the Civil Society Institute at Santa
Antal E. Fekete
Great Depression of the 1930’s was not due to the ‘contractionist propensities’ of the gold standard
as alleged by John M. Keynes. Nor was it due to fractional reserve banking as
alleged by Murray Rothbard. Rather, it was due to the
government’s sabotaging the clearing system of the international gold
standard, the bill market.
Adam Smith’s Real Bills Doctrine reigned supreme in monetary science
throughout the 19th century, and rightfully so. It explained how
it was possible to refine division of labor, and to
lengthen production processes in making them ‘more roundabout’ in
order to improve the efficiency of labor and
capital ― without causing monetary contraction through unnecessarily
invading the pool of circulating gold coins, and without tying up savings in
order to finance circulating capital. It also explained the
‘miracle’ how weekly wages can be paid to workers whose product
will not be sold for perhaps as long as 13 weeks. Clearly, additional fixed
capital can only be financed through increased savings. Additional
circulating capital, however, need not involve savings: it can be financed
through improvements in clearing. Circulating capital can be self-financing,
provided that the goods involved are demanded urgently enough by the
In this address I look forward to the release of the gold standard from a
forty-year quarantine, to become one of the pillars of the reconstruction
after the present credit collapse has run its course. In order to be viable,
the new gold standard has to have a valid clearing system. Bill circulation
would spring up spontaneously. In other words, we have to have a gold
standard of the type that prevailed in the world prior to 1914, when
international trade was financed not through gold flows across national
boundaries, but through trading bills of exchange drawn on London.
It would not be a gold exchange standard as that of the years 1920-1971, with
government promises to pay replacing real bills. But it would not be Murray Rothbard’s so-called 100 percent
gold standard either, which is phantasmagoria.
spite of obvious differences between the two, it is customary to extend the
concept of credit to include clearing. In more details, in addition to credit
arising out of the propensity to save that finances fixed capital, we
also consider self-liquidating credit arising out of the propensity to
consume that finances circulating capital. The latter does not involve
lending; it involves clearing.
Goods making up circulating capital must be in the final phases of production
and distribution, and they must move sufficiently fast to the ultimate,
gold-paying consumer. Thus, then, the bill of exchange is the embodiment of
self-liquidating credit ― so called as the credit is liquidated
directly with the gold coin surrendered by the consumer in 91 days or less
(91 days being the length of the seasons of the year in the temperate zones,
forcing a change of the types of merchandise in greatest demand).
Detractors of the Real Bills Doctrine studiously avoid reference to its
prestigious pedigree and its author, Adam Smith. They also ignore the fact
that, as a matter of merchant custom, producers and distributors hardly ever
pay cash for the maturing merchandise as it is passed on from one hand to the
next. Instead, they endorse the bill of exchange and, in doing so, assume liability to pay it at maturity. This
transaction is called ‘discounting’ as the payee applies an
appropriate discount, calculated at the current discount rate, to the face
value of the bill, proportional to the number of days remaining till maturity.
Banks need not be involved.
Chicken or egg?
a bill circulation was universal in the city-states of Italy
during the Quattrocento and, more recently, in 18th century in
Lancashire before the Bank of England opened its branch in Manchester.
This was duly observed by Ludwig von Mises in his
1912 treatise The Theory of Money and Credit, although he stopped
short of investigating the economic forces animating spontaneous bill
Unlike the question whether chicken was first or the egg, the question
whether bills or banks came into existence first has a definite answer.
Logically and historically, bills predated banks. What is more, it is
perfectly feasible to have an economy without banks, where circulating bills
emerge as suppliers deliver semi-finished consumer goods to the producers.
Instead of recognizing this fact, detractors link
bills and banks as if they were Siamese twins. They are not.
us look at another historical instance of clearing that was vitally important
in the Middle Ages: the institution of city fairs. The most notable ones were
the annual fairs of Lyon in France,
and Seville in Spain.
They lasted up to a month and attracted fair-goers from places as far as 500
miles away. People brought their merchandise to sell, and a shopping list of
merchandise to buy. One thing they did not bring was gold coins. They hoped
to pay for their purchases with the proceeds of their sales. This presented
the problem that one had to sell before one could buy, but the amount of gold
coins available at the fair was far smaller than the amount of merchandise to
sell. Fairs would have been a total failure but for the institution of
clearing. Buying one merchandise while, or even
before, selling another could be consummated perfectly well without the
physical mediation of the gold coin. Naturally, gold was needed to finalize
the deals at the end of the fair, but only to the extent of the difference
between the amount of purchases and sales. In the meantime, purchases and
sales were made through the use of scrip money issued by the clearing house
to fair-goers when they registered their merchandise upon arrival.
Those who would call scrip money “credit created out of nothing”
were utterly blind to the true nature of the transaction. Fair-goers did not
need a loan. What they needed, and got, was an instrument of clearing: the
scrip, representing self-liquidating credit.
Goods in bottoms
example of clearing in action is world trade prior to 1914. Suppose a cargo
ship is ready to sail from Tokyo to Hamburg
carrying in its bottom consumer goods in urgent demand. The sea-voyage takes
up to 30 days with several stops en route. Does the importer need to
raise a loan to pay the supplier for the goods in the bottom prior to
sailing? Hardly. The merchandise has a ready market upon arrival. The cargo
is insured against losses at sea. Accordingly, the supplier bills the
importer for value received f.o.b. Tokyo,
payable in 30 days in London.
The importer endorses the bill, attaches the insurance documents, and sends
it back to the supplier. The boat is now ready to sail. The supplier has an
instrument he could use as ready cash to pay his own suppliers, or he can
keep the bill to maturity as an earning asset. When the boat docks in Hamburg,
the local wholesale merchant pays for the cargo with a sight bill on London
with which the importer can meet his maturing obligation. No loan or lending
is involved in all this, only clearing. The pool of
circulating gold coins has not been invaded, nor are savings tied up
for 30 days while the goods in urgent demand move from the Far East to Western
The tale of the
was a milestone in the history of money. That year, in preparation for the
coming war, the note issue of the Bank of France and of the Reichsbank of Germany were made legal tender. Most people
did not even notice the subtle change. Gold coins and bank notes kept
circulating as before. It was not the disappearance of gold coins from
circulation that heralded the coming destruction of the world’s
monetary and payments system. It was the advent of legal tender. It was the
French and German government’s decision to stop paying civil servants
in gold coin who were now forced to accept paper money. Private firms
immediately followed suit: they also started paying their employees with bank
notes. Never mind that the bank notes were redeemable in gold coin; this
change effectively meant sabotaging the clearing system of the international
gold standard nevertheless. It short-circuited bill circulation. Bills were
supposed to be paid at maturity in the form of a present good, the
gold coin, obtained from the consumer who, in turn, was supposed to get paid
in gold by his employer on every payday. Now they were paid in the form of a future
good, the bank note. Legal-tender coercion created an irreparable leakage in
the gold circulation process.
The banks continued using real bills as an earning asset to back the note
issue. But other subtle changes were to alter the character of the
world’s monetary system beyond recognition. The cuckoo has invaded the neighboring nest to lay her egg surreptitiously. In
addition to bank notes originating in bills of exchange, bank notes
originating in finance bills (including treasury bills) have made their
appearance for the first time. In due course the cuckoo chick would hatch and
push the native chick out of the nest. In five years, by 1914, the
lion’s share of bank portfolios would be replaced by finance bills. The
real bill has become an endangered species. In another few years it became
extinct. Note that, unlike real bills, finance and treasury bills are not self-liquidating.
The change-over from bank notes backed by real bills to bank notes backed by
finance bills was the last nail in the coffin of the clearing system of the
international gold standard.
and lending long
bills are backed by the odds, never the certainty, that a speculative
inventory of goods, or equities, or investments in brick and mortar, may be
unwound without a loss. If the odds do not play out in time, the finance bill
will be ‘rolled over’. This is tantamount to borrowing short and
lending long ― invitation to disaster. By contrast, a real bill is
never ever rolled over. If not paid in gold upon maturity, the drawer of the
bill will go bankrupt and his name will be blacklisted at the clearing house
Finance bills made the portfolio of banks illiquid. Potential demand for gold
coins, should holders of bank notes want to exercise their legal right to
redeem them, could no longer be satisfied. To take away this right was the
reason for making bank notes legal tender in the first place. Redemption
would never be a problem as long as the banks’ assets consisted of real
bills exclusively. Every single day one-ninetieth of the outstanding bank
notes would mature into gold coins, which were available for redemption.
Normally this would suffice to satisfy daily demand.
But what about abnormal demand? Well, a real bill is the most liquid earning
asset that a bank can have. At any time somewhere in the world there is
demand for it. In particular, banks that have a temporary overflow of gold
would be more than anxious to exchange it for real bills. Thus banks would
not have the slightest difficulty to get gold in exchange for real bills in
the international bill market. The assumption that there will always be
takers for real bills offered is just as safe as the assumption that people
will want to eat, get clad, keep themselves sheltered and warm tomorrow and
every day thereafter.
The chimera of
fractional reserve banking
explodes the blanket condemnation of fractional reserve banking. Detractors
are barking up the wrong tree. They should condemn the practice of
discounting finance bills. Actually, ‘fractional reserve’
as applied to banks with nothing but real bills in their portfolio is a
misnomer. The reserves are gold plus bills maturing into gold. The reserves
are not fractional, as they fully back the note and deposit liability of the
bank. By contrast, if the bank portfolio has a component of finance bills,
the designation ‘fractional reserve’ is appropriate. Finance
bills are not maturing into gold like real bills are. It may not be possible
to get gold in exchange for them when the crunch comes.
process of retiring bank notes, after the merchandise serving as the basis
for their issue has been removed from the market by the ultimate gold-paying
consumer, is called ‘reflux’. Some authors, including Ludwig von Mises, have ridiculed the concept of reflux calling it deus ex machina.
They argued that banks were only interested in credit expansion, not in
reflux. Not for one moment would they entertain the idea of voluntarily
withdrawing bank notes from circulation when the underlying real bill
matured. Instead, they would lend them out at interest again and again, to
enrich themselves at the expense of the public.
This is not a valid argument. For the stronger reason, you could also
ridicule the entire legal system in asking the rhetorical question:
“what is the point of making laws when they will be broken
anyhow?” You cannot judge the merit of an institution by the behavior of those who are set upon destroying it.
Birth of the
havoc that the silent monetary revolution of 1909 ushering in legal tender
bank notes would wreak upon society had not been foreseen. Nor was the causal
relation recognized between the expulsion of real bills from bank portfolios
and the massive unemployment that followed it. In Germany
alone, 8 million people, or nearly 50 percent of the trade union membership lost their jobs
after 1929. Economists have failed to point out the causal nexus between the
two events 20 years apart. Here is the explanation of what happened.
Real bills finance the movement of consumer goods, including wages paid to
people handling the maturing merchandise through the various stages of
production and distribution. That part of the circulating capital paid out in
wages is called the wage fund.
The birth of the wage fund is due to the real bills market. Without it,
payment of workers producing consumer goods would not be possible until the
sale to the final consumer.
The size of the wage fund needed to move the mass of consumer goods through
these stages, if financed out of savings, would be staggering. Quite simply,
it could not be done. No conceivable economy would produce savings so
prodigiously as to be able to finance circulating capital that society needed
in order to flourish at present levels of security and comfort.
achievement of the human spirit and intellect
there is no need to employ savings in such a wasteful manner. Circulating
capital can be financed through self-liquidating credit. The discovery of
this fact is one of the great achievements of the human spirit and intellect.
The impact on human life of the invention of the circulating bill of exchange
is fully commensurate with that of the invention of the wheel. Detractors
of the Real Bills Doctrine have missed one of the most exciting developments
of our civilization: the discovery of self-liquidating credit as it emerges
in the wake of the disappearance of risks at the end of the production
process, when maturing goods get within earshot of the final gold-paying
consumer. They have missed the fact, without real bills circulation, wages
could not be paid in advance of the sale of goods, except under the constant
threat of unemployment.
the wage fund
near-perfect system was allowed to disintegrate in the wake of the 1909 legal
tender legislation. By ‘crowding out’ real bills from the
monetary system, governments have inadvertently destroyed society’s
wage fund. It was there to allow wages to be paid as much as 91 days in
advance of merchandise being sold to the ultimate consumer. When real bills
were replaced by non-self-liquidating finance bills, payment of wages has
become haphazard. Employment was made touch-and-go, hiring,
‘hand-to-mouth’. This threatened with unemployment on a massive
scale, unless governments were willing to assume responsibility for paying
wages. Eventually, to avoid undermining social peace, they had to do just
that. Governments invented the so-called ‘welfare state’ paying
out so-called ‘unemployment insurance’ to people who could have
easily have found employment had the wage fund been preserved through
ensuring the proper functioning of the bill market, the clearing system of
the gold standard.
What has been hailed as a heroic job-creation program appears, in the present
light, a miserable effort at damage control by the same government that has
destroyed the wage fund in the first place. Economists share responsibility
for the disaster. They have never examined the 1909 decision to make bank
notes legal tender from the point of view of its effect on employment. They
should have demanded that, instead of treating the symptom: unemployment,
governments remove the cause of the disease: the destruction of the clearing
system of the gold standard, the bill market. Had the governments allowed
bill circulation to return at the end of the hostilities in 1918, the wage
fund would have been replenished at once. Unemployment would not have arisen.
Recall that it was not a problem before 1909.
fiasco of all times
problem of destroying the clearing system of the gold standard by expelling
self-liquidating credit in 1909 was further aggravated in 1971 when the gold
standard itself was destroyed. By 2008 the festering crisis has become a
fully blown credit collapse, encompassing the entire globe.
We must have the humility to admit that it was our reckless experimentation
with irredeemable currency and synthetic credit that resulted in this fiasco
greater than any other man-made disaster in history. The runaway Debt Tower
of Babel is toppling, and the quadrillion-dollar-strong global derivatives
monster is vaporizing. There is no bottom to this collapse. The financial
system is self-destructing. It is in a death-spiral. Every wave of losses in
the mortgage market, in the stock market, in hedge funds, or in derivatives
triggers a new wave of losses. This will continue until total exhaustion is
It is futile to expect the Fed and the Treasury to regain control of the
careening financial system, even if all the central banks of the world pool
resources. There are not nearly enough dollars in existence to cover the
derivatives losses, despite the Fed’s endless stream of bailout money,
and despite the Treasury’s endless stream of bailout bonds donated to
the Fed for collateral, which the latter needs but hasn’t got, to create more bailout money. Halving interest rates
again and again is oil on the fire. It has been the main cause for capital
destruction, and contributes directly to unemployment.
The way out
discussing the necessary monetary reform to be introduced after the dust
settled, the rehabilitation of the gold standard and its clearing system, the
bill market, must be a matter of first priority. The main cause of the
disaster was the elimination of self-liquidating credit from the
international monetary system, a process that started in 1909 with the
introduction of legal tender bank notes. It took almost a full century for
the process to run its devastating course before the financial system started
unraveling in February, 2007. That is the date, it
will be recalled, when the cost of credit-default swaps shot up first, the
salvo marking the beginning of the end.
During that unfortunate century, the 20th, self-liquidating credit
based on positive value, gold, was forcibly replaced with
‘synthetic credit’ based on negative value, debt. Once the
regime of irredeemable currency was in place there was no way to rein in the
fast-breeder of debt in the system. We are forced to draw two conclusions:
There is just no alternative to self-liquidating credit. That is to say, the
production and distribution of consumer goods must be financed through bills
There is just no alternative to the gold standard. The regime of irredeemable
currency is based on debt. Once adopted, the fast breeder of debt is engaged
and will, before long, start spinning out of control.
the problem of the monetary system will also solve the problem of
unemployment. Once real bills start circulating, the wage fund will be
replenished at once, out of which wages can be paid to all those eager to
earn them for work in providing the consumer with goods and services in most
If we want to exorcise the world of the incubus of unemployment with which it
has been saddled by greedy governments in making their bank notes legal
tender, not only must we return to the international gold standard, but we must
also rehabilitate its clearing system, the bill market. In this way the wage
fund can also be resurrected. Then, and only then, can the so-called welfare
state, paying workers for not working, and farmers for not farming, be
Antal E. Fekete
Professor, Intermountain Institute of
Science and Applied Mathematics, Missoula, MT 59806, U.S.A.
DISCLAIMER AND CONFLICTS
DISCLAIMER AND CONFLICTS
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