User talk:Flow5

The Real Bills Doctrine:

The traditional commercial loan was essentially a processing or merchandising loan. It had a maturity of less than one year (usually less than ninety days), and it purportedly was self-liquidating, that is the sale of the merchandise financed by the loan provided the borrower with the funds with which to repay the loan. The bills which this type of lending gave rise to were termed “real bills,” and it was the contention of those who sponsored the “real-bills doctrine” that this type of loan was not inflationary since the banks were financing real things, value being added to product as a result of the lending process. In fact, however, if the theory is applied under the assumption that labor and facilities are fully employed, the injection of new bank credit for financing inventories or any other phase of merchandising or processing is obviously inflationary. It is also inflationary, but less so, if the new bank credit is injected at a time of underemployment. The effect then is to bring about both a rise in prices and some re-employment of factors. Once prices start increasing, it will be necessary for businessmen to secure larger commercial loans, just to carry on the same volume of business, and other so-called commercial loans will be obtained in order to hold larger inventories and engage in more forward buying. All such activity promotes higher prices with no necessary concomitant expansion in the production of “real” things.

In comtemporary times, seasonal mal-adjustments qualify as a substitution for the "real bills" doctrine.

The Bank of England:

In the emergencies that arose in 1763, 1772, and 1783, the bank was able to meet the specie demands of its correspondents, by the Napoleonic Wars presented a crisis the Bank was unable to meet. The rumor that Napoleon’s forces were about to invade England triggered the crisis which culminated in the panic of 1797. Through an Order in Council, the Government authorized the Bank to suspend specie payment and to continue to issue an irredeemable paper currency. This money circulated side by side with specie, but at a discount. It was the judgment of the Bank’s management that under these circumstances, they had no objective means of determining the proper volume of loans. Formerly an outflow of specie signaled the need to contract credit, while an inflow enabled the Banks to expand. Lacking an objective credit barometer and in need of a rationale of their position, the Bank’s management originated the “real bills” doctrine, the naïve theory that as long as money is used to finance trade, an over expansion, with resulting inflation, is impossible.

Discounts and Advances to Commercial Banks:

The Reserve banks extend credit to member (and sometimes non-member) banks in two general ways: (1) by rediscounting paper previously discounted by the borrowing banks; and (2) by advances, that is by purchasing the banks’ own promises to pay secured by the deposit of collateral…

Rediscounting, in effect, is merely the sale of customers’ paper by a member bank to its Reserve bank. because this method of lending presents several mechanical difficulties it is now rarely used as a method of member-bank borrowing. Many pieces of paper may have to be handled to cover one reserve deficiency, the aggregate of all the paper discounted may not correspond to the amount the member banks wishes to borrow, and the maturity of the paper may vary and may be too long or too short, and so on.

The kinds of paper which the Reserve banks will discount for borrowing banks or accept as collateral for advances to them was originally based on the “commercial loan theory of banking.” According to this “real bills doctrine,” commercial banks should confine their lending to short-term, self-liquidating paper – paper originating out of the financing of “goods-in-process.”  The doctrine held that if this procedure were adhered to there could be no inflation of credit since an expansion of credit would be offset by a concomitant expansion in the flow of goods. Furthermore, credit would expand and contract according to the “needs of trade.” In the terms of the original Federal Reserve Act the Reserve banks were adjured to take only “short-term self-liquidating agricultural, industrial or commercial paper which was originally created for the purpose of providing funds for producing, purchasing, carrying or marketing goods.”  As a corollary to this it was assumed that the banks were not to take paper whose proceeds were used to finance fixed investments or investments of a purely speculative nature. This would rule out stock-market credit.

The pre-1914 banking theory that short-term, self-liquidating paper should be given preferential status still survives in the provision that the Reserve banks may rediscount only paper of this type. The provisions are of very limited importance now since most adjustments in reserve positions are made through advances or through the open market. To the extent that banks meet their reserve needs by direct borrowing from the Reserve banks they do so on advances on their own notes.

The demise of the so-called commercial loan theory of banking is due to several reasons: (1) The inadequacy of member-bank holdings of eligible commercial paper. There has never been an extensive “bill market” in the United States such as exists in Britain and in western Europe, and changes in the business structure and in banking lending practices after World War I have pushed this form of bank credit almost into oblivion. The decline was especially pronounced after 1929. (2) The mechanical difficulties of rediscounting customers’ paper referred to above. (3) A recognition of the basic fallaciousness of the commercial loan theory. It has been increasingly clear that “commercial paper” is often less liquid than some other types of bank earning assets, especially short-term governments, and even call loans on securities. Furthermore it is recognized that harmful inflations and deflations could result even though the commercial and the Reserve Banks confined their lending operations to “commercial loans.” It is almost impossible to inject new money into the economy without causing an expansion of demands and a rise of prices. Increased production may take place if the bank credit is injected during a period when there are unemployed factors, but there will also be a rise in prices. And once the rise in prices is underway businessmen will need more “commercial loans” to finance even the same physical volume of business.

There is also an increasing recognition that liquidity theories applicable to the commercial banks lack validity when applied to the Reserve banks. The Reserve banks may, for example, confine their dealings in governments to short-term obligations, but the objective here is not to give the Reserve banks liquidity; rather the objective is to enable the Reserve banks to provide adequate support to the government bond market with the minimum of interference in the general money market. It is difficult to see how any asset of a Reserve bank can be considered illiquid if it can be used as a basis for issuing Federal Reserve notes

Since one of the principal functions of the Reserve banks is to provide liquidity to the commercial banks when they need it, and since the liquidity of bank assets (from the standpoint of the whole system) depends upon the willingness and ability of the Reserve banks to buy or lend on them, it is obvious that the objectives of the System cannot be served by limiting “eligible paper” to an insignificant fraction of bank assets. Furthermore it was recognized that the enforcement of collateral requirements restricting commercial bank access to Reserve bank credit is likely to restrict Reserve credit during a deflation, the very period when it is most needed. This was the experience after 1929; it was so recognized by Congress and led to the enactment of the Glass-Steagall Act which gave government securities the same discounting privileges as short-term, self-liquidating paper.

The principal provisions of the Glass-Steagall Act, February 27, 1932, were made permanent by the Banking Act of 1945. Further liberalization of discount privileges was provided in the banking Act of 1935. These enable Reserve banks to make advances to member banks on their notes “secured to the satisfaction of the Federal Reserve bank.” The effect of this provision is to give the Federal Reserve almost complete freedom to determine the types of collateral it will accept.

As a consequence of this Act (and the possession by the banks of large amounts of government securities plus the relative ease and better terms on which they can be pledged), governments have come to be almost the only asset utilized by the banks to obtain additional; deposits with the Federal Reserve.

For the first 3 years of the Great Depression (September, 1929-June, 1932)Dr. Leland James Pritchard taught political economy courses in the Syracuse University Maxwell School of Public Administration, and earned a masters in statistics. In the fall of 1932 he enrolled the the Graduate School of Economics of the University of Chicago, He shared classes in business cycles, money and banking, monetary theory, and assorted theory courses with classmate - Milton Friedman. He read Keynes' two volume "A Treatise on Money", and all the available books on the Federal Reserve System, etc. He received his Ph.D. in economics and was elected Phi Beta Kappa. He served with the Federal Emergency Relief Administration, The Works Projects Administration, and The War Labor Board. Professor Pritchard has served both as Dean of the School of Business and as Chairman of the Economics Department at the University of Kansas. In 1962-1963, he was a Fulbright Lecturer in Ankara, Turkey. He was President (1963-1964) of the Midwest Economics Association. His extensive research and publication record display a broad knowledge of both Finance and Economic Statistics. His Money and Banking Texts (1958, 1964) were widely used and are perhaps the most literate of all recent American texts in economics. He left the Leland Pritchard economic scholarship for economic stdents. As he preached, the only thing he bought “on-time” in his life was his house. He owned a credit union in Grand Lake Colorado, He died a multimillionare.