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.”

Clearly Rallo does not want to impose any real-bills requirement by statute or regulation, and he does not view the real-bills doctrine as a set of instructions for central bank policy. Rather, he views (Rallo 2013) the doctrine as a prudent banking norm toward which competition will compel free banks to practice:

A bank without privileges in an environment of freedom is therefore to be prudently managed, which in my view would result in having covered its financing with cash or self-liquidating short-term credits and in counting on abundant capital to absorb losses in relation to the risk assumed in its assets. It is what is known as the Real Bills Doctrine.

Modern free banking theorists would agree that competition in an unprivileged banking system promotes prudent bank management (insolvency and its resolution weed out the imprudent), and everyone can agree that prudence includes adequate liquidity and adequate capital. But I have two concerns about the above statement.

First, contrary to the last sentence quoted and as already noted, a prudent banking norm is not the only or even the main idea known as the real-bills doctrine. Historians of economic thought commonly use the name to refer to the money-issuing norm described above. Free banking theory rejects the real-bills-centered view about the process that regulates the quantity of broad money. Again, Rallo is not defending a money-issuing norm here, but rather talking about prudent bank management.

Second, the concept of “self-liquidating” (autoliquidable in Spanish) credit, which Rallo invokes here and in other writings, is unhelpful to clear thinking. In some authors’ arguments it is part of the magical thinking underlying the notion that real-bills-only discounting will properly regulate the quantity of money.

What does “self-liquidating” mean? Every debt instrument of finite maturity is “self-liquidating” in the sense that it eventually comes due and the borrower ordinarily repays the principal. So that can’t be it. Rallo cannot mean by “self-liquidating” only that the debt will come due soon, because then it would be redundant in the above-quoted phrase “self-liquidating short-term credits.” Instead “self-liquidating” seems to signify an IOU that (like a real bill) finances a batch of goods in process through a stage of production, like the batch of flour in the example above, such that the sale of the goods ordinarily enables repayment of the IOU. (Sometimes “self-liquidating” bills are said to be those financing consumer goods, or goods in high demand.) But business loans of all kinds finance projects that are expected to generate revenues sufficient to repay the loans. Granted, real bills were typically lower-risk assets than ordinary business loans, but of course the repayment of a real bill did not carry zero risk. The bill might not be repaid if for whatever reason the goods were not produced in timely fashion (the flour was not baked into bread within 90 days) or the products did not sell at the expected price.

Rallo has a broader concern about imprudent banking: the danger of banks undertaking “harmful maturity mismatch” by making long-term loans with short-term deposits that might not be rolled over. Holding real bills (or other short-term assets) instead of longer-term loans reduces the mismatch. Maturity mismatch, aka maturity transformation or duration gap, is a practice that does carry risks as well as performing a valued service for which there is normally a reward. The reward for a bank with a positive duration gap (assets longer than liabilities) is that it borrows at a lower rate and lends at a higher rate than with a zero gap in a market where (as usual) long rates are higher than short rates. The risk is capital loss when rates rise. If the bank has to pay unexpectedly higher deposit interest rates to roll over its deposits, before it can roll over its loans, then it suffers a loss in net worth. The US savings banks hugely suffered such losses in the 1980s.

Rallo seems to be of two minds on the extent to which a free banking system would exhibit excessive maturity mismatch. On the one hand he writes (Rallo 2009): “While I can agree with Selgin that a system of free banking would curb credit expansion and tend to remain liquid, I deny that any banking system (free or not) can be kept liquid by borrowing short and investing long. And we should not overlook, however superior free banking is in comparison to central banking monopoly, the risks and trends that exist in the former to artificially inflate credit.” On the other hand, and more accurately I think, Rallo (2012) recognizes that a free banking system will limit undue risk-taking by making imprudent bankers bear the consequences of their own actions:

Fortunately, in a market where the currency and banking develop in freedom and without government privileges, banks have little room for these dangerous operations, because as soon as their creditors stop refinancing them, they fall into receivership. Unfortunately, in our ultra-interventionist and ultra-privileged market, a state institution called the central bank has the monopoly of issuing paper money, allowing it to provide cheap refinancing to private banks that have large maturity mismatches … and perversely to prolong the duration and devastation of economic cycles.”

Note that the US savings banks, which suffered from huge duration gaps when interest rates rose sharply in the early 1980s, were not operating under laissez-faire. They had been specifically compelled by law to keep almost all of their asset portfolios in fixed-rate home mortgages.

To summarize: the characteristic of being backed by goods in process does not endow a bank-owned IOU with any special qualities not equally present in, or make it any more prudent to hold than a differently-backed IOU with equivalent default risk, liquidity, and maturity. An emphasis on real bills as the mark of prudent banking is therefore misplaced, as opposed to an emphasis on the management of default risk, liquidity, and capital risk from duration gap. These properties – not “self-liquidation” or any property of automatically regulating money-issue – explain why prudent banks in a historically competitive system, like Scotland’s held real bills in their asset portfolios.

[Cross-posted at Alt-M.org]