“Real bills” banking prevented Minsky moments

The “real bills” approach to banking is profoundly misunderstood, as I explain in this paper. What I’ve just recently realized is that Minsky’s financial instability hypothesis is probably derived from real bills. In particular, Minsky cites Schumpeter, who was I believe familiar with contemporary banking theory.

A real bill is a short-term loan that arises out of a commercial transaction. These bills circulated as money in the commercial cities of Europe in the 17th and 18th centuries because banks stood ready to buy the bills. In accounting terms a real bill monetizes an asset that is earned, but not yet realized. What very few modern writers understand is that if a bank, instead of demanding payment on a real bill, rolls it over, the resulting line of credit is not a real bill. There are many names for this kind of loan including fictitious bill, accommodation bill, and finance bill. Finance bill is the term that stuck and lasted into the 20th century.

Limiting credit to real bills is very constricting, so in Britain finance bills were made negotiable (so they too could circulate easily as money) in the 1830s. Through a series of subsequent crises Britain learned about the dangers of zombie banks and loose credit more generally. By the third quarter of the 19th century, however, the Bank of England had learned how to manage the brave new world of finance bills, and Britain experienced a century of banking stability.

What was the key to banking stability in Britain? The principle that money market instruments should not be used to (i) finance the purchase and carry of capital market assets (or land) or (ii) be rolled over to such a degree that they were effectively playing the same role as an equity stake in a firm. This is the real “real bills” approach to banking.

What I’ve just realized is that the same principle underlies Minsky’s financial instability hypothesis (probably through Schumpeter). In fact, when the early Fed was worried about credit markets, it discusses the problem of an excessive growth of speculative bills. (See the Fed’s 10th annual report.) And the Fed uses the term “speculative” in exactly the same sense that Minsky does.

Recall that Minsky defines three types of finance:

Hedge finance takes place when the borrower is able to pay both interest and principal out of cash flows. This is not destabilizing.

Speculative finance takes place when the borrower only has expectations of paying interest on the loan and thus the loan has to be rolled over repeatedly. Just like the Fed in 1923, Minsky argued that the growth of speculative finance was a sign of destabilization building up in the economy.

Ponzi finance takes place when the borrower’s cash flow leaves the borrower unable even to pay interest, so the borrower must either sell assets or rely on increases in asset value together with new loans to stay current on the debt. Minsky argued that this is what is going on right before a crash.

Overall, the real bills approach to managing the banking system should be understood as a policy of controlling the growth of speculative and Ponzi finance in the economy. The evidence indicates that the Bank of England was actually very good at doing this for many, many years.


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