Adam Smith's Chartalism

[Mathew Forstater <forstate@xxxxxxxx>]

>From Randy Wray's "Money and Taxes: The Chartalist Approach", Levy Working
Paper No. 222.
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Smith on Money

Let us first examine Adam Smith's views of money. We will quote liberally
from Smith to show how "modern" some of his views appear. At the same
time, Smith's views--particularly on bank creation of money and on the
determination of the value of an inconvertible currency--are quite similar
to views presented below. It is thus worth the effort to explore the
arguments of the "father" of economics in detail; our exposition later
might then be easier to follow.

According to Smith, convertible bank notes can substitute for commodity
money:

"When the people of any particular country have such confidence in the
fortune, probity, and prudence of a particular banker, as to believe that
he is always ready to pay upon demand such of his promissory notes as are
likely to be at any time presented to him; those notes come to have the
same currency as gold and silver money..." (Smith 1937: 277)

At this point, the bank can "create (bank) money" by lending its own
notes:

"A particular banker lends among his customers his own promissory
notes.... As those notes serve all the purposes of money, his debtors pay
him the same interest as if he had lent them so much money.... Though some
of those notes are continually coming back upon him for payment, part of
them continue to circulate for months and years together." (Smith 1937:
277)

Because notes circulate as if they were money, the banker need hold only a
fractional reserve against them.

"Though he has generally in circulation, therefore, notes to the extent of
a hundred thousand pounds, twenty thousand pounds in gold and silver may,
frequently, be a sufficient provision for answering occasional demands. By
this operation, therefore, twenty thousand pounds in gold and silver
perform all the functions which a hundred thousand could otherwise have
performed.... the whole circulation may thus be conducted with a fifth
part only of the gold and silver which would otherwise have been
requisite." (Smith 1937:277)

Thus, bank notes "free up" gold and silver. As this "freed" gold and
silver is not needed domestically, it will leave the country--the paper
money "forces" specie abroad. The excess gold and silver will "be sent
abroad, in order to seek that profitable employment which it cannot find
at home. But the paper cannot go abroad; because at a distance from the
banks which issue it, and from the country in which payment of it can be
exacted by law, it will not be received in common payments. Gold and
silver, therefore...will be sent abroad, and the channel of home
circulation will remain filled with...paper..." (Smith 1937:278) At
"home", the force of law ensures the paper money fulfills obligations, but
this law cannot apply abroad, thus, paper circulates domestically while
specie is used internationally. For example, in Scotland at the time, the
vast majority of the circulation was accomplished on the basis of paper.
"The business of the country is almost entirely carried on by means of the
paper of those different banking companies, with which purchases and
payments of all kinds are commonly made." (Smith 1937:281)

In most countries, bank notes enter the economy as banks discount bills of
exchange. "It is chiefly by discounting bills of exchange, that is, by
advancing money upon them before they are due, that the greater part of
banks and bankers issue their promissory notes." (Smith 1937:282) However,
in Scotland, banks had gone one step further, inventing a new method of
increasing note issue.

"They invented, therefore, another method of issuing their promissory
notes; by granting, what they called, cash accounts, that is by giving
credit to the extent of a certain sum....to any individual who could
procure two persons of undoubted credit and good landed estate to become
surety for him, that whatever money should be advanced to him, within the
sum for which the credit had been given, should be repaid upon demand,
together with the legal interest. Credits of this kind are, I believe,
commonly granted by banks and bankers in all different parts of the
the world." (Smith 1937:282-3)

In other words, banks issued notes and held IOUs of borrowers, with the
"surety" of two creditworthy persons. These banks would then accept their
notes in payment of bank loans. This then increased the demand for bank
notes in order to make payments on loans ("cash accounts").

"The banks, when their customers apply to them for money, generally
advance it to them in their own promissory notes. These the merchants pay
away to the manufacturers for goods, the manufacturers to the farmers for
materials and provisions, the farmers to their landlords for rent, the
landlords repay them to the merchants for the conveniencies and luxuries
with which they supply them, and the merchants again return them to the
banks in order to balance their cash accounts, or to replace what they may
have borrowed of them; and thus almost the whole money business of the
country is transacted by means of them." (Smith 1937:283)

Not only does the "paper money" substitute for gold and silver money, it
actually increases the volume of trade. "By means of those cash accounts
every merchant can, without imprudence, carry on a greater trade than he
otherwise could do." (Smith 1937:283) This is because the merchant with a
"cash account" (or, credit line) can safely keep nearly zero precautionary
balances. "The merchant in Edinburgh...keeps no money unemployed for
answering such occasional demands. When they actually come upon him, he
satisfies them from his cash account with the bank, and gradually replaces
the sum borrowed with money or paper which comes in from the occasional
sales of his goods." (Smith 1937:284) This does not mean that the volume
of paper money will exceed the volume of gold and silver that would be
necessary to circulate the same output. If it were to exceed what is
necessary for circulation, it would reflux to the banks (for redemption),
resulting in a drain of gold and silver reserves. "Should the circulating
paper at any time exceed that sum, as the excess could neither be sent
abroad nor be employed in the circulation of the country, it must
immediately return upon the banks to be exchanged for gold and silver."
(Smith 1937:284)

Occasionally, however, banks do issue too much paper money. This could
occur because a bank did not actually require its loans to be repaid; for
example, a bank might allow a customer to deliver a bill of exchange
rather than either commodity money or bank notes. Further, these were
often "fictitious" bills with no commodities circulating behind them.

"Though the bills upon which this paper had been advanced, were all of
them re-paid in their turn as soon as they became due; yet the value which
had been really advanced upon the first bill, was never really returned to
the banks which advanced it; because, before each bill became due, another
bill was always drawn to somewhat a greater amount than the bill which was
soon to be paid; and the discounting of this other bill was essentially
necessary towards the payment of that which was soon to be due. This
payment, therefore, was altogether fictitious." (Smith 1937:295-6)

The problem was that this process would increase interest owed (due to
compounded discounts on the bills submitted for payment) beyond the
ability to pay. Further, excessive note issue would increase reflux,
draining reserves. The bank would find that it actually had to increase
its reserve holdings--which earn less interest--lowering its
profitability. Thus, for the most part, market pressures would ensure that
there would be a tendency to issue the "correct" amount of paper--which
would be equivalent to the quantity of gold and silver required for
circulation--but more than the amount that would have been circulated if
specie were actually used in circulation (because the volume of trade
would be larger).

According to Smith, market pressures are most likely to work if the
denomination of notes is regulated. If banks are permitted to issue small
denomination notes, then unscrupulous bankers will take advantage of
unsophisticated consumers--issuing notes they cannot redeem. This is
possible because for small denominations, little effort is devoted to
determining the financial strength of the issuer; furthermore, small
denomination notes tend to take a circuitous route (from employer to
worker to retailer to intermediary) before redemption--meaning they might
stay in circulation a long time, tempting the banker to increase issue. On
the other hand, large notes circulate mainly among more sophisticated
"dealers" (merchants), are redeemed more frequently, and more effort is
taken to determine creditworthiness of issuer. Smith thus recommends that
"It were better, perhaps, that no bank notes were issued in any part of
the kingdom for a smaller sum than five pounds. Paper money would then,
probably, confine itself, in every part of the kingdom, to the circulation
between the different dealers...." (Smith 1937:307)

So long as paper money is redeemed on demand for gold (or silver), it
circulates at par with the gold coin. "A paper money consisting in bank
notes, issued by people of undoubted credit, payable upon demand without
any condition, and in fact always readily paid as soon as presented, is,
in every respect, equal in value to gold and silver money.... Whatever is
either bought or sold for such paper, must necessarily be bought or sold
as cheap as it could have been for gold and silver." (Smith 1937:308) If
it is not redeemable on demand, then it may circulate at a discount. He
discussed the case where redeemability might be uncertain, or might
require a wait: "Such a paper money would, no doubt, fall more or less
below the value of gold and silver, according as the difficulty or
uncertainty of obtaining immediate payment was supposed to be greater or
less; or according to the greater or less distance of time at which
payment was exigible." (Smith 1937:309) He went on to give the example of
banks in Scotland which adopted an "optional clause" which allowed them
the option of withholding redemption for six months after presentation (in
which case they paid interest for the period). These notes typically
suffered a discount of 4% relative to specie in trade.

As another example, Smith offered the case of the American colonies, which
typically offered conversion only after a wait of several years and did
not pay interest on the paper for the waiting period. Still, these
colonies passed legal tender laws "to render their paper of equal value
with gold and silver, by enacting penalties against all those who made any
difference in the price of their goods when they sold them for a colony
paper, and when they sold them for gold and silver..." (Smith 1937:311)
Smith decried such regulations as "tyrannical" and ineffectual, for the
colony currency would fall relative to the English pound. However, he also
noted that Pennsylvania "was always more moderate in its emissions of
paper money than any other of our colonies. Its paper currency accordingly
is said to never to have sunk below the value of the gold and silver which
was current in the colony before the first emission of paper money."
(Smith 1937:311) Here there is some ambiguity, for he had not previously
argued that the depreciation of a nonconvertible currency was a function
of the quantity of the currency issued, but now he seemed to argue that
the more moderate emission of Pennsylvania might forestall depreciation.

However, in the following paragraph he seems to have solved the puzzle. If
a paper money whose redeemability is uncertain (or is subject to
conditions--such as a waiting period) is accepted in payment of taxes, and
if it is not excessively issued relative to the tax liability, then it
need not depreciate relative to specie.

"The paper of each colony being received in the payment of the provincial
taxes, for the full value for which it had been issued, it necessarily
derived from this use some additional value, over and above what it would
have had, from the real or supposed distance of the term of its final
discharge and redemption. This additional value was greater or less,
according as the quantity of paper issued was more or less above what
could be employed in the payment of the taxes of the particular colony
which issued it. It was in all the colonies very much above what could be
employed in this manner." (Smith 1937:312) [emphasis added]

Thus, the depreciation noticed in the colonies occurred precisely because
the note issue was well above what was required in payment of taxes.

A wiser government could not only prevent depreciation, it might even
cause paper money to carry a premium over specie!

"A prince, who should enact that a certain proportion of his taxes should
be paid in a paper money of a certain kind, might thereby give a certain
value to this paper money; even though the term of its final discharge and
redemption should depend altogether upon the will of the prince. If the
bank which issued this paper was careful to keep the quantity of it always
somewhat below what could easily be employed in this manner, the demand
for it might be such as to make it even bear a premium, or sell for
somewhat more in the market than the quantity of gold or silver currency
for which it was issued." (Smith 1937:312)

In summary, an essentially non-redeemable paper money could actually
circulate above par even under a gold standard if it was legally required
by the state in payment of taxes, and if the quantity issued were kept
"somewhat below what could easily be employed in this manner". The key,
then, is not really redeemability, nor is it "legal tender laws" that
attempt to "render their paper of equal value with gold and silver";
rather, it is the acceptance of the paper money in payment of taxes and
the restriction of the issue in relation to the total tax liability that
gives value to the paper money. Importantly, Smith recognized that this
paper money need not be government fiat currency, for his argument was
predicated upon the recognition that the paper money is the liability of
the banking system, issued as the banks "made loans" and accepted private
IOUs. All that mattered was that the state accepted these bank notes in
payment of taxes, in which case they could circulate at par, or even at a
premium, relative to specie.

In the next section, we will examine Knapp's more general theory of money,
which is consistent with, but expands significantly upon, the observations
of Smith.