Stimulus, Part VI: Does the "Real Bills" Doctrine Work?

As we saw in the previous posting in this series, in theory money can be created as needed if both parties to the creation of the money — the producer of future wealth and the present financial institution — keep their promises. Because the amount of money created matches the value — wealth — to be created, there will be no inflation if everyone keeps the promises made.

In actuality, however, 1) capital typically continues to produce long after the financing of the capital has been repaid, 2) bankers tend to lend based on a low estimate of future production, and 3) producers tend to produce as much as they can over and above the low estimate on which they obtained financing. Thus, money typically buys more than before if all money creation is restricted to financing new capital formation or in exchange for existing inventories. There is not only no inflation, but an actual appreciation of the currency. The amount of goods and services available for sale increases at a greater rate than the creation of new money. This is the opposite of the classic definition of inflation, in which money is created at a greater rate than goods and services are produced.

We do not, however, need to rely on what some people might regard as a bit of esoteric reasoning to prove that the "Real Bills" doctrine works. We have hard data to substantiate the claim — data that Keynes completely ignored. In 1935, Dr. Harold G. Moulton, then-president of the Brookings Institution, published findings that contradicted the Keynesian New Deal that was then in the process of being implemented in the United States. Dr. Moulton's little book, The Formation of Capital, began by examining cycles of consumption and investment covering the period from 1830 to 1930. He then analyzed the results of his examination and determined that what he found directly contradicted the entire justification of the Keynesian New Deal. We can understand the significance of Dr. Moulton's findings by giving two standard Keynesian dogmas (one in this posting, another in the next), showing what Dr. Moulton discovered, and analyzing Dr. Moulton's finding.

Keynesian Dogma Number 1: New capital formation can only be financed by first cutting consumption, saving, then investing.

Dr. Moulton's Finding: From 1830 to 1930, during which the United States experienced periods of the greatest industrial, agricultural, and commercial expansion in history, periods of intensive new capital formation were preceded not by decreases in consumption as Keynes declared was absolutely necessary, but great increases in consumption.

Analysis: Dr. Moulton drew two conclusions from this observation. 1) Effective demand (i.e., consumption) does not derive from an increase in the quantity of goods and services available (i.e., from increased investment). On the contrary, a rational businessman or investor will only invest in new capital formation, or even replace existing worn-out capital, if effective demand for his good or service already exists. The demand for capital goods is derived from consumer demand, not the other way around as Keynes believed.

In any event, given (as Keynes believed as an absolute) that savings necessarily equals investment, it is impossible to finance new capital formation out of existing pools of savings. Why? They don't exist. Banks do not let savers accumulate idle cash in their accounts. On the contrary, every dollar sitting idle in a savings account is a dollar not making money. The function of a "bank of deposit" or savings bank is to aggregate the accumulations of savers, and lend the money to borrowers. An accumulation of savings is already invested. Remember Jimmy Stewart's speech in It's a Wonderful Life? If everyone who had a savings account at a bank of deposit demanded his or her savings in full, in cash, in order to finance new capital formation, the bank would be forced to call in all its loans. This, in turn, would force borrowers to liquidate (sell) their investments — holdings of capital — in order to repay the loans immediately. All new capital investment would be matched by an equal and opposite disinvestment in existing capital, a zero-sum effort. Under Keynes' assumption that saving must precede investment, there could never be any economic development, merely a continuous transfer of existing capital back and forth, an endless game of redistribution.

While Keynesian monetary and fiscal policy is predicated on the necessity of redistributing existing wealth, and is designed to do just that, the real use of existing savings (and thus existing investment) is to insure that bank loans extended to finance new capital formation (and thereby create money) can be paid back, whether or not the new capital formation is successful. The existing savings/investment function as "collateral," so that the bank's shareholders and account holders do not lose too much money if something goes wrong. Consistent with the old saw that you need money to make money, existing savings/investment does not itself provide the financing for new capital formation. It makes new capital formation possible by insuring the lender against unexpected loss.

As we see in the subtitle to the second book by Louis Kelso and Mortimer Adler, The New Capitalists (1961), this use of savings as collateral instead of as the direct source of financing suggests not only that something other than existing pools of savings are used for new investment ... but that something other than accumulated wealth can be used for collateral. If, after all, collateral is a form of self insurance, why not use actual insurance, "capital credit insurance," in the place of savings? Thus the subtitle of Kelso and Adler's second book, "How to Free Economic Growth From the Slavery of Savings," not only makes perfect sense, but frees us from the slavery of reliance on the dogmas of the world's premier defunct economist: John Maynard Keynes.