Having argued in Chapter 2 of Book One of the Wealth of Nations (WoN) that humans have a natural proclivity to truck, barter and exchange one thing for another – thereby putting the study of exchange transactions centre stage, at least in relation to Smith’s interest in the functioning of the economic system – Chapter 4 of the work provides a stylised, evolutionary/historical account of the role that money has played in economic development, by acting as a medium of exchange and a store of value.
After aptly characterising the status quo of the time as a ‘Commercial Society’, Chapter 4 gets going by identifying the high costs of commodity barter:
“But when the division of labour first began to take place, this power of exchanging must frequently have been very much clogged and embarrassed in its operations. One man, we shall suppose, has more of a certain commodity than he himself has occasion for, while another has less. The former, consequently, would be glad to dispose of; and the latter to purchase, a part of this superfluity. But if this latter should chance to have nothing that the former stands in need of, no exchange can be made between them.
Then comes a first-stage development:
“In order to avoid the inconveniency of such situations, every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in such a manner, as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry.”
Any commodity that has an enduring value can serve this latter purpose and, inter alia, Smith mentions salt and cattle (“The armour of Diomede, says Homer, cost only nine oxen; but that of Glaucus cost a hundred oxen”), but the history recounted points to a general emergence of metals and then, later, to a standardised coinage (Smith only considers ‘paper money’, which was an innovation of his time, later in the WoN.)
The key criterion to be satisfied is simply that the commodity is widely accepted as a means of payment in bilateral exchange processes, thus substantially reducing the very high costs of exchange associated with commodity barter. And it is the criterion of a ‘general acceptance’ that means that an established monetary system is an institution: ‘a structure of rules, norms, and conventional practices that shapes and constrains social behaviour on a persistent, relatively enduring basis.’
Given the necessary general acceptance, a secondary ‘selection process’ then kicks in to establish what form the monetary commodity (or commodities, since there can be more than one), should take: for example salt, cattle, gold, silver, copper, metallic coins, pieces of paper or plastic, digital, with the fitness for survival test being functionality in reducing the costs of effecting exchange transactions.
In a nutshell then, the general theorising of Chapter 4 is to the effect that institutional structures (here ‘money’ as an exemplar) have major, direct effects on economic conduct and performance and that institutional evolution is driven by a selection process that guides toward improved performance.
Smith’s focus on the significance of the costs of effecting exchange transactions was a perspective that was subsequently lost in later, high-level theorising in political economy and, a fortiori, in narrower economic analysis, which gave centre stage to the operation of the ‘price mechanism’. That negligence persisted until the arrival of a seminal paper by Ronald Coase (a lad from Willesden in London) in 1937, ‘The Nature of the Firm’.
Coase asked himself a very simple question (at age 21!): starting conceptually from a Smithian view of a massively complex sea of bilateral exchange transactions, why do we see the emergence of large business organisations? And the broad answer he came up with was that these organisations are institutional adaptations to relatively high costs entailed by some sub-sets of bilateral exchange transactions.
The sources of such ‘transactions costs’ are many and varied, and although other institutional forms such as ‘money’ and ‘markets’ had made major contributions to reductions in their levels, over time, the costs had by no means been reduced to zero. Thus, notwithstanding the known dysfunctions of large organisations, there was scope for such entities to ‘beat the market’ in the cost-reduction selection process.
Thus, Coase had recognised the generality of Smith’s reasoning in chapter 4 of the WoN concerning the implications of transactions costs for economic theory and practice. In his Nobel Prize Lecture. He said:
“My contribution to economics has been to urge the inclusion in our analysis of features of the economic system so obvious that, like the postman in G.K. Chesterton’s Father Brown tale, The Invisible Man, they have tended to be overlooked.”
In the same Lecture, he went on to say:
“I know of only one part of economics in which transaction costs have been used to explain a major feature of the economic system and that relates to the evolution and use of money. Adam Smith pointed out the hindrances to commerce that would arise in an economic system in which there was a division of labour but in which all exchange had to take the form of barter. … However, the nature of the benefits secured by the use of money seems to have faded into the background so far as economists are concerned and it does not seem to have been noticed that there are other features of the economic system which exist because of the need to mitigate transaction costs.”
The (wilful?) blindness to an obvious feature of the economic system leads to a rather depressing, Coasean conclusion: “What is studied is a system which lives in the minds of economists but not on earth. I have called the result [by way of reference to an old technology] ‘blackboard economics’.”
It is a poor, relatively unproductive gestalt that tends to percolate in economic thinking. In words used by Keynes in another context, the implicit assumption of zero transaction costs, which is surreptitiously sneaked into most teaching of micro-economics, is “an extraordinary example of how, starting with a mistake, a remorseless logician can end up in bedlam.”