“It would be too ridiculous to go about seriously to prove that wealth does not consist in money, or in gold and silver; but in what money purchases, and is valuable only for purchasing.” (WN, IV.i.17)

In a letter Adam Smith wrote four years after the publication of his Wealth of Nations, the Scottish philosopher describes his magnum opus as “the very violent attack I had made upon the whole commercial system of Great Britain.” (Corr. No. 208, letter from Adam Smith to Andreas Holt dated 26 October 1780) This figurative “very violent attack” begins in earnest in Chapter 1 of Book IV of of The Wealth of Nations (available here), where Smith explodes the most dominant economic theory and policy of his time (and, alas, ours): mercantilism/protectionism (M/P). In summary, M/P is a nationalist economic policy that aims to maximize a nation’s wealth and power through the accumulation of bullion (gold and silver) and a positive balance of trade, i.e. by promoting exports and restricting imports. But as Smith shows, M/P is based on a ridiculous, fruitless, and absurd theory: that money and wealth are the same things.

In a word, Smith calls bullshit! Among other things, he draws a simple analogy, comparing the total amount of gold and silver in circulation at any given moment in time to the total amount of pots and pans and other utensils in kitchen cupboards: “Gold and silver, whether in the shape of coin or of plate, are utensils, it must be remembered, as much as the furniture of the kitchen.” (WN, IV.i.19) As a result, any government policy that would try to artificially increase the total amount of kitchen utensils in a country would be patently absurd (“ridiculous”) as well as counterproductive because the number of pots and pans in a country is a function of the demand for kitchen utensils:

“But it readily occurs that the number of such [kitchen] utensils is in every country necessarily limited by the use which there is for them; that it would be absurd to have more pots and pans than were necessary for cooking the victuals usually consumed there; **** that to attempt to increase the wealth of any country, either by introducing or by detaining in it an unnecessary quantity of gold and silver, is as absurd as it would be to attempt to increase the good cheer of private families by obliging them to keep an unnecessary number of kitchen utensils.” (WN, IV.i.19)

More fundamentally, Smith shows how gold and silver are commodities that are subject to market forces, just like any other article of commerce. Consider what happens, for example, when the demand for gold and silver exceeds the supply of such precious metals. When this happens, there are many ways that a free country — i.e. a country with free markets — is able to overcome this shortfall:

“If … gold and silver should at any time fall short in a country which has wherewithal to purchase them, there are more expedients for supplying their place than that of almost any other commodity. If the materials of manufacture are wanted, industry must stop. If provisions are wanted, the people must starve. But if money is wanted, barter will supply its place, though with a good deal of inconveniency. Buying and selling upon credit, and the different dealers compensating their credits with one another, once a month or once a year, will supply it with less inconveniency. A well-regulated paper money will supply it, not only without any inconveniency, but, in some cases, with some advantages. Upon every account, therefore, the attention of government never was so unnecessarily employed as when directed to watch over the preservation or increase of the quantity of money in any country.”

In other words, barter, credit transactions, and paper money will pick up the slack when the supply of gold and silver is too small relative to demand. Next, consider the more interesting situation when a country has too much gold and silver: “When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation.” (WN, IV.i.13) Why? Because when a country has an excess supply gold and silver relative to demand, the value of these precious metals will drop: it thus makes more sense for people with large amounts of gold and silver to export these precious metals abroad in exchange for consumable goods, and no amount of mercantilist government intervention will be able to stop this outbound flow of precious metals, since gold and silver are easy to smuggle across borders. (WN, IV.i.14)

In short, the total amount of gold and silver in a country is a function of supply and demand. But that said, what about national defense, which Smith describes as the “first duty” of government in Chapter 1 of Book V of The Wealth of Nations? Doesn’t the government need to maintain a positive balance of trade as well as a large amount of gold and silver reserves for national security reasons, i.e. to finance naval fleets and raise armies in the event of invasion or war? I revisit Smith’s original reply to this mercantilist point in my next post. (To be continued …)