Real Bills: an Emergent Market
by Bill Koures
September 26, 2005
History demonstrates that real bills are a spontaneously emergent
phenomenon of free markets with roundabout production cycles. They
arise naturally as a means for the free market to regulate supply
of merchandise in urgent demand. By its very nature, the price
discovery mechanism is too sluggish to adjust to the dynamically
changing needs of the consumer. In contrast, the discount rate
of freely traded bills of exchange will adjust very quickly to
consumer needs, providing timely feedback for the market to adapt
accordingly. Government or central bank interventions may sabotage
real bills but this does not detract from their birthright as clearing
instruments for merchandise in urgent demand. The argument that
real bills are inflationary is a strawman.
Truth refers to what is or was, not to a state of affairs that
is not or was not but would suit the wishes of the truth seeker
Ludwig von Mises, Theory and History, pg. 298
A recent contribution1 to
the debate2-15 on
the efficacy of real bills within a truly free market is characteristic
of the level of emotion that persists on this topic. In this paper,
we will objectively rebut the substantive points that have been made
by supporters of Rothbard's 100% gold standard. We will focus in
particular on Sean Corrigan's working paper1 because
it covers enough theoretical terrain to shed light on the Rothbard
position and its shortcomings. We will, however, steer clear from
ad hominem and vitriolic remarks.
We'll see that the inflation fears associated with real bills may
more properly be attributed to central bank interventions. We will
also show that the assumptions behind Rothbard's 100% gold standard
proposal are flawed and impractical. On the other hand, bills of
exchange originally emerged among freely trading producers, distributors,
and retail merchants during the 14th century.16 These real
bills facilitated more roundabout production processes; thus,
they were a crucial innovation that helped catapult Europe out of
the Middle Ages and into the Renaissance, with its dramatic increase
in productivity and higher standard of living.6,16 Throughout,
we discuss aspects of Antal Fekete's theory of interest17 and
its elegant integration of the historical record within a unified
Real Bills Emerge Freely
Real bills are an emergent market phenomenon. They emerge freely
in markets with roundabout production cycles. The Real Bills Doctrine
(RBD) as expounded by Adam Smith18 and
analyzed by Antal Fekete16 ,
may be viewed as a theory describing the emergence of real bills
in a free market. In this sense, it may be misleading to refer to
the theory of the emergence of real bills as a "doctrine". Real bills
originally emerged as a widespread market phenomenon in the city-states
of Italy during the 14th century.6,19 They
were freely traded among producers, distributors, and retail merchants.
As Antal Fekete observes:
"(T)he question whether bills or banks came first has a definite
answer. There can be no doubt that the former did. Logically and
historically, the bill predates the bank. What is more, it is perfectly
feasible to have an economy without any commercial banks at all
wherein circulating bills of exchange emerge as the supplier delivers
semi-finished consumer goods to the producer." 6
This is an important observation because any subsequent abuses of
real bills may appropriately be attributed to fraud or to government
and central bank interventions. The Mises Institute is big on differentiating
between the free market and statist interventions with the free market.
Mises was keen to point out that statists are prone to blame free
markets for the inevitable failures of interventions, justifying
spiraling rounds of more interventions. Yet, as we'll see later,
some others at the Mises Institute miss the point that the exact
same argument applies to the real bills market--it is the interventions
that are to blame, not the real bills themselves.
Present day vestiges of real bills: Energy Trading
History shows that real bills did emerge spontaneously in free markets
with roundabout production cycles. But vestiges of real bills may
also be observed today. Having been involved in energy risk management,
I can personally relate a contemporary example of incipient real
bills in energy trading. (I refer to them as "incipient" because
real bills would circulate and they could only be extinguished with
gold.) In a typical 30-day contract to deliver natural gas, 50 days
pass between the first day of the delivery period and the settlement
date. For example, if a utility transacts to receive thirty days
of natural gas from a producer during the month of November, the
settlement date will be on December 20th. The utility will be receiving
natural gas every day of November but its bill will come due twenty
days after the last delivery day. The question naturally arises:
Why is this transaction not treated as a loan from the producer to
the utility? Shouldn't a debt accumulate with each delivery day?
Why does interest not accrue to the producer until December 20?
In fact, not only does no interest accrue to the producer but, if
the utility agreed to prepay for the natural gas, it would be entitled
to a discount. What gives? Well, it is not a loan because the consumer
is in charge. The producer must wait for the consumer to pay his
heating bill. Only then can the producer collect its money from the
utility. In fact, any lower order producer, by virtue of being closer
to the ultimate paying customer, always has the prerogative in transaction
terms with the higher order producer. Everyone in the production
chain must wait for the consumer's payment to clear. If the consumer
could pay in gold, he would truly be boss.
By contrast, in a loan transaction it is the lender who is in charge.
For example, if a utility applies for a loan to build an electric
power plant, the consumer does not directly figure into this transaction
because his precise contribution to paying off the utility's debt
is far into the future and speculative. The lender, as a supplier
of savings, is entitled to drawing a fixed income on his loan funds,
irrespective of the relative profitability of the power plant.
It is important to note that a short-term natural gas delivery contract
is not a true real bill because it does not circulate and, when it
matures, it is not extinguished with gold. Therefore, the consumer
has been stripped of his power to fully dictate terms to the utility.
Indeed, the utility's pricing signals, and hence the consumer's choice,
are greatly limited by government regulation. The wings of this incipient
real bill have been clipped.
Nevertheless, it is telling that the vestiges of a real bill have
staged a comeback in the energy-trading arena. We see that a producer
does not accrue interest on his supply of energy. Instead, the distributor
can expect a discount if he chooses to prepay for the delivery. This
transaction is held together by the consumer whose payment of his
heating bill is practically assured. It would be unthinkable for
the producer to approach the distributor and suggest that a loan
has been made and interest payments are due.
Answers to questions: Real Bills are a free market
Recognition that real bills are a free market phenomenon leads to
simple answers to questions that Sean Corrigan poses:1
- Question: How does one determine the reality of a given
bill in today's complex economy?
- Answer: Real bills do not exist in an economy without
a working gold standard. If they did exist, they would be easily
recognized because they would be drawn on merchandise in urgent
demand; they would mature into physical gold within 91 days; and
they would spontaneously circulate and be eligible for discounting.
However, vestiges of real bills may be found today in markets for
goods in urgent demand, with the consumer's payment playing a key
- Question: How are we to gauge the value of, say, the provision
of legal services in a patent dispute, rather than that of a VLCC
cruising the high seas? Or how might the act of contracting the
WPP Group for an advertising campaign differ from laying claim
to the very tangible cargo of iron ore nestling in the hold of
a 1,000-ft carrier plying the waterways of the Great Lakes?
- Answer: We may as well ask, "How do markets work?" These
are good questions to ponder but they're irrelevant to the issue
at hand. Namely, they don't concern real bills unless they relate
to the financing of merchandise in urgent demand by self-liquidating
credits. It may be worth repeating here that real bills are not
a banker's concoction or a statist's policy proposal. Rather, they
are emergent market phenomena. The market itself thus sets the
context of their application.
- Question: One might even maliciously wonder whether a
margin loan on the NYSE is not at least a cousin to a 'real' bill,
since it helps finance the purchase of a direct claim upon the
net productive assets - the stock - of a private corporation. And
what about a repurchase agreement used to finance a holding of
that same corporate's debt and hence to maintain a prior lien on
a share of its income stream?
- Answer: Let's take a margin loan on a stock traded on
the NYSE and compare it to the incipient real bill of our natural
gas trading example. The issuer of a stock certificate on margin
earns interest but the producer of natural gas earns no interest
while he delivers gas for thirty days and then waits for 20 more
days for the bill to come due. The receiver of the stock certificate
has no consumer good in urgent demand to deliver -- his profit
or loss is based on a speculative outcome. On the other hand, the
utility may rest assured that the consumer, who is eager to heat
his home, will extinguish its bill. The margin loan is not a real
bill or even an incipient real bill -- it is a loan, pure and simple.
Similar comments apply to repurchase agreements.
- Question: There is also a deafening silence on how the
good Prof. Fekete might propose to prohibit the issue of finance
("pig on pork"), or accommodation bills (glorified promissory notes)
- and lest the reader thinks we are here arguing about the niceties
of some Victorian anachronism, he should be aware that the traditional
bill's latter day equivalents in this area, asset-backed securities,
are a quintessential feature of the modern credit landscape, comprising
a $1.8 trillion market in the US alone.
- Answer: Au contraire! Answers aplenty are littered throughout
prof. Fekete's lecture series, Monetary Economics 101.16 Lectures
11, 12, and 13 are particularly relevant since they address this
question extensively. Let's also keep in mind that real bills can
function properly only in a free market, without central banks,
and with an unadulterated gold standard20 .
This is not the market environment we have in the modern credit
Corrigan also cites bill-"kiting" in industrial Britain as a reason
for rejecting real bills.1 However,
we'll see later that such abuses can be attributed to central bank
interventions. Besides, how does one reject a free market phenomenon?
With government interventions? The term bill-"kiting" itself is interesting.
Do we reject any free market instrument that can be kited or otherwise
abused? This cannot be a tenable position for a free market advocate.
This point was passionately driven home by Nelson Hultberg:
"The most important mistake being made by Corrigan and the Rothbardians
is that they continue to ignore the fact that in a free-market
system, real bills will automatically spring up and be used wherever
they are functional. There is nothing to stop them! They are not
fraudulent; and they are not governmentally orchestrated. So they
will certainly be utilized among producers, distributors and retailers
if we are going to promote freedom. And I presume that is what
the Rothbardians wish to promote. What are Corrigan and his cohorts
going to do? Suppress the use of real bills with government intervention?
Not very libertarian at all." 12
However, the two pillars on which Corrigan et al. posit their opposition
to real bills are the contentions that (1) real bills are inflationary,
and (2) a 100% gold standard is a viable alternative to real bills.
We now explore each of these claims in turn.
Adam Smith's RBD vs. Central Bank's FBD
Over the years, a common misconception of the real bills doctrine
has developed. Many view the doctrine as a rule by which the money
supply can be geared by central bankers to match the nation's productive
this corrupted "central banker's" version, if the money supply is
properly managed then the extreme swings of the business cycle can
be mitigated and the economy will experience relatively steady growth.
This is a far cry from Adam Smith's real bills doctrine16,18 which
describes how the free market optimally regulates the flow of consumer
goods in urgent demand without the guiding hand of government or
central bank interventions.
In this section we'll see that in Adam Smith's Real Bills Doctrine
(RBD) the gold coin plays a vital role in the free market's regulation
of consumer flows. Gold is the means by which the consumer can exercise
his sovereign choice in the consumer goods market. His gold coin
is absolutely necessary to extinguish maturing real bills. In the
corrupted version of the doctrine, the gold coin is deemed superfluous
and central bankers attempt to regulate the "money supply" by administrative
fiat. The real bill has been stripped of its gold and emasculated.
The financial bill, which cannot be extinguished with gold and can
be continually rolled over, has replaced it. The result is an unstable,
centrally managed system that masquerades as a free market.
Frankly, the difference between the two versions of the real bills
doctrine is like night and day. It is tantamount to the difference
between free markets and centrally managed markets. As we'll see,
the "central banker's" version of the doctrine should more appropriately
be referred to as the Financial Bills Doctrine (FBD).
RBD: free market phenomenon or central banker's
A well-known contemporary presentation of the thesis that the real
bills doctrine is inflationary is the work of Thomas Humphrey.21 This
paper offers a historical overview that, for example, includes a
thorough review of Henry Thornton's much-cited criticisms of the
real bills doctrine.23 It
also presents a mathematical treatment to show that a dynamic instability
results when one attempts to manage the money supply by gearing it
to the "needs of trade". In a nutshell, Humphrey posits that once
money is bureaucratically "governed by the needs of trade", a nonlinear
self-feedback mechanism kicks in that causes prices to rise uncontrollably.21 He
concludes his paper by suggesting that the modern-day "interest-pegging
scheme" is yet another incarnation of the "real bills fallacy":
"Thus the attempt to peg interest rates generates a dynamically
unstable process in which money and prices chase each other upward
ad infinitum in a cumulative inflationary spiral. ... Because of
this the interest-targeting proposal may be viewed as merely the
latest reincarnation of the discredited real bills fallacy." 21
It is clear, however, that Humphrey's criticisms are aimed at the
bastardized, central bankers' version of the doctrine that attempts
to "govern" the money supply. In fact, Humphrey explicitly exempts
Adam Smith's real bills doctrine from his criticisms of what he terms
the "conventional" real bills doctrine:
"Smith argued that under specie convertibility the commodity price
level is determined in world markets by the relative cost of producing
gold and goods and then given exogenously to the open national
economy. And with prices thus predetermined, it follows that they
must be invariant with respect to the domestic note issue, i.e.,
paper money cannot affect prices in the small open economy. This
breaks the vicious cycle of inflation and money growth inherent
in conventional versions of the real bills doctrine and renders
Smith's version immune to the problem of dynamic instability.
... Adam Smith was astute enough to present the real bills
doctrine within the context of a convertible currency regime
in which specie convertibility limits the note issue and price-level
exogeneity prevents it from generating inflation. Later, less
astute writers incautiously extended the doctrine to the case
of currency inconvertibility in which those safeguards are absent. Chief
among these writers were the antibullionists who employed
the doctrine to defend the Bank of England against the charge
that it had taken advantage of the suspension of specie convertibility
during the Napoleonic wars to overissue the currency." 21 [Bold
So, Humphrey himself acknowledges that his inflationary arguments
against real bills do not apply to Adam Smith's real bills doctrine because
Smith was keen enough to recognize that consumer goods in urgent
demand were priced exogenously (i.e., outside the real bills market).
In layman's terms, real bills are drawn only on goods in urgent
demand (i.e., the small open economy). Since these goods are "in-season",
their value to the consumer is clear and it is set in gold money.
In turn, this sets the face value of the real bills drawn on these
goods. No feedback is possible from the real bills market to the
consumer market because bills of exchange cannot generate demand
for urgent goods--the consumer is king because he holds the gold
coin. Note that Humphrey also understood that the doctrine became
unstable when it was later "extended" to apply to the "case of
currency inconvertibility". He even named the chief culprits in
the subsequent distortion of the real bills doctrine: CENTRAL
Antal Fekete also rejects the central banker's version of RBD but
he embraces Adam Smith's RBD.16 He
also recognizes the vital role that is played by the gold coin. Adam
Smith's RBD without an operational gold standard is simply an impossibility:
"A bill of exchange is a real bill in that it represents real
goods making a real move to a real consumer holding a real gold
coin as the carrot (if he spends it) or as the stick (if he doesn't).
An irredeemable bank note is a phoney bill, representing bad faith
on the part of the issuer, ignorance on the part of the producer
who gives up real goods and services in exchange for irredeemable
promises to pay, and bondage on the part of the saver who has been
thrown into slavery by his government when his gold coin was confiscated." 24
It is unfortunate that researchers1,4,9,21,22 have
not paid enough heed to this important distinction. There are two
diametrically opposed versions of the real bills doctrine! Adam Smith's
doctrine describes how the "invisible hand" of the free market allocates
urgently demanded merchandise. The other version refers to a futile
doctrine that purports to be able to gear the money supply to productive
output. Adam Smith's doctrine refers to a free market phenomenon
that is robust and capable of ferreting out rare, isolated cases
of fraud. The other, "central banker's" doctrine creates systemic
problems by breaking the link between the consumer and his gold coin
and by allowing banks to shelter illiquid financial bills in their
Henceforth, to avoid further confusion, we will refer to the bastardized, "central
banker's" version of the real bills doctrine, which can be inflationary,
as the Financial Bills Doctrine ( FBD) and the Adam Smith
Real Bills Doctrine, which is not inflationary, as simply the Real
Bills Doctrine ( RBD). These phrases accurately delineate the
essential features of the two doctrines:
"The changeover from bank notes backed by real bills to bank notes
backed by financial bills was the last nail in the coffin of the
clearing system of the international gold standard. Monetary scientists
and others with intellectual power to grasp the intricacies of
bank note circulation raised their voice, condemning the new paradigm
making financial bills as well as treasury bills eligible for rediscount,
a practice that had previously been prohibited by law with severe
penalties for non-compliance. Most people could not understand
what the fuss was about. But there was a world of difference
between rediscounting real bills and rediscounting financial bills.
It was the difference between self-liquidating credit and non-self-liquidating
credit. Real bills were backed by a huge international bill
market with its practically inexhaustible demand for liquid earning
assets. Financial bills were backed by the odds that the speculative
bets of the drawer in conspiracy with the drawee will pay off,
that is, their speculative inventory of goods and equities, or
brick and mortar in real estate investment, can be unwound without
a loss. Treasury bills represented future tax receipts. If anticipation
attached to these bills did not materialize in time, then at maturity
they would have to be rolled over. This was borrowing short and
lending long through the back door, carrier of the seeds of self-destruction." 25 [Bold
Financial bills would not circulate in a free market. Consequently,
there is a world of difference between Adam Smith's RBD and its bastardized
version, the FBD. Adam Smith's RBD refers to a free market phenomenon.
It is compatible with Antal Fekete's theory of interest, where the
marginal shopkeeper, who performs arbitrage between the real bills
market and the consumer goods market, sets the discount rate.14,17 Its
impostor, the FBD, has severed the direct link between the real bills
market and the consumer goods market. Its natural arbitrageur, the
marginal shopkeeper, has been replaced by a government-sanctioned
central planning committee, the Federal
Open Market Committee, that attempts to "gear money to production".21,22 This
state of affairs would not have been possible without the collusion
of government with central banks.24-26 To
condemn the free emergence of real bills on account of government
and central bank interventions is to throw out the baby with the
Inflationist boogeyman is a strawman
The purported "inflationary" criticism of Adam Smith's RBD is really
a criticism of its statist bastardization, the FBD. But the FBD does
not describe a free market phenomenon. It describes central bankers'
futile attempt to intervene with the free market. The FBD falls under
the rubric of the fallacy of central planning and its refutation
is essentially similar to Mises' argument that socialism must fail
because it lacks the free market's means of economic calculation.27 Just
as it would be silly to criticize free markets because they cannot
work effectively within a socialist framework, it is also silly to
criticize real bills because they cannot work effectively in today's "smoke-and-mirrors
"... Prof. Fekete not only overlooks the sporadic bill-"kiting" crises
which dogged Industrial Britain throughout what he supposes to
be a complete golden age, he also fails to recognize that it would
be only too trivial to disguise such bastard children as the 'real'
thing in today's Andersen-Enron-Citigroup, financially-engineered,
smoke-and-mirrors economy." 1
Once again, this is not a fair assessment of Antal Fekete's position.
As discussed earlier, Humphrey showed that the antibullionists were
already busy at work in the birth throes of Industrial Britain, intervening
with the free market for real bills, at the beckon call of the Bank
of England. Careful study of Industrial Britain reveals that it is
central bank interventions that created systemic problems,
not the naturally emergent real bills themselves. Antal Fekete is
well aware of this and he has never referred to the era of Industrial
Britain as a "complete golden age". Fekete is actually quite critical
of the circumstances under which the Bank of England was founded
and of its subsequent role in the history of banking.28 Here
is Fekete's view on the debauching of accounting standards:
"Once the fraudulent anticipation and accommodation bills are
removed from the bill markets and given shelter in the portfolio
of the bank, then whatever possibility for the detection of the
fraud had existed before was lost. The practice of shortchanging
the public could be perpetuated.
The banks could create something out of nothing only through the
fraud of accepting anticipation and accommodation bills, disregarding
the fact that these bills were no longer self-liquidating. The
banks could not care less how the borrowers would eventually get
the money to repay the loan. In case of a default the bank would
liquidate the collateral and satisfy itself from the proceeds.
The banks were in fact usurping and monopolizing social circulating
capital. They could get away with it by virtue of the government
patent exempting banks from the rigors of bank examinations and
from the strict application of accounting standards." 30
On the other hand, in a free, gold-based market with full disclosure
and legal safeguards against fraud, the real bills market can expedite
the ferreting out of fraudulent bills.12,15,30 Consider
the following oft-quoted1 passage
"Suppose that A sells one hundred pounds worth of goods to B at
six months credit, and takes a bill at six months for it; and that
B, within a month after, sells the same goods, at a like credit,
to C, taking a bill; and again, that C, after another month, sells
them to D, taking a like bill, and so on. There may then, at the
end of six months, be six bills of 100 pounds each existing at
the same time; and every one of these may possibly have been discounted.
Of all these bills, then, only one represents any actual property." 23
This may appear to be an effective criticism but only if we ignore
how real bills were actually traded in the "real" world. Specifically,
not all bills were equally liquid.19 Only
the most liquid bills, those drawn by the supplier on the seller
of first order goods, would actually circulate.19,29 These
bills were drawn only on urgent goods and they all matured into gold
coins within 91 days -- six month bills would not circulate. Opportunities
for fraud were few and they were localized in time and space. Counterfeit
bills were illegal and exposed the perpetrator to severe penalties.
With full transparency and legal safeguards, the free markets were
fully capable of ferreting out bogus bills.
Whether intentional or not, the charge that Adam Smith's RBD is
inflationary is a strawman. It is only when real bills were hijacked
by central bankers and replaced with illiquid financial bills that
systemic problems emerged.30 The
strawman is the Financial Bills Doctrine and it has masqueraded as
the Real Bills Doctrine for too long. Fortunately, Antal Fekete's
work has restored the Real Bills Doctrine of Adam Smith to its rightful
place as a brilliant model that describes a vitally important component
of truly free markets.
The great irony may be that some free market advocates have labeled
Antal Fekete, who has delivered a most devastating refutation of
FBD, as its proponent. He has even been characterized as a modern
day inflationist in the tradition of John Law.1 This
accusation is an egregious injustice that will not stand the test
Freely Traded Real Bills vs. 100% Gold Standard
First, let's frame our discussion by considering a stylized example
set forth by Antal Fekete:
"Consider a hypothetical product called "miltonic". It is in urgent
demand as a medicine that helps preventing cancer. Its production
cycle takes 91 days, with as many as 90 firms participating, so
that the sojourn of the semi-finished product at every one of the
90 stops takes one day. The ultimate consumer is willing to pay
$100 for a bottle while the producer of the 90th order good has
paid $11 for raw materials. We shall also assume that the value
added to the maturing product at every stop is $1. Now if you want
to finance the movement of one bottle of miltonic through the various
stages of production, then the pool of circulating gold coins will
have to be invaded 90 times, and you have to withdraw savings in
the amount of
11 + 12 + 13 + ... + 98 + 99 + 100 = ½(11
+ 100)×90 = 45×111
or $4995, almost 50 times retail value. In other words, there
must be savings in existence in the amount of almost $5000 to move
just one bottle of miltonic through the production process all
the way to the consumer. This sum does not include fixed capital
that also has to be financed out of savings! And what about other
items of food, fuel, and clothes, also urgently demanded by the
consumer? Let me suggest it to you that no conceivable economy
can generate savings so prodigiously as to move all the indispensable
items to the consumer." 6
Hayekian triangle: an aggregate factory
Next, we note that Corrigan recast1 a
version of Fekete's miltonic example within the framework of a Hayekian "triangle".
That is, he organized an aggregate "factory" in a 90-step
triangle of 1-2-3- ... -89-90 "workers". So, step 1 has one worker,
step 2 has two workers, step 3 has three workers, and
so on until step 90 which has 90 workers. The total number
of workers in this factory is 4095 (since the sum of
the numbers 1 through 90 equals 4095). One may think of step 1 with worker 1
as the producer of the 90th order good, step 2 with workers 2
and 3 as the producer of the 89th order good, on up to step
90 with workers 4006 through 4095 as the producer of
the 1st order good.
Accordingly, one may also assume that each worker produces
one value unit (e.g., one gold dollar) as a result of his efforts.
If, like Corrigan, we ignore the value of the raw material inputs31 and
if we assume that each unit of final good output will sell for $1,
then 4095 units of final goods must be sold to equalize the income
of all participating workers. To simplify the discussion further,
let's assume that there is an aggregate "consumer" at the
end of the production chain who is willing to buy a "package" of
4095 units of output; that is, the final product contains
4095 units of output and it sells for $4095. Let's call this final
product a bottle of miltonic. We also introduce the concept
of an aggregate "factory owner" who must pay his producers daily
with gold dollars for their productive output. We may also think
of the production chain through our "Hayekian" factory as
an aggregate "assembly line", with each semi-refinement along
the assembly line taking one day to complete. In this picture, the factory
owner represents the pool of savings that must be drawn on to
pay the producers along the 90-step production chain.
On day 1, the 90th order producer completes its refinement
of the first semi-finished product and gets paid $1 by the factory
owner. On day 2, the 89th order producer completes its
refinement of the first semi-finished product and gets paid $3 while
the 90th order producer completes its refinement of the second semi-finished
product and gets paid another dollar. On day 3, the 88th order producer
gets $6 for its refinement of the first semi-finished product, the
89th order producer gets $3 for refining the second semi-finished
product, and the 90th order producer gets $1 for refining the third
semi-finished product. This process continues until finally, on day
90, we have our first finished product: a bottle of miltonic.
The sum of all the payments is $125,580.
After 90 days, the factory owner has drawn on $125,580 from
savings to pay his producers along the production chain. The
first bottle of miltonic is finished and there are
89 semi-finished bottles on the assembly line. On day 91,
the first bottle of miltonic is sold to the consumer for $4095
and a second bottle is finished and ready to be sold the next day.
From here on out, a finished bottle is produced everyday.
Also everyday, $125,580 is paid by the factory owner to finance
the assembly line with its 90 units of miltonic in various
stages of production.
It is important to emphasize that the cost of producing one unit
of miltonic is $4095, not $125,580. Every day, each producer along
the chain must pay its workers and suppliers. This means that the
money needed on a daily basis to keep the assembly line moving
is $125,580. On the other hand, the value input of each worker into
a single final product is $1 and there are a total of 4095 workers;
hence, the consumer's payment of $4095 is enough to cover
the cost of one final product -- a bottle of miltonic.
To see this more clearly, consider the following. The 90th order
producer must be paid $1 for his output. The 89th order producer
needs $3 to pay his two workers and his supplier, the 90th order
producer. The 88th order producer needs $6 to pay his three workers
and his supplier, the 89th order producer. This continues down the
production chain, terminating with the first order producer, who
needs $4095 to pay his workers and his supplier, the 2nd order producer.
Summing all of this up, a total of $125,580 finances the movement
of semi-refined products through the production chain. The final
product begins its journey from raw material and makes its way
to the consumer through a 90-step series of refinements. On the other
hand, the gold-paying consumer's payment of $4095 for the final
product is enough to cover the production input of each worker on
that one product.
An alternative payment system naturally emerges. The 90th order
producer "bills" the 89th order producer, who bills the 88th
order producer, and so on until the second order producer bills the
first order producer. The consumer's payment of $4095 is now enough
to extinguish all credits. That is, the first order producer receives
$4095 and pays $90 to his workers and $4005 to his supplier, the
second order producer, who then pays $89 to his workers and $3916
to his supplier, the third order producer. The consumer's payment
telescopes its way up to the 89th order producer who receives $3
to pay his two workers and his supplier, the 90th order producer.
The consumer's 4095 gold dollars are thus enough to extinguish all
bills drawn on the successive refinements of the final product.
From here on out, the assembly line may be kept moving every day
by the consumer's 4095 gold dollars together with clearing instruments,
the real bills, with a face of $125,580. This frees up the daily
use of 125,580 gold dollars from savings to be utilized elsewhere
-- real bills are self-liquidating credits.
Recall that our aggregate Hayekian factory took 90 days to
come on line with a fully functional assembly line. Recall
also that it took $125,580 from savings to bring it on line. However,
once the assembly line is fully functional, real bills, maturing
into consumers' gold coins, are enough to fund its ongoing operation.
During those first 90 days, the producers exchange bills but they
must tap into savings to pay their workers and suppliers. From the
91st day onward, a real bill matures everyday and the consumer's payment
of $4095 is enough to keep the assembly line moving as it telescopes
its way up the production chain. We may thus say that it takes $125,580
from savings to build the factory but, once the assembly line is
running, real bills along with the consumer' gold coins will keep
it moving. Producers' savings no longer need to be disproportionately
tapped on a daily basis.
100% gold standard cannot work in today's technological
We may now compare and contrast the two payment systems. In the
100% gold system, all the producers are paid daily with gold. Hence,
each day the amount of savings that is tied up by the assembly
line for urgent merchandise may be huge. Indeed, given the extended
roundabout processes in our modern economy, the savings necessary
to keep our assembly line moving would be overwhelming. This
daily locking up of society's savings is an opportunity cost that
must be paid in the form of forestalled research & development,
alternative capital production, etc. On the other hand, the clearing
system allows the assembly line to be financed daily by real bills
and the consumer's gold coins. Since the factory is producing merchandise
in urgent demand, the consumer's payment is assured; in effect, urgent
merchandise collateralizes the real bills.
How do Rothbard's supporters view this? Interestingly, Corrigan
responds with a qualified concession and an alternative. First, let's
look at the concession:
"Now, narrowly, it is true that a clearing instrument (CI), a
bill (real or otherwise) would greatly facilitate the movement
of the stream of products which emanates from our highly vertically-divided
arrangement of labor. However, we must acknowledge that the income
-- if not necessarily the intermediate revenues -- must be settled
in gold dollars -- in money -- in order to avoid entraining
an inflationary outcome.
Thus, ... in our recasting of Fekete, we could get by with $4095
in gold and supplement its use with just over 30 times its value
On the surface, it appears that we have some agreement here. Real
bills do free up savings and greatly facilitate the movement of products
through the production chain but they must be settled in gold dollars.
A maturing real bill must be extinguished by gold, without exception.
In the interim, it is collateralized by merchandise in urgent demand.
This is the essence of RBD.16,17 However,
Corrigan does not seem to recognize that the real bills innovation
emerged in history among freely trading participants and that the
most liquid real bills, drawn from supplier to seller of first order
goods, circulated as money without government coercion. Also, he
does not appreciate that real bills introduced dramatic new efficiencies.
So, he offers an alternative:
"Alternatively, of course, there is no fundamental reason why
we could not use ... $15 of gold (it is highly divisible and completely
fungible, after all) and allow prices to fall to 1/273 of their
original gold level so as to reflect the sizeable increase in the
output of goods-in-being ..." 1
At last, we may clearly delineate our differences with the Rothbardians.
This, after all, is a principal tenet set forth by Rothbard himself.32 The
critical issue however is not the physical properties of gold but
the observed properties of the market. First and foremost, the real
markets have never displayed a propensity to rescale prices to accommodate
roundabout production cycles. The historical record indicates the
contrary: real bills emerged together with extended roundabout production
as we saw earlier, incipient real bills arise spontaneously, even
in today's markets, whenever the consumer wields influence through
his demand for urgent merchandise.
In science, whenever an apparently logical result is not corroborated
by observation, the scientist must re-examine his assumptions. In
this case, we must scrutinize Rothbard's implicit assumptions behind
the price discovery mechanism. First, we note that the consumer is
not an automaton. His tastes, needs, and desires are always in dynamic
flux. Price signals cannot keep pace with his fickle demands. Furthermore,
the real world is rife with supply shocks, new inventions, natural
disasters, fads, speculative fevers, wars, etc. Quite simply, the
price discovery mechanism is too sluggish to adjust to the fickle
nature of the consumer market or to a multitude of contingencies,
shocks, and innovations. In technical parlance, the relaxation
price adjustments is too long for the fast-changing pace of the market
for consumer goods in urgent demand. A free market for goods in urgent
demand cannot rely on some quasi-steady-flow, near-equilibrium process
in which prices gradually rescale to equalize with available savings.
This is not how markets work, at least not since the Middle Ages.
Yet, this is the type of market that would be needed to accommodate
Rothbard's 100% gold standard.
On the other hand, the discount rate is the beacon that guides the
producer to the consumer's urgent needs. The marginal shopkeeper14 ,
performing arbitrage between the real bills and consumer markets,
sends an early warning signal of the consumer's changing whims. This
lightning-quick signal resonates up the production chain:
"Temporary changes in the demand for staple consumer goods (such
as food, clothes, fuel) does not give occasion to changes in the
price. The price-system in and of itself is neither sensitive nor
quick enough to accomplish the task of alerting merchants to the
impending changes in the mood of the consumer. The message concerning
changes in the propensity to consume is communicated to the distributors
and producers, not through changing prices, but through changes
in the discount rate (and the composition of the social circulating
capital ...). Changes in the discount rate respond quickly and
sensitively to the changes in consumer demand. The lubricating
mechanism that guards the movement of goods against seizing up
when changing to high or low gear is the bill market."34
We should thus resist the temptation to imagine our aggregate factory example
as consisting of a steady-flow, static assembly line. In fact,
the "real" assembly line is dynamic. It is characterized by
fits and starts, requiring almost continual adjustments of its component
production units. For this assembly line to keep moving, it
needs a sensitive flow meter. It must have a sensitive mechanism
with which to detect changes in consumer flows. This way, it will
be able to make adjustments before the imbalance grows and manifests
itself in a price shock. If a price shock were to appear we'd be
in crisis mode. The meter that informs the flow of consumer goods
in urgent demand is the discount rate. Simply put, without
real bills the free market would lose its ability to effectively
calibrate to the dynamically changing needs of the consumer.
Two sources of credit
Let's return to our Hayekian factory one more time. As we
showed, savings must be tapped in the amount of $125,580 during the
90 days when the factory is coming on line. Corrigan presents
this as evidence that the socially circulating capital must be funded
"For what we have demonstrated is that circulating capital, no
less than fixed, must be funded -- i.e. it must be built
out of a store of saved consumption goods or else accompanied by
foregone consumption opportunity -- and that no amount of monetary legerdemain can
avoid this restriction."1
However, this statement exposes the confusion that is created by
refusing to recognize that credit is not monolithic.14 The
markets exhibit two distinct forms of credit: (1) long-term credit
to be financed by savings, and (2) short-term, clearing credit to
be financed by real bills.12,35 After
all, we have shown that our factory owner (i.e., society's
aggregate store of savings) must tap into savings to "build" the factory.
However, once the factory is on-line, real bills can finance
the movement of urgent goods. These bills mature into gold coins
and the goods in urgent demand collateralize them. By definition,
the social circulating capital is not funded from long-term
"Social circulating capital, a concept that we also owe to Adam
Smith, is defined as that mass of finished or semi-finished goods
in urgent need which is moving fast enough to retail outlets so
that it is bound to be removed from the market in less than 91
days (the length of the seasons of the year) by the ultimate cash-paying
consumer. A certain consumer good is part of the social circulating
capital if, and only if, the bill drawn against it will circulate." 35 [Bold
The building of factories is financed from long-term savings but
real bills finance the movement of goods in urgent demand. No monetary
legerdemain is involved. Producers and other actors17 may
freely allocate savings for building factories, performing research & development,
etc. Consumers may allocate a portion of their discretionary spending
for goods in urgent demand, whose movement through the production
chain is financed by real bills. So long as these participants are
allowed to act freely, the markets will operate efficiently and without systemic breakdowns.
To further illustrate the impractical nature of Rothbard's 100%
gold standard, let's consider Corrigan's basis for his inconsistent
claim that circulating capital must be "funded". He imagined a factory
owner, "Poros", who decides to construct a new 90-step factory.1 As
before, Poros must draw from savings a cumulative total of $125,580
during the 90-day period when the factory is coming on-line. Of course,
as Corrigan duly notes, there is no denying that society's aggregate
pool of savings must be drawn to "build" the new factory.
But Corrigan fails to appreciate that, in this Rothbardian world,
an additional $125,580 of savings must be drawn daily for
Poros to keep his old factory operating while he waits for
his new one to come on-line.
Worse yet, what if Poros decided to build a second 90-step factory
to produce another product, a bottle of biltonic, that was
also in urgent demand? Once his second factory comes on line, Poros
must now allocate $251,160 of his savings every day just to keep
his two factories operating. What is he to do if consumer demand
calls for a third factory? Where is he going to find additional savings
for research & development? Can he really rely on prices to gradually
rescale downward and for consumer trends to remain static enough
for him to keep pace? The answer is no. Rothbard's 100% gold standard
is impractical in today's highly specialized, technological society.
In contrast, the real bills market frees up society's savings from
the daily funding of the movement of goods in urgent demand. The
daily opportunity cost is lifted and savings may be put to use for
other productive enterprises. The real bills market was an innovation
that freely emerged and facilitated a great explosion of productivity,
with concomitant improvements to man's quality of life. Such observations
led Antal Fekete to conclude his miltonic example as follows:
"I conclude that the division of labor could have never been refined,
and the "roundaboutness" of the production process could have never
been lengthened, beyond the level reached by the cottage industries
of the medieval manors, wherein every family had to produce not
only its own food and fuel, but also its clothes and shelter.
If it did not happen that way, and production has become vastly
more efficient, was in large part due to the invention of the bill
of exchange, heralding the end of the Middle Ages. Clearing has
been put to work making it entirely unnecessary to invade the pool
of circulating gold coins and divert savings, to finance the movement
of consumer goods through an ever more refined and roundabout process,
provided only that those goods be demanded by the consumer urgently
Rothbard's 100% gold standard advocacy is badly misguided. It is
based on faulty assumptions about market dynamics that have not been
corroborated by observation--the "real" markets do not work that
way. As such, Rothbard's model can only be practically implemented
with the aid of government coercion. If that were to ever happen,
it would result in disastrous consequences.
We have seen that Adam Smith's RBD describes an emergent phenomenon
whereby the "invisible hand" of the free market effectively allocates
goods in urgent demand to the consumer. It is unfortunate that this
theory of an observed free market phenomenon has been confused with
the "central banker's" FBD, which attempts to centrally manage the "money
supply". The FBD should more appropriately be viewed as a misguided
policy of government and central bank interventionists.
Perhaps more damaging, the confusion between these two doctrines
continues to fuel the misguided advocacy for Rothbard's 100% gold
proposal is based on faulty assumptions about how markets actually
work and it cannot spontaneously emerge in today's highly specialized
technological society. Ironically, the 100% gold standard can only
be implemented through government coercion.
Throughout this paper we have referred to Antal Fekete's new theory
of interest.14,17 This
is a scientific theory that successfully integrates Adam Smith's
RBD, accounts for the observed historical record, and has explanatory
and predictive value. Both in spirit and substance, this theory is
a significant extension of Carl Menger's work. As a scientific theory,
it must always be amenable to the scientific method. Therefore, it
is always subject to extension, modification, and even falsification.
In future work, we will be presenting more rigorous and comprehensive
scientific analysis of the new theory of interest. Also, the Intermountain
Institute for Science and Applied Mathematics (IISAM)
will be hosting a gold standard workshop next spring that will be
based on Antal Fekete's Gold
1. Sean Corrigan, Unreal
Bills Doctrine, Mises Institute working paper, August
2. Nelson Hultberg, The
Future of Gold as Money, www.financialsense.com, February
3. Nelson Hultberg, Gold's
Future as Money - Q & A, www.financialsense.com, February
4. Robert Blumen, Real
Bills, Phony Wealth, www.mises.org, June 8, 2005.
5. Nelson Hultberg, Cranks
in the Gold Community, www.financialsense.com, July 11, 2005.
6. Antal Fekete, The
Dismal Monetary Science: Detractors of Adam Smith's Real Bills Doctrine,
www.financialsense.com, July 12, 2005.
7. Bill Koures, Mises
Blog 1 posted for RBD, July 17, 2005.
8. Bill Koures, Mises
Blog 2 posted for RBD, July 18, 2005.
9. Robert Blumen, Real
Bills, Phony Wealth II, www.financialsense.com, July 17,2005.
10. Nelson Hultberg, Real
Bills, Gold, and the Big Picture, www.financialsense.com,
July 25, 2005.
11. Sean Corrigan, Fool's
Gold and Fool's
Gold Redux, LewRockwell.com, August 9, 2005.
12. Nelson Hultberg, Real
Bills vs. Rothbard's 100% Gold System, www.safehaven.com,
September 6, 2005.
13. Sean Corrigan, Clearing
the Air, September 8, 2005.
14. Antal Fekete, Where
Mises Went Wrong, www.safehaven.com, September 15, 2005.
15. Nelson Hultberg, The
Money Fallacies of Rothbard, www.safehaven.com, September
16. Antal Fekete, Monetary
Economics 101: The Real Bills Doctrine of Adam Smith, Lectures 1-13,
17. Antal Fekete, Monetary
Economics 102: Gold and Interest, Lectures 1-6, www.goldisfreedom.com.
18. Adam Smith, An Inquiry Into the Nature and Causes of the Wealth
of Nations (1776). New York: Random House, 1937.
19. Antal Fekete, Monetary
Economics 101, Lecture 5, July 29, 2002.
20. Antal Fekete, Monetary
Economics 101, Lecture 13, October 28, 2002.
21. Thomas M. Humphrey, The
Real Bills Doctrine, Federal Reserve Bank of Richmond, Economic
Review, September/October 1982.
22. Richard Timberlake, Federal
Reserve Follies: What Really Started the Great Depression,
working paper, www.mises.org, August 2005.
23. Henry Thornton, An Enquiry Into the Nature and Effects of the
Paper Credit of Great Britain (1802); and Speeches on the Bullion
Report, May 1811. Edited with an introduction by F.A. von Hayek.
(New York: Rinehart & Company, Inc., 1939).
24. Antal Fekete, Monetary
Economics 101, Lecture 2, July 8, 2002.
25. Antal Fekete, A
Revisionist Theory and History of Money: Real Bills and Employment,
26. Antal Fekete, Monetary
Economics 101, Lecture 3, July 15, 2002.
27. Ludwig von Mises, Socialism: An Economic and Sociological
II, Ch. 5, sec. 1.3, Indianapolis: Liberty Fund, Inc. 1981.
28. Antal Fekete, Monetary
Economics 101, Lecture 9, August 26, 2002.
29. Antal Fekete, Monetary
Economics 101, Lecture 6, August 5, 2002.
30. Antal Fekete, Monetary
Economics 101, Lecture 11, September 16, 2002.
31. Including raw material costs is trivial but it doesn't change
the salient issues in this example. I omit them for ease of comparison:
I want the numbers in my analysis to agree exactly with those obtained
by Corrigan (op. cit. 1).
32. Murray Rothbard, The Case for a 100 Percent Gold Dollar,
Auburn, AL: Ludwig von Mises Institute, 2001.
33. The relaxation time may be viewed as the time it takes
for a shock or innovation to dissipate throughout the system. A more
rigorous treatment of this issue is forthcoming in a more technical
34. Antal Fekete, Monetary
Economics 101, Lecture 7, August 12, 2002.
35. Antal Fekete, Monetary
Economics 101, Lecture 4, July 22, 2002.
the Author: Vasilios ("Bill")
Koures has a Ph.D. in theoretical high-energy physics. Shortly
after receiving his Ph.D., he worked in the oil industry in exploration
geophysics. He then returned to academia, where he taught at the
University of Utah and performed research in theoretical and computational
physics. After a stint in the defense industry, Bill moved to New
York and began working in derivatives research. He worked on various
derivatives risk management projects, including interest rates,
credit risk, equities, FX, energies, and other commodities. His
more recent positions include VP in derivatives research on the
Global Commodities desk at J.P. Morgan and Executive Director and
Head of Quantitative Research at Mitsui Energy Risk Management,
Ltd. At present, Bill lives in Montana, where he founded the Intermountain
Institute for Science and Applied Mathematics (IISAM).
This institute performs cross-disciplinary research in applied
math along with consulting and educational outreach programs. Bill
also runs his own trading company: Quantitative Trading LLC.
Copyright © 2005, V.G. Koures & IISAM Inc.,
All rights reserved.