ECON 307 - Mercantilism

Evolution of Economic Thought

Outline Two: Mercantilism

What is Mercantilism?

No general definition of mercantilism is entirely satisfactory, but it may be thought of as a collection of policies designed to keep the state prosperous by economic regulation.

The expression “mercantilist” was introduced by Adam Smith—and the “mercantilist system” was what he referred to as the protectionist policies of the eighteenth century.

David Ricardo’s followers used the term mercantilists to denote all authors who defended these protectionist policies.

Mercantilism prevailed in France, England, Spain and Holland. And many of its theories/policies are alive and well today.

Let’s recognize two approaches to defining Mercantilism (although not a unified body of thought – there are different strands):

Doctrinal approach—

Policy approach—

Both view mercantilism as a system of power. Economics should be subordinated to the interests of the state.

Perhaps both approaches are correct to some degree?

An important part of Mercantilism was:

Government granted monopolies- "royal letters patent of monopoly"- the government conferred upon private persons or corporations the exclusive right to produce or sell certain commodities.

Chartered companies especially (A chartered company is an association formed by investors or shareholders for the purpose of trade, exploration and colonization.)—were an important source of royal revenue.

Also used to promote the introduction of new lines of industries such as glass and soap.

Sound familiar today? (called "infant" industry protection by the state).

But also often used to grant favors for political or personal reasons.

Economist Jacob Viner explained:

The laws and proclamations were not all, as some modern admirers of the virtues of mercantilism would have us believe, the outcomes of noble zeal for a strong and glorious nation, directed against the selfishness of the profit-seeking merchant, but were the product of conflicting interests of varying degrees of respectability. Each group, economic, social, or religious, pressed constantly for legislation in conformity with its special interest. The fiscal needs of the crown were always an important and generally a determining influence on the course of trade legislation. Diplomatic considerations also played their part in influencing legislation, as did the desire of the crown to award special privileges, con amore, to its favorites, or to sell them, or to be bribed into giving them, to the highest bidders. (Studies in the Theory of International Trade (1937, pp. 58-59). Bolding is mine.

Today we call this political process of granting favors Rent Seeking:

Economic rent:

Rent seeking:

We still see mercantilism in the “rent seeking” activity of business to obtain special government privileges in exchange for financial support of politicians and the government generally speaking.

Tariffs, for example, are partly (mostly?) due to the payments made by industries to politicians.

Mercantilism and Wealth

The Basic Assumption Regarding Wealth in Mercantilist Thought:

The "pie" was considered "fixed" – the only way to get richer was at the expense of others. This is still widely accepted today – if Bob gets richer, people believe it is at the expense of someone else.

Is this true? Does it depend upon how he gets rich?

The idea is that the total volume of power and wealth available for all countries was a more or less fixed magnitude—so that a gain in the struggle for power and wealth of one country could be secured only at the expense of others (or the power and wealth of one company could be secured only at the expense of other companies).

Philosophers of history used this approach to explain the rise and decline of empires. As one empire flourished, another fell.

This idea most likely shaped policy in the middle of the sixteenth century to the middle of the seventeenth century (and to some degree still does).

Wealth was also seen in terms of the amount of money that a country had in circulation. Money at that time was gold and silver. Losing gold and silver meant less money circulating – decreasing wealth in the country.

The Principles of Mercantilism

The following ideas (or rules), then, lumped together, may be called mercantilism. Quotations are from:

Philipp von Hornick (1640 - 1714)—Austrian lawyer and civil servant —published his nine principles in 1684

(1) Bullionism was the belief that the economic health of a nation could be measured by the amount of precious metal, gold or silver, (money) which it possessed.

What was behind this idea? Most likely:

a. The rise of a money economy – people only thought in terms of money (not in terms of real goods and services):

b. the stimulation produced by the influx of bullion from America:

c. the fact that taxes were collected in money,

all seemed to support the view that hard money was the source of prosperity, prestige, and strength.

—“no trouble or expense should be spared to discover gold and silver.”

Bullionism dictated a "favorable" balance of trade. That is, for a nation to have gold on hand at the end of the year, it must export more than it imports:

(2) Each nation tried to achieve economic self-sufficiency. Those who founded new industries should be rewarded by the state. All natural resources should be turned (manufactured) into something to sell.

--- These rules were designed to get a “surplus of gold, silver, and all other things necessary or convenient for its subsistence, derived, so far as possible, from its own resources, without dependence upon other countries…”

(3) A large population was needed to provide a domestic labor force to people colonies. And nobody should be idle! A higher population should come about if the other rules are followed because the demand in other countries will go down (fewer exports) -- decreasing the economy in those countries - which will induce people to move to the prosperous "mercantilist" country for jobs and a better life.

(4) Gold and silver should always remain in circulation within the country. This will ensure that the country will always prosper and not "sink into poverty." Don't bury your gold in the back yard!!

(5) Luxury items were to be avoided because they took money out of the economy unnecessarily. Must buy within the country. This would also help to ensure a favorable balance of trade:

Trade Surplus:

Trade Deficit:

(6) Items that must be obtained from foreign markets should be bought using "domestic wares" (not gold and silver) as much as possible (barter, as such). This also includes transporting the goods - therefore, a powerful merchant fleet would mean that a country would not become dependent on foreign assistance. In addition, a fleet could add to a nation's prestige and military power. Sea power was necessary to control foreign markets.

(7) Any imports should be in the "unfinished form" (in order to produce domestically).

---“the payment of manufacturing generally exceeds the value of the raw material…”

(8) Colonies could provide captive markets for manufactured goods and sources of raw material.

---“consumption, so to speak, must be sought in the farthest ends of the earth, and developed in every possible way.”

(9) Regulated commerce could produce a favorable balance of trade. In general, tariffs should be high on imported manufactured goods and low on imported raw material. No imports should be allowed if they can be obtained domestically.

To add to these nine rules - mercantilism also included:

Thriving agriculture should be carefully encouraged. Domestic production not only precluded imports of food, but farmers also provided a base for taxation.

State action was needed to regulate and enforce the above policies.

Here we have a "big debate" on international trade using the theories of:

English Mercantilist and businessman Thomas Mun (1571-1641) and Scottish philosopher David Hume (1711 – 1776).

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Mun's work, England's Treasure by Foreign Trade is his most famous.

The Favorable Balance of Trade Concept:

Acquisition of precious metals (money) through foreign trade represented an advancement in power over other countries which competed for the available supply of metals.

Domestic trade was pretty much irrelevant.

The concept of “cost” was held to be applicable only to the total volume of a country’s trade with other countries, and a gain could result only when this trade showed a surplus expressed by the inflow of precious metals.

Trade and Specie (Gold and Silver) Flow

Mun took into account the relation between increases in the volume of money and the increase of prices→ he didn’t like increase in P’s→ so he wanted to counteract this by reinvesting the surplus (from exports) in agriculture and fisheries on one hand and in manufacturers on the other – increase productivity in order to decrease the increase in prices.

So he did seem to understand that inflation would not occur with an increase in money if there was an offsetting increase in the demand for money (people would demand more money in order to facilitate more trade that would take place with more productivity to trade). Although he didn't talk about the demand for money as economists do today.

He favored the exportation of commodities which were labor intensive….aversion to importation of luxury goods.

This, of course, flies in the face of the idea that the pie is fixed! So although he agreed with much of what von Hornick wrote – he did have some differences. He seemed to want international trade – but it should be highly regulated.

In steps Adam Smith's friend, David Hume. One of his most famous theories was his explanation of the relationship between specie flow and prices. Although Mun understood that there was a relationship between the volume of money and prices -- Hume disagreed with his solution (reinvesting, etc.) and said that it is impossible for a country to continuously maintain a favorable balance of trade ---

Hume’s Price Specie Flow Mechanism: David Hume is really credited for explaining what is called the specie flow mechanism more correctly (although he had his predecessors). Or at least he pointed to a price-specie flow mechanism that linked the quantity of money to prices and alterations in prices to balance-of-trade surplus and deficits.

The process:

(1) Inflow of gold in England. Only gold can be used as a medium of exchange.

(2) The money stock increases in the same proportion (a fiat money fractional reserve system would magnify the increase).

(3) Price level increases. (Including export goods)

(4) Foreign countries’ (with less money) prices decrease, buy less from England.

(5) British citizens buy more foreign goods, less British goods.

(6) English trade surplus becomes a deficit.

(7) Gold flows out, money stock decreases, prices decrease, surplus again!

The cycle continues and the attempt to accumulate gold is self-defeating

As Hume mentions→ this could be good for industry before prices rise….

“betwixt the acquisition of money and rise of prices…”

But he argued that money is only a “veil” in the economy—it is not real, it does not contribute to real economic growth or productivity — the stock of money, therefore, is not important—after the price level adjusts.

So here we have the beginnings of the “quantity theory of money” - still very famous today (via Irving Fisher, the Monetarists - Milton Friedman, and others):

_ _

MV=PQ

M =

V =

P =

Q =

So we have a direct, proportionate relationship between M and P.

_ _

Or P= f (M, V, Q). (V and Q are held constant).

↑ ↑

This theory will resurface over and over again....

The Defenders of Mercantilism (Then and Now)

(1) The Liquidity Rationale:

Some see mercantile policies as appropriate for their time…after the collapse of the feudal system - those strong policies were justified.

Supply of specie had a very low elasticity at a time when the transactions requirements of commerce and trade were mushrooming.

Review the concept of elasticity (responsiveness) - how responsive is one thing to a change in another?

Output elasticity of the money supply:

How responsive is the supply of money to a change in the output or number of transactions (the pie)?

% change in supply of money/% change in output or transactions = very low number

Remember, any coefficient less than one means inelastic -- not responsive.

The money supply did not adjust quickly to a change in output or number of transactions - so as the pie got larger, the money supply did not -- so need to pull in money to deal with this increase in the need for money transactions. Since the money was "hard money" that could not be duplicated at will (as with non-backed fiat or paper money) - the idea is that as the pie gets larger, need to get more money by importing it.

One response to this was that velocity of money would simply increase to facilitate the increase in the pie or number of transactions.

Velocity should increase with the increase in transactions. But velocity is not indefinitely expansible. Business and consumers can economize just so much on cash-balance holdings.

So the mercantilist quest for specie as a means of facilitating exchange—given the specie is monetized (legal tender) — was a justification for mercantilism.

(2) Keynesian Defense

J. M. Keynes - From The General Theory on Employment, Interest and Money (1936) - "Notes on Mercantilism, The Usury Laws, Stamped Money and Theories of Under-Consumption" was a defender of mercantilism.

Remember that Keynes says that the economy is demand driven.

Aggregate Demand (AD) = C + I + G + Net Exports

Must stimulate AD to stimulate production and employment. If demand is higher, the income of firms would be higher, therefore, employment and personal income would also increase.

By the United States, for example, pushing exports over imports through import tariffs, etc.:

Increases foreign demand -

increase in MS (dollars coming back to the United States)-

decrease in interest rates (more supply of money to loan out) so there is more money borrowed -

GRAPH - the loanable funds market:

this leads to an increase in domestic investment (although Keynes said that only long run domestic investment is a function of interest rates, the short run rates would not change investment very much)-

From Keynes (General Theory):

"At a time when the authorities had no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade were the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of the precious metals was their only indirect means of reducing the domestic rate of interest and so increasing the inducement to home investment."

AD = C + I + G + Net Exports

But Keynes understood that there were "limitations" to this theory "which must not be overlooked":

1. Domestic wages might increase:

His first limitation is that if domestic investment increases so much (leading to an increase in production and employment) - the increased demand for workers could cause wages to increase such that the cost of domestic production increases -- decreasing foreign demand.

"If the domestic rate of interest falls so low that the volume of investment is sufficiently stimulated to raise employment to a level which breaks through some of the critical points at which the wage-unit rises, the increase in the domestic level of costs will begin to react unfavourably on the balance of foreign trade, so that the effort to increase the latter will have overreached and defeated itself."

So AD = C + I (up) + G + Net Exports (down)

Increasing investment would cause the demand for labor and therefore wages to increase – increasing the costs of domestic production and prices of domestic goods. Therefore, foreign demand will decrease - offsetting the increase in investment.

2. Foreign investment might decrease:

His second limitation is that if the interest rate falls too low - foreign investment will move to other countries - taking precious metals out of the country and therefore offsetting the effects of the "favorable balance of trade" (money supply decreases, interest rate goes back up, domestic investment goes back down).

"Again, if the domestic rate of interest falls so low relatively to rates of interest elsewhere as to stimulate a volume of foreign lending which is disproportionate to the favourable balance, there may ensue an efflux of the precious metals sufficient to reverse the advantages previously obtained."

AD = C + I (down) + G + Net Exports

"The risk of one or other of these limitations becoming operative is increased in the case of a country which is large and internationally important by the fact that, in conditions where the current output of the precious metals from the mines is on a relatively small scale, an influx of money into one country means an efflux from another; so that the adverse effects of rising costs and falling rates of interest at home may be accentuated (if the mercantilist policy is pushed too far) by falling costs and rising rates of interest abroad."

Also interesting from Keynes (in relationship to Mercantilism):

A favorable balance of trade should not be overlooked:

"Nevertheless, if we contemplate a society with a somewhat stable wage-unit, with national characteristics which determine the propensity to consume and the preference for liquidity, and with a monetary system which rigidly links the quantity of money to the stock of the precious metals, it will be essential for the maintenance of prosperity that the authorities should pay close attention to the state of the balance of trade. For a favourable balance, provided it is not too large, will prove extremely stimulating; whilst an unfavourable balance may soon produce a state of persistent depression.

A favorable balance of trade for one country means a disadvantage for another country (assuming that gold and silver are not being mined at great rates).

"The fact that the advantage which our own country gains from a favourable balance is liable to involve an equal disadvantage to some other country (a point to which the mercantilists were fully alive) means not only that great moderation is necessary, so that a country secures for itself no larger a share of the stock of the precious metals than is fair and reasonable, but also that an immoderate policy may lead to a senseless international competition for a favourable balance which injures all alike."

Although he does think that too much regulation of international trade is a bad thing -- it will hurt the ability of a country to benefit from the favorable balance of trade - decreasing imports will harm exports.

"And finally, a policy of trade restrictions is a treacherous instrument even for the attainment of its ostensible object, since private interest, administrative incompetence and the intrinsic difficulty of the task may divert it into producing results directly opposite to those intended."

Here he is criticizing Classical Economics - Hume and Smith especially.

"Thus, the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire doctrine upon which I was brought up and which for many years I taught;— against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time."

Criticisms of the overall Keynesian theory are:

(A) Is the economy really demand driven? If you are a "Say's law" economist - trying to increase demand does not make sense. Looking at investment as an increase in productivity, instead of as an increase in demand, is another way to approach this.

(B) An influx of money into an economy doesn't necessarily decrease interest rates - depends upon where the money goes, etc. If the new money is spent and not saved -- does not contribute to the supply of loanable funds (at least in the short run) and therefore would not lower interest rates.

Keynes does qualify this to some degree.

(C) Is this really the best - or even a good - way to stimulate investment in an economy - especially long term? Remember, Keynes was a short-run economist.

IN CLASS DISCUSSION TWO