Real bills doctrine

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The real bills doctrine says that as long as bankers lend to businessmen only against the security (collateral) of short-term 30-, 60-, or 90-day commercial paper representing claims to real goods in the process of production, the loans will be just sufficient to finance the production of goods.^[1][2] The doctrine seeks to have real output determine its own means of purchase without affecting prices. Under the real bills doctrine, there is only one policy role for the central bank: lending commercial banks the necessary reserves against real customer bills, which the banks offer as collateral. The term "real bills doctrine" was coined by Lloyd Mints in his 1945 book, A History of Banking Theory. The doctrine was previously known as "the commercial loan theory of banking".

Moreover, as bank loans are granted to businessmen in the form either of new bank notes or of additions to their checking deposits, which deposits constitute the main component of the money stock, the doctrine assures that the volume of money created will be just enough to allow purchasers to buy the finished goods off the market as final product without affecting prices. From their sales receipts, businessmen then pay off their real bills bank loans. Banks retire the returned money from circulation until the next batch of goods need financing.

The doctrine has roots in some statements of Adam Smith.^[3] John Law (1671–1729) in his Money and Trade Considered: With a Proposal for Supplying a Nation with Money (1705) originated the basic idea of the real bills doctrine, the concept of an "output-governed currency secured to real property and responding to the needs of trade". Law sought to limit monetary expansion and maintain price stability, by using land as a measure of, and collateral for, real activity.^[4] Smith then substituted short-term self-liquidating commercial paper for Law's production proxy, land, and so the real bills doctrine was born.

The British banker, parliamentarian, philanthropist, anti-slavery activist, and monetary theorist Henry Thornton (1760–1815) was an early critic of the real bills doctrine. He noted one of the doctrine's three main flaws, namely that by linking money not to real output as the original intention was, but to the price times quantity—or nominal dollar value—of real output, it set up a positive feedback loop running from price to money to price. When the monetary authority holds the market (loan) rate of interest, below the profit rate on capital, this feedback loop can generate continuing inflation.^[5]

Doctrinal historians have noted the real bills doctrine's place as one factor contributing to the instability of the U.S. money supply precipitating the Great Depression.^[6][7][8] Adhering to the doctrine's second flaw, namely that speculative activity/paper can be sharply distinguished from purely productive activity/paper (as if production motivated by uncertain expected future profits does not involve a speculative element), long-time Fed Board member Adolph C. Miller in 1929 launched his Direct Pressure initiative. It required all member banks seeking Federal Reserve discount window assistance to affirm that they had never made speculative loans, especially of the stock-market variety. No self-respecting banker seeking to borrow emergency reserves from the Fed was willing to undergo such interrogation, especially given that a "hard-boiled" Federal Reserve was unlikely to grant such aid. Instead, the banks chose to fail (and the Federal Reserve let them), which they did in large numbers, almost 9000 of them. These failures led to the 1⁄3 contraction of the money stock, which, according to Friedman and Schwartz, caused the Great Depression. The result was a decade-long fall of real output and prices, which by the needs-of-trade logic of the real bills doctrine justified shrinkage of the money stock.

Here was the doctrine's third flaw. It calls for pro-cyclical contractions and expansions of the money stock when correct stabilization policy calls for counter-cyclical ones.^[9] The doctrine fell into disuse in the late 1930s, but its legacy still influences banking policy from time to time.