Real Bills Doctrine

The Real Bills Doctrine refers to a norm in which currency is issued in exchange at a discount for short-term debt. According to the Real Bills Doctrine, limiting banks to only or primarily issuing money that is adequately backed by equally-valued assets, will not contribute to inflation. By contrast, proponents of quantity theory argue that any increases in the money supply tend to create inflation.

The Real Bills Doctrine is commonly described as a simple transaction between a bank and a business that results in the issuance of money into the economy. For example, a parts supplier sells $10,000 worth of widgets to a manufacturer, along with an invoice with payment due in 90 days. The manufacturer agrees to these terms, as it intends to manufacture and sell the widgets over the 90 days. In effect, the supplier has created commercial paper (a “real bill” that is not secured, but represents tangible goods in process) that has a value of $10,000. Rather than wait to be paid, the parts supplier can sell the paper to a bank at its present discounted value of say $9,800. The bank monetizes the paper, and later collects the bill at full value.

As economic theory, the Real Bills Doctrine evolved from 18^th-century economic thought, including Adam Smith’s “The Wealth of Nations” in which Smith suggested that real bills were a prudent asset for commercial banks to purchase and hold. The Doctrine is often part of the larger debate about the appropriate role of central banks in managing money supply. Many economists argue, for example, that the recently created Federal Reserve adhered too strictly to the real bills doctrine, contributing to the Great Contraction and Great Depression of 1929-1932.

Although many economists find fault with the doctrine and consider it discredited, there is disagreement about which alternative system is most efficient. Economists supporting quantity-theory believe central banks should focus on stabilizing the quantity of money, preferring active open-market policies such as the purchase of government debt to drive liquidity in markets and stabilize currency. The doctrine is most heavily criticized by economists favoring free banking, who argue that the government should not be involved in managing the money supply and that open commercial competition provides the optimal stabilization of money creation.