RealBills/Monetary Policy and the Great Depression 11/14/08 monetary policy and the great depression



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1. The Real-Bills Doctrine

… if only “real” bills are discounted , the expansion of bank money will be in proportion to any extension in trade that may take place, or to the “needs of trade,” and … when trade contracts, bank loans will be correspondingly paid off…. I shall designate these ideas as “the real-bills doctrine.”

Lloyd Mints, A History of Banking Theory in Great Britain and the United States, p.9.

Theory. The real-bills doctrine asserts that changes in the quantity of money leave prices unchanged if money is created in the process of bank extensions of credit for the purchase of goods, that is, in the context of 19th-century institutions, when bank credit consists of real bills of exchange. Self-liquidating paper money (M) rises with goods (output, y), and falls as they are consumed and the loans are repaid. Capital goods, it must be assumed, are financed in the capital markets, that is, by the transfer of existing money balances.

An early application of the principle that increases in money collateralized by goods are not inflationary was John Law’s land bank authorized by the French government in 1720. Henry Thornton criticized Law’s theory (1705) and bank in the course of a parliamentary debate in 1811 on the Bank of England’s lending policy. The “main error of Mr. Law” was that he “considered security as every thing, and quantity as nothing. He proposed that paper money should be supplied (he did not specify in his book at what rate of interest) to as many borrowers as should think fit to apply, and should offer the security of land, estimated at two thirds of its value. This paper, though not convertible into the precious metals, could not, … Mr. Law assumed, be depreciated. It would represent … real property…. He forgot that there might be no bounds to the demand for paper; that the increasing quantity would contribute to the rise of commodities; and the rise of commodities require, and seem to justify, a still further increase” (Thornton 1802, 341-42).2

Thornton’s point that money cannot be tied to goods, that loans are governed by value, has been made formally on several occasions.3 A simple expression in terms of the equation of exchange, where money is created by loans proportionally to the expected value of goods, is

MV = Py or (aPey)V = Py or P = aVPe

The price level is undetermined. It is proportional to what borrowers and lenders think it will be. Pe might be governed by an adjustment mechanism or rationally in the context of a larger model, but in any case neither M nor P is limited by M’s supposed link to y.


Federal Reserve applications? The Fed’s commitment to the real-bills doctrine in its early years is frequently alleged (Friedman and Schwartz 1963, 193; Timberlake 2007; Humphrey 2001; Meltzer 2003, 58), and has found its way into textbooks (Mishkin 2006, 420).4 It is also claimed that the doctrine was written into the Federal Reserve Act of 1913 (Meltzer 2003, 729; Blaug 1985, 54; Green 1987; Walsh 1991). Superficial suggestions of support exist for both claims, but close looks reveal that the Act and Fed practice deviated substantially from the doctrine. Beginning with the former, Section 13 (“Powers of Federal Reserve Banks”) of the Act stated:

Upon the indorsement of any of its member banks …, any Federal reserve bank may discount notes, drafts, and bills of exchange arising out of actual commercial transactions; that is, notes, drafts, and bills of exchange issued or drawn for agricultural, industrial, or commercial purposes.

The gold standard still held. Section 13 states: “Nothing in this Act … shall be construed to repeal the parity provision” [a dollar consisting of 25.8 grains of gold, 9/10 fine] of the Gold Standard Act of 1900. Federal Reserve notes were redeemable in gold, and Section 16 imposed gold reserve requirements against its notes and deposits. Bank credit and the price level were still constrained by gold. Federal Reserve discounts of real bills do not imply the real-bills doctrine.

Claims for the real-bills doctrine in the Federal Reserve Act have been supported by references to Laurence Laughlin, Chicago economist, critic of the quantity theory, and teacher of Parker Willis, who was an aide to Congressman Carter Glass, the chief legislative force behind the Act (Timberlake 1978, 186-87; White 1983, 115-16). Laughlin argued that money properly created follows goods.

[If] loans are … a coining of property into means of payment – that they are based on goods – we see that the deposit item, thus originating, is a fair index of how much property is being moved by this modern medium of exchange. It is a medium which arises out of the transactions in goods; it grows as fast, and no faster (in normal credit) than the exchanges to be performed; it is a machine which expands exactly in proportion to the work to be done, and contracts as transactions fall off…. The perfect elasticity of the deposit currency is its most valuable – as it is at the same time its least appreciated – characteristic (1903, 119-20).

Laughlin urged an institution that would support the discount market and provide elastic money but not lead to overexpansion because it would grow out of actual transactions (1912, 23, 51, 87-89). However, as James Livingston wrote, the “response to Laughlin was swift and, despite the claims of latter-day historians and economists who want to believe that criticism of the real bills doctrine constitutes rigorous criticism of the theory behind the Federal Reserve System, overwhelmingly negative – especially as it was mustered by those economists who would figure prominently in the movement for banking reform … (1986, 147).” Piatt Andrew (1905), quoted favorably by Kemmerer (1909, 80), wrote:5

It is preposterous … to assume that credit can be issued indefinitely upon the basis of goods without any regard whatever to the quantity of available money in which it is likely from time to time to be presented for redemption…. If the banks were to undertake to create either notes or deposits to the extent of the value of all goods and property in the country, bankruptcy would be the inevitable outcome, for the ensuing rise in prices and adverse balance of trade would instigate a demand for gold for export which would sweep every remnant of specie from their reserves. Bankers can no more lend their credit in the form of deposit accounts without regard to their cash reserves than they can in the form of notes. Either course involves disaster.

It should be noted that the Fed’s authority to buy real bills, like other key features of the Federal Reserve Act (including reduced reserve requirements and support for bankers acceptances), stemmed as much from a concern for bank profits as from a desire for monetary control. The new institution’s ability to supply liquidity on demand, to stand ready, as Senator Nelson Aldrich (1909, 1911) had promised, to transform bank paper “into cash or a cash credit at any hour of any business day of the year,” was part of his plan “to make the United States the financial center of the world.” After Paul Warburg of the Hamburg investment banking family emigrated to the United States he became a leading advocate of an American central bank whose actions, like those in Europe, would be based on marketable commercial paper (real bills), or discounts.

The central-bank system and the discount system can not be separated; they are absolutely interdependent. The discount system can not exist without a central bank to which it may resort in case of need and, on the other hand, the central bank can not exist without an efficient bank rate – that is, without the means of protecting itself and the nation through its power to influence upward or downward the general interest rates of the country (1910, 31).

“Despite occasional complaints, which are too easily confused with serious opposition (Kolko 1963, 229),” bankers supported the Act, and have been the leading supporters of the Federal Reserve since (Wood 2005, 346).

Federal Reserve officials could have pursued the real-bills doctrine – for a while – in spite of the Act. But here, too, the evidence indicates otherwise. Arguments over qualitative (real-bills) and quantitative (interest-rate) means of control of credit existed at the Fed, but the latter side, led by the New York Fed’s Benjamin Strong, prevailed (Section 4 below). Richard Timberlake (2007) argued that Fed behavior changed after Strong’s death in 1928, and that the Board, led by Adolph Miller, assumed control and followed the real-bills doctrine. However, in discussing “The Real Bills Central Bank in Operation, 1929-33,” he admits that the Fed – “ironically” -- refused loans even on “eligible paper.” Other references to the real-bills doctrine in the Federal Reserve Act and Fed policy are also accompanied by complaints of confusions and inconsistencies (Friedman and Schwartz, 1963, 193; Meltzer, 2003, 245-46, 398).6 Monetarists identify the Fed’s interest in credit rather than money as evidence of the real-bills doctrine – without defining the doctrine – and find no consistency in consequence.

None of the claims that the Fed was guided by the real-bills doctrine refers to data. The first thing we would have to see, of course, is a constant discount rate, or at least one not related to bank credit. Figure 1 (discussed below) shows that the Fed’s discount-rate varied with bank credit demands throughout the period, including 1929-32. In fact, as indicated in Table 1, the fall in short-term interest rates in 1929-32 exceeded those in previous 20th-century recessions – nominally and, with one exception, as proportions of the rate of deflation.7 Furthermore, Table 2 shows that U.S. securities overtook discounts as a source of Federal Reserve credit in the Great Depression. The Fed might have been guilty of too much attention to credit as opposed to money, perhaps it should have injected more credit into the economy, and it is true that some officials expressed real-bills-doctrine-like sentiments, but policy was far removed from the real-bills doctrine.



Historian Mark Blaug (1985, 54) observed that the real-bills doctrine “survived repeated criticism in the 19th century to be enshrined in the Federal Reserve Act of 1913, thus scoring high on the list of longest-lived economic fallacies of all times.” It must be admitted that politically attractive proposals for allegedly non-inflationary monetary expansion at low interest rates – effectively the real-bills doctrine -- are always with us.8 However, there is no evidence that the real-bills doctrine ever governed monetary policy in Great Britain or the United States. The allegiance of economists and officials to the doctrine has been exaggerated, Keith Horsefield (1946) wrote in his review of Mints (1945), who had admitted as much when he wrote that “it is not entirely clear why [real-bills adherents] should have insisted upon the necessity of convertibility” (90).9




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