle of more money and more inflation. The trouble with this theory is that it assumes that the initial issue of money on sufficient security would cause inflation, even though this contradicts the Real Bills Doctrine. The conclusion is that our usual reasons for rejecting the Real Bills Doctrine must themselves be rejected.
The Quantity Theory asserts, without justification, that base money is unbacked. It concludes that money must derive its value from its scarcity combined with its usefulness for making trades, paying taxes, etc. At least two things make this view implausible: (1) Rival monies would act to reduce the demand for unbacked money, with no stable solution short of zero value, and (2) All central banks do in fact hold assets against their money--an unnecessary and costly practice if their money were a true fiat money.
The Real Bills Doctrine implies that money gets its value from its backing. It follows that the value of money will be unaffected by changes in the quantity of either base money or privately-issued money--provided only that the base money is issued on sufficient security.
When the central bank fails to take sufficient security for
its money, inflation will follow from the resulting drop in its
ratio of assets to units of money. At the same time, the easy
money policy will lead to an increase in the quantity of money,
and observers will wrongly conclude that the increase in the quantity
of money caused the drop in its value. This faulty perception
has allowed the Quantity Theory to become the dominant theory
of money, while the Real Bills Doctrine has been wrongly discredited.
And, much as I fear I am disgracing myself by the avowal, I have
no hesitation in professing my own adhesion to the decried doctrine
of the old Bank Directors of 1810, "that so long as a bank
issues its notes only in the discount of good bills, at
not more than sixty days' date, it cannot go wrong in issuing
as many as the public will receive from it." In that maxim,
simple as it is, I verily believe, there is a nearer approach
to truth, and a more profound view of the principles which govern
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