Before the 20th century, and especially before the 19th century, new ways of thinking about the economy or finance were advanced by people who are not considered to have been economists first-and-foremost. In the English-speaking world, prior to Adam Smith, among the most influential commentators on economic subjects were Nicholas Barbon – a property developer, John Law – a banker, and even Dr. Richard Price – a Unitarian minister. Perhaps the surveyor-turned-aristocrat Sir William Petty came closest to being purely an economist. The Scottish philosopher David Hume is not chiefly remembered as an economist but he had some role in the demise of an old way of thinking about the economy and the eventual advent of a new one.
David Hume
The philosopher David Hume was born in 1711. Remembered for his skeptical empiricism, the ideas he formulated and conveyed, challenging conventional wisdom not grounded in actual experience, were not welcomed everywhere. Hume was even nearly excommunicated by the Church of Scotland. The scope of his written work was broad, spanning a variety of topics, including current events. Hume was also a historian, author of the six volume History of England.
David Hume was not principally an economist. Yet, while hardly a focus of Hume’s work, his economic writing is not insignificant, though it is not at all voluminous. Hume’s economic thoughts are found primarily in Political Discourses, published in 1752, and are largely confined to the third and fifth essays therein, titled Of Money and Of Balance of Trade. The ideas there are not necessarily original to Hume but his fame helped popularize a way of thinking about trade, money, and banking.
Money
To Hume, commercial activity, both purely domestic and international, was the source of wealth and this depends on the “number of people and their greater industry”. This refers to the people, their skills, hard work, and tools, as well as the land and its improvements. By contrast, money was not assigned a large role in explaining why wealth existed where it did. Hume said that “greater plenty of money, is very limited in its use”.
To Hume, money “is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy. If we consider any one kingdom by itself, it is evident, that the greater or less plenty of money is of no consequence; since the prices of commodities are always proportioned to the plenty of money” (Of Money, paragraph 1). What Hume was propounding was the neutrality of money; the quantity of money did not matter, at least not in the long term. Though, as we will see, Hume did concede some effect of more money in shaping the real economy in the short-term.
Still, Hume’s ideas opposed mercantilist theory. Mercantilism was the leading approach to thinking about the economy at the time. It held that the wealth of a country was enhanced by building a surplus of precious metal money which would usually entail perpetuating a trade surplus by selling more to the rest of the world than a nation bought. This would lead to an inflow of gold and silver. In part, mercantilism idealized large stocks of money in a country because of the belief that large quantities of money would lower interest rates.
Hume admitted a correlation between these things but insisted it was a spurious one and rejected a causal link. His argument rested on the idea that someone could make loans in commodities other than money and so the quantity of money should not affect the rate of interest. What mattered instead was the relative proportions of lenders and borrowers, whatever the commodity of their borrowing and lending, and the profitability of alternative uses of surplus capital.
More fundamental to his critique of mercantilism, Hume explained that too much money could also be a problem by lifting prices domestically and encouraging manufacturers to move elsewhere “allured by the cheapness of provisions and labour” (Of Money, paragraph 3). In his view, this would, as we will see, render mercantilism flawed. Indeed, Hume’s opposition to mercantilism did not only result from assigning a differing role for money in the economy, a role which was much more important in the mercantilist mind; he also believed that mercantilism advocated for the impossible.
Price-Specie-Flow Mechanism
What made the mercantilist ideal impossible was the ‘price-specie-flow’ mechanism. This is the process by which trade and prices are affected by an inflow or outflow of money. Hume describes the mechanism in Of the Balance of Trade (paragraphs 9 through 12).
It can be summarized best by way of example: in a country with a trade surplus exporting more than it imports, there is an inflow of money as foreigners pay for the goods produced in that country; this increasing supply of money will raise prices in the surplus-running country. Eventually, this rise in prices locally will make foreign goods look cheaper and so people and firms in the surplus-running country will buy more goods from abroad, which are cheaper since those countries did not see a rise in prices resulting from the flow of money; this buying activity will before too long reverse the trade surplus.
Consider also a country with the trade deficit at the start of this example. The country with a trade deficit will have seen a corresponding outflow of money as its people paid for foreign goods, reducing the money supply there and causing prices to fall. This would have made its goods appear cheaper to foreign buyers and resulting exports of these goods would eliminate the trade deficit. By the price-specie-flow mechanism, Hume thought that trade surpluses were inherently unsustainable.
An exception might exist when a nation’s trade surplus arises from its industry becoming so much more efficient that prices for its products hardly rise at all despite the inflationary pressure. However, these conditions are likely to be rarely satisfied since while an industry may become more efficient with respect to labor, energy, its fixed capital requirements, raw materials, or other inputs, it is unlikely to become more efficient with respect to each and all of these inputs and so the inflation would eventually make its products less appealing to foreign buyers not experiencing inflation in their own economies.
In any case though, the mechanism would still limit the extent of the trade surpluses that could be maintained for long. More or less, once prices rose in response to new money circulating in the economy, the advantage of the inflow of money called for by the mercantilists is negated. Hume, a great empiricist, pointed out the real-world example of the country owning precious metal mines in America, namely Spain. That country was not benefiting from greater industry as a result. This was not a fault of Spain specifically; Hume believed that in the rest of Europe too, the effect of the inflow of precious metals would raise prices to the point where industry would no longer be stimulated.
Hume conceded that the quantity of money did have some short-term effect. He notes that “in every kingdom, into which money begins to flow in greater abundance than formerly, every thing takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skillful, and even the farmer follows his plough with greater alacrity and attention” (Of Money, paragraph 6). Hume accounts for this, despite his rejection of any long-term role for the quantity of money in creating wealth, on the basis of the time it takes for prices to catch up with the increase in money. Essentially, when the amount of money increases, people feel wealthier before they observe the increase in prices which eventually reverses this. By popularizing the price-specie-flow mechanism, albeit with this concession alongside it, Hume contributed to the decline of mercantilism.
Banking
So far, when speaking of money, Hume is referring to the type of money that might circulate internationally, namely precious metal coins and bullion. Of course, already by the 18th century, paper money existed too and each form of it had a more local circulation. Hume was skeptical of paper money issued by banks, though not extremely hostile to it either. He cited unsuccessful experiments with paper money in Scotland (Of the Balance of Trade, paragraph 27).
As a policy, creating too much paper money shared the downsides of excessive metal money in raising prices, but it would not share the advantages of metal money in being able to purchase foreign goods, since paper money could only circulate locally and not globally. Hume wrote that “no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce” (Of Money, paragraph 4).
His concern largely stems from a fear of inflation, specifically “encreasing money beyond its natural proportion to labour and commodities, and thereby heightening their price to the merchant and manufacturer” (Of Money, paragraph 4). That said, he did think that the short-term credit provided by banks was useful and thus the banks’ paper money might have been a necessary evil, attendant to the growth of banking. When Hume says “specie and bullion are not of so great consequence as not to admit of a compensation, and even an overbalance from the encrease of industry and of credit, which may be promoted by the right use of paper-money” (Of the Balance of Trade, paragraph 26), he concedes the usefulness of bank credit in facilitating commerce, and that the positives may outweigh the negatives. Banks were simply too useful to write off, even to a ‘bullionist’ like Hume.
Lesson
David Hume’s Political Discourses stands partway through the demise of mercantilism. Hume may have maintained the usefulness of precious metal money but thought the mercantilists put too much emphasis on it and even thought their means of accumulating it was flawed. Adam Smith, a contemporary and friend of Hume, would go farther with these ideas and would break with mercantilism much more thoroughly. Still, Hume was much more influential than Smith, at least during their lifetimes and its hard to imagine Adam Smith’s game changing ideas reverberating nearly so much without Hume preceding him. If Smith earns credit for the goal, Hume rightfully deserves the assist.
More from the Tontine Coffee-House
Read about what Aristotle had to say about money. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts.
Further Reading
1. Arnon, Arie. Monetary Theory and Policy From Hume and Smith to Wicksell: Money, Credit, and the Economy. Cambridge University Press, 2010.
2. Hume, David. Political Discourses. 1752.
3. Rasmussen, Dennis C. The Infidel and the Professor: David Hume, Adam Smith, and the Friendship That Shaped Modern Thought. Princeton University Press, 2017.
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