Outlined by Scottish philosopher David Hume (1711-1776), among others, as an argument against the Mercantilist view that a nation should have a permanent balance of payments surplus. Specie flow mechanism is a corrective mechanism in the Gold Standard by which deficits and surpluses are eliminated by an induced flow of specie.
In its earliest form (as reported by Hume), the drain of gold would lead to a decrease in the quantity of money held by the deficit country; this in turn would lead to a fall in the general level of prices in relation to other countries.
This would make the deficit country’s exports more attractive and imports more expensive, resulting eventually in a favourable balance of trade. International monetarism is an analysis developed from monetary analysis, and is similar to the specie-flow approach.
L Yeager, International Monetary Relations: Theory, History and Policy (New York, 1976)
The price–specie flow mechanism is a model developed by Scottish economist David Hume (1711–1776) to illustrate how trade imbalances can self-correct and adjust under the gold standard. Hume expounded his argument in Of the Balance of Trade, which he wrote to counter the Mercantilist idea that a nation should strive for a positive balance of trade (i.e., greater exports than imports). In short, the “increase in domestic prices due to the gold inflow would discourage exports and encourage imports, thus automatically limiting the amount by which exports would exceed imports”.
Hume first elaborated on the mechanism in a 1749 letter to Montesquieu.
Hume argued that when a country with a gold standard had a positive balance of trade, gold would flow into the country in the amount that the value of exports exceeds the value of imports. Conversely, when such a country had a negative balance of trade, gold would flow out of the country in the amount that the value of imports exceeds the value of exports. Consequently, in the absence of any offsetting actions by the central bank on the quantity of money in circulation (called sterilization), the money supply would rise in a country with a positive balance of trade and fall in a country with a negative balance of trade. Using a theory called the quantity theory of money, Hume argued that countries with an increasing money supply would see inflation as the prices of goods and services rose while countries with a decreasing money supply would experience deflation as the prices of goods and services fell.
The higher prices would, in the countries with a positive balance of trade, cause exports to decrease and imports to increase, which will alter the balance of trade downwards towards a neutral balance. Inversely, in countries with a negative balance of trade, the lower prices would cause exports to increase and imports to decrease, which will heighten the balance of trade towards a neutral balance. These adjustments in the balance of trade will continue until the balance of trade equals zero in all countries involved in the exchange.
The price–specie flow mechanism can also be applied to a state’s entire balance of payments, which accounts not only for the value of net exports and similar transactions (i.e., the current account), but also the financial account, which accounts for flows of financial assets across countries, and the capital account, which accounts for non-market and other international transactions. But under a gold standard, transactions in the financial account would be conducted in gold—or currency convertible into gold—which would also affect the quantity of money in circulation.
- Trading data from the era of the gold standard tends not to corroborate with the theory.
- the theory ignores the effect of paper/bank/credit money, and assumes that all money is gold. In practice, bank money can more than compensate for shortages of specie, so price levels need not be affected by a shortage of specie.