Tuesday, June 11, 2013

Adam Smith's very own Lehman Crisis

It's interesting to see how after a credit crisis, economists start to take money and banking a bit more seriously. Adam Smith, who experienced his very own credit crisis -- the collapse of the Douglas Heron and Co, or the Ayr Bank, on June 22, 1772 -- is no exception. His views on money and banking became much more nuanced after that event.

Ayr Bank had been founded in 1769 in the Scottish town of Ayr. It expanded to Edinburgh and Dumfries, and in only a few short years it had succeeded in wrestling a significant chunk of Scottish banking business from incumbents the Bank of Scotland and the Royal Bank of Scotland. By 1772, according to Checkland, the Ayr Bank supplied 25% of Scotland's bank notes and deposits. In early June 1772 one of Ayr's largest customers, Alexander Fordyce, skipped London for Paris to avoid debt payments. A run on the Ayr Bank began that precipitated the bank's failure by the end of the month.

Upon observing the bank run, David Hume writes from Edinburgh, Scotland to his friend Smith on June 27, 1772:
We are here in a very melancholy Situation: Continual Bankruptcies, universal Loss of Credit, and endless Suspicions. There are but two standing Houses in this Place, Mansfield’s and the Couttses: For I comprehend not Cummin, whose dealings were always very narrow. Mansfield has pay’d away 40.000 pounds in a few days; but it is apprehended, that neither he nor any of them can hold out till the End of next Week, if no Alteration happen. The Case is little better in London. It is thought, that Sir George Colebroke must soon stop; and even the Bank of England is not entirely free from Suspicion. Those of Newcastle, Norwich and Bristol are said to be stopp’d: The Thistle Bank has been reported to be in the same Condition: The Carron Company is reeling, which is one of the greatest Calamities of the whole; as they gave Employment to near 10.000 People. Do these Events any–wise affect your Theory? Or will it occasion the Revisal of any Chapters?

Of all the Sufferers I am the most concern’d for the Adams, particularly John. But their Undertakings were so vast that nothing coud support them: They must dismiss 3000 Workmen, who, comprehending the Materials, must have expended above 100.000 a Year. They have great Funds; but if these must be dispos’d of, in a hurry and to disadvantage, I am afraid the Remainder will amount to little or nothing.
Hume asks if these events affect Smith's theory, the Wealth of Nations having not yet been published. In a letter to William Pulteney dated September 1772, a few months after the bank crisis, Smith notes that the events had indeed delayed the finishing of his book, which otherwise would have been completed that winter. When it was eventually published in 1776, Book II, Chapter II of the Wealth of Nations would include a long description of the Ayr crisis (though Smith never mentions the bank by name, most probably to protect those involved, see below).

Personal issues arising from bank failure also delayed publication of the Wealth of Nations. In the letter to Pulteney, Smith disavows any financial involvement in the crisis but notes that:
Tho I have had no concern myself in the Public calamities, some of the friends for whom I interest myself the most have been deeply concerned in them; and my attention has been a good deal occupied about the most proper method of extricating them.
According to Antoin Murphy and John Rae [biographer of Smith], the friends to whom Smith refers to probably included Smith's patron, the Duke of Buccleuch. The Duke was one of Ayr Bank's largest shareholders, and the source of Smith's £300 a year pension. Murphy intimates that as adviser to the Duke, Smith would have been privy to much of the gritty details of the bank's demise, as well as advising Buccleuch in the ongoing legal proceedings against the shareholders and directors of the bank. No doubt Smith had plenty to reflect on, including the fact that he might lose his pension.

There is also an odd letter from Hume to Smith, dated October 1772, in which Hume refers to Ayr banknotes in Smith's possession:
I ask’d the Question you proposd; and was told by Sir William Forbes, that tho’ they did not commonly take the Air Notes, yet he woud upon your Account: You may therefore send them over by the first Opportunity.
Not only did the collapse of Ayr put Smith's benefactor in financial trouble, but it seems that Smith himself was in possession of a few Ayr banknotes. Could it be that Smith himself was burned by the Air collapse, only to be helped out by William Forbes, an Edinburgh banker who had survived the crisis and generously agreed to take the notes off of Smith's hands? Or was Smith simply using his connections to help out a London-based friend who was stuck with Ayr Bank notes?

In any case, Smith's views on banking were inevitably modified by a crisis. According to Murphy, Smith became more conservative monetary theorist relative to his pre-1772 stance. Here is a quote from Smith's earlier Lectures on Jurisprudence, about six years before the crisis, in which he pooh-poohs the danger of banking crisis.
The ruin of a bank would not be so dangerous as is commonly imagined. Suppose all the money in Scotland was issued by one bank and that it became bankrupt, a very few individuals would be ruined by it, but not many, because the quantity of cash or paper that people have in their hands bears no proportion to their wealth. Neither would the wealth of the whole country be much hurt by it, because the 100 part of the riches of a country does not consist in money. (1766)
In The Wealth of Nations, Smith's benign view of banks was modified. No doubt influenced by his first hand experience of the Ayr collapse, Smith realized that the ruin of banks could have far greater consequences than he had earlier assumed. He went on to describe a set of guidelines that banks might use to avoid bankruptcy. Bankers, Smith wrote, should always verify that the bills of exchange upon which they issued credit (bills were a common collateral security accepted by banks) had arisen as the result of solid transactions between "real creditors" and "real debtors". Fictitious bills of exchange -- bills whose provenance was obscure and were usually issued by those whom Smith called "projectors", or speculators, and accepted (or co-signed) by collaborating projectors -- were to be treated with skepticism. The blogosphere's very own David Glasner describes this set of rules in this paper.

Like Smith, modern day economists are busily reappraising pre-2008 modes of thought, much of which abstracted from money and banking altogether. They have much to reflect on too. If Smith were alive today, he'd no doubt wonder why banks had lent on such unverifiable collateral, most of which in his eyes would appear to be entirely fictitious.

1: Much of this blog post is indebted to Antoin Murphy's chapter on Adam Smith in The Genesis of Macroeconomics.
2. For a full account of the demise of the Ayr Bank, here is the 1778 inquiry into the affair , or The Precipitation and Fall of Mess. Douglas, Heron and Co, Late Bankers in Air With the Causes of their Distress and Ruin Investigated and Considered. They sure loved long names back then.


  1. Sorry to nitpick, but I think this post gives a slightly misleading impression of the evolution of Smith's views (at least according to what I recall of Murphy's book). IIRC, Murphy emphasizes that Smith's turnaround on banking's importance in the economy and of paper money in general was a kind of negative backstep in economic thinking. So instead of saying "nuanced," perhaps some other word should be used to describe Smith's latter views, since they led him to embrace misguided ideas like the real bills doctrine.

    Thanks for the recommendation, I really loved the book. The only disappointment was the last chapter--from snippets on the blogosphere, I feel that there's a lot more depth to Thornton than what was described by Murphy. It was sort of a disappointing climax to the monetary and banking themes from the rest of the book.

    1. Btw, I would really love to a see a post (or series) on the real bills doctrine. I only vaguely understand the broad outlines, but according to Dick Timberlake and White/Selgin, it's had a very negative influence.

    2. Googling finds a wide range of material on the real bills doctrine:

    3. Specifically apaper by Thomas Sargent:

    4. John S:

      The real bills doctrine is well worth serious study. It was developed by practical bankers over centuries of experience, and as such is the kind of theory that should command the highest respect from academic economists. The fact that it is widely considered to be misguided is a calamity, but it also makes it that much more interesting. See my paper entitled "Three False Critiques of the Real Bills Doctrine" for an explanation of Thornton's errors. There is also my "Reply to Mr. Timberlake". I have also had several blog debates with George Selgin, mostly at the Free Banking blog. George remains (ahem) unconvinced by my arguments.

      Most of my real bills papers can be found by clicking my name above, and they can also be found on REPEC.

    5. Thank you, Mike. I've briefly skimmed your site before, and when I get a bit more time, I will make an effort to understand your arguments.

    6. John, glad you liked Murphy's book.

      I chose to call Smith's post-1772 views more nuanced because I don't think his updated position equates to an original statement of the "real bills doctrine".

      The original real bills doctrine was set out by the Directors of the Bank of England during the period from 1797 - 1821 when Bank of England notes were not convertible into gold. As long as the Bank only discounted on real bills during the Suspension, said the Directors, then it couldn't expand its issue beyond the demand for notes and cause an inflation. But we know that this is false since this ignores the fact that the Bank might discount real bills at unreal prices, thereby setting off an increase in prices. With a gold check, this inflation would immediately be cut off, but without it the inflation could continue unabated.

      Adam Smith, on the other hand, died in 1790, seven years before the suspension, and therefore his environment dictated that he always theorize under the assumption of gold convertibility. Any excess issuance in a gold standard would almost immediately reflux back to the issuer. Smith felt that banks should hold "real" bills to ensure that they could handle the demands of reflux. Bad bills which funded long term speculative projects or were issued in the name of dubious signatories would not be sufficient to cope with reflux.

      So long story short, Adam Smith's story is very different from that of the Directors.

    7. Thanks, this clears things up quite a bit.

      One thought I had: while Smith's personal experience with Ayr led him to conclude "that the ruin of banks could have far greater consequences than he had earlier assumed," weren't the actual effects of the collapse not terribly serious? At least according to White in "Free Banking in Britain," only a few banks associated with the Ayr bank failed, and it did not seem to lead to "contagion," large deposit losses by the public, or general recession. So perhaps if Smith and members of his social circle had been associated with a different, more prudent bank, Smith might have retained his previous view on bank failures.

    8. According to Rockoff, there was a V-shaped recession in 1772 and 1773. See:


      Whether Ayr set of the recession, or was set off by the recession, or amplified the recession, is difficult to say. Of course you're right that anyone who had their deposits at the incumbent Royal Bank of Scotland or Bank of Scotland did fine. But there does appear to be more than a relative shift going on here.

    9. Great find, will read.

  2. "With a gold check, this inflation would immediately be cut off,"

    Sometimes a gold check is more of a suicide pact. Start with a bank that has issued $100, backed by 100 oz. worth of assets, so 1 oz.=$1. If that bank then buys a farmer's bill worth 10 oz., but pays the unreal price of $20 (newly issued) for it, then the bank would have 110 oz of assets backing $120, and each dollar would be worth .916 oz. A gold check of $1=1 oz. would cause a bank run. The first $110 in line would get redeemed for 1 oz each, but the last $10 in line would be worthless, and the community would face a recessionary drop in its money supply. If the bank had suspended convertibility instead, then the dollar would drop to .916 oz without causing nearly as much trouble as a bank run.

    This is the trouble with Timberlake and Selgin. They think that the real bills doctrine only requires that the farmer's bill be based on real production. They forget that the banker must not overpay for that bill.