The Wealth of Nations: Book 4, Chapter 3 Summary & Analysis

“Part I: Of the Unreasonableness of those Restraints even upon the Principles of the Commercial System.” The mercantile system wrongly encourages nations to restrict imports from countries with which they have a negative balance of trade. For instance, Britain puts extraordinarily high duties on imports from France, which has done the same to Britain. As a result, there is almost no legal trade between the two countries—but lots of smuggling.

There are three issues with this policy. First, it mistakenly sees an unfavorable balance of trade with one country as unfavorable overall. But in reality, by importing certain goods from France, Britain would avoid importing more expensive goods from other countries—and thus reduce its overall imports. Second, this policy overlooks re-exportation. Many of the goods Britain imports from other countries get re-exported at a profit, and so bring in more gold and silver than were sent away to purchase them.

Third, it’s impossible to precisely measure the balance of trade. Customs records are based on inaccurate valuations, and even if England pays more bills to another country than that country pays to England, this may be due to commerce originating in a third country. For instance, England pays Holland great sums for goods originating in Eastern Europe. And these exchange calculations aren’t even accurate to begin with, as money is often worth far more or less than its nominal value in different countries. Coin debasing reduces its value, while seigniorage raises it. In some countries, debts are payable in bank money, which is worth more than coin.

“Digression concerning Banks of Deposit, particularly concerning that of Amsterdam.” Large countries only need to use their own currencies for trade, but smaller ones often have to use foreign currencies, which are subject to coin debasing. To protect themselves, small-country merchants often demand payment in bank money, which is worth more than local coin. (This premium is called an agio.) For instance, all the degraded foreign currency sent to Amsterdam reduced the value of Dutch currency by nine percent. In response, the Bank of Amsterdam was established in 1609. It bought any currency, national or foreign, and issued credit (called bank money) for its real value. Soon, all large bills had to be paid in bank money—which was more secure because it couldn’t be debased, stolen, or destroyed. Accordingly, bank money bore an agio, so nobody would withdraw their money from the bank unless absolutely necessary.

The Bank of Amsterdam also took gold and silver bullion deposits in exchange for 95% of their value in bank money, plus a bullion receipt. This receipt could be sold to cover the 5% bank agio, but it also allowed its holder to withdraw bullion by paying its value in bank money, plus a small warehousing fee every six months (0.25% for silver and 0.5% for gold). It became advantageous to deposit bullion when the market price was low and withdraw it when the market price was high. Coin deposit receipts were also available, but generally worthless, so depositors often let them expire without paying the warehousing fee.

During crises, people want to withdraw their bullion, so bank receipts become more expensive. But banks can also make emergency concessions if necessary, buying people’s receipts and allowing people to withdraw their bullion without receipts. In peacetime, bank agios fluctuate because receipt holders try to reduce it, while banks try to increase it. The Bank of Amsterdam solved this problem by permanently selling its bank money at a 5% agio and buying it at 4%. The Bank’s directors sign a yearly oath affirming that its reserves equal the credit it has issued in bank money, but nobody knows how much this really is. The Bank also makes a significant profit by charging fees for every transaction, even though it was originally created as a public service and not a private enterprise.

“Part II. Of the Unreasonableness of those extraordinary Restraints upon other Principles.” It’s absurd to view the balance of trade as a measure of whether trade is beneficial or harmful to society. If two countries have an even balance of trade and are only trading domestically-produced goods, they benefit equally. But if one country is trading in foreign-produced goods—including gold and silver—it will benefit less, since its revenue will go to replace capital employed abroad. Nevertheless, it still benefits: in terms of real value, its revenue will still be higher than if it didn’t trade.

Yet British trade policy is still based on harmful myths. Some argue that the alcohol trade hurts society, but it contributes to the national revenue just like any other business. (In fact, drunkenness is less of a problem in societies with cheaper alcohol.) Similarly, some amateur traders prefer to buy from the same countries that purchase their goods, even though experts know that it’s best to buy goods from whichever country produces them cheapest relative to their quality. Such myths have taught people to envy other nations’ wealth and view trade as a source of conflict instead of a “bond of union and friendship.”

Merchants spread these myths in the hopes of establishing monopolies, and they too often convince governments to do their bidding by banning or heavily taxing imports. In reality, just as building a fortune is easier in cities than the countryside, it’s easier for a nation to grow rich if it has wealthy neighbors and can trade with them. But instead, European countries try to impoverish their neighbors by outcompeting them for gold and silver. Britain and France would benefit immensely from eliminating their mutual trade restrictions, especially because they are neighbors, so trade between them would be far more efficient than trade with Asia or the Americas. In conclusion, an unfavorable balance of trade has never impoverished a country. Rather, the balance of production and consumption determines whether a country’s economy grows or shrinks.