The Real Bills Doctrine: A Short Response

real bills doctrine, larry white, wicksell, mints
Beating a Dead Horse by PotatoeHuman, modified (

real bills doctrine, larry white, wicksell, mintsJuan Ramón Rallo has thoughtfully replied (in English) to my earlier Alt-M post that discussed two versions of the real-bills doctrine and what I took to be his defense of a prudent-banking version of the doctrine.  Here I offer a few comments on his reply.

  1. One topic under discussion is the common banking practice of borrowing short and lending long (aka maturity transformation).  The practice is remunerative to the bank when short-term interest rates are lower than long rates, but it exposes the bank to risks that I previously discussed.  

In his latest piece Rallo suggests a categorical condemnation of the practice: “The banks that transform the maturities of their assets and liabilities are causing a discoordination between savers and investors.  They are promising savers to redeem their liabilities much sooner than the moment when their assets will be paid by investors, i.e., they are promising savers the availability of some future goods before they are provided by the investors’ projects they are financing.”  In my view, by contrast, whether there is a “discoordination” does not depend so much on the promises or contract terms, or what we may call the de jure maturities, as on the de facto maturities.

As Rallo recognizes, holders of short-term liabilities have the option to roll them over.  This is especially obvious for demand deposits that remain in the bank for longer than one instant.  A one-year certificate of deposit that is renewed at an unchanged interest rate can be considered de facto a two-year (or longer, if renewed again) deposit.  This means that a profit-seeking bank faces the challenge of estimating the distribution of actual times-to-withdrawal-or-repricing of its liabilities, which are longer than the de jure maturities.

On the asset side of the balance sheet a similar consideration arises.  When loan contracts allow customers to prepay without penalty (as US home mortgages typically do), the bank must estimate the distribution of times-to-repayment under various interest rate scenarios, which are shorter than the de jure maturities, to properly estimate its risk and reward from maturity transformation.  If the bank’s estimates are approximately correct, then there is coordination all along, despite the de jure maturity transformation.  When depositors roll over their deposits and prepay loans in the expected frequencies, the bank’s plans are fulfilled because it has made good estimates.  This is not a case (contrary to what Rallo seems to suggest) in which the bank is luckily saved ex post by a favorable exogenous change in depositor preferences.

  1. To motivate the prudent-banking real-bills doctrine, Rallo asks: “What is the proper kind of asset … that allows banks to preserve their liquidity while issuing demand liabilities?”

What any individual bank needs to hold to maintain its liquidity in the face of stochastic adverse clearings, in addition of course to reserves of outside money, is not one specific type of earning asset, but a portfolio that includes enough liquid assets, meaning assets that can be sold on short notice with negligible losses from bid-ask spreads.  Stochastic clearings are not a problem for the banking system as a whole, because banks with unexpectedly large adverse clearings (which leave them with smaller reserves than desired) can sell assets to or borrow from banks that experience positive clearings and reserves greater than desired.

Historical banking systems with private note-issue saw seasonal variations in the public’s holding of banknotes.  But these variations posed no liquidity problem in a free banking system where, as in 19th century Canada, notes were withdrawn from and redeposited into demand deposit accounts so that total demandable bank liabilities were steady.  Total reserves were not threatened by such a switch in the form of demandable bank liabilities.

The system as a whole would face a liquidity challenge if there were (say) a predictable seasonal decline in the public’s desired holdings of outside money, leading to mass cashing of demandable bank liabilities, across all banks.  (I don’t know any historical examples of seasonal variations of this sort.)  In such a case a bank having loans or securities that will mature in a timely manner would be safer than counting on selling longer-term assets with negligible losses at a time when many other banks will also be selling.  By not replacing the maturing loans or securities, the bank could shrink its assets simultaneously with its no-longer-wanted liabilities.  What the bank needs in such an (imagined) episode is a set of assets with the right maturities, not assets with a particular backing.

Against an unpredicted mass public attempt to convert bank liabilities into outside money — an internal drain or generalized runs on the banks — neither a portfolio of real bills due in zero to ninety days nor any other asset portfolio would obviate the system’s liquidity problem.  Thus I cannot see the relevance of Rallo’s statement that an individual who holds a demand liability against a bank that in turn holds real-bills assets only, or an individual who holds a real bill directly, holds a claim “whose realization just depends on the fulfillment of the strongest present demands for consumption goods.”  Planned realization in ninety days does not provide outside money today.  Even a bank with a portfolio entirely of immediately callable loans, as Rallo notes citing Mises, would face the problem that many borrowers would default on sudden calls to repay.

  1. This is something of an aside, but Rallo cites a 1936 essay by Melchior Palyi entitled “Liquidity” for its definition of liquidity. I had not seen it before. It is noteworthy that Palyi explicitly rejects free banking (“in view of the violent fluctuations of trade which it implies”) in favor of a central bank that will “set and enforce liquidity standards.”  I think that Palyi, under the influence of the money-issuing version of the real-bills doctrine, exhibits a very imperfect understanding of how free banking and central banking actually work.
  1. In his concluding section, Rallo imagines that free banking theorists might make the following argument: “free money and free banking can provide the optimal amount of prudent banking on its own, so there is no need to theorize about what prudent banking really means (i.e., there is no need to theorize about the Real Bills Doctrine and we can just stay comfortable with the free banking theory).”  In fact I agree that free banking theory needs to examine what prudent banking involves.

At a minimum, as I wrote in my previous piece, “prudence includes adequate liquidity and adequate capital.”  The claim that free banking brings about prudent banking does need specification of what prudent banking means, and what portfolio management policies prudence requires, in order to be more than the empty statement that the banks that best survive free competition are those best suited to survive.  As economic historians, we want to be able to explain which kinds of banks survive and which kinds of banking systems flourish better than others.  Unlike Rallo, however, I don’t think that a sensible account of prudent banking can give us any prescription so simple as his summary of the doctrine he wants to defend, namely that “banks should only discount real bills.”

I entirely agree with Rallo’s concluding paragraph, except for the last half-sentence.  Monetary economists do indeed need to inquire into “what kind of institutional framework” tends most strongly “to produce prudent banking and macroeconomic coordination.”  But we need not and cannot “rely on the tradition of the Real Bills Doctrine” in that undertaking.  That tradition is too fraught with misconceptions.