- The conclusion is unmistakable: Embrace a variety of issuing banks and ensure complete convertibility, and you’ll find bankers exercising caution, leading to a stable and thriving economy. While today’s financial landscape lacks such banks and notes aren’t redeemable for gold and silver, the essence of Smith’s insight remains relevant: competition serves as the most potent mechanism for fostering prudence in the banking sector.
Smith attributes Scotland’s impressive economic advancement during the 18th century to the establishment of a dynamic banking system, bolstered by competition that nurtured prudent practices.
In the 18th century, the role of banks was a contentious topic. Some argued that banks, by introducing paper currency, inflated a nation’s wealth. Others contended that such practices led to impoverishment, as paper money replaced gold and silver, diminishing the nation’s tangible wealth. Smith, however, takes a different stance. He posits that banks indeed enrich an economy by enabling a reduction, not an increase, in the quantity of gold and silver in circulation!
Smith’s argument hinges on the interplay of economic forces and government regulations to inspire the financial prudence necessary for enduring growth.
In Smith’s era, money was primarily commodity-based—gold and silver served as mediums of exchange with alternative uses. Banks were able to issue paper notes that functioned as currency because they were redeemable for gold and silver upon request. These notes weren’t mere receipts for deposits; rather, they operated more like “IOUs.” Banks would extend credit to merchants expecting repayment with interest, allowing these notes to circulate as a means of payment. Smith asserts that paper notes are a more economical exchange medium than gold and silver coins. Alvaro Perpere (2024) provides further clarity on Smith’s rationale.
“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 dependent on banks issuing notes.”
Perpere (2024) elucidates that Smith adopts a medieval distinction between money as pecunia (a medium of exchange) and capitale (capital). Gold and silver can function as mediums of exchange (pecunia), yet also serve as investment capital (capitale). When gold and silver are used as currency, their role as capital is forfeited. Smith likens the emergence of bank money to a suspended highway—where a road on the ground occupies space that could be otherwise productive. By utilizing an alternative medium, such as paper, gold and silver are liberated to be used for investment instead.
Smith’s fundamental premise is that the demand for money remains constant at any given level of industry, irrespective of the volume of notes issued by banks. The introduction of paper currency allows gold and silver to escape their role as mere mediums of exchange, enabling those precious metals to seek out investment opportunities abroad. Once freed, gold and silver can yield returns that would have otherwise been unattainable.
However, paper money faces challenges in international transactions, as foreigners are often hesitant to accept it, lacking knowledge of its issuer and whether it can be converted back into gold and silver. To many, a bank note is merely a piece of paper devoid of intrinsic value. Paper currency, after all, is fiduciary money—its worth is predicated on trust. In the 18th century, banks typically operated on a local scale, with their reputations (and consequently the acceptance of their notes) confined to a limited area, as customers’ trust stemmed from local familiarity. Conversely, gold and silver enjoy universal acceptance, as their authenticity can be verified regardless of location. Thus, contrary to mercantilist fears of gold and silver outflows, Smith asserts that such departures actually stimulate greater economic growth and wealth than their mere presence in a nation!
Critics of Smith’s theory argue that the proliferation of bank money would inflate the money supply, leading to rising prices. Yet, Smith dismisses this concern. He analogizes the demand for money to a channel: excessive water will overflow. If too much money is introduced beyond the economy’s appetite, gold and silver will leave the country, keeping prices stable. In fact, if paper money exceeds demand, it will return to its issuer, as merchants will redeem it for gold and silver instead of letting it stagnate at home. This process facilitates higher consumption and, by extension, more wealth. Hence, Smith contends that an oversupply of money will not occur.
This skepticism regarding bank money often arises from concerns about imprudent overissuance by bankers. After all, banks may have motives to recklessly issue more notes, as greater circulation translates to increased interest earnings. Nevertheless, Smith believes systematic overissuance is unlikely. If it occurred in the past, it was primarily due to ignorance, stemming from the novelty of banking. He argues that, with experience, bankers recognize that prudence is advantageous and that overproduction of notes is a poor strategy.
While Scottish banking has encountered its share of hiccups, these were largely due to inexperience. Competition serves as a teacher, demonstrating that prudent practices yield better outcomes. Should a banker be tempted to overissue, excess notes will inevitably return, necessitating sufficient reserves of gold and silver to honor redemption requests. An overextended bank must then source the necessary gold and silver, often incurring costs that exceed the returns from the issued notes. Such a strategy is unsustainable and leads to bankruptcy. If notes are redeemable on demand and consumers have choices among multiple banks, the competition will compel bankers to act prudently—a lesson that Smith argues can be grasped quickly.
“If ‘beggarly bankers’ go bankrupt, as they often do, Smith warns, the note holders are left with nothing. This creates a dire situation for the working poor, who start with very little.”
Nevertheless, Smith expresses concern over certain imprudent practices that he believes competition alone cannot rectify. For these scenarios, he advocates for government regulation. Smith understands that all parties involved seek specific agreements, suggesting that such regulations infringe upon natural liberty. However, he deems them necessary, akin to requiring partition walls between houses to prevent fire from spreading. While mandating such structures restricts individual freedoms, it ultimately benefits society.
One regulatory “partition wall” Smith proposes is the prohibition of the option clause. This clause allows banks to delay the redemption of notes under specific conditions, effectively giving solvent but illiquid banks a way to maintain liquidity without the threat of a bank run. Smith fears this could be exploited, inciting overissuing and unwarranted crises. Thus, banning it becomes a necessary safeguard for prudence.
The second “partition wall” Smith advocates is the prohibition of small denomination notes. The working poor frequently receive these notes due to an ongoing shortage of small coins. This solution, while well-intentioned, raises concerns. People pay closer attention to the solvency of issuers of large denomination notes. If these issuers face bankruptcy, personal assets of bankers cover liabilities due to unlimited liability rules governing Scottish banks. Even in dire scenarios, wealthy merchants who issue large denomination notes usually find ways to manage their circumstances.
Yet, the situation shifts dramatically with small denomination notes. These notes circulate among the working poor, who may not scrutinize their issuers with the same diligence. If weakly backed banks fail, the holders of these notes are left empty-handed—a catastrophic outcome for those already struggling. Consequently, Smith concludes that small denomination notes should be avoided. Prudence must be enforced when self-regulation falters. He fears that “beggarly bankers” issuing small denomination notes lack the necessary incentives for prudence and integrity, hence the need for this regulatory “partition wall.”
There exists a scenario where Smith perceives no viable solution, primarily because prudence cannot be cultivated or mandated. This situation is more prevalent with government notes than with traditional bank notes.
While Scottish banks are prohibited from lending to the government, this is not the case in the North American colonies. Here, governments issue notes or grant monopolies to banks in exchange for loans. Colonial governments strip away competition by enforcing legal tender laws, compelling colonists to accept these notes as payment, which do not accrue interest. Consequently, there’s little incentive to avoid overissuing. In Scotland, a note redeemable six months later earns interest; in the colonies, a note redeemable six years later accrues none. Such notes diminish in value over time, yet colonists are obligated to accept them. Smith’s condemnation is unequivocal: this represents “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).
Smith’s critique of colonial banking underscores his deep-seated fears regarding monopolies and legal tender, especially when coupled with inconvertibility. The colonial banking framework is imprudent, while his analysis of the Scottish banking system reveals that competition is the true path to prudence and economic growth.
This is how Smith concludes Book II of the Wealth of Nations:
- “The recent proliferation of banking companies across the United Kingdom, a development that has alarmed many, instead of diminishing public security, enhances it. It compels all banks to act with greater caution and to avoid extending their currency beyond its appropriate limits, thereby shielding themselves from the malicious runs that the rivalry among competitors may instigate. This segmentation of circulation into smaller parts ensures that the failure of any one institution—inevitable in the course of events—affects the public less severely. Furthermore, robust competition encourages bankers to be more generous in their dealings with clients to stave off rivals. In summary, if any sector of trade or labor division benefits the public, increased competition invariably amplifies its advantages” (WN II.ii. 106).
The takeaway is abundantly clear: Embrace a diverse array of issuing banks and ensure complete convertibility, and bankers will act with prudence, resulting in a stable and flourishing economy. Although contemporary banking lacks the features Smith championed, his lesson remains vital: competition is the most powerful tool for fostering 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 años): 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, focusing on Adam Smith, David Hume, 18th-century monetary theories, and the connections between the Scottish Enlightenment and behavioral economics.
Read more by Maria Pia Paganelli.
