“The good policy of the magistrate”:

deflation as a policy option

in David Hume’s economic essays

“The good policy of the magistrate”:

deflation as a policy option in David Hume’s economic essays

David Hume’s monetary analysis has often been interpreted as either describing money neutrality, or as promoting mild inflationary policies, or as a combination of the two. This paper challenges these traditional readings of David Hume’s monetary essays by claiming that Hume’s policy prescription is deflationary instead. The position of this paper is derived from a close reading of Hume’s texts, an analysis of his examples, and from highlighting similarities between Hume’s analysis and other 18th century deflationary authors familiar to Hume.

“The good policy of the magistrate”:

deflation as a policy option in David Hume’s economic essays

Hume's economic Essays appeared in 1752. In the related essays: of Money, of the Balance of Trade, of Commerce, Hume follows step by step, and often even in his personal idiosyncrasies, Jacob Vanderlint's Money Answers All Things, published in London in 1734 …he even copies Vanderlint's absurd notion that by accumulating treasures commodity prices are kept down.

Marx 1887

The word deflation tends to have a negative connotation. This may be due in part because of, among others, the deflationary pressure of the Great Depression, in part because of the popularity of Phillips Curve-based policies, or in part because of the recent sympathy for price stability. Even Milton Friedman (1969), one of the most famous scholars to claim that deflation is efficient, backed away from claiming that deflation should be a policy option. But does deflation really deserve such a negative connotation? Has deflation always been a policy to avoid?

This paper presents a case in favor of deflation as presented by a less common reading of David Hume. It does not imply that Hume was right, but simply that Hume looked at deflation in a favorable way.

In his economic essays, Hume claims that industry and commerce determine the equilibrium quantity of money in an economy. Demand determines industry and commerce; and customs and manners of the people determine demand. The combination of this with the specie flow mechanism that Hume describes implies that artificially increasing or decreasing the quantity of money above or below the economy’s equilibrium would have no significant positive real effects on the economy. Nevertheless, part of Hume’s fame as an economist is due to his alleged inflationist claim that the “good policy of the magistrate consists only in keeping [money], if possible, still encreasing” (Hume [1752] 1985, 288).

The problem with Hume’s inflationary policy prescription is two-fold. First, if the equilibrium quantity of money is, in the end, determined by its demand and the demand of consumption goods, wouldn’t it be pointless for the magistrate to attempt to keep money increasing? Second, how could the magistrate increase the quantity of money, given the visceral aversion of Hume for paper-money and the irrelevance of the results of debasement?

Hume may not be promoting a money-driven economic expansion, but a “commerce-driven” productivity expansion. An increase in commerce, in particular an increase in exports, would increase money inflow. Continuing to export would keep the money inflow increasing. The good policy of the magistrate may not be the alleged inflationary increase in money supply, but an attempt to increase exports. By a close textual analysis of the essays “Of Money” and “Of the Balance of Trade,” this paper will show that, paradoxically, to keep the money “still encreasing,” Hume’s “good policy of the magistrate” is to promote a decrease in money supply, rather than its increase. The decrease in money supply is achieved by (individual) hoarding. Hoarding takes money out of circulation, decreasing money supply, and therefore decreasing prices of domestic goods. Lower prices stimulate commerce by stimulating exports. Increasing exports “keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches” (288). And by selling more and more goods abroad because of their lower prices, more and more money would come in, keeping the money “still encreasing.” The decrease in prices achieved through a decrease in money supply stimulates commerce and therefore industry. The decrease in prices achieved through a decrease in money supply is therefore the “good policy of the magistrate” that Hume prescribes.

This paper opens with a brief analysis of the meaning of price and deflation, and of what money consists of for Hume. A concise description of the economic forces relevant for Hume’s deflationary policies follows. Then the paper analyzes the deflationary instruments that Hume considered, and the reasoning that Hume uses to reject inflationary policies and other alternatives to stimulate the economy. Short concluding remarks close the paper.

Definition of price and deflation

Hume uses terms that are not used today, and the relevant modern terminology was basically unknown in Hume’s time. Hume talks about “rising prices” and “sinking prices.” Today we rather talk about inflation and deflation. Hume’s “rising prices” is commonly associated, even if anachronistically, with inflation. As a parallel, his “sinking prices” will be here referred to as synonymous with deflation, given certain qualifications as explained below.

Prices, for Hume, “are always proportioned to the plenty of money” (281), that is, prices are the proportions between the amount of goods in circulation and the amount of money in circulation. Prices “sink”—decrease—when the number of goods in circulation increases more (or at a faster rate) than the quantity of money in circulation or when money in circulation decreases. Vice-versa, prices rise if the amount of goods in circulation decreases, given a certain level of money, or if the amount of money in circulation increases more than the quantity of goods.

The amount of goods in circulation depends on demand, and demand depends on the refinement in society’s tastes. The amount of money in circulation depends on the amount of people and the level of “art and industry” of that country, that is, on the level of demand and of commerce. Therefore, in a “rude and unrefined” society, holding the quantity of money constant, prices would be high because so few commodities are exchanged, because people are happy consuming whatever they can produce themselves. On the other hand, decreasing prices are a symptom of a refining and growing economy. “The necessary effect [of refinement on all these enjoyments] is, that, provided the money encreases not in the nation, every thing must become much cheaper in times of industry and refinement, than in rude and uncultivated ages. It is the proportion between the circulating money and the commodities in the market, which determines the prices. … the proportion being here lessened on the side of the money, every thing must become cheaper, and the prices gradually fall” (291-2). Similarly, since prices are defined as the proportion between goods and money in circulation, assuming the quantity of goods in circulation is constant, changing the quantity of money will change the proportion between money and goods, therefore changing the prices. So “[s]uppose four-fifths of all the money in GREAT BRITAIN to be annihilated in one night … must not the price of all labour and commodities sink in proportion, and everything be sold … cheap…? …Again, suppose, that all the money of GREAT BRITAIN were multiplied fivefold in a night, must not the contrary effect follow? Must not all labour and commodities rise to such exorbitant hight…?” (311)

For the purpose of this paper, there are at least four relevant consequences of considering prices as the proportion between goods and money.

An implication of considering prices as the proportion between output and money is the absence of the idea of velocity. Hume “”does not [even] mention the velocity of circulation” (Holtrop, 1929 p. 513)” (as cited in Cesarano 1998, 177).

A second consequence of considering prices strictly as the proportion between money and goods in circulation, in conjunction with understanding money as “agreed upon,” is a kind of blurring between real and nominal values. Money is what is used as money, regardless of its shape, substance, or color (Hume [1752] 1985, 290). And prices are always the proportion between whatever is used as money and goods. And increase, or decrease, in either paper-money or gold-money would generate the same increase, or decrease, in prices of domestic goods.

An additional consequence of considering prices as the proportion between goods and money is that considering the “sinking of the prices” as devaluation or depreciation is inaccurate. Today a decrease in the price of domestic goods in foreign markets may be achieved by increasing the quantity of domestic currency in the foreign exchange market. This inflationary pressure is what decreases the value of the national currency in terms of other nations’ currencies. On the other hand, when prices are considered as the proportion of goods and money, as in Hume’s case, decreasing the quantity of money rather than increasing it achieves the desired reduction of prices. Furthermore, as Hume considers gold and silver universal currencies, as shown below, and as precious metals were dealt with only in weight in international trade, exchange rate effects may not be considered. International price differences may be treated as simple arbitrage situations.

A final consequence of considering prices as the proportion between goods and money is that, if narrowly defined, the “sinking of the prices” could be called deflation, just as the “rising of the prices” is called inflation. Today, deflation has at least three meanings: “1) A reduction in aggregate demand… 2) A fall in average price level. 3) The elimination of price increases from an index of production or consumption. Economic statisticians are frequently engaged in ‘deflating’ time series to separate real from nominal changes” (Rutherford 1992, 112). The third definition ought not to be considered for our purposes, as alien to Hume. The first definition is also inappropriate here, as for Hume a decrease in demand, holding the quantity of money constant, would increase prices because it would “increase the proportion between money and commodities on the side of money.” If we instead define deflation simply and solely as “a fall in average price level,” with some qualifications, we can use interchangeably the terms “sinking of the prices” and “deflation.” The qualifications are the following. First, Hume talks about “prices” rather than “price level,” a concept invented only later. Second, the mechanisms through which deflationary pressure affects the economy are not to be considered in the definition of deflation. Some economists today associate the definition of deflation with liquidity trap and low interest rates (Black 2002). But Hume completely disconnects all monetary analysis from interest rates.

Defining deflation narrowly as a decrease in prices allows us to use the term as a modern synonym of “sinking of the prices.” Using the term deflation, therefore, parallels the use of the term inflation for “rising of the prices” so commonly used in the literature on Hume. And just as an increase in money supply in Hume is commonly referred to as inflation, a decrease in money supply will be here referred to as deflation.

For Hume, prices decrease if either production increases or if money decreases. Production depends on demand and demand depends on tastes; and as we will see, for Hume, a magistrate has no power over tastes. Therefore, the other possible option to sink prices is to decrease the quantity of money. And as we will see, for Hume, the magistrate may have some power over the quantity of money. The ways in which in actuality money can be “annihilated” or “multiplied” will be discussed below.

Definition of money

A relevant step to analyze Hume’s monetary prescription is to understand his idea of what money is. Hume defines money as “not properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another” (Hume [1752] 1985, 281).

For the purpose of this paper, there are two relevant factors in Hume’s definition of money: the relative lack of relevance of money in the growth of the economy (“money is not one of the subjects of commerce”) and the “agreed upon” character of money. Let us focus here on the “agreed upon” character first. The relative unimportance of money in the economy will be looked upon in conjunction with the analysis of the relevant forces in the economy in the following section.

Hume seems to adopt the traditional idea, still shared in the 18th century, that money is such by convention. Money derives from the Greek nomisma, which shares the root with nomos, human conventions. Due to their desires, men begin to trade. But the more they trade, the stronger is the need to overcome the problems of the double coincidence of wants present with barter. Money emerges, therefore, as “the instrument which men have agreed upon to facilitate the exchange of one commodity for another.”

The forms, shapes, and denominations that money may take do not seem to matter, as long as they are “agreed upon.” So Hume claims that “[t]hese [precious metals] admit of divisions and subdivisions to a great extent; and where the pieces might become so small as to be in danger of being lost, it is easy to mix the gold or silver with a baser metal, as is practiced in some countries of EUROPE; and by that means raise the pieces to a bulk more sensible and convenient. They still serve the same purposes of exchange, whatever their number may be, or whatever colour they may be supposed to have” (290).

Now, in Hume’s time there were two major forms of money, precious metals and paper-money. Gold and silver were “agreed upon to facilitate the exchange of one commodity for another” not only domestically, but also for international transactions such as “negotiations with foreign states” and acquisitions of “mercenary troops [from] poorer neighbours” (282). Gold and silver had therefore the full status of money, as basically universally “agreed upon.” On the other hand, the status of paper-money was more problematic. Paper-money was voluntarily accepted only for some domestic transactions, and not all the time. Paper-money would never be accepted for international transactions being “there absolutely insignificant” (317). Paper-money could not therefore be as real a money as gold and silver because paper would not be “agreed upon” as money internationally. When Hume talks about money, he always means only gold and silver, unless explicitly specified otherwise.

Two relevant economic forces

Hume has elaborate descriptions of economic forces present in an economy. Two of them will be briefly highlighted here as relevant to understand how deflation is a policy option for Hume: demand (and industry) as the driving power of the economy, and the specie flow mechanism.

A demand-driven economy: from demand to industry to money.

Hume describes money as “not properly speaking, one of the subjects of commerce” but just as “the oil which renders the wheels more smooth and easy.” What moves an economy is its demand for goods, as “our passions are the only causes of labour” (261). Money follows the presence of commerce, and commerce follows the presence of demand for consumption goods.

Output increases as a consequence of an increase in demand, and demand increases as a consequence of a change in tastes. But tastes change because of commerce, as commerce allows individuals to discover new wants, and therefore to stimulate industry by producing more and better goods that will be exchanged for the previously unknown or unrefined products. “Thus [with commerce] men become acquainted with the pleasures of luxury and the profits of commerce; and their delicacy and industry, being once awaken, carry them on to farther improvements, in every branch of domestic as well as foreign trade… It rouses men from their indolence; and presenting the gayer and more opulent part of the nation with objects of luxury, which they never before dreamed of, raises in them a desire of more splendid way of life than what their ancestors enjoyed” (264, emphasis in the original).

That money is a consequence of trade and therefore of demand is testified by historical evidence, both from the far and the near past. From history we learn that “[t]he first and more uncultivated ages of any state, ere fancy has confounded her wants with those of nature, men, content with the produce of their own fields, or with those rude improvements which they themselves can work upon them, have little occasion for exchange, at least for money, which, by agreement, is the common measure of exchange … But after men begin to refine on all these enjoyments, and live not always at home, nor are content with what can be raised in their neighbourhood, there is more exchange and commerce of all kinds, and more money enters into that exchange. The tradesmen will not be paid in corn; because they want something more than barely to eat” (291). From a more recent history we can deduce that “the Spanish magistrate’s rapid march of the spirits, consisting of his thirst for conquest, treasure, political advantage, and imperial expansion, is the true causal factor; the consequent expansion in the quantity of money is an unlooked-for endogenous result” (Velk and Rotwein 2004, 6).