Paper money: a reassessment of Adam Smith’s views
Alberto Giacomin*
1. Introduction
In Scotland, at the time when Adam Smith was writing The Wealth of Nations, a
monetary system was taking root in which, besides metallic money, convertible notes
issued by private banks also circulated. In the same period, the English colonies of
North America had embraced an even more revolutionary system, in which only
unconvertible paper currency issued by the government or authorized public banks
circulated. Though in his discourse on money Smith focuses attention on the first
system, he does not fail to devote an accurate analysis to the second.
It is presumable that he considered metallic money if not a relic of the past, an out-ofdate device that was bound to bank safes in order to guarantee the public’s requests
for conversion. On the contrary, he conceived the fiat money as a reaction to an
extraordinary situation: namely, that of countries which, having no mines, were trying
to save on a costly means of circulation such as gold and silver in order to fund the
accumulation of capital in a phase of rapid economic growth.
The scholars who have dealt with Smith’s theory of money have turned their attention
mainly to the convertible paper money system, neglecting almost completely his
analysis of the pure fiat money system, although it deserves consideration for its
freshness and originality.1 In fact, this approach has compromised the chances of an
homogeneous reconstruction of Smith’s thought, which relies on the contraposition
between the traditional system based on a commodity money such as gold and silver
and the new systems which, in different ways, made use of paper money.
Such a contraposition assumes both a theoretical and a practical importance. On the
one hand, it confirms Smith’s idea that money, as a medium of exchange, is
submitted to an incessant process of innovation aimed at reducing the costs of
commodity circulation; on the other, it provides support for his critique of the
mercantilist theory, showing that gold and silver (commonly assimilated to wealth
and reckoned to be the true goal of commercial policy) can be easily, and in some
cases also advantageously, replaced by paper currency.
In such a context this paper pursues a twofold purpose. The first is to bring out the
central thread of the arguments which drove Smith to develop an analysis of the
monetary systems introduced in Scotland and in the English colonies of North
America. To this end, after pinning down the role he assigns to money in the working
of a market economy, we will try to stress the link between his theory of money as a
bookkeeping device and the search for technical innovations that help to reduce the
*
Professor of Economics, University “Ca’ Foscari”, Venice, Italy. This paper has been published in
A. Giacomin and M.C. Marcuzzo (eds) (2007), Money and Markets: A Doctrinal Approach, London
and New York: Routledge, pp. 181–99.
1
costs of trade. The second purpose of this paper is to provide a reconstruction of the
pioneering analysis of the fiat money system advanced in The Wealth of Nations.
2. The role of money in a market economy
2.1. The mercantilist bias
According to Smith, the mercantilist thought rests on the idea that wealth consists in
gold and silver2 and that a country lacking mines has to follow a set course in order to
increase its wealth, i.e. to accumulate precious metals through a constant surplus on
its balance of trade.
In Book IV, Chapter I of The Wealth of Nations Smith puts forward several
arguments aimed at denying this assumption. The principal one is based on the
remark that money is dead capital and therefore that
to attempt to increase the wealth of any country, either by introducing or by
detaining in it an unnecessary quantity of gold and silver, is as absurd as it
would be to attempt to increase the good cheer of private families, by obliging
them to keep an unnecessary number of kitchen utensils.
(Smith 1981: 440)
On the other hand, when trade is free a country supplied with adequate means will be
able to secure all the gold and silver it needs. And if even a country provided with the
necessary means could not secure gold and silver, ‘there are more expedients’ – he
observes – ‘for supplying their place, than that of any other commodity’: through
barter, for example, though ‘with a good deal of inconveniency’; or by resorting to
reciprocal credit deals and their compensation at a monthly or annual rate (in this case
‘with less inconveniency’); or, finally, through the introduction of paper money
which, if ‘well regulated’, will be able to replace gold and silver ‘not only without
any inconveniency, but, in some cases, with some advantages’ (Smith 1981: 437,
passim).
The last option, Smith observes, has been kept not only by Scotland, but also by the
American colonies where, in his opinion, ‘it is not the poverty, but the enterprizing
and projecting spirit of the people, their desire of employing all the stock which they
can get as active and productive stock, which has occasioned this redundancy of
paper money’ (Smith 1981: 941).
The argument usually advanced by mercantilists in support of their view rests on the
inconvenience of money shortage and the necessity of accumulating it in abundance
in order to feed trade. Smith objects that there is no money shortage for the people
who have the means to secure it or the guarantees to supply for borrowing. On the
contrary, it follows very often from overtrading, that is from a decision of
entrepreneurs to employ all the resources at their disposal in risky undertakings,
together with the necessity of facing the payment claims from creditors before the
sale proceeds have been cashed.3
2
Against those who maintained the usefulness of a treasure to finance the growth of
the economy and the costs of war Smith argues that almost all the imports and
military expenses are paid by the commodity exports, not by gold and silver
accumulated. In his view, the mercantilist obsession with precious metals represents a
bias that is theoretically unsubstantiated and is to be condemned. The only
contribution gold and silver can give to the increase of wealth is connected with their
role as medium of exchange, yet in this job they can be validly replaced, at least in
domestic circulation, by banknotes or government paper currency.
2.2. Money as capital
In Book II, Chapter I of his Wealth of Nations which is devoted to analysing the role
performed by capital in the working of the economy, Smith includes money among
the items of the circulating capital together with provisions, materials and finished
products which are still in the hands of merchants or manufacturers and he states that
it is thanks to money that ‘all the other three [parts of circulating capital] are
circulated and distributed to their proper consumers’ (Smith 1981: 282).
However, Smith observes, money closely resembles fixed capital whose aim is ‘to
increase the productive powers of labour’ (Smith (1981: 287).4 He compares ‘the
stock of money which circulates in any country’ to ‘those machines and instruments
of trade’ which ‘require a certain expence, first to erect them, and afterwards to
support them’ (Smith 1981: 288-89, passim). and adds that ‘every saving in the
expence of erecting and supporting those machines’ can be assimilated to that realised
‘in the expence of collecting and supporting that part of the circulating capital which
consists in money’. In effect, if such saving ‘does not diminish the productive powers
of labour’, it causes ‘an improvement of the neat revenue of the society’ as it allows
entrepreneurs to ‘increase the fund which puts industry into motion, and consequently
the annual produce of land and labour’ (Smith 1981: 291-92, passim).
The similarity between money and fixed capital is particularly relevant in Smith’s
eyes as it supports his attempt to reconstruct the history of money as the incessant
pursuit of technical solutions to increase the efficiency of the economic system by
cutting trade costs. He believes that gold and silver are extremely expensive as a
means of circulation and that the introduction of paper money helps to economise on
precious resources that are allocated to increasing capital and production.5
However, there were those, like Hume, who, following the quantity theory of money,
opposed the introduction of banks since they feared the inflationary effects of credit.
‘It seems a maxim almost self-evident,’ – Hume observes – ‘that the prices of every
thing depend on the proportion between commodities and money (…) Encrease the
commodities, they become cheaper; encrease the money, they rise in their value’
(Hume 1955: 41-2). The introduction of banks, by increasing the quantity of
circulating money, produces an increase in the prices of commodities, which makes
him ‘entertain a doubt concerning the benefit of banks and paper-credit’ (Hume
1955: 35).6 The practical conclusion that he draws is that banks should by law only
deal with deposits and custody and they should not be allowed to grant credit: ‘no
bank could be more advantageous, than such a one as locked up all the money it
3
received, and never augmented the circulating coin, as is usual, by returning part of
its treasure into commerce’. ‘This is the case’ – he adds in note – ‘with the bank of
Amsterdam’ (Hume 1955: 36, fn. 1).
Smith disagrees with this opinion and intends to prove how economies where
convertible banknotes circulate together with gold and silver – or even non
convertible notes only – may well, with appropriate adjustments, replace economies
based on metallic money.7 In other words, Smith believes that it is possible to obtain
the advantages of using a cheap means of circulation such as paper money without
necessarily violating the law of value on which exchange economies are based.8
2.3. Money as a social bookkeeping device
At the beginning of Book IV, Chapter I of The Wealth of Nations Smith defines
money as ‘the instrument of commerce’, namely the thing by means of which ‘we can
more readily obtain whatever else we have occasion for, than by means of any other
commodity’ (Smith 1981: 429).
This definition places money at the core of the market system. In fact, the distinctive
feature of that system is the chance individuals are given to have access to the product
of the other members of society going beyond the bounds of an autarchic organization
of the economy.
The advantages afforded by a market economy follow from the push it is able to give
to the division of labour. The more extensive the division of labour, the higher the
level of social welfare. However, in order to get this result every individual must face
a problem that does not arise in an autarchic economy, namely to find a purchaser for
his own product and obtain in exchange what allows him to secure the goods and
services he needs.
Smith is well aware of both these aspects. He observes that as ‘we always find’, the
‘great affair […] is to get money’. Money is what one obtains in exchange for the
resources sold out to other individuals. Once money has been got, he continues,
‘there is no difficulty in making any subsequent purchase’ (Smith 1981: 429,
passim). Actually, he points out elsewhere,
a guinea may be considered as a bill for a certain quantity of necessaries and
conveniences upon all the tradesmen in the neighbourhood. […] If it could be
exchanged for nothing, it would, like a bill upon a bankrupt, be of no more
value than the most useless piece of paper.
(Smith 1981: 290)
The metaphor of the bill shows how Smith guest the role of money as a social
bookkeeping device, namely as an instrument which entitles the bearer to “draw”
from the market commodities having the same value as his contribution to the social
product. Actually, only improperly can money be called a bill, provided that a bill
incorporates the obligation of a private individual, while the monetary medium gives
to its owner a power towards all the members of society. Since this power does not
4
rely on any contract, it can only stem from a rule which every individual conforms
with. In other words, Smith acknowledges that money is a social institution which is
based on an implicit agreement among the members of society.9
It is this agreement which makes it possible to go beyond an autarchic economic
organization and build an alternative economic order where everybody is ready to
produce goods in excess of their needs, with reasonable confidence they can be
exchanged with others’.
2.4. Transactions demand for money
Once acknowledged that money is the means which allows everybody to exchange
his excess resources with others’, the convenience of forming and maintaining a
reserve of this means becomes apparent. Smith himself draws attention to this point.
Referring to the lack of coincidence of reciprocal wants which makes the resort to
barter problematic, he observes that
in order to avoid the inconveniency of such situations, every prudent man in
every period of society, after the first establishment of the division of labour,
must naturally have endeavoured to manage his affairs in such a manner, as to
have at all times by him […] a certain quantity of some one commodity or
other, such as he imagined few people would be likely to refuse in exchange for
the produce of their industry.
(Smith 1981: 37-8)
He repeatedly stresses that economic agents must be able to face in every moment the
payment claims from their creditors and that, consequently, they need to hold a liquid
reserve for this purpose.10 However, in the course of their business, besides
contracting debts, they also get credits and hence, against money outlays, they also
register money receipts. Assuming that outlays and receipts are equal and perfectly
synchronized or that they could be rendered such, liquid reserves would become
useless. Resting on these considerations, we can suppose that Smith had in mind an
embryonic theory of the transactions demand for money, according to which money
is held by economic agents to face the temporary excess of outlays over receipts.
The holding of a liquid reserve raises two problems for economic operators. The first,
which affects the public authority, is the stability of the value of money and will be
discussed later. By contrast, the second affects every individual and concerns the
costs incurred by the very fact of holding such a reserve. Dealing with the advantages
that ‘cash accounts’ (Smith 1981: 299), granted by Scottish – but not English – banks,
ensure to merchants, Smith observes that an hypothetical London merchant
must always keep by him a considerable sum of money, either in his own
coffers, or in those of his bunker, who gives him no interest for it, in order to
answer the demands continually coming upon him for the payment of the goods
which he purchases upon credit.
(Smith 1981: 300, emphasis added)
5
Cash reserves entail a cost for the merchant as they force him to give up the profits or
interests he could otherwise gain from the corresponding sum. Therefore, no
individual will miss the opportunity of transforming totally or partially this ‘dead
stock’ in an ‘active and productive stock’ (Smith 1981: 943), namely in materials,
tools and livelihood for productive labourers. In a famous passage that Keynes
considers a paradigm of the whole classical tradition,11 Smith assumes as a
distinctive feature of individuals’ behaviour the prudent use of the disposable
resources with a view to their aim.12 He observes that where there are conditions of
safety for the life and property ‘every man of common understanding will endeavour
to employ whatever stock he can command in procuring either present enjoyment or
future profit’. In the last case he will employ this stock as ‘fixed’ or ‘circulating
capital’. A man, Smith continues, ‘must be perfectly crazy who, where there is
tolerable security, does not employ all the stock which he commands, whether it be
his own or borrowed of other people, in some one or other of those three ways’
(Smith 1981: 284-85, passim).13
Therefore, it is certain that every individual will try to reduce to a minimum the costs
for holding a liquid reserve, and the introduction of banks represents, in Smith’s eyes,
a great chance to achieve this.
3. The convertible paper money system
3.1. From gold to paper money
According to Smith, at the beginning money consists in a commodity. He draws up a
list of several commodities utilized for this purpose in different times and places, but
he believed that ‘irresistible reasons’ of economic advantage had caused men ‘to give
the preference […] to metals above every other commodity’ as ‘the instruments of
commerce and circulation’ (Smith 1981: 38-9, passim). The same reasons led, over
time, to the substitution of iron with copper and then of copper with gold and silver.
It is through the selection by traders and the subsequent intervention of the state
through coinage14 that – according to Smith – metallic money has acquired ‘in all
civilized nations’ its role of ‘universal instrument of commerce’ by means of which
‘goods of all kinds are bought and sold, or exchanged for one another’ (Smith 1981:
44).
In such a context Smith introduces his considerations on paper money. He sees
clearly the opportunities for economic growth that the new instrument is able to offer
and develops an analysis of the experiments carried out by Scotland and the English
colonies of North America during the eighteenth century. The aim he pursues is
twofold: on the one hand, he intends to prove the inconsistency of the mercantilist
theory, showing that the accumulation of precious metals is not only burdensome, as
it raises the dead stock of the country to the detriment of the active and productive
one, but also useless as gold and silver can be effectively replaced by paper money;
on the other hand, he sets out to neutralize the critiques advanced by those who were
opposed to its introduction, fearing the unlimited increase of a means of circulation
without intrinsic value.
6
Smith identifies accurately the advantages that entrepreneurs can obtain from paper
currency. He starts from the idea that cash reserves represent a loss of capital
entrepreneurs could avail themselves of in order to expand their business. This
remark not only explains the circulation of convertible banknotes, but also accounts
for the issue of unconvertible paper currency by government with the aim of saving
gold and silver in a phase of rapid economic growth.
3.2. The consequences of an excess issue of bills
As stated, David Hume was sceptical about the introduction of banks since he feared
the inflationary effects of credit on prices. Smith’s objection to this argument appeals
to the actual working of two corrective mechanisms which come into play when
currency exceeds public demand.15 The first one produces its effects when the new
system is starting and causes the exportation of gold and silver in excess owing to the
introduction of banknotes. The second, on the contrary, is set in motion when the new
system is already underway and determines the presentation of excess notes to the
banks for conversion into gold and silver. Let us examine these mechanisms
separately, starting with the first.
Smith begins his discourse with an accurate analysis of the behaviour of banks. He
observes that they enjoy the public’s confidence, which allows them to circulate an
amount of notes that greatly exceeds the gold and silver at their disposal.16 To give an
example, he assumes that the currency, as a consequence of this fact, rises from one
million to one million eight hundred pounds sterling. Since the early amount was
enough to meet the public’s demand the economic system comes to have an excess of
currency which ‘cannot be employed at home’ (Smith 1981: 294). Yet, paper money
cannot be accepted beyond the national boundaries. Gold and silver, therefore, will be
sent abroad 17 to purchase foreign goods which for the most part will be employed to
add to the capital of the economy.18
Smith provides no explanation of the process through which gold and silver are
exported. In particular, the lack of any reference to Hume’s price-specie-flow
mechanism has puzzled many scholars,19 also considering that in his Lectures on
Jurisprudence (Report dated 1766) Smith defines ‘Hume’s reasoning’ as
‘exceedingly ingenious’. However, just afterwards he points out that the same author
‘seems […] to have gone a little into the notion that public opulence consists in
money’ (Smith 1982: 507). Probably, he is referring to the passage out of ‘Of money’
where Hume states that ‘though the high price of commodities be a necessary
consequence of the increase of gold and silver, yet […] some time is required before
the money circulates through the whole state’ and that in the ‘interval […] between
the acquisition of money and rise of prices […] the increasing quantity of gold and
silver is favourable to industry’ (Hume 1955: 37-8, passim).20
Smith’s opinion on this point was completely at odds with Hume’s. It is not money
but capital which, according to him, causes the wealth of nations. Money can make a
direct contribution to the growth of economic activity only if it is transformed from a
dead stock to an active and productive stock. Yet, one may ask, how can Smith
7
dismiss the fact that the public’s increased purchasing power will not induce prices to
rise in home market?
A replay can be traced to the passage out of The Wealth of Nations where Smith
states that the availability of every commodity ‘naturally regulates itself in every
country according to the effectual demand’ (Smith 1981: 435).21 This, he adds, is
especially true for gold and silver,
because on account of the small bulk and of great value of those metals, no
commodities can be more easily transported […] from the places where they are
cheap, to those where they are dear, from the places where they exceed, to those
where they fall short of this effectual demand.
(Smith 1981: 435)
Consequently, if the quantity of gold and silver exceeds ‘effectual’ demand, the
excess supply will be exported and ‘no vigilance of government can prevent their
exportation’. If, on the contrary, their quantity falls short of ‘effectual’ demand, the
excess demand will be imported and ‘the government would have no occasion to take
any pain to import them’ (Smith 1981: 436, passim).
Resting on the international prices of gold and silver assumed as given, Smith
succeeds in identifying an alternative mechanism which in every country
automatically adjusts the supply of those metals to demand, leaving unaltered the
domestic prices of commodities.22 The process Smith seems to have in mind is the
following: the surplus of metallic money due to the issue of banknotes flows back to
the markets for gold and silver and lowers their domestic prices below the
international level, making it attractive to holders to resort to exportation or the
melting pot.
Smith’s conclusion is that in a convertible paper currency system the prerequisites for
an increase in prices do not exist because ‘the quantity of gold and silver, which is
taken from the currency, is always equal to the quantity of paper which is added to it’
(Smith 1981: 324).23
Still, even if we were to admit that banknotes do not replace metallic money but add
to it, it is possible, according to Smith, to reject Hume’s conclusion. It is sufficient for
banks to be obliged to convert their banknotes into metallic money at the request of
bearers. Convertibility anyway prevents banks from issuing an excessive amount of
banknotes with respect to the demand of entrepreneurs, since they undergo that
special process, whereby excess paper money would be used immediately by the
public to reduce its indebtedness to the banking system or be converted into metallic
money. It is the process which subsequently will be called the ‘law of reflux’. This
phrase does not appear in The Wealth of Nations, yet Smith is well aware of the
mechanism which it refers to. The mechanism is connected, in his view, with the
convertibility and the transactions demand for money and helps prevent the
inflationary effects of an excess issue of notes.
8
In addition, Smith believed that competition in the credit market would discourage
banks from issuing excess notes because they would have been promptly cashed by
owners, even before them, by the other companies.24
However, although excluding the danger for inflation subsequent to the issuing of
excess banknotes, Smith clearly understands the liquidity risk commercial banks have
to face when granting credits to firms. In his view, the rule banks have to follow to
avoid bankruptcy is to grant short-term loans upon submission of short-term bills
issued by debtors of their clients or on real security. With this aim banks should be
supplied with assets that can be liquidated easily in the event of a decrease in the
demand for loans. They thus avoid losses during attempts to liquidate their own assets
or borrow at high interest rates to satisfy requests for bill conversion.
This is precisely the version of the real-bills doctrine adopted in The Wealth of
Nations. In Smith’s view its prescriptions are aimed at securing the liquidity and
solvency of an individual bank facing a diminishing demand for its notes by the
public. This narrow version of the doctrine has nothing to do with the broad one
which was first advanced by the antibullionists, after the suspension of the
convertibility in 1797, to defend the Bank of England against the charge that it caused
inflation. It is this version which is usually considered and justifiably criticized by
most of the scholars, such as, for example, Thornton, Bagehot, Mints, O’Brien, Blaug
and others.25 The broad version focuses on the entire banking system and states that
inflationary overissue can be prevented as long as all banks advance their notes only
upon the discount of sound, short-term commercial bills, i. e. drawn by merchants
against commodity sales. This way, in fact, they merely respond to a demand for
money stemming from the real needs of trade.
There is no trace of that version of real-bills doctrine in The Wealth of Nations.
Actually, according to Smith, inflation is kept under control by different factors,
namely the convertibility of notes and the public’s transaction demand for money,
from which the law of reflux originates, on the one hand, and the competition among
banks, on the other. Moreover, it should be recalled that Smith focuses mainly on the
Scottish banking system in which, unlike in the English, bills of exchange had less
importance than cash accounts.26
Ultimately, to avoid bankruptcy, banks must not grant medium- or long-term loans,
and this for two reasons. First, it would mean supplying capital to entrepreneurs
without any, but who should acquire it by saving or resorting to loans secured by
mortgages. Second, they might have to face liquidity problems while clients complete
their production cycle or the amortisation of equipment with a substantial increase in
management costs.
Smith condemns the idea of transforming Scottish banks ‘into a sort of general loan
office for the whole country’ (Smith 1981: 316), that is into offices able to supply
entrepreneurs with the capital they need to start business. In his opinion, that is what
banks should never do, as
9
It is not by augmenting the capital of the country, but by rendering a greater
part of that capital active and productive than would otherwise be so, that the
most judicious operations of banking can increase the industry of the country.
(Smith 1981: 320)
3.3. The role of banks
From the preceding observations it is easy to infer that, in Smith’s opinion, the benefit
of paper money does not go beyond the chance offered to entrepreneurs of unfreezing
a portion of their circulating capital and devoting it to an increase in production.
Consequently, the only duty of banks is to provide liquidity for a short time to
entrepreneurs (mainly merchants) who, having already started a business with their
own funds and sold their products, are waiting to be paid by clients while having to
answer unexpected demands. A bank, he notes, ‘ought to observe with great attention,
whether in the course of some short period’, which can go from four to eight months,
‘the sum of the repayments which it commonly receives […] is, or is not, fully equal
to that of the advances it commonly makes’. Only in the first case can it ‘safely
continue’ (Smith 1981: 304-05, passim) to lend money.
These considerations explain Smith’s dislike of traders’ attempts to finance
investment through bank credit. His argument applies not only to fixed capital but
also to the circulating one, as ‘the whole of the returns is too distant from the whole
of the outgoings’ and the intervals surpass ‘such moderate periods of time as suit the
conveniency of a bank’. Smith’s opinion is that capital formation ought not to be
financed by bank credit, but ought to be funded upon the ‘bond or mortgage’ of
savers, i.e. ‘of such private people as propose to live upon the interest of their money,
without taking the trouble themselves to employ the capital’ (Smith 1981: 307,
passim).
Actually – Smith observes – the claim of traders that banks ought to ‘provide them
with all the capital’ they need to realise their production plans was not accepted. This
was the reason why some of them ‘had recourse to an expedient’ which, ‘though at a
much greater expence’, enabled them ‘for a time’ to obtain the desired borrowings.
‘This expedient’ – he points out – ‘was no other than the well-known shift of drawing
and redrawing’ (Smith 1981: 328, passim).
The negative judgement Smith gives on this practice is due to the fact that it
succeeded, without the banks being aware of it, not only in substituting gold and
silver money but in increasing the quantity of currency. In fact, ‘upon many
occasions’, the paper money ‘issued upon [the] circulating bills of exchange’
amounted ‘to the whole fund destined for carrying on some vast and extensive project
of agriculture, commerce or manufactures’ and not merely to ‘that part of it which,
had there been no paper money, the projector would have been obliged to keep by
him, unemployed and in ready money for answering occasional demands’. The final
result – which Smith underlines once more – was that the excess paper money
‘immediately returned upon the banks in order to be exchanged for gold and silver’,
and the banks had to honour their commitment ‘as they could’ (Smith 1981: 311,
passim).
10
Summing up his analysis, Smith calls the entrepreneurs who made recourse to this
practice ‘projectors’ who ‘in their golden dreams’ had, no doubt, ‘the most distinct
vision’ of the great profits they expected from their undertakings, yet ‘very seldom
[…] had the good fortune to find’ (Smith 1981: 310, passim) them.
Projectors’ idea of capitalism is the farthest from Smith’s view one could conceive.
Though in a rough and early form, it had been stated at the beginning of the
eighteenth century by a Scottish economist, John Law, who, during the regency of
Louis d'Orléans, tried to introduce paper money in France. It is precisely Law’s
theories which represent the target of Smith’s criticisms. At the end of his excursus
on the Bank of Scotland’s experience, he explicitly recalls the opinion of his ‘famous’
fellow countryman (according to whom ‘the industry in Scotland languished for want
of money to employ it’) and mentions his proposal ‘to remedy’ this want of money
‘by establishing a bank […] which […] might issue paper to the amount of the whole
value of all the lands in the country’. He defines ‘splendid, but visionary’ the ideas
expounded by Law and advances the hypothesis that they have, ‘perhaps, in part,
contributed to that excess of banking, which has of late been complained of both in
Scotland and in other places’ (Smith 1981: 317-18, passim).
In the face of these ideas Smith reasserts his opinion on the role of bank credit as a
means of converting idle capital into productive capital. He compares the ‘ready
money’ that a dealer keeps by him ‘for answering occasional demands’ to ‘so much
dead stock’ which ‘produces nothing either to him or to his country’. Such stock, by
means of ‘judicious operations of banking’, can be converted into ‘active and
productive stock’ (Smith 1981: 320, passim).
In order to understand Law’s point of view, it might be helpful to remind that in an
economic world which is ruled by the budget constraint, where every individual can
spend only what he has previously earned, bank credit represents a sort of passkey by
means of which firms are enabled to force their way into the market, i.e. to take goods
and services without having capital at disposal, that is without first having to save.
Smith rejects this interpretation of the role of banks. He believes that the creation of
money by banks and the possibility given to entrepreneurs to invest without having
first to save produce destruction rather than increase of social capital.27 As a
consequence, while clearly appreciating the role performed by cash in hand in the
working of the economy and while outlining with great accuracy the circuit of paper
money from the time it is issued by banks to its destruction when loans are
reimbursed by entrepreneurs,28 he rejects the revolutionary implications of bank
credit, i.e. the chances it offers to firms of getting capital without earning any income
in advance.
In Smith’s vision, capitalism is an economic system which is ruled by entrepreneurs
who do not bet on the future with the money they have borrowed from the banks, yet
they cut down to employ ‘the money borrowed’ from private individuals ‘in sober
undertakings […] proportioned to their capitals’, which, having ‘more of the solid and
the profitable’, can repay ‘with a large profit’ (Smith 1981: 317)29 whatever has been
laid upon them.
11
4. The pure fiat money system
4.1. State money
Promissory notes issued by the banks, however, did not constitute the only type of
paper money circulating in the economy at the time of Smith. In order to find a
remedy for the scarcity of gold and silver during the eighteenth century, the
governments of the English colonies in North America had issued paper money in the
form of notes, declaring them to be legal tender. Smith dedicates the final part of
Chapter II, Book II of The Wealth of Nations to an analysis of this experience.
He starts with the conclusion reached regarding the convertible paper money system,
in which banknotes can be considered, in every respect, equal in value to gold or
silver money when they can immediately and without any condition be converted into
such money.30 On the contrary, Smith observes that a money which would not be
convertible immediately and without any condition ‘would, no doubt, fall more or
less below the value of gold and silver, […] according to the greater or less distance
of time at which payment [is] exigible’ (Smith 1981: 325).
Smith gives some examples in support of his statement, one of which introduces the
analysis of the inconvertible paper currency system: ‘The paper currencies of North
America’ – he explains – ‘consisted, not in bank notes payable to the bearer on
demand, but in a government paper, of which the payment was not exigible till
several years after it was issued’ (Smith 1981: 326).31 Nonetheless, the governments
of the colonies did not pay holders any interest and, moreover, imposed the legal
tender of these banknotes for the full nominal value to which they were issued. The
consequence of this decision was that sterling’s exchange rate increased in all the
colonies, from a minimum of 130 to a maximum of 1100 per cent depending on the
case.32
Smith observes that the large differences in the value of the various colonies’ paper
money with respect to sterling arose not only from the factors mentioned, but also
‘from the difference in the quantity of paper emitted in the different colonies’( Smith
1981: 327). The link between the quantity of paper money issued by the government
and its value in gold and silver is reasserted immediately after in relation to
Pennsylvania, which – he observes – ‘was always more moderate in its emissions of
paper money than any other of our colonies’. This is precisely why, continues Smith,
‘its paper currency is said […] never to have sunk below the value of the gold and
silver which was current in the colony before the first emission of its paper money’
(Smith 1981: 327).33 However, moderation in issues was not the conclusive reason for
Pennsylvania’s success. Smith calls attention to the fact that all the colonial
governments accepted their own paper money ‘in the payment of the provincial taxes,
for the full value for which it had been issued’, pointing out that ‘from this use’ paper
money ‘necessarily derived some additional value, over and above what it would
have had, from the real or supposed distance of the term of its final discharge and
redemption’ (Smith 1981: 328).
12
The added value accruing to the colonies’ paper money was – according to Smith –
‘greater or less, according as the quantity of paper issued was more or less above
what could be employed in the payment of the taxes of the particular colony which
issued it’. In this case, the convertibility of notes into specie would lose importance
completely and it would be possible to fix a premium on gold and silver, ‘if the bank
which issued this paper was careful to keep the quantity of it always somewhat below
what could easily be employed in this manner’ (Smith 1981: 328).
Smith realises that in a system in which the currency is purely a sign, the only way to
preserve its value is to establish simultaneously a need and a shortage. A government
with a monopoly of issues and the power to levy taxes can make paper money a
necessity by announcing it will be accepted in payment of taxes, while at the same
time it can use fiscal policy to ensure a shortage, by making expenditure, which
decides the supply of notes, equal or lower with respect to taxation, which determines
demand.
4.2. The Pennsylvania case
In Smith’s analysis of the fiat money system the case of Pennsylvania assumes a
special importance, being the only colony where the introduction of an inconvertible
currency was fully successful. Smith returns later to a discussion of this case in
Chapter II, Book V of The Wealth of Nations, and furnishes additional information
about the monetary system established in the colony. He first explains that the
government’s objective was to provide ‘to its subjects’ a means of payment ‘without
amassing any treasure’, then goes on to state that the method adopted was to set up
local public banks with the task ‘of lending, not money indeed, but what is equivalent
to money […] by advancing to private people, at interest, and upon land security to
double the value, paper bills of credit to be redeemed fifteen years after their date’
34
(Smith 1981: 320). Those bills of credit, Smith adds, were ‘in the mean time made
transferable from hand to hand like bank notes’, and ‘declared by act of assembly to
be a legal tender in all payments from one inhabitant of the province to another’.
From this operation, the government, which Smith defines as ‘frugal and orderly’,
obtained a revenue ‘which went a considerable way towards defraying an annual
expence of 4,500l.’ (Smith 1981: 820), i.e. the whole amount of its ordinary expenses.
Smith ascribes the success of this measure to three factors. The first is the need ‘for
some other instrument of commerce, besides gold and silver money’ (Smith 1981:
820), required to pay for imports from the motherland.35 The second is ‘the good
credit of the government which made use of this expedient’ (Smith 1981: 820).36 The
last is the moderation of issues, borne out by the fact that the quantity of paper money
was barely above the amount needed to pay taxes, whereas in the other colonies it
was ‘very much above what could be employed in this manner’ (Smith 1981: 328).37
Smith concludes his analysis of the pure fiat money system in Chapter III, Book V of
The Wealth of Nations, with a synopsis. He rules out the possibility that the shortage
of specie in the American colonies is ‘the effect of the poverty of that country, or of
the inability of the people there to purchase those metals’, because the inhabitants of
the colonies were not without the means to buy gold and silver ‘if it was either
13
necessary or convenient for them to do so’ (Smith 1981: 940, passim). The true
reason, according to Smith, lies elsewhere. It is a calculated decision based on the fact
that: 1) paper money can perfectly replace gold and silver as a means of payment
within a country, at least in times of peace, as the example of Scotland confirms;38 2)
this replacement is advantageous for the Americans because it allows them to avoid
‘the expence of so costly an instrument of commerce as gold and silver’ and to
employ what they save ‘in purchasing, not dead stock, but active and productive
stock’, namely ‘the instruments of trade, the materials of clothing, several parts of
household furniture, and the ironwork necessary for building and extending their
settlements and plantations’ (Smith 1981: 940).
According to Smith, the abundance of paper money in the American colonies should
be viewed as positive because, like the banknotes in Scotland, it is due to ‘their great
demand for active and productive stock’, which ‘makes it convenient for them to have
as little dead stock as possible’( Smith (981: 943). As a result gold and silver are used
to pay for imports of goods destined for capital formation. Thus, Hume’s pricespecie-flow mechanism is again rejected, as it had been by Smith in the case of the
convertible paper money system.39
Smith’s considerations on the monetary experience of the English colonies of North
America can be summarised as follows.
A system of inconvertible paper money is the result of particular historical
circumstances such as those occurred in the English colonies of North America,
namely the absence of gold and silver mines and the rapid economic growth that had
to be matched by equally fast capital formation, and that made trade surpluses
impossible. Whereas Scotland, in similar conditions, benefited from a stock of
precious metals built up in earlier periods, the American colonies were forced to use
all their gold and silver for foreign trade.
This type of system can work if the government issuing the paper money
declares it will accept it in payment of taxes and takes care to constantly adjust the
stock in circulation according to public’s demand. The method Smith suggests to
achieve this result is to issue no more notes than are necessary to pay taxes. Careful
management, designed to ensure that part of demand is not met, might even allow the
paper money to appreciate against gold and silver. If the quantity of money depends
on a decision of the government, public’s attitude is bound to be affected by
expectations regarding the future trend of the budget. Distrust of the government’s
will or ability to maintain a balance between revenues and outlays over a period of
time will prompt economic agents to get rid of paper money for fear of incurring
losses. If these expectations spread, the fears will become reality and the currency
will devalue.
These observations show that Smith had in mind a particular version of quantity
theory, which closely resembles the one advanced by some scholars for the purpose
of salvaging that theory from several counter-examples signalled by monetary
history. According to Sargent, in order to explain inflation what matters is not ‘the
current government deficit but the present value of current and prospective future
14
government deficits’. Indeed, he adds, the government can be viewed ‘like a firm
whose prospective receipts’ are ‘its future tax collections’. In other words, ‘the
public’s perception of the fiscal regime’ influences ‘the value of government debt
through private agents’ expectations about the present value of the revenue streams
backing that debt’ (Sargent 1982 : 45-6, passim). Smith supposedly refers to that fact
when citing among the causes of Pennsylvania’s success the low level of its public
expense and the good reputation enjoyed by the government. He seems to think that
Pennsylvania’s citizens had formed positive expectations regarding government’s will
and ability to honour the commitments undertaken when issuing paper money.
These considerations prompted Wray to claim that ‘Smith’s views on money […] are
quite similar’ to his own. In fact, the chartalist theory he advances seems consistent
with Sargent’s approach. ‘Money’ – he states – ‘is a creature of the state’ and ‘fiscal
policy would be used to increase stability of the value of the currency’ (Wray
1998:18-19, passim). If government decisively pursues a balanced budget policy,
economic operators will form no inflationary expectations as the actual value of
future final balances will be close to zero.
Notes
1
The works which, to our knowledge, are devoted to Smith’s analysis of the unconvertible paper
currency system are only two: Rosier (1996) and Wray (1998: 19-23). However, only the last one,
tackles the theoretical problems raised by Smith. For a critique of Wray’s approach see Section 4.2.
2
As Roncaglia (2003: 48, fn. 62) points out, Smith made a dummy polemical target for the purpose of
criticizing mercantilist thought. In particular, he seems incapable of catching the principle of effective
demand which is the heart of the doctrine of the favourable balance of trade. As the recent literature
has explained (see, for instance, Perrotta 1991), the commercial policy suggested by this doctrine is
not aimed at accumulating precious metals but at increasing the output and employment of the
country. Actually, the mercantilist authors refer likewise to the balance of trade or to the balance of
labour. They start from the assumption that every country is characterized by an excess labour supply
and suggest as a cure the employment of labourers for the production of commodities bound for
foreign markets. The aim of overseas trade is to complement an insufficient domestic demand for
goods with foreign demand. Smith rejects this assumption. In his view, there is no problem of
effective demand, as the income of society is spent entirely on consumer goods or on means of
production: see, on this point, Smith (1981: 337-8).
3
See Smith (1981: 437-8).
4
Smith’s remark can be perfectly understood if, instead of an individual firm, we consider the entire
economy, as gold and silver even passing from an individual to another remain at the disposal of the
system: see, on this point, Diatkine and Rosier (1998: 249-50).
5
See Smith (1981: 292): ‘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. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to
maintain than the old one’.
6
See also, on this point, Hume (1955: 67-72).
7
This idea is already clearly stated in his Lectures on Jurisprudence (Report dated 1766): see Smith
(1982: 503-4).
8
If an intrinsically worthless substitute for a commodity were to circulate, the value-cost law would
be replaced by the value-scarcity law and it would be up to those issuing the substitute to apply the
15
new law so that the supply of money would constantly adjust to demand. This is how Smith shifts
from a commodity money theory to the quantity theory (see, on this point, Sections 3.2 and 4.1).
9
Therefore, Smith seems to give up in The Wealth of Nations the stance adopted in his Lectures on
Jurisprudence (Report of 1762-3), where he criticized Locke’s opinion according to which the value
of gold and silver ‘is […] founded on an agreement of men to put it upon them’ and observed, on the
contrary, that gold and silver ‘have what we may call a naturall value, and would bear a high {?one}
considered merely as a commodity, tho not used as the instrument of exchange’ (Smith 1982: 370).
However, it has to be reminded that Smith’s criticism rests on a misunderstanding since, in Locke’s
opinion, the ‘general consent’ which gives to gold and silver the role of money is based on the
‘intrinsick Value’ of those metals that is on their ‘Quantity’ (Locke 1991: 233, passim).
10
See, for example, the passage quoted below.
11
See Keynes (1973: 115-16).
12
Smith (1981: 422) observes that the transition from feudal to modern society was the work of
‘merchants’ and ‘artificers’, who, against the ‘most childish vanity […] of the great proprietors’, acted
‘merely from a view to their own interest, and in pursuit of their own pedlar principle of turning a
penny wherever a penny was to be got’.
13
By chance, this passage shows that, in Smith’s eyes, money is a mere medium of exchange and his
use as a store of wealth has no reason.
14
In Smith’s opinion coinage represents only a means of certifying the quality and weight of metal in
order to prevent misuse and fraud to the prejudice of creditors as this would discourage ‘all sorts of
industry and commerce’ (Smith 1981: 40).
15
Namely, the quantity needed for ‘circulating commodities’ (Smith 1981: 440).
16
Actually, five times higher, since ‘the whole circulation may […] be conducted with a fifth part only
of the gold and silver which would otherwise have been requisite’ (Smith 1981: 293).
17
See Smith (1981: 293-4). This idea can be traced in Smith’s Lectures on Jurisprudence (Report of
1762-3) where he observes that ‘the channel of circulation is always of itself sufficiently filled’ and
that, ‘if it is too full, it must sink by exportation to foreign countries and the melting pot’ (Smith 1982:
391, passim).
18
See Smith (1981: 295-7).
19
Namely, all those who share the quantity theory of money. This ‘anomaly’ was firstly noticed by
Viner (1937: 87) who refers to it as to ‘one of the mysteries of the history of economic thought’.
20
This idea is reaffirmed in his essay ‘Of the balance of trade’: see Hume (1955: 68, fn. 1). Petrella
(1968), who firstly drew attention to this point, provides further evidence of Hume’s ‘surrender’ to
mercantilist thought.
21
Namely, he continues, ‘the demand of those who are willing to pay the whole rent, labour and
profits which must be paid in order to prepare and bring it to the market’.
22
According to some scholars (see Girton and Roper 1978: 615-18, Laidler 1981: 188-92, Humphrey
1981 and Glasner 1989: 205-11), Smith’s explanation is very similar to the one provided by the
monetary approach to the balance of payments whereby in a small scale economy dealing with foreign
markets under a fixed exchange rate system (as happens with a gold standard) the prices of tradable
commodities are set at world level and must therefore be considered an exogenous variable.
23
He concludes his argument by stating that the increase in food prices in Scotland in 1751-52, which
Hume refers to, was probably due ‘to the badness of the seasons, and not to the multiplication of paper
money’ (Smith 1981: 325).
24
See Smith (1981: 329): ‘The late multiplication of banking companies in both parts of the united
kingdom [...] instead of diminishing, increases the security of the public. It obliges all of them to be
more circumspect in their conduct, and, by not extending their currency beyond its due proportion to
16
their cash, to guard themselves against those malicious runs, which the rivalship of
competitors is always ready to bring upon them’.
25
See, on this point, Humphrey (1982), Glasner (1992).
26
See, on this point, Marcuzzo-Rosselli (1991: 30).
so many
27
Commenting on the affairs of Ayr bank, whose avowed principle was ‘to advance, upon any
reasonable security, the whole capital which was to be employed in those improvements of which the
returns are the most slow and distant’ and which was obliged to close down its business after only two
years, Smith (1981: 313 and 316-17, passim) observes: ‘though this operation had proved, not only
practicable, but profitable to the bank as a mercantile company; yet the country could have derived no
benefit from it; but, on the contrary, must have suffered a very considerable loss by it’. This because
‘the success of this operation […] without increasing in the smallest degree the capital of the country,
would only have transferred a great part of it from prudent and profitable, to imprudent and
unprofitable undertakings’.
28
See Smith (1981: 299; 45: ls 10-18).
29
Here Smith resorts to a petitio principii in his attempt to bypass the problem of uncertainty which
entrepreneurs and bankers are both obliged to face.
30
See Smith (1981: 324; 95: ls 1-6).
31
As Thayer (1953) explains, the paper currency circulating in the North American colonies was of
two types. The first consisted in bills of credit that the governments issued for various maturities
against future fiscal revenues and declared they would accept for payments. The second, on the other
hand, consisted in notes issued by public land banks in connection with loans granted to private
parties on the security of a real estate (land, farms, town houses, etc.). Unlike bills of credit, which
were used to finance military or current spending, the notes issued by the land banks served the needs
of private entrepreneurs.
32
See Smith (1981: 327; 100: ls 9-13).
33
What Smith wishes to emphasize is that the paper money that replaced specie in Pennsylvania kept
the same value with respect to the pound sterling. In fact, whereas before the emission ‘a pound
colony currency […], even when that currency was gold and silver, was more than thirty per cent.
below the value of a pound sterling’, after the emission the paper currency into which it had been
turned ‘was seldom much more than thirty per cent. below that value’ (Smith (1981: 327, passim):
see, on this point, McCusker (1978: 184-6) who provides the average annual exchange rate of
Pennsylvania currency against English sterling during the years between 1723-74 in which the
colonial government issued paper money.
34
According to documents relating to Pennsylvania, of 500 loans granted in 1744 over 75 per cent
were to yeomen farmers, while most of the others went to mechanics. Farmers gave their farms as
collateral, whereas mechanics offered their homes and land in Philadelphia and other colonial towns.
Generally speaking, loans could not exceed 50 per cent of the value of the property given as collateral.
However, this rule was not always observed and land did not always represent a good collateral. A
major exception was Pennsylvania, where the amount of loans was well below the legal limit and
officials took great care not to overestimate the value of goods offered as collateral: see, on this point,
Thayer (1953: 152-5).
35
See, on this point, Smith (1981: 940): ‘The Americans […] have no gold or silver money; […] the
gold and silver which occasionally come among them being all sent to Great Britain in return for the
commodities which they receive from us’ . Indeed, contemporary documents attest to the great need of
businessmen for liquidity in a period of rapid economic growth of the colony. This requirement could
not be satisfied in the usual way, that is through a trade surplus (there being no mines) because, as
Brock (1975: 2-7) points out, Pennsylvania managed hardly to pay off its debt with Great Britain out
of the revenue from exports to the West Indies.
17
36
This point is also stressed by Galiani (1963: 267-8) who, referring to paper money circulating in the
English colonies of North America, attributes the reliability of the Pennsylvania government to
Quaker virtues. However, in his opinion, such virtues cannot be imitated by other Christian nations.
37
When assessing the impact of issues on the value of the paper money it should be kept in mind that
the North American colonies of the time also used other types of money. In addition to gold and
silver, beaver fur, tobacco and rum, warehouse certificates and bills of exchange and finally books of
credit also circulated, but only gold and silver coin or paper money could be used to settle debts.
38
See Smith (1981: 940): ‘the domestick business of every country […] may, at least in peaceable
times, be transacted by means of a paper currency, with nearly the same degree of conveniency as by
gold and silver money’.
39
See Smith (1981: 941): ‘The redundancy of paper money necessarily banishes gold and silver from
the domestick transactions of the colonies, for the same reason that it has banished those metals from
the greater part of the domestick transactions in Scotland’.
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19