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

Author(s):Goodspeed, Tyler Beck
Reviewer(s):Rockoff, Hugh

Published by EH.Net (January 2017)

Tyler Beck Goodspeed. Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772. Cambridge, MA: Harvard University Press, 2016. x + 208 pp. $40 (hardcover), ISBN: 978-0-674-08888-7.

Reviewed for EH.Net by Hugh Rockoff, Department of Economics, Rutgers University.

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 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.

In Chapter 1 Goodspeed discusses the origins and consequences of the Ayr Bank Crisis, lays out his case against Smith’s interpretation, and outlines his new alternative.  In chapter 2 Goodspeed takes us back to the period of 1760 to 1765. At that time many Scottish banks were issuing low-denomination notes. It has often been described as the “small note mania.” Goodspeed argues, however, that Scotland was suffering during these years from a balance of payments crisis. Small denomination coins were being drained from the Scotland, and the small notes, rather than being a danger for the poor because of the weakness of the issuers, actually constituted a valuable form of relief for the Scottish economy. Goodspeed finds no evidence that people suffered from the failures of what Adam Smith referred to as “beggarly bankers.”

In chapter 3, Goodspeed explores the 1765 restrictions: no notes below £1 and no optional clauses. First of all, Goodspeed shows, convincingly I would add, that these restrictions were pushed by the largest Scottish banks with the goal of reducing competition from smaller competitors. He goes on to argue that these restrictions then discouraged entry and encouraged the larger banks to pursue riskier investments, making the system less stable.

In chapter 4, Goodspeed focuses on an issue that Smith did not, the joint and several liability of the shareholders of the Ayr Bank. The costs of the collapse of the Ayr Bank ultimately fell on its shareholders, which included Smith’s student the Duke of Buccleuch. Goodspeed documents the devastating consequences for investors in the Ayr Bank, some of whom were completely ruined. But Goodspeed finds a silver lining. Bonds secured by the lands of the shareholders were issued. The money raised was then used to pay the short-term liabilities of the Ayr Bank. The Bank of England and the large Scottish banks had refused to lend except on exorbitant terms to the Ayr Bank, but the shareholders then served that function. Goodspeed attributes the rapid recovery of the Scottish economy after the crisis in part to the shareholders acting, as he puts it, as the lender of last resort.

In chapter 5, the final chapter, 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!

Here is not the place to undertake a full examination of Goodspeed’s important contribution. This will be the work of many future financial historians and historians of thought. I do want to draw attention, however, to two minor points.

The Real Bills Doctrine

Goodspeed mentions Adam Smith’s famous “real bills doctrine,” but doesn’t spend much ink on it. After all, Smith doesn’t tell us how to distinguish real from fictional bills or how banks could be restricted by law to real bills.

To be sure, the real bills doctrine is not a useful guide for monetary policy. But some discussions of real bills make it sound like some ancient piece of trivia: something to do with “redrawing” of bills of exchange, whatever that is. It is worth, however, recalling one corollary of the real bills that Smith discusses which contains an obvious lesson. It is contained in a passage of The Wealth of Nations that Goodspeed does not cite: “… of the capital which the person who undertakes to improve land employs in clearing, draining, enclosing, manuring and ploughing waste and uncultivated fields, in building farm-houses, with all their necessary appendages of stables, granaries, etc. … such expenses, even when laid out with the greatest prudence and judgment, very seldom return to the undertaker till after a period of many years, a period far too distant to suit the conveniency of a bank” (Wealth of Nations II.ii.64).

I suspect that there are more than a few banks that would be better off today, in some cases at least alive, if their managers had been reading Adam Smith rather than some of the modern experts on banking.

What’s in a Name?

Today financial historians refer to the Ayr Bank Crisis. But at the time, Air was an acceptable alternative spelling for the town of Ayr. Cristopher Berry tells me that the first statistical account, in about 1791, spells the parish and county as “Air.” And at least some of the notes of what we now refer to as the Ayr Bank, and some of the Bank’s public announcements are signed “Douglas, Heron, and Company, Bankers in Air.” Prophetic?

References:

Sydney Checkland. 1975. Scottish Banking: A History, 1695-1973. Glasgow: Collins.

Hugh Rockoff. 2011. “Upon Daedalian Wings of Paper Money: Adam Smith and the Crisis of 1772.” In Adam Smith Review, eds. Fonna Forman-Barzilai, 6: 237-268.

Hugh Rockoff. 2011. “Parallel Journeys: Adam Smith and Milton Friedman on the Regulation of Banking.” Journal of Cultural Economy, 4 (3): 255-84.

Hugh Rockoff. 2013. “Adam Smith on Money, Banking, and the Price Level,” in The Oxford Handbook of Adam Smith, eds. Christopher J. Berry, Maria Pia Paganelli, and Craig Smith, Oxford University: 307-32.

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Subject(s):Financial Markets, Financial Institutions, and Monetary History
History of Economic Thought; Methodology
Geographic Area(s):Europe
Time Period(s):18th Century