Money and the Balance of Payments

A commercial society is a money-using society. Indeed, any trade or exchange beyond the simplest requires money, so any analysis of a commercial society had to deal with money. What is more, monetary questions had a prominent place in the policy debates of the time, and the “mercantilist” pamphlet literature of the late seventeenth and eight­eenth centuries was frequently focused on money and the balance of payments.

Hume’s magisterial analysis of metallic money in an open economy largely settled the matter, and became the starting point for work in the mainstream of monetary theory for more than a century. It is perhaps his main contribution to the development of economic analysis.

The basic argument was simple. In a closed economy, the quantity of money is of no importance since prices adjust proportionately. (Locke had already argued this point.) In an open economy, a change in the money supply causes a corresponding price change, which in turn affects competitiveness:

Suppose four-fifths of all the money in Great Britain to be annihilated in one night... Must not the price of all labour and commodities sink in proportion?... What nation could then dispute with us in any foreign market?... In how little time, therefore, must this bring back the money which we had lost, and raise us to the level of all the neighbouring nations? Where, after we have arrived, we immediately lose the advantage of the cheapness of labour and commodities; and the farther flowing in of money is stopped. (Hume 1752 [1987]: 311)

Similarly, any excess of money flows out. The conclusion is simple. There is no need to worry about the balance of trade or about a scarcity of money. The system is self-adjusting. The essential elements of the theory - the link between prices and the quantity of money in circulation (now called the quantity theory of money) and the automatic adjustment of the quantity of money to imbalances in the balance of pay­ments (now called the specie-flow mechanism) - were not wholly original, but they had never been stated so clearly, nor had their full consequences been worked out and presented in the way that Hume did.

He was the master of the killer example. Thus, a Mr Gee had presented detailed calculations to show that the British trade balance was “against them for so consider­able a sum as must leave them without a single shilling in five or six years” (Hume 1752 [1987]: 310). Fortunately, that prediction had been made 25 years before, and money still seemed to be plentiful, as Hume’s theory predicted. The data relating to trade was notoriously inaccurate, so attempts such as Gee’s to measure the balance of trade were a waste of time and effort. Hume’s arguments showed that there was no need to rely on such unreliable calculations.

Europe was a single system with a system-wide general price level. India and China were only loosely connected to the European price level because transport costs between Europe and South or East Asia were high and trade was restricted by monopolistic companies. Within the European system, money was more or less abundant in different areas according to demand. Austria, for example, had a small money stock because it was relatively underdeveloped (not the other way around). Within a country, the capital and the major ports will have a larger share of the money stock because more business is done there.

Hume’s treatment of paper currency is an interesting application of his theory. Money, at that date, was primarily precious metal. (The British currency was legally based on silver, but was close to a de facto gold standard.) Banknotes, the relevant form of paper money, were convertible into metal. The creation of additional banknotes would initially increase the money stock, but that would lead to increased prices and an outflow of metallic money, the only kind of money acceptable internationally. Hence, the introduc­tion of paper money would not in the end increase the money stock within the country concerned (except to the extent that it increased the Europe-wide money stock) but would simply displace metallic money within a total determined by real factors.

Hume conceded that there would be some stimulus to economic activity during the process of monetary expansion, because prices and wages are slow to adjust. Extra spending is initially perceived as an increase in real demand. Output and employment rise, but when the price increases have fully worked their way through the system, every­thing returns to normal. Similarly, monetary contraction causes a temporary depression:

[I]t is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. (Hume 1752 [1987]: 288)

This concession has attracted much attention. Hume hardly elaborated on it, leaving it unclear whether he should be counted as an inflationist, encouraging the magistrate to inflate the currency without end. Against this reading of Hume, note that it is not possi­ble to inflate a metallic currency to any significant extent in an open country (or, without unlimited supplies of precious metals, in a closed economy), while adding paper money, as we have seen, simply drives out metal money. Hume’s advice to the magistrate (in modern terms, the government) seems impossible. Mainstream economists have gener­ally averted their eyes from this paragraph in Hume’s essay, though some Keynesians have rather optimistically claimed that it puts Hume on their side.

A second problematic aspect of Hume’s economics is his treatment of what has come to be called the rich country/poor country debate. Does trade between rich and poor countries tend to widen or narrow the gap between them? Hume’s most frequently quoted comment on the question is to be found in the essay On Money of 1752, but the essay On the Jealousy of Trade, added to the collection when it was reissued a few years later, must also be taken into account.

The essay On the Jealousy of Trade was added to counteract the temptation for trading nations to “look on the progress of their neighbours with a suspicious eye and to consider all trading states as their rivals” (Hume 1752 [1987]: 328). Hume’s main line of argument against this zero-sum view is to reassert the arguments in favour of a commercial society, and particularly the argument that imports provide us with opportunities and incentives to learn and copy, while our exports have the same effect in other places. We all benefit from wider trade. The implication in the rich country/poor country context is surely that there is no reason why both should not gain. Hume probably regretted the argument presented in the earlier essay since it portrayed the relation between trading states, rich or poor, as one of rivalry rather than complementarity.

Hume’s essay on interest complements his treatment of money. His main purpose was to refute the common belief that interest rates are determined by the abundance or scarcity of money. This, he argued, was false because prices vary in line with the quantity of money, so (in modern terms) the real quantity of money is not affected by changes in the nominal quantity. Suppose gold were as common as silver, would interest rates be lower? No, he argued, “our shillings should then be yellow” (Hume 1752 [1987]: 296) instead of silver.

What then determines the interest rate? Essentially, the demand and supply for bor­rowing or, in Hume’s terms (1752 [1987]: 298), the demand for borrowing, the riches to supply that demand, and the profits of commerce. (The last of these perhaps could be included in the first.) Note, too, it is the profits of commerce, not the profits made in pro­duction, which Hume cites. The key role of capital in production, and hence the role of accumulation in growth, did not come fully into the story until Smith, a few years later. As determinants of demand and supply for borrowing, Hume emphasized the makeup of the population and the behaviour of different kinds of people. Landlords are more often prodigals than misers, so a society of landlords and peasants will have high interest rates. Commerce, on the other hand, promotes frugality, tending to lower rates, and so on.

Steuart rejected Hume’s quantity theory of money, and hence the automatic adjust­ment of the balance of payments. His argument was that the prices of commodities depend on competition and on the demand for each good separately:

Let the specie of a country, therefore, be augmented or diminished, in ever so great a proportion, commodities will still rise and fall according to the principles of demand and competition... Let the quantity of the coin be ever so much increased, it is the desire of spending it alone, which will raise prices. (1767 [1966]: 345)

In general terms, Steuart had little faith in unregulated markets and saw potential dif­ficulties everywhere. Political economy should provide guidance to what he called a “statesman”, an idealized, altruistic, ruler. The balance of payments is an example. It would not adjust itself, but needed the attention of the statesman - a very mercantilist point of view.

Steuart had a very ambivalent attitude to luxury and to international trade. A taste for (modest) luxuries is needed to stimulate development, examples from outside are needed to arouse demand in the first place, and demand from foreign markets increases employ­ment. However, success in trade leads to wealth, which induces a demand for foreign lux­uries, laziness, and high prices. The balance of trade will turn against a rich country in the end. “No trading state has ever been of long duration, after arriving at a certain height of prosperity” (Steuart 1767 [1966]: 195). At this stage, the statesman must turn away from foreign trade and guide the country towards “inland commerce”, that is, production for the home market, but only in order to preserve industry until it can be directed to some new foreign market “under the direction of an able statesman” (ibid.: 229).