The Classic Ideas on Money

The Origins of the Classical Ideas on Money:
The Automatic Regulation of Foreign Trade

Although many of the Mercantilists themselves deviated at various points from the traditional pattern of mercantilist thought, none gave clearer indication of the changes in the funda­mental ideas of money that were to come in later centuries than did Sir William Petty (1623-1687). He accepted most of the principles of Mercantilism but by his empirical methods and a liberal use of statistical data he was able to throw off the re­strictions of mercantilist doctrine, and offer more advanced ideas. When most of his contemporaries were advocating stronger con­trol of the exportation of money, he maintained that without gov­ernmental regulation a nation might achieve a sufficient quantity of money to meet its internal needs by lending excesses at interest and creating a bank to make up for deficiencies by means of credit. He also gave some intimation that the quantity of money in circulation affected prices. To be sure his discussion was con­cerned more with the fluctuation in the weight of standard coins as they affected prices, but his insight was in the direction of later advances.

It was David Hume, however, who made the first comprehen­sive attack upon the idea that the measure of a nation's economic and political welfare was the size of its stock of precious metal. By these attacks he put an end to the hold of Mercantilism on English economic thought. In spite of the able writing of later economists, Hume's exposition of the fallacies of the bullionist po­sition and his advocacy of automatic regulation of the flow of money is still outstanding for its clarity of reasoning and excel­lence of style. Good partial discussions of the self-regulation of trade and the flow of money are to be found in the writings of John Locke, Sir Dudley North, Isaac Gervaise, and Jacob Vanderlint, but it was Hume who, in his Political Discourses, assem­bled the several points of discussion and wove them into a master­ful analysis of the total idea. The essence of Hume's discussion is that the monetary supply of a country is self-regulating and the best interests of the country will be served without govern­ment attempts to secure a favorable balance of trade or to pro­hibit the export of bullion. A decline in the quantity of money in England will cause a decline in the price of goods; thus foreign buyers will buy English goods and pay for them in money until the quantity of money in England is equal to that of other coun­tries. If money should increase, prices will rise, foreign buyers will seek other markets, and imports will exceed exports until the level of money in the trading countries is once again equal. The flow of metal is also influenced by the rates of exchange between countries which act as forces similar to price levels operating to restore monetary equilibrium. Hume, it appears, believed in a direct and equal relationship between the quantity of money and the price level. The actual quantity of money, he said, made little difference since it was the quantity of money as related to the amount of goods available which determined the price. There was, of course, a temporary advantage to be gained from an in­crease in money. Since prices did not react immediately to in­creases in money, there was a brief period of adjustment when at the same prices the nation possessing more money could de­mand more goods.

This analysis by Hume was readily accepted by most of the economists who followed him. Cantillon (a contemporary of Hume), whose works were not so long ago rediscovered, made a brilliant and detailed exposition of automatic adjustment of money in international trade in his Essai sur la nature du com­merce en general (1755), but Hume's work is the better known. It has appeared strange to later scholars that Adam Smith made no reference to Hume in his work, although his statement of the self-regulating mechanism is similar to that of Hume, and it is known that the two men were well acquainted. In John Stuart Mill's discussion of this topic there is a general acceptance of the Hume point of view, but one important innovation was added. The increase of money in one country actually increased the demand of that country for its own and foreign goods. The effect of this was not only to increase the prices of domestic goods which turned away foreign traders, but it also started the flow of foreign goods into the country, thus sooner or later bringing about an equilibrium.

Little has been added to this theory of the flow of money and the balance of trade since first composed by Hume and clarified by such writers as Mill. Serious questions have been raised in modern time concerning its effectiveness. In practice, govern­ments have manipulated their currencies and gold supply, hoping thereby to secure advantage for themselves; but as yet no new analysis of the process of international trade or international money supply has supplanted what for want of a better name is still called "classical" theory.

Adam Smith made no changes in the basic ideas of money that his predecessors had propounded. Explaining how the origin of money was due to the necessity of exchange arising from a sub-division of labor, he proceeded to show how the quantity of money in circulation was regulated. He conceived of money as both a medium of exchange and a measuring of value, but he denied that it had any value in itself other than that of facilitating exchange. Because of this factor, the greater economy in its use the better. To this end the use of paper money was eminently desirable, for this increased the quantity of coin which was available for purchases of instruments of production abroad without decreasing the supply for domestic use. Money was a com­modity, Smith believed, and like any commodity the amount of it would be regulated by necessity. If a greater quantity was available than domestic trade required, the excess would be used for purchases abroad. In the case of paper money issued by banks an excess would be attended by a rise in prices, and foreign pur­chasing would result, requiring the exchange of bank notes for coin with which to make foreign payments. Thus Smith's real contribution to the theory of money seems to have been his em­phasis upon the value of paper money as an aid to economic ac­tivity.

In a general way the monetary views of David Ricardo follow closely the pattern of Adam Smith. In the movement of bullion and the effect of the quantity of money on prices in international trade he subscribed to the quantity theory and supported the self-regulating mechanism, adding the significant point that even be­fore commodity prices the price of bills of exchange seemed to re­verse the course of trade in the direction of equilibrium between nations. Ricardo's name became closely associated with the ef­forts to solve the monetary problems of his day, in fact he is looked upon as the best exponent of the bullionist position. Eco­nomic crises, the suspension of specie payments for two decades, and price inflation, all marked the span of Ricardo's life. They were so serious that the English government gave close attention to plans for combating them. In his pamphlet, The High Price of Bullion, Ricardo attempted to explain the monetary instability as an effect of poorly regulated paper currency. Although he be­lieved as did Adam Smith that paper money should be substi­tuted for coin wherever possible, he was convinced that in order to bring about economic stability the amount of paper currency should be reduced to conform to the quantity of specie on hand. On the other hand, he advocated as a long term policy the issuance of paper currency rather than specie to meet the demands of increased population and increased business activity, for which a reserve in gold would be kept at the bank. The bank­ing legislation of Great Britain for the first half of the Nineteenth Century reflects the monetary theories of Ricardo, testifying not so much to his originality or the validity of his ideas as to the energy and clarity with which he presented them. There was one point concerning his theory of money that emphasized Ricardo's adherence to Adam Smith's ideas and the classical tradition. While the value of money was primarily determined by the supply and the demand for it as a medium of exchange, the cost of pro­duction of gold and silver also influenced the value of money just as the cost of production tended to influence the value of other commodities. Thus, the relative value of gold and any other com­modity was the relation of their costs of production. It was at this point that Ricardo's ideas seem most confused. Nevertheless, classical economists of later years tended to follow the same line of reasoning without criticism.

The idea that the value of metal money was determined by its cost of production was taken up and elaborated by John Stuart Mill. He was concerned with showing that the value of money could be affected both by its quantity combined, with rapidity of circulation, and by its cost of production. In the case of the former the effect was immediate; the effect of the latter would be felt only over long periods of time. Obviously, said Mill, the law of supply and demand operated more quickly upon money than on other commodities, but since the cost of production ultimately affected the supply of money, it must be considered as influenc­ing value. The thoughts of Mill on this question can be applied only to metal money, but since he advocated the issuance of paper against adequate gold reserves, with the amount of paper money in circulation being controlled to vary as the amount of specie in the country varied, the principle still held. Hence, the value of currency, whether coin or paper, was still controlled in the long run by the cost of production of gold.