In reply to Kurt’s commentary on the backing theory/real bills view, let me start with a reasonable working statement of the real bills doctrine:
Money should be issued in exchange for
(2) real bills
(3) of adequate value.
Rule 3 is by far the most important. No bank should (or would) issue $100 to someone who offered securities worth only $90 in exchange. A bank that fails to follow rule 3 will soon become insolvent, while a bank that follows rule 3 will get a dollar’s worth of new assets for every new dollar that it issues, so that bank’s dollars will hold their value, even as more are issued. Furthermore, no law is needed to force banks to follow rule 3. This is why the real bills doctrine is the natural ideology of free banking. Sargent and Wallace also equate the real bills doctrine with the free banking view.
Rules 1 and 2 also play a role. Rule 1 prevents maturity mismatching, and assures that the assets backing the bank’s money will mature in 60 days or less, so that even if customers want to redeem all their money at once, the worst that can happen to customers (assuming the bank is solvent) is a 60-day wait to get their money. Rule 2 automatically matches the quantity of money to the needs of business. When farmers and factories are busy, they will generate many bills, some of which will find their way to local banks, to be exchanged for newly-issued money. Old-time note-issuing bankers usually found that if they issued new money based on the bills of farms and factories, then their notes would stay in circulation. But if they issued new notes to people not directly engaged in production, the new notes would return to the bank the next day. Here again, no law is needed to force banks to follow rules 1 and 2, though I should add that banks were not terribly strict in following rules 1 and 2, and they often found that new notes could safely and profitably be issued for government bonds or other “solid paper” with maturities over 60 days.
The backing view says that the real bills doctrine avoids inflation by assuring that money does not outrun the issuer’s assets. But quantity theorists mistakenly think that the real bills doctrine aims to prevent inflation by assuring that money does not outrun the quantity of goods produced in the economy. The difference between the “money outruns assets” view and the “money outruns goods” issue has been a prolific source of misunderstanding.
Adam Smith, in the passage referenced by Kurt, takes the view that the real bills doctrine will prevent money from outrunning goods, that is, that “(money) can never exceed the quantity which the circulation of the country can easily absorb and employ”. Henry Thornton (1801) and David Ricardo (1810) took a similar approach. Each of them contended that a bank that followed the real bills rule might still cause its money-issue to outrun the quantity of goods. This seemed to them a sufficient proof that the bank would cause inflation, but they failed to realize that as long as a bank only issued money in exchange for assets of adequate value, the bank’s money-issue would not outrun the bank’s assets, and the money would hold its value. (More on Thornton and Ricardo here)
Lloyd Mints (1945) attacked the real bills doctrine with his “money’s worth” argument, which can be explained with the following sequence of events:
- Banks lend dollars. Borrowers promise to repay the loan, not with a physical amount of their assets, but with a specified dollar’s worth of their assets.
- Lending of dollars creates new money.
- New money causes the value of existing money to fall,
- which reduces the real value of borrowers’ debts,
- which allows borrowers to borrow still more,
- which brings us back to #2, and a self-perpetuating cycle of more loans, more money, and more inflation.
Step 3 above, that new money causes inflation, assumes the correctness of the quantity theory. But on backing theory principles, the new money will be adequately backed by the borrower’s collateral, and so will not cause inflation. Thus Mints’ “self-perpetuating cycle” never gets off the ground. Only by assuming the incorrectness of the real bills doctrine to begin with was Mints able to conclude that the real bills doctrine was incorrect.
Now, to Kurt’s questions and comments:
- Question: Mike, to give me and other readers a better sense of where you fit in the long real bills tradition, please explain (a) whether the real bills doctrine as you define it is similar to the way Sargent and Wallace define it and (b) whether you think it was a misnomer for Sargent and Wallace to call their idea a version of the real bills doctrine.
Answer: I agree with Sargent and Wallace that “there should be unrestricted discounting of real bills”. Banks acting in their own best interest will only issue a new dollar to someone who offers a dollar’s worth of assets in exchange, so the bank’s assets will automatically be sufficient to cover the money it has issued. I disagree with Sargent and Wallace’s claim that the real bills doctrine leads to an indeterminate price level. As long as the bank holds some real assets, these will anchor the currency. Sargent and Wallace also accept the idea that modern paper moneys are fiat moneys, in the sense that they are unbacked. I think that modern paper moneys are backed by the assets of the issuing central bank, but they are normally not convertible into metal. But ‘inconvertible’ is not the same thing as ‘unbacked’.
- Question: Is the real bills doctrine as you define it a theory that is as generally applicable as the quantity theory claims to be, or is it a theory that applies to some kinds of monetary institutions and circumstances and not to others? (See my comment just below for a clarification.)
Answer: The backing version of the real bills doctrine says that money is valued according to the assets and liabilities of its issuer, just like stocks, bonds, bills, notes, warrants, and any other financial securities. In this sense it is generally applicable.
Comment: In wartime many occupying armies have issued a kind of currency, usually forced into circulation at par with the existing currency on the official market. The aim of this currency was frankly to enable the occupier an easy means to commandeer goods. The currency was not readily exchangeable into any foreign currency, including the home currency of the occupying army, and there were no reserve assets of recognized international value held against it. Does the real bills doctrine as you define it apply to analysis of these currencies, or is it confined to more normal historical cases?
Answer: If, for example, Mexico has issued 100 pesos, backed by assets worth 100 oz of silver, then 1 peso=1 oz. If America then takes over, issues 200 “occupation pesos” and spends them, then there will be 300 pesos backed by only 100 oz of assets, so then 3 pesos=1 oz.
- Comment: To me, saying that acceptance of currency for tax payments provides a kind of backing is metaphorical rather than literal. When I think of backing I think of convertibility at a set rate of exchange. A currency that is supposedly backed by certain assets but cannot be exchanged for any of them at a set rate is not backed in the way I believe most people think of the term, or in the way that issuers backed their currencies under most types of gold standard.
Answer: In the American colonial period, colonial governments would collect taxes worth maybe 5 silver shillings (English coin) from each colonist every year. In 1690, the colony issued paper shillings and paid them to soldiers, declaring that those paper shillings would be acceptable in lieu of silver shillings at tax time. If those paper shillings had been convertible in the conventional sense, a colonist could have presented a paper shilling to the government and demanded a silver shilling in return. But these paper shillings were convertible in the sense that the colonist could present them to the tax man and be relieved of having to pay 1 silver shilling. Either way, the paper shilling is convertible. If the present value of the colony’s “taxes receivable” is 1000 shillings, then the colony could issue up to 1000 paper shillings against that asset, just like a banker could issue 1000 paper shillings against 1000 shillings worth of assets held in his vault.
- Comment: In your example of the playing card money, the retort from the quantity theory side is that inflation does not occur when the money supply triples because the velocity of money (inversely related to the demand to hold money) changes. Other things are not equal, in other words.
Answer: Nobody claims that the value of General Motors’ bonds or stock is affected by the velocity with which those stocks and bonds circulate. The values of GM’s stocks and bonds are determined by GM’s assets and liabilities (broadly defined). The backing theory says the same is true of money. In the case where each paper livre is convertible into 1 silver livre, velocity cannot affect that value. Once this is recognized, the next step is to recognize that convertibility can take many forms. A paper livre can be convertible into silver, into bonds, into taxes, land, loan repayments, etc. If metallic convertibility makes velocity irrelevant, then so do the other kinds of convertibility. (I should add that velocity is a notoriously slippery concept, and is easily used to allow quantity theorists’ models to always be right no matter what.)
- Comment: In the 1990s I heard this aphorism about central banks in poorer countries (which, remember, had had a terrible decade from 1982-1992): “The assets are garbage; the liabilities, everyone believes in.” For a floating currency during normal, noncrisis periods, as long as the central bank’s liabilities are limited in quantity, I don’t see what difference it makes whether the assets are Swiss government bonds or dodgy loans purchased from domestic banks. During a crisis it matters, because Swiss government bonds are easy to sell in quantity without having to offer fire-sale discounts and dodgy domestic loans are not. If backing matters so much, though, shouldn't we see less marked a difference between crisis and noncrisis periods in the value of the currency, since the assets on the day before the crisis and the assets the day the crisis begins are the same?
Answer: It makes no difference whether a central bank issues 100 pesos in exchange for Swiss bonds worth 100 oz of silver, or dodgy loans worth 100 oz. of silver. Either way, 1 peso=1 oz. But if a crisis comes along, the Swiss bonds will stay at 100 oz, while the dodgy loans drop to 20 oz, and the pesos that are backed by the dodgy loans will fall from 1 oz/peso to 0.2 oz./peso.