Adam Smith's Wealth of Nations

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Chapter II
OF MONEY CONSIDERED AS A PARTICULAR BRANCH OF THE GENERAL STOCK OF THE SOCIETY, OR OF THE EXPENSE OF MAINTAINING THE NATIONAL CAPITAL

Vocabulary for this chapter:

Chimerical – Given to unrealistic fantasies.
circumspect - Prudence.
Diminution -The act or process of diminishing; a lessening or reduction.
Exchequer - The British governmental department charged with the collection and management of the national revenue.
Exigible - That may be exacted; repairable.
Neat - Left after all deductions; net.
Prodigality - Extreme abundance; lavishness.
Recourse – The right to demand payment from commercial paper, if the first party fails to pay.
Surety - The condition of being sure, especially of oneself; self-assurance.

Terms used in this chapter:
Bills of Exchange - This term basically represents when say company A purchased $500 worth of goods from company B on credit, company A gave a Bill of Exchange to company A saying they will pay them $550 on a certain date. It is basically a promissory note with interest.

Discounting Bills - This has to do directly with bills of exchange, in that company B has sold those goods, but wants cash right away. They will sell their bill of exchange to a bank (or bill discounter) for the face value ($500), and then whoever purchased the bill will receive $550 when the bill comes due and make a profit.

Cash Account - A cash account is a 17th century version of a credit card. Where before cash accounts, somebody would borrow a sum of money and pay it all back plus interest later, but with a cash account they can somebody can borrow a large sum and pay it back in increments much like todays credit cards.

Drawing and Redrawing – This was a technique used by some merchants when they were facing a cash shortage and could not get enough from their cash accounts. What they would do is two merchants would agree to “draw and redraw”. So the first merchant would write out a fake bill to the other, and as soon as that bill would come due, the second merchant would write out another fake bill to the first for the sum of the first bill plus interest. This could continue for a long time at a great expense to the merchants as each time the bill came due, they had to write out another one to pay for the previous plus interest. The first merchant was able to raise money only the first time that they wrote out the bill, and went to a bill discounter to get the cash for it. The rest of the times the bills were just to buy them time to repay the first bill.

Chapter Summary:

The price of goods can always be broken down into three categories, wages, profit, and rent, although sometimes rent or rent and profit can be taken out. Since this is true for all things, when everything is combined, the net produce of a nation can be broken down into those three components as well. For these categories, both a gross and net revenue can be calculated. For rent, the gross would be what the farmer pays the landlord, and the net would be what is left after paying for maintenance and management. The landlords "real wealth is in proportion, not to his gross, but to his neat rent.". These same principles of rent, also apply to the revenues from profits and wages.

As far as fixed capital goes, the purchase and maintenance (both in goods and in labor) must be subtracted from the gross to get the net, because while these improvements and maintenance will lead to greater productivity, it is still time taken away from actual productivity. The real advantage to a factory owner would be if he can cut in half his maintenance costs, and then apply those saving to hiring more workers so he can produce more.

The expense for a society in maintaining fixed capital can be equated with the expense of a landlord repairing and improving his estate, which is necessary to keep up both gross and net revenues. Circulating capital (except for money) and the cost the maintain that should not be deducted from the gross however, because it it routinely is transformed into fixed capital. It should also be noted that while an individual must deduct the cost of maintain circulating capital from it's net revenues, a society does not need to do that. With regards to money, since it is to a society, a form of fixed capital, in that it facilitates trade, does have an inherent cost of manufacture, and maintenance, while contributing no income of it's own to society.

Smith then describes how money can sometimes be counted twice as both the value of the metal, and the value of the goods that the money can purchase. He states that it should only be counted once, and the more proper way to count money would be with the goods and services that it can purchase. Thus when one talks about how much money one makes, they are referring to the purchasing power of that individual, not necessarily how much gold they receive each year. It is for this reason that there can be no more money in a society then the total wages of that society, and it will be much less because money is always being spent, and money can not be counted in a societies revenue.

The third reason that money represents fixed capital is because any improvement made in maintaining that capital (i.e wear and tear on the coins plus loss) will save labor in the society and the revenue of the society will increase.

One improvement in money that Smith takes note of is paper money, as it is cheaper to produce, and just as convenient. One form of paper money that he focuses on are bank notes. He notes that while a bank can issues 100,000 pounds worth of promissory notes, that if the bank is trustworthy, can circulate for months and years before they are returned to the bank. Thus they only need to keep a fraction (20,000 pounds) of that 100,000 pounds in gold and silver in reserve, thus sparing 80,000 pounds of gold and silver from needing to be in use. But then what to do with that extra gold and silver that is saved? Smith argues that it can be sent abroad and employed there to generate a profit (since long distance bank notes do not have as much confidence as local ones) which can be added to the net revenue of the society, to bring in luxury goods, or to replenish stock.

If that gold and silver is used to purchase luxury goods, these are consumed without producing anything in return, and thus hurts the society. If it is used to replenish stock, then it is used for production and is able to sustain itself. Smith then argues that most of the money sent abroad because of banking is used to purchase materials, and not luxuries, because the banks will make sure that they do not loose money.

In order to compute the amount of industry that circulating capital can support, it is necessary only to count the materials, tools, and finished work, not money. When paper money is used instead of gold, that paper money can purchase all the circulating capital that the gold did, but now the gold sits idle and it too can be used to purchase circulating capital. Thus the use of paper money will augment the total circulating capital in a society.

With regards to the total money supply, it is argued that the total money in circulation as a percentage of the total annual produce of a nation is small, but the total money in circulation as a percentage of what is required to maintain industry is large. So therefore when paper money is substituted for gold and silver, much more industry can be supported. Smith then follows up this claim with the example of Scottish banks having adopted a paper money system, and the vast increases in trade that have occurred because of this.

This also benefits the banks who engage in issuing paper money, in that because they can pay out to their customers their own paper money, they can issue more money then they have, and thus make more profit on interest. The other thing though that Scottish banks have done by this time was issue "cash accounts" where they found that by accepting re-payment in their own notes, merchants began to encourage their own customers to pay via bank notes, so that the merchant could then repay the bank. This then established the bank note as a stronger currency and with more notes floating around, they could issue more notes and make more of a profit. In addition to the benefit to the bank, merchants no longer had to keep large sums of money on-hand to pay off their debts when a collector came around, and instead could employ that money in their business. Then when a collector came around, they could pay them from their cash account at the bank. This strategy, coupled with the ability to discount bills, greatly improved the efficiency of Scottish banks.

But there is a limit as to how much paper money can be placed in circulation, and that limit is how much gold and silver would circulate in the absence of paper. This is because if people have more paper money then they need, they will return it to the bank for gold and silver which they can send over-seas as an investment. Thus if everybody has too much paper money, they will all return it and create a run on a bank. To prevent a run on the bank from getting out of hand a bank must have a certain amount of gold and silver on hand, which they do not gather interest on, and they must also pay for the transport of that gold and silver as it runs out. (Those two sums being the principal expenses of a bank). So a bank that issues more paper money then the economy can tolerate, must keep more gold and silver in it's coffers. It must also replenish it's coffers at a much faster rate, and thus issuing more paper money then necessary is a costly enterprise. Smith uses the Bank of England as an example, where because of the gluttony of paper money, the Bank of England was forced to coin more and more gold at their expense, while the Scottish banks had to pay people to make many trips to and from London to supply themselves with gold, which was ruinous to both banks.

With respect to banks that operate properly, they will only circulate enough paper money that would just meet the demand of gold in circulation. This can be done by discounting bills, as well as setting up cash accounts where repayment is regularly made. When in cash accounts, payments are regularly made, this gives the banks two advantages. The first would be that the banks can determine whether or not a debtor of theirs is in a good situation financially based on the regularity of their payments. The second would be that regular payments would ensure that the circulating paper money would not exceed that of the gold and silver that would be required for circulation.

With regard to traders who require more loaned capital then the current value of their circulating capital, these are risky propositions to banks, as repayment if it comes at all will be longer then desired by the bank. An even riskier undertaking would be for a bank to loan out money for somebody’s fixed capital, as the returns from that investment would be even slower then if that money was put into circulating capital. Therefore a bank should stay out of the business of long term loans and leave that to private investors who have the time to wait for the returns on their investment.

After the first 25 years or so of banks loaning out paper money, the circulation reached it’s saturation limit, and they began to restrict how much they lent out. But traders and merchants wanted ever more capital from the banks who refused to loan it out. This then caused them to find other methods to raise capital, namely “drawing and redrawing”. This essentially bled out some of the banks, because even though each time a bill became due, it was never fully repaid as another bill was drawn up to pay the first. This practice also increased the amount of paper in circulation, unbeknownst to the banks, who were essentially loaning out money without their knowledge.

This drawing and redrawing went on for some time, until finally the banks began to slowly figure this out. Once they did, the banks did not want to call out these merchants, and send them into bankruptcy, because then they too would be out of money, so it became a very delicate operation to get out of these circles. Once word got out publicly that this was happening, it was the banks who were generally blamed for being too tight with their money in their refusal to make long term loans, thus forcing the practice of drawing and redrawing.

To fix this problem, a new bank was established in Scotland that was supposed to be very liberal in the bills it discounted, and in giving out loans for long term infrastructure improvement projects that it deemed profitable. It had a noble goal, but failed in it’s application, and within two years it had failed. But the one good thing that it did do was allow all the banks that had gotten tied up in the circles of drawing and redrawing to get their money from this new bank, allowing them to wash their hands of that ordeal.

The original plan for the bank to survive it’s liberal lending policy was to find private investors to purchase the bonds and mortgages that they made, and use that to replenish their coffers. That however proved to be too difficult, and Smith used the analogy that the bank was like a pond with a stream running out of it, and the plan to keep it filled was to have a couple men filling buckets up from a well. However inefficient though, this was the one profitable arm of the bank, but yet did not benefit the country as a whole. This is because the private investors put their money into the bank who loans it out to people with crazy and improbably ideas. Whereas if those investors made those choices themselves, they would make sure that their money would go to those that had good profitable ideas, and thus would improve the wealth of that country.

Smith makes a brief aside to refer to the infamous John Law, and his proposal that the industry of Scotland was in great want of money, and if paper money was to account for the total value of the whole country, all would be good. He also briefly mentions Laws “Mississippi scheme” which is evaluated in much more detail here: http://www.gold-eagle.com/editorials_04/faber102004.html for those that are curious. Then a history of the bank of England is given, with data showing how much in loans they have given out.

The real benefit to banking towards the industry of a country, is not by increasing the total capital of the country, but rather by taking the gold and silver that was used in circulation, and thus not producing anything, and puts it to use by substituting it for paper. Smith uses the analogy that gold and silver are like a road. Wheat must travel on the road to get to the market, but the road does not produce anything. Paper money allows the road to be turned into farmland, and the road built in the sky. But it is more dangerous to use paper money, then gold and silver.

One of those dangers would be war. If a country has most of their gold and silver sent abroad when it goes to war, it may loose that money forever, and then when the paper money comes due, there will be no gold to satisfy the public, and the economy will head for disaster. Thus to prevent total ruin from war, the government should make sure at least some gold and silver stays in the country.

In an economy, there are two types of transactions that are made. One between traders and other traders, and the other between traders and consumers. At no time can the value of the goods being circulated between the traders be different then that is sold to consumers, because everything that is traded, must ultimately reach a consumer. While deals between traders tend to be of large monetary amounts, those between traders and consumers tend to be smaller, and those small coins facilitate more transactions then the bigger ones while those between traders. So therefore when paper money is limited to large sums, it stays between the traders, but when paper money can be printed in small sums, it is frequently found in transactions between traders and consumers.

And thus when bank notes can be printed in small amounts, it encourages people not savvy enough for real banking, to setup their own “banks” anyways, and issue many notes for little sums. This results in many of these micro bankers to go into bankruptcy, and many of the poor who are stuck with their notes are ripped off.

Thus Smith recommends that there be regulations to prohibit the printing of notes smaller then 5 pounds, so that paper money stays between traders. This will then cause coins minted of gold and silver to be the main transaction means between traders and consumers, and keep the gold and silver in the country to prevent the afore mentioned calamity when there is none. Even though with this decision, there will be less gold and silver freed up for investment, this should not hurt the economy too bad, as the traders can still keep their cash accounts, and thus free up their stock as was the original purpose of paper money.

Smith notes that a regulation like this would be in violation of the natural liberty that all people are afforded, but states that sometimes liberties must be curtailed to prevent a few stupid and crooked people from harming the entire society.

When a reputable bank issues paper money, it is good as gold, and so if only reputable banks issue paper money, the amount of gold and silver taken out of circulation will be equal to the value of the paper money put in. This then will not cause inflation. But when less then reputable banks issue paper money, then the value of the paper becomes slightly less then gold, and inflation rises. Such was the case with the Scottish banks and a clause they put on their paper stating that the bank could optimally exchange the paper for gold and silver 6 months after the note had been presented. Another clause that devalued paper, was one that stated that the bank would not pay out for a single small note, but rather would require a number of small notes totalling say a guinea before they would pay.

Another example of paper money being devalued, is that of the North American colonial governments, who issued paper money that was required by law to be accepted for it's face value of gold, but could not be exchanged for upwards of 15 years. Smith then defends the Currency Act of King George, which forbade the colonies from printing their own paper money.

When the colony of Pennsylvania printed money, they wanted to curtail the exportation of gold and silver, and so they declared that a pound Stirling would be worth 1.3 pounds sterling in the colony, and issued their paper money as such. But this did not have the desired effect as the price to import 1 pound Stirling of goods rose according to how the colony raised the value of the silver. Additionally since the paper was officially used for taxes, if there was less paper then needed to pay all the taxes, it's value would go up higher then it's value in gold, but there was more then necessary which added to the depreciation of the colonies paper money.

This concept can also be applied to banks and their concept of "bank money". Say for instance that a merchant in Paris buys 10 steam engines from another merchant in London. Then another merchant in London buys 10 pieces of art, worth slightly less then the steam engines, from an dealer in Paris. For both of these unrelated exchanges to take place (since they are across international borders) would require physical gold to be sent across to each country. But this is expensive to do. So what a pair of banks, one in Paris one in London, would do is tell both purchasing parties to give their gold to the banks. They would then distribute the necessary amount of gold to the sellers in their respective countries, and life would go on. But the art was worth less, so there would be a deficit of gold in London, and a surplus in Paris. The banks would agree to credit each other in their books with "bank money" and if somebody wanted to buy another piece of art, the bank in Paris would give the gold to the dealer, and the bank in London would take the gold from the buyer, and the banks would agree that their books were balanced. Thus no gold had to be shipped anywhere, and the banks could capitalize on this savings.

In conclusion, no matter how much paper money is put out by the banks, it will not affect the purchasing power of gold or silver, only the output of the mines, and the difficulty in obtaining those metals. Additionally if banks are properly regulated, the more of them that there are, the greater the benefit to society. In his last statement of the chapter, Smith states that whenever an industry is of general benefit to the public, the more competitive it is, the more advantageous to the public it will be.

Chapter I<---- ---->Chapter III