Adam Smith and the Financial Crisis – Part 3

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    Banking in the 21st century

    How much of Smith’s stipulations on banking carry over into our modern economy and its difficulties? We first need to update our picture of the monetary economy by replacing gold and silver coin held by banks with central bank money in the form of reserves’ accounts held with the Bank of England and ‘cash’ in the form of notes and coins.

    It is important to understand that modern Bank of England notes are very different entities from the 18th century bank notes issued by individual commercial banks. The latter were backed only by the bank that issued them. Ultimately only the issuing bank would accept these notes. They were of no value to any other bank except in so far as that bank could exchange them for gold or silver, or perhaps in return for notes of their own if two or more banks had agreed to mutual acceptance of each others’ notes. If the issuing bank failed the notes of this bank could not be redeemed in precious metal and so became worthless.

    Modern notes (even those nominally issued in the name of Scottish or Northern Irish banks) are backed by the UK government, not by agreeing to accept them for gold and silver, but in agreeing to accept them in payment of taxes and to guarantee their value in circulation through the government’s conduct of its monetary policy. These notes are automatically accepted in exchanges between banks, along with central bank money (CBM) held by commercial banks in accounts with the Bank of England. The extent of international transactions involving goods and financial exchanges, means that transfers of gold are not generally required for the settlement of international debts, and there is no longer a formal backing of currencies in gold that obliges this.

    Table 2 below shows the links between firms, commercial banks, the central bank and individuals in the 21st century economy. Here central bank deposits are the basis of the system, rather than gold or silver. These deposits are liabilities of the central bank, whose main assets are loans to the commercial banks. Nowadays individuals borrow at least as much as they lend, and firms’ liabilities include the capital they acquire by the sale of shares in their business.

    Balance sheets for the 21st century monetary system
    Balance sheets for the 21st century monetary system

    The modern equivalent to the problems of the 18th century banks that found themselves requiring large amounts of precious metal because of their excess issue of paper money, is banks that have issued loans out of step with their counterparts. As a result the flow of money back into the bank fails to match that flowing from it. These banks then require additional cash and Bank of England reserves to meet the requirements of their own customers and those of other banks for withdrawals of the deposits they have created.
    These additional cash and reserves may be obtained from three main sources in order of expense:

    1. Additional deposits from the bank’s customers
    2. Borrowing of central bank money from other banks
    3. Borrowing of central bank money from the Bank of England

    Since until recently the latter two sources were available on demand, as long as modern banks correctly matched the long-run return on its loans with the costs of acquiring required central bank cash and reserves there was no inbuilt limit to this process by which banks could create deposits. Moreover, since there is no effective limit on the quantities of CBM that can be used to acquire foreign exchange, the former importance of paper money in enhancing foreign trade (for good or ill) and in draining the nation of better-quality metal coin are no longer relevant. The lack of a distinction between gold and silver coin and bank-issued money does mean, however, that it is more likely that when excessive money issue occurs its value may fall, leading to inflation.

    Does Smith’s stipulation that lending for large capital projects is unwise still hold up? It is still true that such projects still involve greater uncertainty and thus risk, but it is generally no longer possible to rely on wealthy individuals to make the loans required to set up such projects. Major infrastructure projects almost always require state backing. For this reason it is probably not here that we should look for the source of problems of the modern banking system.

    What about Smith’s concern about excessive currency? He generally was less concerned about inflation: noting little rise in prices as a result of the activities of the Scottish banks, but as we have noted was concerned about the effect of gold and silver being squeezed abroad as the result of an excess of paper currency. In a modern economy, when there is access to more money (paper currency and deposits) than is required for day to day circulation there are a number of outlets for it. The most obvious is that it is accumulated in bank accounts earning various levels of interest. In normal circumstances there is no more secure form of money than such accounts. Gold and silver can no longer be withdrawn from bank accounts. In abnormal circumstances, as recently seen in runs on the Northern Rock and Icelandic banks, account-holders may attempt to withdraw government-backed paper currency or transfer their accounts from an apparently troubled bank to an apparently safer one. Given government guarantees of bank deposits even this action does not really do much to increase security.

    The second outlet for excess money in the modern economy is for bank account holders to seek a greater return for their money by purchasing assets (usually financial). What is important to understand is that there is only one type of financial asset purchase that actually reduces the total amount of bank deposits rather than simply transferring them from one owner to another, and that is the purchase of government bonds. The purchase of foreign currency for speculation or to purchase goods from abroad moves money out of the country but this has the effect of building up deposits of UK Central Bank deposits in foreign banks. Smith’s problem of a diminished UK stock of gold and silver (both in quantity and quality) is changed to one of an increased foreign holding of the liabilities of the Bank of England.

    Finally there is the possibility that holding greater bank deposits will lead people to offer higher prices for goods. This is the inflationary scenario. It may seem surprising, given the prominence give to monetary policy in the modern era, that Smith is generally not concerned with this possibility. In his view, prudent banknote issue means that

    ‘the quantity of gold and silver, which is taken from the currency, is always equal to the quantity of paper which is added to it’ (WN, IIii, p324).

    There is thus no general increase in the quantity of the whole currency, and so prices need not increase as a consequence. Smith contrasts this with paper money consisting in ‘promissory notes’ unrelated to gold and silver stocks. The value of this money then depends on the likelihood of this promise being kept, rather than simply the quantity issued. This is also true of the modern economy. Inflation need not follow automatically from an increase in money issue. If capital projects for which additional money is created purchase materials and labour at current prices and lead to additional output, then this money should maintain its value. If, however, the initial creation of money in the process of issuing the loan for the capital project were for some reason to involve offering higher prices for raw materials and labour, or were to fail to add to output then this itself may well be inflationary.

    Of most relevance to the current economic situation is Smith’s account of the effect of a chain of financial instruments in the form of short-term bills drawn and re-drawn at intervals and at expanding cost. Smith emphasises the problem of communication this introduces and how once the claim is established, breaking it may ruin the breaker as well as those further along the chain. This precisely mirrors the problem of sub-prime mortgages and other loans whose ultimate realisable values were well below the value at which they were initially transferred from their originators. Once these were bundled and associated with insurance and credit-rating agency approval, no further questions were asked by their holders until it was too late. Banks with reserves of central bank money hoarded these once they feared that their other assets would turn out to have much reduced value. For other institutions such as the Northern Rock bank, whose business model meant that they were reliant on a steady supply of CBM from other institutions rather than their own deposits to maintain their financial throughput, this put them in serious trouble.

    What of Smith’s specific solutions? The expansion of technology and the size of modern infrastructure projects means it would no longer be possible to limit banks to lending only for transaction and precautionary balances, without severely limiting new economic developments even when they could yield future benefits. Private individuals would never be in a position to put forward the funds and take on the risks these involved. However, Smith’s stipulation about banks’ need to scrutinise their own loans seems particularly valid. So too are his warnings about the risks involved with long chains of financial instruments about whose origin the ultimate holders have little or no knowledge. The interdependence this induces Smith rightly sees as threatening the whole financial system.

    One aspect of Smith’s answer to the problems of banking which is favoured by the Adam Smith Institute and other extreme free-market supporters is that of multiple currency-issuing banks in free competition with each other. Is this realistic today? In the days before government deposit guarantees the failure of a bank led to the loss of customers’ deposits. The public and media reaction to the Northern Rock crisis demonstrates that this would no longer be politically acceptable. In the absence of a gold and silver basis to the currency (which would give an arbitrary physical limit to money issue and to economic activity) a common value is required to allow the common valuation of different currencies. It is difficult to see how the current system of a base money issued by the state bank and accepted in payment of taxes could be replaced.

    The effect of a deposit guarantee and a common state-backed currency would be to render all money denominated in that currency to be equivalent in all but nominal terms – as indeed is the case with Scottish and Northern Irish notes today. There is thus no realistic scope for competition in currency issue in a modern economy.

    Much of Smith’s message is valid today, however. Collective action, collectively funded is the right approach to the provision of ‘public goods’. One such is ensuring a beneficial rather than a harmful role for the banking sector. This means guiding the banks to ensure that they lend on the basis of long-term social value and that they must themselves monitor the performance of their own loans and debtors rather than passing this on down an opaque lending chain.

    © 2010 Dr Diarmid J G Weir

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