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Gold, the Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922-1938

Author(s):Humphrey, Thomas M.
Timberlake, Richard H.
Reviewer(s):Thies, Clifford F.

Published by EH.Net (October 2019)

Thomas M. Humphrey and Richard H. Timberlake, Gold, the Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922-1938. Washington: Cato Institute, 2019. xix + 201 pp. $21.21 (hardcover), ISBN: 978-1-948647-55-7.

Reviewed for EH.Net by Clifford F. Thies, School of Business, Shenandoah University.

Thomas M. Humphrey was a long-time research economist for the Federal Reserve Bank of Richmond with a penchant for the history of thought concerning monetary economics, and Richard H. Timberlake is a professor emeritus at the University of Georgia whose writings on money mainly concern the constitution of money, money and the U.S. Constitution, and other institutional arrangements for money. Their book is meant to debunk the “well-established” view that a slavish devotion to the gold standard condemned the United States and much of the rest of the world to the Great Depression. Instead of gold, the authors argue, the problem was the Real Bills Doctrine. Regardless of how persuasive they are in shifting the blame from gold to the Real Bills Doctrine, they tell a tale delicious in its detail, naming the names of those responsible.

According to Humphrey and Timberlake, John Law’s Bank of Mississippi was the first attempt to implement the Real Bills Doctrine (pp. 9-11). This bank, and other land bank schemes such as characterized the U.S. colonial period, may have had some connection to the Real Bills Doctrine, such as antecedents. However, the doctrine says that an appropriate backing for bank demand liabilities is short-term, “self-liquidating” loans collateralized by goods in transit and other such evidences of real activity. Land, not being self-liquidating, would not be appropriate. In addition to the heterogeneity of land, the value of land is speculative because it is based on the present value of its future services. Speculative assets, according to the Real Bills Doctrine, are not appropriate to back bank demand liabilities. Nor would state-issued or railroad-issued bonds be good backing for banknotes, as was mandated by various states during the Free Bank Era, because their values, too, are speculative. Nor would U.S. Treasury bonds as was allowed during the National Bank Era. The market values of long-term bonds and mortgages, even those that are substantially free of the risk of default, are dependent on interest rates and, therefore, are not appropriate to back bank demand liabilities. The misadventure of John Law has been repeated many times since his day, sometimes with banks, sometimes with depository institutions, and most recently with “shadow banks.” But land banks are more like the opposite of the Real Bills Doctrine, than an example.

A good example of the Real Bills Doctrine in conjunction with an operational gold standard was the chartered banks of Louisiana from 1845 to 1861. These banks backed their demand liabilities with a specie reserve of one-third and the remainder by bills of exchange, discounted commercial paper, and other short-term loans. Crucially, as Humphrey and Timberlake repeatedly state in conjunction with the bank panics of the 1930s, the specie reserve of the Louisiana chartered banks was only an initial reserve. During a bank panic, banks could pay out the specie in their vault. If the run on the banks wasn’t directly ended by the paying out of specie, the coming-due of a bank’s short-term loans (which could be paid in the banknotes of that bank or in specie) would either sop up the remaining banknotes in circulation or provide the specie needed to redeem those banknotes. None of the chartered banks of Louisiana suspended during the Panic of 1857, while the several Free Banks of the state suspended (albeit for a short time). Of course, Louisiana being on the losing side of the Civil War couldn’t provide the model for the National Bank Era. New York with its Free Banking system (based on bond collateral) did. As Humphrey and Timberlake correctly argue, the Real Bills Doctrine by itself wasn’t the culprit for the Great Depression (p. xiii). When operated in conjunction with an operational gold standard, as the Louisiana chartered banks did, the doctrine is innocuous. It is when the Real Bills Doctrine operates in a vacuum, without a commodity-money anchor, that something bad will inevitably happen.

The reason something bad will inevitably happen with the Real Bills Doctrine detached from an operational gold standard is, at one level, obvious, and, at another level, sophisticated. The obvious problem with the doctrine is that it links one nominal variable (the money stock) to another nominal variable (the money-value of qualifying loans), leaving the price level indeterminant (p. 5). The sophisticated argument, captured in the one diagram in Humphrey and Timberlake’s book (p. 24), is that the system is unstable. A move to inflation brings about more inflation, and a move to deflation brings about more deflation. During a hyperinflation, because the velocity of money accelerates, there is a shortage of money, requiring more money to prevent recession. Knut Wicksell called this or something like it the accumulation process; Milton Friedman, the accelerationist hypothesis; and, Friedrich Hayek, a tiger by the tail. The book describes this instability in the case of the German hyperinflation of the 1920s (p. 22). We are currently seeing this instability in Venezuela. The key argument of the book is that this instability works in both directions, downward as well as upward, and explains the deflation that accompanied the Great Depression, as well as various episodes of hyperinflation.

Part of the reason the money supply spirals downward as well as upward is because of fractional reserve banking (p. 28). Every dollar withdrawn from a bank results in a multiple contraction of the money stock. At this point, it is important to distinguish between what is today called base money, or M0, and what is called the money stock or money supply, or M1. Humphrey and Timberlake use the term “common money” to refer to the latter (and perhaps something more). The Real Bills Doctrine justifies fractional reserve banking because it says that real bills and not merely base money can be used to back bank demand liabilities. During the 1920s and early ‘30s, the monetary base consisted of gold coins and Gold Certificates, Silver Certificates and U.S. Notes outside the Fed, Federal Reserve Notes, reserves of banks held on deposit at the Fed, and limited legal tender subsidiary coins, mostly silver. The U.S. Notes were fixed in their supply, as essentially were also the Silver Certificates and coins. The dynamics of the fractional reserve system played out in the fractional backing of Federal Reserve Notes and bank reserves by gold, and by the fractional backing of bank demand and time liabilities by the base money in their vaults and their reserves held on deposit at the Fed. During good times, there was a tendency for the banking system to increase the money multiplier, and during bad times, to decrease it. By tracking the monetary aggregates, central banks can counteract these destabilizing tendencies, but the Fed did not track the monetary aggregates at the time. William McChesney Martin during the 1950s characterized the practice of counteracting destabilizing tendencies by saying the Fed should “lean against the wind.” But, unabashed Real Bills-central bankers run with the wind, instead of lean against the wind.

The real culprit precipitating a downturn in the monetary aggregates, however, wasn’t an automatic tendency. It was an explicit decision to suppress “speculation” made by a narrow majority of the Board of Governors of the Federal Reserve led by Adolph C. Miller, overriding the Federal Reserve Bank Presidents, the Federal Advisory Council, and many prominent private bank presidents. Pages 77-85 are the most engaging part of the book. Although the authors do not say so explicitly, by using terminology such as “an evangelical crusade,” they imply that Miller was from the populist and anti-bank wing of the Democratic Party. From the diary of a member of the Federal Reserve Board who served with him, it appears Miller was self-righteous and dogmatic. This is the impression I got reading the referenced articles by Miller justifying the actions of the Fed. That and a whiff of a backstop defense that the Board was compelled to take the actions it took because of the Federal Reserve Act of 1913.

According to the authors, it was the Fed’s actions to suppress “speculation” that precipitated the Stock Market Crash of 1929, and it was the Fed’s slavish devotion to the Real Bills Doctrine that allowed the monetary aggregates to subsequently spiral downward, taking the economy with it. But, this story, even if its fixes the blame, might not fully exonerate gold. Historically, the problems of inflation and deflation have usually been associated with war. In this country, the problems of post-war adjustment include the messy resumption that followed the War of 1812, and the “Grow to Gold” policy following the Civil War that involved a protracted period of deflation and a series of financial panics. Following the Great War, subsequently renamed World War I, there was a significant post-war deflation, but prices were stabilized at a level higher than pre-war. A second bout of deflation might have been necessary or perhaps there was a more creative solution. As other nations sought to return to the Gold Standard, something was going to have to give. The unfinished job of post-war adjustment didn’t mean, however, that we were condemned to the utter calamity that was the Great Depression.

Clifford F. Thies is the Eldon R. Lindsey Chair of Free Enterprise and Professor of Economics and Finance at Shenandoah University. He has recently written on debt repudiation by Mississippi (The Independent Review).

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Subject(s):Financial Markets, Financial Institutions, and Monetary History
Geographic Area(s):North America
Time Period(s):19th Century
20th Century: Pre WWII