Real bills doctrine

The real bills doctrine asserts that money should be issued in exchange for short-term real bills of adequate value. The doctrine was developed by practical bankers over centuries of experience, as a means for banks to stay solvent and profitable. Banks that follow it avoid inflation, maturity mismatching, and speculative bubbles and unwanted reflux of money.

A bank can avoid inflation of its money by always keeping enough assets to back the money it has issued. Thus, a bank that issues $100 must get at least $100 worth of assets in exchange. Failure to get at least $100 worth of assets would leave the bank insolvent and would cause inflation of the bank's money from inadequate backing.

Maturity mismatching occurs when, for example, a bank's liabilities come due in 30 days, but the bank's assets will not mature for 1 year. Bank notes and deposit moneys commonly have 30-day suspension clauses, allowing the bank to delay payment for 30 days. A bank that issues its money in exchange for short-term assets that are payable in 30 days will thus match the maturities of its notes (30 days) to those of its assets, and it will avoid illiquidity and possible insolvency.

A wise banker does not lend money to clients engaged in excessively-risky speculative bubbles. By issuing its money only in exchange for real bills (bills issued by real businesses engaged in real productive activity), a banker assures that it is lending money to solid, reputable businesses rather than to speculators with inadequate capital. Furthermore, banks that issue money only in exchange for real bills will avoid unwanted reflux of banknotes. In the 18th and 19th centuries, a common complaint of note-issuing bankers was that they would issue bank notes on Monday, only to have the same notes return to the bank on Tuesday. By issuing notes only to firms engaged in productive activity, a bank would automatically match its money-issuance to the needs of business by issuing more money during busy times and retiring money during slack times.

According to the real bills doctrine, unrestricted intermediation either by private banks or by a central bank has a beneficial economic effect. The doctrine proposes unrestricted discounting of real bills – evidences of indebtedness which, in accordance with Adam Smith's definition, are safe or free of default risk. The doctrine asserts that one function of banks is to issue notes or similar liabilities that are more convenient and easily held as assets than the bills being discounted. The keystone of the doctrine is that no government regulation ought to restrict the scope of such intermediation. In particular, market forces through competitive banking can be relied on to prevent excess credit creation. Moreover, if there happen to exist regulations that inhibit private intermediation – for example regulations that prohibit banks from issuing bearer notes that make a central bank the monopoly issuer of currency-like assets, then the central bank ought to conduct open-market operations or provide a discount window in order to vitiate such restrictions. By doing this, it brings together borrowers and lenders who might otherwise not be matched.

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