Chapter 2c

Kinds of Paper Money

by Adam Smith Icon

Bank Notes

27 There are many kinds of paper money.

The circulating notes of banks are the best known and best adapted as paper money.

28 When people have such confidence in a banker, they believe that he is always ready to pay upon the presentation of his promissory notes.

Those notes become equal to gold and silver money from the confidence that money can be received for the notes at any time. promissory

29 A banker lends his own promissory notes worth £100,000 to his debtors.

Since these notes are as good as money, his debtors pay him interest. This interest is his gain.

Some of those notes continually come back to him from the debtor’s customers for redemption But some of them continue to circulate for months and years.

Though he has £100,000 of notes in circulation, £20,000 in gold and silver may be enough for answering occasional demands. £20,000 in gold and silver perform all the functions which £100,000 of gold and silver could have performed.

The same exchanges may be made. The same amount of goods worth £100,000 may be circulated through his promissory notes, as when it was circulated by solely by gold and silver money.

£80,000 of gold and silver can be spared from the country’s circulation.

If these operations were done by many banks, the whole circulation may be conducted with 20% of the gold and silver previously needed. 30 Let us suppose that a country’s whole circulating money was £1 million.

£1m was enough to circulate the whole national annual produce.

  • Different banks then issued promissory notes for £1m.
  • They reserved £200,000 in gold and silver for answering occasional demands.

There would remain in circulation=

  • £800,000 in gold and silver, and
  • £1m bank notes, or
  • £1.8m of combined paper and metal money.

But the annual produce the country only required £1m to circulate it to its proper consumers. That annual produce cannot be immediately increased by those operations of banking. £1m will be enough to circulate it.

Since the goods bought and sold are precisely the same, the same amount of money will be enough for buying and selling them. The channel of circulation will remain precisely the same as before.

£1m was enough to fill that channel. Whatever is poured in beyond this sum must overflow.

  • £1.8m are poured into it.38
  • £800,000 must overflow.

This is the excess of what can be employed in the country’s circulation. This sum cannot be employed at home, but it is too valuable to be left idle. Therefore, it will be sent abroad to seek profitable employment which it cannot find at home.

But the paper cannot go abroad because=

  • the issuing banks are too far away, and
  • it is not legal tender in foreign countries
  • £800,000 in gold and silver will be sent abroad.

The channel of home circulation will remain filled with 1 million of paper instead of the 1 million of metals which filled it before.

*Superphysics Note: Bretton Woods made the US paper currency acceptable in foreign countries, creating instability in the entire financial system

31 The gold and silver sent abroad will be exchanged for foreign goods for the home country or another foreign country.

32 If they use it to buy goods from one foreign country to sell to another, it is called the carrying trade.

The profit from this will add to their own country’s net revenue. It is like a new fund for a new trade.

Since paper already circulates all domestic business, the gold and silver can be converted to a fund to circulate this new trade.

33 If they employ it in buying foreign goods for home consumption, they may either=

  1. buy goods such as foreign wines, silks, etc., likely to be consumed by idle people who produce nothing, or
  2. buy more materials, tools, and provisions to maintain and employ a more industrious people, who reproduce the value of their consumption, with a profit.

34 The first method:

  • promotes prodigality,
  • increases expence and consumption without increasing production,
  • does not establish any permanent fund for supporting that expence, and
  • is hurtful to the society in every respect.

35 The second method:

  • promotes industry,
  • increases the society’s consumption,
  • provides a permanent fund for supporting that consumption because the people who consume can reproduce the value that they consumed, with a profit,
  • increases the society’s gross revenue by increasing the whole value added by the labour to those materials,
  • increases their net revenue by deducting the cost of supporting the tools and instruments of their trade.

36 Most of the precious metals forced abroad by banking and used to buy foreign goods for home consumption is used to buy this second kind of goods.

Some people might increase their cost very much without increasing their revenue.

However, no entire class ever does so because most people are prudent. But the revenue of idle people cannot be increased by banking. Only the expense of a few among them may be increased by banking. A very small part of the money forced abroad will be used to buy foreign goods to be consumed by idle people because the demand of the idle will not change much. Most of the money will be used in industry and not in maintaining idleness.


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