Book II, Chapter II, 8

It has been argued that more paper money increases the total quantity of currency and thus diminishes its value, necessarily raising the money price of goods. But because the amount of gold and silver withdrawn from circulation always equals the amount of paper added, paper money does not necessarily increase the total quantity of currency. From the beginning of the last century to the present, provisions in Scotland have never been cheaper than they were in 1759, though ten and five shilling bank notes meant that more paper money circulated there then than now. The relation between the price of provisions in Scotland and their price in England is the same now as it was before the great multiplication of banking companies in Scotland. Corn is generally quite as cheap in England as in France, although England has a great deal of paper money and France scarcely any. In 1751 and 1752, when Mr Hume published his Political Discourses, shortly after Scotland's great multiplication of paper money, the price of provisions rose markedly—probably because of poor seasons, not because of the increase in paper money.

It would indeed be different with paper money made up of promissory notes whose immediate payment depended in any way on the good will of their issuers, or on a condition the holder might not always be able to meet, or whose payment could not be demanded for several years and which earned no interest in the meantime. Such paper money would undoubtedly fall below the value of gold and silver, by more or less according to the perceived difficulty or uncertainty of obtaining immediate payment, or the length of time before payment could be demanded.

Some years ago, various Scottish banking companies used to insert what they called an optional clause in their bank notes. They promised to pay the bearer either on presentation or, at the directors' option, six months afterward, with legal interest for those six months. Directors of some banks sometimes exercised this option, and sometimes threatened people demanding gold and silver for a substantial number of their notes with its exercise unless they accepted only part of what they demanded. The promissory notes of those companies then made up by far the greater part of Scotland's currency, which this uncertainty of payment necessarily lowered below the value of gold and silver money. While this abuse persisted, chiefly in 1762, 1763, and 1764, exchange between London and Carlisle stood at par, yet exchange between London and Dumfries, less than thirty miles from Carlisle, was sometimes four per cent. against Dumfries. At Carlisle bills were paid in gold and silver; at Dumfries, in Scottish bank notes. The uncertainty of exchanging those notes for gold and silver coin had thus reduced their value four per cent. below that of the coin. The same act of parliament that suppressed ten and five shilling bank notes also suppressed the optional clause, restoring the exchange between England and Scotland to its natural rate, whatever trade and remittances might make it.

In Yorkshire's paper currencies, payment of a sum as small as 6d. sometimes depended on the noteholder bringing change for a guinea to the issuer—a condition holders could often find very difficult to meet, and one that must have reduced this currency below the value of gold and silver money. An act of parliament accordingly declared all such clauses unlawful and, as in Scotland, suppressed all bearer promissory notes worth less than 20s.

North America's paper currencies were not bank notes payable to the bearer on demand, but government paper whose payment could not be demanded until several years after issue. Though colonial governments paid holders no interest, they declared this paper legal tender at its full stated value and made it so in practice. Yet even assuming perfectly sound colonial security, £100 payable fifteen years hence in a country where interest is six per cent. is worth little more than £40 in ready money. To force a creditor to accept this as full repayment of a debt of £100 actually advanced in ready money was an act of such gross injustice as scarcely any other government claiming to be free has perhaps attempted. It plainly bears the marks of what the honest and forthright Doctor Douglas tells us it originally was: a scheme by fraudulent debtors to cheat their creditors. When Pennsylvania first issued paper money in 1722, its government indeed claimed it would make that paper equal in value to gold and silver by imposing penalties on anyone who charged different prices for goods sold for colonial paper and for gold and silver. This regulation was as tyrannical as the measure it was meant to support, but far less effective. A statute can make a shilling legal tender for a guinea by directing courts to discharge a debtor who tenders it; but no statute can make a seller, free to sell or not as he pleases, accept a shilling as the equivalent of a guinea in the price of his goods. Despite regulations of this sort, the exchange rate against Great Britain showed that £100 sterling was at times reckoned equal to £130 in the currency of some colonies, and to as much as £1100 in others. The difference arose from variations in the quantity of paper issued by the colonies and in the remoteness and likelihood of its eventual payment and redemption.

No law, therefore, could be more equitable than the act of parliament, so unjustly resented in the colonies, declaring that no paper currency issued there in future should be legal tender for payment.

Pennsylvania was always more restrained in issuing paper money than any other of our colonies. Its paper currency is therefore said never to have fallen below the value of the gold and silver circulating in the colony before paper was first issued. Before that issue, however, the colony had raised the denomination of its coin: an act of assembly directed that 5s. sterling should pass in the colonies for 6s:3d., and subsequently for 6s:8d. A pound in colonial currency, even while that currency was gold and silver, was thus more than thirty per cent. below the value of £1 sterling; once the currency became paper, it was seldom much more than thirty per cent. below that value. The stated reason for raising the denomination of the coin was to prevent the export of gold and silver by making the same quantities of those metals pass for larger sums in the colony than in the mother country. It turned out, however, that the price of all goods imported from the mother country rose in exact proportion to the increase in the coin's denomination, and gold and silver were exported just as rapidly as before.

Because each colony accepted its own paper at full face value in payment of provincial taxes, this use necessarily gave the paper some value beyond what it would have had in view of the actual or supposed remoteness of its final payment and redemption. That additional value was greater or less according as the quantity issued exceeded, by more or less, what could be used to pay that particular colony's taxes. In every colony, the quantity issued greatly exceeded what could be used in this way.

A sovereign who enacted that a certain proportion of his taxes must be paid in a particular kind of paper money could thereby give that paper some value, even if its eventual payment and redemption depended entirely on his will. If the issuing bank took care to keep the quantity of paper somewhat below the amount readily usable for this purpose, demand might even cause it to command a premium, selling in the market for somewhat more than the amount of gold or silver currency for which it was issued. Some explain the so-called agio of the Bank of Amsterdam this way: the premium of bank money over current money, even though, they claim, its owner cannot withdraw bank money from the bank at will. Most foreign bills of exchange must be paid in bank money, that is, by transfers in the bank's books; the bank's directors, it is alleged, keep the total quantity of bank money below what this use creates a demand for. This, they say, is why bank money sells at a premium, commanding an agio of four or five per cent. over the same nominal sum in the country's gold and silver currency. As will appear later, however, this account of the Bank of Amsterdam is largely imaginary.

When a paper currency falls below the value of gold and silver coin, it does not thereby lower the value of those metals or cause equal quantities of them to exchange for fewer goods of any other kind. The relation between the value of gold and silver and that of other goods never depends on the nature or quantity of any particular paper money circulating in a given country, but on the richness or poverty of the mines then supplying those metals to the great market of the commercial world. It depends on the relation between the labor required to bring a certain quantity of gold and silver to market and the labor required to bring a certain quantity of any other goods there.

If bankers are forbidden to issue circulating bank notes, or bearer notes, below a certain denomination, and required to pay all such notes immediately and unconditionally on presentation, their business can safely be made entirely free in every other respect. The recent multiplication of banking companies in both parts of the united kingdom, which has alarmed many people, increases rather than diminishes public security. It compels every bank to act more cautiously, keeping the notes it circulates in due proportion to its cash so as to protect itself against the malicious runs that competition among so many rivals is always liable to provoke. It confines each company's circulation to a narrower sphere and reduces the number of its outstanding notes. Dividing the whole circulation among more companies lessens the public consequences of any one company's failure, an event that must sometimes occur in the course of things. Free competition also obliges all bankers to deal more generously with their customers for fear that rivals will take them away. In general, if a branch of trade or a division of labor benefits the public, freer and more widespread competition will always make it more beneficial.

Some have argued that more paper money raises the total amount of currency and so lowers its value, inevitably raising the money prices of goods. But every addition of paper to circulation replaces an equal amount of gold and silver. Paper money therefore does not necessarily increase the total amount of currency. From the beginning of the last century to the present, food in Scotland has never been cheaper than it was in 1759. Yet ten and five shilling bank notes meant that more paper money circulated there then than now. Food prices in Scotland bear the same relation to those in England today as they did before the great increase in Scottish banks. Corn is generally at least as cheap in England as in France, although England has a great deal of paper money and France hardly any. When Mr Hume published his Political Discourses in 1751 and 1752, shortly after the great increase in Scottish paper money, food prices did rise noticeably. Bad seasons, rather than more paper money, were probably the cause.

Things would be different if paper money took the form of promissory notes whose immediate payment depended either on the issuer's willingness to pay or on a condition the holder might not be able to meet. The same would be true of notes that could not be redeemed for several years and paid no interest in the meantime. Such paper would certainly be worth less than gold and silver. How much less would depend on how difficult or uncertain people thought immediate payment would be, or on how long they had to wait for payment.

Some years ago, Scottish banks used to put what they called an optional clause in their notes. It promised to pay the bearer either on presentation or, if the directors chose, six months later with the legal interest for those six months. Directors of some banks sometimes used the clause. At other times, when holders demanded gold and silver for a large number of notes, the directors threatened to use it unless the holders accepted only part of the amount demanded. These banks' promissory notes then made up by far the greater part of Scotland's currency. The uncertainty of payment necessarily made them worth less than gold and silver money. During this abuse, mainly in 1762, 1763, and 1764, the exchange rate between London and Carlisle was at par, but the rate between London and Dumfries was sometimes four per cent. against Dumfries. Dumfries is less than thirty miles from Carlisle. Yet bills at Carlisle were paid in gold and silver, while bills at Dumfries were paid in Scottish bank notes. Uncertainty about exchanging those notes for gold and silver coin had lowered their value by four per cent. against coin. The same act of parliament that banned ten and five shilling notes also banned the optional clause. This restored the exchange rate between England and Scotland to its natural level, whatever trade and transfers of money might make that level.

In Yorkshire's paper currencies, even payment of 6d. sometimes required the note's holder to bring the issuer change for a guinea. Holders often found this condition hard to meet. It must have made those notes worth less than gold and silver money. An act of parliament therefore outlawed such clauses and, as in Scotland, banned all promissory notes payable to the bearer for less than 20s.

North American paper currencies were not bank notes payable to the bearer on demand. They were government paper that could not be redeemed until several years after issue. The colonial governments paid no interest on them. Yet they declared them legal tender for their full stated value and enforced that rule. Even if a colony's promise to pay were completely sound, £100 due in fifteen years would be worth little more than £40 in cash now in a country where interest is six per cent. Forcing a creditor to accept such paper as full payment for a £100 debt originally paid in ready money was a severe injustice. Hardly any other government claiming to be free has perhaps attempted one like it. It clearly bears the marks of what the frank and honest Doctor Douglas tells us it was at first: a plan by dishonest debtors to cheat their creditors. When Pennsylvania first issued paper money in 1722, its government tried to make the paper equal in value to gold and silver. It imposed penalties on sellers who set different prices for goods in colonial paper and in gold and silver. This rule was equally tyrannical but far less effective than the legal-tender rule it was meant to support. A law can make a shilling legal tender for a guinea by ordering courts to release debtors who offer that payment. But no law can make sellers who are free to sell or refuse a sale treat a shilling as equal to a guinea when pricing their goods. Despite such rules, exchange rates with Great Britain showed that £100 sterling was sometimes treated as equal to £130 in the currency of some colonies, and as much as £1100 in others. The difference in value reflected how much paper each colony issued and how remote and uncertain its eventual repayment was.

No law, then, could have been fairer than the act of parliament that the colonies complained of so unjustly. It declared that no paper currency issued there in the future could be legal tender for payment.

Pennsylvania was always more restrained than our other colonies in issuing paper money. Its paper currency is therefore said never to have fallen below the value of the gold and silver circulating there before paper was first issued. Before that first issue, the colony had raised the stated value of its coin. An act of its assembly made 5s. sterling pass in the colonies for 6s:3d., and later for 6s:8d. Thus a pound of colonial currency, even when it was gold and silver, was worth more than thirty per cent. less than £1 sterling. Once that currency became paper, it was seldom worth much more than thirty per cent. less. The stated reason for raising the value assigned to coins was to prevent gold and silver from leaving. The same amounts of those metals would count for more money in the colony than in the mother country. But prices of goods from the mother country rose in exactly the same proportion as the stated value of the coin. Gold and silver therefore left just as quickly as before.

Each colony accepted its own paper at full stated value for provincial taxes. This gave the paper some value beyond what it would have had given the actual or expected wait for its final repayment and redemption. The amount of that added value depended on how far the paper issued exceeded the amount usable for paying that colony's taxes. In every colony, the issue greatly exceeded what could be used that way.

A ruler could give a certain value to a particular kind of paper money by requiring that a fixed share of taxes be paid in it. That could work even if redemption depended entirely on his wishes. If the issuing bank kept the quantity of paper somewhat below what people could readily use to pay taxes, demand might even make it sell at a premium. It might fetch more in the market than the amount of gold or silver currency for which it was issued. Some people use this argument to explain the agio of the bank of Amsterdam: the higher value of bank money over ordinary money. They claim that owners cannot take this bank money out of the bank whenever they wish. Most foreign bills of exchange must be paid in bank money by transferring entries in the bank's books. According to these people, the directors keep the quantity of bank money below the demand created by that use. They say this explains why bank money sells at a premium, or has an agio of four or five per cent. above the same stated amount in the country's circulating gold and silver. As will become clear later, however, this account of the bank of Amsterdam is largely imaginary.

When paper money is worth less than gold and silver coin, that does not lower the value of those metals or make equal amounts of them exchange for fewer goods of other kinds. The relative value of gold and silver and other goods never depends on the type or quantity of paper money circulating in a particular country. It depends on how rich or poor the mines are that supply those metals to the world's great commercial market at the time. That determines the amount of labor needed to bring a given quantity of gold and silver to market compared with the labor needed to bring a given quantity of other goods there.

Banking can safely be left entirely free in every other respect if two rules are enforced. Bankers must not issue circulating notes payable to the bearer below a specified sum, and they must pay all such notes immediately and unconditionally when presented. Many people have been alarmed by the recent increase in the number of banks in both parts of the united kingdom. But it increases public security rather than reducing it. Competition makes each bank act more carefully. Each must keep its notes in circulation in proper proportion to its cash reserves so that it can withstand hostile demands for payment that its numerous rivals are always ready to provoke. Competition also keeps each bank's notes within a narrower area and reduces their number. Dividing all circulating notes among more banks means that the failure of any one bank, which must sometimes happen, matters less to the public. Free competition also makes banks more generous to their customers for fear that rivals will take those customers away. In general, whenever a branch of trade or a division of labor benefits the public, freer and more widespread competition increases that benefit.