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| | The Gold & Silver precious metals Network is not currently active and cannot accept new posts | | Appalling World-Wide Unemployment of the 1930's -Lack of Gold Coin | Views: 473 | | Jan 16, 2007 6:39 pm | | Appalling World-Wide Unemployment of the 1930's -Lack of Gold Coin | # |
me4you | | THE ROOT CAUSE OF UNEMPLOYMENT
PART II: REAL BILLS AND EMPLOYMENT
Tuesday, January 16, 2007
In Part I we elaborated on the thesis of the German economist Heinrich
Rittershausen that the appalling world-wide unemployment of the 1930's was
caused by the coercive legal tender laws of 1909. The chain of causation is as
follows: the French and German governments, in preparation for the coming war,
wanted to concentrate gold in their own coffers. They stopped paying civil
servants in gold coin. To make this practice legal they had to enact legislation
that gave bank notes legal tender status.
Scarcely did these governments realize that in doing so they set a slow process
into motion which, in the end, destroyed the wage fund out of which workers
could be paid even before merchandise has been sold to the ultimate consumer. In
this second part we examine in greater detail how the wage fund was financed
before 1909. We shall see that the bill market is just the clearing system of
the gold standard. If disabled, sooner or later the gold standard will collapse
as a result.
We hope that detractors of the Real Bills Doctrine will read this analysis with
an open mind, and give their best effort to find a weak point in the argument
(if they can), to refute our conclusion, which is as follows. If the victorious
powers had allowed the bill market to make a come-back, and they had rescinded
legal tender laws at the end of hostilities in 1918, then the gold standard
would not have collapsed in 1931, and there would have been no world-wide
unemployment and no Great Depression.
Bank notes as self-liquidating credit
Previous to 1909 circulating capital for the production of consumer goods in
urgent demand had been financed, not out of savings, but through discounting
real bills at a commercial bank, which would then rediscount them at the bank of
issue that supplied the country with bank notes. To be sure, these bank notes
represented self-liquidating credit. They were merely a more convenient form of
the bill of exchange from which they derived their potency. They came in
standard denomination round figures. Unlike the bill of exchange they could
without hassle and loss be broken up into smaller units. The great convenience
they offered was valued by the public so much so that people were willing to pay
for it in the form of forgone discount.
When the bill matured and was paid, the bank note was retired.
For this very reason it was not inflationary. The bank of issue would under no
circumstances prolong credit beyond the maturity date of the rediscounted bill.
If the underlying merchandise could not be sold in 91 days, then it would not be
sold in 365 days, certainly not before the same season of the year came around
once more. But by that time the merchandise would be stale and could only be
sold at a loss, if at all. Prolonging credit on a mature bill would violate the
letter and spirit of the law governing central banking in Germany prior to 1909.
Could a commercial bank, nevertheless, roll over a real bill at maturity? On
strictly economic grounds it wouldn't. First of all, it would forfeit its
rediscounting privileges at the bank of issue if it did. Secondly, it would make
its portfolio less liquid and so it could no longer compete successfully with
more liquid banks. Having said this, we must admit that in practice some banks
may have been guilty of rolling over mature real bills for various reasons. At
the benign end of the spectrum the reason could be a false sense of loyalty to
clients; at the malignant, conspiracy with them in speculative ventures. It was
this latter practice that Ludwig von Mises could have properly condemned as
'credit expansion'. Be that as it may, unethical behavior on the part of some
banks should be no grounds for issuing a blanket condemnation of all banks and
calling the legitimate practice of discounting real bills 'credit expansion'
with a disapproving connotation.
The lesson from negative past experience must be learned and, in the future,
full disclosure ought to be mandatory for commercial banks discounting bills.
They should be obliged by law to publish their portfolio of real bills
quarterly. Clients would thus be enabled to identify delinquent banks which
habitually make their portfolio illiquid by sheltering dubious assets such as
bills doing overtime after maturity, as well as finance or treasury bills.
Thereupon discriminating clients could take their business elsewhere, to more
liquid banks.
The retired bank note could not be re-issued until and unless a fresh bill
representing new merchandise in urgent demand was offered for rediscount, or
gold was offered for sale to the bank of issue. Re-issuing it under any other
circumstances, say, lending it out at interest, or extending commercial credit
to cover the unsold merchandise after maturity, would violate its charter. It
would be tantamount to extending commercial credit under false pretenses.
Real bills versus financial bills
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. They objected to making financial or treasury bills
eligible for rediscount, a practice that had previously been prohibited by law
with stiff penalties for non-compliance. Most people could not understand what
the fuss was about. But there was a world of a difference between rediscounting
real bills and rediscounting financial bills. It was the difference between
self-liquidating credit and non-self-liquidating credit. Real bills could rely
on a huge international bill market with its practically inexhaustible demand
for liquid earning assets. Not so financial bills which were backed by the odds
that speculative inventory of goods and equities or investment in brick and
mortar may be unwound without a loss by the date of maturity.
Treasury bills were backed by future tax receipts. If anticipation attached to
financial and treasury 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.
The chimera of 'fractional reserve banking'
Financial bills have made the asset portfolio of the bank of issue illiquid. The
bank could no longer satisfy potential demand for gold coins, should holders of
bank notes decide to exercise their legal right to redeem them. To take away
this right was the reason for making bank notes legal tender in the first place
in 1909. We must remember that redemption wouldn't be a problem so long as the
portfolio consisted of real bills exclusively. Every single day one-ninetieth of
the outstanding bank notes matured into gold coins which were available for
redemption. This would normally satisfy daily demand. But what about abnormal
demand for gold coins?
A real bill is the most liquid earning asset in existence. At any time somewhere
in the world there is demand for it. In particular, banks that have a temporary
overflow of gold would be more than anxious to exchange it for real bills. The
bank of issue would not have the slightest difficulty to get gold in exchange
for real bills in the international bill market. Once upon a time the Bank of
England boasted that "it could draw gold from the moon by raising the rediscount
rate to 5%." The assumption that there will always be takers for real bills
offered for sale is just as safe as the assumption that people will want to eat,
get clad, keep themselves warm and sheltered tomorrow and every day thereafter.
This explodes the blanket condemnation of 'fractional reserve banking'.
Detractors are barking up the wrong tree. They should condemn the practice of
rediscounting financial or treasury bills. Real bills were self-liquidating,
while financial and treasury bills had impaired liquidity. Under certain
circumstances the latter might become unsaleable. They are simply unsuitable to
serve as bank reserves.
By contrast, real bills are the most liquid earning asset a bank can have, as
already pointed out. There is always a ready market for them as other banks with
excess gold scramble to get liquid earning assets. It is a grave error to equate
fractional reserve banking with liquid reserves (real bills) to that with
illiquid reserves (financial bills and treasury bills). We may remark here that
the term 'fractional reserve banking' is a misnomer when applied to a bank
utilizing real bills. The note issue is fully backed partly by gold and partly
by short-term gold instruments so that the sight liabilities of the bank are at
all times are payable in gold.
This problem has been thoroughly researched by a host of competent experts in
the 19th century. There is a voluminous literature on this subject. It was not
produced by "monetary cranks" or by "inflationists". It was produced by the best
minds dedicated to sound monetary and fiscal policy. Their unanimous judgment
still stands: real bills, to the exclusion of financial and treasury bills, are
by far the safest earning asset that a bank of issue can have. Prior to 1909
charters of the banks of issue explicitly made financial and treasury bills
ineligible for rediscounting. Moreover, the laws governing central banking
prohibited the use of government paper for the purposes of backing the note
circulation, and prescribed heavy penalties for non-compliance. This was the
corner-stone of central banking of the liberal era which kept the lessons of the
French revolution with its paper-money inflation in evidence. This was not a
controversial issue. Informed people could distinguish between safe banking that
utilized real bills, and unsafe banking that utilized financial and treasury
bills to back the note issue. Their judgment is epitomized by the old saying
that "the easiest profession in the world is the banker's, provided that he can
tell a mortgage and a real bill apart".
It is regrettable that latter-day critics are not sufficiently familiar with
this particular body of knowledge and confuse fractional reserve banking based
on sound assets, with fractional reserve banking based on unsound assets. It is
ironic that they do exactly the same, ostensibly in the name of sound money,
what enemies of freedom have done and are doing in the name or irredeemable
currency, namely, wipe out the important distinction between liquid and illiquid
bank reserves.
Deus ex machina
The process of retiring the bank note after the merchandise serving as the basis
for its issue has been removed from the market by the ultimate gold-paying
consumer is called "reflux". Several authors, including Ludwig von Mises,
ridiculed the concept calling reflux deus ex machina. They argued that the banks
were only interested in credit expansion, not in reflux. Banks would not for one
moment think of withdrawing a corresponding amount of bank notes from
circulation when the real bill matured. Instead, they would lend them out at
interest in order to enrich themselves at the expense of the public. This is not
a valid argument. For the stronger reason, you could also ridicule the entire
legal system asking the rhetorical question: "what is the point in making laws
when they will be broken anyhow?" You can't judge the merit of an institution by
the behavior of those who are set upon destroying it.
Let us follow the trail of gold coins through the path of reflux. Our
description that follows is necessarily schematic. For the sake of simplicity we
assume that only wholesaler-on-retailer bills are discounted. This is reasonable
as these bills are more liquid than producer-on-wholesaler bills, or
higher-on-lower-order-producer bills. We also assume that the retailer is
expected to pay his bill with gold coins flowing to him from the consumers. Gold
serves as proof that the merchandise underlying the bill has been sold to the
ultimate consumer and is not held, contrary to purpose, in speculative stores in
anticipation of a price rise.
Finally, our description follows the practice of the German banking system as it
was before 1909. The practice elsewhere may have been different, but the
essential idea would be the same: with the sale of merchandise the gold coin was
recycled from the consumer through the retail merchant to the commercial bank,
from where it would be withdrawn by producers in order to pay wages, thus
putting the gold coin back into the hand of the consumers. Then the cycle of
supplying the consumer with urgently demanded merchandise could start all over
again.
In more details, as the gold coins flowed from the consumer to the retail
merchant, the latter deposited them at the commercial bank. When he was ready to
replenish his depleted inventory the retailer would order a fresh supply from
the wholesaler and, after endorsing he would return the bill to the latter who
would discount it at a commercial bank. The wholesaler would take the proceeds
in the form of bank notes which the commercial bank obtained from the bank of
issue through rediscounting.
The wholesaler would use the bank notes to pay the producer of first order
goods. The latter would use them to pay the producer of second order goods, and
so on. But when it came to paying wages, all these producers had to draw out
gold coins from the commercial bank against bank notes. They could do no worse
than the government that paid civil servants in gold before 1909.
Upon maturity the commercial bank used the bank notes to pay the rediscounted
bill at the bank of issue. The latter was under obligation by law to retire
these bank notes. It could not lend them out at interest. If it did, it would
violate the law, and would have to pay heavy penalties. Retired bank notes could
be used for only two legitimate purposes: either to buy gold, or to rediscount
fresh bills drawn on new consumer goods moving to the ultimate gold-paying
consumer. Since lending and discounting were two entirely different banking
functions, this was not the same as lending the notes out at interest.
Now the gold coin was in the hands of the wage-earner. As he spent it on
consumer goods, he enabled the retail merchant to make payments on his
discounted bill at the commercial bank with gold. When paid in full, the bill
was returned to the retail merchant. The bill's ephemeral life as a means of
payment has come to an end. But the march of gold coins would continue. They
would be withdrawn by the producers to pay wages, and the cycle of supplying
wage-earners with consumer goods against payment in gold coin could start all
over again. Gold coin circulation in the production cycle is akin to water
circulation through evaporation and precipitation in the atmospheric cycle.
This cycle was short-circuited by the 1909 decision of France and Germany to
make the note issue legal tender while paying civil servants in notes rather
than gold coin.
A stone mason called Michelangelo
The havoc that the monetary coup d'état of 1909 would wreak upon society had
not been foreseen. Nor was the causal relation between the expulsion of real
bills from the portfolio of the bank of issue and massive unemployment two
decades later. Almost one-half of trade union members, or 8 million people, lost
their jobs in Germany alone.
Real bills finance the movement of consumer goods, including wages paid to
people handling the maturing merchandise through the various stages of
production and distribution. The size of circulating capital needed to move the
mass of consumer goods through these stages, if financed out of savings, would
be staggering. Quite simply, it could not be done. No conceivable economy would
produce savings so generously as to be able to finance circulating capital for
the production of all the consumer goods that society needed in order to
flourish at present levels of comfort and security.
Fortunately there is no need to employ savings in such a wasteful manner. It is
true that fixed capital must be financed out of savings. As a result, creation
of fixed capital depends on the propensity to save. Not so circulating capital,
provided that the merchandise moves fast enough to the ultimate gold-paying
consumer. It can be financed through self-liquidating credit which depends on
the propensity to consume, and is independent from the propensity to save.
The discovery of this fact is one of the great achievements of the human spirit
and intellect.
It was made by the giants of the Renaissance who believed that "man is the
measure of all things". Theirs was a feat on a par with the discovery of
indirect exchange. The impact upon human life of the invention of the
circulating bill of exchange is fully commensurate with that of the invention of
the wheel. By the same token, banning of real bills is akin to outlawing the
wheel. What would have happened to the quality of human life if the use of the
wheel had been banned by the governments in the middle ages?
Detractors have missed one of the most exciting developments in the history of
our civilization, namely, the discovery of self-liquidating credit in the wake
of the disappearance of risks in the production process as the maturing good
gets within earshot of the final gold-paying consumer. Their failure is not
unlike dismissing Michelangelo as 'just another stone mason'.
Mistaking the back-seat driver for the boss in the driver seat
Pari passu with the emergence of the need for consumer goods the means to
finance their production and distribution emerges as well. It is in the form of
the bill of exchange. Retailers, wholesalers, and producers of first-order goods
hardly ever pay their suppliers cash. "91 days net" is invariably part of the
deal, to give ample time for the merchandise to reach the ultimate gold-paying
consumer. Producers of higher-order goods could fold tent and go out of business
if they insisted on cash payment for the supplies they were providing. It was
the producers of lower-order goods who were the boss and called the shots, by
virtue of being that much closer to the ultimate consumer and his gold coin.
They would laugh you out of court if you told them that they have just been
granted a loan by the producer of higher-order goods, and the discount is just
interest taken out of the proceeds in advance. They know better. They know that
self-liquidating credit is theirs for the taking. They know that the discount
rate has nothing to do with the rate of interest. For a consideration they may
be willing to prepay their bill before maturity. The privilege is theirs, and
theirs alone. Discount is just the consideration offered to tempt them. Those
who insist that the producer of higher-order goods is the lender and the
producer of lower-order goods is the borrower or, alternatively, the wholesaler
is the lender and the retailer is the borrower, do not know what they are
talking about. They are mistaking the back-seat driver for the boss in the
driver seat.
Quantity Theory of Money
If the victorious powers had realized that the wage fund was destroyed, then
they would have tied the emergence of bank notes to the emergence of real bills
once again after World War I. They would have also repealed the legal tender
laws. This remark puts the Quantity Theory of Money in a rather dim light. This
theory holds that "money is money"; it has one dimension only: quantity. To talk
about the quality of money is hallucinatory. Money can be produced in any
quantity synthetically. If employment falls or prices decline, they can be
compensated for by an increase of the quantity of bank notes outstanding.
The fact that this view reflects a grave error is proved by the bitter
experience of the twentieth century. While it is true that the quantity of bank
notes outstanding can be increased ad libitum, the bank of issue is absolutely
helpless if it wants to prescribe how the public should use its freshly printed
notes. They may flow to the bond market, but they could just as well flow to the
stock market. Accordingly, they may bid up bond prices (drive down interest
rates), but they could just as well drive up equity prices. The quantity theory
blithely assumes that newly printed bank notes are duty bound to flow to the
labor market to put people to work. However, it is always the quality of money,
never its quantity, that will decide where new money will flow. Furthermore, the
quality of bank notes cannot be examined without scrutinizing the assets which
the bank of issue holds against them. Second only to gold, the best assets the
bank of issue can have are the self-liquidating real bills.
If we want the newly printed bank notes to increase employment and production,
rather than merely stoke the fires of speculation, then we have to restore the
nexus between their printing and the emergence of new goods in the production
process. We must rescind coercive legal tender laws. We must rehabilitate the
spontaneous international bill market.
We must have a gold standard cum real bills.
References
Antal E. Fekete, The Root Cause of Unemployment,
Part I: Destroying the Wage Fund, www.gold-eagle.com
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