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.   


  1. I'm glad to see more people adopting this view which to me makes a lot of sense. As far as I understand RBD from Mike Sprouols perspective the time limit on loans or notes has nothing to do with the notes ability to hold value. It is a simple matter of looking at the value of backing compared to the nominal value of the notes. If this relationship changes the real value of each note change.

    1. I agree that it is a simple matter of the total value of the backing compared to the total number of notes. However, long term bonds can go up and down in value as interest rates change. If you need to use the asset while its value is down then you won't have enough value. So there is a real danger in central banks buying long term bonds and low interest rates like they have been.

  2. Vince -

    Are you familiar with Antal Fekete's work? He has written a lot about Real Bills.

    Here is a recent article by Fekete.

    You can also consider reading the works of Sandeep Jaitly, a student of Fekete. Here is a writing sample of Sandeep.

  3. Vince:

    Thanks for a great post!

    The best way to state the RBD is that banks should only issue money in exchange for (1) short term (2) real bills (3) of adequate value.

    Item #3 is the most important. If a bank's assets are not valuable enough to cover the money issued by that bank, then that money will lose value. The more stable the bank's assets, the more stable its money.

    Item #1 is important mainly to avoid maturity mis-matching. If a bank holds mostly 60-day securities, and if people suddenly want to withdraw their money from the bank, then the bank can avoid illiquidity by suspending withdrawals for 60 days. This is inconvenient for customers, but not disastrous.

    Item #2 is the least important and most misunderstood. Its purpose is to match the quantity of money to the needs of business. If banks only issue money to carpenters and farmers (as opposed to gamblers and tourists), then they will automatically issue money when business is booming, and they will soak up money when business slows.

    Unfortunately, quantity theorists focus completely on #2 and ignore the rest. They think the point of the RBD is to maintain the value of money by matching the quantity of money to the needs of business. In fact, the RBD maintains the value of money by assuring adequate backing, not by making the money supply move in step with real output of the economy.

    1. Thanks!

      What do you think of my explanation of hyperinflation in terms of the real bills doctrine? Have you ever seen anyone else talk about hyperinflation from a real bills view? Can you tell I am interested in hyperinflation? :-)

    2. "Can you tell I am interested in hyperinflation? :-)"

      Shoot! You ARE?? I must have missed that Vincent... I'll take another read then.

  4. Vince:

    The RBD says that inflation happens when there is less backing per dollar. It can happen because the bank issued more money without getting adequate backing, or it can happen when the bank loses backing without a corresponding drop in the money it has issued (e.g., from a bank robbery).

    So yes, if a bank is robbed and its money initially loses 10% of its value, then the bank's bonds, being denominated in dollars, will lose value too. If interest rates are being driven up, and this also causes the bank's bonds to lose value, then that's a further loss of assets and you get more inflation. I discuss this under the heading of "inflationary Feedback" in two papers: "The Law of Reflux", and "There's No Such Thing as Fiat Money".


  6. The Real Bills view also works very well for when a central bank is trying to peg their currency to another while still making new money. They can lose all their reserves (backing) trying to hold the peg and then the currency can crash. This is really another route to hyperinflation that I have really neglected.

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