User:Andronico/Real bills doctrine

The real bills doctrine asserts that bankers may safely issue any quantity of promissory notes in exchange for certain types of bills of exchange of higher nominal value. The bills which may safely exchanged in this way are those of short maturity (typically expressed as 60 or 91 days or less) which have been drawn by solvent merchants or their customers during the normal course of business. These bills are known as "real bills". The doctrine is applicable under monetary systems such as the Gold bullion standard where the value of money is tied to a reference commodity by means of redeemability and where negotiable instruments are routinely created and circulated by businesses and individuals.

The first economist to describe banking practices under the doctrine was Adam Smith in Wealth of Nations (1776)(Humphrey, p.6)(Mints "History" p.25) . Endorsing the practices, Smith writes that the paper money varies optimally with the needs of trade when each bank "discounts to a merchant a real bill of exchange drawn by a real creditor upon a real debtor, and which, as soon as it becomes due, is really paid by that debtor" (WoN p.228, 1937 Ed.).

The doctrine has often raised controversy, with one nineteenth century detractor encapsulating it concisely as "the decried doctrine of the old Bank Directors of 1810: that so long as a bank issues its notes only in the discount of good bills, at not more than sixty days' date, it cannot go wrong in issuing as many as the public will receive from it.'"(Fullarton, 1845, p. 207) The doctrine does not feature in most modern economics textbooks and is now rejected by most economists being described as "high on the list of longest-lived economic fallacies of all times" (Mark Blaug, "Economic Theory in Retrospect, 3rd ed, p.56).

If the real bills doctrine is valid, bankers may be able to earn profits reliably by issuing and redeeming notes without incurring risk to themselves or others. In particular, the activity does not increase the risk of bank runs and consequent default on demands for note redemption. There will also be no additional macroeconomic risk such as chronically rising prices, expansion of the money supply or rising quantity of bills or notes in circulation. Banker's profits from issuing notes under the doctrine are limited by competition between issuers and from other exchange media, and the limited supply of discountable bills.

The doctrine is sometimes invoked by bankers when trying to deflect blame for problems such as bank defaults or inflation. It was invoked by the antibullionists in their defence of the Bank of England for rising prices after it suspended specie convertability during the Napoleonic Wars. The doctrine was also invoked by Rudolf Havenstein, president of the newly privatised Reichsbank, during the hyperinflation of the irredeemable Papiermark in Germany, 1922-1923.

Bill basics

A bill of exchange is a written multi-party contract used by merchants in clearing payments for the purchase of goods or services. A bill normally goes through the steps of creation, acceptance, endorsement, payment and disposal. Although best understood as payment clearing instruments, some refer to them as form of "self-liquidating credit" . The modern cheque and time draft is derived from the bill of exchange.

Bills of exchange have been central to the internal payment clearing systems of many countries up until the end of the redeemability under the gold bullion standard in 1914. Bills were also an essential instrument for foreign trade, greatly reducing the need to move bullion. In the UK, Bankers' Magazine noted in 1851 that "skilful re-distribution of the bill currency of the country is one of the greatest achievements of our banking system" as bills were drawn in "immense number" and according to evidence presented to the Bullion Committee of 1810, the system was "very nicely adjusted".

A bill is created when a person (the drawer) writes on a piece paper an instruction to one party (the drawee) to pay money unconditionally to (usually) another party (the payee) as part of a contract. The bill can be a convenient medium of exchange when purchasing goods or services, since it avoids the risk of carrying coin or bullion, and it is payable only after a certain date . The bill usually includes words such as "value received" confirming that there is consideration to the drawer as part of a contract, and may even specify the consideration. In many jurisdictions, a government stamp is required to show payment of duty.

Once drawn, the payee will wish to confirm that the drawee is willing to commit to make the payment when the bill matures. The bill is taken to the drawee and if they are willing to pay it, the drawee "accepts" the bill by signing it and writing "accepted". The drawee may refuse to accept the bill if he believes it to be counterfeit, if it is illegible or malformed, or he is simply unwilling to make the payment on behalf of the drawer perhaps through concerns over solvency. Once the bill has been accepted, the drawee is contractually obligated to pay on maturity and becomes known as the "acceptor". If the drawee refuses to accept the bill, the drawer is liable to pay.

A bill may be endorsed to another party, typically after acceptance. The payee (the "endorser") signs the bill and names the new beneficiary known as the "endorsee". This ability to endorse a bill is central to its ability to be used as a circulatory medium.

Once the payment date has arrived, the beneficiary can take the bill to the acceptor who will make the payment, take the bill and mark it as paid. The bill must be paid during the usance period, typically 2 weeks to 2 months depending on country. If the bill is presented to the acceptor but dishonoured, the drawer can be given notice and required to pay (p.39). Bills do not circulate after they mature. They are disposed of after payment.

Bills of exchange are orders to pay, representing a general obligation of the acceptor or drawer, but do not confer a security interest and convey no specific rights over any collateral. Bills which have been accepted by a bank are sometimes known as "banker's acceptances" and are considered high quality debt instruments. Bills are typically handwritten and in any nominal value according to the contract amount.

Good bills

A good bill is one which is very likely to be paid. This means:

• It is not a forgery, illegible or uncertain
• It is formed in accordance with normal merchants' practice
• It has been accepted by a financially strong business or individual and/or the drawer is highly solvent

Promissory notes

Promissory notes are a promise to pay money either to a named party or the bearer either on demand or after a future date. Unlike merchants' bills of exchange, they may be issued without an underlying transaction in real goods, and are obligations only on the issuer. Although sometimes handwritten, they are now generally printed and are issued in round number values.

Promissory notes under the gold bullion standard were typically issued by multiple competing banks and were not legal tender. In England and Wales, Bank of England notes over £5 were given legal tender status from 1833, but the bank only gained a monopoly on issue in 1921. If notes are not legal tender, they may be refused for the payment of debts, especially if the solvency of the issuer is in question.

Three types of currency

The doctrine involves three different types of currency (circulating media of exchange) all linked to underlying specie (typically gold or silver):

• Base money which is specie as coins or bullion bars in circulation or held at banks

This money defines the unit of account used in contracts and debt instruments but is not itself a form of debt. The base money has no counterparty default risk, and is sometimes defined as legal tender for settling monetary debts. This money is created when a mint coins gold or silver, thereby certifying the weight and fineness of the metal. The base money can be thought of as "cash".

• Bank-issued promissory notes payable by the issuer to the bearer on demand in specie

The bank-issued promissory notes usually circulate readily at par value because they can be immediately redeemed at that bank for specie, and banks only rarely default. The notes may or may not be legal tender, however. The promissory notes represent unsecured debt and can be thought of as "bank IOUs" including a promise to pay the bearer on demand. These instruments are also known as "notes of circulation". or simply banknotes, have no intrinsic value, but are convenient in conveying debts between parties.

• Privately issued bills of exchange which are unconditionally payable in specie by a named party after a certain date

The privately issued bills circulate much less readily and normally at less than par value. This is because the payment is usually due at a future date and the redemption depends on the future solvency and integrity of the issuer who may be unknown to a potential recipient of the bull. The bills can be thought of as "post-dated cheques", and like the promissory notes, have no intrinsic value.

None of these media pay interest. Other circulatory media may also be present but do not directly participate, these might include uncoined metals, scrip, non-bank promissory notes, bills of exchange with conditions or bearer bonds. Where a merchant draws a bill on a bank, the settlement will involve deposits held in the merchant's account at the bank.

Discounting a bill of exchange

A bill may be endorsed to another party. That party will then be able to demand payment upon maturity. The payee of the bill may offer to endorse the bill to a third party as a mutually convenient alternative to paying them immediately in specie. The bill however will normally only be accepted at a lower value than the nominal value paid on maturity. This is known as discounting a bill, the discount reflecting the time value of money and perhaps settlement risk and inconvenience.

A promissory note will typically be preferred in exchange over a bill of exchange. Note will usually be printed, in convenient denominations and issued by a bank. By contrast, bill will usually be handwritten, be in large and/or inconvenient values, and drawn by merchants unfamiliar to the public. Because of this, it may sometimes be advantageous for a beneficiary of a bill of exchange to swap it for promissory notes.

The real bills doctrine holds that a banker may safely profit from such a swap by issuing notes to a slightly lower nominal value than the nominal value of the bill of exchange. The bill beneficiary endorses the bill to the banker and in return, the banker draws and hands over a promissory note. The banker simply holds the bill waiting for the bill to mature, and collects the base money, retaining a profit since the issued notes are of lower nominal value than the payout from the bill.

A business which specialises in the discounting of bills of exchange is known as a discount house(finance) or bill broker.

Variations on the doctrine

Some versions of the doctrine omit Smith's requirement for note redeemability (Humphrey).

Some versions require real collateral underlying the bills. Thornton (1802) describes a variant backed by land. Some versions are applied to legal tender notes. One version of the doctrine states that banks should only issue promissory notes in the discount of good bills (Blaug 195).

The version of the doctrine held by The Banking School is also known as the "Law of Reflux" (Blaug p.195), and states that even if banks issue promissory notes above that supported by the doctrine, perhaps as loans for speculative purposes, inflation will still not result since the notes will simply be returned to the bank to repay interest-bearing debt and for conversion to specie.

Economists may support Smith's original doctrine but reject less restrictive versions (Humphrey). Historically, bankers have supported the least restrictive version .

Informative example

A wealthy landowning gentleman wishes to purchase a new custom-made horse buggy. He negotiates and signs a contract with a buggy maker on January 1st. The buggy maker agrees to make the buggy and deliver it to the gentleman on April 1st. The price agreed is $205, payable on the delivery date by means of a bill of exchange drawn on a bank ("91 days net"). The maker expects to pay $100 to his craftsmen, $60 to his suppliers, $5 to the bank, leaving $40 in profit.

When the contract is signed on the 1st January, the gentleman writes an instruction (or "order") to his banker at Plutobank to pay $205 to the buggy maker on April 1st for the buggy which will have just been received. The instruction is handed to the buggy maker. This written instruction is the kind of bill of exchange known as a "real bill" under the doctrine - it an unconditional order to pay (in specie) in 91 days for the value received. The bill is taken to the banker at Plutobank who says that the gentleman is in good standing at the bank and will not default. The banker "accepts" the order.

The buggy maker needs to pay his craftsmen and his suppliers. He takes the accepted bill to his banker, CommerceBank, and ask the banker to issue promissory notes in exchange. The banker agrees to issue eight promissory notes each of $20 in exchange for the bill and credit the buggy maker's account by $40, a total of $200, reflecting a discount of $5 on the bill. The buggy maker endorses the bill to the banker and hands it over. The banker writes and hands over the eight promissory notes, credits the maker's account and puts the bill in the bank vault, removing it from further circulation.

The buggy maker now schedules his craftsmen to make the buggy and orders the materials. The maker hands over three notes of $20 each to his suppliers. When the materials arrive, his five craftsmen each work for a week building the buggy. At the end of the week, the maker hands each craftsman wages of $20. The craftsmen can then offer the CommerceBank promissory notes to others as an alternative to specie. Some may be used to pay rent to the landowning gentleman who takes them to Plutobank which credits his account knowing that the promissory notes will be paid. When April 1st arrives, the maker delivers the buggy to the gentleman.

The banker at CommerceBank now presents the $205 bill of exchange to Plutobank for payment. Plutobank then presents eight of CommerceBank's $20 promissory notes. Plutobank and CommerceBank agree to net out the bill against the notes, leaving $45 to be paid to CommerceBank in specie. The buggy maker has retained $40 profit in the his CommerceBank account and CommerceBank holds $45 in specie, reflecting $5 profit and $40 available to be withdrawn by the buggy maker.

The bill of exchange is marked as paid and eventually destroyed, and CommerceBank's promissory notes are all back with the issuer for destruction or reuse.

Limits on note issue

The doctrine is controversial because it asserts that promissory note issue by banks for good bills is unlimited. If there is to be a limit in practice, it must come from a limit to the good bills offered by merchants. Bills are drawn by merchants and their customers in the normal course of trade based on what they know will be able to settle directly in specie or through specie deposits at a bank. There is a strong disincentive to draw bad bills, not only from damage to reputation but also risk of prosecution for fraud. If the drawee is to accept the bill, he must have confidence both that he can pay in specie and the finances of the drawer are sound. The drawer must have already money on deposit with the drawee or the drawee must be confident that the money will be forthcoming.

The requirement of convertibility of promissory notes into specie is the overriding check on their over-issue, and prices would be set in relation to the cost of producing additional specie through mining (Humphrey, p.8, Adam Smith WoN). Smith understood that the doctrine itself doesn't limit the note quantity and said that the redemption in specie should be a legal obligation which would prevent over-issue.

The limit to good bills offered to bankers by merchants is thus imposed by their own solvency constraints and enforced by the drawee's willingness or otherwise to accept the bill.

Interaction with fractional reserve banking

The doctrine assumes that bankers hold specie in case of withdrawal requests by depositors, demands for payment by holders of promissory notes, and for payment of bills coming due for which they are acceptors. Bankers usually hold less specie than their demand obligations imply. This is fractional reserve banking.

Effect of following the doctrine

In economies where the real bills doctrine is in use, people have the added convenience of dealing with banks' relatively standardised paper promissory notes instead of exchanging specie directly or using non-standard, usually handwritten bills of exchange in odd values. Both forms of paper exchange media are preferable to handling specie because of the lighter weight and lower security costs. People receiving the notes can have greater confidence that they will be paid when the circulatory medium is presented.

When bankers add their promissory notes to the circulations of exchange media they withdraw to their vaults the corresponding bill of exchange which always has a nominal value exceeding the value of the notes. The total nominal value of circulating media therefore falls slightly. When the bill matures and is presented for payment by the banker, the banker increases their specie reserve by more than the full value of the notes issued and can later redeem the notes if they are still circulating and book the profit. The banker's note issue has no effect on the market value of publicly circulating media when they are competitively issued in exchange for the bills, and consumer purchasing power is unaffected.

Default risks

The doctrine asserts the safety of bank note issue in the form of the above example. How are the various default risks averted?

• Holders of the bank-issued promissory notes turn up at the same time asking for money.

In this case, the banker will pay the noteholders with specie held at the bank. In the event that this is insufficient, the banker may be able to borrow specie from other sources, including customers or a lender of last resort. If this fails, the banker may be forced to delay redemption of the notes until bills he holds become due and will be paid. Since the banker has only discounted short maturity bills against his note issue, this will be only a matter of days or weeks.

• Drawee of the bill of exchange refuses or is unable to make payment. In this case, the banker takes the loss himself. Provided depositors and noteholders do not rush for repayment, a rare defaults can be tolerated. The drawee may refuse payment if the bill is forged or he has not previously accepted it.

Inflation risks and relationship with the quantity theory of money

Simple application of the quantity theory of money suggests that banks' issue of promissory notes is an expansion of the money supply, and unless the velocity of money falls correspondingly, prices will rise. The doctrine in contrast asserts however that prices are not destabilised.

Issue of bills of exchange or promissory notes does not change the stock of base money - no specie is created or destroyed. The use of what are, in effect cheques does not enable a consumer to pay ever rising prices. This is because the base money needs to be available when the bill becomes due. This acts as a constraint on spending. Any attempt to draw bills for successively higher sums without the ability to make payment is fraud and will rapidly be uncovered. The exchange of notes for bills under the doctrine does not change the value of circulating media in the economy.

The consumers' inability to legitimately write limitless bills of exchange ensures that bankers will find a limit to the rate that bills brought for discount. The doctrine holds that all legitimate short-maturity bills can be discounted. Smith advises bankers to be observe their customers "with great attention", and only to deal with those whose repayments to the bank generally match advances to them over the course of four-eight months. Customers whose repayments fall very much short of advances are not safe to deal with. Under the doctrine, bills drawn by merchants apparently in financial difficulties are not "good bills".

The US Federal Reserve System built on discounting bills of exchange

The Federal Reserve Act contains provisions closely related to the real bills doctrine. Section 13 of the Federal Reserve Act states...

The maturity must be under 91 days, (except for agricultural purposes). Must not be drawn for investment purposes (eg for stocks, bonds or other investment securities). But the Act deviates from the doctrine by placing a limit to the nominal value which may be issued in this way. Although bills of exchange are not convertible into assets, nor are they legally secured on assets, the Act refers to "bills of exchange, secured by staple agricultural products, or other goods, wares, or merchandise".

Instruments not covered by Smith's doctrine

Confusion often arises over exactly what financial instruments can and can't be discounted under the doctrine. Instruments which are not covered by the doctrine may still in practice be discounted, but the doctrine's assertion of safety cannot be applied. Such doctrinally non-discountable instruments include:

• Bills of exchange drawn in relation to goods not part of a bona fide sale transaction, including repurchase agreements and sales to self
• Bills of exchange of long maturity

and the following instruments which are not bills of exchange:

• Instruments drawn to pay debts or taxes or as gifts (no value received and not a contract)
• Instruments used for purchasing real estate (not short-term merchants' bills)
• instruments payable not in money but some other form, eg bills, notes or commodities
• IOUs which are simply acknowledgements of a debt, having no repayment terms

Applicability to modern monetary systems

The doctrine arose under monetary systems different in crucial ways from those prevailing today. Banks and other businesses are now generally prohibited from competitive issue of bearer notes. Banks are no longer required to redeem in the form of a limited specie. Irredeemable promissory notes issued by central banks have been made legal tender for the payment of debts, both private and public, forcing acceptance at par regardless of solvency concerns. Specie no longer circulates in the form of coin. Cheques may not be endorseable and are no longer negotiable instruments in some jurisdictions [citation needed]. Electronic money transfer networks have made bills of exchange obsolete for most purposes.

The consequence of these monetary, regulatory and technological changes is that the real bills doctrine cannot be transferred from lightly regulated commodity-backed systems to modern highly regulated fiat systems.

Modern monetary systems do not have specie convertibility of notes, and this constraint on over-issue makes the doctrine in the form expressed by Adam Smith inapplicable.

Criticisms and support

The doctrine has come under heavy criticism by economists during the 20th century.

Economist Thomas M. Humphrey in a paper for the Federal Reserve Bank of Richmond rejects some later versions of the doctrine describing it as "the long-discredited real bills doctrine according to which the money supply should expand passively to accommodate the legitimate needs of trade". Applying the quantity theory of money and contradicting the doctrine he states that "monetary expansion would raise prices" which would "thereby requiring further monetary expansion leading to still higher prices and so on in a never-ending inflationary sequence". The flaw in the doctrine was identified as the "price-money-price feedback loop that renders the real bills mechanism dynamically unstable" and a mathematical model given (Federal Reserve Bank of Richmond Economic Review,Sept/Oct 1982).. Humphrey accepts however that Smiths original version of the doctrine was valid because of the requirement for redeemability, declaring "Smith's version immune to the problem of dynamic instability" (p.8).

Lloyd W. Mints ("A history of banking theory" pp15-161945), Frank W Fetter ("Development of British monetary orthodoxy 1797-1875" 1965, pp7-9) and Milton Friedman were also critical.

Earlier economists who identified this instability include Henry Thornton (1802), David Ricardo (1810) and rejected the bankers' doctrine claiming that the real bills doctrine placed no effective limit on the nominal value of notes that banks might create.

Thomas Cunningham in 1992 did an empirical survey which concluded: "The results provide clear evidence supporting the Real Bills doctrine, that the value of assets backing money determines its value, over the Quantity Theory." supporting the least restrictive version of the doctrine Other economists who support the doctrine include Professor Antal Fekete and Professor Mike Sproul (supporting the Law of Reflux version).

See also

• Fiat money
• Fractional reserve banking

Related theories

• Quantity theory of money, the mainstream economic theory
• Fiscal theory of the price level, a heterodox economic theory

External links

Information

• The Real Bills Doctrine by Mike Sproul
• Monetary Economics 101 by Antal E. Fekete
• Backed Money, Fiat Money, and the Real Bills Doctrine by Mike Sproul
• Don't Fix the Price of Gold! by Antal E. Fekete