Mercantilism is the economic theory that a nation's prosperity depended upon its supply of gold and silver, that the total volume of trade is unchangeable. This theory suggests that the government should play an active role in the economy by encouraging exports and discouraging imports, especially through the use of tariffs. The economic policy that flourished in the early modern period is often referred to as mercantilism or as the mercantile system. These ideas stemmed from bullionism, a theory that precious metals equal wealth.

The term was coined by the political economist Adam Smith in 1776, from the Latin word mercari, which means "to run a trade", from merx, meaning "commodity". It was initially used solely by critics, such as Smith, but was quickly adopted by historians. Today mercantilism is rejected by all serious economists, though some elements are looked upon favourably.

Theory

Mercantilist points:

• Nations are in a direct zero-sum competition with each other for wealth
• Gold and silver bullion are synonymous with wealth

The main objective of these precepts, which would define international relations for centuries, is that a country needs a positive balance of trade to gain more precious resources. A favourable balance of trade would mean an influx of bullion, while a negative one would mean the bullion suplies would gradually be reduced. Thus each nation has to export more goods and services than it imports, except for nations that can produce a lot of their own precious metals.

Gold was essential as it was used to fund the military. A nation with large gold reserves could thus field a larger force for a longer period of time than its rivals and would thus be victorious.

Not all states believed in mercantilism. The Dutch, who were the most important economic power for much of this period, rejected the theory and instead advocated free trade. Mercantilism was most important in Britain and France, these were the other two major trading nations and both had important rivalries with the Dutch. In an open market the more efficient and better operated Dutch traders could out compete both of these larger powers. Much of the coastal trade around both Britain and France was in Dutch hands and the Dutch had a firm control over many trade routes, including the lucrative Baltic one. Frace and Britain thus had a vested interest in closing their economies to foreigners.

Effects

Mercantlism had a profound effect on the economies and societies of early modern Europe as fiscal and trade policy were altered to conform with the theory. A key tenet of mercantilism is that exporting raw or unfinished materials disadvantages a nation, as greater wealth results from performing value-added manufacturing work within that nation. Thus England, for instance, banned the export of unfinished cloth to the Netherlands.

Reliance on foreign trade is also harmful as the money paid to these traders would reduce the national supply. Thus England passed the Navigation Acts, requiring that ships entering English ports either be English or be carrying goods from their country of origin. This prevented the Dutch from most trade with England (as they produced few goods of their own).

Mercantilism also fueled the intense violence of the 17th and 18th centuries in Europe. Since the level of world trade was viewed as fixed, it followed that the only way to increase a nation's trade was to take it from another. A number of wars (for example, the Anglo-Dutch Wars and the Franco-Dutch Wars) can be linked directly to mercantilist theories. The unending warfare of this period also reinforced mercantalism as it was seen as an essential component to military success.

One key complaint of American revolutionaries in the late 18th century related to the British use of tariffs. Mercantilist theory implies that if one wants as much gold as possible in one's empire, one's colonies cannot trade gold for international goods. Thus, trade restrictions limited commerce with outside powers, forcing colonists to buy finished goods only from their ruling power, and keeping prices higher than Adam Smith would have viewed as efficient. The presence of a small Caribbean island (St Eustace) owned by the Dutch, who had supported the idea of free trade since the days of Hugo Grotius (1583 – 1645), played a major role in the revolution that followed. The island was open to all and had no tariffs whatsoever. After the Declaration of Independence, its governor decided to salute the USS Andrea Doria, a warship under the flag of the Continental Congress. This was the first recognition of the United States as an independent country.

Thus for instance mercantalists argued that England should establish North American colonies to have an independent source of timber, rather than depending on purchases from the Baltic area, a trade that saw a net outflow of bullion. Mercantilism in general fueled colonialism under the belief that a large empire was the key to wealth.

Rejection of mercantilism

Adam Smith's Invisible Hand and liberal theory of economics gradually put an end to the dominance of mercantilism. Liberalism and mercantilism differed on one key issue. Mercantilism states that all the world's people must compete for the world's limited wealth. Adam Smith believed that wealth and trade was a non-zero-sum game, which essentially means two parties involved in a transaction could each actually gain, because the exchanged items were more valuable to their new owners. Bullionism dictated that gold was gold — period. Thus, what one party gained, the other party had to give up (i.e., the zero-sum game assumption). Smith felt that gold was nothing more than a yellow mineral that was valuable only because there wasn't much of it. The majority of economists now agree with Smith.

Modern influence

The economist John Maynard Keynes supported some of the tenets of mercantilism. While Adam Smith rejected the idea of bullion being more important than any other commodity, Keynes saw an inflow of gold and silver as being beneficial. He argued that greater gold reserves leads to lower interest rates, and thus the ability to borrow more money at a lower cost. This would both stimulate growth and aid government borrowing. Keynes also adopted the essential idea of mercantilism that government intervention in the economy is a necessity. A number of political parties embraced Keynes' theories, and they came into force under Franklin Roosevelt's New Deal program in the United States and also under Britain's Labour government after the Second World War. These policies continued under all parties until the end of the "post-war consensus" in the mid 1970s.

Elements of mercantilist theory have remained in economic discourse throughout the years. There is a limited amount of gold in the world and, more importantly today, a limited amount of oil. A key motivator of Japan's World War II expansionism, for example, was the need to acquire control of natural resources, primarily petroleum, as well as others including minerals, timber, and rubber, which the Japanese islands lacked in bulk. Latin America's Cold-War Populism, and import substitution economic schemes, along with past and present Marxist theories, rest on the belief that the colonial economic structures still remain in place, with raw-goods exporters at odds with what equates to finished-goods exporters. (McDonald's products, for example, are in their own way finished goods.)

Mercantilist theory also influences the notion that trade surpluses are automatically good and that trade deficits are automatically bad. Some economists argue that Japanese trade policy in the 1970s and 1980s was in large part based on mercantilist concepts and that these policies form one of the causes of Japanese economic stagnation in the 1990s. Hence, one result of the growing deficit of the USA was that the American financial markets offered good investments and growth, whereas the Japanese market languished and financial returns were meager if not negative. Japanese banks also offered interest to depositors of less than one quarter of one percent. This reality contradicted mercantilist theory that a trade surplus and appreciating currency are automatically good.