Real Bills Doctrine - Informative Example

Informative Example

Issuing money "in the discount of good bills" is a strange concept to the modern reader. The banker's T-account below will clarify the concept.

In line 1, the banker receives 100 ounces of silver on deposit, and issues 100 paper receipts (“dollars”) in exchange. Each paper dollar is convertible at the bank into 1 ounce of silver. At this point each paper dollar will be worth 1 ounce of silver in the open market. Note that it is immaterial whether the dollars are issued as printed pieces of paper or as bookkeeping entries transferable by check or other means.

In line (2) we suppose that a farmer requests a loan of 200 paper dollars from the bank. Assuming the farmer offers adequate collateral and pays an adequate interest rate, any profit-seeking banker would agree to print 200 additional paper dollars and lend them to the farmer. The farmer, for his part, might write an IOU to the banker, promising to pay $220 after 1 year. At a 10% interest rate, this IOU or “bill” will be discounted to $200. That is, the banker will pay $200 in paper today for the farmer’s $220, 1-year IOU.

Can we say that the 200 paper dollars were issued “in the discount of good bills”? That depends. If the farmer will repay out of his future production of corn, then the farmer’s IOU satisfies the traditional idea of a real (i.e., good) bill: “Borrowers and banks agree that these forthcoming productions serve as collateral for the dollar value of the loans.” (Timberlake, (b) 2005, p. 3.) If the farmer's crop failed, then there would be no direct “forthcoming production” and the farmer’s IOU would not qualify as a real bill. Furthermore, the farmer’s IOU does not meet the condition of being due “at not more than sixty days’ date”.

Contrast the above to the loan of $300 newly-printed dollars to a gambler on his way to a casino (line (3)), supposing that the gambler offers his house as collateral, which is worth at least $300. Because gambling profits are not a result of production but are pure transfers, the newly-printed $300 may not correspond to any forthcoming production. This appears irrelevant to the banker who has received adequate collateral for his loan but this also shows that the new money may be inflationary. Indeed, the gambler may win (part of) this money from the farmer, in which case the farmer's actual production backs more than the dollars issued in its expectation. Therefore, although it appears as if the real bills doctrine is not inflationary, because it appears that the debtors believe they will produce real value, in fact they may not.

A different way of framing it is this: After the bank has completed all the transactions shown in Table 1, having issued a total of $500 newly-printed dollars on loan, thus multiplying the original $100 six times, what is the value of a paper dollar? The answer is the same as it always was: one paper dollar is worth one ounce of silver. It is obvious that if the bank had issued only $100 against 100 ounces of silver, then each dollar would be worth 1 ounce. It is also obvious that if the bank issued the additional $500 without taking any additional assets in return, then the public would hold $600 against only 100 ounces of silver in the bank, and each dollar would be worth only 1/6 ounce of silver. The banker thinks he did receive one dollar’s worth of assets for every dollar issued, and each dollar is adequately backed but in reality it may not be.