"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.

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 Real Bills Doctrine (RBD) has a long and controversial history. Many of the key concepts originated with the monetary crank John Law. [1]^, [2]   In 19^th-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.[3]^,[4]

The Doctrine of Real Bills 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).[5]

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.[6] 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 loans this credit into being as money. The money exists either in the form of either 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 for the credit 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 the discounting mechanism. This series of articles will address some, but not all of their arguments. The current article will respond to a series of arguments advanced against transfer credit and in favor of credit expansion. The authors 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); or, equivalently, expanding credit beyond savings enable 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.

The “monetary crank,” wrote Mises, is one who “suggests a method for making everybody prosperous by monetary measures.”[7]  All variants of monetary crankism suffer from the same error: The printing press cannot create actual goods. All of the arguments for the RBD will be seen to be variants of monetary crankism.

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. 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.”[8] Paper claims of this type were are called fiduciary media[9] by Mises, meaning media of exchange that circulated at parity with real money, but came into existence as the result of credit expansion.[10]

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”:

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.[11]

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.”[12] 

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 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 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 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. The French economist J.B. Say brilliantly observed:

Thus, to say that sales are dull, owing to the scarcity of money, is to mistake the means for the cause; an error that proceeds from the circumstance, that almost all produce is in the first instance exchanged for money, before it is ultimately converted into other produce: and the commodity, which recurs so repeatedly in use, appears to vulgar apprehensions the most important of commodities, and the end and object of all transactions, whereas it is only the medium.

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.”[13] 

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.[14] 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.[15]

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, 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.[16]

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 in to produce other goods, the original owners they 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.[17]

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 from others who might have consumed them to 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 off 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.” 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.

An earlier version of this article appeared on the web site of the Ludwig von Mises Institute

[1] “There are men who are commonly stigmatized as monetary cranks. The monetary crank suggests a method for making everybody prosperous by monetary measures.” Mises, Ludwig von, Human Action, Auburn, Alabama: Ludwig von Mises Institute, 1998, 186.).
[2] Law was the second greatest inflationist of all time after Alan “two bubbles” Greenspan. See: Makin, John H., Greenspan's Second Bubble, 2005.
[3] Interview with Allan H. Meltzer, http://minneapolisfed.org/pubs/region/03-09/meltzer.cfm#bills, September, 2003.
[4] Noland, Doug, Henry Calvert Simons, Credit Bubble Bulletin, August 24, 2001.
[5] From Mises Made Easier: Bill of Exchange: A negotiable document drawn up and signed by one party (usually, but not necessarily, a seller) on a second party (usually a buyer) providing that the second party unconditionally promises to pay to the order of bearer or a third party, but which may be the drawer or first party, a specified sum on sight (upon acceptance by the second party) or upon a specified or determinable date. The bill becomes valid only upon the signed acceptance by the second party. A bill payable at a future date is a credit instrument discountable at banks in advance of maturity, depending upon the credit of the parties signing the bill. At certain times and places in history, bills of exchange have been used as media of exchange.
[6] Mises used the term “commodity credit”
[7] Mises, Ludwig von, Human Action, 186.
[8] Hayek, Friederich A. von, Prices and Production, Augustus Kelley, 1931, 114.
[9] Mises, Ludwig von, Human Action, 430.
[10] Hultberg raises the issue of whether this sort of transaction is inherently fraudulent, and concludes that it is not if the bank fully informs its customers.  To address the legal-theoretic issue fully would take the discussion too far afield for the current article.  Note however that the resolution of the juridical issues has no bearing whatever on the economics of the problem, the focus of the current article.
I agree with Hultberg that legal powers given to banks, such as the option to suspend convertibility of bank notes when they are bankrupt, are a form of special privilege and should be abolished.   However, I believe Hultberg’s view is mistaken that fractional reserves per se are not a problem if they are fully disclosed.  Even if a bank had a large sign stating “this bank does not have sufficient gold coins to redeem all of the bank notes and deposits” this system would still pose legal problems.   For a full explanation of this view, the interested reader might wish to read the following articles: Hans Hoppe and Jörg Guido Hülsmann, Against Fiduciary Media; Jesús Huerta de Soto, A Critical Note on Fractional-Reserve Banking and A Critical Analysis of Central Banks and Fractional-Reserve Free Banking;  Jörg Guido Hülsmann: Free Banking and the Free Bankers, Free Banking and Fractional Reserves: Response to Pascal Salin, Has Fractional-Reserve Banking Really Passed the Market Test?,  and Banks Cannot Create Money.
[11] Carroll, Charles Holt, 1860, in Hunt's Merchants' Magazine and Commercial Review, XLIII, "Currency of the United States,"; reprinted in Edward C. Simmons, ed., Organization of Debt Into Currency and Other Papers, William Volker Fund Series in the Humane Studies, Princeton, New Jersey: William Volker Fund, 1964, 234.
[12] Hülsmann, Jörg Guido, Free Banking and the Free Bankers,, Review of Austrian Economics, 9(1), 1996, 39-40.
[13] Mises, Ludwig von, Lord Keynes and Say's Law, Ludwig von Mises Institute, April 25, 2005.
[14] Hülsmann, Jörg Guido, Free Banking and the Free Bankers, 32-33.
[15] Hülsmann, Jörg Guido, Free Banking and the Free Bankers, 32-43.
[16] Mises, Ludwig von, The Theory of Money and Credit, Indianapolis, Indiana: Liberty Fund, 05/04/10, 1980, 378.
[17] Mises, Ludwig von, Human Action, 186.

© 2005 Robert Blumen