Book II, Chapter II, 2

If this is clear enough for an individual, it is clearer still for a society. The amount of coin paid to an individual each year is often precisely equal to his revenue and is therefore the shortest and best way of expressing its value. But the amount of coin circulating in a society can never equal the revenue of all its members. The same guinea that pays one man’s weekly pension today may pay another’s tomorrow and a third man’s the following day. Thus the value of coin circulating in a country over a year must always be far less than the sum of the monetary payments made annually with it. The purchasing power exercised by these successive payments—or the goods successively bought with them—must, however, equal their value exactly, as must the revenue of their recipients. That revenue cannot, then, consist in the metal pieces, whose total value falls so far short of it, but in purchasing power: in the goods those pieces can buy as they pass from hand to hand.

Money, then, is the great wheel of circulation and the great instrument of commerce. Like other instruments of trade, it forms a valuable part of capital but no part of the revenue of the society to which it belongs. The coins that compose it distribute to everyone the revenue properly belonging to them as they circulate through the year, yet themselves form no part of that revenue.

Third and finally, the machines and instruments of trade composing fixed capital resemble the money portion of circulating capital in one further respect. Any saving in the cost of constructing and maintaining machines that does not reduce the productive powers of labor improves society’s net revenue; so does any saving in the cost of acquiring and maintaining the money portion of circulating capital.

It is fairly plain, and has already been partly explained, how any saving in the maintenance of fixed capital improves society’s net revenue. The capital of every entrepreneur is necessarily divided between fixed and circulating capital. If the total remains unchanged, the smaller one part is, the larger the other must be. Circulating capital supplies the materials and wages of labor and sets industry in motion. Therefore, every saving in the cost of maintaining fixed capital that does not diminish the productive powers of labor must enlarge the fund that sets industry in motion and, with it, the annual produce of land and labor—society’s real revenue.

Replacing gold and silver money with paper substitutes a far cheaper instrument of commerce, sometimes just as convenient, for a very expensive one. Circulation proceeds by means of a new wheel, less costly to construct and maintain than the old. But just how this substitution works, and how it tends to increase society’s gross or net revenue, is less obvious and calls for further explanation.

Paper money takes several forms. The circulating notes of banks and bankers are the best known and seem best suited to this purpose.

When the people of a country trust a banker’s wealth, honesty, and prudence enough to believe that he will always pay on demand the promissory notes likely to be presented to him, those notes circulate like gold and silver coin, because people trust they can exchange them for coin at any time.

Suppose a banker lends his own promissory notes to his customers to the amount of a hundred thousand pounds. Because the notes serve every purpose of money, the borrowers pay him the same interest as if he had lent them that amount in coin. This interest provides his profit. Some notes continually return to him for payment, but others remain in circulation for months or years. Although he normally has a hundred thousand pounds in notes outstanding, twenty thousand pounds in gold and silver may often be enough to meet occasional demands. Thus twenty thousand pounds in coin performs every function that would otherwise require a hundred thousand. His notes worth a hundred thousand pounds permit the same exchanges and circulate and distribute the same quantity of consumable goods to their proper consumers as an equal value of gold and silver. Eighty thousand pounds in precious metals can therefore be released from the country’s circulation. If many banks and bankers conduct similar operations at once, the entire circulation may be carried on with only a fifth of the gold and silver otherwise required.

Suppose, for example, that at a certain time all the circulating money of a country amounts to one million sterling, enough to circulate the entire annual produce of its land and labor. Suppose that later several banks issue bearer notes totaling one million, while holding two hundred thousand pounds in their vaults to meet occasional demands. Eight hundred thousand pounds in gold and silver would then remain in circulation alongside a million in banknotes: eighteen hundred thousand pounds in paper and coin together. Yet before these banking operations the annual produce needed only one million to circulate and distribute it to its proper consumers, and the banks cannot immediately enlarge that produce. One million will therefore suffice afterward. Precisely the same goods are bought and sold, and the same amount of money will suffice to buy and sell them. The channel of circulation, if I may use the expression, remains precisely as it was. One million was enough to fill it; whatever is poured in above that sum cannot enter the channel and must overflow. Eighteen hundred thousand pounds have now been poured in, so eight hundred thousand pounds must overflow: that sum exceeds what the country can employ in circulation. Though it cannot be employed at home, it is too valuable to lie idle and will be sent abroad to seek a profitable use. Paper, however, cannot be sent abroad: far from its issuing banks and the country where its payment can be enforced by law, it will not be accepted in ordinary transactions. Thus eight hundred thousand pounds in gold and silver will be sent abroad, while the domestic channel remains filled by a million in paper instead of the million in metal that previously filled it.

We should not imagine that this great quantity of gold and silver goes abroad for nothing, or that its owners give it away to foreign nations. They exchange it for foreign goods, either to supply another foreign country’s consumption or to supply their own.

If they use it to buy goods in one foreign country for consumers in another—the carrying trade—any profits they earn will add to their own country’s net revenue. It is as though a new fund were created for a new trade: paper now conducts domestic business, while gold and silver become the fund that conducts the new trade.

If instead they use it to purchase foreign goods for consumption at home, they may buy either, first, goods likely to be consumed by idle people who produce nothing, such as foreign wines and silks; or, second, an additional stock of materials, tools, and provisions to maintain and employ additional industrious people, who reproduce the value of what they consume in a year, together with a profit.

To the extent that it is spent in the first way, it encourages extravagance and increases expense and consumption without increasing production or establishing any permanent fund to support that expense. In every respect it harms society.

To the extent that it is spent in the second way, it encourages industry. Though society’s consumption rises, a permanent fund is established to support it, because those who consume reproduce the whole value of their annual consumption, with a profit. Society’s gross revenue—the annual produce of its land and labor—rises by the entire value the workers’ labor adds to the materials they work on. Its net revenue rises by the portion of that value remaining after the cost of maintaining their tools and instruments has been deducted.

It seems not merely likely but almost inevitable that most of the gold and silver driven abroad by these banking operations, insofar as it buys foreign goods for domestic consumption, buys goods of the second kind. Some individuals may sometimes greatly increase their spending without any increase in revenue. But we may be sure no whole class of people does so: ordinary prudence may not always govern every individual, but it always influences the majority within any class. Considered as a class, idle people do not gain the slightest increase in revenue from these banking operations. Their spending as a group, therefore, cannot greatly increase, though that of a few individuals may and sometimes does. With their demand for foreign goods unchanged or nearly so, little of the money driven abroad by banking and used to buy foreign goods for domestic consumption is likely to purchase goods for their use. Most will naturally support industry rather than idleness.

In calculating the amount of industry a society’s circulating capital can employ, we must consider only the portions consisting of provisions, materials, and finished goods. The remaining portion, money, serves merely to circulate those three and must be subtracted. Three things are needed to set industry in motion: materials to work on, tools to work with, and the wages or reward for which the work is performed. Money is neither material nor a tool. And although workers are commonly paid in money, their real revenue, like everyone else’s, consists not in the money but in what it is worth—not in the pieces of metal but in what they will buy.

The amount of industry a capital can employ must plainly correspond to the number of workers it can provide with materials, tools, and support appropriate to their work. Money may be needed to purchase both the materials and tools and the workers’ support. But the industry that the total capital can employ cannot equal both the purchasing money and the materials, tools, and support purchased with it. It equals only one of these two values, more properly the latter.

When paper replaces gold and silver money, the materials, tools, and support that the whole circulating capital can supply may increase by the entire value of the gold and silver formerly used to purchase them. The value of the great wheel of circulation and distribution is added to the goods that wheel circulates and distributes. This resembles, in some measure, the action of an entrepreneur who improves his machinery, takes down the old equipment, and adds the difference between its price and the new equipment’s price to his circulating capital—the fund from which he provides his workers with materials and wages.

It may be impossible to determine the ratio of a country’s circulating money to the total value of the annual produce it circulates. Different authors have estimated the money at a fifth, a tenth, a twentieth, and a thirtieth of that value. Yet however small a share of the whole annual produce the circulating money represents, only part of that produce—and often a small part—is ever assigned to maintaining industry. The money must therefore always be a very considerable share of the part assigned to industry. Consequently, if substituting paper reduces the gold and silver needed for circulation to perhaps a fifth of its former amount, adding the value of even most of the remaining four-fifths to the funds that maintain industry must considerably increase that industry and, in turn, the value of the annual produce of land and labor.

If this is clear for one person, it is even clearer for a whole society. The coins paid to a person in a year often equal that person’s revenue exactly. So stating their amount is the simplest and best way to state its value. But all the coins circulating in a society can never equal the revenue of all its members. The same guinea can pay one person’s weekly pension today, another’s tomorrow, and a third person’s the day after. The value of all the coins circulating during a year must therefore be much less than the value of all the money pensions paid with them during that year. Yet the buying power of those pensions, or the goods they can buy as they are paid out one after another, exactly equals their value. So does the revenue of the people receiving them. That revenue cannot consist of the coins, whose total value is so much lower. It consists of buying power, or the goods those coins can buy as they pass from hand to hand.

Money, then, is the great wheel of circulation and a major tool of commerce. Like any other tool, it is a valuable part of capital but not part of the revenue of the society that owns it. As its coins circulate each year, they distribute to each person the revenue that belongs to that person. But the coins themselves are not part of that revenue.

Third and finally, fixed capital’s machines and tools resemble circulating capital’s money in another way. Any reduction in the cost of setting up and maintaining machines that does not reduce labor’s productive power raises society’s net revenue. Likewise, any reduction in the cost of obtaining and maintaining the money part of circulating capital raises net revenue in exactly the same way.

It is fairly clear how saving on the maintenance of fixed capital raises society’s net revenue, and I have partly explained it already. The capital of anyone running a business must be divided between fixed and circulating capital. If total capital stays the same, a smaller share in one means a larger share in the other. Circulating capital supplies materials and wages and sets industry to work. So every saving on fixed capital’s maintenance that does not reduce labor’s productive power increases the fund that sets industry to work. This raises the annual output of land and labor, society’s real revenue.

Replacing gold and silver money with paper replaces an expensive tool of commerce with a much cheaper one, which is sometimes just as convenient. A new wheel carries circulation at less cost to set up and maintain than the old one. But how this works, and how it raises society’s gross or net revenue, is less obvious and needs further explanation.

Paper money takes several forms. Notes issued by banks and bankers are the best-known kind and seem best suited to this purpose.

People may trust a banker’s wealth, honesty, and good judgment enough to believe he will always pay any of his promissory notes presented to him on demand. Those notes then circulate like gold and silver money, because people believe they can exchange them for such money at any time.

Suppose a banker lends his customers his own promissory notes totaling a hundred thousand pounds. Because the notes work like money, his borrowers pay him the same interest they would pay if he had lent them that much money. This interest is his gain. Some notes constantly return to him for payment, but others keep circulating for months or years. So although he generally has a hundred thousand pounds in notes circulating, twenty thousand pounds in gold and silver may often be enough to meet occasional demands for payment. In this way, twenty thousand pounds in gold and silver do everything that a hundred thousand would otherwise have done. His notes worth a hundred thousand pounds can carry out the same transactions and distribute the same amount of consumable goods to the people who use them as an equal value of gold and silver money. Eighty thousand pounds in gold and silver can therefore be removed from the country’s circulation. If many banks and bankers do the same thing at once, circulation can be maintained with only a fifth of the gold and silver it would otherwise need.

For example, suppose a country has one million sterling in circulating money, just enough to circulate everything its land and labor produce each year. Suppose various banks and bankers then issue one million in notes payable to the bearer, while keeping two hundred thousand pounds in their vaults to meet occasional demands. Circulation would then contain eight hundred thousand pounds in gold and silver plus a million in banknotes: eighteen hundred thousand pounds in paper and coin together. Before this, one million was enough to circulate the yearly output and distribute it to the people who use it. Banking cannot immediately increase that output, so one million is still enough. The goods being bought and sold have not changed; the amount of money needed to trade them has not changed either. The channel of circulation, if I may call it that, stays the same size. We assumed one million filled it. Anything poured in beyond that amount must overflow. Of the one million eight hundred thousand pounds poured in, eight hundred thousand pounds must overflow because the country cannot use it in domestic circulation. But it is too valuable to leave idle, so it will go abroad to seek profitable use. The paper cannot go abroad. Far from the issuing banks and the country where payment can legally be demanded, it will not be accepted in ordinary transactions. Thus eight hundred thousand pounds in gold and silver will go abroad. Domestic circulation will contain a million in paper, replacing the million in gold and silver that filled it before.

We should not imagine that this large amount of gold and silver is sent abroad for nothing, as a gift to other nations. Its owners will exchange it for foreign goods, to be used either in another foreign country or at home.

If its owners buy goods in one foreign country to sell for use in another—the carrying trade—their profit adds to their own country’s net revenue. It is like a new fund created to conduct new trade. Paper now handles domestic business, freeing gold and silver to finance this new trade.

If instead they buy foreign goods for use at home, they have two choices. First, they can buy things consumed by idle people who produce nothing, such as foreign wines and silks. Second, they can buy more materials, tools, and provisions to support and employ more productive people. Those people reproduce the value of what they consume each year, plus a profit.

Money used in the first way encourages wasteful spending. It raises spending and consumption without raising production or creating a lasting fund to support that spending. It harms society in every respect.

Money used in the second way encourages industry. It increases society’s consumption but creates a lasting fund to support it, because the people consuming reproduce the full value of their yearly consumption, plus a profit. Society’s gross revenue—its land and labor’s yearly output—rises by the full value those workers add to the materials they work on. Its net revenue rises by what remains of that value after the cost of maintaining their tools and equipment is deducted.

It seems not just likely, but almost inevitable, that most of the gold and silver driven abroad by banking and used to buy foreign goods for domestic consumption buys goods of the second kind. Some individuals greatly increase their spending at times without any increase in revenue. But we can be sure no entire class of people does this. Ordinary caution may not guide every person, but it does guide most people in every class. Banking does not increase the revenue of idle people as a class in the slightest. Their spending overall therefore cannot rise much because of it, though some individuals’ spending can and sometimes does. Their demand for foreign goods stays the same, or nearly so. Only a small share of the money driven abroad by banking and spent on foreign goods for domestic use is likely to buy goods for them. Most of it will naturally support industry, not idleness.

When calculating how much industry society’s circulating capital can employ, we must count only its provisions, materials, and finished goods. We must leave out its money, which only circulates those other three parts. Industry needs three things to get going: materials to work on, tools to work with, and wages or other payment that motivates the work. Money is neither a material nor a tool. And although workers are usually paid in money, their real revenue, like everyone else’s, is what that money buys, not the money itself; it is not the coins but what they can get for them.

The number of workers a capital can supply with materials, tools, and support suited to the work determines how much industry it can employ. Money may be needed to buy those materials, tools, and provisions for the workers. But the industry the whole capital can employ cannot equal both the money spent and the things bought with it. It equals one of these two values, more accurately the value of the materials, tools, and support than of the money.

When paper replaces gold and silver money, the total circulating capital can supply additional materials, tools, and support worth as much as the gold and silver previously used to buy them. The value of the great wheel of circulation and distribution is added to the goods it helps circulate and distribute. This is rather like the owner of a large enterprise replacing old machinery after a mechanical improvement. The owner puts the difference between the old machinery’s price and the new machinery’s price into circulating capital, the fund used to provide workers with materials and wages.

It may be impossible to say what share of a country’s yearly output is represented by the money circulating that output. Various writers have estimated it at a fifth, a tenth, a twentieth, or a thirtieth of the output’s value. Yet only a portion of yearly output, often a small portion, is ever set aside to support industry. So however small circulating money’s share of total output is, it must represent a substantial share of that portion. Replacing gold and silver with paper may reduce the metal needed for circulation to perhaps a fifth of its former amount. If just the greater part of the other four-fifths is added to the funds supporting industry, it must greatly increase the amount of industry and therefore the value produced each year by land and labor.