The lesson is thus clear: Welcome multiple banks of issue and make sure there is always full convertibility, and bankers will be prudent and the economy will be stable and prosperous. Today we do not have banks of issue and notes cannot be converted into gold and silver, yet Smith’s lesson still applies: competition is the most effective instrument to generate and guarantee prudence in banking.
Smith attributes the remarkable economic growth that Scotland experienced in the 18th century to the development of a vigorous banking system, made prudent through competition.
In the 18th century, banks are a bit controversial. Some believe that banks, by introducing paper money, increase the quantity of money in a country, thus making it richer. Others claim that banks make a country poorer instead, because paper money substitutes for gold and silver as a means of domestic payment, thus decreasing the quantity of gold and silver, thereby decreasing the country’s wealth. Smith differs. For Smith, banks do help an economy to grow richer (not poorer) by decreasing (not increasing) the quantity of gold and silver in the country!
Smith’s logic relies on economic forces and government regulations to generate the prudent financial conduct needed for stable growth.
Money in Smith’s time is commodity money, a medium of exchange that has an alternative use, such as gold and silver. Banks can issue paper notes that circulate as money because they can be redeemed for gold and silver on demand. These paper notes are not receipts for deposits but sort of an “IOU.” Banks issue credit to merchants who promise to repay it with interest. And those notes circulate as means of payment. Smith explains that paper notes are a cheaper medium of exchange than gold and silver coins. Alvaro Perpere (2024) may help in understanding Smith’s logic.
“The key assumption in Smith’s logic is that the demand for money is fixed at any given level of industry in a country, not on banks issuing notes. “
Perpere (2024) explains that Smith adopts the medieval distinction that money can be both pecunia (medium of exchange) or capitale (capital). Gold and silver can be used as mediums of exchange (pecunia), but they can also be used as investment capital (capitale). If gold and silver are used as money, they cannot be used as capital. Smith compares the introduction of bank money to a highway in the sky. If a road is on the ground, that ground cannot be used to produce anything. But if that road is suspended in the sky, the ground below is now freed and can be used for agricultural purposes. Using a different medium of exchange, like paper, frees gold and silver from that function and allows them to be used for investment purposes.
The key assumption in Smith’s logic is that the demand for money is fixed at any given level of industry in a country, not on banks issuing notes. When banks introduce paper money, they free gold and silver from their function as a medium of exchange. That gold and silver can now go abroad in search of investment opportunities. Now that the gold and silver can go abroad they can generate returns that previously they could not.
It is harder, if not impossible, for paper money to go abroad because foreigners are unlikely to accept it, not knowing the issuer and not knowing if that paper would actually be converted into gold and silver on demand. For foreigners, a bank note may just be a piece of paper, not a claim on precious metals. Paper money is after all fiduciary money, money based on trust. Banks in the 18th century usually are local, their reputation (and thus the circulation of their notes) limited to a small area, because the trust customers give to the bankers is based on local knowledge. Gold and silver, on the other hand, are accepted everywhere since it is relatively easy to attest their veracity regardless of where one is. And so, contrary to mercantilists who fear the outflow of gold and silver, Smith is telling readers that when gold and silver leave the country, they generate more economic growth and wealth than when gold and silver are present in the country!
An objection to Smith’s logic is that the introduction of bank money would increase the quantity of money in the country, and thus raise prices. But for Smith this is not something to worry about. Smith explains that the demand for money is like a channel. If we pour too much water in it, the water will overflow. If we pour in more money than the economy wants, gold and silver will go abroad, thus leaving prices unchanged. Indeed, paper money, if in excess of its demand, will go back to its issuer. Merchants would redeem it for their gold and silver and would not keep that gold and silver idle at home. They would invest abroad. Domestic prices are not affected; the returns allow for higher consumption, which is to say, for more wealth. For this reason, Smith argues that an excess supply of money will not take place.
This objection to introducing bank money is based on the possibility of over issuing, that is, of imprudent behavior on the side of bankers. Banks, after all, have incentives to be imprudent and overissue notes, because the more paper money they have in circulation, the more they will earn in interest. But Smith does not believe overissuing would systematically take place. If it did happen in the past, Smith believes, it may have been out of ignorance, when banking was a new phenomenon. But with experience bankers learn it is in their interest to be prudent and not over-issue notes.
It is true that there have been some hiccups in the history of Scottish banking, but that was mostly due to inexperience. Thanks to competition, bankers learn that prudence is the best way to do banking. If a banker is tempted to overissue, the notes of the bank will come back because they are in excess of their demand. This means that the bank needs to have enough gold and silver to pay the notes that are coming back for redemption. But if the bank has over issued, it means that it issued more than its reserves of gold and silver. So the bank needs to find the gold and silver needed for redemption, often by sending agents to London. This means that the costs of getting the precious metals will be more than the returns they would get from the issued notes. This is not a good strategy, especially for the long run. It is a sure way to bankruptcy. If notes are convertible on demand, and if there are multiple banks to choose from, if bankers are not prudent on their own, competition will make them prudent. This is a lesson that, according to Smith, can quickly be learned.
“If ‘beggarly bankers’ go bankrupt, as they often do, Smith says, the holders of the notes are left with nothing. This is a catastrophic situation for the working poor because they have very little to begin with.”
That said, Smith does worry about a couple of imprudent practices which he fears competition will not correct. For those, Smith calls for government regulations. He is very much aware that all the parties involved want some specific agreements, so that the regulations are an infringement of natural liberty. But he deems them necessary, just like requiring “party walls” (the partition walls between houses meant to prevent the spreading of fire) is an infringement of natural liberty but necessary for preventing fire from spreading from house to house. That the house must have a partition is a violation of natural liberty, but it is necessary for the wellbeing of society.
One “party wall” Smith calls for is banning the option clause. The option clause is a cause that the bank puts on a note, and the receiver of the note willingly accepts. The clause says that the bank may not redeem the note on demand, but may postpone redemption for a specified time and pay interest for that suspension period. The clause is used by solvent but illiquid banks so that they can get liquidity without fearing a bank run and bankruptcy. But Smith fears that this instrument would be misused and would incentivize overissuing and thus cause unneeded crises. Banning it is a necessary party wall to impose prudence.
The second “party wall” Smith favors is a ban on small denomination notes. The working poor are paid with small denomination notes because of a chronic lack of small denomination coins. This is a solution to the problem of small coins that both parties welcome.
People pay attention to the solvency of the issuer of large denomination notes. If the issuers of large denomination notes should go bankrupt, the personal asset of the bankers is used to cover all the bank’s liability due to the unlimited liability that governed Scottish banks. So, if the issuer is not trustworthy, there is a lot to lose. And even in the worst case, should the banker not have enough to cover their liabilities, dealers of large denomination notes are usually relatively wealthy merchants, so they would be able to find ways to survive.
The situation is different for small denomination notes. People do not pay the same attention to issuers of small denomination notes, because the notes are of small denomination. They may not always have the assets to cover their liabilities. The problem is that small denomination notes circulate among the working poor. If “beggarly bankers” go bankrupt, as they often do, Smith says, the holders of the notes are left with nothing. This is a catastrophic situation for the working poor because they have very little to begin with. Thus, Smith concludes that small denomination notes should be avoided. Prudence should be imposed if the conditions are such that it would not emerge by itself. Smith thus fears that “beggarly bankers” who issue small denomination notes do not have the incentives to be as prudent or honest as one may hope for, and this is why this “party wall” is called for.
There is a situation for which Smith sees no solution, though, because prudence cannot emerge or be imposed. This may happen more with government notes than with bank notes proper.
Banks in Scotland are forbidden from lending to the government. But in the North American colonies, it is different. Governments themselves issue notes, or give monopolies to banks in exchange for lending to them. The colonial governments eliminate competition, imposing legal tender, forcing the colonists to accept the notes as payment, and the notes do not pay interest. Now there is no reason for not overissuing. In Scotland, a note redeemed six months in the future will earn interest. In the colonies, a note redeemed six years in the future will earn no interest. Notes lose value over time but colonists are forced to accept them anyway. Smith’s words are categorical: this is “an act of such violent injustice, [that] has scarce, perhaps, been attempted by the government of any other country which pretended to be free. It bears the evident marks of having originally been […] a scheme of fraudulent debtors to cheat their creditors” (WN II.ii.100).
His account of colonial banking indicates that what Smith really fears are monopoly and legal tender, especially if combined with inconvertibility. The colonial system is imprudent. On the other hand, his account of the banking system in Scotland explains to the readers of his time and ours that competition is the way to prudence and growth.
This is how Smith closes WN II.ii:
“The late multiplication of banking companies in both parts of the United Kingdom, an event by which many people have been much alarmed, instead of diminishing, increases the security of the publick. It obliges all of them to be more circumspect in their conduct, and, by not extending their currency beyond its due proportion to their cash, to guard themselves against those malicious runs, which the rivalship of so many competitors is always ready to bring upon them. It restrains the circulation of each particular company within a narrower circle, and reduces their circulating notes to a smaller number. By dividing the whole circulation into a greater number of parts, the failure of any one company, an accident which, in the course of things, must sometimes happen, becomes of less consequence to the publick. This free competition too obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away. In general, if any branch of trade, or any division of labour, be advantageous to the publick, the freer and more general the competition, it will always be the more so” (WN II.ii. 106).
The lesson is thus clear: Welcome multiple banks of issue and make sure there is always full convertibility, and bankers will be prudent and the economy will be stable and prosperous. Today we do not have banks of issue and notes cannot be converted into gold and silver, yet Smith’s lesson still applies: competition is the most effective instrument to generate and guarantee prudence in banking.
This article has been cross-posted from Liberty Matters, part of the Liberty Fund network. It is part of the series “Compounding Interest: Revisiting the Wealth of Nations at 250“.
References
Perpere, A. (2024). “Capital, interes y usura: tensiones y continuidades entre la escolastica franciscana y Adam Smith.” Estudios Publicos 2(Adam Smith 300 anos): 291–310.Smith, A. ([1776] 1981). An inquiry into the nature and causes of the wealth of nations. Indianapolis, Liberty Classics.
* Maria Pia Paganelli is a Professor of Economics at Trinity University. She works on Adam Smith, David Hume, 18th century theories of money, as well as the links between the Scottish Enlightenment and behavioral economics.Read more by Maria Pia Paganelli.
