Wednesday, September 11, 2013
The Real Bills Doctrine
In comments on another post Tom Brown linked to work by Mike Sproul on The Real Bills Doctrine. I think this is well worth understanding.
My interpretation of some key points:
1) Many people think "fiat money" has no backing but really the central bank has assets with real value that back the notes it issues. By selling these assets it can pull back the money it issues and so support the value of that money.
2) If the bank loans money for 60 days or less and has solid collateral the notes it issues will hold value no matter the quantity issued.
3) If a central bank buys 30 year bonds and interest rates go up then the market value of these bonds can drop so much that it can not withdraw all the notes it has issued. This then is inflationary. So interest rates going up when a central bank has long term bonds as assets is inflationary. This fits with other things I think I understand.
4) The Real Bills theory of money is better for predicting the future value of money than The Quantity Theory of Money.
5) Historically when the assets of the bank have fallen in value the notes have fallen in value as well. This is inflation.
I think there are often several very different but good ways of thinking about a problem and it is really fun when I can understand more than one way and get the same answer either way. I think Real Bills is one of these things. Again, I recommend understanding this.
This Real Bills view is very different from The Equation of Exchange view that I usually use when talking about hyperinflation but I think it is a very valid view.
So let me try to explain hyperinflation from a Real Bills point of view. If the main assets a central bank has is long term bonds in their own currency then there can be a dangerous feedback loop. As inflation or interest rates go up the value of its bonds used as backing go down. The longer term the bonds are the bigger the drop in value. But as the value of its backing assets go down so does the value of the currency, and so the value of all bonds in that currency also go down. The bonds go down much faster than the currency alone as they are a projected future value of the currency. This, or the fear of more of this, can cause more people to sell. This can make a feedback loop where the more people sell bonds the worse the backing for that currency, but the worse the backing the more people sell. This feedback loop can drive the value of the currency lower and lower.