Abstract
This chapter uses the classical money model introduced in Chapter 2 to explain the different views of Adam Smith and David Hume on banking and the price-specie-flow mechanism (PSFM). These differences reappeared in the debates between the Banking School and the Currency School over Peel’s Bank Charter Act, the Banking School echoing Smith and the Currency-School echoing Hume. Smith’s theory of banking was also echoed by J. B. Say in his explaining his law of the markets. Say’s Law (Identity) is in fact analytically equivalent to Fullarton’s law of reflux. Cairnes’s Humean quantity-theoretic interpretation of the effects of gold discoveries in California and Australia is shown to be inferior to an interpretation consistent with a Smithian classical interpretation.
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Notes
- 1.
Unless otherwise indicated, I use Say’s Law in the strong sense of Say’s Identity throughout the chapter.
- 2.
The asset into which convertibility is promised need not be a real commodity. An inconvertible fiat money issued by the government or a bank with monopolistic privileges like the Bank of England would also qualify.
- 3.
The Scottish banks, for example, had an option clause that allowed them to postpone converting notes into gold for six months after presented for redemption. Smith (1937, 309) condemned the option clause and favored legislation prohibiting its use. But K. Dowd (1988, 1989) reexamined the option clause and cast it in a more favorable light than did Smith.
- 4.
In this model, the nominal rate on loans corresponds to Wicksell’s “natural rate.” The competitive model assumes that banks charge the natural rate on loans. For a deviation between the natural rate and the market rate for loans to occur, some sort of market imperfection must be introduced. In Thornton, the sources of the imperfection were the 5% usury limit on interest, the monopoly power of the Bank of England, and the suspension of convertibility. See footnote 19.
- 5.
If there were some positive, but constant, marginal cost of maintaining the money balances held by the public, the supply curve would be perfectly elastic at k, where k is the annual cost of issuing one unit of money. If the marginal cost of producing money balances increases with the quantity of money balances, the supply curve rises. In other words, (i − rM) = k(M) where k(M) is the marginal annual cost of maintaining the money balances held by the public as a function of the quantity of money balances. Note, however, that even if the supply curve in panel (c) were upward-sloping, the supply curve in panel (b) would still be perfectly elastic with respect to 1/P.
- 6.
Classical theorists were of different minds about the “smallness” of Great Britain in the early nineteenth century. Ricardo, as we shall see in Sect. 3.5, did not believe Britain was small after the Napoleonic Wars. He blamed the Bank of England for causing gold to appreciate by rapidly accumulating gold in anticipation of the resumption of convertibility. However, Senior (1830), explicitly addressing the smallness issue, concluded that the whole British gold coinage was a small fraction of the world gold stock. By the middle of the century, the smallness assumption was likely valid for Britain. That Britain was not small in relation to the markets for manufactured goods in the early nineteenth century is true, but not relevant to the properties of the model discussed in the text. Those properties depend on the relation between the demand for and supply of money and the relative price of gold. As l argue in the text, markets for real goods in this model are insulated from changes in the demand for, or supply of, money.
- 7.
It is curious that in discussing the historical origins of the monetary approach to the balance of payments, neither Frenkel and Johnson (1976) nor Frenkel (1976) included Smith among the forerunners of the monetary approach who recognized the international determination of price levels under the gold standard, while including Hume despite recognizing that his analysis of international adjustment assumed that national price levels could deviate from the internationally determined value of gold. On this point, see Frenkel (1976, 41–42).
- 8.
Unfortunately, the contribution by Smith to banking theory usually singled out for attention (Mints 1945, 9, 25–27) is the real-bills doctrine (Smith 1937, 288–292). Since his discussion of the real-bills doctrine presumed convertibility, one should not assume that he, like some of its later advocates, believed that adherence to it would prevent depreciation of banknotes even without convertibility. Smith (1937, 309–313) explicitly recognized that inconvertible banknotes could be depreciated. For Smith, the real-bills doctrine was simply a rule of thumb for bankers to follow to maintain their liquidity and to permit their balance sheets to expand and contract in response to changes in the demand for money. See Smith (1937, 288–292), where he mentions the real-bills doctrine among other expedients for a bank to gauge how much money it could safely issue. This point is discussed at length in Chapter 4.
- 9.
Girton and Roper (1978, 615–618, especially fn. 53) suggested a similar solution to Viner’s mystery. They also show that Laughlin (1903) had developed a sophisticated version of the classical monetary position. Also see Humphrey (1981), Laidler (1981) and Bloomfield (1975 [1994]) for similar solutions to the mystery. Although recognizing that PSFM is not applicable in Smith’s model, these solutions to the mystery overlook the domestic mechanism that equilibrates the demand for, and supply of, money under a competitive banking system.
- 10.
Schumpeter (1954, 367) wrote:
In The Wealth of Nations, Adam Smith did not advance beyond Hume but rather stayed below him. In fact it is not far from the truth to say that Hume’s theory, including his overemphasis on price movements as the vehicle of adjustments, remained substantially unchallenged until the twenties of this century.
It is remarkable that Schumpeter could, in one breath, have dismissed Smith for not having reached Hume’s level in analyzing international monetary adjustment, and in the next one praised Hume’s analysis as remaining unchallenged until the 1920s when his overemphasis on price movements was corrected. It is remarkable, because it was on just this point that Smith rejected Hume’s analysis.
- 11.
Samuelson’s argument shows that, contrary to an objection voiced by an anonymous referee, a non-PSFM model of international adjustment such as the one presented here can provide a causal explanation of the adjustment process and does not simply assert accounting identities or long-run equilibrium conditions.
- 12.
An anonymous reader suggests that this passage shows that Thornton acknowledged that price-level differences were necessary to international adjustment and that an over-issue of a mixed currency would depreciate the whole currency. However, this effect only arises because of the costs of transporting gold. If there were no such costs, the adjustment process would operate without the minor price-level deviations possible within the gold points.
- 13.
I am indebted to two anonymous referees for noting that Wheatley had held the country banks responsible for the depreciation.
- 14.
This argument should not be confused with the Smithian one concerning the export of gold that follows the introduction of banknotes into an economy without any notes. That efflux is part of an equilibrating adjustment by the banking system to what may be viewed as a parameter change: a reduction in banks’ costs of creating notes. The new equilibrium entails a larger quantity of banknotes and a smaller quantity of coin. The efflux the Currency School had in mind is an equilibrating international adjustment to disequilibrating behavior by the banking system. According to the Currency School, the banking system was, except when undergoing a substantial loss of reserves, always inclined to create a domestic excess supply of money. In Smith’s case, no contraction by the banking system is required in response to the efflux. According to the Currency School, an efflux always requires the note issue to be reduced.
- 15.
Both of these are traceable to Smith (1937, 284–286, 313).
- 16.
An early statement of this position dating back to the Bullionist period was that of Lord King (1804 [1844]) quoted in Viner (1937, 239).
An excessive issue of notes by any particular banker is soon detected, if not by the public, at least by the interested vigilance of his rivals; an alarm is excited; and he is immediately called upon to exchange a very large portion of his notes in circulation for that currency in which they are payable.
- 17.
One could argue that if a single bank tried to increase its lending and were willing to tolerate diminished reserves, the rest of the banks would acquire excess reserves on which to base their own expansion. There are two points to note here. First, the bank in question would not in fact be expanding its asset portfolio by lending since, by assumption, there was no increased demand for its liabilities. It would simply be acquiring additional loans at the expense of reserves. Second, if the bank wishes to maintain the new composition of its portfolio, and if other banks in the system do not want to add to their reserves, then the total demand for reserves by the banking system has diminished and the excess supply of reserves must somehow be extinguished. In a small open economy with fixed exchange rates, this implies an export of the reserves by way of a temporary balance-of-payments deficit. In a closed economy or small economy with flexible exchange rates, either the domestic price level rises until the demand for reserves equals the supply, or the authority controlling the stock of reserves must retire the excess supply of reserves. In the case of a small open economy with fixed exchange rates, about which the Banking and Currency Schools were arguing, the adjustment exactly corresponds to the Banking-School version of adjustment since the export of specie is self-limiting, and is not evidence of an excess supply of money that requires a contraction of the banking system. I am indebted to an anonymous referee for bringing this issue to my attention.
- 18.
The nature of the imperfection the Currency School had in mind is not entirely clear. Joplin (1832) believed that it stemmed from the dual role of banks as suppliers of loanable funds and suppliers of currency. The latter function somehow kept them from adjusting their lending rates to match changes in the profitability of investment. Presumably this was because banks did not have to raise the funds they lent by offering interest but could simply create the currency they lent out. This, of course, ignores that banks must induce the public to hold their moneys, which they do by, among other things, paying competitive interest to holders of their moneys. So it is a misunderstanding to suppose that the power of producing money enables the producer to ignore changes in the market that dictate changes in the structure of interest rates.
- 19.
Nor did Fullarton accept the validity of Thornton’s argument that a bank, like the Bank of England, with monopolistic powers could keep the loan rate below the natural rate long enough to stimulate investment and raise prices. White (1984a) has shown that there was a Free Banking School that accepted the validity of Thornton’s analysis for the Bank of England while denying that it applied to the country banks. Like the Banking School, they opposed the Bank Charter Act of 1844, but also suggested abolishing the monopolistic privileges of the Bank of England and allowing free banking in England on the Scottish model. However, since by 1830, there was free banking in England in the creation of deposits, it is not obvious that the monopoly power of the Bank of England was very substantial.
- 20.
Other than my 1985 article (Chapter 2) in which I made the point explicitly, the only hint of a such a connection occurs in Fetter (1965, 232). Fetter did recognize that the real-bills doctrine implied that the banking system would provide as much money as the public demanded, without seeing that this is also what was meant by Say’s Law.
In the setting of the gold standard there were subliminal traces of the idea that if banks continued to loan on good assets the total means of payment would increase with the volume of business, and that hence, even though the gold supply did not increase as rapidly as production, there was no danger of price decline from an inadequate money supply.
- 21.
As an anonymous referee points out, Mill’s famous discussion (1844a [1967]) of Say’s Law interprets it in the weaker equality sense. However, Mill makes no reference to the operation of banks in that essay. That is legitimate if the excess demand is for outside money not inside money. In the classical model, an excess demand for outside money does impinge on the real sector, which is not surprising since the typical outside moneys—gold and silver—were also real commodities. But if the public does not lose confidence in banks, an excess demand for money is ordinarily an excess demand for inside money. And Mill does ascribe the excess demand for money to a “want of commercial confidence.” So it should not be assumed that Mill, a supporter of the Banking School, would have rejected Say’s Law as I have interpreted it.
- 22.
The passage in brackets is a footnote in the original text.
- 23.
Although Ricardo went on to write that he did not consider the objection to be as serious as those who raised it imagined, he did not reject the underlying rationale. Instead, Ricardo proposed a mechanism whereby the Bank could accommodate an increased demand for banknotes without causing them to depreciate further.
- 24.
Smith (1937, 313) wrote:
The late multiplication of banking companies in both parts of the United Kingdom, an event by which many people have been much alarmed, 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 their cash, to guard themselves against those malicious runs, which the rivalship of so many competitors is ready to bring upon them. This free competition too obliges all bankers to more liberal in their dealings with their customers, lest their rivals should carry them away. In general, if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so.
To be sure, in an earlier passage, Smith (1937, 308) advocated suppressing small-denomination banknotes and the option clause. The restrictions were calculated to protect presumably ill-informed holders of small notes from losses when banks failed and to avoid even the slightest impairment of convertibility. Smith did not want mismanaged banks to shift their losses onto the rest of the community which is why he regarded them as no greater violations of natural liberty than the “obligation of building party walls, in order to prevent the communication of fire.”
- 25.
Say (1880, 271): “The establishment of several banks, for the issue of convertible notes, is more beneficial than the investment of any single bank with the exclusive privilege; for the competition obliges each of them to court the public’s favour by a rivalship of accommodation and security.”
- 26.
An anonymous referee suggests that the rise in prices before gold coins reached Australia could be attributed to an expectation that the quantity of gold coins would soon increase. This is a different argument from Cairnes’s and does not account for the effects gold discoveries had on relative prices. But the relative-price effects alone do explain the behavior of the price level, so the quantity theory adds nothing to the explanation and may, therefore, be ignored.
- 27.
To avoid confusion, let me repeat that I do not deny that the gold discoveries raised prices. My difference with Cairnes is that, in my interpretation, the gold discoveries depressed the value of gold. Under a gold standard, that meant a more or less uniform increase in nominal prices. However, aside from the general price-level effect, there were also relative-price effects which Cairnes ascribed to PSFM, but which can also be derived from an international-barter-trade model with both tradables and non-tradables. The increase in money supplies, as distinct from gold stocks, emphasized by Cairnes was, rather, a passive response to the relative-price and income effects of the gold discoveries.
- 28.
Although they favored making convertibility a legal obligation of the banking system, they were not oblivious to the competitive pressures on banks to make their obligations convertible, even if not legally obligated to do so. But they felt so strongly about convertibility that they wanted to avoid even the slightest departures from instant convertibility on demand that might emerge in a fully competitive environment.
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Glasner, D. (2021). On Some Classical Monetary Controversies. In: Studies in the History of Monetary Theory. Palgrave Studies in the History of Economic Thought. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-83426-5_3
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