Backed Money, Fiat Money, and the Real Bills Doctrine

EMAIL FROM AARON FONTAINE 10/15/2003

Hello Mr. Sproul,

I am a self interested and self directing learner in

the field of economics and monetary theory. It has

become a recent obsession for the past year or so. In

trying to find the definition of the Real Bills

Doctrine I came across your paper: "Backed Money, Fiat

Money, and the Real Bills Doctrine". I did not fully

understand everything on the first read through, so

I'm going back through it again, slowly, writing notes

in the margins. Your paper has already helped me come

to many small realizations plus a fuller and more

appreciative understanding of the Real Bills Doctrine.

Although I don't fully agree with your refutation of

government money as fiat money, it's interesting I

never really thought of money as I do other financial

securities. I think that's what's going to finally

knock the Quantity Theory from my mind. I liked the

elegance of the Monetarist Theory when I first came

across it, but I always run into the problem of what

exactly do you define as money. How derivative can a

dollar be? Does corporate scrip count?

Anyway, all this brings me to another realization I

made while reading your paper. I noticed that in

section 1, "The Quantity of Money", the IOUs added to

the hypothetical bank had a *current market value* of

100 oz of gold. This is the first time I ever made the

distinction that the Federal Reserve values all of its

government securities at face value, not current

market value. Wouldn't that make all of the Treasury

Bills in its portfolio overvalued and thus reduce the

value of its credit? It's interesting since they have

to buy and sell the securities in the open market,

which means they are paying market value. Is this even

a concern? It's interesting to ask why gold is approx.

$370 an oz. when the Fed still holds a gold stock

valued at the statutory price of $42.22 an oz.

According to the Real Bills Doctrine, that implies

that the Fed is overvaluing the other assets it holds.

It would be interesting to do an analysis of the Fed

and see how much this can account for the devaluation

of the dollar. Unfortunately I don't know enough about

the Fed's other assets to know how to value them

properly in such a calculation. I tried some

rudimentary calculations with the equation G+xP=yP. G

is the quantity of gold held by the Federal Reserve

(261 or 263 million I think). x is the value in

dollars of the securities held by the Fed. y is the

liabilities in dollars of the Fed, and P is 1/(the

price per oz of gold ($370 or $380 I think)).

Depending on how I mess around with it I can get

market value roughly equal to between 87% and 93% of

face value. Is this making any sense? Can this at

least partially account for the loss of value of the

dollar? Am I even doing this right? I'd sincerely

appreciate your analysis and input on this.

Thank you,

Aaron Fontaine

COMMENTS FROM AARON FONTAINE 10/26/2003

Backed Money, Fiat Money, and the Real Bills Doctrine

Ok, first of let me start by saying I am in no a way an authority on monetary or economic matters. The extent of my formal education in economics consists of micro econ course from my freshman year of college. Nonetheless I have taken up a tremendous personal interest in these issues. Although my knowledge may have gaps and I may not fully understand everything, I’m always driven to complete this knowledge. I have done much studying, including several chapters of my old econ textbook, books ordered off the internet, and through websites.

I personally like your defense of the Real Bills Doctrine. It has a lot of intuitive appeal, much like the Monetarist Theory did to me when I first studied it. However, I see this paper more as a rebuttal of the arguments that defeated the Real Bills Doctrine in the first place. I find it a salient point that many of the arguments you dissect had assumed the validity Quantity Theory in their arguments for such validity. I’m not personally well versed in the debates and history of paper money, so there’s not much I can do to say you’ve represented both sides of the argument in historical fairness, but I feel I have gleaned much from your paper and that has even helped to grow and shape my understanding of the concept of money. Also, my lack of knowledge shouldn’t prevent from pointing out where the paper felt weak to me. I know this paper is very theoretical and even admits there is not enough appropriate historical data collected to verify its thesis. I also know I’ve spoken to you about the Federal Reserve and the possibility of analysis on such a central bank, but I concede such analysis is far beyond my ability at this point.

What I have for this discussion are two different goals. First is to examine the points brought up in your paper in relation to the Federal Reserve and see how perhaps their policies influence the value of money. The other is to examine the points of your paper in defense of the Real Bills Doctrine that were weak to me and discuss how perhaps the Real Bills Doctrine may only be a partial determinant of the value of money.

A few notes before I begin:

1st, check the labels of each section, I don’t think they are numbered/lettered correctly.

2nd, Friedman 1948, referenced on page 11, does not appear in the references.

3rd, “easy money” as you use the term, appears a biased distortion of the actual meaning. Easy money is generally means an expansion of the money supply and says nothing about “sufficient security” whereas you take it to specifically mean money created on insufficient security.

Now I will step through your paper section by section.

1. THE QUANTITY OF MONEY

I am very much in agreement with you in this part. The price of money should not change relative to gold. However we know this is not the case with the Federal Reserve, so that naturally leads to the question, why is this so? As I mentioned previously, I believe the Fed overvalues its holdings of government securities. In your paper, you were careful to use the current market value of the IOUs held by the bank in question. I have found it difficult to determine the exact operational model of the Fed but I believe they are not using the current market value of their securities. As evidence I refer you to their statistical release: Factors Affecting Reserve Balances.

Scroll down to the 2nd table: Consolidated Statement of Condition of all Federal Reserve Banks. Notice that all Securities Held Outright, except Inflation Compensation are value at face value, according to footnote 2. For bills, this is obviously more than current market value. From the Bureau of Public Debt: “You buy T-bills for a price less than their par (face) value, and when they mature we pay you their par value.” Also I contend that notes and bonds are overvalued as well, because although the Fed is collecting interest on these items, the public sector holding the dollars they back is not. For the most part, this is not a genuine concern amongst the public since they can simply convert their base dollars into derivative forms, such as demand deposit accounts, which do pay interest. This would seem however, to drive the value of base money to zero, the only mitigating factor being that base money is the only form of money acceptable for taxes. If the Fed were to reestablish convertibility, I contend that a vast majority of people would redeem their notes for the bonds held by the Fed so that they could realize the interest for themselves and perhaps deposit them for notes at their own local banks in the hopes of realizing a better interest rate than they were receiving on accounts consisting of derivative dollars.

I will contend also at this point that I recognize a tradeoff between security and liquidity and the expected rate of return. So the base money, being the most secure and liquid type of financial security available, would naturally have the lowest expected rate of return. However, its tough to say whether a properly organized system would realize a negative real rate of return on its base money, as US dollars do. But then again, what lies at the heart of this discussion also lies at the heart of inflation, so who knows?

2. THE CONVERTIBILITY OF MONEY

This is where I draw my biggest contention with your paper. The question I initially asked myself here is, if dollars are not convertible, now or ever, what difference does it make whether they are backed or not? If the dollar is never going to be exchangeable in your lifetime, does it matter that the Fed is holding assets against it? Now I grant that I am not this skeptical. If the Fed were ever to get rid of its assets, I’m sure the value of the dollar would drop to zero. You compare FRNs to shares of stock, so let’s analyze that. The main difference I see here is that normally stocks pay dividends, and the main value of stocks comes from the total future expected return of all dividend payments. FRNs pay no interest and no dividends, but even still, a stock that paid no dividends would still be worth something, simply because there are assets backing it. I have enough faith in the government that if the Fed ever were dissolved that the assets backing its notes would remain. So it’s a fair contention that although not convertible, dollars may still maintain some of their value. I would like also to look at non-convertibility from a different angle. In your paper, “no such thing as fiat money”, you gave the current value of a bank note to be ((1+C)^n)/((1+R)^n). Where n is the number of years until convertibility, C is the marginal cost per year to maintain notes in circulation, and R is the current expected rate of interest. Now this is an interesting an equation, for if we make n infinity, as the Fed has done, then the value either drops to 0 or rises to infinity, depending on whether C is less then or greater than R. This however may be too difficult to analyze meaningfully and I wouldn’t be surprised if they were close. My skepticism tells me that C is probably less than R though, which again would bring us back to the question, why do the FRNs have any value if they are never convertible and never pay any returns?

3. MONEY DEMAND

In this section you denounce the acceptance of paper money as taxes as a possible reason for its value, yet in your paper on the history of paper money, you recognize taxes collectible as a perfectly valid asset behind the value of paper money. I would contend then that in the case of the US dollar that taxes collectible on the part of the federal government is at least partially responsible for its value. This could be then a kind of double backing on top of the assets held by the Federal Reserve. Also I believe the statement that money has value because others value it is valid. That’s what a medium of exchange is about. In this case its being valued for its facility in increasing liquidity and efficiency in the market.

4. THE QUANTITY OF DERIVATIVE MONIES

My main contention here is that derivative monies are less distinguishable from actual money than derivative stocks are from actual stock. I hope most people recognize how banks and financial institutions really work, but the line is still blurry. Look at a bank statement. It will say you have x dollars in your account when in reality they are holding bonds and loans worth that amount. Look at a statement for a mutual fund account. It will say you have x dollars in your account when in reality they are holding stocks and bonds worth that amount. This all serves to make it appear as if there is more money than there really is. Now from a purely monetarist standpoint, there are two ways of looking at this. First you can say well yeah, such accounts really do count as money and you get into a big hassle making different definitions, such as M1, M2 and M3. Or you can recognize these accounts as increasing the efficiency of the base money and thereby increasing its velocity, which is the viewpoint I favor.

5. FISCAL POLICY

What I see here is a distinction being made between fiscal policy and monetary policy. I observe the open market operations as an important part of the fiscal and monetary processes. It means that the government can’t create more debt than the public is willing to hold to begin with, which means money can never be created beyond the government’s available credit.

I had hoped to talk about more at this point, but I’ve written on and analyzed this stuff enough for now. I will get back with more later.

SPROUL-FONTAINE DISCUSSION 11/09/2003

10/26/03-11/05/03

Hi Aaron:

I’ll try replying right in your document. Thanks very much for all this input. It is really hard to find an economist who is interested enough in this subject to give any useful feedback, and you’ve given it in spades.

Backed Money, Fiat Money, and the Real Bills Doctrine

A good starting point to understand both sides in historical fairness would be David Laidler’s entry on the real bills doctrine in the Palgrave Dictionary of Economics. David is anti-RBD, and you might have noticed the discussion with him that I posted on my website. He gives about as intelligent an exposition of the anti-RBD view as you can find nowadays, and he’s not that hard to get hold of thru email.

When I first started thinking about this stuff in 1989, I kept a journal of random observations about money as they occurred to me. It took 5 years before I was able to first put my thoughts into a cogent paper in 1994. During that time I discovered, as you no doubt have, that modern economic textbooks have NOTHING to say about the RBD. Not just nothing intelligent—I mean the words “real bills doctrine” don’t even appear in 99% of the textbooks out there--even the advanced ones. Very true. Most books don’t discuss the history of economic thought. They especially seem to omit Smith’s RBD, which is interesting considering how much emphasis is placed on Smith’s other theories as being basic. An excellent online resource can be found at the “History of Economic Thought Homepage” [ Their page on monetary theory can be found at [ The essays at this website (amongst many other things) cover the RBD and QT, the bullionist debates, and the views of people such as Thornton, Ricardo, and Wicksell. In the few cases where it does appear the coverage is a few sentences (e.g., Mishkin’s Money and Banking book).

This got me looking up old books. The first was Knut Wicksell’s “Lectures on Political Economy”, which was anti-RBD. I didn’t know there was such a thing as the RBD at the time. Anyway, from there I read Thomas Tooke’s “Inquiry into the Currency Principle”, which read at the time like a foreign language, although nowadays I can read it easily. Probably the book I liked best was John Fullarton’s “Regulation of Currencies of the Bank of England”. Both of these books were pro-RBD, and they really kept me going. Then I read the anti-RBD books: Henry Thornton’s “Paper Credit”, Mises’ “Money and Credit”, Lloyd Mints’ “History of Banking Theory”, etc. It’s a few years’ worth of reading, but there it is. Thanks for the references. The only book I’m familiar with in this list is Mises’ “Money and Credit”, which is available online at [ I have intended to read the entire work, but it is so incredibly long-winded I find it difficult. Considering what I think of Rothbard and Mises, I don’t consider it a great loss.