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.


  1. Any good effect of government deposit (investment) guarantees has to be balanced against the costs and the systemic bad effects. The FDIC is in trouble ( moneyteachers dot org/FDIC dot html ) and has cost $100+ billion from time to time above the insurance premiums which it collects from banks.

    The movie "It's a Wonderful Life" is interesting.
    In the bank run scene ( youtube dot com/watch?v=qu2uJWSZkck ) James Stewart explains to the crowd that their money isn't really in the bank, it has been lent out to build houses. This is news to them! They thought their money was safe in the bank vault, and now they are told it is gone, dependent on the bank staying in business. That is not reassuring.

    Would anyone loan money to a bank (make deposits) without the government guarantee? I wouldn't. I would find a pure vault and checking service and pay $100 per year for the service. Of course, banks might devise a private system of deposit (investment) insurance which would meet the demands of risk investors.

    I think the guarantee is absolutely necessary. It shows the primary instability of US banking and the fundamental misdirection that keeps banks going in their current form.

    There is risk if you want interest on a loan. Banks have transfered their huge risks onto the government to the extent that their FDIC premiums are not sufficient to pay for bank failures. Worse, each bank is encouraged to take excess risk both to meet political pressure and to make extra profits. Heads they win, tails we lose.

    Government is not merely intermediating, that is enabling a voluntary market which might not otherwise exist. Instead, government is subsidizing an industry where the depositers are ignorant. The depositors do not really want to "invest" their money and take risks. The bank dearly wants to make money from lending out these deposits, but does not want to bear the full costs of doing this.

    It is beside the point to discuss the type of assets needed by banks to be a safe investment company. Let "banks" be restricted to vault and checking services. Let investment companies choose investments, insurance, and redemtion policies which suit the market for informed clients.

    Everyone would get the results which they expect and there would be no bank runs or bailouts. Yes, there would be less investment through the new "bank investment companies". The availability of capital would match the preferences of depositors and investors, and government would not be a shadow investor commandeering resources to support favored industries and social planning.

  2. " so long as a bank issues its notes only in the discount of good bills,
    at not more than sixty days' date, it cannot go wrong in issuing as many
    as the public will receive from it." (Fullarton, 1845, p. 207)"

    Things to notice about this statement of the real bills doctrine:
    1) It refers to bank notes, not to other forms of money such as demand deposits.
    2) A "good bill" does not necessarily refer to bills issued on goods-in-process. It can mean a bill issued by a reliable person or institution. That's why old-time bankers who professed to adhere to this principle sometimes issued notes in exchange for government IOU's.
    3) When a bank's assets mature in 60 days, and when that bank issues notes with an optional 60-day suspension clause, then that bank will never suffer from a maturity mis-match, or the resulting bank run.
    4. Such a bank "cannot go wrong" because the bank will have received a dollar's worth of good bills for every paper dollar that it issued. The bank will have sufficient assets to cover the notes that it has issued. Real bills critics like Larry (and Mints and Wicksell) mistakenly think that the RBD aims to avoid inflation by matching the amount of money issued to the economy's output of goods. In fact the RBD avoids inflation by matching the amount of money issued to the assets of its issuer.

  3. The thing is, there need not be any worry about what are the best assets. In a milieu where anyone is free to start a bank and there is no bailing out of incompetent bankers we will soon see what works best.

    Banks operated with skill and prudence will survive and prosper and those that are run poorly will fail and become object lessons.

    There are a lot of people and many economists that think there should be "general policies" that determine how things happen and this top-down approach hampers their ability to see into the entrepreneurial underlayment that supports all business. And it's these entrepreneurs that will, through trail, error and analysis find the best way to organize their banks.

    Personally I think the RBD is bunk as it's only bills of exchange and there's nothing anymore special about bills than there is about stocks, bonds, annuities, or loan portfolios. They are all just tools in the toolbox of those in the business of providing liquidity.

    All banks will have a bundle of these things in certain proportions. Some banks will have more of one than the other while other banks have a different bundle. Why should I worry about that?

    All I need to know is how sound my bank is generally and in a situation where only sound banks are allowed to use the note clearing system (which was the case in Scotland I believe) if my bank can clear than I'm in the clear, so to speak.

  4. A predictable seasonal increase in the demand for outside money may occur in a hypothetical dollarized economy with free banking (free issue redeemable into and with dollar reserves) when vacation season begins, however if it is predictable a competitive banking system would seek financial integration to provide payment services to travelers and settle adverse clearing from foreign banks, such that it could handle the seasonal increase in the demand for outside money.

  5. Larry's comment reply in his earlier article.

    Great stuff here for the "banking-funds" constructors.

    ""Thanks, Tom. I agree with your analysis of what's correct and what's
    fallacious. But I find it clearer to call the correct
    endogenous-money-stock doctrine something other than "the real bills
    doctrine" because the linkage from an increase in real money demand to
    an inflow of money need not involve banks discounting anything at all —
    the simple Humean PSFM works in a pure coin economy. Where there is
    bank-issued money, it doesn't matter what sort of assets banks acquire
    in expanding the quantity of bank-issued money.""

    But for the money-fund constructors, a look at another alternative from the BoE.

    Seems we're much better off abandoning the endogenous money foundation and having government ensure adequate loanable funds for the economy.

Comments are closed.