Money and Say’s law

David Hume had argued, as early as 1752, that a change in the quantity of money in circulation must lead to a corresponding change in prices. This is the quantity theory of money. It followed that a shortage of money in circulation could not be a problem in itself because prices would adjust, while an increase in the stock of money would bring no lasting benefits because increased prices would leave the real situation unchanged. He admitted that activity might be stimulated temporarily while prices rose, but in the long run the only result would be inflation. Nineteenth-century economists took this to heart. Governments might be tempted to take a short-term view and stimulate the economy by creating money, but they should be prevented from doing so. Sound money became a quasi-moral imperative.

The natural complement to Hume’s monetary theory was Say’s law (so named much later), which was implicit in Smith but was developed and stated more clearly by JEAN- BAPTISTE SAY and James Mill at the beginning of the nineteenth century. According to Say’s law there can never be a general shortage of demand, or general overproduction, though there can be overproduction of particular things. The basic idea is simple and, up to a point, correct. People do not aim to earn money for its own sake, but to be able to buy things with it. An increase in production would normally generate a corresponding increase in incomes and in demand. The corollary is that there is no need to stimulate demand, say by an expansionary monetary policy. No one doubted that there were occasional crises and depressions, but they were mere blips caused by wars or other shocks. John Stuart Mill explained how demand might fall if people delayed spending, but argued that accumulated money holdings would be released after a while, restoring demand.

Hume’s theory dealt with the international dimension as well. In his time, money consisted of gold and silver. A deficit in trade with other countries would lead to an outflow of monetary metals, hence to a reduction in the money stock and a fall in prices, restoring competitiveness, righting the balance of trade and inducing a return flow of money. The world’s money stock would flow between countries until an equilibrium was reached. It followed that there was no need to worry about the balance of trade. The system would look after itself.

Hume’s monetary theory dominated throughout the nineteenth century but monetary debates flared up from time to time because the monetary and financial system was changing and developing. As banknotes came to be used more extensively in place of gold and silver coins, an outflow of precious metals (still the international standard) no longer automatically cut the supply of money in circulation. New legislation was required to control the issue of notes by (privately owned) banks. In Britain, for example, the right to issue notes was progressively confined to the Bank of England and the Bank’s note issue was linked to its gold reserves, to make a predominantly paper money behave as if it were metallic money.

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Money and Say’s law