"The fundamental error of our financial policy lies in the attempt to
create wealth by creating currency: it is putting the servant before the
master — the wrong power, in advance. We can create wealth only by producing
commodities." The frequency with which monetary crank schemes are
proposed indicates that this great truth written
by Charles Holt Carroll (148) in 1859 has not yet been learned.
Case in point is Nelson Hultberg and Antal Fekete’s call for a
revival of the Real Bills Doctrine (RBD). The Real Bills system is a form
of monetary crankism: at its core is the fallacy that paper can create
wealth. Carroll, one of the most astute critics of paper money, had it right
when he wrote
that the RBD is "the most remarkable and the most mischievous heresy
that ever found an advocate in any science."(267)
Limiting the danger of inflation is most prominent reason for using gold
as money. While the supply of gold can at best grow slowly, the quantity of
paper can be multiplied without limit. The resulting inflation erodes the
purchasing power of wages and savings. The Real Bills Doctrine — a theory
advocating the creation more paper money substitutes — cannot be exempt from
this evil.
Yet RBD theorists hold that the discounting of bills that they propose is
non-inflationary. They believe that they have discovered Inflation Lite: a
miraculous form of fiduciary
media that facilitates more trade but does not increase prices.
Implementation of the RBD would be a path to inflation; non-inflationary
monetary expansion is a mythical beast.
The doctrine states that banks should be allowed to monetize short-term
business loans. Part
1 presents an explanation of the monetization bills of exchange, explain
the difference between transfer
credit and credit
expansion, and exposes the fallacy of a credit shortage. In addition, part 1 shows
that only savings can fund production, and describes how forced savings
occurs in response to credit expansion.
The proposal advanced by Fekete is a non-solution to a non-problem.
Because it provides no benefit, there is no point in adopting it. In the best
case, something that has no benefit would be harmless. However, the RBD is
far from being harmless. The current article will show that adoption of the
RBD would inevitably be inflationary without any limit The current article
will also emphasize some subtleties of the Austrian critique of monetary
expansion.
The discounting of bills as per the doctrine would introduce fiduciary media into
circulation. The creation of fiduciary media is always inflationary because
the paper notes have equivalent purchasing power to money itself and
therefore affect prices in the same way. Carroll sees the point clearly:
"Nothing is created by this operation but debt — no capital, value, or
wealth whatever — but price is added to commodities thereby as effectually as
if so much gold had been produced or earned by labor and added to the
currency." (137)
A market price is created any time money or a paper claim functioning as
money is spent. As Mises explains here, money
prices are formed through the use of all real money and fiduciary media in
circulation:
If notes are issued by the banks, or if bank deposits subject to check or
other claim are opened, in excess of the amount of money kept in the vaults
as cover, the effect on prices is similar to that obtained by an increase in
the quantity of money. Since these fiduciary media, as notes and bank
deposits not backed by metal are called, render the service of money as safe
and generally accepted, payable on demand monetary claims, they may be used
as money in all transactions. On that account, they are genuine money
substitutes. Since they are in excess of the given total quantity of money in
the narrower sense, they represent an increase in the quantity of money in
the broader sense.
When money is loaned in a credit transaction, the increase in the
purchasing power of the borrower is offset by the saver’s withdrawal of
purchasing power. When a saver loans to a borrower, different prices will be
created than if the saver had kept the money instead of loaning it. This is
so because the money loaned will be put to different uses by the borrower
than it would have by the saver. The borrower might use the money to rent
office space, while the saver might have used it to purchase a car. But there
will be no general tendency toward higher prices in an economy based on
transfer credit even when credit transactions are common.
On the other hand, an increase in the quantity of fiduciary media
necessarily results in a higher market price for some good because when they
are issued, there is no offsetting savings that withdraws demand elsewhere.
When a business sells its bills to a bank for unbacked paper claims, the firm
might use their phony paper money to pay wages to employees, rent office
space, or purchase machinery. Whatever it is, it will sell at a higher price
than would be the case in the absence of the fiduciary media. As Hülsmann explains:
Suppose I get an additional fiduciary banknote of one ounce of silver
sterling from my banker. This banknote permits me to satisfy wants that
hitherto were not sufficiently important to be considered (they were
submarginal). If I pay for a meal in a restaurant with this banknote then,
without any doubt, I have affected market prices. In fact, by my very
purchase I have formed market prices. These prices would have never come into
being without the additional issue of a banknote. Selling the meal to other
persons would have required a price reduction to attract submarginal
consumers.
Suppose that a merchant is short of cash but he possesses a bill. He tries
to sell his bill for cash. There are two possibilities: under a system of transfer credit, he sells the
bill by obtaining credit (the transfer of someone else’s savings). Or, if the
RBD were adopted, a bank would expand credit and pay the merchant with
fiduciary media. The first potion, borrowing savings, is more costly to the
merchant because then he must offer the saver a sufficient rate of interest
to make them willing to part with their money. The alternative, fiduciary
media, can be printed at nearly zero cost. The bank that prints money instead
of borrowing savings can therefore offer a lower rate of interest. Credit
expansion allows the merchant to pay less interest — which means to receive
more cash — for his bill.
Consider the situation of a merchant who needs some quantity of cash to
pay current expenses, and who owns a bill of exchange. Suppose that a bank
operating according to the RBD is willing to offer him exactly as much cash
as he needed for his bill. Then, under a system of strict transfer credit,
the bank would offer him less than that amount because of the higher cost of
borrowing savings compared to creating fiduciary media. Starting from the
same initial conditions in a transfer credit system the merchant would not be
able to sell his bill for enough cash to pay his obligations.
There are two possibilities here. One is that he might be bankrupt. As I
explained in part
1, this is not a bad thing; it is part of the market’s process of
allocating resources. The assets to do not go away, or even necessarily cease
to be productive. The firm’s creditors would take over the ownership, the
assets would be revalued at lower prices, and in more solvent hands might be
put to better use.
The other possibility is that the merchant can reduce his costs. Suppose
that he is able to do so either by negotiating with his suppliers for lower
prices or with his employees for lower wages or by purchasing fewer inputs.
Then transactions would occur but at lower prices than under a system of
credit expansion. This example illustrates how, under a flexible price
system, prices change to facilitate transactions. There is no need for an
"elastic" monetary system when prices can move.
There is a difference between the prices of a bill under transfer credit
and under the RBD. The difference consists of purchasing power shifted from
one person to another by the monetary expansion that occurs when fiduciary
media are issued. The additional purchasing power of the merchant only comes
into existence at the expense of all other money holders elsewhere, by
diluting the value of their monetary units. The issuance of fiduciary media,
then, enables the seller of the bill to obtain something that they could not
afford in economic terms, at the expense of the rest of the population who
find their own money to be worth less as a consequence.
It defies logic to say that a thing is true and that it is not true. For
the system of monetizing bills of exchange to be non-inflationary would mean
that it did not result in higher prices. Yet the entire motivation for the
system is to enable business transactions that could otherwise only take place
at lower prices, or not at all.
It is claimed that paper money printing if done according to the rules of
the RBD is not inflationary because the paper finances the production of
particular goods and then goes away. There are two problems with this. In the
first place, is a serious misunderstanding of the nature of productive
activity. The paper does not fund production. There is no
way that paper by itself can fund production, only the goods purchased
with the paper fund production. The holder of the phony paper notes is only
able to buy existing goods because he can outbid others who were not so lucky
as to be sitting next to the printing press. The only way to provide goods
more cheaply is to produce more of them through savings, work, and
investment.
Secondly, this line of thinking rests on the idea that the certain money
somehow corresponds to specific goods. Under a commodity money system, money
is a good in the economy that functions as the medium of exchange. Money
prices are the exchange ratios between money and goods. Money prices are
formed through the interaction of all money holders and all goods owners in
the economy. There is no identification between specific money units and
particular goods. In the process of price formation, money is acquired to be
spent, and then acquired again and spent again, forming price at each
exchange along the way. The explication
of this point by the French economist J.B. Say could not be improved
upon:
The silver coin you will have received on the sale of your own products,
and given in the purchase of those of other people, will the next moment
execute the same office between other contracting parties, and so from one to
another to infinity; just as a public vehicle successively transports objects
one after another.
There do exist instruments that are collateralized by particular goods. These
are known as bonds, equity shares, etc. But these instruments are not money.
The evaluation and pricing of these instruments is complex as they are
heterogeneous and carry different degrees of credit risk. Even collateralized
bills of exchange are subject to market risk. Firms can produce inventory and
then find themselves unable to sell it.
There are additional fallacies in the association of monetized bills with
particular goods. Fiduciary media are created at a distinct point when they
are loaned into existence. This is called the "point of injection."
When a bank expands credit by monetizing a bill, the point of injection is
the credit market. However, the point where this new paper enters the
spending stream does not limit its effect on prices to that point. As Mises explained,
"variations in the value of money always start from a given point and
gradually spread out from this point through the whole community."
Even for short-term loans, there is nothing about spending of new money
that limits its purchasing power to the production of those particular goods
in process that were the collateral for the monetized bill. In the short term
as in the long term people receive wages, buy groceries, pay rent, go on
vacation, and fill up their gas tank.
A major point in Fekete’s writings
is that bills are liquidated within 91 days or less. The fiduciary media are
withdrawn from circulation after a short time, so they can’t do much harm, or
so we are told. The defense of this theory rests heavily on the belief that
credit extended for 91-day-or-shorter periods is economically fundamentally
different than credit for longer periods.
Numerology notwithstanding, there is nothing special about the number 91.
There is no economic distinction between loans shorter than or longer than
some number of days. It makes as much sense to say that purchases of bananas
should be paid in gold coin while strawberry consumption should be funded
with bank credit expansion. All stages of production — including shipping
partially finished goods in process — consume real resources that have
alternative uses. All credit must be borrowed (whether for a short or a long
time) from the same potential pool of savings, namely present goods. Present
goods are scarce in the present. There exists nothing with which to fund
investment other than present goods that have been saved. The choice is only
whether the savings are voluntary (as they would be if they were offered on
true credit) or forced (as would be the case when fiduciary media are
issued).
The focus on the life cycle of a particular bill is misplaced. It is the
total volume of credit expansion and contraction in the banking system that
is responsible for inflation and deflation within an economy. The life
expectancy of any particular bill of exchange does not provide a measure of
the credit expansion that would occur if the RBD were implemented.
If, as Mises
wrote on this subject, "When the loan is paid back at maturity, the
banknotes return to the bank and thus disappear from the market," then
there would be only a small amount of credit expansion, followed by an
equal-sized credit contraction. But, he continues, "this happens only if
the bank restricts the amount of credits granted.… The regular course of
affairs is that the bank replaces the bills expired and paid back by
discounting new bills of exchange. Then to the amount of banknotes withdrawn
from the market by the repayment of the earlier loan there corresponds an
amount of newly issued banknotes."
Mises reminds us
that
The fatal error of Fullarton [a member of the Banking School] and his
disciples was to have overlooked the fact that even convertible banknotes
remain permanently in circulation and can then bring about a glut of
fiduciary media the consequences of which resemble those of an increase in
the quantity of money in circulation. Even if it is true, as Fullarton
insists, that banknotes issued as loans automatically flow back to the bank
after the term of the loan has passed, still this does not tell us anything
about the question whether the bank is able to maintain them in circulation
by repeated prolongation of the loan.
During the historical debates between the Currency School and the Banking School, the latter
made a similar argument. They maintained that banks, by expanding credit,
were only accommodating the "needs of trade." They argued that the
issuance of unbacked paper notes was a market mechanism that arose simply to
fill a need for a certain quantity of credit.
This argument runs aground on the following problem: the demand for credit
is not independent of the volume of bills issued. To say otherwise
ignores the impact of money supply on money demand.
Unlike for other goods, money demand depends in part on money supply. To
understand this, first consider why it is non-money goods do not behave this
way. It is quite reasonable to suppose that an increase in the supply of
lawnmowers will more fully meet existing demand. For every new lawnmower that
is produced, a previously sub-marginal purchaser will be supplied. But there
is no reason to think that an increase in the supply of mowers will change
the existing level of demand because the value of a lawnmower to one home
owner does not depend for the most part on how many other people have them.
But money is different. Unlike other goods, the supply of money influences
the demand for money. The reason for this is that the services provided by
money depend on the purchasing power of a single unit, while the purchasing
power of each unit depends on the total supply. This will be explained as
follows.
People hold cash in order to have a certain amount of real purchasing
power, not any fixed number of money units. The number of money units
required to provide the desired amount of purchasing power depends on the
purchasing power of a single unit. But the purchasing power of each money
unit depends in part on the total quantity of money circulating. If the
quantity increases through inflation, prices increase causing the purchasing
power of each unit to decrease. As the unit purchasing power decreases,
people will need more units of it to carry out transactions at the same real
prices, so money demand will rise.
Imagine that you were in another Italy before the transition from the
Italian Lira to the Euro. You are used to carrying around some quantity of
Lira in your wallet. Now you must determine how many Euros to carry around
for the same purpose. It is impossible to answer this question unless you
know the prices, in Euros, of various goods that you might wish to buy. The
purchasing power of the Euro is nothing other than the inverse of the prices
in Euros of goods. If a newspaper cost u20AC1, you might carry around u20AC10
in your pocket, while if the same paper were priced at u20AC1000, you might
need to hold u20AC10,000 to get through your day.
If credit expansion is taking place then fiduciary media will be issued.
For the same reason that money demand increases when money supply increases,
money demand will increase as credit expands. But in this case, the fiduciary
media will satisfy some of the demand for money. This is precisely what would
happen if the RBD were adopted. As more bills were discounted and more
fiduciary media would enter the system, prices in general would increase. At
a higher level of prices, more credit would be needed to finance the same
investments as before. The demand for money and credit to complete the same
volume of transactions would increase. A self-reinforcing spiral of
increasing credit supply, increasing prices, and increasing demand that in
the end would be limited only by the solvency of the banking system.
Here again we see the error in the idea that particular fiduciary media
are "backed" by specific goods and therefore non-inflationary. The
money prices of goods are formed by the interaction of everyone who has a
money balance and everyone who has something to sell in exchange for money.
This means that the goods in process, in the case of a non-monetized bill,
have already been priced given the existing supply of money. When the bill
becomes a fiduciary medium, new prices are formed, through the interaction of
all money and fiduciary media in relation to the same set of goods. This will
result in higher prices for the goods in relation to the new total supply of
money and fiduciary media.
We turn to Mises
for a restatement of this argument:
It is not true that the maximum amount which a bank can lend if it limits
its lending to discounting short-term bills of exchange resulting from the
sale and purchase of raw materials and half-manufactured goods, is a quantity
uniquely determined by the state of business and independent of the bank’s
policies. This quantity expands or shrinks with the lowering or raising of
the rate of discount. Lowering the rate of interest is tantamount to
increasing the quantity of what is mistakenly considered as the fair and
normal requirements of business.
Carroll
provides a historical example:
Adam Smith supposed that an excess of convertible paper currency could not
be circulated, because the excess would at once return upon its issuers for
redemption. This is one of his errors, and the more surprising because of the
experience of France with Law’s banking sixty years before the “Wealth of
Nations” was written. For four years the inflation continued there, until
general prices advanced fourfold, indicating a fourfold expansion of the
currency, and yet the currency did not return upon the bank for redemption to
any inconvenient extent until a few weeks before its doors were closed in
hopeless insolvency, although money was rushing out of the country all the
time. It is a question of confidence on the part of the people; if they prefer
the paper to money, and do not call upon the bank for payment, there is no
difference in effect between and inconvertible and a so-called convertible
currency, and, as we see in the example of France, it is easily possible to
press upon a credulous community as much convertible as an intelligent people
will bear of an inconvertible currency.
Inflation of consumer prices is harmful to employees and business firms
for many reasons: people get inflated into higher tax brackets, retired
people living on fixed incomes are impoverished, the purchasing power of
wages does not keep up with prices, and others.
It is too simple to say, as
Hultberg does, that Rothbard and other Austrians have rejected the RBD because
it is inflationary, if they mean that a demonstration of the stability of the
CPI under the RBD would rebut Rothbard’s critique. Austrian economists see
inflation as more than changes in final goods prices. A further clarification
of the Austrian critique of credit expansion will help distinguish the
Austrian view from the RBD and show that this criticism is groundless.
While economists of the Austrian school would deplore these evils, they
are have done heroic work in drawing attention to an even bigger problem. If
banks can lower the rate of interest by expanding credit, one might ask, why
not encourage this to enjoy the benefits of a lower interest rate all the
time? Mises and later Hayek investigated the relationship between the
organization of an economic system and bank credit expansion. What they found
was that the below-market interest rate brought about by credit expansion is
a temporary phenomenon. The below-market rate of interest distorts the
productive structure of the economy, resulting in a wasteful boom-and-bust cycle. During the
transition from boom to bust, the interest rate will rise to or above its
market rate.
Austrian economists have been critical of inflation not only for its
effects the purchasing power of money, but also because the credit cycles
waste scarce accumulated savings. All credit expansion causes a credit cycle
to some extent, whether or not ordinary consumer price inflation shows up.
When an Austrian economist says that a monetary system, such as the RBD,
would be "inflationary," they do not necessarily mean that would
result in an increase in end goods prices. Nor would it be sufficient to say
in response to the Austrian that "if end goods prices did not rise under
that system, then everything is fine."
Credit expansion can coexist with stable or even declining prices as
measured by inflation indexes, as they did for example in the 1920s and the
1990s. During a period of credit expansion alongside rapid investment in new
technology resulting in high productivity growth, prices will
not fall as fast (or not rise as fast) as they otherwise would have in
absence of credit expansion. And this credit expansion will drive a boom and
bust cycle.
Selgin’s Less
than Zero: The Case for a Falling Price Level in a Growing Economy is an
economic history of periods during which overall prices fell due to
productivity growth in excess of the growth in the supply of money. While
wages did fall in nominal terms, nominal prices fell faster. Far from being
anti-labor, these were periods of rising real wages. Selgin explains that
prices in England fell so rapidly during 1873—1896 that economic historians
who believe that falling prices must indicate a depression cannot explain the
general prosperity of this period. The standard of living of laborers
improved because their lower nominal wages were able to purchase more goods
at even lower nominal prices.
It is unfortunate, as Mises wrote,
that "no one should expect that any logical argument or any experience
could ever shake the almost religious fervor of those who believe in
salvation through spending and credit expansion." The complex
rationalization that Fekete presents for discounting bills of exchange should
not obscure that the essence of the Real Bills system is, to cite Mises again,
"Stones into Bread."
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Robert Blumen [send him mail] is
an independent software developer based in San Francisco.