Literature Study GuidesThe Wealth Of NationsVolume 1 Book 2 Chapter 2 Summary

The Wealth of Nations | Study Guide

Adam Smith

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The Wealth of Nations | Volume 1, Book 2, Chapter 2 : Of Money, Considered as a Particular Branch of the General Stock of the Society, or of the Expense of Maintaining the National Capital | Summary

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Summary

Smith begins by extending his discussion of wages, profit, and rent to society as a whole, arguing that the three categories account for "the whole value of the annual produce of the land and labor of every country." He further distinguishes between gross and "neat" (i.e., net) revenue, with real wealth depending on the latter. Money, he observes, occupies a special relationship to a country's net revenue. It is not a part of that revenue, but is more like a "great wheel" that allows commerce to keep moving within a society by distributing revenue to individuals. Like a machine, the money supply needs to be repaired from time to time—such as when coins become worn down and debased. The cost of minting new coins, however, must itself come out of a society's net revenue.

The remainder of the chapter consists of a long discourse on paper money, a form of currency Smith views in a generally favorable light. The first advantage Smith notes is the cheapness of replacing paper money, in contrast to the expense of topping up the gold and silver money supply with fresh bullion. When paper money is in widespread use, gold and silver coin can be sent abroad in foreign trade, while a small fraction remains at home to cover the occasional withdrawals from the banks. With the establishment of cash accounts (similar to modern lines of credit), merchants can put the entirety of their capital to work and pay the occasional bills on credit at their bank, then repay the bank as sales are made. There are, however, dangers and drawbacks to paper currency, as Smith is quick to note. One major problem is the possibility of a bank overextending itself financially, circulating a greater quantity of banknotes than "the country can easily absorb and employ." By a similar principle, paper money also allows individual merchants to overtrade, thus initiating a cycle of greater and greater indebtedness that ends in bankruptcy. Both problems, Smith suggests, can be mitigated by greater vigilance on the part of the banks.

Analysis

Paper money in Smith's Britain was not a novelty. Bills of exchange—written documents ordering one person to pay another at a specified time—were widespread in Europe as early as the 13th century. Banknotes—pieces of paper redeemable for metallic currency at a bank—were introduced somewhat later, starting in Sweden in 1661 and gradually spreading across the continent. Originally, these were handwritten notes, little more than simplified contracts signed by a bank official. By Smith's time, however, banks had switched to "part printed" notes, with blanks for the names of the payee and the cashier authorizing the note. Only in the 1850s did fully printed notes begin to circulate in England.

More importantly for the purposes of Smith's argument, government paper money was still a relatively recent development in 1776. The earliest territory in the British Empire to issue its own currency was the Massachusetts Bay Colony, which circulated paper banknotes in 1690. Prior to that time, the issue of banknotes throughout the empire had been left to the management of private banks, which sometimes tried to drive one another out of business by forcing their competitors to honor a large number of banknotes in a short time (a bank run). The Bank of England set up shop in 1694 with government funds, and the Bank of Scotland—a commercial institution, but one with several government-granted privileges—was established a year later. Smith, in this chapter and elsewhere, is unsurprisingly skeptical of these government-backed banks, since they seem to stifle competition among private institutions. Still, he acknowledges that private banks—with less capital and less chance of a government bailout—are widely viewed as unstable by comparison. The solution, he argues, is to allow more such banks to operate, with the increased competition forcing the private bank operators to be prudent and moderate in their lending.

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