2.2 Money as Capital Stock
In a system in which money is used, it represents stock, but must be considered differently from other materials. There are certain ambiguities of language that give rise to the misunderstanding of money: chiefly, that money represents on one hand "nothing but the metal pieces" of coinage, but on the other hand, it represents the goods that can be had in exchange for it, from which it is significantly different.
Money is not directly consumed in the act of production (except in the rare instance where silver coins are melted to fashion goods made of silver), nor is it destroyed or consumed by its use in commerce, but merely passes from one hand to another as a token of exchange. Neither is it significantly diminished in value or use in circulation. And finally, the amount of money in circulation does not have any impact on the amount of goods available in a society.
Money, Wealth, and Welfare
Thus, when we calculate the amount of money in a market, this has little to do with the wealth or productivity of a nation. However, when we determine what a given worker or production operation is "worth," money is considered a direct representation of the quantity of goods that are produced. And when we consider the value of a good in money, we consider the effort that must be undertaken to produce or obtain it.
This is generally understood to be the value of money, as in negotiating wages, the workman must consider his needs in terms of the goods he must purchase to determine whether a given sum of money is sufficient to meet them. This distinction is often lost in the aggregate, when considering the welfare of a nation, money is often used as a measure.
And while money is considered "the great wheel of circulation," and does indeed serve a valuable function in exchange, it has practically nothing to do with the amount of goods being produced and consumed in a society, which is the true measure of the welfare of the people.
And finally, another parallel is to be drawn between capital such as land and equipment and money - in that the mere having of these things does not generate any revenue, but only their productive use. That is, to measure the welfare of a people by the amount of coins they have and hoard. One does not assess population counting empty houses, or measure production by the number of idle factories - and it follows that the welfare of a people cannot be assessed by tallying hoarded money.
The Need of Capital
When considering the need of stock, in the form of materials and goods, we must consider the consumption of goods as the root of all demand. A producer seeks to produce only as much goods as he expects will be demanded by those who will consume them.
In turn, the producer's own need for materials and labor are determined by the amount he needs to produce (to satisfy consumption); and those who produce materials for the use in production of goods are likewise driven by the demand for their materials, as determined by the level of production of finished goods needed ultimately for consumption.
There may be an offset of time, where goods are presently produced that are stored for later sale (for later consumption). There may also be an offset of location, where goods are produced in one town for consumption in another (EN: The notion of foreign trade will be considered later). But these do not impact the quantity of goods, but merely the time at which a given quantity will be produced.
As such, the producers' need of capital is driven by consumption, and calculated based on the cost of production, primarily the costs of wages and materials. The consumer's need of capital is likewise driven by his own consumption, the need to have as much capital as he will need to obtain the goods he wishes to consume.
Taken together, these two factors can be used to calculate the amount of money that is needed in a given society at any given time.
Paper Money
The most common form of paper money is that issued by banks: provided that the individuals who are offered bank notes have confidence in the capability and willingness of the bank to redeem them for metal coinage, paper money functions as the equivalent of metal in commerce.
(EN: Smith makes no distinction between commodity money, whose value is backed entirely by metal reserves at the issuing bank, and credit money, for which the bank may not presently have sufficient metal to redeem all at once, but expects to be able to redeem in future. I'll avoid making distinctions here, as it is done in other sources.)
In issuing paper money, banks are able to increase the amount of money in circulation. Though some banknotes are redeemed promptly for metal, others remain in circulation for "months and years," and a banker is therefore able to issue more notes than he has in metal reserves, provided that he is successfully able to predict the amount he will need to redeem notes when they are presented. For example, a banker may underwrite notes for one hundred thousand pounds' of silver, but knowing only 20% of them will be redeemed in the present year, needs only twenty thousand pounds of metal in reserve.
(EN: Later in the chapter, quite some consideration is given to the method by which this estimation may be made, and the risk to the banker in miscalculating - if he overestimates his need of reserves, he fails to make efficient use of capital; if he underestimates his need, he may find himself unable to redeem the notes he has issued, damaging his ability to have his notes accepted. It does not generally result in the invalidation of his notes, as the debts payable to him are not cancelled, but merely a temporary cash flow issue that prevents the bank from generating income from extending additional loans until it regains liquidity. The only way in which ha banknote can become worthless is for the creditors of the bank to default on their loans.)
By the issue of paper money, commerce in his market can take place using only a fifth of the metal that would be required if only silver coin were used in transactions (or viewed another way, there can be five times as much commerce as there is metal).
If exchange is made solely upon commodity money, gold and silver coin, the lack of coinage may be inhibiting to production and trade on the level required by a given society. This results in the reduction of prices to reflect the scarcity of money. The opposite occurs when there is an abundance of commodity money in circulation, such that the scarcity of goods as compared to a plentitude of money cause the value of money to fall and the prices of goods to rise in terms of their money-prices.
Where paper money is substituted for gold and silver money, production and prices are liberated from strict correspondence to the amount of metal available to be used in trade. Thus by issuing more or less money, prices in a market can be stabilized, and the availability of money adjusted to the level at which money is deemed to be needed for exchange (so the quantity of money, rather than the value of each coin, is adjusted - or can be adjusted).
(EN: The author presents historical evidence of the value of paper money in stabilizing value and promoting industry in Scotland - it's a lengthy account that substantiates but does not augment the ideas expressed above.)
Commercial Credit
The use of credit can also be seen to facilitate production. The producer who does not have sufficient funds at present to obtain the materials and pay the wages of workers to produce his goods may obtain a loan for the duration of production, to be repaid when his goods are finished and sold.
Were he unable to obtain a loan, he would be unable to produce, and the market would be deprived of the goods he could produce were credit extended, to the detriment of consumers who have need of his goods.
However, this too is merely a displacement of value. In the instance of credit, the value to be created by production is not realized until the future. And this future is transferred to a promissory note in the present - so long as the loan is repaid, value is neither created nor lost in the borrowing and repayment of a sum.
In requesting credit, a producer is likewise encouraged to make an accurate estimation of future income from operations. If a business underestimates its future income, it will be inefficient in its use of capital - borrowing more money and paying more interest than is necessary. If it overestimates its future income, it may be unable to service its debt and damage its ability to obtain the credit it may require in future.
Paper Money and Foreign Trade
One limitation to paper money is that it cannot be used in foreign commerce. Because of the distance from the bank that issues a note, the fact that those abroad may not have familiarity with the reputation of the banker, and the differences in jurisdictions to provide legal remedy for the redemption of currency, paper money of one nation is generally not accepted abroad, and merchants who import goods must recourse to the use of metal for obtaining them.
The incidence of foreign trade , like trade among two villages in the same nation or even among two workmen on the same street, represents the consumption of goods in one location that are produced in another and is presumed, in an ideal situation, that the trade of goods achieves a balance, such that the imports to an exports of goods are equaled.
So long as foreign exchange results in the consumption of goods by individuals who produce goods, it promotes industry within a nation. But where foreign goods are exchanged for money, there is also the potential for them to be purchased for consumption buy those who do not produce goods, to the detriment of domestic industry.
However, even the latter case represents a temporary adjustment: a person who does not produce presently must have produced in the past (or has come by the capital of past production, in cases such as inherited money) to have wealth to trade for foreign goods. And as such, trade to obtain foreign goods is necessarily the exchange of production in one location for production in another.
(EN: This consideration seems to allay the concerns about "trade deficits" among nations - the notion that one nation "drains" the wealth of another, or that the second is being looted of its production by the former, is largely stripped of the tone of hysteria and panic that normally accompanies it - though I do sense that there is a ripple effect that could have temporary unfortunate consequences, in the longer view, it's of little concern.)