histofthought1

462 Economic thought before Adam Smithcentury, the value of gold and silver in Europe to about a third of what it had beenbefore. As it cost less labour to bring those metals from the mine to the market, sowhen they were brought thither they could purchase or command less labour. ..Even those few economists who laud Adam Smith as really adopting theHumean price-specie-flow mechanism concede that he dropped this approachwhen considering a mixed monetary system including bank notes or papermoney.28 Indeed, even though Smith occasionally adhered to the quantitytheory of specie money in its effects on prices, he here throws it over altogetherand asserts that convertible bank notes are always equal in value togold and hence their quantity will always remain the same. Any increase ofbank notes beyond the total of specie wilI 'overflow' the 'channel of circulation'and therefore return to the banks in what was later called a 'reflux', inexchange for specie which immediately flows out of the country. Smiththerefore explicitly denies that an increase in bank notes can raise the pricesof commodities. But why did Smith abandon the quantity theory completelyhere, in exchange for such nonsense? Plausibly, because of Smith's need tointegrate all value theory on the basis of the labour cost of production. If heever conceded that an increase in the quantity of paper money could affectvalues, even temporarily, then Smith would have had to admit an enormoushole in his labour-cost theory. For the 'labour cost' involved in printing papermoney obviously bears no relation whatever to the exchange value of thatmoney. Therefore, paper money, including bank paper, had to be assimilatedtightly to the value of specie.Adam Smith wrote in an eighteenth century Britain where virtually all hispredecessors had denounced the new institution of fractional-reserve bankingas inflationary and illegitimate. His friend David Hume (1752) had called forthe radical repudiation of this institution on behalf of 100 per cent speciereservebanking. Other important writers had taken the same position, includingJacob Vanderlint (d. 1740) in his Money Answers All Things (1734), andJoseph Harris (1702-64), master of the Royal Mint, in his An Essay UponMoney and Coins (1757-58). Harris had stated that banks were 'convenient'so long as they 'issued no bills without an equivalent in real treasure', butthat their increases of credit beyond that limit are inflationary and will eventuallyendanger the banks' own credit.If Smith had continued in his predecessors' footsteps, his commandingauthority and prestige might have been able to bring about a fundamentalreform of the fractional-reserve banking system. But, unfortunately, Smith, inhis need to meld all monetary theory into a long-run labour cost of productionapproach, abandoned the quantity theory and the specie-flow-price mechanismin his discussion of paper money. He thus set economic theory onceagain on an erroneous and fateful road by embracing the institution of frac-