Guidebook to the Wealth of Nations: CH 6 Book II

 

 

Chapter 6: Book II.

 

BOOK 2: Of the nature, accumulation, and employment of stock

After seeing the causes of the improvement in the productive power of labor –the division of labor— Smith tackles what is needed for that division of labor to take place. He again opens the book and the chapter by mentioning labor. Labor is always center stage: labor is the source of wealth.

So, what do we need to have division of labor? When there is very little division of labor, little exchange, and basically no “stock” accumulation (stock will soon be redefined as capital), we are still in a “rude” society. Under these circumstances, we would expect to have not much more than self-sufficiency.

Let’s suppose we have some increase in the division of labor. Now we can no longer supply our own wants by ourselves: we need the labor of other men. If I specialize in the production of pins, I will not produce food, so I will not have much to eat. I need the baker, brewer, and butcher to have my dinner. If we do not allow for credit, we have a problem: we can buy the labor of others only after we sell our own labor. So in the time during which our labor is not yet sold, we need something to live on: some “stock”. This means that we cannot have division of labor before some accumulation of “stock”. This also means that the more division of labor there is, the more accumulation of “stock” we need to have. Which in its turn means that it is only through this accumulation of “stock”, that improvement is possible.

So let’s look at how we can get and use this “stock”.

 

BOOK II, chap 1: of the division of stock

If someone has something on the side, some “stock”, to support himself only for couple of days, he will not think to use that “stock” to generate revenue for himself. He will get his revenue only from his work, and this is the condition of most workers. If, on the other hand, someone has enough “stock” to support himself for a few years, he will use the “stock” that he does not consume to generate revenue for himself.

So, stock can be divided into two types. One that generates revenue, called capital (finally!). And one for immediate consumption.

Capital, the part of stock we do not use for immediate consumption, in its turn, yields profits in two ways. If we make a profit by parting with it, that is by buying and selling or by making and selling goods, we call it “circulating capital” because it is its circulation that generates profits. And, if we get profits by keeping it, rather than by circulating it, we call it “fixed capital.” Land improvement, machineries, for examples, are capital that does not change hands, thus our fixed capital.

Merchants tend to have circulating capital, manufacturers both circulating and fixed capital, and the mining industry mostly fixed capital in the form of big equipment needed to mine. Agriculture also has fixed capital, but it is more of a mix. Wages of the workers are circulating capital. “Cattle for fattening” are circulating capital—the farmer makes a profit by selling them — while “cattle for labor” are fixed capital — the farmer makes a profit by keeping them. Similarly, sheep for wool are fixed capital because farmers make a profit by keeping the sheep.

The stock of a country is divided in the same three parts: there is a stock for immediate consumption, such as housing (which gives no revenue and so no profit); fixed capital, such as machinery, shops, warehouses, stables, granaries, improved land, useful skills of all the inhabitant of society (which generate profits without changing master); and circulating capital, such as the money used to circulate the other capital, provisions, the input materials for future production, and inventories of finished goods that are waiting to be sold (which generate profits by changing master).

Note that for Smith what we called today human capital (the skills of the members of society) is part of the fixed capital, while wages paid to workers are circulating capital.

Fixed capital needs circulating capital to yield revenue. A machine cannot function without inputs and workers. Circulating capital is what brings them to it. Furthermore, parts of circulating capital go into fixed capital and stock for immediate consumption, which means that circulating capital needs to be continuously replenished or it will end. This replenishment comes from the produce of land, fishery, and mines.

This argument, as appropriate as it may have been in the 18th century is a bit unsettling today. Natural resources replenish the circulating capital, which in its turn supports both fixed capital and stocks for immediate consumption. It is a unidirectional flow that requires constant extractions from nature. With the exception of mining, Smith does not yet see the possible difficulties of sustainability of the finite resources of the planet.

Smith concludes the chapter with a remark on the fixity of human nature and the importance of good institutions. If there is tolerable security, people use their stock for either present enjoyment, that is current consumption, or for future profit, that is fixed or circulating capital: not doing this is “perfectly crazy.” If there is violence, on the other hand, people will bury their stock in the ground or hide it.

This is an implicit argument against his friend David Hume, who suggests that hoarding stock may be a good way to encourage low domestic prices and therefore a mild stimulation of industry. For Smith, instead, unless there is violence, hoarding is “perfectly crazy.”

A final consideration is spelled out in this chapter. Smith is setting up his attack: the purpose of both fixed and circulating capital is to maintain and increase the stock for immediate consumption. This means that the goal of production is consumption. In fact, we judge wealth or poverty by the abundance or scarcity of stock available for immediate consumption. Labor is the only source of wealth and wealth is our ability to consume. Gold and silver? They have nothing to do with either.

 

BOOK II. Chap 2: Of Money considered a particular branch of the general stock of society

With this second chapter Smith continues his criticism of Hume, who does not seem to appreciate the advantages of money and banking as much as Smith does, and his much stronger criticism of those who believe, incorrectly, that gold and silver are wealth. Smith’s argument is based on the idea that only one’s ability to consume is wealth.

Here again Smith starts by tiptoeing around aggregation fallacies. A private estate has a gross rent, which is the value of all the rent collected, and a neat rent which is what is left after covering all the expenses, including the maintenance of fixed and circulating capital. The stock for immediate consumption comes from the neat rent. Similarly a country as a whole has also a gross revenue and a neat revenue; and the stock for immediate consumption is what comes out of the neat revenue. How do we know a landlord’s real wealth? We look at his neat rent. How do we know a country’s real wealth? In the same way: we look at its neat revenue.

The costs of maintaining fixed capital cannot be part of the neat revenue of society, just like the costs of repair in a private estate are not part of its neat rent. They are, though, both necessary and beneficial.

The expenses needed to maintain circulating capital are more complicated. The circulating capital in the form of provisions, raw materials, and finished goods regularly become either fixed capital or stock for immediate consumption. The stock for immediate consumption is neat revenue, as we just saw. Here though we need to differentiate between individual and society: the content of a merchant’s shop is not for his immediate consumption, so it is not part of his neat revenue. But it is part of society’s neat revenue, because it is for society’s consumption. So the maintenance of these three parts of the circulating capital in the form of immediate consumption will not decrease the neat revenue of society. When, on the other hand, circulating capital is transformed into fixed capital, it will.

Money, which is a part of circulating capital, is even more complicated. The maintenance of money may actually decrease neat revenue. Money, despite being part of the circulating capital, behaves as if it was fixed capital.

Money is like a machine. They are both expensive to make and to maintain. Some valuable materials (gold and silver in case of money) and labor have to be taken away from consumption to support this “great but expensive instrument of commerce”. Now, machines, being fixed capital, are not part of the gross or neat revenue. Similarly, money is not part of any revenue, neither neat nor gross. Money just circulates revenue. It is not by chance that Smith claims that money is “the great wheel of circulation [which] is altogether different from the goods which are circulated by means of it”. The revenue of society is the goods, the wheels are not revenue.

A possible reason why we may get confused about this is an ambiguity in the language. If a person has a pension of a guinea (a coin originally containing a quarter of an ounce of gold) per week and spends it all each week, his weekly revenue is not equal to both the one guinea and what he bought with it. His weekly revenue is a guinea’s worth of stuff, not the guinea. Similarly, the metal pieces in society are not the revenue of the members of society. Don’t believe it? Then think: most metal pieces pay several people, so there are fewer metal pieces around than the value of the whole money pensions annually paid through them. In today’s language: the value of all dollar bills in circulation is less than the value of all the things that those dollar bills buy because the same bill changes hands multiple times, buying more than one thing.

The revenue of society is therefore the purchasing power not the number of metal pieces used as money. Again Smith tells us, money is just a great wheel of circulation, a great instrument of commerce, a part of capital, but not a part of the revenue. The people who think that money is wealth are mistaking the wheel for the produce it carries.

The final reason why money is like fixed capital, like a machine, is that the less one spends to maintain it, the more neat revenue one gets. The capital saved can be used in productive ways. Substituting paper money for gold and silver money is like replacing a very expensive high-maintenance machine with a cheaper but equally convenient one. Paper money is a wheel of commerce too, and a cheaper one.

To better understand the rest of Smith’s argument, we need to consider that the monetary system he lived with is different from ours. The first big difference is that today we have a fiat system, while Smith did not. Fiat money is a form of paper money. It is not convertible into precious metals. The paper is declared money by government decree, by fiat. And it is usually monopolistically produced by a central bank. This form of money was basically non-existent in Smith’s time. When Smith talks about money, he usually talks about commodity money: a commodity, like gold and silver, which emerged as a commonly accepted medium of exchange. Paper money, in his day, was not fiat money, but a sort of certificate that could be converted into gold and silver more or less upon demand. The other difference is that rather than a monopolistic production, the issuing of paper money was competitive. Anybody could, in theory, issue paper money. Smith indeed describes a monetary system in which there are several banks of issue. The final main difference to keep in mind is that the kinds of banks Smith talks about are not like our commercial banks. They did not generally accept deposits. They lent money on credit, or better, rather than actual gold and silver, they lent a piece of paper that was redeemable for gold and silver upon request. While there were no legal restrictions for who may become banker, there were some practical ones. A banker needed to be wealthy enough to guarantee that all the paper he issued could be converted into gold and silver. Unlimited liability was typical of the time: the entire personal assets of a banker were on the line and could be used to fulfill his obligations. The other fundamental characteristic that a banker needed to have was trustworthiness. A banker needed to be renowned not just as having a large fortune, but also as being prudent and honest. After all, one businessman accepts a piece of paper as payment for his goods or services because he trusts that piece of paper will be accepted by others and that it will be convertible into gold and silver upon demand. This is why paper money is also called fiduciary money, because it is a form of money based on trust.

Now, Smith tells us that the most common form of paper money is circulating notes of banks. If there is confidence in the fortune, probity, and prudence of a banker and that he will pay his promissory notes on demand, those notes will be as good as gold and silver. When a banker lends by issuing his own promissory notes, he gains interest on them as if he was lending gold or silver. And since not all notes come back for payment at the same time, he can keep only about 20% of the value of the notes in circulation in gold and silver to answer occasional demands. This means that 20 thousand pounds of silver can perform the same operations of 100 thousand pounds, which means we can save 80 thousand pounds of silver. This is precious metal that is now freed from having to circulate as money. Ergo, paper money is cheaper and just as effective as a wheel of circulation.

How is that possible? Smith works with an implicit assumption: the demand for money is constant, at least in the sense that it depends on the level of economic growth. If so, he can say that money circulates in fixed “channels”. When these channels are full, their content “overflows”. So if paper is introduced, it will substitute for gold and silver. Gold and silver will go abroad to seek profitable employment. Paper money, on the other hand, cannot go abroad because it is difficult for people to accept it, because they do not know or trust the issuers. Gold and silver do not go abroad as gifts, though. They go to buy foreign goods to bring either to other countries, via the so-called carrying trade, or to the domestic market; or they go as foreign investment.

So, while banking cannot directly increase the annual produce of a country, it can free gold and silver from being used as currency at home, so that they can be used to promote industry instead. But careful: it is the extra material to work with, the extra tools, the extra wages that put industry into motion, not the money itself. Here, again, Smith differs from Hume. Hume would say that the introduction of paper money would increase domestic prices and discourage domestic industry, the high prices making it less competitive internationally and encouraging consumption of foreign goods. For Smith, banking does not affect prices. As with Hume, gold and silver will go abroad, but for Smith they will not encourage idleness, instead they will bring back more industry.

For Smith, the new banks in Scotland did just that. Almost all business in Scotland was now done with paper. Silver and gold were rarely seen. Yet, trade and industry increased significantly. At the time of the Union of parliaments between Scotland and England (1707), there was in Scotland about 1 million worth of gold and silver. At the time when Smith was writing there was only half that amount. But real riches had increased significantly. And that is what matters.

So let’s go back to the circulating notes of banks. What exactly are they? A bank discounts bills of exchange, which are promises that a specific amount will be paid on a specific date, with interest. Discounting bills of exchange means advancing the money of the bill before the bill is due but deducting from the advance the legal interest. When the payment of the bill is due, it replaces the advance and the interest remains as a clear profit for the bank.

Smith does not give us an example, but it may help. I buy flour from you to make bread for my bakery. I pay you with a note that promises to pay you $xxx + % interest in one year. You go to a bank, give them my note in exchange for $xxx in cash. A year from now, the bank comes to me, with my note. I pay them $xxx +%interest. The bank gave $xxx to you earlier, so the $xxx I gave them covers that. But I also gave them %interest. Which is the clear profit for the bank.

Let’s continue with Smith. Usually, rather than advancing actual commodity money, the bank would issue its own promissory notes. In this way, the bank could discount more bills.

Now, the greatest innovation in paper money and banking actually comes from the so called cash accounts. A cash account is a way for a bank to give credit to people who can provide two guarantors. The advance should be paid on demand and with interest. But the innovation with the cash account is that they can be paid back a little at a time and there will be no interest charged on the portion of the debt that is repaid. The bank advances the money with its own promissory notes; the merchant uses the notes to pay the manufacturer; the manufacturer uses them to pay the farmer; the farmer uses the notes to pay the landlord; the landlord uses them to pay the merchant, and the merchant returns them to the bank to balance his cash account. Without cash accounts, merchants need to keep money unemployed to answer demands for payments, which means that they have less money to do business with. With a cash account, when bills come in, they can pay with the cash account, which they can then pay back when they sell their goods.

You may ask, as many did in Smith’s time, wouldn’t having many independent banks of issue create inflation or instability? The answer Smith gives is no. Smith already took care of the problem of inflation, and he will return to it again later in the chapter to hit directly against Hume: banking does not create inflation because the demand for money is fixed. When too much is poured into a canal, it overflows. Gold and silver will go abroad in search of productive and profitable activity. Banking will also not create instability, for the same reason. Here is why.

The total amount of paper money cannot exceed the value of gold and silver it replaces. If there is more paper than needed, today we would say if the quantity supplied of money is larger than the quantity demanded (remember that for Smith the demand and the quantity demanded of money are not affected by the quantity of money in circulation, but by the level of development), the excess paper money would return to the bank. Paper money cannot go abroad. If it is not needed for domestic circulation, it returns to the bank to be exchanged for gold and silver, which can go abroad and are indeed sent abroad. If the bank is not ready to pay, it may very well start a bank run. A bank run takes place when many customers run to the bank to make sure they get their gold and silver, before the bank runs out of them through excess demand. If the bank runs out of money it is a problem. The problem can be so severe that it can cause bankruptcy. It is therefore in the interest of the bank not to over-issue paper.

Here is a more detailed explanation of what came to be known as the law of reflux. A bank faces two kinds of expenses. The expense of keeping the money in coffers to answer occasional demand, and the expense of refilling the coffers as fast as they are emptied. If a bank over-issues, it needs to increase the quantity of gold and silver it has for its payments, and it needs to do it in a proportion larger than the amount over-issued, because the notes come back for conversion at a much faster rate than in normal circumstance. Remember that people pay interest on the notes they hold. This is why they will hold only what they need. Now, the additional coins received as payment for the unwanted paper will go abroad as investment, which makes it even more difficult, and thus more expensive, for the bank to find gold and silver to replenish its coffers.

The bank of England, which has to supply coins to support the English and Scottish over-issuing, due to the high price of bullion, is forced to coin gold and silver at a 2.5%-3% loss.

Many Scottish banks kept an agent in London to get the gold and silver needed. Add shipping and insurance cost, and the replenishing of metals in their coffers becomes quite expensive. Sometimes, if they cannot find enough gold and silver, they have to use bills of exchange with other banks, and the interest they have to pay on those bills is another significant expense. At 8% cost and 6% interest received, over-issuing is a receipt for bankruptcy.

But if over-issuing increases both kinds of expenses of a bank and can lead to bank failure, why do banks over-issue, as some have done? Banking is still something relatively new, Smith claims. Over-issuing is something that banks have not always understood. And some “bold projectors” want to over-trade. Note here who gets the blame: bankers are ignorant; they make mistakes because they do not know any better. Projectors know the consequences of their actions but they do it anyway because it is in their short term (deluded?) interest.

So what is it that banks have not always understood? First, if banks advance only real bills from real creditors to real debtors, if debtors really repay the bills, and if the advances are really only for that part of ready money needed for occasional demand, then the coffers of a bank are like a pond, what goes out will come back in. The pond will stay at the same level at a little cost. No problems here.

In addition, it is difficult for a bank to evaluate the prudence of all its debtors, if it has 500 of them. What today we call asymmetry of information would be overwhelming. But a solution may be possible, even if not always well understood. If, like Scottish banks do, banks require frequent and regular payments, so that a merchant can pay back his advance within few months, the bank will experience few problems. It will be in a better position to judge whether its debtors are doing well or not. If a merchant does pay regularly and repays within few months, this merchant is a good customer. He is a keeper. If on the other hand, he does not, it is not safe to deal with him anymore. Solution for asymmetry of information problem? Check.

Finally, the successful bank is a bank that does not lend circulating capital. Long term loans are not good for a bank: the repayment time is too distant in the future. Lending to finance fixed capital? Even worst. The returns on fixed capital are even further out in the future, often several years in the future. They are too slow to come in. If someone wants to borrow to finance his fixed capital, he should borrow from private people upon bond or mortgage, not from a bank. There are enough people who want to live on interest without taking the trouble to employ their capital themselves. Debtors would prefer borrowing from a bank because there is less paperwork and expense than issuing a mortgage, but these debtors are “the most inconvenient” for a bank.

There is more to understand. “Bold projectors” over-trade, creating losses for a bank. Traders want more and more credit. Banks, if they understand the risk associated with it, will not extend credit. But these bold traders will start using a trick: a “shift of drawing and redrawing”, a technique usually used as an act of desperation before bankruptcy. It consists in paying a loan with another loan, which makes it very expensive because of the commission and the interest. Profits barely make it to 6% and drawing and redrawing costs no less than 8%: an “enormous expense.” This practice is also called raising money by circulation. With this technique, all bills are paid, but with another bill of a larger amount. So, even if bills are paid, they are not actually paid: they are fictitiously paid. This kind of overtrading is often done without the banks’ knowledge, or consent, or even suspicion. If one draws and redraws from the same bank, the banker will know and will prevent it. But if this is done with different banks, it is difficult to know where the money comes from. By the time the banker eventually discovers it, it will generally be too late. Refusing to discount further has the very concrete risk of making all parties involved bankrupt. So the vicious circle will continue. Until something breaks.

Without ever naming it, Smith tells us that a “new bank” is created to relive the distress of some of the Scottish banks. Unfortunately, its execution was “imprudent.” “This bank” discounts all bills indiscriminately, real and fictitious ones: a problem. Of course it over-issues and its bills return immediately to be redeemed for gold and silver. But the coffers are not well filled: another problem. The proprietors of the bank open their own cash accounts, which the directors think they cannot refuse: yet another problem. They lend to improve land, which means that the returns are too slow for the bank to be profitable. “This bank” loses 3% on more than ¾ of its dealing: a big problem. So big that the bank does not last two years. It lasts so long because of unlimited liability: the immense estates of the proprietors of the bank is the pledge used to continue doing business. But rather than solving the problem, it made it worse because it extended the activities for an additional two years. Smith brings back the pond metaphor: water goes out but not in. The attempts to keep the level constant is to get water from a distant well by carrying it in buckets. What Smith does not tell us is that the failure of “this bank” is the most catastrophic one in Scottish history. And yet, all the creditors will be paid with the sale of the estates of the bank’s backers: the largest land redistribution in Scotland (about a third of the land of Scotland changed hands). This nameless bank does have a name: it is the so called Ayr Bank. One of the proprietors is the Duke of Buccelauch, the pupil for whom Smith quits his job at Glasgow to become his private tutor and eventually lifetime friend, who pays Smith a hefty pension for the rest of his life.

Smith describes two additional kinds of bank: a land bank, and the Bank of England.

A country can issue paper in proportion to the value of the land, creating a so-called land bank. A Scot, of all people, came up with this idea. His name was John Law. Scotland did not consider his model. So Law went to France, which adopted the idea. The result was the Mississippi Scheme: “the most extravagant project… the world ever saw” and also the biggest financial bubble at the time. For Smith, a bank that lends to “chimerical projectors” and “extravagant undertakings” cannot benefit a country. It will transfer capital from prudent and profitable to imprudent and unprofitable activities. Something to keep in mind when Smith talks about usury laws.

The Bank of England was incorporated in 1694 to lend to the government, which at the time must not have had good credit given that it was borrowing at a higher rate than usual. The capital stock of the Bank was less than its loan until it bought the South Sea Company, a trading company which was the cause of another big financial bubble. Now the stability of the Bank of England is basically the same as the stability of the British government. The Bank is not an ordinary bank, but acts as an engine of the state: it pays annuities to the public, it circulates exchequers bills, it advances land and malt taxes to the government. And of course, it over-issues.

So there are risks and costs associated with banking, mostly associated with ignorance, which can be overcome. There are benefits too. If banking learns to be judicious, which Smith believes it does, benefits are significantly larger than expected costs. The judicious operations of banking increase the industry of a country. Banking, if judicious, does not increase the capital of a country though. It renders a greater part of it active, which otherwise wouldn’t be. It converts dead stock into an active and productive stock.

Money goes from being a wheel of circulation to being a like a highway: the land used as highway is used to bring produce to market but does not produce anything. Paper money is like a wagon-way in the air, a suspended highway: it lets us convert old highways into pastures. But like Daedalus who flies in the sky with his wings but ends up dead by flying too close to the sun, the “Daedalian wings of paper money” are never as safe as the solid ground of gold and silver. Indeed, if there is an unsuccessful war, if the enemy gets the treasury or the capital which supports banking and paper money, there is much more confusion than otherwise. What are the chances that a capital, say London, is conquered by a foreign army, one may ask…

According to Smith the judicious operation of banking alone may not be enough to assure security. He proposes two banking regulations — a ban on small denomination notes and the abolition of the optional clause, — to insure safety and justice.

The circulation of paper money takes place between dealers and dealers, and between dealers and consumers. A dealer to dealer exchange usually implies exchanges of large sums, which require large denomination bills. A dealer to consumer exchange usually implies exchanges of small sums, requiring small denomination notes. If issuing of small notes is allowed, there will be a lot of bankers of dubious stability, because small change is easily accepted without checking it. But this implies that bankruptcy among these bankers will be frequent. This can be a calamity for the poor who received these notes as payment. It is therefore better not to have notes under 5 pounds.

An added benefit of restricting notes only between dealers, is that there will be more silver in circulation, like in London, as opposed to very little silver in circulation if there are notes also between dealers and consumers, like in Scotland or in the North American Colonies.

The ban on small denomination notes can be seen as a “manifest violation of natural liberty”. It is. But if the liberty of a few endangers the whole society, it makes sense to violate that liberty. Party walls, after all, are built to prevent fire to spread from house to house in cities and can be similarly considered violation of natural liberty. Yet they are accepted because of the greater good they produce. The same is true with small denomination notes: innocent poor may face catastrophic consequences. If this can be avoided, then it should be. It is too bad that Smith does not consider that the prohibition of small denomination note issuing may cause de facto a reduction in competition, raising barriers to entry in banking. The small notes are promissory notes used by suppliers and employers. They fill a vacuum in the market. Their elimination not only creates a shortage of means of payment but also, and most importantly, imposes in practice higher capital requirements for banks. This means that only fewer and larger banks could now enter the market. And, in combination with the abolition of the optional clause, the other banking regulation Smith favors as we’ll see in a moment, it increases what today we call balance-sheet risk and therefore the likelihood of bank failure.

The second regulation Smith favors is the ban on the optional or option clause. His logic is as follows. Paper money does not increase prices, as long as it is fully convertible on demand. When Hume published his Discourses, in 1751-52, prices of provisions were high because of bad weather, not because of an increase in paper money. Hume was fooled and mistaken. Smith’s criticism of Hume’s understanding of money and banking is now explicit. Back to the option clause. For Smith, if paper is not immediately convertible, the value of paper money would fall below the price of gold and silver because of the uncertainty of its conversion. The optional clause, the option to convert paper into metal at a later time, and paying interest for the time in which it is not converted, as opposed to pay on demand, should therefore not be allowed.

Recent studies indicate that Smith here again may not notice the unintended consequences of this policy. The optional clause, which allows banks to temporarily suspend convertibility of their notes, is in practice not used, but it does serve as a deterrent against raids by rival banks. Domestically it functions as a deterrence against over-issuing, as opposed as a means to over-issue. It is instead used, very selectively, as a private form of capital control. In addition, without the optional clause, solvent but illiquid banks, are now forced to temporarily close their doors when faced with overwhelming demand for specie. But closing their doors implies indiscriminate suspension of all payments and uncertainty regarding their reopening. The increased uncertainty prevents notes from being acceptable as payment and increases redemption demands, encouraging bank runs and instability. The opposite of what Smith hopes to see.

The final form of paper money Smith considers is the paper currency of North America, which is actually government paper and not bank notes. It is something to avoid. It is made legal tender and it carries no interest. So a 15 year note at zero interest when the interest is at 6% forces a creditor to accept only 40 pounds of ready money for a debt of 100 pounds. This is a “violent injustice” “never attempted by governments of any other country which pretend to be free”. It is a scheme of fraudulent debtors to cheat their creditors.

The chapter ends with the juice of its content. If small denomination notes are banned, and if there is immediate and unconditional payment of the notes, if there is genuine competition, that is, then the multiplication of banking will increase security rather than decrease it. Competition will force banks not to over-issue to avoid bank runs. And by dividing circulation in greater number of parts, by having several banks of issue, the failure of one will have only local consequences not global ones. As for any branch of trade, the freer and more general the competition, the more benefits for the public. Competition remains the answer.

 

Book II, Chapter 3: of the accumulation of capital or of productive and unproductive labor

As we saw, “stock” is either fixed capital, circulating capital, or stock for immediate consumption. Capital is the productive part of it. How do we increase it so we can be more productive? Smith’s answer is as easy as it is alien to a modern reader: put capital in productive hands rather than unproductive hands. This turns out to be an odd distinction and it makes this chapter one of the most problematic of the Wealth of Nations. Smith uses a distinction made by the French economists, the Physiocrats, (and he was unjustly accused of some form of plagiarism for it), but he changed the meaning of “productive” and “unproductive” so that he could criticize the French Physiocrats. Some earlier editors of the Wealth of Nations saw this, but many other commentators took this an endorsement of the Physiocrats and fueled confusion.

Yet again, Smith starts from labor. Here he claims that all labor is valuable and needs compensation. But some labor produces something that adds value, something that stores up labor for future use: that is, some labor produces something that reproduces itself. Some labor, instead, despite being valuable, does not increase value, it does not reproduce itself. It produces something that perishes the moment it comes into existence. Smith calls he labor that reproduces itself “productive labor”, and the one that perishes the moment of performance “unproductive labor”. One grows rich by hiring productive labor; one grows poor hiring unproductive labor.

We need to be careful in understanding Smith’s words. He does not use “unproductive” as a derogatory term; it is not a moral description of something useless or wasteful. Unproductive here simply means that it does not reproduce its own value.

Unproductive labor can thus be honorable, necessary, as well as frivolous. It is always valuable. The sovereign, the officers of justice and of war, churchmen, lawyers, physicians, men of letters, buffoons, musicians, opera singers and dancers, are all unproductive laborers. They are servants of the public; they are maintained by the industry of other people. The product of their labor this year will not give more product next year.

Smith may have borrowed the terminology from the French economist Quesnay, whom he met in France during the grand tour of Europe Smith did with the Duke of Buccleuch. But while Quesnay claims that only agriculture is productive and manufacture is unproductive, Smith twists the roles and show that manufacture is not only productive, but even more productive than agriculture, because of the different behaviors of landlords and manufacturers. Here is how.

The produce of the land supports all labor. That produce is not infinite, thus the more unproductive labor there is, the less productive labor we can maintain. And if we maintain less productive labor, produce itself will have to decrease. The proportion of productive and unproductive hands depends on how much the produce of land and productive labor is destined to replace capital, and that proportion varies from rich to poor countries, as Smith told us in his own introduction to this work.

Now, the produce of land creates enough revenue to replace used capital and also to create profits of stock or rent of land. The great landlord spends his profits and rent to feed more unproductive than productive hands. Also the produce of the great manufacturers replaces the used capital and creates a profit, which is the revenue of the owner of capital. The part of it that replaces capital goes to maintain productive hands, while the part of it that goes into profits or rent can maintain either productive or unproductive hands. If that stock is used on productive labor, it is considered capital. If it is used on unproductive labor is considered stock for immediate consumption. Also rich merchants maintain both productive and unproductive hands with their activities and their expenses. Finally, even common workmen maintain unproductive hands. They may go to a puppet show and surely pay taxes. Not just landlords, but all, landlords, manufacturers, merchants, and workers, they are all productive and support unproductive labor.

Today, Smith tells us, a large part of revenue goes to replace capital. In the past, that part was small because the amount of capital then was small. You can also think of it in these terms: rent increased in absolute terms, but it decreased as a share of the produce of the land. In rich countries, there is great capital in trade and manufacturing, while in ancient times, there was little trade, so there was little capital and thus large profits. How do we know? We can look at the interest rates.

In the past the interest rate was more than 10% while today is less than 6%, closer to 4% actually. As we saw in Book I, the interest rate is a good indicator of profit rates because one needs to generate enough profits to pay interest. This also means that the part of the revenue derived from profits is always larger in rich than poor countries. Why? Think of a cake. A large slice of a small cake may be smaller than a small slice of a large cake. Here it is the same. The stock is larger, even if in proportion to the stock, profits are smaller. So, the part of the annual produce coming from the ground and from productive labor destined to replace capital is larger in rich countries and it is a larger proportion to profits and rent, just like the fund for the maintenance of productive labor is not just greater, but it has a greater proportion to that used to maintain unproductive labor.

An implication of this larger pie? We are more industrious than in the past, because the funds for industry are proportionally more today than in the past. Our ancestors were idle not because they were lazy, but because they had too little capital to work with: “it is better play for nothing than work for nothing”, Smith cites the proverb. We can see this also today if we compare manufacturing towns with court cities. People in manufacturing towns are more industrious, sober, and thriving. In court cities, people are more idle, dissolute, and poor. The only exceptions, according to Smith, may be London, Lisbon, and Copenhagen, but that maybe because they are both trading and court cities. Edinburgh was idler before the union than now, even if it is still less industrious than Glasgow because it still has the court of justice of Scotland and the boards of customs and excise (where Smith eventually would work). Thus, the proportion between capital and revenue regulates the proportion between industry and idleness. The more capital, the more industry. The more revenue, the more idleness.

So, how does capital increase?

Smith answers categorically: capital increases thanks to parsimony and it decreases because of prodigality and misconduct. When someone saves, he can use the capital himself or lend it at interest letting someone else use it. It is therefore parsimony, and not industry, that increases capital. Industry gives us something to save. But we can have industry and no parsimony, and therefore no capital accumulation. Notice, again, that saving and investment are for Smith equivalent.

For Smith it is also true that saving and consumption are quite similar, in the sense that they are both spending, even if on different things. What is consumed is spent on idle guests or menial servants and once it is spent, it is gone. What is saved is employed as capital and is spent on laborers and manufacturers who reproduce with a profit the value of their consumption.

Now, are prodigals public enemies and frugal men public benefactors? The frugal man’s saving maintains additional productive men. We do not need laws to guarantee this productive use of resources: it is in the interest of their owner to invest his savings productively. On the other hand, the prodigal encroaches upon his capital. He is like someone who uses the revenue of a pious foundations to profane purposes, and example that Smith will use again to describe how the “High Church” (the Roman Catholic Church) loses power. The frugal needs to, and usually does, compensate for the prodigals or the country will get poorer. Smith’s choice of words is careful. The prodigal “appears” to be a public enemy. Is he? Maybe. But we are not sure.

For sure we know that the people who think that as long as the prodigal spends on domestic goods, gold and silver will remain in the country, and so all will be fine, are wrong. Money cannot stay at home when the value of the annual produce decreases, which will decrease because of the decrease in productive labor. If there are fewer ways to use money at home, money will go abroad. So the exportation of silver is the effect, not the cause, of the decrease in industry. Similarly, the quantity of money increases as the value of the annual produce increases, as it requires more money to circulate. So part of the increased produce goes to get gold and silver, which are needed to circulate the rest. Again, the increased quantity of money is the effect not the cause of public prosperity. Here again, Smith is very cautious of the problem of understanding causation, and that reverse causation is more common than not.

Misconduct is like prodigality, it diminishes the funds for the maintenance of productive labor, even if the project was undertaken by productive hands. This is because the project, in failing, cannot reproduce its value. This will become even more relevant in the next chapter, when Smith talks about usury laws. As for now, Smith is not too worried. The frugality of many generally compensates for the imprudence of few.

The explanation is grounded in a psychological description of human behavior that Smith takes (implicitly) from his Theory of Moral Sentiments. Profusion is a passion of present enjoyment, but it is a short-lived passion. On the other hand, saving comes from our desire to better our condition, which is, yes, a calm desire, but a desire that is always with us. We always want to better our condition and the means to do it is to increase our fortune, which is most likely done with saving. Frugality dominates, on average at least.

Similarly, successful undertakings are usually more frequent than unsuccessful ones. And the threat of bankruptcy, for Smith the greatest and most humiliating calamity an innocent men can experience, is a strong deterrence. True, though, deterrence does not work for everybody: some do get bankrupted, just like some get to the gallows.

Let’s go back to the prodigal. The prodigal may only appear to be a public enemy because in reality, private prodigality never impoverishes a nation. But sometimes public prodigality does. The majority of public revenue is used to support unproductive hands. Worse, great courts can multiply the unproductive hands they support to an unnecessary number. Even wars cannot compensate for the expense of the military, which, remember, is unproductive just like the king, the courts of justice, and the buffoons. Courts can consume so much that productive labor decreases and frugality cannot compensate for all caused “by this violent and forced encroachment”.

And yet, most of the time, individual frugality can compensate both individual and public prodigality. The desire of men to better their conditions is such a powerful force that it can maintain the natural progress toward improvement “in spite both of the extravagances of governments and of the greatest errors of administrations”, just like we are able to restore the health “in spite not only of the disease, but of the absurd prescriptions of the doctor.”

Not all prodigals are the same, though. There are two different kinds of prodigality. One is the expenditure on immediate consumption, such as banquets; the other is the expenditure on durables, such as clothes, or ornaments, or furniture. The magnificence of who spends on durables increases over time, since all add up and it becomes a stock of goods with value. The one of who spends on immediate consumption, such as banquets, disappears and leaves no trace of it in the future.

Another advantage of consumption on durable is that the durable goods can be resold. When a rich man stops using his house, his furniture, and his clothes, people from inferior ranks will buy them and use them. In addition, consumption on durables is somehow favorable to frugality. If one needs or wants to cut down expenses, nobody will notice. But if one spends on non-durables, such as on servants and banquets, one cannot cut his expenses without it being noticed, and it is more likely that he will go bankrupt trying to keep up appearances. Durable goods maintain more people and are more productive in this sense. Hospitality, the pinnacle of non-durable consumption, generates a lot of waste with its banquets, and is in this sense more unproductive. Hospitality, on the other hand, is an expenditure on other people, while durable consumption is an expenditure directly to the self, which unleashing our “selfish disposition”. Yet, the consumption of durables is more favorable to growth and public opulence. Here Smith is setting up Book III, where the transition between consumption on hospitality and on durable goods is at the base of the transition from an agricultural society to a commercial society.

Now let’s go back to capital accumulation. The annual produce increases only with the increase in the number of productive hands or with an increase in the productive power of labor. The increase in productive labor increases with an increase in capital; the increase in the productive power of labor increases with better machines or better division of labor. In either case, more capital is needed. That is to say, if the annual produce has increased, it must be that capital had increased.

And in most nations, despite imprudent governments, we do see that improvement, especially if we look over a long span of time. There are always people complaining that wealth actually decreases over time. That may be true in times of expensive and unnecessary wars, where there is a lot of waste and destruction. But when there is no such war and destruction, the annual produce does increase. The profusions of governments may retard it, but cannot stop it. Capital does increase over time, gradually and silently, because of individual’s frugality and our universal and uninterrupted efforts to better our conditions, especially if those efforts are protected by laws and allowed by liberty. For the third time in eight paragraphs, Smith tells us that our universal and constant desire to better our condition is the driving engine of prosperity, despite wars, fires, plagues, and prodigality.

Governments can protect our efforts to better our condition by law, but can at the same time be prodigal, impertinent, and presumptuous enough to want to restrain the expense of private people with sumptuary laws or with limits on the importation of luxury goods. For Smith, this is hypocritical. For Smith, governments are always and without exception the greatest spendthrifts in society. If their extravagance does not ruin the state, that of their subjects never will.

 

II.iv: Of Stock Lent at Interest

So we accumulated some stock. What if I do not want to use it myself? I can let someone else use it, by lending it at interest. For the lender, the stock lent at interest is therefore always capital. For the borrower, it can be either capital if it is used to reproduce its value, or stock for immediate consumption if it cannot restore itself or pay back the interest.

If one borrows to spend, he will soon be ruined. Lenders will soon regret their decision. Borrowing to spend is contrary to both parties’ interest and it does not happen frequently. It is therefore more common to lend for productive uses than for immediate consumption. Only the country gentleman borrows without expectation of repayment, but his situation is different because he borrows upon mortgage, meaning he borrows using his asset as collateral: he will be forced to sell it, should he not be able to pay. He bought so much on credit already that needs to borrow to repay. In a sense he is not borrowing to spend on immediate consumption, but to replace capital already spent.

Since capital is lent out and paid back in money, lenders are called monied interest. Monied interest is different from landed interest and the trading interest because these use their own capital. The lender instead gives their capital to others to use, giving others power to purchase.

But this does not imply that lending is a monetary phenomenon. What is borrowed and lent is capital. Indeed, the same money can be lent several times. This implies that the stock lent is the value of all the goods that can be bought with it, which is more than the money used to buy it.

Furthermore, we can see that even if loans are always made in money, be it paper or metal, the stock lent at interest is not regulated by money, but by the value of capital in another way: through the interest rate. A borrower does not want money per se, but the money’s worth. And the amount of capital demanded and available will depend on how much extra capital there is after replacing the existing one and how much extra capital an owner of it does not want to employ himself. The more capital, the more stock will be lent at interest. And as the quantity of stock lent increases, the interest decreases, that is, the price to use that stock decreases. Interest rate decreases also because as capital increases, profits decrease, since it is more difficult to find profitable ways to use capital. So interest rates decrease not because of an increase of gold and silver, as Locke and Montesquieu believe. For once, Hume got this right: the increase in gold and silver increase not the real value but the nominal value only.

Two more things about interest rates.

First, interest rates regulate the market price of land. If you have extra capital you can either buy land or lend at interest. Land is safer, so you would prefer land to lending at interest. But if rent is much less than interest, land will attract few buyers and the price of land will decrease. And, vice versa, if rent is significantly more than interest rate, then there are incentives to buy land and its price will increase.

Second, and quite controversially, in some countries interest is prohibited by law. But this does not prevent usury, which is the charging of high interest. It actually makes it worst. The debtor will pay for the use of money and for the risk that the creditor incurs: he will now have to pay also for the insurance against penalties the creditor may face.

For Smith, there should be usury laws, laws dictating the maximum rate one can change, but they should fix the interest rate a bit above the safest interest rate. If the law fixed the interest rate lower than the safest one, it is as if it was fixed at zero or close to it. If it is fixed much above it, prodigals and projectors will end up being the only ones willing to pay such high interest rates, as sober people would not borrow. In either case, capital would flee from those who could use it productively toward those who would waste it. If, on the other hand, the interest is fixed a bit above the minimum, the sober investors would get the capital because a sober investor is more attractive than a prodigal projector: the lender would get the same back, but one is a safer bet. And lenders prefer safer bets, all else equal.

Smith’s call for legal control of interest rate is a controversial aspect of his thought. From the beginning, he was harshly criticized for this proposal. Jeremy Bentham, with his “In Defense of Usury” is probably his most famous critic, suggesting that Smith would strangle entrepreneurs and innovators. New ideas are risky: they would not be able to be legally financed with a low legal interest rate.

 

II.v: Of Different Employment Of Capital

Recall that in Book II chapter iii, Smith distinguished between productive and unproductive labor, and that distinction was also used to differentiate between different types of stock. Capital is productive stock. Now Smith goes back to look at capital and its different productive uses. As he will more explicitly explain at the end of Book IV, agriculture is not the only productive sector of the economy. Contra the Physiocats, he will argue that trade and manufacturing are productive too. The use of capital in these activities is his evidence for this.

Here Smith tells us that capital can be used in four different ways: to support rude produce for consumption which means for the cultivation of land, to support manufacturing, to support transport of rude produce or transport of manufactures which means wholesale business, and to support dividing goods for occasional demand which means retailing business.

Each of these uses of capital is necessary for the other uses. If there is no rude produce, there cannot be manufacture and trade. If there is no manufacture, there cannot be produce since there is no demand for produce if there is no trade. If there is no transport, there cannot be production, and if there is no division, things will be too big to be bought.

Breaking and dividing goods, such as a butcher does, is therefore a valuable activity which benefits all, especially the poor. Restricting the number of retailers hurts the public; increasing it benefits the public because it increases competition and thus lowers prices. And the more retailers, the lower is the chance they can collude successfully. Occasionally a consumer may be deceived into buying something he does not need (allegedly a reason to want fewer retailers), but that is not going to go away with the decrease in number of retailers, just like the number of ale houses is not what causes drunkenness, but it is drunkenness that causes the presence of ale houses. The prejudice against shopkeepers and tradesmen are therefore without foundation.

Retailers have little capital. Wholesalers have more. Manufacturers even more. And Farmers have the most.

The farmer’s capital is the one that puts in motion the largest quantity of productive labor. In agriculture, in fact, man and nature work together. The rent charged by the landlord can be seen as the landlord lending nature’s work to the farmers. Agriculture is the most advantageous use of capital in society, states Smith.

What is interesting about the capital used in agriculture and in retail trade is that it is linked to a country and does not move from it. The capital of wholesale merchants, instead, does not have a fixed residence. It goes where it can buy cheap and sell high. The capital of manufacturer is rooted to where the manufacture is but where that is may be far from home.

Smith goes on, setting up parts of Book IV. When domestic capital is not sufficient to support agriculture, manufacture, transport, and retail trade, it means that a society is not opulent enough to support all these activities, and trying to do all of them prematurely will lead to failure. One should concentrate first on agriculture, then on manufacturing, and finally on trade. But historically it is difficult to find examples in which a country did agriculture, manufacturing, and trade all with its own capital. America saw fast growth because all its capital is in agriculture, it has no manufactures, and exports are done with British capital. If they had tried to do manufactures or exports with their own capital, their growth would be slower. China, Egypt, and Indostan were big in agriculture but had no foreign trade. That was done by foreigners.

Wholesale trade is of three kinds: domestic, international, and carrying trade, where the domestic capital transports goods from a different country to yet another country: for example, the Dutch carry the corn of Poland to Portugal. Usually all these are done by exchanging goods for gold and silver. It is easier to buy imports with gold and silver than with exports because of the lower costs (transport and insurance) of gold and silver compared to goods of equal value which would be bulkier and more difficult to carry.

Now, when the produce at home is more than the domestic demand, the surplus will find its way abroad. Without exports, productive labor would decrease as well as the value of the produce. Only with exports does the surplus get enough value to be worth producing. When foreign goods at home are more than the demand for them, their surplus will also go abroad. The carrying trade is therefore the natural effect of the great wealth of a nation, not the cause of it. In addition, the returns of foreign trade come more slowly than home trade. The returns on carrying trade are even slower because they depend on two separate foreigner trades.

We should not, therefore, encourage one branch of trade over others. It will inevitably happen on its own accord without constrains or violence. The consideration of his own profits is the sole motive that the owner of capital has when he uses it in agriculture, manufacture, or trade. How much productive labor he puts in motion never enters his thoughts. This idea will come back with a lot more power later on in the volume, in Book IV’s account of the invisible hand in particular. For now, we are just told that in the next book (Book III) there is an explanation for the circumstances which give trade in towns an advantage over the trade in the country.

 

 

 Further Readings ???

Paganelli, Maria Pia. 2016. "Adam Smith and the History of Economic Thought: The Case of Banking." In Adam Smith: A Princeton Guide., edited by Ryan Patrick Hanley, 247-261: Princeton University Press.

———. 2014. "David Hume on Banking and Hoarding." Southern Economic Journal 80 (4): 968-980.

 

Legislating instability

Hollander on usury laws