We have seen that David Hume's famous elucidation of the price-specie-flow mechanism in international monetary relations, though attractively written, was itself a deterioration from the pioneering and highly sophisticated analysis of Richard Cantillon. It was, however, better than nothing. Yet, as Jacob Viner put it, ‘One of the mysteries of the history of economic thought’ is that Adam Smith, though a close friend of Hume for many years, included none of the Humean analysis in his Wealth of Nations. Instead, Smith propounded the primitive and erroneous view that every country will have as much specie as it allegedly needs to circulate trade, the surplus overflowing ‘channels of circulation... to seek that profitable employment which it cannot find at home’. Gone is any reference whatever to the causal nexus between the quantity of money, price levels, and balances of trade. The mystery deepens when we realize that The Wealth of Nations is a grave deterioration even from Smith's own Lectures of over a dozen years earlier. For in those Lectures, unpublished in Smith's own day, we find a clear presentation and summary of the Humean analysis.
Thus, in his Lectures Smith had written that Hume proves
that when ever money is accumulated beyond the proportion of commodities in any country, the price of goods will necessarily rise; that this country will be undersold in the foreign market, and consequently the money must depart into other nations; but on the contrary whenever the quantity of money falls below the proportion of goods, the price of goods diminishes, the country undersells others in foreign markets, and consequently money returns in great plenty. Thus money and goods will keep near about a certain level in every country.
Even Smith's modern admirers despair of his confused and scattered, as well as hopelessly inadequate, theory of money and theory of international monetary relations.25 Professor Petrella tries to explain Smith's later rejection of Hume's specie-flow-price mechanism as a reaction to Hume's giving hostage to the alleged employment benefits of mercantilistic increases in the quantity of money, benefits which Smith was anxious to deny. Petrella cites in support a sentence critical of Hume following the passage from the Lectures just quoted: ‘Mr Hume's reasoning is exceedingly ingenious. He seems, however, to have gone a little into the notion that public opulence consists in money...’. But here Petrella attempts to prove too much, for why couldn't Smith simply continue to adopt the specie-flow-price mechanism and then repeat or elaborate on his criticisms of Hume's position, demonstrating the latter's inconsistency?
It seems clear, in contrast, that the mystery of Smith's abandonment of the price-specie-flow mechanism can be solved if we realize that this particular deterioration in his economic analysis was not unique. Indeed, we have noted a similar fatal deterioration in his value theory from the time of the Lectures to the Wealth of Nations. It seems plausible that the cause of the decay, in each case, was the same: Smith's shift of concentration from the real world of market prices to the exclusive vision of long-run ‘natural’ equilibrium. The shift from the real world of market process to focusing on equilibrium states made Smith impatient with the process analysis that was the hallmark and the merit of the specie-flow approach. Instead, Smith treats only a world of pure specie money, and assumes that all countries are always in equilibrium. Moreover, any departures from worldwide monetary equilibrium are eradicated swiftly, leaving the world in a virtually perpetual equilibrium state.
Smith's focus on the long run, in fact, led him to apply his general labour cost-of-production theory of value to the value of money. The value of money, i.e. the value of the metal commodity gold or silver, then becomes the embodiment of the labour cost of producing it. In that way, Smith attempted to integrate the values of money and other goods by assimilating all of them into a labour-cost theory. Thus, Smith wrote, in The Wealth of Nations:
Gold and silver, however, like every other commodity, vary in their value, are sometimes cheaper and sometimes dearer... The quantity of labour which any particular quantity of them can purchase or command, or the quantity of other goods which it will exchange for, depends always upon the fertility or barrenness of the mines... The discovery of the abundant mines of America reduced, in the sixteenth century, the value of gold and silver in Europe to about a third of what it had been before. As it cost less labour to bring those metals from the mine to the market, so when they were brought thither they could purchase or command less labour...
Even those few economists who laud Adam Smith as really adopting the Humean price-specie-flow mechanism concede that he dropped this approach when considering a mixed monetary system including bank notes or paper money. Indeed, even though Smith occasionally adhered to the quantity theory of specie money in its effects on prices, he here throws it over altogether and asserts that convertible bank notes are always equal in value to gold and hence their quantity will always remain the same. Any increase of bank notes beyond the total of specie will ‘overflow’ the ‘channel of circulation’ and therefore return to the banks in what was later called a ‘reflux’, in exchange for specie which immediately flows out of the country. Smith therefore explicitly denies that an increase in bank notes can raise the prices of commodities. But why did Smith abandon the quantity theory completely here, in exchange for such nonsense? Plausibly, because of Smith's need to integrate all value theory on the basis of the labour cost of production. If he ever conceded that an increase in the quantity of paper money could affect values, even temporarily, then Smith would have had to admit an enormous hole in his labour-cost theory. For the ‘labour cost’ involved in printing paper money obviously bears no relation whatever to the exchange value of that money. Therefore, paper money, including bank paper, had to be assimilated tightly to the value of specie.
Adam Smith wrote in an eighteenth century Britain where virtually all his predecessors had denounced the new institution of fractional-reserve banking as inflationary and illegitimate. His friend David Hume (1752) had called for the radical repudiation of this institution on behalf of 100 per cent specie-reserve banking. Other important writers had taken the same position, including Jacob Vanderlint (d. 1740) in his Money Answers All Things (1734), and Joseph Harris (1702–64), master of the Royal Mint, in his An Essay Upon Money and Coins (1757–58). Harris had stated that banks were ‘convenient’ so long as they ‘issued no bills without an equivalent in real treasure’, but that their increases of credit beyond that limit are inflationary and will eventually endanger the banks’ own credit.
If Smith had continued in his predecessors’ footsteps, his commanding authority and prestige might have been able to bring about a fundamental reform of the fractional-reserve banking system. But, unfortunately, Smith, in his need to meld all monetary theory into a long-run labour cost of production approach, abandoned the quantity theory and the specie-flow-price mechanism in his discussion of paper money. He thus set economic theory once again on an erroneous and fateful road by embracing the institution of fractional-reserve credit. No longer holding such credit to be inflationary, Smith went on to adumbrate one of the major defences of paper money, still held to this day: that gold and silver are mere ‘dead stock’, accomplishing nothing. The banks, by substituting their paper notes for specie, ‘enable the country to convert a great deal of this dead stock into active and productive stock...’.
Indeed, so far did Adam Smith rhapsodize about paper money that he likened its accomplishments to providing a sort of highway through the air:
The gold and silver money which circulates in any country may very properly be compared to a highway, which, while it circulates and carries to market all the grass and corn of the country, produces itself not a single pile of either. The judicious operations of banking, by providing... a sort of waggon-way through the air, enable the country to convert, as it were, a great part of its highways into good pastures and cornfields, and thereby to increase considerably the annual produce of its land and labour.
Adam Smith failed to realize that the stock of gold and silver was far from ‘dead’; on the contrary, it performed the vital function of being a money commodity, among other functions providing to every member of society an insurance against paper money inflation, whether launched by government or banks. The stock of gold, in short, performs a ‘store of value’ service which Smith totally overlooks. Smith's critique of specie as ‘dead stock’ also stems from his belief that money is not a commodity serving as a medium of exchange, but a claim, a sign, a ‘voucher to purchase’. The French economist Charles Rist is justly highly critical of the dead stock approach and its influence on later generations:
this idea was seized upon with extraordinary alacrity and found high favour... it dominated the thought of English writers in the nineteenth century. The belief that the use of metallic money is a retrograde and costly system, to be discouraged by all possible means, is firmly fixed in British thought on currency and banking. The use of the cheque and the bank-note was for a long time regarded only from this point of view. These two instruments were considered merely as means of economizing money; the idea was taken as the guide to the country's currency policy, and the most disastrous conclusions were drawn from it.