Real Bills Doctrine

Real Bills Doctrine

The real bills doctrine holds that if banks make loans only to finance short-term commercial transactions, the money supply will expand and contract to meet the needs of trade and fluctuations in the money supply will not be a source of economic instability leading to either inflation or deflation. The self-liquidating nature of these loans, and their use to finance the production of goods and services, allegedly checks the rise of inflationary forces. The doctrine found favor with Adam Smith and it has commanded some interest to the present day.

To appreciate the doctrine one must first understand that when banks advance loans, the money supply expands. When banks allow money to build up as vault cash or other forms of reserves, the money supply contracts.

The real bills doctrine first broke into public debate in England during the Napoleonic Wars. Under the stress of wartime finance, England had suspended the convertibility of bank notes into precious metal, putting England on an inconvertible paper standard comparable to inconvertible paper standards in the United States or England today. So-called bullionists argued that the money supply should remain proportional to precious metal reserves, such as gold reserves, to maintain its value and avoid inflation or deflation. Antibullionists defended the suspension of convertibility on the grounds of the real bills doctrine and attributed problems of rising prices and currency depreciation to other causes. After the Napoleonic Wars England established a gold standard and a new monetary debate developed between the banking school and the currency school. Both schools supported the gold standard but the banking school felt that banks should have the flexibility to make loans according to the real bills doctrine, allowing the money supply to expand and contract to meet the needs of trade. The currency school made the case that the money supply should remain proportional to gold reserves, and should only change as gold flowed in and out of the country.

In the early stages of development the Federal Reserve System followed the real bills doctrine in practice. During the post–World War II era the real bills doctrine and similar doctrines have lost credibility in favor of proposals to increase the money supply at a fixed rate, such as 3 to 5 percent per year, to encourage the economy to mirror the same stability.