Some Thoughts on Money, Part VII: The Banking School and the Real Bills Doctrine

To return to our interrupted series on some thoughts on money, we start by taking a look at the "school" that opposed the position of the Currency School, the Banking School. The basic tenets of the Banking School were that 1) a paper currency was at least as good as a gold currency, even having several advantages over gold, and 2) the definition of "money" included anything that can be used in settlement of a debt, but especially banknotes and commercial ("mercantile") paper of all types. The one proviso that all adherents of the Banking School insisted must be in place was that the backing of a paper currency has to consist of real assets, that is, something with a present value that can be expressed in terms of the currency.

This is, in essence, the real bills doctrine. According to such supporters as Adam Smith (The Wealth of Nations, 1776, II.ii), Henry Thornton (An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, 1802), and John Fullarton (On the Regulation of Currencies of the Bank of England, 1845), paper money (and, of course, demand deposits) can be created at will without inflation or deflation if (and only if) the amount of paper money does not exceed the present value of existing and future marketable goods and services in the economy. Smith added the caveat that, in order to ensure that people had confidence in the paper currency, the amount of paper currency could not exceed the value of gold and silver in the economy.

Subsequent economists, such as David Ricardo — who supported the Currency School — twisted Smith's meaning and stated that Smith meant that the amount of paper currency could not possibly exceed the amount of gold and silver in the economy. That is, Ricardo claimed that Smith declared that the real bills doctrine would somehow magically prevent the amount of paper currency from exceeding the amount of gold and silver in the economy. This is demonstrably false — paper issues can certainly be created at will and in unlimited amounts — and clearly not what Smith meant at all. It was, however, an easy straw man that has been used to "discredit" Smith's argument in support of the real bills doctrine ever since.

Thornton agreed with Smith that it was a good idea to have the paper currency convertible into gold in order to build people's confidence in the paper currency. Once confidence was established, however, it was far more expedient and much more efficient to eliminate gold altogether as too expensive and unnecessary to use as currency.

John Fullarton argued that, in accordance with a "law of reflux" that he invented, the proportion of paper currency (including demand deposits and all other negotiable instruments), and gold would be self regulating . . . always given that the backing of the paper currency was in the form of real bills, not fictitious bills, speculative projects, derivatives, consumer debt, or government debt. Excess paper issues would flow back to the issuer for redemption in gold or in payment of the debt by means of which the paper currency was created until parity was reestablished.

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