Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772

This is the title of a book by Prof Tyler Goodspeed. A brief of the book is here.

The failure of Ayr Bank in 1772 was a turning point in financial history. It led to change in thinking of Adma Smith who till then favored banking free of government regulation. Thus, this event continues to inspire financial historians who look for different viewpoints to explain the crisis.

Prof Hugh Rockoff reviews the book and sums up:

In 1772 a banking crisis started in Scotland. It is known as the Ayr Bank Crisis after the bank failure that precipitated the crisis. But it quickly turned into an international crisis. London, Amsterdam, Stockholm, St. Petersburg, even the American colonies, were affected. This crisis is important not only to financial historians, but also to historians of economic thought because in the wake of the crisis Adam Smith modified his views on banking and advocated several legal restrictions on banking. These were important exceptions, although far from the only ones, to his working rule that laissez-faire is best.

Much has been written about this crisis. (Goodspeed’s bibliography would be a good place to start. The classic general history of banking in Scotland is Checkland. And full disclosure, I have written several papers about the Smith and the Ayr Bank Crisis.) But Tyler Goodspeed has written the fullest account yet. He has carefully worked his way through a mountain of material, toiling away in libraries and archives, and examining many documents that previous historians have ignored or given only a cursory glance. Even more important, Goodspeed offers a new, radical interpretation of the crisis. I think it is well grounded and generally persuasive, although it will undoubtedly inspire many critics. All future accounts of this episode will need to take Goodspeed’s work into account.

Most writers have followed Smith in seeing the crisis as one in which bankers, particularly the famous Ayr Bank, made foolish investments, and then failed, starting a panic. Smith’s conclusion was that fractional reserve banking was inherently unstable, and for this reason regulation of banking to prevent or at least ameliorate crises was justified. The Ayr Bank crisis and the Lehman Brothers crisis are, to this way of thinking, sisters under the skin.

Specifically, Smith supported four important restrictions on banks. (1) The minimum size of notes should be set at the rather large sum of £5. (Using the calculator at http://www.measuringworth.com this would be about £600 today using a price index as an inflator, or £7,500 using average earnings! Perhaps the point is simply that £5 was a lot of money in those days.) This was the only specific change in existing banking law advocated in The Wealth of Nations. In 1765 legislation had prohibited notes smaller than £1, but as Goodspeed puts it, Smith doubled down on this restriction. (2) The “optional clause” in bank notes should be prohibited. Privately issued bank notes at that time constituted an important part of the money supply. Until prohibited in 1765 Scottish banks were permitted to issue a note that contained a clause which allowed them to postpone redemption of the note in coin while paying interest on it. In other words, before 1765 notes were not necessarily required to be payable on demand. (3) The interest banks could charge for loans or pay on deposits should be limited by law. Smith’s famous support for usury laws, however, was based on his reading of the long history of usury laws, and not directly connected to the Ayr Bank Crisis. (4) Banks should only invest in “real bills”: short-term loans resulting from “real” transactions. Smith did not offer, however, a clear legislative path for enforcing real bills. Perhaps it was intended mainly as advice to bankers or would-be bankers.

But according to Goodspeed, the prohibition on £1 notes, the prohibition of the optional clause, and the usury law had destabilized the financial system causing the crisis of 1772. And real bills was unworkable. If Adam Smith was hoping that his regulations would stabilize the banking system, Adam Smith was wrong.

Lots of interesting stuff and ideas like limited liabilities vs unlimited liabilities, partnerships vs companies etc come while reading such accounts.

Lessons for today? Making regulations without understanding the causes is dangerous:

Goodspeed asks what practical lessons we can draw from this episode. It’s a tough question. Obviously financial institutions have changed so much since Smith’s day that we can’t directly import ideas appropriate for the 1770s into our time. Nevertheless, Goodspeed to his credit has given a good deal of thought to this question and has come up with some useful ideas. For one thing, he suggests that an examination of the crisis of 1772 should make us more aware of regulatory and intellectual capture of the process of reform. Another conclusion is that after a financial crisis we should take some time to understand the crisis before legislating. It is hard to argue with this, judgments made in haste often turn out to be wrong. But the unresolved question is how long should we wait to be sure we have an adequate understanding of the crisis. Goodspeed’s radical reinterpretation was published in 2016 about 250 years after the crises of 1765 and 1772. If the same lag holds, we won’t understand the crisis of 2008 until about the year 2260!

Hmm.

Should get a copy and read this one..

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