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Free Banking Theory versus the Real Bills Doctrine

By Feux Follets following x   2018 Jun 13, 2:50am 75 views   1 comments   watch   sfw   quote     share    

The “real-bills doctrine” was roundly rejected by postwar monetary theorists of both the Chicagoan and the Austrian perspectives (Lloyd Mints 1945, Ludwig von Mises 1949). But George Selgin (1989) was right to warn us that “it would be a mistake to think of the real-bills doctrine as a ‘dead horse’” because “dead horses of economic theory have a habit of suddenly springing back to life again.”

In recent years no less prominent an economist than Thomas Sargent (2011) has declared that in the debate over alternative monetary regimes, “The real bills doctrine is alive and well today.” Most recently the leading young Spanish economist Juan Ramón Rallo of the OMMA business school and the Juan de Mariana Institute in Madrid has defended propositions that he identifies with the real-bills doctrine. Rallo draws on the writings of Antal Fekete, who has been advancing what he calls “Adam Smith’s real bills doctrine” for more than 20 years. I had the pleasure of an on-stage dialogue with Professor Rallo in Madrid this summer, where we discussed aspects of the doctrine. Fortunately, what Rallo actually defends is mostly free of the shortcomings of the usual versions of the real-bills doctrine.

To begin, let’s identify what is a real bill. To use a common example, a miller sells $1000 worth of flour to a baker and presents a bill for $1000 with payment due in 90 days. The baker endorses the bill, pledging to pay $1000 in 90 days. He plans to pay out of income to be made by producing and selling bread from the flour. The miller need not wait 90 days to get paid but can immediately sell the endorsed bill to a bank (one that considers the baker a good credit risk) at its present discounted value, say $980. The bill is “real” in being “backed” by tangible goods in process. Thus real bills are short-term commercial IOUs that finance goods through stages of production. High-quality real bills are low in default risk and liquid (have a thick secondary market with small bid-ask spreads).

It is crucial to distinguish between two different doctrines that refer to real bills.

(1) The first real-bills doctrine is a norm for money issuing. It says that a banking system will automatically issue the right (equilibrium) quantity of monetary liabilities (banknotes and checkable deposits), and will not over-issue no matter what quantity it issues, if it always issues in exchange for real bills offered to it, and never in exchange for other assets (government bonds, ordinary loans). In some versions it doesn’t matter whether the system is dominated by a central bank or whether it is on a gold standard. Thus the British anti-Bullionists claimed that the Bank of England could not have over-issued while off gold 1797-1819 because the Bank only discounted real bills, a claim endorsed by John Fullarton of the Banking School in the 1840s. The Federal Reserve proclaimed a similar doctrine in the 1920s. A monetary policy guide is clearly what Sargent (2011) has in mind when he contrasts the real-bills doctrine to the quantity theory of money. (As David Laidler (1984) showed, however, what Sargent and Wallace (1982) enunciated wasn’t the traditional money-issuing real-bills doctrine. Neither is the position that Sargent (2011) defends.)

The errors of the monetary policy doctrine are well known. (a) It wrongly takes the nominal quantity demanded of a particular type of credit as a reliable guide to the nominal quantity of money the public wants to hold. Not only are these quantities different but, as Henry Thornton noted back in 1802, a central bank can increase the quantity of credit demanded simply by supplying more money, which lowers its discount rate and raises the price level. (b) It wrongly takes the quality of bank assets acquired as a reliable governor of the quantity of monetary liabilities issued. (c) It makes redeemability of bank liabilities (in gold or otherwise) an inessential “fifth wheel” in the process that determines the quantity of money.

The money-issuing norm is what critics of fractional-reserve banking have in mind when they assert (Hülsmann 1996, p. 20) that modern free banking theorists “are nothing but modern advocates of the real-bills doctrine” or (Baeriswyl 2014, p. 13) that our theory “repeats basically the same error as the real bills doctrine.” Such criticism is completely off the mark, because modern free banking theorists (among which I count myself) have consistently rejected the real-bills money-issuing norm. In particular, Selgin (1989) and White (1995, ch. 5) emphasize its errors and show how it differs from our theory of the self-regulating properties of a free banking system.

In a nutshell, our account of the self-regulation of the quantity of bank-issued money (banknotes and checkable deposits, redeemable on demand) in a competitive free banking system centers on the premise that profit-seeking banks must carefully attend to their reserve positions. Running out of reserves and defaulting is costly. A bank that issues an excessive volume of demandable liabilities will soon experience adverse clearings (will lose reserves to other banks). To lower the risk of payment default it will be compelled to reverse its expansion to stop the outflow and rebuild its reserves. Conversely, a bank that issues less than its clientele wants to hold will gain reserves and find it profitable to expand. These responses to adverse or positive clearings will return the quantity of bank-issued money at an individual bank, and economy-wide (where flows of reserves out of and into the system play an important role), to the quantity demanded. This account does not refer to the type of earning assets that any bank holds, whether real bills or otherwise, as central to the self-regulation of the money stock. Thus it does not share any of the errors of the real-bills money-issuing norm.

While not offering a quantitative guide, selling and buying real bills did offer a convenient means for a bank to contract and expand the volume of its demandable liabilities in response to changes in demand (Glasner 1992), as indicated by changes in its reserves. Attention to reserve surpluses and deficits, not any property of the bills themselves (short duration, low default risk, liquidity) automatically guided a bank (and the banking system) to contract and expand appropriately. The maturation of bills of exchange did not as such compel a commercial bank or a central bank to contract (it did not “close a vent,” contrary to the Banking School’s “law of the reflux”). A bank unconcerned about its reserves could always purchase new bills to replace maturing bills.

Nor did a system-wide reduction in the quantity of bills offered to the entire banking system at a given lending rate – even a reduction associated with fewer goods in process – compel the banking system to decrease the overall quantity of monetary bank liabilities by an equivalent amount to maintain monetary equilibrium. A decrease in the demand for credit is not the same as a decrease in the quantity of bank liabilities that the public wants to hold. Though both are correlated with a decrease in output, the correlation is less than 100%, and the coefficient is not one (the demand to hold bank-issued money does not decline 1:1 with the volume of real bills discounted). Normally a system-wide decrease in the demand for credit in the bill market calls for an equilibrating decrease in the market discount rate.

Conversely an increase in the quantity of bills offered at a given lending rate, associated with more goods in process, does not signal that the entire increased volume of bills can be prudently purchased at the previous discount rate. A rise in the rate is called for to ration the scarce supply of funds that the banks have with which to intermediate. Competition for now-scarcer funds implies a concomitant rise in the deposit rate, which will somewhat increase the quantity of deposits demanded, but again not generally 1:1 with the volume of bills discounted. By contrast the money-issuing norm version of the real-bills doctrine calls for accommodating all offers of real bills for discount, presumably at an unchanged interest rate, and is silent on the need for equilibrating changes in interest rates.

(2) The second real-bills doctrine – and the one that Rallo proposes – is a prudent banking norm. Its origins lie in remarks Adam Smith made in The Wealth of Nations. Smith recommended real bills as a safe commercial bank portfolio asset. (Actually both real-bills doctrines are in Smith, including an erroneous money-issuing norm. But Smith also offered a more correct analysis of money-stock self-regulation, noting correction via reserve losses when a bank or a banking system tries to issue more liabilities than the public wants to hold.) A prudent bank should avoid purchasing unreal bills, Treasury bonds, or mortgages.

The prudent-banking real bills doctrine, which is what I take Rallo to be defending, is basically innocuous with respect to monetary theory so long as it does not contend that a bank purchasing only real bills cannot over-issue its liabilities. It is irrelevant to understanding how redeemability and the adverse clearing process regulate the quantity of bank-issued money.

There is much to commend (in my view!) in Rallo’s writings when he rejects mandatory 100% reserves in banking and when he favors free banking over central banking. [All the quoted passages to follow are my Google-aided translations from the original Spanish.] He rightly observes (Rallo 2013a) that a 100% gold reserve requirement “will provoke such economic inefficiencies that it will inevitably be abandoned.” Thus “the real choice is between a free-market monetary and credit system” and an unfree system. He told an interviewer: “Of course society without monopolistic state organs can soundly self-regulate the value of money and credit,” adding that healthy credit “occurs naturally in a competitive market.”

More: https://www.cato.org/blog/free-banking-theory-versus-real-bills-doctrine

#Finance #Economics #MonetaryPolicy #Banking

1   Feux Follets   ignore (0)   2018 Jun 13, 2:51am   ↑ like (0)   ↓ dislike (0)   quote        


The first theme in The Wealth of Nations is that regulations on commerce are ill-founded and counter-productive. The prevailing view was that gold and silver was wealth, and that countries should boost exports and resist imports in order to maximize this metal wealth. Smith’s radical insight was that a nation’s wealth is really the stream of goods and services that it creates. Today, we would call it gross national product. And the way to maximise it, he argued, was not to restrict the nation’s productive capacity, but to set it free.

Another central theme is that this productive capacity rests on the division of labour and the accumulation of capital that it makes possible. Huge efficiencies can be gained by breaking production down into many small tasks, each undertaken by specialist hands. This leaves producers with a surplus that they can exchange with others, or use to invest in new and even more efficient labour-saving machinery.

Smith’s third theme is that a country’s future income depends upon this capital accumulation. The more that is invested in better productive processes, the more wealth will be created in the future. But if people are going to build up their capital, they must be confident that it will be secure from theft. The countries that prosper are those that grow their capital, manage it well, and protect it.

A fourth theme is that this system is automatic. Where things are scarce, people are prepared to pay more for them: there is more profit in supplying them, so producers invest more capital to produce them. Where there is a glut, prices and profits are low, producers switch their capital and enterprise elsewhere. Industry thus remains focused on the nation’s most important needs, without the need for central direction.

But the system is automatic only when there is free trade and competition. When governments grant subsidies or monopolies to favoured producers, or shelter them behind tariff walls, they can charge higher prices. The poor suffer most from this, facing higher costs for the necessities that they rely on.

A further theme of The Wealth Of Nations is that competition and free exchange are under threat from the monopolies, tax preferences, controls, and other privileges that producers extract from the government authorities.

For all these reasons, Smith believes that government itself must be limited. Its core functions are maintaining defence, keeping order, building infrastructure and promoting education. It should keep the market economy open and free, and not act in ways that distort it.

More: https://www.adamsmith.org/the-wealth-of-nations/

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