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Book 2, Chapter 1
Themes
and Colors
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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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.
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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.
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