Adam Smith on Trade, Money, and Banking

Adam Smith is one of the two most famous of the 18th century Scottish Enlightenment thinkers and he counted the other, David Hume, among his closest friends. David Hume receives a handful of mentions in Smith’s The Wealth of Nations. Hume likely influenced some of Smith’s thoughts but Hume was also widely read, far more so than Smith, and so referencing his works could be useful in ensuring readers of The Wealth of Nations were kept on track. Nonetheless, Smith’s focus was dedicated more thoroughly to economics than Hume’s and Smith went much farther than Hume in breaking with an orthodoxy, mercantilism, which was admittedly already on the way out, and advancing new ways of thinking about trade, money, and banking that would be relevant for the next century.

Smith and Hume

Adam Smith, born in 1723, was a Scottish philosopher and economist. He drew heavily from French and Scottish Enlightenment thinkers, including David Hume. Almost all of Hume’s works were written before Adam Smith published his Theory of Moral Sentiments, his first of two books ever published.

The two were friends and of the relatively small amount of Adam Smith’s personal correspondence that survives, a very large fraction is between him and David Hume. As for Hume’s letters, we can see that he wrote more frequently to Smith than to anyone else except his publishers. Their friendship is attested to in the writings of many contemporaries. Smith’s economic thoughts, and where they stood in relation to Hume’s, are found not just in The Wealth of Nations but also in his Lectures on Jurisprudence, a collection of lectures delivered a decade earlier.

Statue of Adam Smith in Edinburgh by Alexander Stoddart

In Agreement

Like Hume, Smith believed money greased the wheels of commerce by facilitating exchange between economic actors and thereby the division of labor. Both knew that an increase in the money supply beyond what a growing economy required would cause inflation. Both also discounted the role of the quantity of money in determining interest rates (The Wealth of Nations, Book II, Chapter IV, ‘Of Stock Lent at Interest’). Smith too is dismissive of mercantilism. He argues that an industry actually serves the national interest when it buys foreign inputs in order to advance its own interests since by acting in their best interest, they make their industry more competitive and productive (The Wealth of Nations, Book II, Chapter IV, ‘Of Stock Lent at Interest’).

Adam Smith encapsulates Hume’s price-specie-flow mechanism in his Lectures on Jurisprudence, saying that Hume proved “very ingeniously that money must always bear a certain proportion to the quantity of commodities in every country, that wherever money is accumulated beyond the proportion of commodities in any country the price of goods will necessarily rise, that this country will be undersold at the forreign market and consequently the money must depart into other nations”.

Mercantilism and Capitalism

That said, Smith did not elaborate much on the price-specie-flow mechanism, foregoing explicit mention of it in The Wealth of Nations. There is disagreement as whether this absence is due to Smith now possessing a different opinion about the mechanism or whether he simply found it unnecessary to mention in detail, at least in the same terms as Hume.

In either case, Smith likely thought it a welcomed but an insufficient break with mercantilist thought; even Hume conceded that in the short-run at least, trade-surplus-induced inflows of money can be stimulative to the economy. Hume leaves open the possibility that running trade surpluses could actually remain stimulative as long as they led to a steady and gradual inflow of money, rather than a torrent. So, his criticism of mercantilism thus seems to rest on the theory’s focus on the aggregate quantity of money rather than a fundamental disagreement about the desirability of an inflow of precious metals.

This was not a sufficient break with the old theory for Adam Smith who was keen to reduce the role of money still further. Whereas Hume would concede that flows of money could explain short-term movements in trade, Smith placed far more importance on capitalist and ‘real’ factors such as the accumulation of capital and the division of labor in explaining why goods circulated around the world. Hume thought that, to a large extent, the competitiveness of a nation’s industry, or lack thereof, depends on the change in prices resulting from an outflow or inflow of gold or silver. This change in competitiveness then affects the flow of money in the next period, which offsets the earlier movement of goods and the money to pay for them, in a self-correcting pendulum which gradually brings the system to balance.

Smith did not make use of this pendulum in his theory. He thought it was actually a nation’s competitiveness that determined the flow of precious metals, not vice-versa. According to Smith, “the quantity of money, on the contrary, must in every country naturally increase as the value of the annual produce increases. The value of the consumable goods annually circulated within the society being greater, will require a greater quantity of money to circulate them. A part of the increased produce, therefore, will naturally be employed in purchasing, wherever it is to be had, the additional quantity of gold and silver necessary for circulating the rest … The country which has this price to pay, will never be long without the quantity of those metals which it has occasion for; and no country will ever long retain a quantity which has no occasion for.” (The Wealth of Nations, Book II, Chapter III, ‘Of the Accumulation of Capital, or of Productive and Unproductive Labour’).

Envisioning the relationship between trade balances and money flows as a one-way street, Smith was doubtful of the other leg of Hume’s cycle, the other ‘movement’ of Hume’s pendulum, namely that the flow of money would in turn impact competitiveness. Smith went on, saying that notwithstanding the limited extent mentioned in the paragraph above, the “increase of the quantity of gold and silver in Europe, and the increase of its manufacturers and agriculture … have scarce any natural connection with one another” (The Wealth of Nations, Book I, Chapter XI, ‘Of the Rent of Land’). Hume would have endorsed the statement but only as a description of the long run state of things. Hume thought they were connected in the short-run, in the period between when the money supply grew and prices caught up and thereafter there was still a relationship, though an inverse one as the inflow of money made local commodities and manufactured merchandise more expensive.

Banks and Paper Money

Like Hume, Smith thought banking was useful, allowing businesses to keep fewer surplus resources on hand at all times in the form of idle money and instead invest this in their operations. Smith also had a more welcoming view of paper money as a viable alternative to precious metals albeit while retaining a critical role for the later. Smith noted that maintaining a large stock of circulating precious metal coins was a drain on the economy. The capital tied up in precious metal coins, representing the cost incurred searching for, extracting, and transporting precious metals and maintaining a stock of coined money, could be invested elsewhere to more productive ends.

He thought of a circulating stock of metal coins much like the fixed capital of a country or firm. Essentially, it was part of the fixed capital of an entire nation. Of course, some amount of circulating money is important, but just as it would be wasteful to needlessly accumulate fixed capital since “as capitals increase in any country, the profits which can be made by employing them necessarily diminish” (The Wealth of Nations, Book II, Chapter IV, ‘Of Stock Lent at Interest’), it was wasteful to accumulate coined money.

This point is an insight which made Smith more supportive of banks and paper money than Hume. Smith said, “The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient.” (The Wealth of Nations, Book II, Chapter II, ‘Of Money’). To Smith, paper money is not an often-problematic byproduct of bank credit, which may admittedly be good for society, but rather is desirable in its own right; so, Smith seems to depart from the ‘bullionist’ tendency of Hume.

Smith gave money a more passive role in explaining the economy and so was generally unconcerned with the use of paper money. Justifying his comfort with the concept, Smith was less concerned than Hume about over-issuance. He believed that if too many paper banknotes were issued, beyond the needs of a country, enough metal coins would be exported abroad to pay for cheaper imports, keeping the local money supply in check. The paper money would displace the metal coins but the total money supply would not change (The Wealth of Nations, Book II, Chapter II, ‘Of Money’).

You may ask, as the skeptical Hume might, what if so much paper money was issued that it totally displaced metal coins and bullion? And what if still more paper money was issued after that? Smith thought prudent banking practices, such as full convertibility of paper money into metal coins and bullion and keeping the term of credit provided short, would prevent this from happening. Convertibility, for example, would prevent banks from issuing too much money and ensure that the money supply could later be reduced by conversion of paper into metal and the export of that metal abroad where money was scarcer (The Wealth of Nations, Book II, Chapter II, ‘Of Money’).

Real Bills Doctrine

Among these other conditions, prudent banking meant adherence to what became known as the ‘real bills doctrine’ and this Smith believed was the approach by which paper money could be safely issued. The ‘real bills doctrine’ says that banks can issue paper money through certain activities without risk of over-issuing banknotes. Specifically, if banks issued banknotes to provide liquidity supporting real economic activity, then the money printed would be safely absorbed into the economy without ill effect.

So, if a merchant or manufacturer went to a bank asking that money be advanced against ‘real bills’ or receivables due to them from their legitimate business activities, then the money advanced to them, even if printed by the bank for this purpose, could not be excessive. Money growth tied to ‘real bills’ would be tied to the genuine needs of the economy. When the merchant or manufacturer is paid, the bank is also repaid on the credit it extended. According to Smith, “The coffers of the bank, so far as its dealings are confined to such customers, resemble a water pond, from which, though a stream is continually running out, yet another is continually running in, fully equal to that which runs out; so that the pond keeps always equally, or nearly equally full.” (The Wealth of Nations, Book II, Chapter II, ‘Of Money’).

Lesson

Adam Smith might be remembered today as a lone revolutionary in the history of economic thought. He did seem to go further than others in formulating a fairly comprehensive new systemization of the economy but he was not alone in burying the old system. The demise of mercantilism was already in the works before The Wealth of Nations made its appearance. These sorts of changes generally require a multitude of efforts. Still, Smith had more fundamental issues with mercantilism than Hume and was much more dedicated to studying the economy, a subject which consumed only a small part of Hume’s talents. So, without Adam Smith, the advent of capitalism as a new way of thinking about the economy and the prioritization of its formulations would otherwise have been delayed.

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