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redit versus
clearing
Strictly
speaking a bill of exchange, pejoratively called "real bill" by
Milton Friedman following his mentor Lloyd Mints, is not a credit
instrument. It is a clearing instrument. It enables the market to
clear goods in most urgent demand without needlessly invading the pool of
circulating gold coins that would cause monetary contraction whenever
division of labor is further refined and production processes are made more
"roundabout" (to use the phrase of Böhm-Bawerk) by the most
progressive elements in the ranks of entrepreneurs and inventors. Lending and
borrowing are not involved. The real bill circulates on its own wings and
under its own steam by virtue of the urgent demand for the underlying
consumer good.
Self-liquidating
credit
In
spite of the conceptual difference between credit and clearing, it is
customary to extend the concept of credit to include, in addition to credit
arising out of the propensity to save that finances fixed capital,
self-liquidating credit arising out of the propensity to consume that
finances circulating capital in the final phases of production of
merchandise moving sufficiently fast to the final, gold-paying consumer.
Thus, then, the bill of exchange is the embodiment of self-liquidating
credit, so called as the credit is liquidated directly with the gold coin
surrendered by the consumer in 91 days or less, 91 days being the length of
the seasons of the year. With the change of seasons the type of merchandise
demanded most urgently by the consumer also changes in the temperate zones
where spontaneous bill circulation has taken its origin during the
Renaissance. For this reason bills of exchange are limited to maturities 91
days or less. Under no circumstances would a bill circulate after maturity.
If the underlying merchandise couldn't be sold during the current season,
then it wouldn't be sold until the same season comes around again the
following year.
Chicken or egg?
Detractors
of the Real Bills Doctrine (RBD) studiously avoid reference to its
prestigious pedigree and its author, Adam Smith. No less are they anxious to
avoid reference to self-liquidating credit and to clearing. They also ignore
the fact that, as a matter of merchant custom, producers and distributors
would hardly ever pay the producers of higher order goods cash. The terms
"91 days net" are standard and part of the deal. It is understood
by everyone concerned that the bill will not be paid in full until the
underlying merchandise is sold to the final consumer. Yet the supplier can
use the bill to pay his own suppliers. Endorsed on the back, the bill can be
passed along a number of times, the endorsement indicating that title to the
proceeds has thereby been transferred from payer to payee. This transaction
is also called "discounting" as the payee applies an appropriate
discount, calculated at the current discount rate, to the face value of the
bill proportional to the number of days remaining to maturity. Upon maturity
the last payee presents the bill for payment to the producer on whom the bill
is drawn.
Such bill
circulation was wide-spread in the city-states of Italy in the Quattrocento
and, more recently, in the 18th century in Lancashire, before the Bank of
England opened its branch in Manchester, as observed by Ludwig von Mises in
his 1912 treatise Theorie des Geldes und der Umlaufsmittel, although
he stopped short of investigating the economic forces animating spontaneous
bill circulation.
Unlike
the question whether the chicken was first or the egg, the question whether
bills or banks came first has a definite answer. There can be no doubt that
the former did. Logically and historically, the bill predates the bank. What
is more, it is perfectly feasible to have an economy without any commercial
banks at all wherein circulating bills of exchange emerge as the supplier
delivers semi-finished consumer goods to the producer. Instead of recognizing
this fact, detractors link bills and banks as if they were Siamese twins. In
refraining from ever mentioning the self-liquidating nature of the bill
detractors of the RBD insist that credit has been created "out of
nothing" and the bill is the engine driving paper-money inflation. Their
methodology consists in summarily denouncing any and all as a "monetary
crank" who is searching for and disseminating truth pertaining to bill
circulation, without the slightest effort to examine the evidence for
spontaneity. In doing so they betray their ignorance. Their blinkers do not
let them notice the extensive body of scholarly literature on clearing and
self-liquidating credit.
A "fairy"
tale
Let us
look at another instance of clearing and self-liquidating credit that was
vitally important in the Middle Ages: the institution of city-fairs. Among
the most notable ones were the fairs of Lyon in France, and those of Seville
in Spain. They were annual events lasting up to a month. They attracted
fair-goers from places as far as 500 miles away who brought their merchandise
to sell, as well as their shopping-list of merchandise to buy. One thing they
did not bring was gold to pay for the purchase of goods on their shopping
list. They would leave it home for fear of highwaymen. They hoped to pay for
their purchases with the proceeds of their sale. However, this presented
problems. The fact is that there were far fewer gold coins available at the
fair than the total value of merchandise waiting to be sold. Fairs would have
been a total failure but for the institution of clearing. Buying one
merchandise while selling another could be consummated perfectly well without
the physical mediation of the gold coin. Gold was needed to finalize the deal
only to the extent of the difference between the purchase price and the sale
price.
In the
absence of clearing the merchant arriving from a far-away place would have to
sell before he could buy. Moreover, he would have a hard time selling because
of the dearth of gold coins in the hands of prospective buyers. But even if
he could sell out his wares, by the time he has done so the cream of the
offering at the fair would be gone, and he might be left with the choice
between seconds and rejects.
To
avoid this, organizers of the fair set up a clearing house. Merchants from
afar registered their merchandise upon arrival and received a quota of scrip
money in proportion to its value at the clearing house. Scrip money could be
used right away to make purchases, even before the purchaser sold any part of
his registered merchandise. The quota had to be returned to the clearing
house at the end of the fair. Scrip money in excess of the quota was
redeemed, and shortfall made up, in gold coin. The marvelous institution of
the clearing house and the invention of scrip money could move a far greater
amount of merchandise than scarce gold coins ever could.
Those
who call the issuance of scrip money "credit created out of nothing"
are utterly blind to the true nature of the transaction. Fair-goers did not
need a loan. What they needed was an instrument of clearing. The clearing
house was not an engine of inflation. Its scrip money represented
self-liquidating credit that was extinguished just as soon as the fair was
over. As this example clearly demonstrates, a loan is very different from an
advance to the seller of wares with a ready market at hand. The advance,
scrip money, circulated spontaneously at the fair, while other credit
instruments such as loan contracts and mortgages would never do.
Goods in bottoms
Or
look at one other example of clearing that was important before World War I.
Suppose a cargo ship is ready to sail from Tokyo to Hamburg carrying in its
bottom consumer goods in urgent demand in Western Europe. The sea-voyage
takes up to 30 days. Does the importer need to raise a loan to pay the
supplier for the shipment prior to sailing? Hardly. The goods are known to be
in high demand and to have a ready market upon arrival. The cargo is insured
against losses at sea. Accordingly, the supplier bills the importer for value
received f.o.b. Tokyo, payable in 30 days in London. The importer endorses
the bill, attaches the insurance documents, and sends it back to the supplier.
The boat is now ready to sail. The supplier has an instrument he could use as
ready cash to pay for goods needed in order to replenish his depleted
inventory. When the boat docks in Hamburg, the wholesale merchant pays for
the cargo with a sight bill on London, with which the importer meets his
maturing obligation. This is self-liquidating credit "on the go".
No loan is involved. There is no need to invade the pool of circulating gold
coins and to tie up savings for 30 days in moving goods in urgent consumer
demand.
If you
insist that this is credit expansion as money has been created out of nothing
without recourse to saved funds to finance the movement of cargo across the
high seas, and if you say that the bill drawn on the importer has been misused
to fan the fires of inflation, then you have failed to grasp how foreign
trade is financed.
Vanishing risks
It is
true that production and distribution of consumer goods, no less than that of
producers goods, involve risks. However, there is a difference. Risks of
dealing in consumer goods in urgent demand vanish as the "journey"
of the "maturing" good is coming to an end, and the final
cash-paying consumer is already in sight, so that the consummation of sale
can no longer be doubted. From this point on the last leg of the journey can
be financed with self-liquidating credit. By contrast, for producers goods,
risks do not disappear even after the sale.
Of
course, not every consumer good has the quality that risks disappear during
the last leg of its journey. Luxury goods and specialty items, for example,
fall into this second category. So do consumer goods sold on instalment
plans. The production and distribution of these have to be financed out of
savings through loans, as is done in case of producers goods. Merchandise of
the first category may occasionally have to be downgraded to the second, if
demand for it slackens. Conversely, consumer goods of the second category
could be upgraded to the first if demand for them picks up sufficiently. The bill
market is the final arbiter to draw the shifting line of demarcation
separating the two categories. If a bill can find takers and is readily
discounted, then the underlying merchandise belongs to the first category.
Otherwise it belongs to the second.
"Telescoping"
payments
We
have seen that the RBD has nothing to do with credit expansion by the banks.
On the contrary, the remarkable fact is precisely that the RBD works also in
an economy bereft of banks. It deals with the singular phenomenon that bills
drawn on emerging goods sufficiently close to the ultimate cash-paying
consumer circulate on their own wings and under their own steam, provided
only that those goods are in urgent demand.
For
this reason, if you want to refute the RBD, then it is not good enough to
attack the banks for their part in credit expansion. You have to refute the
phenomenon, acknowledged by Mises himself, that the bill of exchange is, in
and of itself, fully capable of spontaneous monetary circulation. Typically,
it is used in payment for higher-order goods by the producer of lower-order
goods. In more details, bills drawn on the producer of an (n ! 1)-st
order good, by virtue of his being that much closer to the ultimate
gold-paying consumer, become a means of exchange in the hand of the producer
of n-th order goods when he pays the producer of (n + 1)-st
order goods for supplies. As the final product is sold to the consumer, his
gold coin will liquidate all claims that have arisen along its journey
through the various stages of production. Several payments have been, as it
were, telescoped into one. This is clearing at work. This is the meaning of
the assertion that the credit represented by the bill of exchange is
self-liquidating. This is credit the volume of which flows and ebbs with the
propensity to consume.
Can circulating
capital be financed out of savings?
Moreover,
as I shall now show, it is not possible to finance all of society's
circulating capital out of savings. It would put inordinate demand on savings
that simply could not be met. Consider a hypothetical product called
"miltonic". It is in urgent demand as a medicine that helps
preventing cancer. Its production cycle takes 91 days, with as many as 90
firms participating, so that the sojourn of the semi-finished product at
every one of the 90 stops takes one day. The ultimate consumer is willing to
pay $100 for a bottle while the producer of the 90th order good has paid $11
for raw materials. We shall also assume that the value added to the maturing
product at every stop is $1. Now if you want to finance the movement of one
bottle of miltonic through the various stages of production, then the pool of
circulating gold coins will have to be invaded 90 times, and you have to
withdraw savings in the amount of
11 + 12 + 13 +
... + 98 + 99 + 100 = ½(11 + 100)×90 = 45×111
or
$4995, almost 50 times retail value. In other words, there must be savings in
existence in the amount of almost $5000 to move just one bottle of miltonic
through the production process all the way to the consumer. This sum does not
include fixed capital that also has to be financed out of savings! And what
about other items of food, fuel, and clothes, also urgently demanded by the
consumer? Let me suggest it to you that no conceivable economy can generate savings
so prodigiously as to move all the indispensable items to the consumer. I
conclude that the division of labor could have never been refined, and the
"roundaboutness" of the production process could have never been
lengthened, beyond the level reached by the cottage industries of the
medieval manors, wherein every family had to produce not only its own food
and fuel, but also its clothes and shelter.
If it
did not happen that way, and production has become vastly more efficient, was
in large part due to the invention of the bill of exchange, heralding the end
of the Middle Ages. Clearing has been put to work making it entirely
unnecessary to invade the pool of circulating gold coins and divert savings,
to finance the movement of consumer goods through an ever more refined and
roundabout process, provided only that those goods be demanded by the
consumer urgently enough.
Detractors
of the RBD, above all Nobel prize laurate Milton Friedman, put his foot into
his mouth when he ridiculed the idea of bill circulation suggesting that it
was inflationary. It is hard to see how thoughtful people can treat the
notion, that circulating capital no less than fixed capital must be financed
out of savings, with respect.
Rate of interest versus
discount rate
Although
Mises was fully cognizant with the bill of exchange, he failed to come to
grips with the idea that there was no credit expansion involved in its
spontaneous circulation. Bills emerged together with the emergence of
marketable merchandise, and were extinguished when the latter was removed
from the market by the consumer. At no point did the bill increase the amount
of purchasing media relative to the available supply of merchandise. The bill
is an instrument of clearing or, if you will, self-liquidating credit. It is
one of the marvelous creations of the human genius, fully commensurate in
importance with the evolution of indirect exchange, arising spontaneously and
opening up new avenues to human progress. Unfortunately, Mises was not
interested in the concepts of clearing and self-liquidating credit. He
dismissed them as paraphernalia belonging to credit expansion. In this way
Mises missed his chance to make his theory of money and credit withstand the
ravages of times.
His
error of omission led to several errors of commission, the most conspicuous
of which was his assumption that the discount rate at which maturing
commercial paper changed hands was simply a subset of the rate of interest,
in particular, the rate on short-term borrowing. This was a most serious
error indeed, as the rate of interest and the discount rate were governed by
entirely different, sometimes diametrically opposing, economic forces. They
could move independently of one another, frequently in opposite directions,
subject to the only constraint that the rate of interest can never be lower
than the discount rate. If it were, the propensity to save would outstrip the
propensity to consume. But saving becomes pointless if human life cannot be
sustained for lack of spending on the wherewithal of life. If you save too
much, then you die of starvation. No one ever has done so, rumors
notwithstanding. The anecdotal miser is just that, anecdotal. This also
explains why the rate of interest cannot go to zero. However, the discount
rate may, whenever consumer confidence becomes most exuberant making
shop-windows spill over their contents to the curbside.
To
recapitulate: the rate of interest is governed by the propensity to save and,
by contrast, the discount rate is governed by the propensity to consume. In
either case the rate changes inversely with the propensity. For example, the
higher the propensity to save, the lower is the rate of interest; the lower
the propensity to consume, the higher is the discount rate. That the two
propensities are not rigidly linked is due to the existence of a cushion, the
propensity to hoard.
Irredeemable
currency: present good or future good?
But
Mises spurned the idea that there was a theory of an independent discount
rate. In consequence his theory of interest is flawed. This fact cannot be
swept under the rug, as it has led to further curious errors and
contradictions. For example, Mises concluded that fiduciary money, i.e.,
money originating in the credit expansion of banks, was a present good
on exactly the same terms as was the gold coin, and not a future good
as was the bill of exchange. In his eyes even irredeemable currency was a
present good, in spite of the fact that it could be created at the pleasure
of the government ad libitum. Elsewhere Mises rightly ridicules
irredeemable currency by saying that only the government is capable of the
feat of taking two perfectly useful goods, such as paper and ink, and make
the former perfectly worthless by sprinkling some of the latter on it. But if
we declare irredeemable currency a present good, then we credit the
government with power to create wealth out of nothing, a notion antithetical
to Mises' opus.
Had
Mises admitted that a discount rate existed independently of the rate of
interest, then he could have avoided such contradictions. Fiduciary money and
irredeemable currency belong to the species of a promissory note and as such
are not a present good but a future good. Even a gold certificate is a future
good: "there's many a slip between cup'n lip". Only a gold coin
qualifies as a present good among the multifarious forms of purchasing media.
This makes the gold coin sui generis, one of a kind, in the context of
the theory of interest. In fact, a theory of interest without gold is "Hamlet
without the prince". The interest rate on a loan repayable in
irredeemable currency can never be the benchmark on which to build a theory
of interest, no matter how many armored divisions the government foisting off
currency on the world may have at its disposal. Debt repayable in irredeemable
currency is nothing but an interest-bearing promise to pay that is
exchangeable at maturity for a non-interest-bearing one. Bonds at maturity
are exchanged but for an inferior instrument, insofar as
interest-paying debt is considered preferable to non-interest-paying debt.
The time-preference theory of interest is vacuous unless it explicitly
stipulates that interest and principal be payable in gold coin. Without this
provision prestidigitation is involved: future goods are juggled to make the impression
that debt is being retired through the surrender of a present good.
But
debt can never be retired under the regime of irredeemable currency. At
maturity it is shifted from one debtor to another. People are constructing a
Debt Tower of Babel destined to topple in the fullness of times.
The Lady of
Threadneedle Street
It is
commonplace to badmouth the Bank of England for her role in the corruption of
the gold standard of Sir Isaac Newton, the Master of the Royal Mint from 1699
to his death in 1727. But whatever one can say of the low circumstances of
her birth in 1696, and of her most recent role as the "Bag Lady of
Threadneedle Street" in selling her gold reserve to the drumbeat from
the paper mill on the Potomac, we must give the Bank of England credit for
financing Pax Britannica for a period of one hundred years between the close
of the Napoleonic Wars and the outbreak of World War I. Authors often
wondered how the Bank of England could run the international gold standard on
a shoestring of a gold reserve.
The
mystery readily finds its solution if we contemplate that the Bank of England
acted as the clearing house for real bills financing world trade between 1815
and 1914. This was history's most successful episode demonstrating the power
and the potential of the RBD. By 1913 world trade in consumer goods had
reached a high mark that was not surpassed until the 1990's. In whichever
countries they were domiciled, the exporter billed the importer and the terms
of the bill "91 days net payable in London" were standard. The
importer endorsed the bill, attached shipping and insurance documents, and
sent it back to the exporter. Thereafter the bill circulated world-wide in
lieu of gold till it matured. Hardly ever did a default occur, and even then
it was in consequence of violations of bill trading rules. Gold was shipped
only to the extent of the difference between imports and exports. The modest
size of the gold reserve of the Bank of England was no fetter on a most
prodigious increase in world trade, a monument to the triumph of clearing.
Goods in bottoms did not have to sail anywhere near England to be eligible
for financing through bills drawn on London.
It is
incumbent on the detractors of the RBD to explain how the phenomenal increase
of world trade in consumer goods, on which the remarkable prosperity of the
world before World War I depended, was possible with only a negligible amount
of gold changing hands.
The permanent
crisis of the world's monetary system
The
outbreak of World War in 1914 put an end to international bill circulation
and wiped out world trade in consumer goods almost entirely. When the war
ended, the garrison states that emerged did not allow real bill trading to
recover. Bill trading assumes that the gold is outside of the banks, in the
hands of the people. Strategic imperatives called for the concentration of
monetary gold in bank vaults. People had to be weaned from the gold coin. Nor
was the reintroduction of real bill trading considered an option at the
Bretton Woods conference in 1944 that was charged with the task to regenerate
the world economy and trade after the ordeal of World War II. The world is
still doing without the benefits of real bills. Trade has been placed under
the direct control of governments. Political, not economic considerations
govern the flow of consumer goods across international boundaries. Government
regimentation of the lives of the people has become virtually complete.
The
expulsion of real bills and the failure of world trade to recover after World
War I, together with the advent of "cash and carry" mentality, was
one of the main causes of the failure of the international gold standard and
the Great Depression about a dozen years after the cessation of hostilities.
A strong case could be made that if bill circulation had been allowed to
return, then world trade would have quickly recovered, too, and the
international gold standard would not have collapsed. Collapse it did
because, without the clearing mechanism provided by real bills, it could not
cope with world trade, much reduced though it was. People were talking about
an "acute shortage of monetary gold". Money doctors rose with a
phony diagnosis that the malady was due to the increase in the price level
that was not accompanied by a commensurate increase in gold reserves. This
diagnosis holds no water. It is based on the Quantity Theory of Money, a
flawed theory that is applicable only in a world where all changes are in a
linear relationship with their causes. In reality, however, changes in our world
are a non-linear function of causes. There is no way of telling how much
trade a given amount of monetary gold can support at any given price level.
The volume of trade depends, not on the stock of monetary gold, but on the
clearing system which can be improved to meet the challenge. Instead of
improving it, governments conspired to sabotage the clearing system by
blocking international trade in real bills that had worked so efficiently
before the war. The proper prescription should have been the restoration of
the clearing mechanism through real bills. Please remember that you have seen
it here first: the main cause of the Great Depression of the 1930's was
government sabotage of the Real Bills Doctrine of Adam Smith. The world's
monetary and payments system is still limping from crisis to crisis, and will
continue doing so until the RBD is fully rehabilitated.
The pipedream of
the 100 percent gold standard
Some
detractors of the RBD advocate what they call the "100 percent gold
standard" in which they leave no room for real bill circulation. They
maintain that real bills must be superseded by loans financed out of savings.
This
is a momentous issue that must be addressed adroitly and fairly by all
protagonists of sound money. We must put aside prestige, rancor, and personal
ambitions in order to bring about a consensus concerning the shape of the
gold standard that we all hope will arise from the ashes of the regime of
irredeemable currency. We must all cooperate that the new gold standard will
not only survive but flourish as well.
The
first thing to be observed about the "100 percent gold standard" is
that nothing approximating it has ever been tested in practice. All
historical metallic monetary standards had a supporting clearing system, more
or less developed, which limited the actual payment in the monetary metal to
net trade, that is, the difference between the value of total purchases and
that of total sales. It follows from my analysis above that a "100
percent gold standard" will not be able to survive for reasons having to
do with the burden it unnecessarily puts on savings. There isn't, nor will
ever be, savings in sufficient quantity to finance circulating capital in
full, given our highly refined division of labor and roundabout processes of
production. Luckily, this is no problem, as so much circulating capital to
move merchandise in sufficiently high demand by the final consumer can be
financed through self-liquidating credit. Advocates of the "100 percent gold
standard" must realize that they have grossly underestimated the degree
of sophistication of the structure of production in the modern economy. They
must also come to grips with the fact that financing circulating capital with
real bills is not inflationary. Real bills enter and exit circulation pari
passu with the emergence and ultimate sale of consumer goods.
Only
if we approach our differences with sufficient humility can we prevail
against the evil forces opposing freedom armed, as they are, with the formidable
weapon of irredeemable currency. Given the stakes, I am convinced that Ludwig
von Mises would, if he were alive today, put pride aside and admit that his
1912 judgment in dismissing the discount rate as an independent variable,
distinct from the rate of interest, was a mistake.
Antal
E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
Read
all the other articles written by Antal E. Fekete
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Copyright © 2002-2008 by Antal E. Fekete - All rights reserved
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