How the crisis of 1772 shaped change in Wealth of Nations…

Supposed father of economics, Adam Smith also had to go through an economic crisis to shape and change his views about banking.

Tyler Godspeed has a piece on the same. Starts with Hume writing to Smith:

June 27, 1772, as the city of Edinburgh reeled from its worst financial crisis since the collapse of the Darien Company in 1700, David Hume posted an anxious letter to Adam Smith, who was then working on An Inquiry into the Nature and Causes of the Wealth of Nations. Hume noted:

We are here in a very melancholy Situation: Continual Bankruptcies, universal Loss of Credit and endless Suspicions. There are but two standing Houses in this Place, Mansfield’s and the Couttses … Mansfield has pay’d away 40.000 pounds in a few days; but it is apprehended, that neither he nor any of them can hold out till the End of the next Week, if not Alteration happen. The Case is little better in London … even the Bank of England is not entirely free from Suspicion.

He concluded by inquiring of Smith whether “these events any-wise affect your theory? Or will it occasion the revisal of any chapters?”

Hmm..

Then he discusses the events which led to failure of Ayr Bank which Smith discusses in his tome. These events apparently changed the thinking of Adam Smith and the book as well:

The Scots Magazine reported that the ongoing crisis was “said to be the greatest that ever happened in Scotland,” worse even than the aftermath of the South Sea Bubble or the collapse of the Darien Company. Horace Walpole wrote that “one rascal” could thus “shake the mighty credit of such a nation as Great Britain,” yet 20 years would be insufficient to “remove the prejudice that men will contract against bankers.”

Among those contracting such prejudice was, in fact, none other than Adam Smith, for whom the events of June 1772 did indeed seem to “occasion the revisal” of at least one chapter of the still incomplete Wealth of Nations, perhaps not coincidentally, as several of his intimate friends and associates were financial casualties of the Ayr Bank’s demise, as well as shareholders in the failed bank itself.

It was not that Smith wished for credit and banking to be rigidly bound by gold and silver manacles. But the “party walls” Smith advocated to fireproof the banking trade—prohibition of small-denomination banknotes, a maximum legal rate of interest, and prohibition of contingent liability banknotes—could hardly have been expected to deliver effective protection against what Smith called the “accidents” of both the “unskillfulness” of bankers as well as causes against which no amount of “prudence or skill” on their part, but only public regulation, might guard.

The crisis changed the views of even the most celebrated free marketer.

To be clear, it is not my contention that the introduction of legal restrictions into Scottish banking caused the 1772 crisis, but rather that they critically undermined the flexibility and resilience previously exhibited by Scottish finance, and thereby elevated the risk that adverse economic or financial shocks might metastasize into broader threats to financial stability. The Bank Act of 1765, advocated for by Smith, not only misdiagnosed the source of Scotland’s macroeconomic troubles as one of too many bankers, but also did nothing to resolve the fundamental problem that Scotland’s was a rapidly developing economy with a fixed exchange rate, large external debt, and chronic current account deficit balanced by large but often highly volatile capital inflows.

Moreover, by effectively restricting entry, raising the minimum efficient scale of banking, and removing the voluntarily contracted option of selective capital controls, the act also undermined some of the strengths that had previously enabled the Scottish banking system to absorb such volatility. In other words, in the wake of 1765, you still had an unresolved perennial balance-of-payments problem, but now with the additional problems of bigger, more systemically important financial institutions, higher barriers to entry for new banks, and no contractual “circuit-breaker” to allow temporarily illiquid but otherwise solvent banks to liquidate assets without incurring fire-sale losses. The result was that when a major external financial shock hit in 1772, the flexibility and resilience that the system had previously exhibited, most notably in 1756 and 1763, was substantially diminished. Thus, while there were certainly macro-prudential motivations for Scotland’s largest banks to lobby for regulatory intervention, the unintended second- and third-order effects were no less adverse on account of somewhat noble intentions. It is a cautionary tale of the risks of rushing to regulate in the middle of an ongoing financial crisis and before the causes of that crisis are sufficiently understood.

History of history of thought…

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s


%d bloggers like this: