The quantity theory versus banknotes
The quantity theory with its corollary, the neutrality of money, was first expressed by William Potter in The Key of Wealth (1650): “an increase of money would occasion an increase in the price of commodities to such increase of money...
consequently... would not occasion any increase in the sale of commodity: therefore not any increase of trade” (1650, in Hegeland 1951 [1969]: 31). However, Potter does not share this approach and believes that the quantity of money impacts on economic activity, by granting credit. His formulation of the quantity theory was rhetorical. Affirmation of the quantity theory, coupled with adherence to it, only appeared during the following century. It was present in the writings of authors who wished to demonstrate the uselessness and dangerousness of banks: first Richard Cantillon, in the manuscript (1728-30) of his Essay on the Nature of Trade in General (1755), written after the South Sea and Mississippi bubbles (1719-20); second, David Hume, in the 1752 edition of Moral, Political and Literary Essays, at the time when the Scottish country banks began issuing banknotes.Cantillon integrates the quantity theory into a representation of economic activity that predates Quesnay’s Tableau Economique (1766 [1958]). Given the real proportions between production and real incomes, the level of nominal variables - prices of goods and nominal incomes - is determined by the quantity and velocity of specie: “the actual quantity in weight and fineness of the coins, taking into account the rapidity of circulation, is the base and regulator of values” (Cantillon 1755 [1959]: 299). Next, Cantillon introduced banks and the credit multiplier: the deposit of specie provides the bank with the cash that allows banknotes to be issued; loaning the specie leads to new deposits, then to new issues. According to Cantillon, the bank can issue a quantity of notes equal to ten times the level of its cash reserve, thus taking a liquidity risk.
He then pondered the sustainability of banking activities. His answer was that private banking is desirable in small states and when it is limited to wealth management. On the contrary, it should be avoided in the case of a general bank in a great state which fuels speculation “with the complicity of a Minister” (ibid.: 323).In fact, Cantillon was questioning the usefulness of paper money: issuing “fictitious” and “imaginary” money leads to an increase in the velocity of circulation of “real” money, or “ready cash” (“argent au comptant” in the French edition), which causes prices to increase, thereby bringing about a balance of trade deficit, then an exit of specie that endangers bank liquidity. The same conclusion was obtained by Hume, who formulated the Price Specie Flow Mechanism (hereafter referred to as PSFM), a mechanism already present in Malyne’s book, The Maintenance of Free Trade (1622). The PFSM is an arbitrage based on the hypothesis that specie have the same value in neighbouring countries. This arbitrage brings about their international equilibrium distribution among countries. If economic activity grows in one country while it is stagnant in the others, the value of specie increases in this country - that is, the monetary price level decreases. This stimulates exports and discourages imports, resulting in a favourable balance of trade and an inflow of specie. The process operates smoothly until the value of specie reaches its international level. Inasmuch as the value and quantity of specie adjust themselves according to the needs of trade, issuing banknotes is useless. Symmetrically, if paper money were to expand in one country, prices would rise, resulting in a balance of trade deficit and an outflow of specie, thus endangering banks.
The quantity theory of Cantillon and Hume does not postulate the neutrality of money as Potter does. An increase in the quantity of money induces a change in the relative prices of goods. Depending on the channel through which additional money enters the economy, the money prices of some goods increase more or less, and some do not change. This is called the Cantillon effect. In any case, Cantillon and Hume’s analysis is enough to conclude that variations in prices lead to adjustments of the quantity of specie according to the needs of trade, and that banks are both useless and dangerous. Cantillon and Hume are the originators of one of the two main trends in classic monetary and banking theory.