Published by EH.Net (October 2019)

Thomas M. Humphrey and Richard H. Timberlake, Gold, the Real Bills
Doctrine, and the Fed: Sources of Monetary Disorder, 1922-1938.
Washington: Cato Institute, 2019. xix + 201 pp. $21.21 (hardcover),
ISBN: 978-1-948647-55-7.

Reviewed for EH.Net by Clifford F. Thies, School of Business,
Shenandoah University.


Thomas M. Humphrey was a long-time research economist for the Federal
Reserve Bank of Richmond with a penchant for the history of thought
concerning monetary economics, and Richard H. Timberlake is a
professor emeritus at the University of Georgia whose writings on
money mainly concern the constitution of money, money and the U.S.
Constitution, and other institutional arrangements for money. Their
book is meant to debunk the “well-established” view that a slavish
devotion to the gold standard condemned the United States and much of
the rest of the world to the Great Depression. Instead of gold, the
authors argue, the problem was the Real Bills Doctrine. Regardless of
how persuasive they are in shifting the blame from gold to the Real
Bills Doctrine, they tell a tale delicious in its detail, naming the
names of those responsible.

According to Humphrey and Timberlake, John Law’s Bank of Mississippi
was the first attempt to implement the Real Bills Doctrine (pp. 9-11).
This bank, and other land bank schemes such as characterized the U.S.
colonial period, may have had some connection to the Real Bills
Doctrine, such as antecedents. However, the doctrine says that an
appropriate backing for bank demand liabilities is short-term,
“self-liquidating” loans collateralized by goods in transit and other
such evidences of real activity. Land, not being self-liquidating,
would not be appropriate. In addition to the heterogeneity of land,
the value of land is speculative because it is based on the present
value of its future services. Speculative assets, according to the
Real Bills Doctrine, are not appropriate to back bank demand
liabilities. Nor would state-issued or railroad-issued bonds be good
backing for banknotes, as was mandated by various states during the
Free Bank Era, because their values, too, are speculative. Nor would
U.S. Treasury bonds as was allowed during the National Bank Era. The
market values of long-term bonds and mortgages, even those that are
substantially free of the risk of default, are dependent on interest
rates and, therefore, are not appropriate to back bank demand
liabilities. The misadventure of John Law has been repeated many times
since his day, sometimes with banks, sometimes with depository
institutions, and most recently with “shadow banks.” But land banks
are more like the opposite of the Real Bills Doctrine, than an
example.

A good example of the Real Bills Doctrine in conjunction with an
operational gold standard was the chartered banks of Louisiana from
1845 to 1861. These banks backed their demand liabilities with a
specie reserve of one-third and the remainder by bills of exchange,
discounted commercial paper, and other short-term loans. Crucially, as
Humphrey and Timberlake repeatedly state in conjunction with the bank
panics of the 1930s, the specie reserve of the Louisiana chartered
banks was only an initial reserve. During a bank panic, banks could
pay out the specie in their vault. If the run on the banks wasn’t
directly ended by the paying out of specie, the coming-due of a bank’s
short-term loans (which could be paid in the banknotes of that bank or
in specie) would either sop up the remaining banknotes in circulation
or provide the specie needed to redeem those banknotes. None of the
chartered banks of Louisiana suspended during the Panic of 1857, while
the several Free Banks of the state suspended (albeit for a short
time). Of course, Louisiana being on the losing side of the Civil War
couldn’t provide the model for the National Bank Era. New York with
its Free Banking system (based on bond collateral) did. As Humphrey
and Timberlake correctly argue, the Real Bills Doctrine by itself
wasn’t the culprit for the Great Depression (p. xiii). When operated
in conjunction with an operational gold standard, as the Louisiana
chartered banks did, the doctrine is innocuous. It is when the Real
Bills Doctrine operates in a vacuum, without a commodity-money anchor,
that something bad will inevitably happen.

The reason something bad will inevitably happen with the Real Bills
Doctrine detached from an operational gold standard is, at one level,
obvious, and, at another level, sophisticated. The obvious problem
with the doctrine is that it links one nominal variable (the money
stock) to another nominal variable (the money-value of qualifying
loans), leaving the price level indeterminant (p. 5). The
sophisticated argument, captured in the one diagram in Humphrey and
Timberlake’s book (p. 24), is that the system is unstable. A move to
inflation brings about more inflation, and a move to deflation brings
about more deflation. During a hyperinflation, because the velocity of
money accelerates, there is a shortage of money, requiring more money
to prevent recession. Knut Wicksell called this or something like it
the accumulation process; Milton Friedman, the accelerationist
hypothesis; and, Friedrich Hayek, a tiger by the tail. The book
describes this instability in the case of the German hyperinflation of
the 1920s (p. 22). We are currently seeing this instability in
Venezuela. The key argument of the book is that this instability works
in both directions, downward as well as upward, and explains the
deflation that accompanied the Great Depression, as well as various
episodes of hyperinflation.

Part of the reason the money supply spirals downward as well as upward
is because of fractional reserve banking (p. 28). Every dollar
withdrawn from a bank results in a multiple contraction of the money
stock. At this point, it is important to distinguish between what is
today called base money, or M0, and what is called the money stock or
money supply, or M1. Humphrey and Timberlake use the term “common
money” to refer to the latter (and perhaps something more). The Real
Bills Doctrine justifies fractional reserve banking because it says
that real bills and not merely base money can be used to back bank
demand liabilities. During the 1920s and early ‘30s, the monetary base
consisted of gold coins and Gold Certificates, Silver Certificates and
U.S. Notes outside the Fed, Federal Reserve Notes, reserves of banks
held on deposit at the Fed, and limited legal tender subsidiary coins,
mostly silver. The U.S. Notes were fixed in their supply, as
essentially were also the Silver Certificates and coins. The dynamics
of the fractional reserve system played out in the fractional backing
of Federal Reserve Notes and bank reserves by gold, and by the
fractional backing of bank demand and time liabilities by the base
money in their vaults and their reserves held on deposit at the Fed.
During good times, there was a tendency for the banking system to
increase the money multiplier, and during bad times, to decrease it.
By tracking the monetary aggregates, central banks can counteract
these destabilizing tendencies, but the Fed did not track the monetary
aggregates at the time. William McChesney Martin during the 1950s
characterized the practice of counteracting destabilizing tendencies
by saying the Fed should “lean against the wind.” But, unabashed Real
Bills-central bankers run with the wind, instead of lean against the
wind.

The real culprit precipitating a downturn in the monetary aggregates,
however, wasn’t an automatic tendency. It was an explicit decision to
suppress “speculation” made by a narrow majority of the Board of
Governors of the Federal Reserve led by Adolph C. Miller, overriding
the Federal Reserve Bank Presidents, the Federal Advisory Council, and
many prominent private bank presidents. Pages 77-85 are the most
engaging part of the book. Although the authors do not say so
explicitly, by using terminology such as “an evangelical crusade,”
they imply that Miller was from the populist and anti-bank wing of the
Democratic Party. From the diary of a member of the Federal Reserve
Board who served with him, it appears Miller was self-righteous and
dogmatic. This is the impression I got reading the referenced articles
by Miller justifying the actions of the Fed. That and a whiff of a
backstop defense that the Board was compelled to take the actions it
took because of the Federal Reserve Act of 1913.

According to the authors, it was the Fed’s actions to suppress
“speculation” that precipitated the Stock Market Crash of 1929, and it
was the Fed’s slavish devotion to the Real Bills Doctrine that allowed
the monetary aggregates to subsequently spiral downward, taking the
economy with it. But, this story, even if its fixes the blame, might
not fully exonerate gold. Historically, the problems of inflation and
deflation have usually been associated with war. In this country, the
problems of post-war adjustment include the messy resumption that
followed the War of 1812, and the “Grow to Gold” policy following the
Civil War that involved a protracted period of deflation and a series
of financial panics. Following the Great War, subsequently renamed
World War I, there was a significant post-war deflation, but prices
were stabilized at a level higher than pre-war. A second bout of
deflation might have been necessary or perhaps there was a more
creative solution. As other nations sought to return to the Gold
Standard, something was going to have to give. The unfinished job of
post-war adjustment didn’t mean, however, that we were condemned to
the utter calamity that was the Great Depression.


Clifford F. Thies is the Eldon R. Lindsey Chair of Free Enterprise and
Professor of Economics and Finance at Shenandoah University. He has
recently written on debt repudiation by Mississippi (The Independent
Review).

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