David Hume and the Theory of Money
[Excerpted from An Austrian Perspective on the History of Economic Thought, vol. 1, Economic Thought Before Adam Smith (1995). An MP3 audio file of this article, read by Jeff Riggenbach, is available for download.]
David Hume (1711–1776), the famous Scottish philosopher, was a close friend of Adam Smith's who was named Smith's executor, an acquaintance of Turgot's and of the French adherents of laissez-faire, and a member of the moderate élite of the Scottish Enlightenment.
Born in Edinburgh the son of a Scottish lord, Hume studied on the Continent, where he published his epochal philosophical work, A Treatise of Human Nature (1739–1740), at the age of 28. Hume's Treatise was pivotal in its corrosive and destructive skepticism, managing unfairly to discredit the philosophy of natural law, to create an artificial split between fact and value, and therefore to cripple the concept of natural rights on behalf of utilitarianism and indeed to undermine the entire classical-realist analysis of cause and effect.
There is no figure more important in the unfortunate discrediting of the classical philosophical tradition of natural-law realism, a tradition that had lasted from Plato and Aristotle at least through Aquinas and the late Scholastics. In a sense, Hume completed the corrosive effect of the 17th-century French philosopher René Descartes's influential view that only the precisely mathematical and analytic could provide certain knowledge. Hume's skeptical and shaky empiricism was the other side of the Cartesian coin.
While highly influential in later decades, Hume's Treatise was ignored in his own day, and after writing it he turned to brief essays on political and economic topics, and eventually to his then-famous multivolume History of England, which he presented from a Tory point of view.
Barred from academia for his skepticism and alleged irreligion, Hume joined the diplomatic corps and served as secretary to Lord Hertford, the British ambassador to France. In 1765, Hume became the British chargé d'affaires in Paris, and two years later rose to the post of undersecretary of state. Finally, in 1769, Hume retired to Edinburgh.
Hume's contribution to economics is fragmentary, and consists of approximately 100 pages of essays in his Political Discourses (1752). The essays are distinguished for their lucid and even sparkling style, a style that shone in comparison to his learned but plodding contemporaries.
Hume's most important contribution is his elucidation of monetary theory, in particular his clear exposition of the price-specie-flow mechanism that equilibrates national balances of payments and international price levels. In monetary theory proper, Hume vivifies the Lockean quantity theory of money with a marvelous illustration, highlighting the fact that it doesn't matter what the quantity of money may be in any given country: any quantity, smaller or larger, will suffice to do money's work of facilitating exchange. Hume pointed up this important truth by postulating what would happen if every individual, overnight, should find the stock of money in his possession to have doubled miraculously:
For suppose that, by miracle, every man in Great Britain should have five pounds slipped into his pocket in one night; this would much more than double the whole money that is at present in the kingdom; yet there would not next day, nor for some time, be any more lenders, nor any variation in the interest.
Prices then, following Locke's quantity theory of money, will increase proportionately.
The price-specie-flow mechanism is the quantity theory extrapolated into the case of many countries. The rise in the supply of money in country A will cause its prices to rise; but then the goods of country A are no longer as competitive compared to other countries. Exports will therefore decline, and imports from other countries with cheaper goods will rise.
The balance of trade in country A will therefore become unfavorable, and specie will flow out of A in order to pay for the deficit. But this outflow of specie will eventually cause a sharp contraction of the supply of money in country A, a proportional fall in prices, and an end to, indeed a reversal of, the unfavorable balance.
As prices in A fall back to previous levels, specie will flow back in until the balance of trade is in balance, and until the price levels in terms of specie are equal in each country. Thus, on the free market, there is a rapidly self-correcting force at work that equilibrates balances of payments and price levels and prevents an inflation from going very far in any given country.
While Hume's discussion is lucid and engaging, it is a considerable deterioration from that of Richard Cantillon. First, Cantillon did not believe in aggregate proportionality of money and price-level changes, instead engaging in a sophisticated microprocess analysis of money going from one person to the next. As a result, money and prices will not rise proportionately even in the eventual new equilibrium state.
Second, Cantillon included the "income effect" of more money in a country, whereas Hume confined himself to the aggregate-price effect. In short, if the money supply in country A increases, it will equilibrate not only by prices rising in A, but also by the fact that monetary assets and incomes are higher in A, and therefore more money will be spent on imports. This income, or more precisely the cash balance, effect will generally work faster than the price effect.
There are more problems with Hume's analysis, problems other than the omission of previously discovered truths. For while Hume conceded that it does not matter for production or prosperity what the level of the money supply may be, he did lay great importance on changes in that supply. Now it is true that changes do have important consequences, some of which Cantillon had already analyzed. But the crucial point is that all such changes are disruptive and distort market activity and the allocation of resources.
But David Hume, on the contrary, in a pre-Keynesian fashion, hailed the allegedly vivifying effects of increases in the quantity of money upon prosperity, and called upon the government to make sure that the supply of money is always at least moderately increasing. The two contradictory prescriptions of Hume for the supply of money are actually presented in two successive sentences:
From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means he keeps alive a spirit of industry in the nation.
Hume goes on, in proto-Keynesian fashion, to claim that the invigorating effect of increasing the supply of money occurs because employment of labor and other resources increases long before prices begin to rise. But Hume stops (as Keynes did) just as the problem becomes interesting: for then, it must be asked, why were resources underemployed before, and what is there about an increase in the money supply that might add to their employment?
As W.H. Hutt was to point out in the 1930s, deeper reflection would show that the only possible reason for unwanted unemployment of resources is if the resource owner demands too high a price (or wage) for its use. And more money could only reduce such unemployment when selling prices rise before wages or the price of resources, so that workers or other resource owners are fooled into working for a lower real, though not lower, money wage.
Furthermore, why should idle resources, as Hume implicitly postulates, reappear after the effects of new money have been fully digested in the economy in the form of higher prices? The answer can only be that after the price increases are accomplished and a new equilibrium attained, wages and other resource prices have caught up and the "money illusion" has evaporated. Real resource prices return to being excessively high for the full employment of resources.
Hume's inner contradictions on the quantity of money and inflation permeate his meager writings on economics. On the one hand, continuing inflation over the centuries is depicted as bringing about economic growth; on the other, Hume sternly favored ultrahard money in relation to the banking system. Thus Hume delivered a hard-hitting attack on the unproductive and inflationary nature of the very existence of fractional-reserve banking. He wrote of
those institutions of banks, funds, and paper credit, with which we are in the kingdom so much infatuated. These render paper equivalent to money, circulate it throughout the whole state, make it supply the place of gold and silver, raise proportionately the price of labour and commodities, and by that means either banish a great part of those precious metals, or prevent their further increase. What can be more short-sighted than our reasoning on this head? We fancy, because an individual would be much richer, were his stock of money doubled, that the same good effect would follow were the money of every one increased; not considering, that this would raise as much the price of every commodity, and reduce every man, in time, to the same condition as before.
Elsewhere Hume noted that inconveniences result from the increase of genuine money (specie), but at least they are "compensated by the advantages which we reap from the possession of these precious metals," including bargaining power in negotiations with other nations. But, he added, "there appears no reason for increasing that inconvenience by a counterfeit money, which foreigners will not accept of in any payment, and which any great disorder in the state will reduce to nothing." To "endeavour to increase" paper credit "artificially," then, merely increases money "beyond its natural proportion to labour and commodities," thereby increasing their prices.
Hume concluded his penetrating analysis with an ultra-hard-money policy proposal — 100 percent specie-reserve banking: "it must be allowed, that no bank could be more advantageous, than such alone as locked up all the money it received, and never augmented the circulating coin." Hume added that this was the practice of the famous 100 percent specie-reserve Bank of Amsterdam.
Another important flaw in Hume's analysis of money was his propensity, picked up and magnified by Smith, Ricardo, and the classical school, for leaping from one long-run equilibrium state to another, without bothering about the dynamic process through time by which the real world actually moves from one state to another. It is this brusque neglect (or "comparative statics") that leads Hume to omit the Cantillonian analysis of micro-changes in cash balances and income, and that causes him to neglect income effects in the price-specie-flow mechanism of international monetary adjustment. Ironically, by doing so, and thereby neglecting the "distribution effects" of changing assets and incomes during the process, Hume — as well as countless other economists following him — distorts what happens in equilibrium itself. For they then cannot see that the new equilibrium will be very different from the old. Thus, when the money supply changes, there will not be an equiproportionate increase in all prices across the board.
Professor Salerno puts the point very well:
there is some truth to Keynes statement that … "Hume began the practice amongst economists of stressing the importance of the equilibrium position as compared with the ever-shifting transition towards it." For, in reading Hume, one gets an unmistakable whiff, if not the full flavor, of the notion that it is in the states of long-run equilibrium that the economy actually resides most of the time. The transition between these states, Hume conceives as proceeding rapidly and terminating before another change in the economic data can intervene and propel the economy toward a new equilibrium. This notion at times leads Hume to truncate a full step-by-step analysis of a given change in the data, thus slighting or skipping over altogether its short-run effects in order to focus upon a comparative-static analysis of its ultimate consequences.
In reality, as the Austrians have emphasized, the situation is precisely the reverse of the Hume-British classical assumptions. Rather than the long-run equilibrium state being the fundamental reality, it never exists at all. Long-run equilibrium provides the tendency toward which the market is ever moving, but is never reached because the underlying data of supply and demand — and therefore the ultimate equilibrium point — are always changing.
Hence a full step-by-step analysis of a given change in the data is precisely what is needed to explain the process of successive short-run states which tend toward but never reach equilibrium. In the real world, the "long run" is not equilibrium at all, but a series of such short-run states, which will keep changing direction as underlying data are altered.
A final problem with Hume's monetary views is that, in contrast to the French laissez-faire school, he believed that money need not be a useful marketable commodity but was a mere convention. Writing to Abbé Andre Morellet (1727–1819), a disciple of Gournay's and lifelong friend of Turgot's, Hume opines that money functions as such because of the belief that others would accept it. Very true; but this does not mean that money originated as a mere convention. And Hume acknowledges that money should be made of materials "which have intrinsic value," for "otherwise it would be multiplied without end, and would sink to nothing."
Hume's thoughts on interest are illuminating, if only in contrast to the profundity and brilliance of Turgot's exposition 20 years later. Since money's impact is ultimately on prices only, Hume shows that interest can only be a phenomenon of real capital rather than of money. He discusses the relation between interest rates and profit rates (i.e., the fundamental rates of return on investment). Here he points out correctly that "no man will accept of low profits, where he can have high interest; and no man will accept of low interest where he can have high profits." In short, interest and profit rates tend to be equal on the market.
Very true, but which causes which, or what is the underlying cause of both? Hume characteristically abandons the search for cause, and says that "both arise from an extensive commerce, and mutually forward each other." Böhm-Bawerk is surely right when he says that this view is "somewhat superficial." But more than that, it is incorrect and reverses cause and effect by stating that "extensive commerce, by producing large stocks (capital), diminishes both interest and profits." For there is no reason why larger stocks of capital should lower interest or profit rates; what they do lower is the prices of capital goods and consumer goods.
The causal chain is the other way round: lower time-preference rates, which usually but not always attend higher standards of living and greater prosperity, will cause both capital to accumulate and profit and interest rates to fall. The two, as the Austrian School would later point out, are different sides of the same coin. 
Turning to the other areas of economics, it is possible that some of the deep flaws in Adam Smith's value theory were the result of David Hume's influence. For Hume had no systematic theory of value, and had no idea whatever of utility as a determinant of value. If anything, he kept stressing that labor was the source of all value.
On political economy, David Hume may be considered a free trader and opponent of mercantilism. A friend and mentor of Adam Smith from their first meeting in 1752, Hume came to know the French laissez-fairists during his years in that country, and Turgot himself translated Hume's Political Discourses into French.
 Professor Salerno attempts to justify Hume's curious assumption of a permanent tendency to unemployed resources by applying the Alchian–Allen information cost analysis. But this approach only explains the maintenance of any business inventory, inventory that, as Salerno shows, is not truly "idle" but performs an important function to the businessman of dealing with uncertainty. But such inventory hardly explains the unemployment of labor and other resources, which is presumably unwanted (since inflation supposedly eliminates this idleness) and hence involuntary. Of course if, as we would maintain, unemployment results from excessively high asking prices for resources, then this unemployment is brought upon the resource owners by their own actions, although as an undesired consequence. In a deep sense, then, this unemployment is really "voluntary." See Joseph T. Salerno, "The Doctrinal Antecedents of the Monetary Approach to the Balance of Payments" (doctoral dissertation, Rutgers University, 1980), pp. 160–2, and W.H. Hutt, The Theory of Idle Resources, (2nd ed., Indianapolis: Liberty Press, 1977).
 Unfortunately for the development of the British classical school and of economics itself, Hume failed to heed the criticism of his friend, and Adam Smith's childhood friend, James Oswald of Dunnikier (1715–1769). Oswald, an important MP who might have become Chancellor of the Exchequer, and whose advice on economics was sought by Hume and Smith, wrote to Hume that "the increased quantity of money would not necessarily increase the price of all labour and commoditys; because the increased quantity, not being confined to the home labour and commoditys, might, and certainly would, be sent to purchase both from foreign countries." Though Hume answered by conceding this cash-balance effect in the balance-of-payments adjusting mechanism, he failed to incorporate it into his fuller presentation of the price-specie-flow process. See Salerno, op. cit., note 6, pp. 252–3.
 Salerno, op. cit., note 6, pp. 165–6.
 Eugen von Böhm-Bawerk, Capital and Interest (South Holland, 111.: Libertarian Press, 1959), I, p. 30.
 Spiegel hails Hume's analysis as presaging "modern economic theory, with its functional approach" that replaces old-fashioned concern with cause and effect. Hume, he says, foreshadows "the later concern of economic science with functional rather than casual relationships, which … did not become common before the twentieth century." So much the worse for both Hume and 20th-century theory! For the functional, noncasual relations of mathematics are scarcely appropriate for an analysis of human action, where human preferences and choices are the cause, and have specifically traceable effects. Ironically, moreover, the great destroyer of cause and effect did not lack a causal theory of interest; instead, he picked the wrong end of the causal chain by claiming that low interest and profits were both caused by the accumulation of capital goods. Cf. Henry W. Spiegel, The Growth of Economic Thought (Englewood Cliffs, NJ: Prentice-Hall, 1971), pp. 211–2.