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

by Tyler Beck Goodspeed

From 1716 to 1845 Scottish banks were among the most dynamic and resilient in Europe, effectively absorbing economic shocks that rocked markets in London and on the continent. Tyler Beck Goodspeed explains the paradox that Scotland’s banking system achieved this success without the regulations Adam Smith considered necessary for economic stability.

220 pages, Kindle Edition

Published April 4, 2016

Reviews

[Kyle Macleod · Rating 5 out of 5]

I found this fascinating, although I had a pre existing interest in both the concept of free banking and the failure of Ayr bank. The author was more in touch with the economics literature on financial crises than most economic historians. I also enjoyed learning about Adam Smith’s subsequent reappraisal of his ideas on banking regulation in the wake of the 1772 credit crisis.

[Frank Stein · Rating 4 out of 5]

This is an innovative and original look at the financial panic of 1772, which was precipitated by the failure of the aristocratic "Air Bank" in Scotland. This panic should be interesting to the contemporary reader for several reasons. First, the panic had geopolitical consequences, including the near bankruptcy of many American planters caused by declining tobacco exports to Britain and the demands of desperate Scottish creditors. The panic caused these American debtors to close civil courts in Virginia and Maryland and exacerbated tensions with the mother country. It also led the British government to bail-out the East India Company and pass the Tea Act of 1773, in order to encourage more tea sales in America, which in turn helped spark the American revolution. Importantly for the history of economics, however, the panic also changed what Adam Smith thought about banking, and led him to support several government interventions in the market, including bans on small bank-notes and the requirement of immediate redemption of notes as a means of averting such a panic.

Goodspeed shows, however, that the regulations Adam Smith demanded had actually been put in place by the government back in 1765, at the demand of several large bankers, who hoped to squelch competition from small, private banks. Goodspeed shows that these regulations in fact made the the chaos of 1772 greater, by preventing small notes taking the place of disappearing coin and by forcing banks to close instead of merely delaying redemption of their notes. He also shows that the usury ceiling of 5% prevented Scottish banks from attracting coin back to the area in times of "capital flight," like during the panic or the Seven Years War. Yet Smith surprisingly defends such a usury limit in his "Wealth of Nations," along with these other questionable financial regulations.

So the main takeaway of the book is that in one of the few areas that Adam Smith advocated government intervention over laissez faire, Smith should have stuck to his innate preference to "natural liberty" over what he called the "party walls" of financial regulation. The book would have been helped immensely if it had organized a clearer chronology or more obvious cast of characters, but it is a worthy and important addition to the literature on financial history and economic thought, one which corrects a 250 year-old mistake.