Balance of trade approach and exchange rate
Ricardo (1810) criticized Thornton and rehabilitated the balance of trade approach. According to him, the flows of precious metals, and the high price of bullion in the context of inconvertibility, are not the effects of exchange rate fluctuations but the cause.
He rejected the causality between gold flows and exchange rate specific to the GPM and improved the PSFM. Relying on the quantity theory, he explained that the value of gold fluctuates with its quantity and that gold is exported and imported according to this value. The discovery of a gold mine, like the establishment of a bank issuing notes convertible into gold, lowers the value of gold and silver, in the form of either coins or bullion, whereas they remain unchanged abroad, thus making them “articles of exportation” (Ricardo 1810 [1951-62]: 54). This export causes the balance of trade deficit, and the symmetrical balance of trade surplus in the foreign country: “In return for the gold exported, commodities would be imported” (ibid.: 54). According to Ricardo, only an excessive quantity of money can cause a deficit: “the temptation to export money in exchange for goods, or what is termed an unfavourable balance of trade, never arises but from a redundant currency” (ibid.: 59). By diminishing the quantity of money, the export of gold and silver remedies this cause, then gives rise to a balance of trade equilibrium. On the other hand, when the bank notes are inconvertible, or are convertible into degraded coins, the adjustment of the quantity of money is impeded. Without describing any market process, Ricardo concludes that, in this case, the temptation to export money results in the high price of bullion. Then this high price, through arbitrage, causes the exchange rate to fall: “the fall in the exchange, or the unfavourable balance of trade, is stated [according to Thornton] to be the cause of the excess of the market price above the mint price of gold, but to me it appears to be the effect of such excess” (Ricardo, ibid.: 64, n. 1, original emphases).Therefore, when arguing in favour of the bullionist thesis, Ricardo did not simply take up Hume’s PFSM. He stressed further that the export of gold defines a balance of trade deficit: “an exportation of bullion, in exchange for commodities... is called (I think very incorrectly) an unfavourable balance of trade” (Ricardo 1810 [1951-62]: 64). It is not the means to pay the deficit, it causes the deficit: “The exportation of the coin is caused by its cheapness, and is not the effect, but the cause of an unfavourable balance” (ibid.: 61). In fact, the export of gold does not occur through the need to pay a deficit, it results from the choice to export redundant currency: “We should not import more goods than we export, unless we had a redundancy of currency, which it therefore suits us to make a part of our export” (ibid.: 61). The idea that the balance of payments deficit results exclusively from a choice concerning money - that is, the choice to export money - would be dominant among the following classical and the first neoclassical economists in Europe until the First World War, and would be taken up and reshaped by the monetarists at the end of the twentieth century.
In the nineteenth century, Ricardo’s approach reached its peak with the 1844 reform of the Bank of England. According to the Ricardian approach, in order to preserve the liquidity of the Bank, it was crucial to enable the corrective effect of gold exports that are caused by the excess of currency and which diminish the Bank’s reserves. The Bank must stop issuing notes by granting credit at the moment when gold exporters demand the reimbursement of notes in gold. These new credits would maintain the excess of currency, causing the continuous export of gold. By prohibiting the Bank of England from issuing notes through credit, Parliament showed its adherence to the Ricardian quantity theory and balance of trade approach.