Smith’s oversight

It is difficult to state how influential the means of exchange theory inspired by Smith’s parable has been. In the view that became orthodoxy in classical and neoclassical economics, “money is what money does,” as John Hicks puts it,Footnote ⁴ and while money serves various functions, the “means of exchange” function is original or primary, money’s raison d’etre. Any further functions of money—as a “store of value,” “unit of account,” and “means of payment or debt-settlement”—are secondary; they are somehow to be explained in terms of money’s prior role as a means of exchange.Footnote ⁵ For being seen as at bottom a mere transaction technology, money is often treated as a “neutral veil” for the “real” economy, which can be adequately modeled (in general equilibrium) as so many bartered trades, even if there is then no possibility of monetary and financial instability or crisis.Footnote ⁶

What, then, is a “means of exchange”? Something that emerges to ease the inconvenience of barter identified in Smith’s famous parable. Without money, it can be difficult to find others who have what we want and want what we have—a “double incidence of wants,” as it came to be called. And so it is wise for any trader to keep ready at hand something both buyers and sellers have and something they will want, if not rude bars of copper, then some commodity (nails, dried cod, and so on) that others are likely to accept in trade. Easing barter—“minimizing transaction costs,” in today’s terms—is not just something money does for us; it defines the very nature of money, what money, in essence, is.

What often went unnoticed is that Smith’s parable contains a potentially significant omission. This is well explained by British financier and diplomat Alfred Mitchell-Innes in a pair of articles in the Banking Law Journal in 1913 and 1914.Footnote ⁷ Of the butcher, baker, and brewer, Smith puts the “inconveniency” of their situation starkly (twice in the passage quoted above, as if to underline the point): “No exchange can, in this case, be made between them.” Yet as Mitchell-Innes points out, this was never a problem in trusting communities. Put roughly, if the butcher had no need of bread on a given day, the baker would just exchange the meat for a credit, paying the butcher today with a promise. The butcher could then pass along the IOU (“I owe you”) in exchange with a cobbler or metalsmith for some good he wanted. And when IOUs are allowed to circulate in this manner, being widely enough accepted as payment, a community has a “good and sufficient” credit-money for commerce.

In effect rewriting Smith’s origin story, Mitchell-Innes elaborates this way:

Mitchell-Innes concludes: “There is absolutely no reason for assuming the existence of so clumsy a device as a medium of exchange when so simple a system would do all that was required.” What is needed is just “a general sense of the sanctity of an obligation,” “based on the antiquity of the law of debt.”Footnote ⁹

Mitchell-Innes urges, further, that Smith’s oversight reveals a fundamental error. An exchange of meat or bread or beer, in the ordinary economic sense, is not just goods physically “changing hands.” Behaviorally speaking, that could equally be a case of gift, theft, or abandonment. As Mitchell-Innes explains, a sale, and corresponding purchase, between a seller and a buyer is a mutually agreed-upon exchange of a good or service for a spendable credit, which settles a commercial debt for goods or services received in a recognizable fashion. But, crucially, nothing in Smith’s parable and origin story in Book I of the Wealth of Nations tells us how that is possible. To say only that some medium or means of exchange smooths passage of goods between hands is not yet to indicate how the parties passing them are not gift-givers or thieves. It is not yet to say how they are buyers and sellers engaged in purchase and sale, using money for payment in ordinary commerce. For all the parable says, traders could be trading relatively convenient barter objects, and not money. But commerce runs on payment in credit money, as Smith himself tells us in Book II.Footnote ¹⁰

In other words, the standard theory blurs the very distinction one would expect a theory to explain. It is not enough to be money that something usefully, even most usefully compared to anything else on hand, solves the double incidence of wants problem. A salient barter object might do that. What any money must do, in contrast with barter, is effectuate the exchange of a good or service for a credit in a recognized means of payment or debt settlement. For again, a sale is not the exchange of a commodity for a commodity, but the exchange of a commodity for a credit, a credit that is, equivalently, a promissory debt redeemable in a community.

The problem is resolved, Mitchell-Innes suggests, if we define money as a recognized means of payment, which is to say, as something that is such as to settle debts for beer, bread, or meat purchased in ordinary commercial exchange. We can still assume money is what money does. What money does in exchange—its basic, essential function—is settle debts in a recognizable fashion. So what money is, at bottom, is a recognized means of payment or debt settlement. It is not, that is, just any “means of exchange,” however convenient. Specifically, money serves commerce as a “means of exchange” because it settles debts. The means of payment function explains the means of exchange function.Footnote ¹¹ What is left over as “means of exchange” (for example, barter objects, gifts, favors, and so on) are not, as such, money.

The upshot, Mitchell-Innes suggests, is that Smith’s parable has us looking for money in the wrong place: in tangible stuff. When cod, shells, or rude bars of copper do happen to stand for money—because passing them around is easier than keeping a ledger, say—they do so by serving as tokens or representations of circulating IOUs, which are recognized as settling commercial or public debts. Paper money or ledger credits are not, then, mere credit instruments “substituting” for money proper. All such forms of “credit money”—whether coin, bank paper, or state-issued promissory notes—are money, money proper, a means of payment or debt-settlement. Even cigarettes circulating in prisons, to take the orthodox economist’s favorite example of a “commodity money,” are better seen as tokens of credits and debts. A standard cigarette is quite handy as a unit of account, a way of keeping track of how credit and debt positions shift when trust is limited. A ledger could accomplish the same, but which prisoner (the murderer? the fraudster?) could be trusted as its keeper?

Rereading the parable

To heterodox critics such as Mitchell-Innes or John Maynand Keynes, who Mitchell-Innes influenced,Footnote ¹² classical orthodoxy turns on a false or at best confused theory of money’s nature. I side with the critics in one respect: the theory often attributed to Smith obscures what money is. But when I stare down the text of the Wealth of Nations, I simply do not find the theory in the pages.

Recall the tale. In Smith’s Book I, “Of the Origin and Use of Money,” otherwise willing traders, for lack of anything more than the products of their own industry, face “inconveniency” in finding others who have what they want and want what they have. For this reason, Smith tells us, “every prudent man … [must] have at all times by him … a certain quantity of some one commodity or other”—be it cattle, oxen, salt, shells, dried cod, tobacco, hides, nails, rude bars of copper, or, among rich commercial nations, gold and silver—which “few people would be likely to refuse in exchange” (WN I.iv.2). So far, so good. But as for how such goods become money, what would mark them as such, Smith never quite says exactly. What he says is that even rude copper bars and other items can come to serve “the function of money” (WN I.iv.6). He never says expressly what money, as such, is.

Money, so called, is introduced only in his subsequent account of the origin of “coined money” (WN I.iv.7). Coined money is, of course, money for Smith, one form of money, but not money as such (as bank notes or bank credits also count). Because standardization in coin is meant to give commerce and industry additional encouragement, however, Smith is understandably read as supposing that money itself emerges one step prior to coinage. But then what is money? He has not said. Again, at the prior step he speaks only of items serving the “function of money.” Rude bars and coined money, it seems, both have money’s function: they are both ways of reducing “inconveniency.” Book II then simply continues the story of how a prospering economy conveniently runs on bank credit used as means of payment in circulating promissory notes. None of this amounts to a theory of money’s nature. Instead, like his fellow empiricist Hume, Smith simply offers a broad description of how money tends to work, in various way easing “inconveniency.”

A chief advantage of this “quietist” reading is charity. If the theory usually attributed to Smith papers over the difference between barter and monetary payment, this is a potentially serious flaw. Insofar as the Wealth of Nations was intended to provide a theory of what money is, in a sense that contrasts with barter, it has caused centuries of confusion. But if Smith is not offering a theory of money in the first place, he has made no mistake.

Smith’s parable does contain a significant omission, as Mitchell-Innes notes: it overlooks an important method of exchange (promising), which arguably does bear on the very nature of money as a convenient tool of debt settlement. The oversight is easily fixed. Instead of saying “no exchange is possible,” Smith could have said “suppose no exchange is otherwise possible, for lack of trust….” Yet the omission takes on great importance if Smith’s parable is supposed to be the basis for a theory—not to mention a foundation for the classical and neoclassical citadel. If Smith never gave a theory, the parable can be the charming parable it is without bearing the weight centuries of economics has placed upon it.

To be sure, many orthodox readers are happy to squint and fill in details, resorting to “rational reconstruction.” Money is what money does, and money does indeed help us solve the double incidence of wants problem in Smith’s parable, no? But then why not just add that money proper just is a commodity that, for being widely enough accepted in trade, is such as to bring buyers and sellers together conveniently? Here, my point is that this is a reconstruction and properly assessed as such. It is not in the text, or just beneath it. It is also problematic by glossing over what Smith’s original parable itself misses, obscuring what any good reconstruction of money should illuminate.

Mitchell-Innes criticizes Smith for bad monetary history, picking apart his historical examples (for example, cod among newfoundland fishermen). His own lack of historical documentation prompts Keynes to return to historical study and, after a spell of “Babylonian madness,”Footnote ¹³ develop his own credit-debt theory of money, the foundation of his influential depression economics.Footnote ¹⁴ Anthropologists have since argued there never was a time in which money emerged from barter’s inconvenience.Footnote ¹⁵ Still, I take it Smith’s origin parable is most charitably seen as “conjectural history,” a rational reconstruction. The story, or a theory it inspires, is to be judged not for historical or anthropological accuracy but by how clarifying and illuminating it is.Footnote ¹⁶

Even so, Mitchell-Innes’s main challenge does not depend on his claims about history; his true point is that a credit theory is far more illuminating as a rational reconstruction. I take it the means of exchange theory gains unwarranted plausibility in part for lack of proper appreciation of alternative reconstructions. So, I now explain more carefully what Smith’s parable misses: how trusted, transferable promissory IOUs could easily catch on as credit money and serve commerce in decentralized cooperation. A realistic example would be contemporary “shadow banks” creating “shadow bank money” within financial markets, as circulating dollar promises to pay.Footnote ¹⁷ For simplicity, I will use Smith’s homespun parable.

Mitchell-Innes’s rendition

Pure credit: Suppose the butcher wants candlesticks, but the candlestick maker is a vegetarian with no interest in meat. One option is for the butcher to borrow candlesticks from the candlestick maker on pure credit. He would simply promise to return them at a later date or pay her back in some comparable good or service. His promissory debt—his IOU—is outstanding until settled upon delivery later (for example, next Tuesday, for candlesticks today).

Final settlement: Borrowing on credit is not yet monetary payment.Footnote ¹⁸ But money is not far off. Suppose the candlestick maker wishes not to wait until Tuesday. In that case, the butcher could take the candlesticks and settle up with her right away. How so? Perhaps the baker owes him bread. If all are amenable, he just swaps the baker’s debt to him over to her. If the candlestick maker would accept the baker’s bread in exchange, the butcher could just ask the baker to bring bread to her instead of him. Or, still more conveniently, she could simply hold the baker’s IOU for a future delivery, being paid today in a baker credit. The baker would still owe her bread. But, as for the butcher, he has paid her; the two are “square.” The credit he gave her settles his account with her; it cancels the debt he owed her for gaining title in the candlesticks, and he may owe her nothing more.

Transferable IOUs: Is this money? Not quite yet. But if swapping debts in this fashion is helpful, a community could make a practice of it. They just reach a certain understanding: the IOUs created in promising are transferable among its members. And if they circulate widely enough in a group, they can indeed come to acquire the status of money in that group. A promissory IOU can thus become money, by becoming spendable, widely enough.

As before, the butcher can then pay the candlestick maker today, in those transferable IOUs, without ever delivering a good or a service to her himself. He could pay in the baker’s IOU, giving her a credit for the baker’s bread, which she could then spend or save. To spend she could simply transfer the bread credit to the cobbler for shoes, who himself might pay it to the doctor for an examination, who herself might finally buy bread from the baker. If she saves instead, making a habit of it, she may be in surplus relative to the cooperative, perhaps with designs of becoming a capitalist.

To be sure, the baker’s IOU is outstanding until such time as he delivers bread to her or to whomever it is that presents it to him for redemption. But there is no reason many such IOUs cannot be outstanding at any given time. In an ongoing cooperative, promissory IOUs are constantly created and extinguished, perhaps with some IOUs or other always outstanding. In principle, this can last in perpetuity, perhaps with IOU wealth accumulating in the hands of certain aspiring capitalists. The community need only keep up cooperation and confidence, with enough buying and selling or investment, so that their IOUs constantly retain a good promise of future redemption.

Accounting: Busy people with memories prone to error and open to dispute will of course require trustworthy methods of keeping track of all the shifting debits and credits, deficits and surpluses. The means for doing this will have to be serviceable for paying without too much fuss, the options depending on what clay, wood, metal, or digital material are available and workable as credit media in a given age or place. It can thus become useful to appoint a trusted scorekeeper. Perhaps the scorekeeper might even be a banker, whose own IOUs circulate or even displace the rest.

Unit of Account: Also, to avoid confusion about who owes what to whom, especially as IOUs are offset and balances shift back and forth, any very sturdy scheme will evaluate what is promised by a common standard, in some “unit” for valuing the credits and debts tracked in keeping accounts. Perhaps a unit called “lama”—in honor of the glorious lama—catches on by word of mouth. A first one lama is valued at ¼ lb. of choice cut beef. This anchors initial lama bid and ask prices on bread or beer, until lama prices adjust and change through offers, refusals, and negotiations, according to supply and demand.

Standard of Value: The unit of account is thus a standard of value for goods and services pricing itself valued by some average price of those goods and services over time. And so, in this fashion IOUs can function in the marketplace just as Smith says a commodity would:

Except the money prices are in lama prices. And the money “changes hands” only with the simple acknowledgment of the transferrable IOUs, perhaps in a knowing nod (“owe ya one!”) or as noted on scrip or in books being kept. No need to even carry paper, let alone lug metal around, vulnerable to thieves, footpads, and brigands.

Accountability: Where not legislated and enforced by courts, what Mitchell-Innes calls “the ancient law of debt” can work informally. When claims to an IOU’s redemption are made but not honored, they can be enforced by requests and then demands for accountability aided by a sense of fairness, and, if necessary, risks or threats to reputation and future business. Formal law may further enhance general confidence in the IOU’s redeemability.

Credit money: Whether a group comes to this arrangement by formal enactment, informal convention, or mere common tacit understanding, a money just is that which pays. Whatever it is that people together count or recognize as settling debts in their credit and debt accounting in a community—for example, lamas—that is their money.Footnote ¹⁹

Hierarchy: IOUs may thus have a credible enough promise of redemption for general use in buying and selling, paying and receiving within a trusting cooperative. They may or may not be of high quality outside it. In the many Local Exchange Trading Systems (LETS) that exist today, for example, their currencies are usually not accepted (at face value) outside of a network of trust. A LETS currency is thus less liquid than state money or the notes of a trusted banker for being lower down a hierarchy of credibility.

A banker or state money higher up the ladder may be far more prone to scale up in a larger population of strangers who would not otherwise trust each other, perhaps by snowballing network effects. Local LETS IOUs may even be said to have less “moneyness” than bank or state moneys higher up the hierarchy, or they may even count as “bad money” compared to “better” highly liquid state moneys, not to mention a “best” money resting at the very top of a global hierarchy (such as U.S. dollars). Even so, the IOUs that stay local are still perfectly good money in their relevant trust network; they can buy meat or bread or candlesticks in final settlement, as good promises.

They are not, then, “mere credit,” but rather credit and money. Which is which? The answer is: what counts as “money” versus “credit” is relative to position in a hierarchy of credibility.Footnote ²⁰ Chartered banks can thus issue promissory IOUs that are at once credit relative to state central bank IOUs (in paper notes or “high powered money” reserve accounts) and at the same time money relative to households or business in ordinary commerce and tax payments. And today’s “shadow banks,” even beyond state charter or management, can be relatively low in the domestic or global hierarchy of credit—lower than central or chartered banks—but still create money by issuing promissory IOUs to pay, among those still lower in the hierarchy, such as households or business (who themselves may mostly pay in credit card promises rather than cash). More and more of the global dollar money supply is in fact created by “shadow” financial institutions in this way, a way that works much as in Mitchell-Innes’s rendition of Smith’s famous parable.

In defense of the classical theory?

If a credit theory is right, Smith does very well in Book II to place bank promissory notes at the center of both commercial exchange and the “great wheel of circulation.” But, again, his barter parable in Book I never quite fastens onto, let alone illuminates, the distinctive service money provides, as a recognized means of payment, to commercial exchange itself. Blanket talk of a “means of exchange” in the classical tradition papers over the issue, lulling us into imagining that we have explained money when we have not yet emerged from barter.

But have not many, many orthodox economists thoroughly explained how money could be a “means of exchange,” with proper clarification and defense? Without pretending to do justice to a large literature, which is rich in sophisticated developments, I explain why two prominent paragons of the classical theory—Karl Menger and Ludwig von Mises—mainly ignore the problem Mitchell-Innes’s argument poses.

Menger explains how certain commodities (or documents standing for them) catch on as “universally acceptable means of exchange” as a matter of special features such as their relative “saleability,”Footnote ²¹ by which he means “the greater or less facility with which [goods or wares] can be disposed of at a market” without too much loss compared to purchase price.Footnote ²² A money, Menger proposes, can emerge as the most saleable thing at hand, for a large enough group of hands in proximity, as the “spontaneous outcome” of the “individual efforts of the members of a society” who “have little by little worked their way to a discrimination of the different degrees of saleableness in commodities.”Footnote ²³ It emerges, in other words, by a network effect, its value increasing the more others use it.

By “disposed of” Menger presumably means sold at an agreed-upon price, as opposed to being merely thrown away or abandoned. Yet he lacks an account of the difference. How does a sale differ from other ways of parting with one’s stuff, be it trash disposal, theft, or barter? Menger offers no answer. A “saleable” item that allows one to find a double incidence of wants can still be a barter object. Keynes put the point this way: a convenient medium of exchange used “on the spot” may hold “purchasing power,” but as yet, he says, “we have scarcely emerged from the stage of Barter.”Footnote ²⁴

For instance, suppose one has hopes of trading a dead elk for a fine suit. It will surely be of help in one’s journey to bring along something else people seem likely to find interesting. Rummaging through one’s belongings, one could guess that many would enjoy the fine Chinese tea one brought home from one’s foreign travels and plan to offer it as a deal-sweetener. It might well be highly “saleable,” indeed more so than any item in the vicinity. Perhaps it is portable, divisible, and nonperishable as well, which is all very convenient. Having caught on by network effect in those parts, it may be a very attractive “common medium of exchange,” in one sense. Everyone in the neighborhood might make similar coordinating predictions that others will accept it. A man in the bazaar who happens to have the exact suit one wants may be reluctant about the elk, but he also takes note of the tea’s exotic attractions. Though not especially fond of tea himself, he will bet that others he will encounter will be intrigued and receive the tea as well, themselves betting that still others will accept it in lieu of other desired things. And maybe he is right about the others; they will make the same bet about still others, who make that same bet about still further others, and so on. But is the tea money? Not simply for being passed between many hands in so many bartered trades, given its salient appeal. If at each stage anyone can bet that others will be enticed by the tea’s golden container and aromatic contents, the tea might well be “generally” accepted, given such coordinating predictions. A rare and beautiful diamond, golden calf, or ensemble of beads might be passed around or treasured for similar reasons. Yet, like the diamond, the calf, and the beads, the Chinese tea would not be a money as opposed to a mere saleable barter object.

What’s missing here? The tea has convenient “on the spot” purchasing power, but it is not necessarily a recognized means of payment. To be sure, some “saleable” commodity could well become recognized as that which pays, as that which counts as settling debts, if not by state decision, then by informal convention or some general understanding.Footnote ²⁵ Perhaps silver, gold, or copper at some point gained cosmopolitan acceptability in payment, in a manner that surpassed the promises of kings or states to redemption or convertibility. Perhaps sovereigns at some point had to make such promises to signal their own credibility. But the metal or other tangible “medium of exchange” was never the money, as opposed to its representation. Its value, as money, always consisted in its being recognized as that which pays debts, private or public.Footnote ²⁶

Mises approves of Menger’s analysis, but wants to help us clear our heads about why money is just a “common medium of indirect exchange” used over time.Footnote ²⁷ Barter involves “direct exchange,” at the same time; money involves “indirect exchange,” when one exchanges now for something that one bets will later trade for something else (perhaps unknown). But then, why isn’t this just more barter, albeit over time? Again, it will help with uncertainty in one’s journey through time to carry a highly saleable, divisible, nonperishable object, which many will want by network effect. But, as above, if we say nothing else, these are barter objects, not yet money.

Mises does admit that, along with “commodity money,” a “fiat money” and “credit money” are money proper. He observes that modern business runs on “claims,” which he prefers to call “money substitutes,” rather than money proper, simply on “grounds of convenience.”Footnote ²⁸ One could quibble over words here. Why not just call a spade “a spade,” a money “money”? But as for the deeper question Mitchell-Innes poses, of how all money or money-like claims are such as to make all the payments they evidently make in routine commerce, Mises is aware of lawyerly concern for the question, but dismissive: “For the jurist, money is a medium of payment.” But “the economist may not adopt this point of view if he does not wish at the very outset to prejudice his prospects of contributing to the advancement of economic theory.”Footnote ²⁹

This is perhaps understandable if Mises wishes to preempt appeal to Georg F. Knapp’s state money chartalism.Footnote ³⁰ Mises criticizes Knapp for ignoring the importance of a money’s acceptance “from below” within an economy, as Mises puts it, “in catallaxy.”Footnote ³¹ Mitchell-Innes would not disagree.Footnote ³² At the same time, there is no “prejudice” against economic theory if the question is about not law but commerce in the first instance. What is economics about, if not commercial exchange? Let us assume purchase and sale of a banana from a vendor, in money payment as opposed to gift, theft, or abandonment, can indeed happen with or without law or a state. The question is still how is this possible? How is purchase and sale in money different from mere barter?

Mises does touch upon payment expressly. He treats it as a “secondary” function of money on the grounds that in “deferred payment” money drops out of the picture: “Credit transactions are in fact nothing but the exchange of present good against future goods.”Footnote ³³ Money again looks like barter, delayed over time. So where, again, is the money? (Could it lie in the promises that take us from present to future, which can themselves be extremely valuable?) It is true that borrowing on pure credit is one method of “intertemporal barter,” but, as noted, it is not credit money, either.Footnote ³⁴ Again, credit money can be paid in final (rather than deferred) settlement, even in catallaxy, as explained above. Did Mises perhaps not quite notice that finer point? Is that why payment for him is deferred payment instead of payment today?

Smith’s credit economy

The foregoing should suffice to suggest why the classical theory may be lacking, and so why, if Smith holds it, he could or should be read as having tried and failed to say what money is. In that case, one may speculate: did Smith the empiricist fall into transcendental confusion, mistaking the tangible appearances of money, in its token representations in coin or paper notes, with money, the intangible credit and debt relations themselves?Footnote ³⁵ But, as I now explain, the Wealth of Nations is open to a more charitable reading, more in keeping with Smith’s empiricism.

The main idea is as follows. Smith does not give a wrong answer to a question he was asking; he is simply not concerned with the very nature of money in the first place. The analysis of money as such is assumed not to be central, important, or even relevant to Smith’s picture of money in a commercial society. Focusing on “the function of money,” as he calls it from the start in Book I, sets that issue aside.

Smith’s remarks on money across Books I and II thus have a larger thrust: money in various forms facilitates productive commerce and industry, in several ways he gradually elaborates. What matters is simply that money does function to ease commerce, smoothing many different “inconveniencies,” turning “the great wheel of circulation, the great instrument of commerce,” by which the revenue of society is distributed among its members (WN II.ii.23). He therefore emphasizes the convenience of bank credit in circulating paper promissory notes (“a new wheel”), which, he says, is less costly than silver and gold coin and “sometimes equally convenient” (WN II.ii.26).

On this reading, Smith’s celebrated origin story of money emerging from the inconveniencies of barter in Book I is mainly throat-clearing: it notes one preliminary job money does for us, which is to make it easier for buyers and sellers to find each other. That is indeed one thing a good money does. But that rather modest point does not give us any theory of money’s essential nature—not simply for appearing in a pleasing parable. It does not show, and was not meant to show, that avoiding certain specific inconveniencies is the essential or fundamental role or nature of money, or that money is primarily or at bottom a “means of exchange,” or that other functions are “secondary.” Rather, the nature of money is not Smith’s concern.

Can we at least assume Smith endorsed a thin theory—“functionalism”—that is, the view that “money is what money does,” as later economists would say? Possibly, but even that claim does not appear in the text, nor need it have. What Smith does in the text is elaborate various ways money functions to reduce “inconveniency.” This is hardly a “theory” at all, or at best is the beginnings of a theory, if Smith wanted one.

To say Smith has no theory of money is not to say he would accept a credit theory of money, not least as he was aware of it in the writings of James Steuart.Footnote ³⁶ He was certainly wary of its role in inspiring monetary experimentation in Mississippi or Pennsylvania (the latter of which he condemned as tyrannical) (WN II.ii.100). Yet the Wealth of Nations has no occasion to either accept or reject a credit theory if Smith is simply not asking what money is. Smith’s preoccupation is instead with sturdy, prosperous order, especially in the normal regulation of money, in contrast to the currency-debasing activities of sovereigns of yore (WN I.iv.10) and what he saw as the disorderly money experiments in North America (“much more disorder than conveniency”) (WN V.ii.a.11).

Far from offering a theory of money, then, Smith’s broad aim is to depict normal regularities of a prosperous economy and sweep away mercantilist confusions and special interests, whatever the very natures of things. Smith resists the mercantilists not by offering a rival theory of what money is, but by sidestepping the question as irrelevant. What matters, he suggests, is not the nature of money but what augments the wealth of nations.

Hume, Smith’s dear friend and long-time colleague, says that money is “only the instrument which men have agreed upon to facilitate the exchange of one commodity or another … . [I]t is the oil which renders the motions of the wheels more smooth and easy.”Footnote ³⁷ On this reading, Smith means to elaborate the many ways we oil the squeak. He elaborates upon the many “inconveniencies” greased, summing up Hume’s “motions of the wheels” in his own terms as “the great wheel of circulation.”

Both Hume and Smith offer broadly “functionalist” stories about how an economy might work smoothly. A functionalist story might be purely descriptive: a function is described, along with claims about what does or does not in fact serve it. We might add, though I will not argue the point here, that for Smith, as for Hume, the “normal” is in one sense “normative,” that is, something we might cheerfully approve of upon reflection. The “normal” is not then the “purely descriptive” theory that positive social science would later aspire to, holding a candle to physics. Beyond carefully observing how things in fact happen, Smith’s aim is to clarify and center certain laudable tendencies, while sidelining and criticizing certain other less salutary tendencies (for example, mercantilist ones). The resulting mosaic presents an overall vision of well-functioning commercial society. The account is broadly “descriptive” of goings-on, but in a way that calls for our approval, much as the colorful rendition of human nature in Hume’s A Treatise on Human Nature was intended to.Footnote ³⁸

Specie as discipline

One challenge for this reading is to explain the special role of gold or silver in Smith’s Book II account of bank credit. In certain passages, Smith seems to regard a commodity such as specie as money proper and bank promissory notes as “mere credit,” by comparison. This invites the conclusion that Smith does have an implicit commodity theory. So I should explain why this interpretation is not inevitable.

Admittedly, when Smith highlights bank paper money’s great conveniency, he relates it directly to its redeemability on demand for gold and silver money:

Smith adds that when “[a] particular banker lends among his customers his own promissory notes … those notes serve all the purposes of money, his debtors pay him the same interest as if he had lent them so much money” (WN II.ii.29, emphases added). But “as if” money is not money, one might say; it is mere credit that “serve[s] all the purposes of money,” without being money proper.

At the same time, Smith consistently refers to promissory notes as “paper money,” which suggests that he believes paper money is money. Paper money is of a different material than “gold and silver money,” to be sure. But, taken at face value, it is not mere credit; it is money. The passage just quoted can be read accordingly. Smith goes on to introduce the idea that bankers can issue promissory notes while holding only a fraction of gold and silver in reserve, in “sufficient provision for answering occasional demands.” In effect, then, a small fraction of coin held in reserve “perform[s] all the functions” that a larger amount of coin might have performed in circulation, allowing it to be conveniently “spared from the circulation of the country” (WN II.ii.29). With paper in circulation, it is “as if” coin had circulated instead, and so “as if” borrowers of bank IOUs had borrowed coin instead. But this is true not because paper money is not money proper; it is merely a case of one kind of money (paper) substituting for another (coin), bringing certain conveniences. The two have functional continuity: coin and paper are both money proper, each in different ways convenient for commerce and industry, and there is no further “fundamental” difference being ascribed to them. Again, the very nature of money is not Smith’s concern.Footnote ³⁹

At the same time, specie plainly does have a privileged status within Smith’s credit-economy. It has a special role in foreign trade (where local bank notes are not accepted) (WN II.ii.30). Even at home, it is the preferred reserve asset. Silver and gold coins thus enjoy a high position in a hierarchy of credibility, both for their scarcity (given the high costs of mining and coinage) and because they are so widely trusted, quite aside from any specific bank’s prudence and probity. So gold or silver money was indeed the basis for bank discipline for a time. But this is not to say specie is “the real money.” It is only to say that its perceived high credibility and cosmopolitan acceptance in foreign trade gives it a special role in the social-monetary nexus that regulates and disciplines the larger credit-money economy.

This reading finds support in a parallel passage later in the text, which both affirms the value of paper money (“in every respect, equal in value to gold and silver money”) and ties the value of paper to the promise of redemption in coin:

Here, Smith asserts that new paper issued will not inflate prices on what would have been purchased with coin. Why Smith believes this is a delicate matter open to interpretation.Footnote ⁴⁰ Here, I take it to be relatively uncontroversial that for Smith, one way or another, some equilibrium mechanism on a metal standard could be trusted to work, given the general prudence of bankers (with exceptions), combined with preferences at home and abroad to hold gold over paper. This is to say that paper money is money proper, but preserving its stable value in relation to what it buys or sells depends on certain general practices of credit-money regulation, namely, those that discipline prudent bank money issuance by tying it to something relatively scarce, subject to ready demand.

Smith was accordingly pleased with private banking. In competition with each other, bankers could be trusted from mere prudence to issue money for the greater prosperity as though guided by an invisible financial hand. Needing at most minimal regulation, they could “with safety to the publick, be rendered in all other respects perfectly free” (WN II.ii.106). Market discipline under a metal standard would suffice for monetary discipline, more or less. While imperfect (WN II.ii.72), it was better for sturdy prosperity than either mercantilist policy or untested state paper money experiments in North America.

In other words, I suggest that Smith is, in Joseph Schumpeter’s terms, a “practical metalist,” namely, someone who supports “a principle of monetary policy, namely, the principle that the monetary unity ‘should’ be kept firmly linked to, and freely interchangeable with, a given quantity of some commodity.”Footnote ⁴¹ Money is not itself essentially a commodity, or necessarily tied to one, on this view.Footnote ⁴² And yet, one can still support a substantial tie to something scarce—such as gold or silver—as political and monetary discipline, as Schumpeter explains, for “lack of confidence in the authorities or politicians, whose freedom of action is greatly increased by currency systems.”Footnote ⁴³ For Smith, a money-society nexus of this sort, which relied heavily on private banks (but included public and central banking), could be trusted to turn the “great wheel of circulation” smoothly.

Smith the progressive

Hayek’s defense of free private banking internationally (within Europe and perhaps North America) fits a similar pattern: relative trust in banker prudence; market discipline as adequate money discipline; skepticism about financial regulation, not to mention politicians.Footnote ⁴⁴ Still, coming after two centuries of further monetary experimentation, Hayek’s position bore a heavier burden of justification than Smith’s did in his own time.

Smith lived on the cusp of the industrial revolution (his celebrated pin factory had ten workers). If Smith was impressed by the success he observed in private Scottish banks, the mid-nineteenth-century “wildcat” or “free banking” era in the United States was hardly a clear success. Civil war in the United States along with growing interstate commerce spurred monetary nationalization. A new gold standard brought repeated crises and political upheaval over private banker failure to serve agriculturalists in the heartland. Globally, trade and money flows had changed dramatically by the early twentieth century. State credit-money issuance and management changed with them.Footnote ⁴⁵

On the reading I have suggested, Smith’s functional depiction in the Wealth of Nations was responsive to tendencies in the nexus of credit and society as he observed them. His vision of a well-functioning system of promissory elasticity through private bank credit and specie-based market discipline was sensitive to the technology, administrative capacity, and institutional quality of his day. It is, of course, impossible to say what Smith would have said had he observed the subsequent course of history. But surely a good Smithian empiricist would be open to update as new historical evidence came in. After the steady rise of the mixed economy over two centuries, the same functional method behind the Wealth of Nations, used with the benefit of hindsight, might well render a different picture of how a balance of discipline and elasticity in a credit-money system can advance the cause of prosperity.

Elizabeth Anderson argues, plausibly, that Smith was an egalitarian of sorts for his time.Footnote ⁴⁶ Aligned with the Levellers of a century prior, he hoped market society would weaken relations of domination and subjection and loosen inherited barriers of class and status. Looking back today, a good Smithian would surely be delighted to observe the dramatic reduction in poverty globally since Smith’s time, albeit perhaps with mixed feelings about periods of yawning inequality. The extent of Smith’s egalitarian commitment is difficult to estimate, so it is perhaps an open question what a good Smithian should make of today’s inequalities. Yet Smith’s commitment to steady progress in the wealth of nations is beyond question. And there is a decent case to make, on that score alone, that Smith’s model of monetary discipline went out of date.

Smith was already clear that the elasticity of central banking credit money had a role in society, at least when well directed. Of the Bank of England—“no ordinary bank,” but “a great engine of state”—he comments that “its duty to the publick may sometimes have obliged it, without any fault of its directors, to overstock the circulation with paper money” (WN II.ii.85). He also explains that “the most judicious operations of banking can increase the industry of the country … not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so” (WN II.ii.86, emphasis added). It would do that by expanding credit money, subject to good discipline. Smith regards the South Sea Bubble and John Law’s Mississippi misadventure as the cautionary tales they were (WN II.ii.78). Law had contributed to an “excess of banking” in Scotland and elsewhere, though Smith nevertheless says Law had “splendid, but visionary ideas.”

While Smith objects to the government paper currencies of North America, which had sprung up for lack of specie, his concern is narrower than it might at first appear. For starters, Smith nicely explains how a colony could issue its own promissory notes and demand them back in payment of a tax obligation. They would thus acquire a degree of currency aside from their connection to specie:

Careful to note that Pennsylvania was even “more moderate” than other colonies, so that its paper money “never … sunk below the value of the gold and silver” (WN II.ii.102), Smith took objection not to state paper money per se, but to certain legal tender laws—“an act of such violent injustice”—that required creditors to accept state paper as payment despite significant depreciation (WN II.ii.100).

Smith is plainly indignant at the violation of creditor rights to their due. But his objection applies only to certain legal tender laws, which are not strictly necessary for state paper money. It can be enough, in context, for a state to offer firm assurance that its taxmen will indeed accept back its own paper in settlement of the tax obligation it imposes. Legal tender laws were in any case improved in ways that would only enhance the ability of governments to give their own money currency—by fiat—in just the manner Smith describes. In time, the same procedure became normal state practice the world over, and it would help explain how all states could eventually abandon any promise of convertibility to gold.

A harbinger came in Smith’s own day, not long after the 1776 publication of the Wealth of Nations. In 1797, the Bank of England suspended gold convertibility for war finance. The Bank of England resting at the apex of the global credit-money hierarchy, England—and by extension much of the world—shifted to a naked (or at least topless) credit-money economy for over two decades.

Plus, by then, Alexander Hamilton’s American experiments in public finance had shown fruit.Footnote ⁴⁷ And if nineteenth-century metal standards hardly brought a growth miracle to North America, the miracle did begin and happen by the mid-twentieth century, after the establishment of the U.S. Federal Reserve System in 1913 and the abandonment of domestic gold convertibility by U.S. President Franklin Delano Roosevelt in 1933.

Did unprecedented prosperity come in the twentieth century mainly despite what had by that time become a heavy, visible financial-regulatory hand in the United States and elsewhere? Would free private banking have achieved even better results had it only been tried properly? Would the United States have been set upon on an even greater path of growth, being less prone to crisis, had it only trusted private bankers even more than it did during decades of financial liberalization? Perhaps some would take that bet. A good Smithian might cautiously celebrate the miracle.