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Book 2, Chapter 1
Themes
Key
LitCharts assigns a color and icon to each theme in The Wealth of Nations, which you can use to track the themes throughout the work.
Labor, Markets, and Growth
Capital Accumulation and Investment
Institutions and Good Governance
Mercantilism and Free Trade
Money and Banking
Summary
Analysis
Just like the revenue of any particular enterprise, the revenue of society as a whole is divided into wages, rent, and profit. Any estate’s gross rent (what the farmer pays) is more than its neat rent (what the landlord retains after the cost of management and repairs, and which goes into the reserve for consumption or capital improvements). Similarly, a country’s gross revenue is everything its land and people produce, while its neat revenue, the amount its people can actually spend on consumption, is the gross revenue minus the expense of maintaining fixed capital and replacing circulating capital. Fixed capital is designed to make workers more productive, but keeping it in working condition requires diverting resources from elsewhere. In this sense, it’s like the repairs on a landlord’s estate.
The difference between gross and net figures is the cost of the capital that was necessary to do business in the first place. But the cost of wages and (net) rent does count as part of net revenue, because workers and landlords spend it on their own consumption. But a nation must grow its total pool of capital over time in order to become wealthy, and investment in fixed capital is one of the best ways to increase productivity. Thus,it is not necessarily a bad thing for net revenues to be significantly lower than gross. Over the course of centuries, this consistent investment and growth has enabled many countries to achieve the kind of “universal opulence” that Smith earlier identified as the end goal of all economic policy.
Themes
The expense of maintaining circulating capital—producing new provisions, raw materials, and unsold products to replace those that have been turned into fixed capital or the reserve for consumption—is different. The circulating capital that turned into fixed capital is not part of society’s neat revenue, but the circulating capital that went to consumption is.
The circulating capital that people consume includes food, energy, and provisions. The circulating capital that gets turned into fixed capital includes building materials and the gold and silver that gets minted into coinage. The ratio of circulating capital that becomes fixed capital investment to circulating capital that gets consumed helps determine a nation’s rate of economic growth.
Themes
The cost of maintaining the money supply (or the coins in circulation) is similar to the cost of maintaining fixed capital, as they both enable the rest of the economy to function. Thus, the cost of maintaining money is not part of neat revenue. It’s important not to miscalculate revenue by counting both the money people receive and the goods they buy with that money. After all, one coin can represent many people’s revenue as it circulates, and the value of all money in circulation in a country is always less than its annual revenue.
It’s useful to conceptualize the money supply as the infrastructure (or fixed capital) on which the rest of the economy runs. First, this helps us understand ways to improve the monetary system—like the banking reforms that Smith will propose shortly. And second, it helps us avoid the mercantilists’ error of confusing money with true wealth. As Smith points out here, the money supply is meant to circulate, not sit idle in wealthy people’s coffers.
Themes
Paper money is a better alternative to gold and silver coins, which are unduly costly to obtain. Banknotes are the best kind of paper money because people’s confidence in banks is as strong as their confidence in gold and silver markets. Banks can circulate much more in banknotes than they actually hold in gold and silver reserves. For instance, they can issue £100,000 in notes based on £20,000 of gold and silver reserves, freeing up £80,000 in assets that can be used to buy goods from abroad, whether to trade for profit or to bring back to the home country for consumption.
Given how the global economy functioned in Smith’s time, his argument in favor of paper money is radically forward-thinking. He doesn’t quite advocate for abandoning the gold standard, but he does suggest that banks can accelerate investment throughout the economy by leveraging their deposits. Paper money is essentially a gold-backed loan, so by issuing more currency than they actually hold in gold, banks can increase the total amount of money in circulation—while saving the exorbitant cost of mining, transporting, and minting coins out of gold and silver.
Themes
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This consumption can take the form of luxury goods, which is harmful for society because it’s simply an expense that produces no revenue. But it can also take the form of “materials, tools, and provisions” of manufacture, which does add to society’s revenue. This is the wiser decision, and the one that most of society will generally make. Thus, just like a factory can scale up production with new machines, a country can scale up its industrial sector by replacing gold and silver coins with paper money.
It’s undesirable to spend money importing luxury goods, because they simply get consumed, without producing any long-term economic benefit for the nation. In contrast, by investing the extra resources freed up through paper money in circulating capital, nations can expand their productive capacity. Indeed, whenever they have extra disposable income, people and nations face this same dilemma—spending on consumption or investing in capital. The choice they tend to make plays a crucial part in determining whether they grow or stagnate over time.
Themes
This approach has dramatically increased the scale of trade and wealth in Scotland, even as banks have taken almost half of the country’s gold and silver out of circulation. Banks typically create banknotes by discounting, or issuing people credit in exchange for a later repayment with interest. But Scottish banks created a different system: they offer cash accounts for anyone who can get “two persons of undoubted credit and good landed estate” to sign for them, then let clients pay back the money at their convenience, only charging them interest depending on how long it takes them to pay. This more flexible system has become dominant in Scotland, as it enables merchants to employ more people, trade more goods, and earn greater profits.
Like a modern credit card, Scotland’s cash account system allowed people to borrow up to an established limit and then pay off whatever they could afford, whenever they could afford it. This flexibility enabled merchants to withstand the inevitable fluctuations in their revenue. It also saved them the extraordinary hassle of shipping gold and silver back and forth around the world. The cash accounts show how different financial systems can create very different incentives and opportunities for people in different nations. Indeed, readers should think of financial innovations as productivity improvements like any other: just as new machines can make a factory more efficient, new financial tools can make a nation’s currency, trade, and investment more efficient by expanding its access to capital.
Themes
The amount of paper money in circulation cannot exceed the minimum amount of gold and silver that would need to circulate to complete all of a country’s transactions. This is because any excess paper would just sit around unused, so its owners would return to the bank to exchange it for gold and silver, which they would send abroad. As banks must cover the cost of accumulating and replenishing large stocks of gold and silver money, a bank that issues too much paper money will run up significant extra costs, without meaningfully increasing its profits.
This counterfactual might seem complex and irrelevant, but it’s actually crucial to turning Smith’s theory of paper money into policy. The principle behind it is that only a small portion of society’s wealth actually needs to circulate in the form of money. If people have more gold and silver coins than they need for all their transactions, they can either leave those coins unused, or spend them so that they no longer have excess money. If this gets replaced with paper, the same principle still applies. In fact, Smith is suggesting that gold and silver currency aren’t necessary at all—bullion can sit in the bank, while paper circulates. Of course, this is exactly how the global money supply worked until the U.S. dropped the gold standard in the late 20th century, largely because banks chose to follow Smith’s lead.
Themes
For instance, the Bank of England frequently spent nearly a million pounds a year buying gold to mint coins to service the excess paper it issued. Scotland’s banks had to pay London agents a fortune to obtain and transport gold for the same purpose. Customers would withdraw their money in gold coin, then immediately melt down the heaviest coins into bullion and either send it abroad or sell it back to the bank at a higher price. This accelerated coin debasing over time, leading banks to lose more and more money.
This wasteful cycle of melting and debasing proves Smith’s point that there’s a natural limit to the amount of paper money that can circulate. The excess just gets turned back into gold, creating unnecessary work for the bank and hastening inflation. This example shows why banks ought to identify the proper amount of paper money, rather than just printing it indefinitely.
Themes
The banks’ original error was to lend merchants more than the amount their operations required them to hold in cash. Banknote issuance cannot cross this threshold as long as the notes are tied to real-world debts, but cash accounts can, as some merchants will withdraw more than they repay. But Scotland’s banks remedied this problem by only issuing cash accounts to serious, reliable customers who pay their bills. This helped them keep an eye on their debtors and ensure they didn’t issue more paper than they should. Yet banks should never lend merchants all or most of the capital they need to operate, as this will never produce adequate returns in the moderate term. Lending merchants their fixed capital would produce even slower returns for banks. If merchants want long-term credit, they should seek bonds or mortgages instead.
Again, it’s crucial to distinguish between a business’s total expenses and its cashflow rate, because misallocating credit can be costly and counterproductive. Just like giving a child a credit card with a $1,000,000 limit, giving business too much credit is wasteful at best and financially ruinous at worst. A responsible merchant will simply never use the excess credit, but the bank still has to back this credit with money, which means there’s an opportunity cost to issuing it. And unscrupulous merchants could easily use excess credit for the wrong ends, like to expand prematurely, cover up losses, or buy luxuries for personal consumption. This is why Smith believes that banks should only issue paper money and cash accounts for businesses to cover day-to-day operating expenses. Unlike bonds and mortgages, this credit is not linked to a particular timeline—people can pay it back whenever they want, which means the bank will earn more money (and do more to boost the economy) the faster its credit gets repaid.
Themes
Scotland’s economy has had the right amount of paper money circulating for 25 years, so there is no need for bankers to issue more. But merchants got used to having access to credit. To compensate, they started “drawing and re-drawing” their bills, or repeatedly lending bills back and forth to cover their debts to banks. In the process, they incurred very high interest rates, risked bankruptcy, and increased the supply of paper money past its natural limit. When they realized what was happening, bankers started withdrawing their credit. The merchants were dissatisfied, but the bankers actually saved the British economy.
The Scottish merchants’ behavior suggests that businesses will rationally use the maximum amount of credit they can access, since the more credit they have, the faster they can scale their business—even if in financially unsound ways. The “drawing and re-drawing” was a warning sign that they couldn’t pay their bills. This example again shows that, even if credit is a wondrous tool for expanding economic activity, too much of it can be counterproductive or even catastrophic. This danger persists today—in fact, excess credit caused the 2008 global financial crisis. As Smith emphasizes, given the risks associated with issuing credit, the economy cannot function smoothly unless banks are managed effectively.
Themes
A new bank, Ayr Bank, opened to try and satisfy the merchants’ demand for credit, but it issued too much debt, started losing far too much money, and shut down in two years. Ayr Bank left merchants even more indebted than they were before, but it helped save the rest of Scotland’s banks by taking on their insolvent customers. Ayr Bank considered raising money on all the property its borrowers pledged as collateral, but this would have been too slow, and it wouldn’t have solved the core problem: the oversupply of paper money relative to the country’s circulation levels. Furthermore, if this bank had succeeded, it only would have propped up unscrupulous borrowers who wasted its money on imprudent business ventures. It is simply impossible to keep creating more paper money indefinitely, beyond what a society’s economic fundamentals can support.
Ayr Bank’s failure was a blessing in disguise: by bringing together all the most irresponsible debtors, it ensured that only one bank had to collapse, instead of the entire Scottish banking sector. Clearly, Smith’s long digression on the oversupply of paper money in England and Scotland is designed to warn his contemporaries not to repeat their mistakes (and put the whole British economy in jeopardy). If easy credit encourages risky investments and business ventures, then limiting the amount of paper money in circulation forces people to stick to prudent ones that can succeed in their society’s real economic situation.
Themes
Parliament created the Bank of England to lend to the government in 1694, and it has grown steadily since, loaning money, enlarging its capital stock by selling shares, and paying dividends to its shareholders. It is “a great engine of state” because it pays the government’s bills and supports the country’s industries. Indeed, banking in general grows a country’s economy by putting unproductive capital to use—including the gold and silver in its money.
The Bank of England reflects another crucial development in the history of finance: it shows how nations can take greater control of their economic futures by marrying state power with centralized financial planning. Today, virtually every country has a central bank, which ensures that the government never runs out of money. In fact, since the end of the gold standard in the 20th century, such central banks now control the global monetary supply.
Themes
Paper money also creates risks—for instance, an invading army capturing the nation’s treasury would be more devastating. Sometimes, as in London, paper money is only used in high denominations among wholesale dealers. But elsewhere, like in Scotland and North America, it’s also available in small denominations and retailers use it to do business with consumers. These low denominations mean that all sorts of people become bankers—and many of them go bankrupt, harming the poor people who were using their banknotes. It’s better to limit banknotes to higher values, which ensures that gold and silver continue to circulate, while still enabling merchants to trade without having to keep substantial gold and silver on hand. This restriction on low-value banknotes might violate some people’s liberty, but it’s necessary for society to function in general.
Once again, Smith emphasizes that the banking sector needs proper regulation in order to function properly: its financial tools are simply too powerful to be placed in untrained hands. His argument that such regulations are necessary despite infringing on human freedom shows how he’s developing a liberal system of values similar to the one that prevails in Western democracies today: he thinks the government should preserve people’s liberties, so long as they don’t infringe on others’. Of course, the question of what counts as infringement is central to all subsequent political theory. Over the course of human history, banks consolidated and central banks started issuing notes on behalf of their national governments, so the issues that Smith identifies with smalltime bankers tended to resolve themselves.
Themes
Paper money does not affect the price level if it’s payable on demand, as it’s merely replacing gold and silver at the same value. But if there are conditions on its repayment, then the paper is less valuable than gold and silver, and it can affect the price level, as happened with paper emitted by many of the North American colonies. Still, requirements that taxes be paid in that paper gave them a particular value. Some Amsterdam bankers even made the money they issue more valuable than its denomination by restricting its supply. And even when paper currency depreciates, this doesn’t affect the value of goods in terms of gold and silver. In conclusion, the banking industry should be allowed to grow, and only two restrictions should be placed on it: there should be no small banknotes, and banks should be required to pay back all notes on demand.
Smith concludes with a specific and well-reasoned plan for banking regulation. Much like gold and silver coinage, the real value of banknotes can deviate from their nominal value based on market conditions. However, Smith argues that these deviations are less likely to damage the economy than those in gold and silver. Notes are payable on demand if the holder can take them to the bank at any time and exchange them for coinage; all modern paper money is originally based on this principle, even if it can no longer be exchanged for gold or silver. Conditions on repayment mean that the bills aren't truly liquid—they can’t be used to pay for any transaction, anytime. Just as seigniorage raises the value of coins, the cost of actually redeeming banknotes with conditions gets subtracted from their face value.
Themes
