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 including 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 this Part IV, we consider another kind of credit: the Real Bill. We must acknowledge that this topic is controversial because of the belief that Real Bills are inflationary. This author proposes that inflation should not be defined as an increase in the money supply per se, but of counterfeit credit.
Let’s start by looking at the function served by the Real Bill: clearing. This is an age-old problem and a modern one as well. The early Medieval Fairs were large gatherings of merchants. Each would come with goods from his local area to trade for goods from other lands. None carried gold to make the purchases for two reasons. First, they didn’t have enough gold to buy the local goods plus the gross price of the foreign goods. Second, carrying gold was risky and dangerous.
The merchants could have attempted some sort of direct barter. But they would encounter the very problem that led to the discovery and use of money originally. It is called the “coincidence of wants”. One merchant may have had furs to sell and wants to buy silks. But the silk merchant does not want furs. He wants spices. The spice merchant may not want silks or furs, and so on. It would waste everyone’s time to run around and put together a three-way deal, much less a four-way or a 7-way deal so that every merchant got the goods he wanted to bring to his home market. They developed a system of “chits” to enable them to clear their various and complex trades. In the end, all merchants had to settle up only the net difference in gold or silver.
Clearing is necessary when merchants deal in large gross amounts with small net differences.
The same challenge occurs in the supply chain of consumer goods. Each business along the way adds some value to the product and passes it to the next business. For example the farmer starts the chain by selling wheat. The miller turns wheat into flour and sells it to the baker. The baker turns flour into bread and sells it to the consumer. These businesses run on thin margins, and this is a good thing for everyone (though the baker, the miller and the farmer might disagree!) The question is: on thin margins, how are they to pay for the gross price of their ingredients before selling their products?
This is an intractable problem and it only gets worse if they attempt to grow their businesses. Further, it would be impossible to add a new business into the supply chain. For example, a processor to bleach the flour might be a separate company. And then it may turn out that when the bakery grows and grows, that it is more efficient to operate a small number of very large regional bakeries and then the distributor enters the supply chain to buy the bread from the baker and sell it to another new entrant in the chain, the grocer.
With each new entrant into each supply chain, the supply of gold coins would have to grow proportionally. This is not possible. Fortunately, it is not necessary. If there were a means of clearing the market, then only the net differences would have to be settled in gold. If consumers buy 10,000 grams of gold worth of bread from the grocer, the grocer could keep his 5% profit of 500g and pass 9,500g to the distributor. The distributor would keep his 2% profit of 190g and pay 9310g to the baker. The baker would keep his 10%, 931g and pay 8379 to the flour bleacher, and so on up the chain.
The obvious challenge is that the payments move in the opposite direction compared to the goods. Whereas the wheat is eventually turned into bread as it moves from the farmer to the consumer, the gold moves from consumer to farmer. The Real Bill is the clearing mechanism that makes this possible.
Without the Real Bill, the enterprises in the supply chain would have to borrow using conventional loans and bonds, which is less efficient and more expensive. Or else the division of labor along with highly optimized specialty businesses would not be possible.
As we discussed in Part III of this series, everyone benefits if it is possible to efficiently exchange wealth in the form of savings for income in the form of interest on a bond. The saver’s money can work for him his whole life, and he can live on the interest in retirement without fear of outliving his money. The entrepreneur can start or grow a new business without having to spend his career saving a fraction of his wages, working a job in which he is underemployed. Everyone else gets the use of the entrepreneur’s new products, and thereby improve their lives.
The same analogy applies to the efficient clearing of the supply chain for every kind of consumer good. This is especially true as new entrants come in to the chain and make the process more efficient (i.e. less expensive to the consumer). And it is also necessary for seasonal demand, such as prior to Christmas. Clearly, there is an increase in the production of all kinds of consumer goods around September or October. Everything from chocolates to wrapping paper must be produced in larger quantities than at other times of the year. Without a clearing mechanism, without the Real Bill, the manufacturers would be forced to limit production based on their gold on hand. There would be shortages.
In practice, the Real Bill is nothing more than the invoice of the wholesaler on the retailer. In our example, the distributor delivers bread to the grocer and presents him with a bill. The grocer signs it, agreeing to pay 9500g of gold in 90 days (probably less for bread). It is an important criterion that Real Bills must be paid in less than 90 days, for a number of reasons. First, the Real Bill is for consumer goods with known demand. If the good does not sell through in 90 days, that indicates a problem has occurred or someone has misestimated the demand. The sooner this is realized, the better.
Second, 90 days represents the change of the season in most countries. What had been in demand last season may not be in demand in the next.
Third, the Real Bill is a short-term credit instrument that is not debt. At the Medieval Fair, there was no borrowing and no lending. The same is true for the Real Bill. The wholesaler does not lend money to the retailer. He delivers the goods and accepts that he will be paid when the goods sell through to the consumer. The retailer agrees to pay for the goods when they sell through, but he does not borrow money.
Finally, if a business transaction requires longer-term credit, then it is appropriate to borrow money via a loan or a bond. The Real Bill is not suitable for the risk or the duration. Longer-term credit means that it is not simply being used to clear a transaction, but that there is some element of speculation, storage, and uncertainty.
What has happened in different times and in different countries is that Real Bills circulate. Spontaneously. No law is required to force anyone to accept them. No banking system is necessary to make them liquid. Real Bills “circulate on their own wings and under their own steam” in the words of Antal Fekete. The Real Bill is the highest quality earning asset, and the highest quality asset aside from gold itself (incidentally, this is why Real Bills don’t work under irredeemable paper—it would be a contradiction for a Real Bill to mature into a lower-quality paper instrument).
Opponents of Real Bills have a dilemma. They can either oppose them by means of enacting a coercive law, or they can allow them because they will spring into existence and circulate in a free market under the gold standard. We can hope that the principle of freedom and free markets leads everyone to the latter.
It is not the job of government to outlaw everything that experts in every field believe will lead to calamity. And those experts should be cautious before prejudging free actors in a free market and presuming that they will hurt themselves if left alone.
In Part V, we will take a deeper look at the Real Bills market, including the arbitrages and the players…