The masses are misled by the assertions of the pseudo-experts," wrote
Mises, "that cheap money can make them prosperous at no expense
whatever." The damage that the inflationary fallacy has done to our
monetary institutions cannot be over-estimated. In spite of efforts by
classical and Austrian economists to refute it, it refuses to die. It has
been resurrected under many guises, but all with the same error at its core:
that printing money can create real wealth.
The "monetary crank," wrote Mises, is one who "suggests a
method for making everybody prosperous by monetary measures." All
variants of monetary crankism suffer from the same error: The printing
press cannot create actual goods. The arguments for the RBD (Real Bills
Doctrine) will be seen to be variants of monetary crankism. An article
(by a libertarian writer on a gold site, no less) proposing a revival of the
Real Bills Doctrine is a recent addition to this literature.
The RBD has a long and controversial history. Many of the key concepts
originated with the monetary crank John Law. In 19th-century
England, controversy over the issues around the doctrine raged between two
schools of monetary thought, the Currency School and the Banking School. In the United
States, the RBD was
a key plank in the platform of the first
generation of US Federal Reserve bankers.
The Doctrine concerns debts contracted by business firms for the shipment
of goods in process, as when a firm purchases raw materials or partially
finished goods on credit.. The goods in question might be for use in the
purchasing firm's own manufacturing processes. The receiver promises to pay
the supplier in cash plus interest at some future date. (See the definition from Mises Made Easier for more
detail).
As an example, a manufacturer of chairs purchases wood from his supplier
and, instead of paying cash, pays with a bill of exchange due in 30 days. Two
weeks later, finding himself short on cash to make payroll, the wood supplier
takes the bill to his local bank, which purchases the note from him for 98%
of its face value. The discount rate (here 2% for 14 days) annualized, would
be the bank rate of interest on the transaction.
Suppose that the holder of a real bill needs cash before the bill falls
due. (Perhaps he needs to pay off his own bills to his own suppliers further
down the line before their bills fall due). He would then present the bill to
a bank. If the bank purchased the bill for cash, then all would be well and
good. However, the banker, having been persuaded by some clever monetary
theorist to adopt the RBD, "discounts" the bill, that is, prints
the money with which to purchase the loan. The "discount" is the
purchase price paid by the bank, an amount less than the principal value of
the loan.
No special banking doctrine is required to justify an ordinary loan
transaction. This is simply transfer
credit. Nor is any new monetary theory required when firms wish to resell
their paper assets to buyers for cash on the commercial paper market. This is
merely the resale of existing credit. In the workings of RBD, bills are to be
funded not with the bank's own equity capital, nor with savings loaned to the
bank by its creditors.
According to the Doctrine, banks would monetize short-term business debt.
Monetization of debt means to create paper credit out of nothing and then to
loan this credit as money. The money exists either in the form of bank notes
or checking account balances. The purchase of the bill is therefore a kind of
loan from the bank, but a curious sort of loan in which the funds were not
previously loaned to the bank by anyone. This is called credit expansion.
Hultberg and Fekete present a series of arguments for the adoption of this
kind of discounting mechanism. This series of
articles addresses some, but not all, of their arguments. The current
article responds to a series of arguments advanced against transfer credit
and in favor of credit expansion. Hultberg and Fekete suggest that transfer
credit without expansion is not "elastic;" transfer credit by
itself is "too rigid;" the limitation of total borrowing to total
saving will reduce economic growth (the term "contractionist" means
essentially the same thing). Equivalently, they argue that expanding credit
beyond savings enables more goods to be produced; in the absence of paper
credit, business firms will not be able to obtain a sufficient amount of
short-term credit; similarly a "liquidity shortage" will prevail
without money printing.
To understand the mechanics of inflation, the difference between transfer credit and credit expansion must be
explained. Transfer credit is extended when a borrower borrows money that
someone saved. When a bank is involved in this type of transaction, the bank
brokers the exchange and takes on some of the risk. The bank locates
borrowers and savers who wish to participate but might not otherwise know
each other. When a bank is involved in this type of transaction, the bank brokers
the exchange and takes on some of the risk. The bank first borrows from
the saver and then loans the money to the creditor.
Credit expansion is an entirely different type of transaction. When banks
expand credit there is no saver anywhere involved. For a bank to expand
credit, it creates new paper claims to money — bank notes or fractional
reserve checking deposits — out of nothing at all and loans them as if they
were money. These paper money substitutes "give to somebody the means of
purchasing goods without at the same time diminishing the money spending
power of somebody else," explained
Hayek. He adds, "This is most obviously the case when the creditor
receives a bill of exchange which he may pass on in payment for other
goods," (p. 114). Paper claims of this type were are called fiduciary media by Mises,
meaning, media of exchange that circulated at parity with real money but came
into existence as the result of credit expansion.
Bullionist writer and opponent of fiduciary media Charles Holt Carroll
clarifies the distinction between cash — either gold or fully redeemable
paper — and fiduciary media. Carroll aptly termed the
latter "debt organized into currency" (p 234):
Some writers have placed promissory notes and
bills of exchange in the category of currency, but it is altogether a
mistake; their affinity is with circulating property, not with money… They
are, however, neither money, nor currency, nor property, but more records of
an unfinished bargain; the purchase money is not paid, and these are
memoranda or written evidences of what the debtor is to do to complete the
contract. One species of property exchanges for another; this is barter, the
fundamental principle of trade; and when promissory notes and bills of
exchange are exchanged for money, they take the position of property as
essentially different from money as the goods that were delivered for them,
or for the fund upon which they are drawn.
Opponents of RBD are not attacking debt as such (either
businesses-to-business or between banks and bank customers). Lending
transactions are a crucial mechanism for the allocation of savings within a
monetary economy. It is the distinction between debt by itself and the
"organization of debt into currency" that turns debt into money
that makes all the difference.
Cash is the commodity that can be most readily exchanged for any other
good on the market. Rent, raw materials, payroll, or office supplies are
often needed on short notice. Without credit expansion, liquidity could only
be supplied by someone who is willing to reduce their own consumption.
Chief among the rationalizations for paper credit is the claim that
requiring someone to save before someone else can borrow is too onerous a
condition. Allegations against the gold coin system are "insufficient
liquidity," an excessively rigid credit system, and an inelastic
monetary system. We are told that the magic elixir of paper credit will solve
these problems by "creating liquidity" and "providing
elasticity".
There is always insufficient quantity of any good to meet all possible
uses of a good at that time. Scarcity is the quality that defines what it
is for something to be an economic good. Liquidity, another economic good, is
no different. Hülsmann writes,
"one has always to remember that money is a present good. It can be used
now. No present good is available in a quantity that would satisfy all
demands. This is precisely why it is a good. Hence, there is always demand
for some more money to secure hitherto less important (submarginal)
satisfactions."
A motivated borrower in search of liquidity could always obtain a loan at some
rate of interest, as there would always be someone holding cash that would
part with it at a sufficiently high rate of interest. As in all markets, a
price for bank loans will emerge in credit markets through supply and demand.
Even without adding to the supply through credit expansion, firms that need
funds could attempt to borrow at the market rate of interest.
Prices ration resources. Prices by their nature exclude. The interest rate
is a price that is formed in credit markets. The market rate of interest is
always higher than some potential borrowers are willing to pay — that is what
makes it a price.
But to call this state of affairs "insufficient liquidity" is to
say that a particular amount of credit supplied and demanded at the market
price is the wrong amount and rate of interest determined on the market is
too high. Anyone who says that the market is getting it wrong must have some other
criteria for evaluating what is enough of the good, outside of the
ability of market participants themselves to supply it and demand it. But
what other criteria could there be? Modern economics calls this situation
"market failure," a term that substitutes the learned judgment of
expert economists for the preferences of market participants.
A business that pays expenses by issuing bills to its supplier instead of
cash is taking on credit risk. Suppose that the cash receivable does not arrive
at the time that it was promised, or that the firm's goods may not be sold as
expected. Even if the time structure of assets and liabilities match on the
firm's balance sheet, a credit crunch is always a real possibility. Faced
with such a situation, if the firm could not raise cash by obtaining more
credit immediately, it would be insolvent.
Yet this is a problem for that firm, not a problem with the
monetary system as a whole. A firm cannot obtain employees and office space
because some other firm already is hiring the employees and leasing the
office space that it wants. The problem is that goods are scarce, not money.
Owners of business firms must evaluate the supply of things that they need to
buy, the marketability of their goods, and the credit-worthiness of their
customers.
It is the firm, not the monetary system that has made an error. "What
may hurt the interests of the producer of a definite commodity," Mises observed, "is his failure
to anticipate correctly the state of the market. He has overrated the
public's demand for his commodity and underrated its demand for other
commodities. Consumers have no use for such a bungling entrepreneur; they buy
his products only at prices which make him incur losses, and they force him,
if he does not in time correct his mistakes, to go out of business."
It might be objected here that the problem is really liquidity, not
insolvency: A firm that cannot obtain credit is not really insolvent, it only
has a
teeny-weeny liquidity problem, and if the banks were allowed to discount
the bills in its possession that would solve the liquidity problem. The pain
of bankruptcy is not necessary. However, the distinction is bogus: The
inability of a business to pay its creditors on time is the
definition of insolvency. To this it might be objected that firms only need a
bit more time, such as is provided to them when a bank is willing to discount
their bills. However, to say so would be to ignore the role of time in
production. Present goods are scarce in the present as Hülsmann clearly explains:
If we always disposed of just a little bit more
time we could be sure to have reached nirvana. With always just a little bit
more time one could provide all the money in the world. Unfortunately, every
means in the mundane life of the human race is limited. Time, therefore,
plays a crucial role for the success of action. In every place outside
nirvana one has to pay for the time-saving means called goods. There is no
possibility of providing "liquidity to the market only." One cannot
pay with liquidity; one can only pay with goods.
A market, as Mises argued in his seminal critique of economic calculation
under socialism, can only bring about a rational allocation of productive
factors under the clear light of profit-and-loss accounting. The
definition of making a loss is to consume more scarce factors of production
(labor, real estate, machinery, energy, etc.) than are produced. Bankruptcy
redistributes factors of production away from wasteful uses toward productive
ones. It is a critical part of the market process.
Having a "liquidity problem" is the definition of insolvency.
An illiquid firm is a bankrupt firm, if it cannot pay its bills. Insolvent
businesses should be taken over by their creditors, not allowed to stay on
life support with phony paper credit. Firms are not insolvent because of some
general shortage of money but because their judgments about supply and demand
were incorrect. Loss-making firms sustained through the issue of fiduciary
media are artificial forms of life.
They consume accumulated savings, and impoverish society.
When the smoke and mirrors are cleared away, the Real Bills Doctrine is in
essence the idea that credit by itself can create wealth. But credit as such
does not fund productive activity because any productive activity consumes
goods and services. What the RBD theorists wrongly identify as an
insufficient quantity of credit is in reality the scarcity of goods in the
world. Credit expansion is an attempt to paper over this problem.
Businesses usually do not borrow solely to increase their cash holdings
without the intention of spending the borrowed money. They need to earn a
return that will be sufficient to eventually repay the loan. They can only do
this by producing something at a profit. The demand for credit by businesses
is a demand for office space, computers, machinery, employees, and raw
materials. The scarcity of the real things that business firms need in order
to produce goods for consumption is what limits the their ability to produce
more. Mises explains
this clearly:
An entrepreneur who wishes to acquire command
over capital goods and labor in order to begin a process of production must
first of all have money with which to purchase them. For a long time now it
has not been usual to transfer capital goods by way of direct exchange. The
capitalists advance money to the producers, who then use it for buying means
of production and for paying wages. Those entrepreneurs who have not enough
of their own capital at their disposal do not demand production goods, but
money. The demand for capital takes on the form of a demand for money. But
this must not deceive us as to the nature of the phenomenon. What is usually
called plentifulness of money and scarcity of money is really plentifulness
of capital and scarcity of capital.
Issuing more paper claims to the existing stock of goods is not the same
as producing more goods. Only goods fund the production of goods, not credit.
Bank credit expansion does not fund production because it does not transfer
savings; it only creates new claims to the same amount of savings. In order
for goods to be used to produce other goods, the original owners must set
them aside, then transfer them to the producers who will use them up while
creating something new and more valuable. This is why only savings can fund investment.
As Mises explains,
[the masses do] not realize that investment can
be expanded only to the extent that more capital is accumulated by saving.
They are deceived by the fairy tales of monetary cranks. Yet what counts in
reality is not fairy tales, but people's conduct. If men are not prepared to
save more by cutting down their current consumption, the means for a
substantial expansion of investment are lacking. Those means cannot be
provided by printing banknotes and by credit on the bank books.
Antal Fekete (cited by Hultberg) denies
this fact: "the real bill will do the miracle of financing
production and distribution spontaneously, without taking one penny out of
the piggy-banks of the savers." It would indeed be miraculous — even
violating the laws of physics — if the production of some goods could be
financed without the consumption of any other goods merely by printing
paper. A simple objection to Fekete's view is to note that the employees of
manufacturing firms will eat, wear clothes, drive to work, and turn on the
lights at their factory. If credit could fund real productive activity, why
have savings at all? Why not fund all production through credit expansion,
not just short-term goods in process?
Economists have used the somewhat obscure term "forced savings"
to describe the shift in the expenditure of savings set in motion by credit
expansion. This term can be explained as follows. In the market, purchasing
power comes from the ability to supply goods to others who demand them. When
fiduciary media are created, new purchasing power is obtained, not by
supplying but, by diluting the purchasing power of existing money. While the
immediate recipients of the new credit have more purchasing power, they have
only obtained this power at the expense of other money holders. The business
firms that have borrowed fiduciary media obtain the ability to outbid other
holders of money. By shifting those goods away from others who might have
consumed them toward production, they exclude others who might have purchased
them for consumption. That is, they save-and-invest the goods. The savings is
"forced" in the sense that the loss of purchasing power by the rest
of the community is not made willingly, as would be the case if the others
had chosen to save and invest by loaning their funds.
Mises was overly optimistic when he wrote, "The absurdity of
[inflationists'] arguments is so manifest that their refutation and exposure
is easy indeed." In fact it has not been easy. Inflationism has been the
most enduring and harmful fallacy of monetary economics. The progress of
sound economics against this doctrine has not been without setbacks. The
fantasy of wealth creation through paper inflation never loses its appeal.
Each new generation of monetary cranks has rekindled hope for the
long-awaited Christmas Day when the Santa Claus of money creation arrives.
Only when the distinction between real savings and empty paper promises is
understood will economics drive a stake through the heart of this fallacy for
all time.