Monetary policy: The ghost of the real bills doctrine

An idea that floats around among policymakers is that if bank credit is channelled into 'productive sectors' it would both promote economic growth and keep a lid on inflation. Importantly, this view seems to have found strong support from Bangladesh Bank, the institution entrusted with the regulation of the flow of money and credit in the economy. The Governor of Bangladesh Bank has claimed this in some of his speeches. The latest Monetary Policy Statement (January-June 2013) also states: "BB will continue to encourage banks to focus on productive sectors and limit share of consumer credit."

However, BB has not publicly said which sectors are regarded productive. Ordinarily final goods and services worth one taka produced in any sector contribute exactly one taka to GDP. Unless one can make a convincing story, such as money earned in a particular sector has greater subsequent impact on the national economy, it is difficult to see why any sector might be regarded more productive than the others.

There is a lurking danger in the policymakers regarding some sectors as more productive than others since subsequent policies are likely to be influenced by such a perception. In the olden days policymakers believed that the 'heavy industries' (steel, petrochemicals, machinery etc.) were the most productive, and hence most important for economic development. These industries were heavy in terms of both investment and skill requirements. The government itself set up these industries as the private entrepreneurs were not forthcoming. None of these industries in the public sector proved to be very profitable; they were essentially loss makers and a drain on the meagre resources of the government. It is unlikely that they could have contributed more to national economic development than other industries that did not receive government largesse.

Curiously the most productive industry to emerge in Bangladesh turned out to be a light-weight industry whose prospects had never occurred to the policymakers and even the economists of the country. It was the lower-end readymade garments industry that was just the polar opposite of the heavy industries. It became an incubator of private entrepreneurship and an engine of economic development. Today the nation's fortunes ride on this low skill labour-intensive industry.

The main focus of this paper is however not on the identification of 'productive sectors' and their role in economic development, but on the argument that credit to 'productive sectors' helps to contain inflationary pressures, which apparently underlies BB's monetary policy measures. This argument is reminiscent of the real bills doctrine of the yesteryears which suggested that the central bank should not worry much about credit flows as long as these are channelled to 'productive sectors' through short term bills of exchange:  "… so long as banks lend only against sound, short-term commercial paper the money stock will be secured by and will automatically vary equiproportionally with real output such that the latter will be matched by just enough money to purchase it at existing prices. In other words, inflationary overissue is impossible provided money is issued on loans made to finance real transactions." (T. H. Humphrey, Economic Review, Federal Reserve Bank of Richmond, 1982).

Bangladesh Bank seems to have been convinced of the essential merit of this argument just as the US Federal Reserve System was a century ago. It was then "the working blueprint of the primary policymakers in the Fed" and continued to influence its policy until the pitfalls became evident after the Great Depression of the 1930s. Many economists held it responsible for the severity and the long duration of the Depression (Richard H. Timberlake Jr. The Independent Review, 2007). By the end of the Second World War the doctrine was, according to F.S. Mishkin, 'thoroughly discredited' and lost prominence in policy discourse although variants of the doctrine still have adherents.

The fatal flaw in the real bills argument was that it failed to recognise the link between money and prices and the fact that inflation could occur independently of the quantity of real output. Inflation is an aggregative concept that does not depend on the balance of individual sectors.  It is caused primarily by an excess of aggregate demand over aggregate real output. The aggregate demand is in turn fuelled by an excess supply of money, and hence inflation ultimately depends on the money supply.  The real output of any sector is at any moment constrained by its capacity. If the economy is working at full capacity, a flow of additional credit to investment in 'productive sectors' will exert inflationary pressures as surely as additional credit spent on consumer goods. The difference is that the former will increase the capacity of the economy in future while the latter will not; but this is not relevant to the inflation issue. Frequently inflation picks up during economic booms when business investment rises excessively and falls off during recessions.

If the principal objective of BB is to maintain price stability, it should ensure that aggregate demand does not exceed the normal capacity of the economy.  Channelling credit to 'productive sectors' does not necessarily help to attain this objective as the critics of the real bills doctrine have conclusively proven. Furthermore, production and investment in any industry or sector is a business decision based strictly on business calculations, and BB is unlikely to control it with extraneous rationale. The recent experience with SME credit, much of which has flown into other sectors, should be a pointer.

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M. A. Taslim is Professor and Chairman of Department of Economics, University of Dhaka.