Brief Thoughts on the Real Bills Doctrine

There was a brief but interesting conversation on my post on the neutrality of money, between me and commenters Blue Aurora and Dinero, centering around the Real Bills Doctrine (RBD). I had not really looked into the RBD in too much depth before, but it seems like a natural ally of endogenous money (and MMT) theory, and it adds a lot of insights that, in my opinion, the Quantity Theory of Money (QToM) lacks.

The RBD comes in different flavours, but my reading of the modern version, popularised by Mike Sproul, is that RBD states the value of money is determined not by the amount of it in circulation (as in the QToM), but by the value of the asset the money is backed by. If a currency is tied to a gold standard, its value is determined by the convertibility rate of said currency to gold. If a currency is fiat, its value is determined by the assets of the bank that issued it. The value of a newly created loan is determined by the future goods and services generated by the borrower using said loan. Furthermore, RBD implies there is no real distinction to be made between various financial assets and money, as they are all claims on some real asset: the value of stocks, for example, changes with the value of a company, not when new stock is issued (though speculation obviously plays a role here).

Discerning which theory is ‘true’ can be difficult, as there is in some senses a large overlap between the RBD and QToM: in both cases, if the money supply expands without a corresponding increase in value/ wealth, money loses its value through inflation. Despite this “observation equivalence” between the two theories, Thomas Cullingham has tried to test which one is true by seeing whether it is the ‘backing’ of money or its quantity that have the biggest impact on the price level, and he found that it was the former. Furthermore, the RBD implies central banks should passively provide money based on the economy’s needs, which is consistent with endogenous money theory and the failure of monetarism. Finally, the RBD is consistent with the idea that hyperinflation is not a monetary phenomenon, but is instead determined by loss of confidence in a nation’s assets and economy due to political instability.

Oddly, the RBD is consistent with a fairly mainstream economist’s story of monetary policy: Paul Krugman’s babysitting coop. The members of the coop exchanged vouchers worth one night’s babysitting, but found themselves in a quasi-recession as nobody was willing to part with their vouchers. The solution was to increase the money supply, but this didn’t result in any change in the ‘worth’ of the vouchers. Those who object that this story is an exception because the value of a voucher was ‘fixed’ should answer the question: by what, exactly? Social conventions, confidence? Because these things are true of large amount of wealth in the real economy, too.

The RBD implies that many financial assets are speculative in nature, as their value depends on future flows of goods and services. Hence, if loans are issued for ‘speculation’, but with no expansion of goods or services, it will cause asset inflation. This wouldn’t have the ‘even’ impact of Friedman’s helicopter analogy, but would primarily take place through inflation of whatever was speculated on, such as houses. Hence, the RBD implies that the primary way of regulating inflation is not through monetary policy but through regulation and management of credit and the financial sector.

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  1. #1 by Lord on July 27, 2013 - 6:08 pm

    Doesn’t total endogeneity imply an RBC model?

    • #2 by Unlearningecon on July 28, 2013 - 1:04 pm

      You’ll have to elaborate on this one

      • #3 by Lord on August 6, 2013 - 2:10 am

        Total endogeneity would mean banks are passive bystanders, incapable of affecting the economy or creating inflation or deflation, not that I know anyone believes this, but if they were passive bystanders then only shifts in the real economy could create business cycles. So while money is endogenous, it most likely is not totally endogenous and interest rates have an effect, at least when they can be used.

      • #4 by Unlearningecon on August 6, 2013 - 10:46 am

        Agree, but I don’t think Sproul or Keen or any endogenous money proponent (hopefully) would endorse that position. Banks clearly have autonomy over what they choose to lend and who they choose to lend it to.

      • #5 by Mike Sproul on August 6, 2013 - 7:33 pm

        unlearningecon #4

        An easy way to think of endogenous money is to think of an old-fashioned mint. If the economy needs more coins, then the mint will profit by stamping silver into coins. If the economy has too many coins, people will find it profitable to melt the coins and make them into spoons and such. The supply of coins is endogenous, except that mints can cheat and debase the metal, and people can clip the coins, thus stealing a little metal from each coin.

        A smart mint owner will figure out that he can store the silver in his vault and issue paper tokens to circulate in place of the coins. This prevents clipping, and the paper tokens can still expand and contract with the needs of business.

        A smarter mint owner will figure out that he can issue paper tokens, not just for silver deposited in his vault, but for anything of comparable value to the silver. He will naturally issue paper tokens when they are needed, and when they are not, he can redeem them either for silver or for any of the other stuff in his vault.

        In all cases, money is endogenous, unless the mint (aka bank) is able to cheat and debase the money.

    • #6 by Boatwright on August 6, 2013 - 4:18 pm

      The writings of Irving Fisher deserve wider discussion, particularly his ideas about endogenous money.

      One of the problems we seem to have when discussing “money” is the tendency to want to define it narrowly. “Real money” is given, by definition, attributes such as convertibility, etc., when in fact we see many forms of endogenous money, that are fully functional in their area of economic activity, that lack these attributes. An example would be the marker of a gambler. Take it to the bank and one will not find any takers. Take it to a poker game and it will function just fine.

      It would be more productive to broaden the discussion and create theory that allows for the reality of endogenous money, while allowing money to have different functional attributes.

      Also, Karl Marx’s ideas re the tendency of current forms being looked at as “natural” bear examination when we hear that bank money, RBD money, etc. is the only real thing.

  2. #7 by Rob Rawlings on July 27, 2013 - 7:13 pm

    I think that Mike Sproul does a great and entertaining job of defending RBD against all comers. I think under commodity/convertible money it may well be a correct theory.

    However with nonconvertible modern money it seems to have some problems:

    1, Without genuine convertibility a currency will lose value if more is issued
    than the public wish to hold at the current value no matter how much backing that currency has. For example if the fed (in non-ZLB times) bought $1 Trillion of assets with newly printed money the dollar would lose value even though the new money was all backed by assets of equal value.

    2. By doing things like paying government workers in it, and insisting that taxes are paid in it, a government could probably give its currency some value even without backing

    For these reasons I think the backing theory is false.

    • #8 by Unlearningecon on July 28, 2013 - 2:32 pm

      For example if the fed (in non-ZLB times) bought $1 Trillion of assets with newly printed money the dollar would lose value even though the new money was all backed by assets of equal value.

      Is there an example of this happening? What about the ZLB changes the relationship? Many proponents of the QToM/monetarism, such as Scott Sumner, see the ZLB as irrelevant.

      There is a crossover between the QToM and RBD here, though. Both suggest that the rate of inflation depends on the value of real goods and services compared to money.

      2. By doing things like paying government workers in it, and insisting that taxes are paid in it, a government could probably give its currency some value even without backing

      I also wonder what relationship the value of money might have due to its ability to extinguish tax and debt payments, and whether this is compatible with the RBD.

      • #9 by Rob Rawlings on July 28, 2013 - 3:24 pm

        On the ZLB issue, I only added that as in the New Keynesian model it is thought that monetary policy at the ZLB is ineffective. I actually happen to agree with Sumner on this point.

        However leaving aside the ZLB there seems to be much empirical evidence that monetary policy does have an effect on the economy , and works by swapping assets for new money (and vice versa. This shouldn’t happen if RBD is true.

        On Taxes and RBD: I know that MMTers believe that the main purpose of taxes in their model is to maintain the value of the currency. As far as I know this means that “backing” is not needed si I am doubtful that they would support the RBD.

      • #10 by phil on July 29, 2013 - 2:27 pm

        According to Mike Sproul ‘taxes receivable’ is one of the assets backing fiat money

    • #11 by NeilW on July 29, 2013 - 4:15 am

      The backing is the ability to enforce those taxes. A weak state cannot and that reduces the ability of that state to induce monetary circulation.

      So its the dislike of the published social punishment for evasion of taxes that provides the backing.

      • #12 by Unlearningecon on July 29, 2013 - 2:44 pm

        Is this ultimately backed by the state’s own assets and services? Or by its perceived legitimacy?

    • #13 by Mike Sproul on July 29, 2013 - 5:23 pm

      Rob:

      1. Once you see that the RBD is correct under metallic convertibility, it is a short step to see that it’s right under other forms of convertibility as well. My favorite example is a landlord who collects rent in ounces of silver. Sometimes he can buy groceries by writing out a piece of paper that says “Acceptable for 1 oz rent on my property”. If the grocer rents from the landlord, or does business with someone who does, then the landlord’s IOU is usable as money. Note that the IOU is not directly convertible into silver, but just into rent.

      If the landlord’s assets add up to 1000 oz, then the landlord can safely issue up to 1000 IOU’s without causing them to lose value. The landlord can even issue another 2000 IOU’s, use them to buy assets (like land) worth 2000 oz, and his IOU’s will still hold their value, since the landlord now has 3000 oz of assets backing 3000 IOU’s.

      Note that the IOU’s can be convertible into rent, into land, or into the landlord’s other assets. As long as SOME form of convertibility is available, the RBD will apply to these IOU’s whether or not they are directly convertible into silver.

      2. As Phil and NeilW pointed out, ‘taxes receivable’ are an asset to a money-issuing government, and as such, taxes receivable back money, as well as providing another form of convertibility for money.

      3. We’ve actually seen a case of the fed issuing another trillion of money while getting another trillion of assets. No inflation, just like the RBD says.

      • #14 by Rob Rawlings on July 30, 2013 - 1:58 am

        Mike:

        on 1: I think the value of the landlords notes would depend upon the demand to hold. them. if he issued 3000 non-redeemable tokens with a face value of $1oz of silver and demand to hold them then was insufficient then they would trade below par no matter how many assets he had. If they served a useful purpose on the other hand and were in short supply then they could trade at a total value greater than his assets.

        I would be interested in your views on the following:

        http://jpkoning.blogspot.com/2013/03/orphaned-currency-odd-case-of-somali.html

        on #2: I’m a bit confused how taxing in dollars provides backing for the dollar. Seems circular.. I still think taxation merely creates demand for dollars and helps maintain its value.

        on #3: The last 5 years would seem to support the RBD but what about the 2 decades before that when many CBs targeted inflation ? If the RBD doctrine was correct they would have just printed and distributed n% more money each year (or destroyed n% of their assets). But they didn’t. They swapped money for assets and still managed to induce inflation.

      • #15 by Mike Sproul on July 30, 2013 - 11:06 pm

        Rob:
        1) If the landlord’s IOU’s fell below 1 oz there would be arbitrage opportunities. Anyone could buy a dollar for (say) .9 oz, and redeem it for 1 oz worth of rent. If the landlord refuses to redeem at 1 oz., then that is a default, and of course the notes will lose value just like any bond would.

        2) The landlord’s “rents receivable” are initially worth 1000 oz, and can back up to $1000 of the landlord’s IOU’s. To the government, ‘taxes receivable’ are an assets, just like ‘rents receivable’ are to the landlord.

        I think I posted a few replies to JP’s blog, which gave my views on the Somali shillings.

        3) A bank with assets worth 100 oz, which has issued $100, can if it wants, peg the dollar to a CPI basket in such a way as to make each dollar worth .98 oz. It’s a default by the bank, but a central bank can get away with it. Once the dollar is worth 2% less, people will demand 2% more dollars, and we’ll see M rising 2% while P also rises 2%, thus giving a misleading “confirmation” of the quantity theory.

      • #16 by Rob Rawlings on July 31, 2013 - 1:56 am

        OK: But if the IOUs can be exchanged for rent then this is an example of redeemable money, where I have already agreed that something like the RBD doctrine holds. If his notes are not redeemable for anything then no matter how much “backing” they have their value will ultimately depend not upon that but upon demand to hold.

        It is true that a govt could tax $1b and issue $1B of notes without this being inflationary. But I don’t think this is due to backing, but merely to the fact that its leaving the quantity of M unchanged. If it destroyed all the tax revenue then I do not think there would be inflation. You presumably think there would be.

        On “It’s a default by the bank, but a central bank can get away with it”: The only reason a CB gets away with it is that its notes are not redeemable so the value of its currency is determined by supply and demand. The bank controls the supply and I can see no credible argument to indicate that demand is determined solely by the assets held by the CB, which would have to be the case for RBD to be true

      • #17 by Mike Sproul on July 31, 2013 - 2:40 am

        Rob:

        If money isn’t convertible, then it isn’t backed. But convertibility can take many forms. There’s gold convertibility, bond convertibility, tax convertibility, etc. There’s also the possibility that 200 years from now, the Fed will use its remaining gold to buy back the last federal reserve note. That’s a form of convertibility too. So if you think the RBD is right for convertible currencies, then it must be right for all the kinds of convertibility just listed.

        If money gets its value from the fact that people demand it, and not from backing, then the issuer of money gets a free lunch. That should raise all kinds of red flags. The RBD implies no such nonsense. It just says that money is valued for the same reason that stocks and bonds are valued, which is that it has backing.

      • #18 by Rob Rawlings on July 31, 2013 - 3:22 pm

        “If money isn’t convertible, then it isn’t backed”. Ok, we agree on that. I also agree that convertibility can take many forms. If convertibility exists then checks and balances will be in place to ensure that a currency stays close to the value it is convertible for (and these check-and-balances will consist of the quantity in circulation adjusting to maintain the demand at the level that will allow it to hold that value).

        I just don’t see such convertibility existing for a modern currency like the USD. You just can’t go to the fed and say “I’d like to swap these dollars for another asset”. And the fact that you can buy govt bonds and pay taxes doesn’t really change that as far as I can see – those things will adjust the money supply but not in such a way that will maintain the value of dollar at any level.consistent with the backing theory.

      • #19 by Mike Sproul on July 31, 2013 - 4:14 pm

        Rob:

        Suppose a bank has issued $100, against which it holds 20 oz of silver plus bonds worth $80 (=80 oz). The bank sets a peg of $1=1 oz. At this peg, 12 people decide they have 1 extra dollar each, so $12 starts down to the bank, to be redeemed for 12 oz. The bank sees what is happening and immediately sells $12 of its bonds for $12 of its notes, which it retires. Those $12 of unwanted notes have just been soaked up by an open market sale of bonds, and the bank was saved the trouble of paying out silver. Notice that as long as the bank conducts open market operations, its gold doesn’t need to be touched. (Unless the bank has paid out all $80 of its bonds, and all that’s left is the 20 oz. In that case a reflux of the last $20 of notes would have to be handled by paying out the 20 oz of silver.)

        What I’ve described is exactly what the fed does, except that the fed pegs the dollar to a CPI basket instead of to silver.

        There’s also the fact that if the fed ever shut down (say, 200 years from now), it could use its bonds, gold, and buildings to buy back every dollar note it has issued. This couldn’t happen if the fed’s assets had been dumped in the ocean. The fed’s assets matter.

      • #20 by Rob Rawlings on July 31, 2013 - 6:28 pm

        You’re describing how monetary policy works. This is how the fed control the value of money. If the fed didn’t carry out monetary policy and didn’t offer redemption of notes for other goods then the value of money would just fluctuate based upon people’s demand to hold it , independent of the size of the feds balance sheet..

      • #21 by Mike Sproul on August 1, 2013 - 1:11 am

        Rob:
        (#16)
        That’s certainly the mainstream view, but it raises all kinds of nasty problems:
        1) Why do all central banks hold assets if not to back their currency?
        2) If governments can issue paper dollars without holding assets against them, then they get a free lunch. This would attract rival money issuers (like nearby governments and private banks) until the paper dollars are worth their backing (i.e., zero)
        3) Stocks, bonds, etc, are all valued according to their backing. Why should paper money be different?
        4) If you agree that the RBD is right for convertible currencies, and you agree that convertibility can take many forms, then where do you draw the line? At what point do you call a currency inconvertible? Especially when the bank constantly swaps bonds for currency so as to maintain bond convertibility.

      • #22 by Rob Rawlings on August 1, 2013 - 4:40 pm

        Ok Mike,

        I am going to make a concession. Much of the value of the dollar comes from the fact that the fed has huge amounts of real assets that it could use to defend its value should it need to.

        As the dollar is not convertible however in addition to these assets there has to be an implicit commitment along the lines of “We promise to maintain the value of the dollar give or take 2% or 3% inflation each year and will use our assets to that end”.

        So what would happen if the fed decided to create $1T of new dollars that it planned to use to buy assets?

        People probably wouldn’t want to hold all those extra dollars (lets say this is happening in 2003 and not now). If the dollar was convertible they would bring backs dollars back to the fed as fast as the fed could print new ones if its value started to fall. If it was not convertible then people would feel the fed had reneged on its implicit promise and dump the dollar causing inflation. This would happen no matter what backing the dollar had.

        So: A convertible currency needs backing. A non-convertible currency needs backing plus some sort of credible commitment that it will use that backing to maintain value over time.

        .

    • #23 by Dinero on July 30, 2013 - 12:40 pm

      The backing theory can‘t be right. The notion that bank notes will hold their perceived value simply on the basis that they are backed by collateral cannot be correct, as the people using them have no idea what the composition of that collateral could be.

      • #24 by Unlearningecon on July 30, 2013 - 5:24 pm

        Surely everyday use of currency is simply based on trust, and whatever backs the currency only becomes important once that trust is violated in, say, a crisis?

      • #25 by Dinero on July 31, 2013 - 1:31 pm

        Exactly – the colateral can’t be the source of value as only a tiny proportion of loans default, or as you say only feature in a crisis. The use of money is defferd barter an so the value comes from the goods and services created by the borrower. And an important demand for bank notes which regulates their scarcity is and value comes from the debtors need to regain possession of them to discharge their liability to the bank.

  3. #26 by Boatwright on July 28, 2013 - 1:55 pm

    “Furthermore, the RBD implies central banks should passively provide money based on the economy’s needs, which is consistent with endogenous money theory and the failure of monetarism. Finally, the RBD is consistent with the idea that hyperinflation is not a monetary phenomenon, but is instead determined by loss of confidence in a nation’s assets and economy due to political instability.”

    The 1994 experience of Brazil confirms this. Faced with a developing hyper-inflation there was a complete, over-night replacement of all currency with revalued notes, and the adoption of strict controls over the banking sector. In spite of gloomy predictions, this move was completely successful. Brazil’s currency has been in a basically stable relationship with the dollar ever since.

    “Hence, the RBD implies that the primary way of regulating inflation is not through monetary policy but through regulation and management of credit and the financial sector.”

    Recent events argue strongly in favor of the equivalence between financial assets and money, as well as the consequent need to closely regulate the banking and financial sectors.

    • #27 by Unlearningecon on July 29, 2013 - 2:50 pm

      Isn’t it funny how countries who ignore neoliberal dogma, like Iceland, manage to reestablish strong economies and avoid hyperinflation or collapse?

  4. #28 by Aman Austrian on July 29, 2013 - 10:37 am

    There are no bills of exchange under fiat money.

    You should read Antal Fekete, he is a traditional proponent of RBD.

  5. #29 by Boatwright on July 29, 2013 - 3:01 pm

    “There are no bills of exchange under fiat money.”

    Sez who? I find statements such as this completely opaque. Meaningful economic statements should not be about the meaning of words, but rather about how the economic world actually works. It seems a fundamental problem in the discussion of money that many persist in believing that money is a concrete “thing” — a mathematical object if you will. Money is a FUNCTION, the form and meaning of which is completely determined by how we use it.

    This statement implies the following logical construct: We have bills of exchange. Therefore, since “there are no bills of exchange under fiat money”, we must necessarily have asset based money.

    This is a self-referential tautology. We do not find truth in logical manipulations, independent of provable evidence as a starting point. The evidence indicates that money as we use it has both qualities: Fiat AND Asset Backed

  6. #30 by Mike Sproul on July 29, 2013 - 4:56 pm

    Thanks for a great post!
    Here’s one quibble:
    “if loans are issued for ‘speculation’, but with no expansion of goods or services, it will cause asset inflation.”

    The RBD (backing version, anyway) implies that if a bank issues 100 new dollars to someone who offers $100 worth of collateral to the bank in return, then the bank’s dollars will hold their value (relative to assets and relative to goods in general), since the bank’s assets will have moved in step with its liabilities. That collateral might be speculative (i.e., risky) or it might be safe, but if it has a fair market value of at least $100, then the bank’s assets will rise by enough to cover the newly-issued money, and the money will hold its value. Of course, if the collateral subsequently falls in value, then the bank’s money can lose value. But that wouldn’t be just ‘asset inflation’, but generalized inflation.

    Critics of the RBD have a long history of stating it incorrectly. They often say that if banks only make loans for ‘productive’ (not speculative) purposes, then the money supply will (allegedly) move in step with real output of goods. This version of the RBD is not defensible, and this is the version that has been attacked by Thornton, Ricardo, Mints, etc.

    The backing version asserts that what matters is that the money supply moves in step with the assets backing that money. That’s the defensible version of the RBD.

    • #31 by Dinero on July 29, 2013 - 7:02 pm

      In the Real Bills Doctrine the collateral is an invoice with 60 days maturity. The old word for invoice was Bill and the Real part of the phrase meant its good quality of viabilaty. The idea was that a bank would have no future problems resulting from issuing bank notes in a loan to a merchant who offered a credible invoice as collateral.

      • #32 by Dinero on July 29, 2013 - 7:30 pm

        a 60 day loan on an 60 day Invoice

      • #33 by Mike Sproul on July 29, 2013 - 7:49 pm

        Dinero:

        That’s the way the RBD is usually stated by its critics. Historically, the advocates of the RBD usually said that money should be issued only for “solid” short-term assets, including things like government bonds in addition to commercial bills. The RBD was developed by practical bankers over centuries of experience. They found by trail and error that the RBD was the best rule to follow for a bank that wants to stay profitable.

        Three key features of the RBD are that money should be issued in exchange for assets that are (1) solid, (2) short-term, and (3) based on real transactions. Consider each in turn:
        (1) Solid: Obviously, a bank that issues $100 of its money must get assets worth at least $100 in return. Those assets should be low risk, to minimize the chance that the bank will become insolvent and be unable to cover the money it has issued.
        (2) Short-term: This prevents maturity mismatching, thus avoiding bank runs. A bank’s notes were usually redeemable on demand, but during bank runs, banks would exercise their option to delay payment for 60 days. If the bank’s assets are also payable in 60 days, then the bank will be able to meet its note-redemption obligations.
        (3) Based on real transactions: This was a way to assure that the money supply would move in step with the needs of business. When carpenters, farmers, etc. are busy and in need of cash, they will automatically bring their commercial bills to the bank in exchange for the bank’s notes. When business slows, they will bring the notes back to the bank to pay off the bills. If the banks did not follow this rule, and issued notes in slack periods when notes weren’t wanted, then the banks would face the inconvenience of having their notes return to them the day after they were issued.

  7. #34 by Dinero on July 29, 2013 - 7:38 pm

    so lets say the merchant was a carpenter who had not yet produced the product in question. The money supply would be inflated over the amount of goods in circulation for a maximum of 60 days.
    Then the equilibrium would be restored. But macroeconomics was not the concirn of the instigators of the Real Bills doctrine, only the reputation of the bank’s currency.

  8. #35 by Dinero on July 29, 2013 - 8:17 pm

    The Real Bills Doctrine is the original buisiness model of the Bank of England. The significant point is that the value of the currency issued is fundamentally arrived at by the goods and services created by the borowers. Then it was invoices and now, credit is more widespread, and expectations of salaries take the place of invoices, and in the contemporary system there is an extra back up in the independent colateral posted, such as houses and land ,
    . But this addition to the loan contract is a back up in case the the credit contract is defaulted, which of course most of the time it is not, and so is a distraction in the understanding of the nature of credit.

  9. #36 by Mike Sproul on July 29, 2013 - 9:08 pm

    “The money supply would be inflated over the amount of goods in circulation for a maximum of 60 days. Then the equilibrium would be restored.”

    That’s still looking at the RBD through the eyes of its critics. Let’s say there are 20 farmers in some town. Their busy season has just started and they need more cash. One farmer (the most desperate for cash) will take a commercial bill worth $300 down to the bank, and he’ll get $300 in notes in return. That $300 will change hands several times in the next few weeks, and thus might serve the cash needs of all 20 farmers. Once the busy season is over, that one farmer brings $300 of notes back to the bank to pay off the bill.

    Notice that the money supply has not inflated over the amount of goods. It has simply responded to the needs of business. There is no restoration of equilibrium because the town never left equilibrium in the first place. And it is not the goods and services created by the farmers that determines the value of the bank’s notes; it is only the assets of the note-issuing bank that matters.

    • #37 by Unlearningecon on July 30, 2013 - 5:50 pm

      So what would cause inflation in this story?

  10. #38 by Dinero on July 29, 2013 - 9:20 pm

    – Mike
    You just stated that the farmers contract has not been settled . So therfore the circulating credit is infact above the amount of goods in circulation.. I don’t see why it is a sticking point with you. If that was not the case then there would be no credit in the first place and there would only be a barter economy, and the discusssion would be mute

    • #39 by Dinero on July 29, 2013 - 9:32 pm

      Mike,

      you say the payments ,created by the goods and services, by the farmers are not the assets of the bank and that which is a contradiction in terms.

    • #40 by Mike Sproul on July 30, 2013 - 10:22 pm

      Unlearning econ:

      Inflation is caused by loss of backing. So if the bank issued $300 of its notes, while getting a bill worth only $200 in exchange, then the bank has lost assets. If the loss is enough to reduce the bank’s net worth below zero, the bank’s notes will lose value.

  11. #41 by Dinero on July 29, 2013 - 9:43 pm

    >Mike

    the goods and services of its borrrowers are the assets of a bank. There is no other source.

    • #42 by Mike Sproul on July 30, 2013 - 12:27 am

      Dinero:

      Maybe the farmers have to pay workers and suppliers before the wheat is harvested, and maybe the farmers sell the wheat before it is harvested. Any number of things might make people require more cash before contracts are settled. So the farmers have a crop in the ground, which is their asset. One farmer borrows against his own asset to get more cash. In effect, the bank just coined his crop into money. That new cash can be spent and lent among the other farmers, thus providing all the cash they need.

      The new cash would not be issued unless it was needed, so the amount of cash does not exceed the needs of business. If it did, the excess cash would reflux to the issuing bank.

      • #43 by Dinero on July 30, 2013 - 10:35 am

        Mike I agree with you on the particular point that the ratio of money to goods analysis is not in fact a correct way of analysing the monatary system.
        However it is important that finally the subject of the bill of exchange is actually produced, that the invoice is paid and that the bank credit is repaid.
        Some background to the RBD is that in the 18th century buisnessmen were allready exchanging bills and using them as money. So the RBD can be seen as formalising and underwriting a system that was allready operating.

  12. #44 by Aman Austrian on July 29, 2013 - 10:47 pm

    Sproul said: “Historically, the advocates of the RBD usually said that money should be issued only for “solid” short-term assets, including things like government bonds in addition to commercial bills.”

    Which proponents of RBD claimed that solid short-term assets included government bonds ?

    It is true that this is what in practice was done and that some part of the central bank portfolio consisted of a limited amount (limited by law, in terms of its proportion) of government bonds, often to give the newly established bank credibility.

    However the main object was commercial bills, precisely because of their liquidity when issued in accordance with seasonal variations in demand.

    Dinero: “The old word for invoice was Bill and the Real part of the phrase meant its good quality of viabilaty.”

    “Real” is just a derogatory term invented by Lloyd Mints. The were traditionally simple called bills of exchange, and the ones that were solid and accepted were those that were issued according to the definition of a bill of exchange.

    Dinero: “and in the contemporary system there is an extra back up in the independent colateral posted, such as houses and land ,”

    Not at all, the traditional RBD is actually the antithesis of lending against houses and land which are not bills of exchange.
    They explicitly outlawed the discounting of mortgages and etc in most European banking and central banking laws from the very beginning. Precisely because they believed it led to bubbles and crises.

    Furthermore, the monetization of houses etc under todays monetary system actually works to crowd out traditional loans to the industrial sector.

    • #45 by Dinero on July 29, 2013 - 11:21 pm

      well of course tangeble assets as collateral is the antithesis of RBD ,that was the distinction I just made. In RBD the asset IS the bill of exchange. The banker acts as a trusted intermediary and converts the invoice into a tradable currency due to the fact that they discount the invoices and thus have a margin to cover the possibility of occasional defaults

  13. #46 by Mike Sproul on July 30, 2013 - 12:18 am

    Aman Austrian:

    “Which proponents of RBD claimed that solid short-term assets included government bonds ?”

    Here are a few that I can come up with on short notice:

    ““The notes of the Bank of England, “the committee observes, “are principally issued in advances to government for ”the public service”…and in advances to the merchants upon the discount of their bills.” (Charles Bosanquet, Practical Observations, p. 53.)”

    See also in Bosanquet, p. 78, the line where Mr. Stuckey explains that his bank uses its exchequer bills to regulate its quantity of notes.

    Then there’s John Law, who advocated backing notes with land.

    Then there were the American colonies, which backed their notes mainly with taxes receivable, which is a less roundabout way of backing their notes with government bonds. Ben Franklin wrote about this, so I suppose you could say that he advocated a form of the RBD where the assets backing notes included government bonds.

    In any case, as you say, note issuing banks normally held government bonds in practice.

  14. #47 by ziddy on July 30, 2013 - 3:43 am

    • #48 by Unlearningecon on July 30, 2013 - 5:43 pm

      Yeah I had a look over those when I was googling around. Interesting, but of course I see no need to invoke mainstream models.

  15. #49 by Unlearningecon on July 30, 2013 - 5:28 pm

    @Mike

    Thanks for stopping by!

    I am unable to grasp the distinction between what I said and what you said about loans for ‘speculative’ purposes. Are you merely suggesting that the assets must exist first, before the loan takes place?

    In any case, as you say, note issuing banks normally held government bonds in practice.

    Surely this creates a circularity problem, though: government bonds are backed by currency, and currency is backed by government bonds?

  16. #50 by Dinero on July 30, 2013 - 9:04 pm

    >UE
    Thre is no such thing as a problem of circularity. Circular flows of money are the basis of economics.Especially the credit monetary system. A person gives an transferable IOU in exchange for some goods and eventually they have to honour it. Credit is circular by its very nature. Government bonds are not backed by currency , they are backed by the potential for the bonds to garner currency.

  17. #51 by Mike Sproul on July 30, 2013 - 10:51 pm

    Unlearningecon:

    When you said this: “if loans are issued for ‘speculation’, but with no expansion of goods or services, it will cause asset inflation.”, I presumed you were thinking like a quantity theorist, that MV=PQ, and that if M rises while Q does not, then P must rise. The RBD response to that is that P does not depend on the ratio of M to Q, but on how much backing the issuing bank holds for each bank note it issues.

    The circularity problem concerns what I call “inflationary feedback”. I explain it in my paper entitled “There’s No Such Thing as Fiat Money”, easy to google.

    It is in fact possible to back a dollar with another dollar, so long as there are at least some real assets held as backing. Start with a bank that has issued 100 bank notes (‘dollars’) backed by assets worth 100 oz of silver. $1=1 oz, no circularity (yet). Then let the bank issue another $200 of notes in exchange for assets worth 200 oz. The bank now has 300 oz of assets backing $300 of notes, so it’s still true that $1=1 oz. So far, the RBD is right and the quantity theory is wrong.

    But now suppose the bank issues another $500 of notes while getting a bond worth $500 in return. Note that the bond is denominated in dollars, so now the bank is backing a dollar with another dollar. (but it also has 300 oz of real assets.) Now we have a problem. If the bank lost assets, the RBD tells us that its dollars will lose value, but then the bonds, being denominated in dollars, will lose value. This reduces backing even more, so the dollars fall still more, etc. That’s feedback.

    Where does feedback stop? Let E=the value of a dollar (oz/$), which is initially 1 oz/$. Setting assets=liabilities yields

    300+500E=800E

    (Assets=300 oz plus bonds worth 500E oz. Liabilities=notes worth 800E oz.)

    Solving, we get E=1 oz/$.

    But what if the bank is robbed of 80 oz of assets (10% of its assets)? The equation becomes

    220+500E=800E, or E=.73 oz.

    The 10% loss of assets caused 27% inflation, because of the feedback effect.

    • #52 by Dinero on July 31, 2013 - 12:57 pm

      Mike your thesis doesnt include a mechanism by which the assets could affect the value of the bank notes. The truth is inflation can only be cause by spending and people’s only knowledge of bank notes is their scarcity value ,the demand for them, and the cost of obtaining them.

      • #53 by Mike Sproul on July 31, 2013 - 4:15 pm

        Dinero:

        The mechanism is convertibility and reflux, as explained in #15 above.

    • #54 by Unlearningecon on July 31, 2013 - 5:35 pm

      Sorry to keep repeating a similar question but I’m just trying to get my head round this:

      You say the fed backs up its assets by pegging them to a CPI basket. This confuses me, as surely the CPI basket is not actually an ‘asset’ which the fed can exchange for notes if needs be? I’m tending to agree with some commenters that I can only see the RBD being truly correct if there is a solid asset backing things. Dinero’s point that the assets of the bank’s borrowers are ultimately what backs money also seems intuitive, do you disagree with this entirely?

      • #55 by Mike Sproul on August 1, 2013 - 1:23 am

        The CPI basket is not the fed’s asset. The fed’s assets are the fed’s gold and the fed’s bonds.The fed uses those assets to maintain the dollar’s peg to some CPI basket. It used to use those assets to maintain the dollar’s peg to 1/35 oz of gold.

        About Dinero’s point: Money issued by some bank is backed by the bank’s assets. Some of those assets are IOU’s promising $100 payable in 1 year, and most of those IOU’s include a lien on the borrower’s house that allows the bank to seize $100 worth of the house if the borrower fails to pay.

  18. #56 by Dinero on July 31, 2013 - 5:32 pm

    >Mike a few observations
    a)you seem to be overly concirned with the quantity of money in issue rather than the interest rate
    b)silver is not an asset of the bank, colateral for loans maybe so your balance sheet is mixing up colateral and assets
    c)how would the notes backed by silver get into circulation.
    d)in your example the people wanting to hold silver coins would still want them after the bond sale that they of course would not be aware of.
    e)bank notes are not convertable and silver is not held by banks and is not part of the credit process

    • #57 by Mike Sproul on August 1, 2013 - 1:31 am

      Dinero:
      a) The interest rate determines the present value of the bank’s assets, and the assets determine the value of the bank’s money.
      b) If the bank is in possession of silver, the silver is the bank’s asset. A $100 IOU held by the bank might include a lien on the borrower’s house. The IOU is the asset, and the house is the collateral, so if the borrower fails to repay the IOU, the bank takes the house, and the house becomes the bank’s asset.
      c) The bank prints up $100 in notes and uses them to buy $100 worth of silver.
      d) The point is that bond convertibility can make silver convertibility unnecessary.
      e) Modern private banks are prohibited from issuing bank notes, but in the 1800’s, before the prohibition, banks held silver (or gold) and their notes were convertible into that silver or gold. As soon as silver or notes were lent they became part of the credit process.

  19. #58 by Dinero on August 1, 2013 - 9:22 am

    The reason a borrower issues a bond is in order to buy goods and services, and the mechanism by which bonds are honoured is that the borrower produces goods and services.
    Currrency is given value by bonds, bonds are given value by goods and services, and so therfore , without a doubt, currency is given its value by the goods and services produced by the borrower.

  20. #59 by Boatwright on August 1, 2013 - 1:01 pm

    After following the debate on these pages, I have found it helpful to leave aside the issues of convertibility, etc. and go back to the original idea as proposed by the BoE and others over two centuries ago. Simply stated we see the seductive power of a simple idea:

    If banks only issue money for assets of matching value, the money will maintain its value no matter how much is issued.

    History has shown, time and again, from the days of John Law, the South Sea Bubble, and the Tulip Mania, to today’s CDO’s, etc., that banks, in spite of repeated negative experiences, still seem to wish the RBD true. The idea is VERY seductive. Banks, including central banks, regularly and predictably lose their way, fueling unhealthy increases in the supply of money chasing after asset bubbles.

    We also need to leave the debate over what is “real” money behind, admit that money is a social construct, and that just about anything the human mind can think up — from wampum and poker chips, to the most arcane financial instruments — all can and do function as money.

    The RBD is seductive. It is also wrong, There is no simple way to distinguish between money created against “real bills” and money created for speculation. No one can completely and accurately see the future. ALL human economic activity is more or less speculative.

    • #60 by Mike Sproul on August 1, 2013 - 5:19 pm

      Boatwright (#55)

      It doesn’t matter if the asset is ‘real’ or not. A bank can issue $100 of new notes to a farmer or to a gambler, and as long as their IOU’s are backed by adequate collateral, the bank’s assets will move in step with the issuance of money and the money will hold its value.

      When the money issued by John Law et. al. lost value, it was because the assets backing the money lost value, or else new money was issued in exchange for assets of inadequate value.

      Also, I’m going to the mountains until sunday—out of touch. Thanks to everyone for an interesting discussion!

  21. #61 by Boatwright on August 1, 2013 - 10:54 pm

    Mike Sproul (#56)

    “When the money issued by John Law et. al. lost value, it was because the assets backing the money lost value, or else new money was issued in exchange for assets of inadequate value.”

    You make my point for me. The assertion of RBD proponents is that as long as the issuance of new money is limited to the value of what you describe as “adequate collateral”, “the money will hold its value”. The problem with the RBD is, In order for this to be true, the valuation of assets must ALWAYS be known and be sufficient to provide said collateral.

    When faced with criticism that the valuation of assets can be speculative and uncertain, proponents of the RBD will say, no problem, that in order for this method of money creation to work in practice, all we have to do is make careful distinctions between sound or speculative collateral.

    My simple assertion is that it is impossible to distinguish between correctly valued collateral and speculative collateral. Not only it doesn’t matter whether an asset is real or not, but with the fundamental impossibility of knowing the future, it is and always will be impossible to tell the difference between adequate collateral and moonbeams.

    You have also chosen to ignore the reality of non-convertible money as it exists in today’s economy. When I was a kid a long time ago, bills were “silver certificates” and coins were valued by their metal content. As I said, that was a long time ago and a large and complex economy has been functioning with what you call fiat money ever since. Not always without crises, however the same thing can be said about the many monetary crises under the gold-standard or the Mississippi Bubble real bills of John Law.

    • #62 by Unlearningecon on August 2, 2013 - 5:12 pm

      I am also confused about the issue of causality here. If an asset declines in value, why does that happen? Is it simply because the bank issued loans that did not correspond to the needs of the economy?

      • #63 by Boatwright on August 2, 2013 - 6:21 pm

        “If an asset declines in value, why does that happen? ”

        Any of a very large number of reasons, including excessive, leveraged speculation financed by the unwise loans you mention.

        But also:

        Tastes and fashions change.

        A new mine is discovered.

        An unseen defect is revealed.

        Etc., etc..

        All of which are often unpredictable and therefore create a fundamental flaw in the foundations of the RBD. For the RDB to be valid, bankers must be clairvoyant.

        It is obvious that prudent bankers, with intimate knowledge of the soundness of their collateral, are more likely to collect on their notes. However, bankers often lose their way, and to say that a universally applied RBD guarantees sound money is a foolish overreach.

      • #64 by Mike Sproul on August 6, 2013 - 7:39 pm

        Nothing about the RBD says that the assets against which money was issued will hold their value forever. The RBD says that IF money is issued for assets of adequate value, then issuing new money will not cause inflation. The RBD also says that IF those assets lose value, then the money issued against those assets will lose value.

        Money has value for the same reason that stocks and bonds have value.

      • #65 by Boatwright on August 6, 2013 - 10:32 pm

        Mike

        I’m a little unclear as to what you mean by “forever”. In the case of the collapse of a speculative bubble forever can be very brief.

        I seem to remember confident predictions of those fueling the last real estate bubble, that it was IMPOSSIBLE for real estate values to collapse everywhere at the same time, because such a thing had never happened in the past. This view defined what was said to be prudent money creation, when in fact what was happening was a huge inflation, and then came 2008.

        I have to say that you are making a distinction without a real difference here. Please explain how one tells the difference between “assets of adequate value” and assets who’s value has been inflated by speculation. (It is of course easy to do this looking backward. I challenge anyone to do it reliably while living in the present.)

      • #66 by Mike Sproul on August 6, 2013 - 10:57 pm

        Boatwright:

        The RBD says that if a bank issues 100 bank notes in exchange for 100 oz of silver, then each note will be worth 1 oz. If silver loses value relative to apples, then the notes will lose value too. The issuing bank might lend 80 oz of its silver to someone who buys a house with it. A smart banker will insist that the house be worth 120 oz or more, in case the price of the house drops. If the house should drop to 79 oz., then the banker has lost 1 oz on the loan, and he must either take the loss out of his own capital or else his notes will each lose 1/80th of their value.

  22. #67 by Boatwright on August 7, 2013 - 1:14 am

    Mike,

    I understand the principle of RBD. It rests on the claim that “if money is issued for assets of adequate value, then issuing new money will not cause inflation.”. This is a tautology.

    Please answer the question: As business proceeds, how do bankers, lacking perfect knowledge and clairvoyance, distinguish between “adequate value” and values inflated by irrational exuberance?

    History has shown, time after time, that bankers will believe that they are creating money with sound assets as collateral, when in fact they are just as susceptible to the follies of bubbles as anyone.

    • #68 by Mike Sproul on August 7, 2013 - 3:13 am

      Boatwright:

      Bankers are better at identifying ‘adequate value’ than most people, or they wouldn’t be bankers. But of course they make mistakes, and when they do, they lose assets and there will be downward pressure on the value of their bank notes.

      • #69 by Boatwright on August 7, 2013 - 4:19 am

        Mike,

        What then is the meaning of your assertion that banks following the RBD cannot cause inflation, if you then say that “of course they make mistakes” that will cause inflation.

        Which by the way is precisely the point I have been laboring to make. The RBD, when examined, is saying nothing more than prudent bankers who know their customers are more likely to collect on the notes they issue. It can never be more than that, and it is certainly not a sure-fire formula for sound money.

        I do agree, by the way, that the value of money is largely determined by the value of the real things for which it can be exchanged. Money issued is given its fundamental value by the goods and services produced. It is hellishly difficult, however to find a clear divide between that value and the functional value that comes from the manipulation of the money itself.

      • #70 by Mike Sproul on August 7, 2013 - 5:51 pm

        Boatwright #69

        The meaning is that IF new notes are issued for assets of adequate value, then the notes will hold their value, but if notes are issued for assets of inadequate value, or if those assets subsequently lose value, then the bank’s notes will lose value. The same is true of any financial security. If a firm issues new bonds in exchange for assets worth 100 oz of silver, then those bonds will be worth 100 oz. But if those assets are worth only 99 oz, or if they subsequently fall to 99 oz, then the bonds will lose value since they have less backing.

        Speaking of tautologies: “the value of money is largely determined by the value of the real things for which it can be exchanged. Money issued is given its fundamental value by the goods and services produced. “

  23. #71 by Boatwright on August 7, 2013 - 1:33 pm

    Reflecting on the course of this debate, I would like to propose that the RBD is a useful guide for prudent banking. As a theory of money creation, however, it has its limits. In many ways it points to endogenous theory, and it makes sense to say that it is perhaps a subset of that theory.

    Too many economists are prone to look for simple linear, reductionist explanations, when what is actually happening is multi-variable, chaotic, non-equilibristic, all too human complexity.

    Searching for direction, the work of Steve Keen comes to mind.

  24. #72 by Dinero on August 7, 2013 - 5:48 pm

    >Mike

    you aknowledge bonds are assets , and so silver just confuses the issue . People trade in order to exchange goods and services. Bank notes are a proxy for this and silver is also a proxy for this. Therefore valuing bank notes in ounces of silver tells us nothing about the value of money.

    Or are you presenting your take on The Real bills Doctrine as an Historical account rather than an academic description of credit and banking.

  25. #73 by Dinero on August 7, 2013 - 5:50 pm

    In Banking there is Capital, Assets, liabilaties and collateral. In this discussion all three are being confused and used interchangably. I think it would be useful to recognise that assets are bonds, tangeble things like houses and land are collateral, liabilaties are deposits and, capital is the difference between the two or cash from shareholders.

    • #74 by Mike Sproul on August 7, 2013 - 6:15 pm

      Valuing things in terms of ounces of silver is just a convenient way of denominating values. Silver is an actual good, in addition to being a useful proxy for the exchange of apples for oranges.

      We can then decide that $1=1 oz, and at this point the RBD tells us that new dollars should only be issued in exchange for various assets that are worth at least 1 oz. of silver.
      “In that maxim, simple as it is, I verily believe, there is a nearer approach to truth, and a more profound view of the principles which govern circulation, than
      in any rule on the subject which since that time has been promulgated.”
      (Fullarton, 1844, p. 207)

      • #75 by Dinero on August 7, 2013 - 6:27 pm

        But when the borrower promises to return the issue of 1 note by returning 1 note you have have just issued a note for something that has not been valued at 1oz silver

      • #76 by Mike Sproul on August 7, 2013 - 6:42 pm

        Dinero:

        As long as the bank holds some real assets, it can issue a new dollar in exchange for a promise to repay a dollar. By analogy: Suppose shares of GM stock are backed by GM’s assets, which consist mostly of buildings. Suppose 1GM=$60. GM can issue 1 million new shares of GM in exchange for a building worth $60 mil, and everything will be fine. GM shares will hold their value because GM issued its new shares in accordance with the RBD.

        But now let GM issue 1 new share, and in exchange GM gets a call option on GM stock, with a strike of zero and no expiration. The share price will be unaffected by this transaction, and GM has just backed one of its shares with something denominated in GM shares.

    • #77 by Dinero on August 7, 2013 - 6:17 pm

      that is four things

      and capital is made up from the difference between assets and liabilities, and also includes cash from shareholders.

  26. #78 by Dinero on August 7, 2013 - 7:06 pm

    >Mike

    The GM shares will not hold there value as the market cap allready included the building. So they would have diluted the share pool and the hence the value of an individual share .

    But when the borrower promises to return the issue of 1 note by returning 1 note you have just issued a note for something that has not been valued at 1oz silver. So can you see the value of the note issued is the things that the borrower does to repay the loan.

    • #79 by Mike Sproul on August 7, 2013 - 10:46 pm

      Dinero #78:

      “GM shares will not hold there value as the market cap allready included the building.”

      No, GM issued 1 million NEW shares, for which the public paid it $60 million. GM then spent the $60 million on a NEW building worth $60 million.

      • #80 by Dinero on August 8, 2013 - 10:17 am

        Ok got that. but in the second part GM swaps shares for a call option. For the period while those shares are in circulation the share pool is diluted and the exchange value reduced, as with Bank notes.

      • #81 by Mike Sproul on August 8, 2013 - 4:36 pm

        Dinero #78:
        No, the new share is worth $60, and the call option is worth $60. GM issues the NEW share and gets the NEW call option, so the backing per share is unchanged.

  27. #82 by Dinero on August 7, 2013 - 8:29 pm

    > Mike

    Consider what happens if the borrower spends the notes and then does nothing and then defaults on the loan. The amount of notes in circulation will be permanently inflated and devalued. You say this can be reversed by the bank selling bonds, but that is not the case. If all the loans are repaid whilst the bonds are in the possession of the bank then the result is no notes in circulation. But if a bond has been sold then the possessor of that bond will receive a quantity of notes and those notes will remain permanently in circulation with no way of them being retired by the bank.
    This illustrates that the value of the notes must be retained by the bonds being repais and establish by what goods and services of the borrower the market deems appropriate to exchange for the notes.

    • #83 by Mike Sproul on August 7, 2013 - 10:42 pm

      Dinero#79

      “You say this can be reversed by the bank selling bonds”

      No, if the bank sells $100 of bonds for $100 of its own notes (which it presumably retires), then the bank loses $100 of its assets while it also loses $100 of its liabilities, and none of the ‘lost’ loan is recovered.

      • #84 by Dinero on August 8, 2013 - 10:07 am

        and therefore you can’t maintain the value of the notes in circulation if a default takes place

      • #85 by Mike Sproul on August 8, 2013 - 4:38 pm

        Dinero #84:

        Correct.

  28. #86 by Dinero on August 8, 2013 - 6:33 pm

    Therefore to maintain the value of notes in circulation defaults must not occur .
    Therefore borrowers must obtain notes and how do they do this ? –
    Their goods and services are exchanged for notes.
    And so to maintain the value of notes in circulation goods and services must be produced.
    Which answers Unlearnigecon’s question.

    • #87 by Boatwright on August 9, 2013 - 3:43 pm

      Dinero,

      Thanks for your Socratic efforts educating on the details of bank balance sheets.

      One of the things the Gold Bugs (& silver too) can never seem to grasp is that banks in fact look for “assets” AFTER they create money. Banks expect (without the defaults as in the several examples you outline) notes to be retired as the result of newly created goods and services financed by the original loan. But importantly, the bank’s asset on the day the note is issued – the offsetting liability of the customer – is often no more than a shoeshine and a smile.

      In banking since the days of Venice, there has never been the hard, one to one relationship between the asset and the note, whether it be a real bill or an ounce of metal, that hard money theorists believe will make the monetary world perfect. Historically the RBD seems to have grown out of the need to guard against the excesses of the John Laws of the world. History has shown, however, that the RBD cannot do this simply because human knowledge and ability to see the future will always be imperfect.