The Real Bills Doctrine

With recession lingering and interest rates remaining high, one hears increasingly that the Fed should abandon its money growth targets and move to a policy of lowering interest rates to full employment levels. All would be well, we are told, if only the Fed would set a fixed low interest rate target consistent with full employment and then let the money stock adjust to money demand to achieve that desired target rate. In effect, this means that the Fed would relinquish control over the money stock, letting it expand as required in a vain effort to eliminate discrepancies between the market rate and the predetermined target rate. This low target interest rate proposal has much in common with the long-discredited real bills doctrine, according to which the money supply should expand passively to accommodate the legitimate needs of trade. Both views contend that the money supply is (or should be) essentially demand determined. Both see causality as running from economic activity to money rather than vice versa. And, in their simplest versions at least, both treat the price level and its rate of change as predetermined exogenous variables and deny that inflation originates in the central bank. In fact, both views prescribe positive monetary ‘expansion even in the face of inflation, the one to allow real transactions to take place at ever-rising prices, the other in an attempt to lower interest rates to target levels. In essence, both tie the money supply directly to an uncontrolled nominal variable that reflects inflationary pressures-the volume of eligible bills offered for discount in the case of the real bills doctrine and the nominal market rate-target rate differential in the case of the interest-pegging scheme. Finally, because they link the money stock to variables that tend to rise in step with prices, both generate inflationary feedback mechanisms in which prices and money chase each other upward indefinitely. In these respects, at least, the interest-pegging proposal may be viewed as a recent variant of the old real bills doctrine.1 The purpose of this article is to trace the origin and historical evolution of the real bills doctrine and to show how that doctrine survives today in the interest-targeting scheme. Before doing so, however, it is necessary to spell out the essential features of the doctrine and to identify its underlying error.