Adam Smith On Banking Regulation

Paul Krugman writes in the New York Times HERE

Financial Reform End Game

“For one thing, governments always, when push comes to shove, end up rescuing key financial institutions in a crisis. And more broadly, relying on the magic of the market to keep banks safe has always been a path to disaster. Even Adam Smith knew that: he may have been the father of free-market economics, but he argued that bank regulation was as necessary as fire codes on urban buildings, and called for a ban on high-risk, high-interest lending, the 18th-century version of subprime. And the lesson has been confirmed again and again, from the Panic of 1873 to Iceland today.”

Comment
Krugman is correct about the details – Adam Smith did advise that government regulation of elements of banking practice justifiably could be legitimised by the consequences to innocent others from failures in certain specific activities, notably the issue by banks of low denomination promissory notes, such as for 6 pence, even though customers and their customers were prepared to accept them, and certain high risk lending (WN II.ii.94: 324).

He acknowledged that such regulations are “a manifest violation of that natural liberty which it is the proper business of law, not to infringe but to accept” (no prevarication there then), but set against the “security of the whole society” the “natural liberty of a few individuals” which “might endanger” that “security”, should and “ought to be restrained by the laws of all governments; the most free, as well as the most despotical” (no lack of clarity either).

He went further too: not only must bankers be “restrained from issuing” low value bank notes (the central bank had not monopoly at the time in circulating paper currency), they must also be required to make “an immediate and unconditional payment of such bank notes as soon as presented”. The consequence of this last regulation would be that “their trade, may with safety, be rendered in all other respects perfectly free” (WN II.ii.106: 329).

The purpose of banking regulations was to oblige “all of them to be more circumspect in their conduct, and by not extending their currency beyond its due proportion to their cash [in Smith’s day, gold and silver], to guard themselves against the ruinous runs, which the rivalship of so many competitors is always ready to bring upon them”.

He added that by “dividing the whole circulation into a greater number of parts, the failure of any one company, an accident which, in the course of things, must sometimes happen, becomes of less consequence to the publick” (WM II.ii.106: 329).

This chapter on banking in Wealth Of Nations should be a highly advised read set by tutors to their students in any course on banking and finance.

Some so-called “free-market” ideologues, who oppose all regulation whatsoever, should recognize, as Smith did (he was no ideologue), that the freedom of the market works best, when protected by laws of justice and when its participants exercise a high degree of prudence in their conduct before they can ruin it for everybody else.

Two Errors on Adam Smith

"dakinikat" writes (19 Sept) “Support your new Alphabet Soup Agency” (HERE):

“Even Adam Smith, creator of the invisible hand and the term laissez-faire economics, realized the need for government regulation of certain markets.”

Comments
Oh, dear!

Two blatant errors, “creator of the invisible hand and the term laissez-faire economics”.

For the “invisible hand” see Lost Legacy (previous post and scores of earlier ones (also read my:

“Adam Smith: a moral philosopher and his political economy”, 2008: Palgave Macmillan).

For “laissez-faire economics”, $1000 if “dakinikat” can show that Adam Smith ever used the words “laissez-faire”.

Yes, Adam Smith identified that there were circumstances when there was a need for “government regulation of certain markets”.

Can “dakinikat” show where in Wealth Of Nations he did so? (Hint: in a business sector very much in the news recently).

Adam Smith Did Not Make Predictions

The Daily Reckoning HERE: carries an post, “Bubble Deniers”, by Bill Bonner, co-author of three New York Times best-selling books, Financial Reckoning Day, Empire of Debt, and Mobs, Messiahs and Markets:

“Long gone are the days when economists thought deeply about how life actually works. Adam Smith, Adam Ferguson, Anne-Robert Turgot - the great “moral philosophers” - all died hundreds of years ago. Since then, the trade has gone bad. They’re all numbers guys now. An economist, of the modern variety, is a statistician…an extrapolator…and a mountebank.* If numbers go up two months in a row, he predicts they will go up another one. He rarely stops to ask whether his numbers really make any sense. Instead, he merely adds them up and rolls them out. Thus - at the bubbly top in 2006 - he was he able to describe the likelihood of default on a certain derivative instrument as a “Six Sigma event” without laughing. A Six Sigma event happens once every 2,500,000 days. Then again, when the Bubble of 2002-2007 popped, they happened once a week.

The blogs are full of chatter on the subject. What good is the economics profession, asks Paul Samuelson, if it cannot foresee the biggest single economic event in at least a quarter-century?”

Comment
I agree with the broad sentiments of Bill Bonner with a few caveats.

There are an enormous number of economists working today and it is more than likely that some of them did warn about the pending bubbles before ‘sub-prime’ entered financial discourse. Popular books of the pending stock market crash, like a stopped clock are likely to be right at sometime.

Paul Samuelson, characteristically, hits the nail on the head: why did the economics profession fail to “foresee the biggest single economic event in at least a quarter-century?”

Partly, the answer is that large as it is, economists are not members of a unified science. Many economists focus solely upon in-doors experiments, with real people, or imaginary experiments with equations.

Some do not look out of their windows at all and in fact have been carefully groomed not to do so; most do not look over-the-fence at what closely aligned disciplines are doing or have done (think of sociology, psychology, anthropology and, above all, history), and they suffer promotion-withholding disdain from colleagues if they do so, and are disregarded by the sniffy-nosed severity of those who form tenure committees that pass over anyone showing evidence of a lack of disciplinary-defined gravitas.

For those who master the black arts of econometrics, only as good as the data they sometimes painfully collect, or the harder tests of stratospherically higher mathematics and their fateful misunderstandings of the real world, despite their mastery of their imaginary worlds without humans in them, the result is largely the same - neither the colourful future they arrogantly believe they see (with pay-cheques to match) nor the black-and-white past they virtually invent are connected to the real world.

Prediction in modern economics is the Holy Grail (more like the Devil’s Jest). Adam Smith avoided making predictions; he observed, as was the rightful duty of a moral philosopher, and reported to all who would read his books. He stuck to the humble arts of an influencer; he was not a man hawking a career-winning system.

He held on to humble hopes that legislators and those who influenced them would think about his observations and, slowly and gradually, they might adopt measures to change some of their and their predecessors’ behaviours a step at a time.

His sense of history (surely the great laboratory of human experience), based on a remarkable understanding of the whole range of human behaviours across and at all levels of society throughout history and the present, lowered his expectations as to what was tolerable by ‘so weak and imperfect a creature as man’, contrasted with what was possible if the world perfectly conformed to utopian imaginations, where the people in it behaved impeccably as ‘rational maximisers’ in the manner the out-of-touch theorists believed they would (give-or-take a few heroic, not to say fool-hardy, assumptions). Ironically, Smith is described today as such a philosoper in the image of today's 'rational maximisers!

Readers perplexed by the crisis should consult ‘The Recession: causes and cures’ (2009) by David Simpson, a classical economist. It is available from the Adam Smith Institute: www.adamsmith.org

At Last! Great Sense on the Current Crisis!

Dr Madsen Pirie, of the Adam Smith Institute (London) reports on an analysis of the current recession, written by Professor David Simpson: The recession – whodunit? (HERE)

A publication the Adam Smith Institute is particularly proud of is The Recession – Causes and Cures by Dr David Simpson. Dr Simpson was Economics professor at Strathclyde, and then economic advisor to Standard Life. His piece is short, eloquent, and utterly convincing. It forms a crucial part of our counter-attack on the facile but common notion that it was greedy bankers who brought about our downfall.

Not so. Dr Simpson methodically traces the bust's causes to the previous credit-fuelled boom instigated by governments and their central bankers. There were indeed bankers who made foolish (rather than greedy) decisions, and who read risks wrongly. But they did so amid a sea of cheap money which governments had flooded onto them. The asset-price bubbles (which are now bursting or deflating as markets correct the errors) resulted from interest rates deliberately kept too low for too long.

The best way to treat a bust is to avoid it altogether by not stoking up the antecedent boom, but given a bust, the treatment should be lower corporate and personal taxes. These should be financed by spending cuts, not by borrowing which signals future tax rises. And the policy-makers who oversaw this crisis should be replaced.

The book is a terrific read, and puts its whole case in fewer than 40 pages. It is both compelling and convincing. Do read it. (HERE)

[Disclosure: I am a Fellow of the Adam Smith Institute]

Maxedoutmama joins the fray

‘Maxedoutmama’ posts a most interesting and imaginative explication of Adam Smith’s views related to the current financial crisis (HERE):

“I Digress: Taking a break from the somewhat grim global economic news:

”I always feel embarrassed to use a non-journalist's name when I am pointing out that someone's assertions are lunatic, so I won't cite the author's name. Instead, I will confer a charitable anonymity by using the sobriquet "Wonder Dummy" for the author henceforth.

The basic theme of Wonder Dummy's post:

‘Adam Smith first coined the term “The Invisible Hand” in his important book “The Wealth of Nations.” With this term he was trying to capture the idea that the marketplace would be self-regulating. The basic principle of the invisible hand is that though we may be unaware of it, an unseen hand is constantly prodding us along to act in line with what’s best for the whole economy. This means that when this invisible hand exists, when we all pursue our own interest, we end up promoting the public good, and often more effectively than if we had actually and directly intended to do so. This is a beautiful idea, but the question of course is how closely it represents reality.’

Comment
Do you recognise the author whom ‘Maxedoutmama’ quotes? I posted my criticism of him yesterday (Clue: he’s at Duke University).

‘Maxedoutmama’ continues:

“Of course the answer to the question is preordained by this careful miscast of Adam Smith's main assertion. That assertion is that economic efficiency is best for the economy, and that economic efficiency can best be attained by not interfering with prices in the marketplace. In fact, I suspect that Wonder Dummy has never read Adam Smith. I prefer to be charitable and assume that Wonder Dummy is not knowingly lying in order to lend credence to a meme that is currently popular, if completely wrong.”

And she recommends reading Adam Smith’s Moral Sentiments and Wealth Of Nations:

”If you want to find out what Adam Smith (1723-1790) really said, you can find most of his writing online….Adam Smith was no superficial thinker, and his economic musings were not based on an unrealistic view of mankind… To which I must add … my favorite Adam Smith quote:

‘What can be added to the happiness of the man who is in health, who is out of debt, and has a clear conscience?’

Comment
To which she adds a remark about Dan Ariely’s transmutation of the invisible hand into ‘government debt’:

“What a surprise. In fact, those who have actually read Adam Smith know that the "invisible hand" is used in the context of government control of trade, specifically, protectionist tariffs against foreign goods. The discussion is found in Chapter 2 of Book IV "Of Systems of Political Economy" …

“In short, this is about what governments can and cannot accomplish. Chapter 2 begins as a discussion of government-granted monopolies to domestic industries, and continues as an explication of the harm that such monopolies cause to the general welfare.

Comment
The rest of the post by ‘Maxedoutmama’ is on the details in the chapter which mentions the metaphor of an invisible had and the causes of the current crisis, and you should read it in detail (follow the link above).

While enjoying the skewering of Dan Ariely’s version of the invisible hand, I have reservations about Maxedoutmama’s version too. The survey of the build-up to the singular use of the invisible hand metaphor demonstrates that she has read Wealth Of Nations, which is an improvement on Dan’s version.

However, it neglects the specific details of the risk-aversion of those merchants who prefer the home trade to foreign trade. In doing so, it swaps a more realistic role for The Metaphor for the unrealistic and imaginative role accorded to it by Dan Ariely.

Thus, though more authoritative that Dan’s, ‘Maxedoutmama’s version is too close to the orthodox version, and also implicitly accepts some role for The Metaphor, when in my opinion it is just a literary metaphor.

However, congratulations to ‘Maxedoutmama’ (she seems to have the rhetorical punch of Deirdre N. McCloskey, of the University of Illinois) for her valiant efforts against Dan’s error.

“Do economists know any more than us? ~ No damn way!”

Kevin McKern of Ashfield, New South Wales, writes News Kontent and posts a long piece by Nick Fraser who asks and answers: “Do economists know any more than us? ~ No damn way!”

It is a most informative article with which I agree (well, most of it). It is not a rant, nor the meanderings of someone ignorant of the subject. It is a considered exposition on the state of our subject. Nick clearly is very familiar with the state we economists are in, brought to the fore by the vapid response of the profession to what is going on.

Frankly, no one seems to have a clue, and governments are thrashing about trying to appear in charge. I strongly recommend that you follow the link HERE: and read the whole piece – it’s rather long but never loses its tempo.

I just wish one of our noisy academic media types (you know of whom I speak) would write so honestly of the fine mess that modern economics has brought us to.

Be clear, economists are not the cause of the crisis; they are just too damn silent about the failure of their certainties about their so-called ‘hard science’, superiority over other social sciences, and their right to sit (well paid and pensioned) near the centre of decision-making, whether in corporate enterprise or Big Government and its international agencies.

For a taster, here is a sort of postscript:

‘What we now suffer in economics is a hardness of intellect, a meanness of spirit, a narrowness of vision and a rigidity of thinking that utterly distorts the role of what economics in our society should be. Instead of economics being our tool for societal advancement, happiness, health, and sustainability, the profession has lost its way in econometrics, neo-liberal cant and equlibrium theory. It has become little more than cheerleaders to our enslavement to a towering edifice of debt, consumption and greed and the mouthpiece of vested interests. Unless repudiated we face not only economic but soceitial and ecological collapse.’

To which I am tempted to add: ‘Amen’.

Those Who Stoked the Fires are Least Able to Make them Safe

Balgeet Grewal, managing director and vice-chairman of Kuwait Finance House, ‘the largest Islamic bank in the world’, writes in the StarOnline (Malaysia)(HERE):

“Can Asia spend its way out of the crisis?”

“Policy makers very often confuse disenchantment with truth. The inconvenient truth in financial markets today is that government spending is crucial to jumpstart a beleaguered global economy.
The “invisible hand” of Adam Smith is more and more being replaced by perceptible government intervention as the tangled knot of economic problems becomes difficult to unravel.”

Comment
Adam Smith’s use of the metaphor of ‘an invisible hand’ was originally used in the context of the risk avoidance of some merchants in 18th-century Britain who took what they considered to be a safer route of investing their scarce capital in local business rather than take the risk of losing it by sending it to the British colonies in North America, where its security was more doubtful, access to fair treatment in the justice system operating in those colonies was suspect, the rate of return, if any, would take several years instead of several months, and the unpredictable weather and sea journey was unknown, apart from the risks of fraud from distant personages.

Because these risk averse traders invested locally, this added to local, and national, investment in productive activities, which led to a higher level of local economic activity and output than would be the case if they, and those who were less risk averse, sent their capital abroad.

A simple arithmetic case of the whole being the sum of its parts.

Now that takee quite a lot of space to explain, briefly, what Adam Smith considered to be the main issues. He actually took a little longer in fact in Wealth Of Nations to cover the same points (Wealth Of Nations, IV.ii: pp 452-56; 5 pages).

To keep his readers alert to his main point he ‘coined a phrase’ so to speak, and called upon a well-known metaphor from contemporary, and much earlier, literature which readers would be familiar, of ‘an invisible hand’.

Smith lectured in rhetoric and we have a set of his lectures taken down by some of his students in 1762-3, in which he described the role of metaphors.

While discussing how Shakespeare used metaphors, he described them as a ‘figure of speech’ in which ‘there must be an allusion betwixt one object and an other’, and that a metaphor can have ‘beauty’ if it ‘is so adapted that it gives due strength of expression to the object to be described and at the same time does this in a more striking and interesting manner’. (See Smith, A. [1762] 1985, Lectures in Rhetoric and Belles Lettres, 29 November, 1762, p 29, ed. J. C. Bryce, Liberty Fund, Indianapolis).

In short, a metaphor is representative; it does not have substance; it is not identical to its object. It is not a paradigm, nor a theory of markets; it is ‘a figure of speech’.

The problem is that some brilliant economists from the late 1940s (Samuelson, Debreu) and from the 1950s (Friedman, Stigler, Arrow) Tobin, and almost everybody since in academe, took the metaphor (which had hardly been notice before then – Edwin Canaan’s 1937 still popular text does not mention it as a side note in his authoritative edition of Wealth Of Nations, p 423) and popularised the invisible hand, credited to Adam Smith – though he had many predecessors, including Shakespeare, Defoe, Voltaire, as a mystical, almost divine (in some cases among US economists of a religious disposition, specifically the ‘hand of God') force said to be present in the operation of markets.

That ‘semi-divine’ view of the invisible hand now dominates academic and popular discourse and it is a view that Lost Legacy has conducted and will continue to conduct a relentless struggle, in order to rescue Adam Smith’s name from association with such unscientific – frankly nonsensical –treatment of how markets work.

The importance of this lonely struggle is seen today when capitalist market economies are driven and discredited from the centre of policy discussions on what to do about the current crisis, and the whole burden of counter-recessionary actions is transferred from markets to the sole determination of politicians, who were directly complicit in the very causes of the current crisis.

Those who stoked the fires of credit-based growth are judged by themselves to be those best able to put them out. The Labour government is preening itself as the saviour of the problems it created, and early manifestations of their ‘solution’ is to demand that the banks lower their interest-rates - wait for it - and offer more credit to propositions that are unprofitable and which they consider on current pricing to be too risky.

Balgeet Grewal’s article, written in the petro-dollar safe-haven of Kuwait, advises us that: “The inconvenient truth in financial markets today is that government spending is crucial to jumpstart a beleaguered global economy”, and “beleaguered” governments all know the address from where they can get the big loans they judge they need (what else can the billionaire dollar holders ‘invest’ their dollars?).

On Throwing Out the Baby With the Bathwater

Joel Bakan teaches law at the University of British Columbia and he is the author of The Corporation: The Pathological Pursuit of Profit and Power, and writer/co-creator of the documentary film ‘The Corporation’. He has a piece in today’s Vancouver Sun, which is fairly typical of many of the current crop of op-eds and columns around at present; they take the current financial crisis to kick their boots into either markets or government interventions in pursuit of their firm views on what’s wrong with international finance, or into those who have different views to theirs about what’s right about the way the economy is or is not working.

Ideologues Unanimous are holding packed meetings to celebrate their certainties, while foaming at their mouths when tossing their bile at whomsoever they regard as complicit in the failure of confidence within financial markets. It is amazing how many of them are so certain about the causes of the current problem – even down to naming the individuals whom they judge to be guilty – when if it were as simple as that we’d all be in the know too, but aren’t.

Lost legacy does not take sides in what is essentially a political problem. It observes; it doesn’t proselytize in the debate about the balance between free markets and free governments. It does express views on the alleged, asserted, and impugned contributions of Adam Smith in the ideologues’ obsessions.

Take Adam Smith’s alleged role in Joel Bakan’s article (HERE):

“Meltdown is a sure sign that free markets don't work"

“To begin with, he [Milton Friedman] said, corporate firms have one, and only one, obligation -- to make as much money as they can for their shareholders. "A corporation is the property of its shareholders," he said. "Its interests are the interests of its stockholders. Now, beyond that, should it spend the stockholders' money for purposes which it regards as socially responsible but which it cannot connect to its bottom line? The answer I would say is no."

Second, Friedman told me, there is little, if any, legitimate place for government to regulate what corporations do in their pursuit of profit. Accordingly, he said, governments should wind up their roles as economic overseers. They should deregulate.
The meltdown on Wall Street was caused, in part, by the inherent contradiction between these two ideas. If corporations are designed solely to make money for their shareholders, and if governments have no place in regulating what they do, what is to stop them from acting recklessly and dangerously in their pursuit of profit?
Friedman's answer to this question -- which he borrowed from, and attributed to, Adam Smith -- was that an "invisible hand" guides markets to ensure firms act responsibly to society, consumers and their investors. The popularity and influence of this idea, spouted by economists with near mantra-like devotion (at least until the past few weeks), is puzzling. Would you want an invisible hand to guide your surgeon's knife, or protect your neighbourhood from crime?

Why is the economy so special -- how is it that the invisible hand works there but nowhere else? The Wall Street meltdown suggests that, in fact, it does not.”

Comment
I have one major problem with Joel Bakan’s article.

“Friedman's answer to this question -- which he borrowed from, and attributed to, Adam Smith -- was that an "invisible hand" guides markets to ensure firms act responsibly to society, consumers and their investors.”

Milton Friedman was an effective propagandist for markets in preference to legislatures running an economy, and with this I have no quarrel in general. But like many commentators, he over-stepped the mark when he associated Adam Smith with parts of his advocacy.

Regular readers of Lost Legacy will be familiar with my constant corrective comments on the myth of ‘an invisible hand’ – to which Milton Friedman was a major disseminator – and they will know, as will all who actually read Adam Smith’s works (The Theory of Moral Sentiments and Wealth of Nations), that Adam Smith used in metaphor only once in each book and on both occasions it had nothing to do with his how markets work, as reported in Books I and II of Wealth Of Nations.

His sole reference to ‘an invisible hand’ in Moral Sentiments [TMS p 184) was about rich landlords having to distribute the produce of their farms to their employees, otherwise they would not survive the winter to labour in the fields in the Spring, despite their landlord’s illusions that their ownership of a beautiful and bountiful harvest was for their own consumption only. His sole reference to ‘an invisible hand’ in Wealth of Nations (WN IV.ii. p 456) is about the arithmetical consequences of risk aversion (the whole is the sum of its parts) and had nothing to do with markets (nor was it a theory, nor a principle, nor a paradigm - it was a metaphor).

Hence, Milton Friedman’s claim that Adam Smith believed or asserted ‘that an "invisible hand" guides markets to ensure firms act responsibly to society, consumers and their investors’ is patently incorrect, false, and a myth. The contrary view that Adam Smith did write what Friedman – and many others, including Nobel Prize Winners, distinguished scholars and eminent members of our profession – say he did is a study in the psychology of unsubstantiated beliefs.

Now I do not assert that convincing such personages to the contrary is ever going to be easy – several distinguished colleagues at the recent 40th Anniversary Conference of the History of Economic Theory, in Edinburgh, remained ‘unconvinced’ in the discussion of my paper *(that was my failing, of course) and two at least were quite antagonistic of the very notion of an invisible hand being a mere metaphor, and nothing I said, even by reading out from Moral Sentiments or Wealth Of Nations, affected their firm views.

So it’s not surprising that Joel Bakan’s report of his conversation with Milton Friedman is sincerely believed by him to be the link between free markets and the errors that caused the present crisis. Though to be fair, he does qualify his own report about Adam Smith and Friedman’s assertion about the invisible hand: ‘which he borrowed from, and attributed to, Adam Smith’. Joel, after all teaches law and knows the weakness of unqualified assertions.

Where I agree with Joel’s article is that Friedman’s often pronounced belief that corporate bodies have no responsibility for anything other than making money for their shareholders. Such extravagant assertions are not correct, in my view. Corporations, like any other institution or natural person, have obligations, not the least of them, to conduct themselves within the law (including such regulations as are passed lawfully to make laws operational).

The history of corporations includes the kinds of behaviours criticised by Adam Smith in Books IV and V of Wealth Of Nations regarding the awful behaviours of the East India Company and the people in it.

There is also the history of slavery, which history should not be confined only to the experiences of slavery in the British Colonies and afterwards in the USA, of which the British slave trade was stopped by law in 1808. There is also the unfortunate neglect of the millennia of experiences of slavery in eastern Europe, the near East and the Arab sphere of influence in Africa, and in India and China too until recent times. This history suggests that left to their own ideas of corporate responsibility there is a real danger that corporation, governments, and private individuals will behave irresponsibly and inhumanely unless the legislature intervenes.

Therefore, in advocating minimalist corporate responsibility, Milton Friedman was plain wrong. Working within the law and common decency, corporations are better suited to operating in competitive market economies. That part of Friedman’s outlook was right, considering the alternatives.

But overall I do not accept that Joel is right when he claims that "Meltdown is a sure sign that free markets don't work". In the absence of free markets, within the law and actining decently, he would soon notice the difference in Vancouver.

*Readers interested in the myth of an invisible hand can find it discussed in my book, ‘Adam Smith: a moral philosopher and his political economy’, Palgrave Macmillan, 2008, or in my paper, ‘Adam Smith and the Invisible Hand: from metaphor to myth’, 2008. The latter is available online if you write to: gavin –at – negweb-Dot com