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A first reply on the “backing” theory of money

Concerning Mike Sproul’s guest post on the “backing” theory of money, also known as the present-day real bills doctrine, some readers may appreciate more background, which I provide in bare-bones form here. There is more than one version of the real bills idea. Adam Smith famously wrote these words in book II, chapter 2 of the Wealth of Nations:

What a bank can with propriety advance to a merchant or undertaker of any kind, is not, either the whole capital with which he trades, or even any considerable part of that capital; but that part of it only, which he would otherwise be obliged to keep by him unemployed, and in ready money for answering occasional demands. If the paper money which the bank advances never exceeds this value, it can never exceed the value of the gold and silver, which would necessarily circulate in the country if there was no paper money; it can never exceed the quantity which the circulation of the country can easily absorb and employ.

When a bank discounts to a merchant a real bill of exchange [emphasis added] drawn by a real creditor upon a real debtor, and which, as soon as it becomes due, is really paid by that debtor; it only advances to him a part of the value which he would otherwise be obliged to keep by him unemployed, and in ready money for answering occasional demands. The payment of the bill, when it becomes due, replaces to the bank the value of what it had advanced, together with the interest. The coffers of the bank, so far as its dealings are confined to such customers, resemble a water pond, from which, though a stream is continually running out, yet another is continually running in, fully equal to that which runs out; so that, without any further care or attention, the pond keeps always equally, or very near equally full. Little or no expence can ever be necessary for replenishing the coffers of such a bank.

The University of Chicago economist Lloyd Mints criticized a number of versions of the real bills doctrine in A History of Banking Theory in Great Britain and the United States (1945), a book well known at least among economists interested in monetary thought.  (For an online treatment that draws in part from Mints, see this article by Thomas Humphrey of the Federal Reserve Bank of Richmond.)

It seemed as if Mints had buried the real bills doctrine. In 1982, though, there appeared an article by Thomas Sargent and Neil Wallace called “The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration.” Their article spurred much debate and imitation. In a reply article (requires subscription to see the whole thing), the Canadian monetary economist David Laidler criticized Sargent and Wallace for implying a continuity of their views with older views that Laidler argued was not the case—terming their view the real bills doctrine was a misnomer, he claimed.

Mike Sproul has been thinking about the issues involved for a long time now. He has material on his Web site about the real bills doctrine, which he did not mention in his post but I believe has cited in some comments he has made on old posts on this site.

This is an extensive throat clearing preliminary to getting into my questions and comments, to which Mike will reply when he has the time.

  1. Question: Mike, to give me and other readers a better sense of where you fit in the long real bills tradition, please explain (a) whether the real bills doctrine as you define it is similar to the way Sargent and Wallace define it and (b)whether you think it was a misnomer for Sargent and Wallace to call their idea a version of the real bills doctrine.
  2. Question: Is the real bills doctrine as you define it a theory that is as generally applicable as the quantity theory claims to be, or is it a theory that applies to some kinds of monetary institutions and circumstances and not to others? (See my comment just below for a clarification.)
  3. Comment: In wartime many occupying armies have issued a kind of currency, usually forced into circulation at par with the existing currency on the official market. The aim of this currency was frankly to enable the occupier an easy means to commandeer goods. The currency was not readily exchangeable into any foreign currency, including the home currency of the occupying army, and there were no reserve assets of recognized international value held against it. Does the real bills doctrine as you define it apply to analysis of these currencies, or is it confined to more normal historical cases?
  4. Comment: To me, saying that acceptance of currency for tax payments provides a kind of backing is metaphorical rather than literal. When I think of backing I think of convertibility at a set rate of exchange. A currency that is supposedly backed by certain assets but cannot be exchanged for any of them at a set rate is not backed in the way I believe most people think of the term, or in the way that issuers backed their currencies under most types of gold standard.
  5. Comment: In your example of the playing card money, the retort from the quantity theory side is that inflation does not occur when the money supply triples because the velocity of money (inversely related to the demand to hold money) changes. Other things are not equal, in other words.
  6. Comment: In the 1990s I heard this aphorism about central banks in poorer countries (which, remember, had had a terrible decade from 1982-1992): “The assets are garbage; the liabilities, everyone believes in.” For a floating currency during normal, noncrisis periods, as long as the central bank’s liabilities are limited in quantity, I don’t see what difference it makes whether the assets are Swiss government bonds or dodgy loans purchased from domestic banks. During a crisis it matters, because Swiss government bonds are easy to sell in quantity without having to offer fire-sale discounts and dodgy domestic loans are not. If backing matters so much, though, shouldn't we see less marked a difference between crisis and noncrisis periods in the value of the currency, since the assets on the day before the crisis and the assets the day the crisis begins are the same?

As I mentioned in a recent post, online discussions do not necessarily change the minds of the participants, nor should they, necessarily. I do think, however, that we can clarify some of the issues involved in the topic, and I look forward to Mike's reply. I have also invited Mike, if he wishes, to summarize the main points raised in the comments on his first post and to offer his replies, separately from what he may have to say about this post.