Real Bills & Fractional Reserve Banking

Economics Economics Questions
1

Here is an email I sent to Antal Fekete, the proponent of the real bills doctrine:

Hey Prof. Fekete,

I’m a young follower/layman of the Austrian school. My question pertains to real bills and business cycles. The way I understand it, business cycles occur because banks issue credit in excess of saving, altering the price structure, thereby making it more profitable to put money into higher order goods production like housing, construction, machinery production, etc. However, because peoples’ underlying time preferences have not changed, they will consume more, making lower order industries more profitable. These lower order industries then outbid the higher order industries for resources, forcing the higher order industries to slow production and lay off workers, who then consume less, which makes the lower order industries less profitable, thereby leading us into a recession.

Now, the way that I understand real bills is that banks issue credit based on future production and collateral. For example, I could loan a paper note redeemable for 10 gold ounces as long as the collateral behind the loan was at least 10 gold ounces and there was a reasonable chance that I’d get the 10 gold ounces plus interest back. This would be liquid, so I wouldn’t have to worry about banking panics running me out of business. Isn’t this inflationary though? By issuing paper certificates in excess of my supply of gold, wouldn’t I be making the paper certificates worth less than my gold reserves, since the supply of the paper would be in excess of the supply of gold? Wouldn’t this lower the value and liquidity of my securities and therefore make me vulnerable to bank runs?

Moreover, wouldn’t real bills lead to business cycles, since business cycles are caused by credit issued in excess of savings? It seems to me that regardless how liquid real bills are, they are still credit issued in excess of savings, which would lead to the problem of malinvestment and overconsumption in the real economy first. Perhaps real bills could soften recessions by preventing financial meltdowns like the ones we have now, but wouldn’t they still be the root cause of booms and busts?

In any case, I’m pretty sure I’m misunderstanding your advocacy of the real bills doctrine, since you must have rebutted such criticisms before. However, I have never seen any such rebuttal, which is why I had to send an email with this question. I am very interested in the real bills doctrine, I just don’t fully understand it, and all of its implications, yet. Any response you send will be greatly appreciated.

Thank you,

[name redacted]

Now, I’m wondering if there are any proponents of real bills here. I remember one poster, scineram maybe, who was a proponent of fractional reserve banking. Could any such supporters explain their positions here? It seems that real bills fall into the same category of “unsafe” methods of fractional reserve banking: they expand credit beyond savings, lower interest rates below their market level, and alter the price structure in such a way that encourages unsustainable paths in investment and rising levels of consumption.

2

Did he reply to your message?

3

Mike Sproul is the biggest proponent of real bills in the blogosphere, commenting a lot here, econlog and other places. He says all money is backed by issuer assets.

When was the last time he was able to redeem a dollar bill at the New York Fed for its assets?

4

Scineram, I think I remember you vouching for fractional reserve banking. Wouldn’t fractional reserves expand the amount of credit beyond the amount of savings, thereby creating an unsustainable boom?

Nope.

5

http://www.csun.edu/~hceco008/realbills.htm

I saw no claims that this asset backed money supposed to prevent inflation or boom/bust cycles. I guess all debt is backed by an asset and therefore if a debtor defaults he releases his asset to the creditor.

This scheme has to be inflationary. If I take 100 silver ounces into the bank, deposit it, and then take out $100 then do I still own the silver? Where did the bank get the $100 to give me for the silver? Created out of thin air? Can I withdraw and use my silver even with the $100 in cash I already spent? Seems to me I deposit my asset and take the new money value of the asset to go spend in the economy.

If I still own or have utility of my asset while I have new bank credit then there has been no savings of capital (no one is foregoing consumption) that enables me to borrow and consume in place of another saver. If I sold my silver to the bank then I would get $100 but the bank could turn around and sell / return the silver to the economy. But still, if the bank created the $100 out of thin air the money supply increased $100 while the number of assets/products/goods in the economy remained unchanged.

Savings are what’s borrowed & repaid. Owning or having control over fixed assets or consumables are not the same as having savings. Savings is having the right to own an asset but not exercising the right to secure those assets. Rather, the creditor lends that right to someone else to consume them instead of you. The debtor is then liable to reproduce those consumed goods back to the economy so something will be there to buy/consume by the creditor when the debtor repays the permission of consumption back to the creditor.

6

By savings do you mean cash holdings and deposits together?

7

You talk’in to me?

When I say savings I mean consuming less than what you produce or not consuming that which you have earned the right to consume. By lending my savings I mean foregoing the consumption of those excess goods/services/commodities I produce and lending that right to someone else to allow them consume instead.

I was thinking about it a bit more. If you have 100 rounds of silver or have an automobile or whatever asset, to mortgage the asset is just borrowing against ones equity in the object. What sets the money price of the assets equity? If you have debt collateralized by silver, but then there is a glut of silver and silver’s money price falls then the debt is no longer covered by the silver. But still, if you take out a mortgage on your home’s equity then that is still debt that you must pay back. The debt is collateralized as long as the house’s money price remains high enough so you still have sufficient home equity to cover the debt. The money borrowed against the equity, to go out and spend to consume other goods in the economy, will be inflationary if created out of thin air considering there is no reason other consumers will forego their consumption so you can consume the products entitled to them.

8

To mortgage your 100 rounds of silver, take the cash, and then earn back the money to pay your debt owed against your 100 rounds of silver… why not instead just sell your 100 rounds of silver, take the $100 and spend that. Then earn money and buy back your 100 rounds of silver that you want again. No money would be created in this process. This is not the same as putting the silver in a safe deposit at a bank and spending $100 created out of thin air worth the value of the silver. This is clearly an expansion of the money supply. There are not necessarily any additional (surplus) wealth or goods/services/commodities in the economy that I can buy with my new counterfit money.

9

By savings I mean the total amount of money not being spent. My problem with fractional reserve banking is that when I put $10 in a vault, they loan out more than that $10. Because money is not neutral, that newly created credit makes certain business ventures more profitable than others, creating an unsustainable boom.

I suppose I can imagine a situation in which banks practice very minute fractional reserve banking. For example, I might put $100 in a demand deposit, the bank might take $10 and loan it out. That way, they are not de facto expanding credit and are under minimal risk of failure as long as their assets remain liquid.

10

Then isn’t newly created money an increase in savings until spent?

I think this is false. It means they loan out a fraction of the $10, at most $9 with current(?) reserve requirements.

11

It’s forced savings, not real savings. The problem is that, due to the non-neutrality of money, when it is first lent out, it is worth more than when the money begins to circulate, sending false signals about the profitability of higher order industries. When the money circulates throughout the economy and market time preferences take over, lower order industries become relatively more profitable, taking credit and business away from higher order industries, causing them to lower wages, lay off workers, and/or go out of business, starting the business cycle.

If this were true, then there would be no difference between M0, M1, and M2. The money multiplier is m=(1/r). So with the current 10% reserve requirement, m=[1/(1/10)]=10. As an example, you deposit $10 in Bank A, which then loans out $9, which is deposited in Bank B, which it then loans out $8.10, etc. So in this case, with only two banks, you already had 9+8.1=17.1 dollars loaned out of $10 in savings.

12

“In any case, I’m pretty sure I’m misunderstanding your advocacy of the real bills doctrine, since you must have rebutted such criticisms before. However, I have never seen any such rebuttal”

That is great comedy! Sure he’ll answer you after you having, very politely, caught him with his pants down and spanked his ass red. Or rather he’ll just defer that episode to his subconscion and take it up with his shrink later on.

You’re not really 17 years old, are you? Nobody is THAT perfect…

13

He is a professor, I wouldn’t want to insult him. I am trying to get a response, after all.

14

I think I remember him making some hundred posts in the mises.org blog, endlessly going in circles and confusing basic concepts. It gets tiring after a while.

edit : sorry, I was talking about Mike Sproul.