In Part I, we looked at the period prior to and during the time of what we now call the Classical Gold Standard. It should be underscored that it worked pretty darned well. Under this standard, the United States produced more wealth at a faster pace than any other country before, or since. There were problems; such as laws to fix prices, and regulations to force banks to buy government bonds, but they were not an essential property of the gold standard.
In Part II, we went through the era of heavy-handed intrusion by governments all over the world, central planning by central banks, and some of the destructive consequences of their actions. We covered the destabilized interest rate, foreign exchange rates, the Triffin dilemma with an irredeemable paper reserve currency, and the inevitable gold default by the US government which occurred in 1971.
In Part III, we looked at the key features of the gold standard, emphasized the distinction between money (gold) and credit (everything else), and looked at bonds and the banking system including fractional reserves.
In Part IV, we discussed the problem of clearing. The problem of clearing arises when merchants deal in large gross amounts, on which they earn small net profits. They would not typically have the gold coin to pay for the gross value of the goods they purchase. This is an intractable problem in a strict gold-coin-only system and it only grows if specialized enterprises are added.
We considered the mechanics of Real Bills. It is interesting that goods flow from raw material producer to the consumer but the money flows from consumer to raw material producer. Without government involvement, and without banks, Real Bills circulate spontaneously.
In this final Part V, we look at the economics of Real Bills (or “Bills” for short). In Part IV, we noted that a Real Bill is credit that is not debt, so let’s start here.
The Real Bill is credit provided for clearing, without lending or borrowing. It is different than a bond. To review the bond, in Part III we showed how it arises out of the need to save. People must plan for retirement and senescence during their working years. Even if there is no way to lend at interest, this need still exists. So people hoarded part of their income by buying a commodity with a narrow bid-ask spread that was not perishable. Salt and silver are two commodities that were used for this purpose. For many reasons saving, in which one lends one’s wealth at interest, is superior to hoarding. Thus the bond was born.
The Real Bill is quite different. It isn’t lending at all. It is a clearing instrument that allows the goods to move to the gold-paying consumer before said consumer pays with gold. The Real Bill does not earn interest, and there are no monthly payments. The Real Bill is an opportunity to buy gold at a discount. The Real Bill sells in the market for less gold than its face value, based on the discount rate and the time to maturity. For example, a 1000g Bill would sell for 9975 grams 90 days from maturity, assuming the discount rate was 1%. When the merchant has sold all of the goods to consumers, and thus has all of the gold, he pays the bill with 1000g of gold.
By contrast, Bills occur wherever people consume. It is certain that people will eat bread tomorrow. Therefore, it is not risky to provide the gold to clear the flour sale. Bills come into existence because of the chronic need to consume. Bills increase in quantity at times of high seasonal consumer demand (such as Christmas) and decrease at times of low demand.
Bills provide the responsiveness necessary for a large and complex economy, without the sinister elements that come with “flexible” irredeemable paper money, central banking, and fiat elements such as “legal tender” laws. This is because Bills respond to market signals (the chief “virtue” of irredeemable paper money, or indeed any government interference in markets, is that does not). Most importantly, every Real Bill is extinguished after it has cleared one delivery of goods. Real Bills are said to be “self-liquidating”. Unlike the mortgage on a building, or the bond that finances a factory, the Real Bill is paid in full upon the sale of the asset it financed.
Real Bills are a simple mechanism, but they enable some very elegant arbitrages. For example, seasonal businesses have a problem for part of the year. What does the heating oil distributor do in the spring and summer? As he sells down his stocks of oil, he does not want to buy more oil. He can buy Bills, perhaps issued by a garden supply store that is in its busy season (and therefore is generating Bills). In this vignette, the heating oil distributor is directly financing the inventories of the garden supply! Without a bank or any other intermediary needed, it’s more efficient.
There is a subtler arbitrage, between retail merchandise and Real Bills. Every retailer can calculate a rate of return for every product on the shelves. The goods are financed by the issuance of Bills; it makes no sense to carry any goods that have a return lower than the discount rate. Instead, the retailer should not stock those goods and put spare capital into the Bills issued to finance higher-yielding merchandise. Today, without a market discount rate, even in the information age with software to track everything, many retailers make poor decisions of what merchandise to carry.
There are many other even more subtle arbitrages, but let’s look at one that is especially interesting. It is basic Econ 101 that if a natural disaster strikes then prices must rise. For example, if the wheat crop is hit by hail then there is a wheat shortage in the region. Prices must rise before wheat is diverted to the empty bakeries and hungry people. Real Bills provide a buffer mechanism. If the shortage is local (and hence small in proportion to the global market), what happens is that the discount rate falls in that region.
Let’s look at this. The Real Bill arises, as discussed above, from consumption. In case of shortage, there is greater confidence that goods shipped into the region will be consumed even more rapidly. A lower discount rate means that the distributor is effectively paid a higher amount. This will attract goods out of other regions where there is no shortage. It is not necessary for the baker to pay a higher price on flour, or for the consumer to pay a higher price for bread. What is necessary is that the distributor receives a higher price to divert the flour to the region. The lower discount rate provides that higher price.
Real Bills serve a vital role in the banking system, particularly for the savings bank. To back a demand deposit account, the bank can have 1/3 of the assets in gold and 2/3 in Real Bills. It must be emphasized that this has nothing to do with fractional reserves! The Real Bill is not lending. More importantly, the Bill market cannot go “no bid”. All Bills will be fully paid in 90 days, with the average being 45 days.
In contrast, with the lending of demand deposits (a form of duration mismatch), the system becomes unstable. This is not due to the risk of default per se. It is because the banks expand credit into a structure that is not in accord with the wishes of the savers. Eventually, it is guaranteed to collapse in a no-bid bond market with panic, liquidations, defaults, and bankruptcies.
The problem with duration mismatch is not merely one of liquidity. If today’s crisis, ongoing after more than four years(!) of flailing by central banks shows anything, it is that a mismatched and unbalanced credit structure cannot be fixed with liquidity. What happened is that projects for more and higher-order factors of production were started. But there was insufficient real capital to finance them, so those projects must be written offs with losses taken by banks and investors. The demand deposit backed by Bills does not create this problem.
In a free market, if people want a bank to provide only safe storage of gold with perhaps payment processing, then that service will exist for a fee. Such an account will effectively have a negative rate of interest. Most people prefer not to pay fees, and to earn a nominal rate of interest (in gold, of course there is no currency debasement so even 0.01% is positive). The Real Bill makes this possible.
Real Bills are a topic that could fill an entire book. The goal of parts IV and V iof this series is to provide an overview, show some of the elegant mechanisms of the Bills market, and address some of the controversy that has swirled around Real Bills from at least the time of Ludwig von Mises, and more recently when Professor Antal Fekete published his ideas about them on the Internet.
To conclude this entire series on the Unadulterated Gold Standard, it is fitting to provide the formal definition now that the reader has sufficient understanding of the concepts and ideas.
The unadulterated gold standard is a free market in money, credit, interest, and discount based on the right of the people to hold and use gold coins, and which includes Real Bills and bonds.
As we could only hint in this series, there are numerous specialists conducting transactions that are not obvious (or even counterintuitive) and the credit market can evolve into a structure that is quite complex. So long as there is no force or fraud involved, the system remains stable under a gold standard.