Equilibrium versus Balance of Trade Surplus
Because they feared a currency shortage, mercantilists promoted policies - taxes, industrialization, creation of commercial companies, establishment of banks, colonization and wars - intended to achieve a balance of trade surplus.
The entry of gold and silver coins was seen both as an accumulation of wealth and power and as the way to provide the economy with money to meet the needs of growing trade. The first break with this approach was made by John Locke, with Some Considerations on the Consequences of the Lowering of Interest and the Raising of the Value of Money (1691). In his view, because the levels of monetary prices in neighbouring countries are necessarily close to each other, the international stock of coined money will be distributed among countries in proportion to each country’s level of internal trade. This leads to an equilibrium approach to the international distribution of gold and silver money, which assumes one property of the quantity theory of money previously expounded by Bernardo Davanzati in his Lezione delle Monete: “all these earthly things are, by the consent of nations, worth all the gold (and in this I include silver and copper) that is wrought” (1588: 32) and then by Geminiano Montanari in his Della Moneta: “all the commodities in commerce between men, taken together, are worth as much as the gold, silver, and copper, coined and in circulation” (1683 [1804]: 45). However, Locke did not address the problem of the stability of the equilibrium he defined, nor did he expound the quantity theory of money per se.In the eighteenth century, the balance of trade surplus was understood as a stage in an equilibrium process. Any discrepancy in the proportions between quantities of money and commodities is removed: a relative redundancy (insufficiency) of money in a country results in an outflow (inflow) of money incurring a trade deficit (surplus).
Trade deficit or surplus lasts until the equilibrium defined by Locke is reached; trade deficit and surplus correspond to temporary situations that only exist until equilibrium is attained. Isaac Gervaise deserves to be credited with having first described such a process in The System or Theory of the Trade of the World (1720). This was at the time of the Mississippi Bubble in France and the South Sea Bubble in England.According to Gervaise, the proportion in a nation between the quantities of money - “the grand real measure or denominator of the real value of all things” (Gervaise [1720] 1954: 6) - on the one side, and the goods produced by labour on the other is at equilibrium when the expense of the rich is balanced by the labour of the poor. In this case, the nation has the appropriate “proportion of the grand denominator of the world” (ibid.: 7). If, however, the nation has “attracted a greater proportion [of the grand denominator] than its proper share, and the cause of that attraction ceases” (ibid.: 7) while production remains unchanged, then the increase of expense will result in a disequilibrium in the market for goods. Exports will decrease and imports increase in order to clear this market, thereby creating a balance of trade deficit. As payment of the balance reduces the quantity of money, it narrows the gap between consumption and production. Inasmuch as it restores the equilibrium, the outflow of money does not last long. If the nation has less than its just proportion of the grand denominator, the same mechanism will operate in the opposite direction. Then Gervaise explained that credit expansion has the same effect as the discovery of a “gold or silver mine” (ibid.: 9) in disturbing the equilibrium by increasing expense, thereby inducing an outflow of coins or bullion.
Gervaise’s description of the stability of the balance of trade equilibrium did not involve either the quantity theory or any price process. By contrast, David Hume’s theory did.
In the 1752 edition of his Moral, Political and Literary Essays, Hume expounded the price specie flow mechanism (hereafter PSFM): any increase in the quantity of coined money in one country leads to an increase in the monetary prices of goods, which induces a decrease in exports and an increase in imports, that is, a balance of trade deficit. The payment of the balance consists in an outflow of specie, that is, a decrease in the quantity of money, which leads to a decrease in prices. This mechanism lasts until the initial equilibrium is restored. In a reciprocal way, if the quantity of goods increases in one country, the monetary prices of goods fall, inducing an increase in exports and a decrease in imports, that is, a balance of trade surplus. The inflow of money resulting from the payment of the trade balance leads to an increase in prices; again the process operates until the initial equilibrium is restored.For example, consider France and England with respectively the franc FF and the sterling £ as monies of account. In France, 1 FF is the legal price of 0.290 grams of fine gold. In England, £1 is the legal price of 7.322 grams of fine gold. The ratio between the two legal prices of gold defines the par of exchange between the two monies of account:
In France, the “20 francs or” coin, known as the “napoleon”, containing 5.806 grams of fine gold, circulates with 20FF as legal tender. In England, the “guinea” coin, containing 7.688 grams of fine gold, circulates with £1.1s. as legal tender. The par of exchange between the two currencies is:
Suppose that the gold price of the quantity Q of goods circulating is the same in both countries, 7688 grams. The prices of Q expressed in the monies of account and currencies are as in Table 1.
Now, consider the discovery of a gold mine which increases the quantity of gold circulating in England by 50 per cent, so that the gold price of Q becomes 11 532 grams in this country whereas it remains unchanged in France at 7688 grams.
The prices are now as in Table 2.| Table 1 Money prices | in France and England | |
| Price of Q in | Money of account | Currency |
| France | 26 482.55 FF | 1324.13 napoleons |
| England | £1050 | 1000 guineas |
| Table 2 Money prices | after the discovery of a new gold mine | |
| Price of Q in | Money of account | Currency |
| France | 26 482.55 FF | 1324.13 napoleons |
| England | £1575 | 1500 guineas |
| Table 3 Situation after the adjustment | ||
| Price of Q in | Money of account | Currency |
| France | 33 103.19 FF | 1655.16 napoleons |
| England | £1312.5 | 1250 guineas |
Considering the par of exchange between the guinea and the napoleon (that is, 1.32 napoleon/guinea), the purchasing power of 1500 guineas in France is equal to the purchasing power of 1986.19 napoleons, that is, 1.5 Q instead of Q in England. The guineas are melted, exported from England to France, coined in France, and then spent in the purchase of goods, which are imported into England. This gives rise to a decrease in the gold price of Q in England and an increase in France. The process stops when gold has the same purchasing power in the two countries, therefore when the following equilibrium is reached.
With the PSFM, Hume provides a description of the stability of the balance of trade equilibrium, which states the quantity theory as a central issue. The double and simultaneous price and quantity adjustment process shows as groundless the fear that a country’s balance of trade deficit could last indefinitely and result in the outflow of all its precious metals. Equally, it refutes the idea that banks may be an unavoidable device to provide the country with money. First, thanks to the adjustment of prices, there cannot be a lack in the quantity of money: any quantity of money satisfies the needs of trade. Second, given the international price level, and thanks to the balance of trade adjustments, the quantity of money adjusts itself to enable the circulation of commodities at this price level. Hume’s PSFM raises the fear that the development of banks will cause a pernicious substitution of paper money for coined money - that is, “banish the precious metals” (Hume 1752 [1972]: 72) - and ultimately provoke bankruptcies and public discredit. In his Essai sur la nature du commerce en general (written in 1728-30 and published posthumously in 1755; English translation 1959, Essay on the Nature of Trade in General), Richard Cantillon had already expounded a similar idea.
In An Inquiry into the Nature and Causes of the Wealth of Nations (Smith 1776), published 24 years after Hume’s Essays, at a time when the Scottish banking experiment had showed its efficiency, Adam Smith did not share Hume’s quantity theory and hostility to bank money. Furthermore, although Smith did not really focus on the balance of trade, he nevertheless developed an “anti-mercantilist” view on this matter, distinct from Hume’s, which is worth noting. According to Smith, when banks issue their notes by discounting real bills rather than fictitious ones, they substitute these notes for gold and silver coins without either causing prices to rise or incurring a liquidity risk. Moreover, they allow to economize a costly means of circulation, that is, to save unproductive circulating capital and to increase investment in real capital. This occurs through the export of precious metals that is synonymous with an increase in the wealth of the nation.
Thus, these eighteenth-century authors converged in criticizing the mercantilist view of the balance of trade surplus; however, they conceived not one but two approaches to the balance of trade. Gervaise and Smith did not describe gold outflow with a price mechanism, whereas Cantillon and Hume did. Gervaise, Cantillon and Hume thought that the development of bank credit would result in bank illiquidity, whereas Smith rejected this view.