David Hume The Major Economic Themes

The Major Economic Themes, David Hume Theory

David Hume Argument

The remarks on Hume's methodology have made it possible to introduce aspects of Hume's treatment of some of the broad issues in economics, as they are treated in Political Discourses. Hume's reputation as an economist today rests less on these broad issues, in which he is perhaps overshadowed, unjustifiably I believe, by Adam Smith, and more on his handling of such subjects as the role of money and interest in the economy, international trade policy and the financing of government by taxes and by public debt. At least these are the subjects which warrant him a place in those economic texts which are more than simply teaching manuals designed to minimize the agony of having to pass examinations.

Consider the kind of discussion of the significance of money found in the financial press today. There is a clear agreement that money as a medium of exchange is essential for both national and international trade, for otherwise specialization of production and gains from exchanging products become impossible or intolerably inefficient. Hume makes much of this point towards the end of his essay 'Of Money' but clearly identifies money as an acceptable medium with gold and silver coin (specie) and he is suspicious of paper credit unless clearly convertible into specie. There is also clear agreement that there is some connection between a change in the quantity of money and the change in the level of prices, but disagreement about the transmission mechanism, the precise quantitative relationship between changes in money and changes in prices and the time it takes for the change in money supply to produce a change in prices. These disagreements worry governments who want to use the money supply as an instrument to promote policy objectives such as the control of inflation. Hume is usually given a 'good press' in economic texts for his discussion of such matters. He examines the facts and finds that over long periods of time the supply of specie has risen at a slower rate than the rise in prices. There is therefore a positive relationship established between money and prices, but it is not a proportional one. Why is this so? Because, Hume explains, it takes time for any price adjustment to take place and, in the course of that time period, the increase in demand produced by an increase in money supply may be counterbalanced by alterations in the goods available to be bought. Indeed, the expectation that demand will increase encourages more production, though eventually prices must begin to rise as labour and materials become scarcer.

Hume's policy conclusion is interesting:

It is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or lesser quantity. The good policy of the magistrate consists 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.
This maxim has an obvious affinity with the common Central Bank maxim that increasing the supply of money is mainly justified by the need to accommodate a growth in potential Gross Domestic Product. However, it should be noted that Hume is describing what is desirable and is not certain that what is desirable is also possible. In his essay 'On Public Credit' he makes it abundantly clear that governments should not rely on the expansion of paper credit as the means for controlling the supply of money. Increasing the government deficit by the issue of public stocks will bring about a lack of confidence in the currency and cause inflation rather than engender an expansion in output. Government can only influence the money supply, that is gold and silver coin, by creating the conditions which enable its citizens to expand and develop its trade with those in possession of specie or who produce gold and silver: 'a government has great reason to preserve with care its people and its manufactures. Its money, it may safely trust to the course of human affairs' (see the essay 'Of the Balance of Trade').

Hume's discussion of money is the point of departure for two further excursions into important economic problems. The first of these is his theory of interest. It was commonly asserted by his contemporaries that one of the advantages of increasing the money supply was that it lowered interest rates. Typically, Hume begins by asking the question: how do we test this proposition? Presumably if the assertion were true, countries with relatively large money supplies would have relatively low interest rates. This is not found to be the case. Then he argues that the assertion is implausible in any case. Doubling the money supply, for example, only means that if you lend me so much labour and so many commodities, I have to repay you the equivalent money value in labour and commodities plus some interest which is a proportion of the equivalent money value. There is no reason to suppose that that proportion of equivalent value would alter simply because the value of labour or commodities had doubled in money terms. Further proof is offered by Hume in the form of historical evidence to back up his 'cross-section' study of countries:

an effect always holds proportion with its cause. Prices have risen near four times since the discovery of the Indies: and it is probable gold and silver have multiplied much more: But interest has not fallen much above half. The rate of interest, therefore, is not derived from the quantity of precious metals. ('Of Interest')

Hume therefore uses his knowledge of history to refute a common hypothesis of the time, but turns back to the Treatise as the basis of his own explanation of the determination of interest rates. We have to look at the motives for supplying funds and for borrowing them. Concentrating on the fall in interest rates as countries develop, he explains this phenomenon in the following way. Countries develop because of the human desire for 'exercise and employment', as already stated. This is associated with a greater desire to provide for the future by saving. At the same time the 'opportunity cost' of saving diminishes because the growth of commerce produces growing competition amongst merchants which lowers the rate of profit. Accordingly, merchants accept more willingly a lower rate of return on lending. Thus 'an encrease in commerce by a necessary consequence, raises a great number of lenders, and by that means produces lowness of interest'. Space hardly allows extensive discussion of this interesting analysis, but it must be noted that Hume is considering only long-term, gradual changes in the economy. Consider his example of the 'miracle' where every citizen in Great Britain wakes up to find £5 in his pocket. According to Hume, all that would happen is that prices would double and the rate of borrowing and lending would not change. However, Hume has already argued that price adjustments take time, and, if this is so, the extra money could be saved rather than spent unless every person anticipates an immediate rise in the prices of all goods. The extra saving would lower interest rates, though in the longer run, these could rise again as individuals have to pay more for goods. Furthermore, Hume seems to envisage a society where borrowing is used solely in order to finance present consumption and not for the purchase of capital equipment. The level of interest rates simply reflects the degree of advancement of the economy. It does not influence its advancement. There is a good deal of controversy on this point, even today. If the money supply can be used to reduce interest rates, even temporarily, and this were to stimulate the demand for increasing and improving the capital stock, then a change in the interest rate in the short run might affect economic growth in the long run - so the argument goes.

It is a short step from this proposition to the policy recommendation that a government should use monetary policy in order to prevent interest rates from rising, even temporarily, so that capital investment is not discouraged. We can only speculate on how Hume would have replied to this argument. One supposes that even if he were to admit that governments could control the monetary supply, keeping down interest rates by monetary policy would suggest to Hume that the expected rise in prices would raise the costs of investment goods which would counteract any attractions to invest because interest rates had fallen. The debate continues until this day!

The second excursion derived from Hume's view of money is to be found in his analysis of international trade. Hume examines the famous mercantilist view that a country is rich or poor according to whether its stock of specie or precious metals is large or small. This view led naturally to the proposition that a country should aim at amassing gold and silver by maintaining a positive balance of trade with its neighbours, for example by discrimination against foreign imports which would have to be paid for in specie. Hume argues that this policy is both undesirable and impossible to operate in the long run. Suppose, says Hume, a situation where specie flows into Britain as a result of some measure which increases the balance of payments surplus. The increase in money raises prices so that neighbouring countries cannot afford to buy from us whereas their commodities become relatively cheaper. Money flows out. The outflow of money acts as a correcting mechanism for it results eventually in a fall in domestic wages and prices which restores domestic competitiveness. A kind of natural economic law is at work which preserves the money supply in trading countries in proportion to the 'art and industry of every nation' (see 'Of the Balance of Trade'). Of course, a country might attempt to cut itself off completely from other countries and run a siege economy but, Hume argues, this would reduce its standard of living. He illustrates this very graphically by the consequences of the barriers to trade between France and Britain: 'We lost the French market for our woollen manufactures, and transferred the commerce of wine to Spain and Portugal, where we buy worse liquor at a higher price.' Hume was to develop this argument much further in essays written after the Political Discourses. His international trade analysis is much admired today by international economists. They argue that if international gains from trade are to be fully realized, then countries who try to manipulate their money supply so that it fails to conform with their command over internationally accepted currency will find themselves facing major adjustment problems as their prices of internationally traded goods fall out of line with those of trading partners. Free trade in inter­nationally traded goods, some of them argue, requires a return to the Humeian 'rules' of expansion and contraction of the increase in domestic money supply according to movements in each country's balance of payments. A continuing surplus in a major country matched by deficits in others would require the surplus country to increase the percentage growth in its money supply, whereas the deficit countries would have to contract their percentages. The reasons why governments act otherwise are not mentioned by Hume, but his own analysis of human nature can easily be used to explore them. The process of adjustment to the 'natural' level of money in any country takes time and is painful to those who have to take cuts in their relative wages and prices in order to regain their international markets. Hume prefers to end on a note of idealism which anticipates that of the founders of the European Economic Community. In a later essay written in 1758 entitled 'Of the Jealousy of Trade', he closes with a statement on the consequences of autarkic trade policies:

were our narrow and malignant politics to meet with success, we should reduce all our neighbouring nations to the same state of sloth and ignorance that prevails in Morocco and the coast of Barbary. What would be the consequence? They could send us no commodities: They could take none from us: Our domestic commerce itself would languish for want of emulation, example and instruction: And we ourselves should fall into the same abject condition, to which we have reduced them. I shall therefore venture to acknowledge, that, not only as a man, but as a British subject, I pray for the flourishing commerce of Germany, Spain, Italy, and even France itself!

The present-day interest in Hume as an economist now extends to the analysis of the government as an economic entity. Although Hume includes in his Political Discourses his fascinating essay on 'Idea of a Perfect Commonwealth', the content of this essay concerns the process through which government power should be exercised. To understand Hume's recommendations, it is necessary to go back to his previous essays on the origin of government and the principles which he believes should control its operations. A full discussion of Hume's theory of government would fill volumes. It can only be said here that he traces the origin of government from the need to devise an instrument for resolving conflicts about the use of resources where this cannot be achieved by negotiation in the market. He offers as an example his now famous case of the draining of a meadow which may be generally conceived as mutually beneficial amongst a group of men.

Two neighbours may agree to drain a meadow which they possess in common, because it is easy for them to know each other's mind; and each must perceive that the immediate consequence of his failing in his part is the abandoning of the whole project. But it is very difficult, and indeed impossible, that a thousand persons should agree in any such action; it being difficult for them to concert so complicated a design, and still more difficult for them to execute it; while each seeks a pretext to free himself of the trouble and expense, and would lay the burden on others. Political society easily remedies both these inconveniences. (Treatise of Human Nature, Book HI, 'Of the Origin of Government')

Governments, therefore, reduce the transaction costs amongst citizens who perceive that compulsory exactions to finance on indivisible benefit are a lesser evil than the risk that, if there were no government, the benefit could not be realized. This still leaves unresolved three vital questions: who should decide which projects should be undertaken, how can one check on the efficiency of those who undertake and administer them and how should the burden of financing them be divided amongst the beneficiaries? Readers can trace for themselves Hume's answers to these difficult questions in the Political Discourses, notably in 'Of Taxes' and 'Of Public Credit' in which he clearly indicates that governments have to be prevented from actions which remove the incentives to save and to invest and which oppress the poor.