Adam Smith and the Financial Crisis – Part 2

Go back to Part 1 of Adam Smith and the Financial Crisis

Banking in the 18th century

Unlike many economists today, Smith’s understanding of what bankers actually do is pretty accurate. He describes how the issue of ‘promissory notes’ by banks can increase economic activity. In Smith’s day what was ‘promised’ in the issue of these notes was a specific quantity of gold and/or silver. Confidence in banker’s notes meant that in normal times banks need only hold a fraction of the value of their issued notes in gold and silver. Thus a saving of precious metal was made.

Smith argues that the quantity of industry should be considered equivalent to the quantity of money used to maintain the required the number of workmen and to supply them with materials and tools. He argues that by the extent to which paper money replaced gold and silver this added to the funds available for the maintenance of industry. By this he explains the increased wealth of Scotland following the establishment of the Scottish banks at the turn of the 18th century. By using ‘cash accounts’: i.e. short-term overdrafts, each trader could carry on a greater trade, since the constant access to cash from his banker allowed him to hold a greater value of goods in his warehouse. Profitable transactions could take place, irrespective of the timing of the actual transfer of goods, without having to keep stocks of gold and silver for the payment of wages and materials.

Smith was concerned about the effect of an issue of paper money greater than that required to ‘circulate the whole annual produce of land and labour’. When this paper could not be used in its country of issue, gold and silver would be redeemed for the purchase of foreign goods with a resultant flow of gold and silver from this country. Smith distinguishes critically between the purchase of foreign consumption goods in this way, which

‘promotes prodigality, increases expense and consumption without increasing production…and is in every respect hurtful to society’, and the ‘purchase of an additional stock of materials, tools and provisions, in order to maintain and employ an additional number of industrious people, who re-produce with a profit, the value of their annual consumption…[which]…promotes industry’ (WN IIii, p294).

Smith argues that the latter must generally be the case, since the expense of the non-productive considered as a class or order cannot be increased by the operations of banking. This latter would seem to be a rare failure of foresight on Smith’s part. Today, credit card issue by banks and the activities of many other service industries would seem to have achieved precisely this.

Smith argues that when the paper money in excess of the needs of exchange returns to the banks for re-conversion into gold and silver this risks a run on the banks as the banks suffer from a loss of interest on gold and silver reserves and the consequent expense of re-supplying these with the issue of bills to London banks. Since this excess issue is against their own interest this should prevent over-issuing of paper money, although as Smith admits it often didn’t, with ‘the over-trading of some bold projectors in both parts of the United Kingdom [being] the original cause of this excessive circulation of paper money.’ Smith advised that the issues of bank’s promissory notes was limited to short-term convenience lending so that

‘[t]he coffers of a bank, so far as its dealings are confined to such customers (those to whom the quantity of paper money is only needed for a short period between successive transactions), resembles a water pond, from which though a stream is continually running out, yet another is continually running in, fully equal to that which runs out!’

Smith also points out the importance of banks monitoring the regularity of payments into the accounts of their customers, since they could have other intimate knowledge of all of their debtors’ circumstances. This also prevented large excesses of paper money existing at any time. Thus, Smith argues, banks cannot ‘consistently with their own interest and safety’ advance the whole or a greater part of circulating capital or any considerable part of fixed capital, because of the gap between loan and repayment. If such a loan is requires it must be secured and preferably obtained from private sources (and thus pre-existing money).

When these rules were ignored it led to the practice of ‘drawing and re-drawing of bills’ so that the original bill was not finally repaid, but only replaced with a larger bill (to cover commission and interest). The wide extent of the exchange of such bills meant that banks might find themselves unexpectedly having to find gold and silver on the basis of bills they themselves had not issued, but must continue to honour if he was not to make bankrupt the issuers of his bills he himself held, and thus ruin himself. But sometimes the banks had no choice but to refuse further lending, to great public outcry.

It was the duty of the banks, they seemed to think, to lend for as long a time, and to as great an extent as they might wish to borrow. The banks, however, by refusing in this manner to give more credit to those, to whom they had already given a great deal too much, took the only method by which it was now possible to save either their own credit, or the publick credit of the country (WN II.ii, p312).

Smith recounts the history of the ‘Ayr Bank’ set up to ‘relieve the distress of the country’. This bank was more liberal in granting cash accounts, and in discounting bills of exchange. Because of this it soon found itself unable to supply gold and silver as demanded without itself borrowing by drawing upon English banks with circulating bills that perhaps cost it 8% of their value. When the losses of this bank finally caused it to cease issuing cash accounts and discounting bills, those indebted to it and their creditors were in trouble. Moreover, argues Smith, even if the Ayr bank had been able to carry out its operations without incurring a loss, since it relied heavily on the funds of wealthy investors it would only have been transferring the act of lending to itself from those who had lent the bank money, with a reduction in prudence and profitability.

Smith makes it abundantly clear that the nature of banking is such that it affects the security of the whole society and so aspects of it must be regulated by government on the grounds that

[T]hose exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments…(WN, II, ii, p324)

It is true that Smith declares himself pleased with the multiplication of the number of banks, since it leads to the following:

1. Banks must restrain the issue of banknotes, since in the presence of competition this may lead to runs on their bank
2. Banks must make more effort to be liberal in their dealings with their customers.
3. The failure of one bank (and then the loss of value of its note issue) is less damaging.

We will come back to whether this can be a solution to modern banking problems.

Let us summarise Smith’s views on banking. To understand the nature of banking we must realise that the bank and a firm are ‘fictional’ entities and must at all times have assets equal to liabilities. If assets are greater than liabilities this surplus is simply transferred to the banks or the firm’s own account as profit; if assets are less than liabilities this is either subtracted from the bank or firm’s own account as a loss or they become insolvent.

Table 1 below shows how the balance sheets of firms, banks and individuals were linked together in the 18th century monetary economy. Gold and silver were the basic assets underlying the system. Notes issued by banks were liabilities to the banks but assets to their holders. Firms acquired additional capital by drawing bills on banks or borrowing from wealthy individuals. Banks short of gold and silver reserves could draw bills from other financial houses.

By issuing promissory notes 18th century banks could acquire gold and silver from the public and from traders. As long as these notes retained value and utility for the public they would remain in circulation. To the extent that the gold and silver thus replaced remained in the control of the bank the bank could lend this out to traders when it was confident of full repayment (plus interest and commission) in a short period of time. In exchange the bank accepted a (real) bill from the trader denoting the loan and its conditions. The bill replaced the gold and/or silver lent out on the asset side of the bank’s balance sheet.

As long as the above description delimited the operations of banks, Smith was happy. Since gold and silver could be employed in paying for long-term capital projects, in particular purchasing what is needed for these from abroad, instead of being ‘wasted’ in day to day convenience and precautionary balances. For these latter traders could draw from their cash accounts as required making day-to-day transactions in notes rather than gold and silver coin. As long as the issue of notes did not exceed the total quantity of gold and silver, bank notes were just a token for gold and silver held by the banks or loaned out by them in exchange for real bills. Ultimately all notes could be exchanged for gold and silver, although it was reasonably assumed by the banks that not all note-holders would do this at any one time. In this way the return of notes to the banks was kept stable and banks could lend out or invest most of their gold and silver.

In Smith’s view this advantage was offset when the banks started to issue notes in excess of that required for day-to-day circulation. The return of this to the banks often required them to access more gold and silver than they currently held. According to Smith this problem was exacerbated by the fact that much of the gold and silver thus acquired from the banks was be exported abroad, making it more difficult for the banks to re-acquire. The result was that they must sometimes ‘draw and re-draw’ successive bills on London banks, with the risks described.

The correct rule, Smith claimed, was that while a bank could advance ‘that part of a merchant’s capital which he would otherwise keep unemployed’ it should not ‘with propriety advance…either the whole capital with which he trades or any considerable part of it’. Moreover, by assuring that regular repayments were made directly to the banks they could judge whether their debtors were in thriving or declining circumstances.

© 2010 Dr Diarmid J G Weir

Go to Part 3 of Adam Smith and the Financial Crisis