Adam Smith on the non inflationary effect of privately issued money.

Warning: this article (as the above title rather implies) is concerned with a somewhat technical point about the history of economic ideas – not something that is of interest to some people maybe. Anyway…

Seeking Alpha recently published an article of mine entitled “To enable private banks to create and lend out money, households must first be driven into debt.”

The basic argument was that assuming the state has issued enough base money to keep the economy working at capacity, then any attempt by private banks to add to that money supply will be inflationary, which means that in order to keep inflation under control, the state must impose some sort of deflationary measure like raising taxes and confiscating some of the private sector’s stock of base money. That in turn will drive a significant number of households and firms into debt: and potential debtor / borrowers is exactly what money lenders (i.e. private banks) want.  In short, private banks solve a problem which they themselves create!

Adam Smith actually considered this issue, but claimed the effect of introducing private money WOULD NOT be inflationary because all of the excess supply of money resulting from private money creation would be spent abroad. That’s in Ch2 Book2 of his “Wealth of Nations”. See the final paragraph below for Smith's actual words.

Adam Smith was certainly a great thinker, but the latter idea about excess quantities of money all being spent abroad is plain bizarre. Certainly A PROPORTION will be spent abroad: indeed, when the average household comes by a windfall, it basically just augments spending on the various items the average household spends money on ANYWAY. That includes housing, cars, restaurant meals, and yes, foreign holidays, imported cars and so on.

And I dare say the PROPORTION of consumer spending that goes on imports in the event of a windfall is HIGHER than the equivalent proportion in the absence of a windfall. But Smith’s idea that 100% of windfall money is devoted to imports or foreign investments is clearly wrong.


Interest.

Another error Smith makes is that he treats privately issued money as a direct substitute for base money (which consisted of gold in Smith’s day). Base money and privately issued money are very different animals.

Base money is a net asset as viewed by the private sector. In contrast, money issued by private banks is not: reason is that for every dollar of money issued by private banks there is a dollar of debt owed by bank customers to such banks. I.e. private banks, as I explain in my Seeking Alpha article, manage to muscle in on the money creation business only because they can lend at below the prevailing rate of interest. And they can do that because it costs them nothing to come by the home made money they lend out: that is, they do not need to earn or borrow it – they just print it.

Thus the addition to the money supply that private banks are responsible for will not be spent on consumer goods, as Smith implied (and indeed as I implied just above): the extra money will be invested. Indeed, a sizeable proportion of money borrowed from private banks goes to mortgages.


Adam Smith's actual words.

Let us suppose, for example, that the whole circulating money of some particular country amounted, at a particular time, to one million sterling, that sum being then sufficient for circulating the whole annual produce of their land and labour. Let us sup¬pose, too, that some time thereafter, different banks and bankers issued promissory notes, payable to the bearer, to the extent of one million, reserving in their different coffers two hundred thousand pounds for answering occasional demands. There would remain, therefore, in circulation, eight hundred thousand pounds in gold and silver, and a million of bank notes, or eighteen hundred thousand pounds of paper and money together. But the annual produce of the land and labour of the country had before required only one million to circulate and distribute it to its proper consumers, and that annual pro¬duce cannot be immediately augmented by those operations of banking. One million, therefore, will be sufficient to circulate it after them. The goods to be bought and sold being precisely the same as before, the same quantity of money will be sufficient for buying and selling them. The channel of circulation, if I may be allowed such an expression, will remain precisely the same as before. One million we have supposed sufficient to fill that channel. Whatever, therefore, is poured into it beyond this sum cannot run in it, but must overflow. One million eight hundred thousand pounds are poured into it. Eight hundred thousand pounds, therefore, must overflow, that sum being over and above what can be employed in the circulation of the country. But though this sum cannot be employed at home, it is too valuable to be allowed to lie idle. It will, therefore, be sent abroad, in order to seek that profitable employment which it cannot find at home. But the paper cannot go abroad; because at a distance from the banks which issue it, and from the country in which payment of it can be exacted by law, it will not be received in common payments. Gold and silver, therefore, to the amount of eight hundred thousand pounds will be sent abroad, and the channel of home circulation will remain filled with a million of paper, instead of the million of those metals which filled it before.