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TWoN Book 2 Chapter 2 Part 4

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On page 244, Smith reiterates what he said before about not counting money when reckoning wealth.  This–both his reasoning and my problems with it–are covered in my earlier posts, so there’s no point my restating them.

On page 245 he talks about the substitution of paper for gold and silver, and from there discusses the proportion of money (gold, silver, and paper) that is in circulation at any given time to the total value of the produce of a nation.  He speaks in particular of the money destined for maintainance of industry.  What is interesting here is that he seems to be implying that money is often the limiting factor in production, on a national level, whereas earlier I thought he was saying that labor was the limiting factor.  I think I’m just confused here.

NB: Page 247: The phrase “discounting bills of exchange,” which is used a lot, means “advancing money upon them before they are due.”  Now, if I just knew what “bills of exchange” were, I think I’d have it.

On page 249 he gives an example, referring to “cash accounts” as practiced at the time in Edinburgh–basically automatic short-term loans, presumably for relatively small amounts.  He talks of how merchants without access to this cash account must keep funds on hand to pay bills as they become due.  Suppose the amount this merchant must keep in hand for lack of this account is five hundred pounds.  Then, “His annual profits must be less by all that he could have made by the sale of five hundred pounds worth more goods; and the number of people employed in preparing his goods for the market, must be less by all those that five hundred pounds more stock could have employed.”  Well yes, except that he is ignoring the interest the merchant must pay on that cash account as he uses it.  He is assuming that the interest he pays must be less than what 500 pounds invested in his business would bring in; I’m not sure that is always the case.

Further down.  “The whole paper money of every kind which can easily circulate in any country never can exceed the value of the gold and silver, of which it supplies the place, or which (the commerce being supposed the same) would circulate there, if there was no paper money.”  Here he is warning against putting into circulation more paper within a country than the amount of gold and silver that would circulate there.  This says nothing about circulation (of gold and silver) outside of the country, which, added to the paper circulating within, will be a significantly greater total than the amount of gold and silver.  His objection, then, is to excess currency within a country; not to producing currency in excess of that which is backed by precious metal.

On page 250 he mentions two expenses unique to bankers.  “First, in the expence of keeping at all times in its coffers, for answering the occasional demands of the holders of its notes, a large sum of money, of which it loses the interest; And, secondly, in the expence of replenishing those coffers as fast as they are emptied by answering such occasional demands.”  I’m having trouble seeing how those two things aren’t just two ways of saying the same thing.  Moreover, it seems that, in some sense, every business must have money on hand to meet occasional expenses, barring access to a “cash account” as discussed above (in which case, there is the replacement cost of the interest on the cash account).

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Author: corwin

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  1. “The whole paper money of every kind which can easily circulate in any country never can exceed the value of the gold and silver, of which it supplies the place, or which (the commerce being supposed the same) would circulate there, if there was no paper money.”

    I have no academic training in economics, but it seems to me that this sentence shows dated (and no longer valid) logic in attempting to analyze the meaning and value of currency.

    Money now represents the services and labor that are owed the bearer; it no longer represents the amount of precious metal that can be redeemed for the numerical value on the currency. We don’t really measure the wealth of a nation by the amount of agricultural produce it yields, either. The value of the produce is a function of the amount of labor that went into growing it and the demand for it on the market. I think fertile land counts for something, but only in terms of the labor that must be invested in it to produce a marketable good and the demand for the good.

  2. Lenny: I’m pretty sure that when Smith speaks of “produce” he is referring to anything that is produced (ie, any commodity), not merely agricultural produce.

  3. A “Bill of Exchange” is a negotiable instrument, where one party, the “drawer”, instructs the “drawee” to pay money to the “payee”. The most common example of this is a check, where the drawee is a bank, the drawer is the person with the checking account and the payee is whoever’s name is on the “pay to the order of” line. The payee is also able to transfer the right to receive the money to a fourth party by signing the Bill over.

    There are more complicated ways of using Bills of Exchange. For example, they were (and are) often written with a specific payment date (payable January 1, 1700) and place (payable at the City of London). They could also be written in foreign currency. With those two additional provisions, they come to resemble a currency forward contract, and can be used for international trade transactions, among other things.

    It is also possible to embed a discount (or interest rate) into the Bill, in which case it takes on aspects of a short term loan. Example: commercial paper.

    In the rest of the sections, he’s talking about liquidity constraints: the gold standard is one (which we no longer have, thankfully), inability to have trade credit (accounts payable/ accounts receivable) is another, and reserve requirements are a third.

    The banker’s two problems are, in fact, distinct but connected. One is that you’ve got to have a certain percentage of cash on hand for any of your demand depositors who come in the door, and two is that you’ve either got to have extra cash (so that you never fall below a minimum level) or you have to be able to either borrow more quickly or call in some loans (to make up the difference). In the 21st century US, we have both a reserve requirement and a system of interbank lending (the federal funds system) that allows banks to cover their reserve requirements on a daily basis, and further backed by the “discount facility” at the Fed itself.

  4. I should add that there’s a lengthy subplot in Neil Stephenson’s _The Confusion_ involving the movement of large quantities of cash using Bills of Exchange.

  5. Thank you, Scott!

  6. Re Smith’s p. 245 and money as a limiting factor in production. More money has the power to leverage more–and more motivated–labor, even to the extent of bringing it in from ever-greater distances. And did you notice that Smith is agreeing with you here about gold and silver coins having value as a commodity? He alluded to it earlier, when he talked about the paper-replaced coinage going to foreign trade, but that took a lot of extra thinking about exactly how coinage was valued between different countries (which he spells out a little more fully later on). Now he’s flat-out saying “the whole value of gold and silver which used to be employed in purchasing” materials, tools, and maintenance can be “added to the goods which are circulated and distributed” by means of the rebuilt-with-paper great wheel.

    Re bills of exchange. Scott’s right, of course; my sources say much the same thing. With an added note about how the ability to define a specific rate of exchange for foreign transactions (or even not-so-foreign, as between Smith’s oft-invoked London and Edinburgh) gave merchants a stay-out-of-hell-free card to play against the party-pooping hardline stance the Catholic church had taken on usury.

    Unfortunately, this entirely correct description will only get you in trouble when you try to sort out the check-kiting–uhh, bill-of-exchange-discounting scam that Smith describes up ahead. Whether he didn’t know BoE mechanics all that well himself or was just trying to keep the discussion simple (as if), he doesn’t assign the various parties to their correct roles.

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