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Real Bills Doctrine, You Have Never Ever Seen An Elephant Fly

Interest-Rates / Credit Crisis 2011 Jul 09, 2011 - 03:34 PM GMT

By: Professor_Emeritus

Interest-Rates

Best Financial Markets Analysis ArticleIn the 19th century a saying, long since forgotten, was current on Lombard Street: "There is nothing easier in the world than the banker's profession - provided that he can tell a real bill and a mortgage apart."


I would like to engage Dr. Joseph Salerno in a friendly debate on this maxim. In an interview published in the Daily Bell on July 3, 2011, he says he sees nothing wrong with people drawing bills of exchange, or accepting them in payment, as these instruments are completely consistent with a society based on free contract. I heartily welcome this statement of his. It should be much more widely known. After the death of the dollar people in the United States, and in other countries wherever the dollar also circulates, will not want to die along with their currency. They will still want to eat, get clad, shod, and keep themselves warm in winter. In order to be able do so they will just have to draw bills on retail merchants and other producers whom they supply with finished or semi-finished goods. These bills will serve as cash with which to buy food, clothes, shoes, fuel. We may expect that banks, central or otherwise, will have earned themselves such a bad name by then that nobody will want to be known as a 'banker'. 'Bill-monger' will sound much more honorable.

Dr. Salerno adds: What I vigorously reject is the age-old fallacy known as the 'real bills doctrine' asserting that when a bank issues currency or creates a bank deposit in discounting a bill of exchange, it is not causing inflation. In the next sentence he clarifies his position further when he suggests that whether a fractional-reserve bank buys a mortgage, or whether it discounts a real bill, it comes to the same thing: the bank increases its demand deposit liabilities to finance the expansion of assets.

While this is true, it does not prove that the bank is guilty of causing inflation when discounting a real bill. The difference is this, and in ignoring it Dr. Salerno dodges the real issue here: when the bank discounts a real bill, it withdraws from the market an instrument that circulates as money. Ephemeral, to be sure, but money nevertheless. Ludwig von Mises, no friend of the real bills doctrine, admits that bills of exchange have circulated as a means of payment among spinners, weavers and other tradesmen dealing in cotton products in Lancashire before the Bank of England opened its branch in Manchester.

There was a time, not too many years ago, when it was strictly against the rules for a commercial bank to put a mortgage or a bond in its portfolio of assets. "You have never ever seen a mortgage, a bond, or an elephant for that matter, fly." Real bills, by contrast, can and do circulate on their own wings and under their own steam as currency. The present Great Financial Crisis started with commercial banks overloading their portfolio with mortgages disguised as 'securitized equity'. Yet no one is inquiring whether the violation of the old time-tested rules has caused the crisis in the first place. Most sound-money economist expect a runaway inflation, but will be mightily surprised that in spite of mending the mountain-sized holes of their balance sheets with taxpayer money the banks will crash nevertheless as their main assets, government bonds, still cannot fly.

In discounting a real bill the banker only substitutes his own credit that has a higher name-recognition. The potent ingredient of the credit is that of the weaver, even though it has a lower name-recognition. The searching question to ask therefore is this: does the weaver really cause inflation when he passes along the bill he has drawn on the fabric merchant to the spinner in payment for the yarn?

I hope Dr. Salerno agrees with my answer: no, the weaver causes no inflation. It is true that he puts a purchasing medium, his bill drawn on the fabric merchant into circulation, but it is matched by the cloth, a new merchandise of the same value he offers for sale. The bill and the cloth appear simultaneously and will disappear simultaneously. The former disappears when it matures, and the latter disappears when it is purchased by the ultimate consumer. An increase in purchasing media that is matched by an increase of merchandise in urgent consumer demand is not inflationary.

Bankers of old on Lombard Street expressed this by saying that the credit embodied by a real bill is self-liquidating as it is extinguished by virtue of the sale of underlying merchandise on which it is drawn. By contrast, the credit embodied by a mortgage is not self-liquidating as it is not normally extinguished out of the proceeds of the sale of the underlying property.

Dr. Salerno also makes a comment on the suppression of the rate of interest, allegedly caused by bankers in discounting real bills at a discount rate lower than the rate of interest. This suppression, he suggests, generates an unlimited supply of bills to discount, causing an inflationary spiral of money-creation and price increases.

Mises explicitly stated that the discount rate is just another name for a short-term interest rate with interest taken out of the proceeds of the loan up front. However, this description is mistaken, as pointed out by several authors, among others John Fullarton and Charles Rist. The nature and origin of the discount rate are entirely different from that of the rate of interest. The two rates are completely independent of one another. The rate of interest is determined by the propensity to save; the discount rate by the propensity to consume. In either case the relationship is inverse: the greater the propensity, the lower the rate, and conversely.

When the spinner delivers yarn to the weaver and is offered payment in the form of a bill drawn on the fabric merchant, he will accept it but will apply a discount to the face value. The question is how the two tradesmen can come to an agreement on what rate to apply. There can be only one answer to this question: a lower discount rate will be acceptable to the spinner if the market is brisk; however, a higher discount rate will be insisted on if the market is lethargic. Thus the discount rate is determined by the condition of the consumer goods market, and not by the availability of savings. It reflects the propensity to consume (with apologies to Keynes). There is no loan involved in discounting, so the rate of interest is irrelevant. Tradesmen processing semi-finished goods are not expected to pay cash for supplies to their suppliers. The prices they are quoted are not cash prices. They are "90 days net". The credit is part of the deal: you need not even ask for it. On the rare occasion when you don't need the credit you pre-pay your bill, having applied the discount to its face value.

References:
Dr. Joseph Salerno, Explaining Everything You Ever Wanted to Know about Money (but were afraid to ask) The Daily Bell, July 3, 2011
Lawrence White, on Austrian Economics, Free-Banking and Real Bills, The Daily Bell, October 24, 2010
A. E. Fekete, Real Bills and Gold, The Daily Bell, October 30, 2010
A. E. Fekete, More Real Bill Fallacies, www.safehaven.com, Nov.1, 2010
A. E. Fekete, Real Bills: Waggon Ways in the Air, www.professorfekete.com August 7, 2006

Come to Munich, the capital of Bavaria, for the next ten-day course of the New Austrian School of Economics, from August 20-29, 2011, where I shall answer any questions you may have on the opening the Mint to silver. Also on hand will be Sandeep Jaitly to tell you about the marginal utility of silver, as well as about the gold mine of the silver basis, and about the last contango in Washington. For details, consult: nasoe@kt-solutions.de

By Professor Antal E. Fekete,
Intermountain Institute for Science and Applied Mathematics

"GOLD STANDARD UNIVERSITY" - Antal E. Fekete aefekete@iisam.com

For further information please check www.professorfekete.com or inquire at GSUL@t-online.hu .

We are pleased to announce that a new website www.professorfekete.com is now available. It contains e-books, archives, news about GSUL, and material of current interest

Copyright © 2011 Professor Antal E. Fekete
Professor Antal E. Fekete was born and educated in Hungary. He immigrated to Canada in 1956. In addition to teaching in Canada, he worked in the Washington DC office of Congressman W. E. Dannemeyer for five years on monetary and fiscal reform till 1990. He taught as visiting professor of economics at the Francisco Marroquin University in Guatemala City in 1996. Since 2001 he has been consulting professor at Sapientia University, Cluj-Napoca, Romania. In 1996 Professor Fekete won the first prize in the International Currency Essay contest sponsored by Bank Lips Ltd. of Switzerland. He also runs the Gold Standard University on this website.

DISCLAIMER AND CONFLICTS - THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT, IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.

Antal E. Fekete / Professor_Emeritus Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

Rick
11 Jul 11, 15:31
Real Bills Vs. Fiat Currency

"Dr. Salerno adds: What I vigorously reject is the age-old fallacy known as the 'real bills doctrine' asserting that when a bank issues currency or creates a bank deposit in discounting a bill of exchange, it is not causing inflation. In the next sentence he clarifies his position further when he suggests that whether a fractional-reserve bank buys a mortgage, or whether it discounts a real bill, it comes to the same thing: the bank increases its demand deposit liabilities to finance the expansion of assets".

Ideally, (although arguably not necessarily in a practical sense), real bills can not in themselves rampant up inflation; only politicians can be entrusted to fulfil that role. Moreover, the fractional banking system is not predicated on 'real money', but rather 'quantity' money (as the name implies).


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