Adam Smith's Simplified Wealth of Nations, Book 2, Chapter 2b: Paper money
Chapter 2b: Paper Money
27 There are many kinds of paper money.
The circulating notes of banks are the best known and best adapted as paper money.
28 When people have such confidence in the fortune, probity, and prudence of a banker, they believe that he is always ready to pay upon the presentation of his promissory notes.
Those notes become equal to gold and silver money from the confidence that money can be received for the notes at any time.
29 A banker lends his own promissory notes worth £100,000 to his debtors.
Since these notes are as good as money, his debtors pay him interest.
This interest is his gain.
Some of those notes continually come back to him from the debtor's customers for redemption
But some of them continue to circulate for months and years
Though he has £100,000 of notes in circulation, £20,000 in gold and silver may be sufficient for answering occasional demands.
£20,000 in gold and silver perform all the functions which £100,000 of gold and silver could have performed.
The same exchanges may be made.
The same amount of goods worth £100,000 may be circulated through his promissory notes, as when it was circulated by solely by gold and silver money.
£80,000 of gold and silver can be spared from the country's circulation.
If these operations were carried on by many different banks, the whole circulation may be conducted with 20% of the gold and silver previously needed.
30 Let us suppose, that a country's whole circulating money was £1 million.
£1 million was enough to circulate the whole national annual produce.
Different banks then issued promissory notes for £1 million.
They reserved £200,000 in gold and silver for answering occasional demands.
There would remain in circulation, £800,000 in gold and silver, and a million bank notes or £1.8 million of combined paper and metal money.
But the annual produce the country only required £1 million to circulate it to its proper consumers.
That annual produce cannot be immediately increased by those operations of banking.
£1 million will be sufficient to circulate it.
Since the goods bought and sold are precisely the same, the same amount of money will be enough for buying and selling them.
The channel of circulation will remain precisely the same as before.
£1 million was sufficient to fill that channel.
Whatever is poured in beyond this sum must overflow.
£1.8 million are poured into it.
£800,000 must overflow.
That sum is over and above what can be employed in the country's circulation.
This sum cannot be employed at home but it is too valuable to be left idle.
Therefore, it will be sent abroad to seek profitable employment which it cannot find at home.
But the paper cannot go abroad because:
the issuing banks are too far away.
it is not legal tender in foreign countries
£800,000 in gold and silver will be sent abroad.
The channel of home circulation will remain filled with a million of paper instead of the million of metals which filled it before.
Translator's Note: Bretton Woods allows the US paper currency to overflow, making the entire financial system unstable
31 The gold and silver sent abroad will be exchanged for foreign goods for the home country or for another foreign country.
32 If they use it to buy goods from one foreign country to sell to another, it is called the carrying trade.
The profit from this will add to their own country's net revenue.
It is like a new fund for carrying on a new trade.
Since paper already circulates all domestic business, the gold and silver can be converted to a fund to circulate this new trade.
33 If they employ it in buying foreign goods for home consumption, they may either:
Buy goods likely to be consumed by idle people who produce nothing, such as foreign wines, silks, etc. 34 This way:
increases expence and consumption without increasing production
does not establish any permanent fund for supporting that expence
hurtful to the society in every respect
Buy more materials, tools, and provisions to maintain and employ a more industrious people, who reproduce the value of their annual consumption, with a profit. 35 This way:
increases the society's consumption
provides a permanent fund for supporting that consumption because the people who consume can reproduce the whole value of their consumption, with a profit
increases the society's gross revenue by increasing the whole value added by labour to those materials
increases their net revenue by deducting the cost of supporting the tools and instruments of their trade.
36 Most of the gold and silver forced abroad by banking used to buy foreign goods for home consumption is almost unavoidably used to buy this second kind of goods.
Some men may increase their cost very much without increasing their revenue.
However, no entire class ever does so because the principles of prudence always influences the majority, though it does not always govern every individual's conduct.
But the revenue of idle people cannot be increased by banking.
Only the expense of a few among them may be increased by banking.
A very small part of the money forced abroad will be employed to buy foreign goods for the consumption of idle people.
Because the demand of idle people will not change so much
Most of it will naturally be destined for the employment of industry and not for the maintenance of idleness.
37When we compute the amount of industry which a society's circulating capital can employ, we must always have regard only to provisions, materials, and finished work.
The circulating capital which consists in money, and which only circulates those three, must always be deducted.
Three things are needed to mobilize industry:
Materials to work on
Tools to work with
Wages or recompense for the work done
Money is neither a material to work on, nor a tool to work with.
Though wages are commonly in money, a worker's real revenue is in the money's worth.
The real revenue of people consist in what can be bought with money, and not in the physical money.
38The amount of industry which any capital can employ must be equal to the number of workers whom it can supply with materials, tools, and a maintenance suitable to the nature of the work.
Money may be needed to buy:
the materials and tools of work and
the maintenance of the workers.
The amount of industry which the whole capital can employ is certainly not equal to both the money which buys, and the materials, tools, and maintenance, bought with that money.
It is equal only to the materials, tools and maintenance more properly than to the money.
39 When gold and silver money is replaced with paper, the amount of materials, tools, and maintenance (the circulating capital) may be increased by the value of gold and silver used to buy them in the past.
The increased value of this great wheel of circulation is added to the goods it circulates.
This operation resembles an undertaker of a great work who takes down his old machinery and replaces it with a newer and cheaper one of the same quality.
He adds his cost savings to the fund that provides materials and wages to his workers.
40 It is perhaps impossible to determine the proportion of a country's circulating money to the whole value of its annual produce circulated by that money.
Money has been computed by different authors at 1/5, 1/10, 1/20, and 1/30 of the value of the annual produce.
No matter how small money is compared to the annual produce of a country, it forms a great part of the stock used to maintain industry.
When gold and silver money is reduced to 1/5 because of the introduction of paper money, the value of the remaining 4/5 is added to the funds for maintaining industry.
It makes a very big addition to the quantity of that industry and to the value of the national annual produce.
41 This operation has been done in Scotland within the past 25-30 years by the establishment of new banks in every considerable town and some country villages.
Its effects were precisely those above described.
The business of the country is almost entirely done with the paper of those banks through purchases and payments.
Silver very seldom appears except in the change of a 20 shilling bank note, and gold still more seldom.
The country has derived great benefit from the banks even though they are not exceptional and were regulated by an act of Parliament.
I heard that the trade of Glasgow doubled 15 years after the establishment of the banks there.
The trade of Scotland has more than quadrupled since the establishment of the two public banks at Edinburgh.
The Bank of Scotland was established by act of Parliament in 1695
The Royal Bank was established by royal charter in 1727
I do not know whether the trade of Scotland or Glasgow has really increased so much during so short a period.
It seems to be too great to be caused by banks alone.
However, I do not doubt that the banks contributed to the big increase in the trade and industry of Scotland during this period.
42 Before the union in 1707, the value of the silver money circulating in Scotland was £411,117.
It was immediately brought into the Bank of Scotland to be recoined after the union.
There is no account of the gold coin.
The ancient accounts of the mint of Scotland show that the value of the gold annually coined exceeded that of the silver.
There were many people who did not bring their silver into the Bank of Scotland because of the diffidence of repayment.
Some English coin was also not called in.
The whole value of the gold and silver circulating in Scotland before the union cannot be less than £1 million.
£1 million seems to have been almost the whole circulation of Scotland.
The circulation of the Bank of Scotland was considerable and had then no rival.
Its circulation made a very small part of the union's whole circulation.
Presently, Scotland's whole circulation cannot be less than £2 million.
The part which consists in gold and silver probably does not amount to £500,000.
Scotland's circulating gold and silver was greatly diminished during this period.
But its real riches and prosperity did not diminish at all.
Its agriculture, manufactures, and trade have increased.
Discounted Bills of Exchange
43 Most banks issue their promissory notes chiefly:
by discounting bills of exchange or
by advancing money before they are due.
They always deduct the interest from the sum they advance, until the bill becomes due.
The payment of the due bill replaces to the bank the value that was advanced, with a clear profit of the interest.
The banker who advances a discounted bill (of reduced value) to the merchant in notes instead of gold and silver, is able to discount more, according to the total value of all of his circulating promissory notes.
He can make his clear gain of interest on a larger sum.
44 The commerce of Scotland is not very great at present.
It was smaller when the first two banks were established.
Those companies would have had little trade had they confined their business to discounting of bills of exchange.
They invented cash accounts -- another method of issuing their promissory notes
They give credit (£2,000-3,000 for example) to anyone who could procure two persons of undoubted credit and good landed estate to become surety for him.
Whatever money advanced to him based on the given credit should be repaid on demand, with the legal interest.
This kind of credit is granted by banks around the world.
But Scotch banks peculiarly give them on easy terms.
The easy terms perhaps were the principal cause of the great trade of those banks and the benefit the country received from it.
45 People with this credit who borrow £1,000, may repay it piecemeal, by £20-30 at a time.
The bank discounts a part of the interest of the £1,000 from the day each of those small sums are paid, until the the whole is paid.
All merchants and almost all businessmen, find it convenient to keep such cash accounts.
They are interested in promoting the banks:
by readily receiving their notes in all payments
by encouraging others to receive their bank notes too
The banks advance the loans in the bank's own promissory notes.
The merchants use these notes to pay the manufacturers for goods.
The manufacturers pay these notes to the farmers for raw materials and provisions.
The farmers pay these to their landlords for rent.
The landlords pay these to the merchants for goods.
The merchants return these to the banks to balance their cash accounts or to replace what they borrowed.
Thus, almost the whole money business of the country is transacted by promissory notes, creating the great trade of those banks.
46 Through those cash accounts, every merchant can carry on a greater trade.
Let us say that there is one merchant in London and another in Edinburgh, both employing equal stocks in the business.
The Edinburgh merchant, using cash accounts, can carry on a greater trade and employ more people than the London merchant.
The London merchant, with no cash accounts, must always keep a big sum of money to answer the payment demands for the goods he purchases on credit.
If this amount is £500, then he must keep £500 in money instead of spending it to add £500 of additional goods in his warehouse.
If he is able to sell all his goods in the year, he would have lost the sale of £500 worth of goods.
His annual profits must be less, by the profits of those £500 of goods;
The number of people he employs must be less, by the employment generated by those £500 of goods.
On the other hand, the Edinburgh merchant keeps no money unemployed for answering such occasional demands.
He satisfies occasional demands with his cash account with the bank.
He gradually repays the bank with the money or paper from the sales of his goods.
With the same stock, he can have more goods than the London merchant.
He makes a bigger profit and provides more employment.
Hence the great benefit which Scotland has derived from this trade.
47 Discounting bills of exchange gives the English merchants a convenience equivalent to the cash accounts of the Scotch merchants.
But the Scotch merchants can and have discounted their bills of exchange as easily as the English merchants, in additional to their cash accounts.
48 All kinds of paper money which can easily circulate in any country can never exceed the value of the gold and silver it substitutes.
If 20 shilling notes are the lowest paper money in Scotland, all paper money which can easily circulate there cannot exceed the sum of gold and silver needed for transactions worth 20 shillings or more.
If the circulating paper exceeds that sum, it must immediately return on the banks to be exchanged for gold and silver.
Because the excess could not be sent abroad nor employed in the circulation of the country.
Many people would immediately perceive that they had more of this paper than was needed for business transactions at home.
Since they could not send it abroad, they would immediately demand payment of it from the banks.
By converting this superfluous paper into gold and silver, they can easily find a use for it abroad.
But they could find no use for it while it remained in paper.
There would immediately be a run on the banks to the whole extent of this superfluous paper.
If the banks showed any backwardness in payment, a greater alarm would be created, increasing the run.