Adam Smith’s Analysis of Money
Adam Smith may have had a number of great insights in The Wealth of Nations, but he fails to fully explain the process by which banks and investors make money when the currency is pegged to a precious metal. There are other failings in the first two books of the greater work- Smith lacked the foresight to realize that great nations could indeed be impoverished by private misconduct (p. 305) and that bankruptcy would not always be the worse fate a man could endure. These specific faults lie with the evolution of our economic system beyond what Smith had envisioned. The fault of explanation of interest and money lies with Smith (or this student).
The following is an analysis of the paper money argument in Chapter II of Book II, “Money A Branch of the General Stock”.
First off, Smith explains that in order for a banker to have the ability to issue promissory notes to the stock of precious metals he holds, the members of the community must have great trust in him and his “fortune, probity and prudence”. This is no longer the case, of course- on the one hand, banks are insured by the federal government and on the other, money itself is the providence today of the government. But we go along with Smith anyway to the next step of the analysis, that the notes of the bank are the same as hard currency, and all one has to do is to present them for payment to the banker. Thus we see the necessity of trust in the banker by community, otherwise his notes would be worthless and there would be little reason to purchase the notes from him in the first place.
The trust from the community to the banker is beneficial to both parties, though more so to the banker. The more the people of the community trust in him, the less likely they are to trade in their notes for hard currency and the more likely they are to circulate the notes around. And by charging interest on the notes he lends out, to be repaid once the labor of the supplicant has met the threshold of the loan plus interest, the banker makes his profit. “This interest is the source of his gain” (p.257). The notes he gives out circulate as currency within the market. Things become tricky.
The amount of notes in circulation are said to be in the amount of one hundred thousand pounds, but the banker has only twenty thousand on hand to answer the occasional demand (paraphrased from 257). So, as Smith says triumphantly, “by this operation, therefore , twenty thousand pounds in gold and silver perform all the functions which a hundred thousand [in circulation] could otherwise have performed”. (ibid.) But if there is one hundred thousand pounds, and all in circulation, where does the interest come from? Let us assume the one hundred pounds is the limit of the stock of gold and silver and let us further assume that the banker is the only banker around and owns all of it. Where does this profit come from when his notes are out in the amount of one hundred pounds? He cannot create more gold and silver out of thin air, so where does the profit come from?
The problem with the analysis of money in this section of The Wealth of Nations is that it comes from the assumption of a finite stock of money. Yet money’s entire worth and value is dependent upon the trust and belief in its value by the people. Thus, when the American currency was taken off of the gold standard by President Nixon in 1971, the actual value of the dollar was relatively unchanged. People’s belief in the value was the same (though this may have a bit to do with the lay-person’s willful ignorance of the subject), and those who had a stake in the fixed standards of currency watched as the entire global system unraveled around the American economy. With a finite stock of money, it is difficult to see how profit can be made.