When the Directors of the old Bank of England were accused of having allowed the pound to depreciate between 1797 and 1810, their defense was based on the Real Bills Doctrine. They stated that they had only issued money to those customers who offered good security in exchange for the money. Therefore, they claimed, the Bank had only issued as much money as the legitimate needs of business required. The Bullion Committee appointed by the House of Commons in 1810 denounced this defense as "wholly erroneous in principle" (Gilbart, 1882, p. 53). Sixty-three years later, the bankers' answers were still derided as "almost classical by their nonsense." (Bagehot, 1873, p. 86) It would be difficult to count the number of times that similar debates over the Real Bills Doctrine have flared over the centuries. A few episodes are summarized by Mints (1945, p. 9.):
The real-bills doctrine has been a most persistent one. Given its most elegant statement in all its history by Adam Smith in the Wealth of Nations, it has since served as the defense for the directors of the Bank of England during the period of the Restriction. With some changes it re-appeared as the banking principle; it was the main reliance of the agitators for banking reform in the United States before 1913; it was as comforting to the Federal Reserve Board following the depression of 1921 as it had been a century earlier to the directors of the Bank of England; more recently it has re-emerged as the doctrine of "qualitative" control of bank credit; and, quite aside from these special uses to which it has been put, it has been consistently defended throughout all these years by a large proportion of bankers and economists.
Since Mints' time, a dissident tradition opposed to the Quantity Theory (and sometimes favorable to Real-Bills principles) has been evident in the writings of Tobin (1963), Black (1970), Samuelson (1971), Wallace (1982), and Sargent and Wallace (1982). Still, most economists' attitudes toward the Real Bills Doctrine have remained far from charitable. G. A. Selgin (1989, p. 489.), for example, comments that
The dead horses of economic theory have a habit of suddenly springing back to life again, which is why it is necessary to beat them even when they appear lifeless.
In what follows I hope to revive this dead horse.
II. BACKED MONEY
Empirical studies by Sargent (1982), Smith (1985), Calomiris (1988), Siklos (1990), Bomberger and Makinen (91), and Cunningham (1992) have found that the value of money is more accurately predicted by a Real-Bills type "Backing Theory" than by the Quantity Theory. Cunningham (1992) in particular, notes that his study of Taiwan provides "clear support for the Real Bills doctrine over the Quantity Theory." These results deserve serious attention, but the Real Bills Doctrine is still widely regarded as "thoroughly discredited" (Mishkin, 1994, p. 503). One reason for this inattention is that most economists’ understanding of the Real Bills Doctrine does not go beyond the simple (and inadequate) statement that "Money issued in exchange for real bills will not be inflationary." This paper attempts to fill a clear need for an explanation of the elements of the Real Bills Doctrine, while correcting errors that have crippled past discussions.
This paper examines backed money from a Real-Bills perspective. I contend that economists have been too quick to accept the idea that what we call fiat money is actually unbacked, since it is possible for money to be inconvertible but still backed.
A. THE REAL BILLS VIEW OF BACKED MONEY
The Real Bills Doctrine holds that money issued in exchange for sufficient security (usually short-term commercial bills) will not cause inflation. For example, Figure 1 represents a bank which has taken in 100 ounces of gold on deposit and issued 100 'credits' (either bank notes or deposits), each of which is a claim to one ounce of gold.
Bank Assets Bank Liabilities 100 oz. gold 100 credits