Three False Critiques of
the Real Bills Doctrine
Michael F. Sproul
Department of Economics
California State University, Northridge
18111 Nordhoff
Northridge, CA 91330
January 12, 2000
JEL Code: N01
Three False Critiques of
the Real Bills Doctrine
Michael F. Sproul
ABSTRACT
The real bills doctrine has been discredited largely by the critiques of Henry Thornton, David Ricardo, and Lloyd Mints. In this paper I show that all three men were wrong in their criticism, and that their errors were substantial enough to undercut their positions. Each man misunderstood the nature of backed money, and failed to understand that the real bills rule of only issuing money in exchange for good security would automatically assure that backing moves in step with the quantity of money, thus preventing inflation.
I. Introduction
In this paper I defend the real bills doctrine against the attacks of its three most prominent critics: Henry Thornton, David Ricardo, and Lloyd Mints. I contend that the critiques of all three men contain errors that are serious enough to render their fundamental points invalid. The discussion is necessarily brief and selective, but the arguments I focus upon give sufficient grounds for economists to reconsider their rejection of the real bills doctrine.
John Fullarton, in quoting the Directors of the Bank of England, approvingly summed up the central ideas that we now know as the real bills doctrine:
...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. (Fullarton, 1845, p. 207.)
On the other side of the debate, Lloyd Mints offered the following statement of the real bills doctrine:
Briefly, those who have defended this position have held that, if only "real" bills are discounted, the expansion of bank money will be in proportion to any extension in trade that may take place, or to the "needs of trade," and that, when trade contracts, bank loans will be correspondingly paid off. (Mints, 1945, p. 9.)
Based on these statements, and a host of similar statements by other writers, a reasonably complete statement of the real bills doctrine would be that money which is issued in exchange for good security will not cause inflation, where good security is understood to mean collateral that is:
1. Sufficient--meaning that a bank that lends $100 should take collateral worth at least $100 in exchange;
2. Productive--meaning that loans should be made to carpenters and farmers, as opposed to gamblers and spendthrifts;
3. Short-term--generally less than 60 days.
One additional clarification should be made: The money referred to in the above statement is understood to be token money (convertible or inconvertible) that is recognized as the liability of the entity (governmental or private) that issued it. It would not include commodity money, but it would include bank notes and token coins, checking accounts, and various other credit instruments that are recognized as the liability of their issuers.
With this definition of the real bills doctrine in mind, we can now turn to the views of its critics.
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 sufficient security:
"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. The scenario Thornton described is illustrated in Figure 1. 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, and the process repeats six times. If B is respected in the community, then his IOU might serve as money, and the exchange would have increased the money supply by 100 pounds. Alternatively, as Thornton states, B’s IOU might be discounted by a banker, and the banker’s IOU would then serve as money. In either case, each exchange potentially increases the supply of money, and it is possible, as Thornton states, that six successive sales of the same wheat could increase the money supply by 600 pounds.
Thornton’s error becomes apparent once we 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. It is as if B’s IOU were actually backed by a lien on B’s property (Figure 1), C’s IOU by a lien on C’s property, etc. 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.
Figure 1
Thornton’s argument that the six IOU’s are backed only by the single unit of wheat is plainly indefensible, and it is surprising that a banker such as Thornton would have forgotten the importance of collateral to the value of an IOU.
Case 1: Backed Base Money
The implications for Thornton's refutation of the real bills doctrine depend upon whether the British pound is regarded as backed or unbacked. Let us first suppose that the pound was backed by the collateral held by the Bank of England, as was clearly the case before 1797. In that period, paper pounds issued by the Bank of England were convertible (instantly or subject to delay, as on weekends) into approximately 1/4 ounce of gold, and the Bank's assets were sufficient to redeem every paper pound that the Bank had issued--either directly for 1/4 ounce of gold, or indirectly for securities worth 1/4 ounce. It is reasonable to suppose that the Bank's activities had little or no effect on the world price of gold, so money-creation by the Bank of England would have affected neither the value of gold, nor the value of the Bank's notes in terms of gold.
AssetsLiabilities
1)1 million oz. of gold4 million pound notes
2)government bonds worth4 million pound notes
4 million pounds
Figure 2
This is illustrated in Figure 2. In line 1, the Bank initially takes in 1 million ounces of gold on deposit, and issues 4 million pound notes in exchange, each of which must be worth 1/4 oz. of gold. The Bank then prints and lends 4 million more pound notes, in exchange for collateral (in the form of government bonds) worth 4 million pounds. Note that this is a given "money's worth" of collateral, and not a given "gold's worth". Let P represent the price, in gold, of a pound. In order for assets (1 million oz. plus bonds worth 4,000,000P) to equal liabilities (notes worth 8,000,000P), it must be true that 1,000,000+4,000,000P=8,000,000P, or P=1/4 oz. The money-creation of line (2) has no effect on the value of the pound, since backing has increased in step with the quantity of money. Put another way, there are 8 million notes laying claim to assets worth 2 million ounces of gold, so each pound must still be worth 1/4 ounce. If the pound traded in the market for any less than this, then all noteholders would return their notes to the bank for 1/4 oz. of gold. The Bank could react by first selling all of its bonds for 4 million pound notes, which notes it could then destroy. (Alternatively, the Bank could call in the 4 million pound loan that it had made in line 2. The borrowers would happily comply, since, by our assumption, 4 million pound notes can now be obtained for goods worth less than 1 million oz. of gold.) The remaining 4 million pound notes could then be directly redeemed for 1/4 ounce each. Thus the value of the pound cannot diverge from 1/4 ounce.
Continuing to suppose that pound notes issued by the Bank of England are backed, we see that Thornton's argument is not only unsound, but would be irrelevant even if it were correct. His argument was unsound because he wrongly claimed that the IOU's of Figure 1 were unbacked money, when they were actually backed by the property of their issuers. If pound notes issued by the Bank of England were unbacked, and if privately-issued moneys denominated in those pounds (i.e., derivative moneys) were backed, then not only could the Bank of England safely issue pounds without causing inflation, but private individuals and banks could also issue derivative pounds without causing inflation. To see this, it is only necessary to note that derivative pounds are the liability of the party that issued them, and not the liability of the Bank of England. If the Bank of England has 8 million outstanding pound notes laying claim to assets worth 2 million oz. of gold, then those notes will be worth 1/4 oz. each regardless of how many derivative pounds have been issued (and backed!) by other parties.
Thornton's argument, even if it were correct, would still miss the point. If private parties issue derivative moneys that are unbacked, what is that to the Bank of England?. That bank's 8 million notes are still backed by assets worth 2 million ounces, and so must still be worth 1/4 oz. each. If a country bank issued derivative moneys that were unbacked, as Thornton alleged, then it would be that bank's money that would depreciate--not the Bank of England's.
Case 2: Unbacked Base Money
Thornton himself believed that the pound was unbacked, since at the time he wrote (1802), the pound had been inconvertible for five years. Whether the pound was truly unbacked is doubtful, since the Bank of England still recognized its pounds as its liability, still maintained assets as collateral against those pounds, and actually restored convertibility in 1821. Nevertheless, in order to give Thornton's logic a chance to work let us suppose, as he did, that the paper pound had value because of a limitation of supply, and not because of backing.
Even if the pounds issued by the Bank of England (i.e., base money) had been unbacked, it remains true that privately-issued money (i.e., derivative money) must have been backed by its issuers. Thus the issue of derivative pounds would have depreciated base pounds. On Thornton's principles, base pounds had value because they were limited in supply, and because the public had a demand for them; but the issue of (backed) derivative pounds would reduce the demand for base pounds and thus reduce their value. If derivative pounds were denominated in base pounds, as opposed to a given weight of gold, then the derivative pounds would fall in value as well. With private banks free to issue bank notes, checking accounts, and other derivative moneys, there is nothing to prevent base pounds from falling to zero value as derivative moneys proliferate.
In conclusion, Thornton was clearly incorrect in his belief that derivative moneys were unbacked. If base money is also backed, then the value of base money is unaffected by changes in the quantities of either base money or derivative money, and Thornton's argument is incorrect for both kinds of money. If base money is unbacked, then base money would depreciate from an increase in its own quantity and from an increase in the quantity of derivative moneys. This result would agree with Thornton's position, but it is difficult to reconcile with the fact that the Bank of England always maintained backing against the paper pound, and with the related point that if the pound had been unbacked, there would have been nothing to prevent the issue of rival moneys from driving its value to zero.
David Ricardo
Ricardo's "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 subject of political economy." (For a history of the period, see Ashton & Sayers (1953)). The subject of the controversy was the inflation that occurred subsequent to the suspension of payments by the Bank of England in 1797. Charles Bosanquet had argued for the real bills (or 'Antibullionist') proposition that the Bank of England could not have been the cause of the inflation, since that bank only issued its money in exchange for good security:
...(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.)[1]
A brief digression: Nothing in Bosanquet's statement implies that money must be issued only for 'productive' purposes. He only insisted that money must be issued for security of sufficient value, and he emphasized the importance of money being recognized as the liability of the entity that issued it. The Antibullionist school has been widely misunderstood on this point. Humphrey (1974, p. 10), for example, claims that:
The real bills doctrine states that just the right amount of money and credit will be created if bank loans are made only for productive (nonspeculative) purposes. Defending the Bank of England against the Bullionists' charge of note over-issue, Antibullionists argued that excessive issues were impossible as long as the Bank's note liabilities were based on sound commercial paper, i.e., were issued only to finance genuine production and trade.
A key error is evident in this passage, and it has insinuated itself into virtually all of the anti-real-bills literature. It is the belief that the money supply should move in step with real output, as opposed to moving in step with the assets of the money-issuing entity. It is this belief which leads to the misplaced emphasis on 'productive' loans, as opposed to loans that are made on security that is merely of sufficient value.
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, p. 117.)
In this statement, Ricardo convincingly showed 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. Unfortunately, Bosanquet and his fellow Antibullionists also failed to consider this explanation, and instead pointed, unconvincingly, to crop failures and military expenditures as the cause of inflation[2].
Ricardo held that during the Restriction period the pound was a true fiat money, whose value was determined by its quantity. (“...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.)) His mistake was in confusing backing with convertibility. On February 27, the day after the 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 (Table 1 (Cannan, 1969, p. xliii)). 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.