Real bills doctrine facts for kids

The real bills doctrine is an old idea about how banks should lend money. It suggests that banks should only give loans to businesses if those loans are backed by goods that are being made or sold. Imagine a baker needing money to buy flour. The real bills doctrine says the bank should lend money for that flour, because it's a real item being used to make bread.

The main goal of this idea was to make sure that the amount of money in the economy matched the amount of goods being produced. This way, prices wouldn't go up or down too much. When businesses sold their goods, they would pay back the loans. Then, the money would be taken out of circulation until more goods needed to be financed.

This idea was first called "the commercial loan theory of banking." Later, a person named Lloyd Mints gave it the name "real bills doctrine" in his 1945 book, A History of Banking Theory.

How the Idea Started

The basic concept of the real bills doctrine came from John Law in 1705. He thought that money should be connected to real property, like land. This would help keep prices stable.

Later, Adam Smith, a famous economist, changed Law's idea. Instead of land, Smith suggested using "commercial paper." This is like a promise from a business to pay back a loan in a short time, usually 30, 60, or 90 days. This paper would represent real goods being produced. This is how the real bills doctrine as we know it began.

Why the Idea Had Problems

Not everyone agreed with the real bills doctrine. Henry Thornton, a British banker, pointed out some big problems with it.

One problem was that the doctrine linked money to the price of goods, not just the amount of goods. If prices went up, banks would lend more money, which could make prices go up even more. This creates a cycle where prices keep rising, leading to inflation.

Another problem was trying to separate "productive" loans from "speculative" loans. A productive loan helps make something real, like a factory. A speculative loan might be for buying stocks, hoping their price goes up. The doctrine said banks should only make productive loans. But it's hard to tell the difference, because even making goods involves some risk and hope for future profit.

The Great Depression and the Real Bills Doctrine

The real bills doctrine played a part in the Great Depression in the United States. In 1929, a leader at the Federal Reserve, Adolph C. Miller, started a program called "Direct Pressure." He made banks promise they had never made speculative loans if they wanted help from the Federal Reserve.

Banks needed help because many people were taking their money out. But bankers didn't want to be questioned about their loans. So, instead of asking for help, many banks failed. Nearly 9,000 banks closed! This caused the amount of money in the country to shrink by one-third. Many historians believe this huge drop in money supply caused the Great Depression.

The real bills doctrine's third flaw became clear here. It suggested that if the economy was shrinking, the money supply should also shrink. But to fix a shrinking economy, you often need more money, not less. This is called a "counter-cyclical" policy. The doctrine called for a "pro-cyclical" policy, which made things worse.

The real bills doctrine was mostly stopped in the late 1930s. However, its ideas still pop up in banking discussions sometimes.

Gold Standard and the Doctrine

Some people blame the gold standard for the Great Depression. The gold standard meant that the amount of money was tied to the country's gold reserves.

However, economists like Richard Timberlake and Thomas Humphrey argue that the real bills doctrine was a bigger problem. They say the doctrine made the Federal Reserve afraid to use the country's gold reserves to help banks. This was because the doctrine wrongly saw all "speculative" activity as bad, even though some speculation is part of a healthy economy.

Modern Echoes of the Doctrine

Even today, some of the ideas from the real bills doctrine can be heard. For example, in 1982, economist Thomas Humphrey noted that some people wanted the Federal Reserve to lower interest rates and let the money supply grow to meet demand. He said this idea was similar to the old real bills doctrine, which had been proven wrong.

In 2019, Thomas Humphrey and Richard Timberlake wrote a book about the real bills doctrine. They again pointed to Adolph C. Miller and his "Direct Pressure" initiative as a major cause of the bank failures during the Great Depression. They explained that the doctrine made the Fed reluctant to help banks, leading to the crisis.

The Real Bills Doctrine Today

The real bills doctrine still influences how we think about money and banking. For example, during the financial crisis of 2007–2009, the Federal Reserve had to lend money to banks in an emergency. This was allowed by a special rule (Section 13(3) of the Federal Reserve Act).

This rule was added during the Great Depression, when lawmakers realized the strict rules of the real bills doctrine were making things worse. They changed the law to allow the Fed to lend money more broadly in emergencies. This shows how the lessons learned from the real bills doctrine's flaws helped shape modern banking rules.

For new digital money systems like cryptocurrency, the real bills doctrine might not apply directly. These systems don't have a central bank controlling the money supply in the same way.