Thursday, March 26, 2009

The Real Bills Doctrine of 2009

In the late 1920s and early 1930s the Federal Reserve System followed a theory called “The Real Bills Doctrine.” While the theory has been totally discredited, it nevertheless emerges in the news and in political circles from time to time. The real bills doctrine makes a distinction between the financial sector of the economy and the “real” economy.

In the late 1920s, the central bank was worried about the amount of money flowing into Wall Street. Many claimed that there was too much speculation, which was creating a false stock market boom. As a result, the central bank stated that it would only loan money to banks and corresponding projects that were “productive.” In others words, the central bank would only loan money to projects that were to be used to produce real goods and services. With the production of real goods and services, the loans would not be inflationary. Or so the theory goes. The reality is that all monetary creation is inflationary regardless of what it is used for.

Today, we are suffering from the real bills doctrine again. It is just dressed up a little differently. The politicians are calling for more economic stimuli to “jump start” the economy. Some politicians are objecting to the direction that Washington is taking not because the theory of increasing government spending to create an economic recovery is flawed (which it is); but rather politicians are objecting to the idea that the money isn’t going toward “real stimulus” projects. They claim that instead of using the money for balancing state budgets, the federal monies should go to “shovel ready” projects. It is in this distinction that the real bills doctrine emerges. When it comes to inflationary pressures, there is no difference between balancing state budgets, shovel ready projects, road construction, stock market speculation, and so on. The more dollars put into the economy devalue each and every dollar, regardless of how it gets into the system.

Furthermore, spending federal dollars will not restart economic growth. The source of economic growth ultimately comes from savings and capital accumulation. Capital accumulation means the production of better tools, better machines, and better equipment. More capital is necessary because it allows each worker to become more productive and raise the standard of living for everyone. This formula has been known and followed by the US since our revolutionary days. Following it has transformed the US from a bunch of small, backwater colonies into the largest economy in human history.

The current stimulus package cannot be funded by using today’s tax receipts. The government will try to get the money to cover these expenditures through borrowing, which will result in the largest deficit ever. Unfortunately, there is simply not enough money to borrow to cover all of the spending. The balance will have to come from money creation. Regardless of what is done with this money, it will cause prices to rise in the near future. Furthermore, since our banks adhere to a fractional reserve system, it means that the newly created base money will be loaned, deposited and reloaned, over and over. This credit creation process will multiply the money supply throughout the economy by a factor of about nine.

We are standing at the edge of a very nasty inflationary period. We can turn back or we can make things worse. If we follow the path of monetary expansion, it will come at a very high cost. Not today, but not too far into the future. It will be at that point when the real bills will have to be paid.


Anonymous said...

Thank you for this post, P F Cwick. It's simple to understand and straight to the point - not to mention very true.

Anonymous said...

I follow your theory and agree with one exception. The balance sheets of banks are riddled with assets that have fallen in value. The FED and Treasury have strong armed FASB to forget about mark to market accounting for the time being at least. Since money, is nothing more than income streams of performing loans, a huge amount of money has evaporated into thin air even though it still exists on the balance sheets of our nations banks.

Inflation will not appear, in my opinion, until banks begin to loan out their reserves and this won't happen as long as asset prices (residential and commercial loans) stop falling at a minimum. Even when this occurs, the general public won't have the means to buy or the desire to buy until general prices at least stabilize.

Federal spending could indeed jump start growth but most probably won't in this case since what ails us is systematic in the broken financial system. In other words, it will help temporarily but is not sustainable. Think of throwing lighter fluid on wet coals.

So yes we are standing on the edge of inflation but I think it is the edge of a long, long downward sloping hill rather than a cliff.

Steve Davis

P F Cwik said...


I agree with your thoughts on FASB and the delay in seeing inflation.

However, I don't think that Federal Spending can jump start the economy--ever. Mises sums it up nicely, "The government, appearing on the market as a buyer, replaces the individual citizen: the citizen buys less, but the government buys more." There are unseen consequences to government buying. It is this unseen state of affairs that economists have to compare with the seen.

Mike Sproul said...

The real bills doctrine says that newly-issued money will hold its value as long as the new money is issued in exchange for assets of adequate value. It also says that if the money-issuer gets assets that are of inadequate value, then the money will lose value.

The article seems to confuse Keynesian theory with the real bills doctrine. It is Keynesians who favor stimulus by deficit spending, not real bills'ers.

P F Cwik said...


I am glad to see your comment. My hope is that these posts stimulate thought.

I don't see that there is much difference between what I wrote and your perspective. I think the terminology is different, but the idea is the same. In other words, my understanding is that the Real Bills Doctrine argued that "adequate value" investments only come from the "real" sector of the economy, not the "financial" side.

My point in the post was that there is the same flaw in the reasoning for "shovel ready" stimulus projects. That flaw is this false separation of dividing the economy into "real" and "financial" sectors.

Thus, the Keynesians (actually the politicians who probably don't know or care who Keynes was) are making an argument that has been repeatedly discredited by the economics profession. The difference is that it has been dressed up differently and then recycled.

Anonymous said...

Keyensians don't typically draw a distinction between spending on "real" projects and "fake" projects.

P F Cwik said...


You make a good point about pure Keynesians. I don't think that politicians are pure Keynesians on an intellectual level. I think that they will use whoever and whatever idea that supports their position. Keynesianism just tends to go along the lines that politicians like: spend, spend, spend.

Nevertheless, last year during the stimulus debate, which I think can be looked upon as a Keynesian recommendation, there was the argument made that the stimulus should go to "shovel ready" projects because they are better for the economy. It was point that I was commenting upon.

But you are right, a true Keynesian does not care how Aggregate Demand is moved, as long as it is moved.

Mike Sproul said...

The RBD has been around long enough to have been stated incorrectly many times, usually by its critics. Here is a version of the RBD that is logically defensible:

A bank accepts 100 oz. of silver on deposit and issues 100 paper receipts (dollars) in exchange. Each dollar is backed by one ounce, so each dollar is worth one ounce. Next, the bank prints and lends 200 new dollars to a farmer who offers his farm as (adequate) collateral. The farmer promises to repay 220 oz of silver in 1 year. At a 10% interest rate, the IOU is worth 200 oz today.

Note that the bank tripled the quantity of dollars, but it also tripled the assets backing those dollars, so each dollar remains worth 1 oz. In other words, issuing money in exchange for assets of adequate value is not inflationary. That's the correct version of the RBD, and to avoid bad associations with old, fallacious arguments, it should be called the backing theory.

Naturally, this is a simplified version. The more complete version can be found by clicking my name above.

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