Studying the Wealth of Nations (Part 4)

Banking, Credit, and the Austrian Business Cycle

This is the fourth part of a weekly project marking the 250th anniversary of Adam Smith’s Wealth of Nations. You can find the third installment here.

Adam Smith is rarely associated with theories of economic instability. He is more often remembered as a theorist of order: of markets coordinating dispersed knowledge, of institutions emerging organically, and of commercial society tending toward prosperity. His discussion of banking and paper money in Book II of The Wealth of Nations offer plenty of these latter insights, but he also departs from this reputation to emphasize an example of credit expansion and collapse that anticipates what would later be come to be known as the Austrian Business Cycle Theory (ABCT).

In the first installment of this series, I examined Smith’s theory of the origins of money and noted its close resemblance to Carl Menger’s later account. The readings from this week extend that analysis beyond the emergence of money itself to its institutional development. Smith turns his attention to the rise of paper money, the practices of early banks, and the risks introduced when credit expansion outruns the real economic conditions that support it. His discussion is quite detailed, describing the lending instruments of his day, the methods banks used to assess creditworthiness, and the reserves they held to meet expected demands.

Most notably, Smith recounts the failure of a Scottish bank in a way that reads, in hindsight, like a case study in ABCT. The theory holds that credit expansion that is not backed by real savings distorts intertemporal coordination by pushing interest rates below their natural level. These artificially low interest rates encourage entrepreneurs to undertake projects that appear profitable under these conditions but cannot be completed sustainably. Interest-sensitive industries experience malinvestment, and although further credit expansion can delay the reckoning, it cannot prevent it. When the eventual correction occurs, the losses are greater than they would have been had adjustment been allowed to take place earlier.

The Origins of Paper Money

Coined money, Smith observes, brought immense benefits to commercial society, but it wasn’t without cost. Precious metals had to be mined, minted, and maintained due to normal wear and tear and clipping. Each ounce locked away in coin was also an ounce unavailable for other productive uses. Paper money emerged as a partial solution.

The process began simply. Individuals seeking to safeguard their gold and silver deposited their metal with a banker and received, in exchange, a promissory note entitling them to a specified quantity of coin. Once the public developed confidence that a banker could “pay upon demand such of his promissory notes as are likely to be at any time presented to him,” his notes would begin to circulate as money themselves.

Fractional Reserve Banking

If note holders rarely demanded redemption in specie, the banker would discover that he only need to keep a fraction of his customers’ deposits in reserve. For example, if a bank held £100,000 in gold and silver and had issued £100,000 in notes, but experience showed that only £20,000 in gold and silver was required to meet “occasional demands,” the banker could either lend out the remaining £80,000 of metal or could issue additional notes beyond the existing £100,000. This practice—issuing notes beyond the quantity of metals held at the bank—is known today as “fractional reserve” banking.

The obvious question follows: what prevents a bank from issuing an unlimited quantity of paper notes? Smith’s answer is straightforward: convertibility. For Smith, a country can only tolerate a limited quantity of currency. Any currency beyond that limit would cause citizens to look to other countries to trade with. But since other countries would not accept the paper notes of a foreign bank, gold and silver would be required to trade internationally. Thus, citizens would redeem their excess notes for specie:

Should the circulating paper at any time exceed [the country’s needs]… it must immediately return upon the banks to be exchanged for gold and silver. Many people would immediately perceive that they had more of this paper than was necessary for transacting their business at home, and as they could not send it abroad, they would immediately demand payment of it from the banks… There would immediately, therefore, be a run upon the banks to the whole extent of this superfluous paper.

But Smith’s analysis glosses over the mechanism that causes citizens to shift their trade internationally and to demand redemption of their notes. It seems to me that the cause would be domestic inflation. As banks issued excessive paper notes it would cause domestic prices to rise. Foreign prices, which would be unaffected by the domestic bank’s practice, would then become relatively cheaper. Citizens would facilitate this shift from domestic to foreign products by redeeming their notes for metals.

I should note that the risk of banks runs did not force banks to maintain 100 percent reserves. Rather, it imposed a practical limit on over-issuance. Each bank learned this limit over time by observing its customers’ habits, creditworthiness, and their likelihood of demanding payment.

Notably, Smith does not display any sort of hostility toward banks who practiced fractional reserve banking. Unlike his skepticism towards businessmen elsewhere in The Wealth of Nations, he treats banking as a largely beneficial institution. He explicitly links the rapid economic growth of Scotland—particularly in Glasgow and Edinburgh—to the establishment of banks in those cities.

The real danger, in Smith’s view, came not from banking per se, but from imprudence—sometimes driven by pressure from borrowers themselves. He singles out “projectors,” speculative entrepreneurs pursuing ventures of dubious viability, as a source of instability.

One difficulty banks faced was assessing the creditworthiness of borrowers who were not regular customers. A bill of exchange might be responsibly issued to a known client, but if that bill were subsequently passed along to others—a process known as redrawing—the bank could find itself exposed to borrowers whose solvency it could not evaluate. To mitigate this risk, banks raised interest rates on subsequent redraws, discounting the bills more heavily each time. Eventually, the cost of borrowing became intolerable for the projectors, who were apparently reliant on this practice.

This restraint by the banks produced a “clamour and distress” among projectors. In response, the Ayr Bank was founded in 1769 in Scotland with the explicit aim of more liberal lending. It granted cash accounts freely, discounted bills generously, and issued large quantities of banknotes in pursuit of what Smith called its “publick spirited purposes.”

The experiment failed. Within months, the Ayr Bank was forced to borrow from the Bank of London to meet redemption demands, paying eight percent on funds it had lent at five. Less than three years after its founding, the bank collapsed.

Smith’s verdict is unsparing.

This bank, no doubt, gave some temporary relief to those projectors, and enabled them to carry on their projects for about two years longer than they could otherwise have done. But it thereby only enabled them to get so much deeper into debt, so that when ruin came, it fell so much the heavier both upon them and upon their creditors. The operations of this bank, therefore, instead of relieving, in reality aggravated in the long-run the distress which those projectors had brough both upon themselves and upon their country. It would have been much better for themselves, their creditors and their country, had the greater part of them been obliged to stop two years sooner than they actually did.

Smith’s account of the Ayr Bank thus anticipates the core insight of ABCT: that credit expansion can temporarily disguise real economic constraints, but cannot eliminate them. By extending credit beyond what underlying savings could sustain, the bank merely postponed adjustment while increasing its eventual severity. The apparent prosperity it generated was not evidence of success, but a signal of distortion. In this way, Smith’s analysis suggests that financial institutions cannot create stability by suppressing market discipline; they can only defer it, at the cost of greater disruption when reality finally reasserts itself.

Bonus Quote

Every man of common understanding will endeavour to employ whatever stock he can command in procuring either present enjoyment or future profit. If it is employed in procuring present enjoyment, it is a stock reserved for immediate consumption. If it is employed in procuring future profit, it must procure this profit either by staying with him, or by going from him… A man must be perfectly crazy, who, where there is tolerable security, does not employ all the stock which he commands, whether it be his own or borrowed of other people, in some one or other of these three ways. (emphasis added)