Excellent Writing But Still Mythical

Atanu Dey writes a highly readable and lively piece on “Why education matters” HERE

“I am sure that there is no secret cabal of powerful people with evil glints in their eyes plotting to keep Indians illiterate. But individual behavior motivated by private incentives - micro behavior - have consequences at the social level - macro outcomes - that are not intended by individuals. The most famous example of this is Adam Smith's "invisible hand" - the market mechanism that grinds out the socially beneficial outcome even though an individual is only interested in his or her own welfare. So also, there could be what we can call the "invisible fist" of the government which can pummel the life out of a society even though no single government official is doing anything more than making his or her life comfortable.”

Comment
Atanu Dey writes well and complains that 33 per cent of Indian adults are illiterate. An alarming statistic for any country and doubly so for the world’s largest democracy.

His clever construction of the possible reason why government action fails to address the illiteracy problem by drawing a parallel with the invented notion of an “invisible hand” in the economy, wrongly attributed to Adam Smith by modern economists is well stated. But good writing is still vulnerable to the evidence.

Because Adam Smith didn’t write anything about the “invisible hand” being a “market mechanism” that “grinds out the socially beneficial outcome even though an individual is only interested in his or her own welfare” - see numerous posts in Lost Legacy that expose this myth – it was at root a myth created by well-meaning modern economists as part of anti-Soviet planning propaganda during the Cold War (and over enthusiastic mathematicians carried away with their 'proof' of general equilibrium applying to the real world).

Their motives were laudable – Stalin’s Soviet planning was backed by repressive civil violence and threatened to cause World War III (and IV and V, etc.,). But by their apparent endorsement of unrestrained behaviours their own unintended consequences created a mythical monster that self-interest, elided by epigones in selfishness, worked out, Panglossian-like, for the “best of all possible worlds”, covering over a plethora of externalities that damaged the interests of the rest of society (pollution, environmental destruction, monopoly pricing, protectionism, and local wars arising from them.

By associating Adam Smith with the invented myths, they traduced his reputation too. Most economists actually believe that Smith was the author of the myth. He wasn’t.

Yet many climb on the bandwagon that the current recession ‘exposes’ the ‘failures’ of following Adam Smith’s policies, in particular ‘laissez-faire’ (which he never supported – nor mentioned even once), ‘lack of regulation’ (when in fact he specifically advocated the exact opposite where it came to bank policies “which might endanger the whole security of the society”; see WN II.ii.94: 324) and the mythical “invisible hand”, mere metaphor for an entirely different set of circumstances).

The Loose Morality of Accountability in Banking

A correspondent drew my attention some time ago to a statement in Moral Sentiments, which was withdrawn from edition 2, but is reproduced in edition 6 as an editor’s footnote on p 111 (Oxford University Press edition):

‘A moral being is an accountable being. An accountable being, as the word expresses, is a being that must give an account of its actions to some other, and that consequently must regulate them accordingly to the good liking of this other. Man is accountable to God, and his fellow creatures. But tho' he is, no doubt, pricipally accountable to God, in the order of time, he must necessarily conceive himself as accountable to his fellow creatures before he can form any idea of the Deity, or the rules by which that Divine Being will judge of his conduct.’ (TMS III.1.3. footnote [2], p 111)

Comment
Apart from this being an example of Smith's editing out of earlier several references to God and the Deity, the idea of accountability to ‘fellow creatures’ may have some relevance to those bankers, traders, fund managers, and their assorted ilk, who seem to have escaped accountability even to today’s, and future, taxpayers who are paying to keep them in business and, apparently, in bonuses.

Thoughts on the Banking Crisis, Invisible Hands, and Risk Aversion

It strikes me that the current banking crisis provides a useful illustration of the behaviour which Adam Smith noted in his famous chapter 2 in Book IV in Wealth Of Nations.

I have quoted this chapter many times here when discussing Smith’s use if the 18th century popular literary metaphor of ‘an invisible hand’, which modern economists since the 1950s elevated into a ‘theory’, ‘concept’, ‘principle’ and even a ‘paradigm’ of how markets work.

Of course, it was nothing of the sort; it became a convenient piece of semi-mystical ideology to propagandise on behalf of leaving large corporate entities to do whatever they found convenient to their interests.

Looking at the political issues around the ‘credit crunch’, the complaint is often presented as the banks being unwilling to make loans to willing borrowers, presumably of good quality, or even to each other. Much angst is suffered asking to why this should be so, given the billions of pounds they have been ‘given’ by various governments.

The answer is partly concealed in the cause of the problem. I refer to the risk-aversion of the banks. They have taken onto their books billions of pounds worth of ‘toxic assets’, most of which neither they nor those who carry them as ‘assets’ are sure exactly as to their true worth. Lending to people with undisclosed – because unknown – liabilities is no way to run a profitable or any other kind of bank.

Borrowers from the general public may receive a trickle of loans, but these are nowhere sufficient to ‘kick-start’ the sluggish economy, and without bank credit flowing more freely, the economy becomes increasingly sluggish.

Borrowers from within the banking sector, even those supported by government loans, guarantees, and assurances, are unlikely to engage in normal ‘inter-bank lending’, while nobody is willing to disclose even to other banks because they may not know themselves the extent of their ‘toxic’ debts, nor their true level of toxicity. This fully explains the current impasse in bank lending.

Hence, the frustration of hapless government ministers, whose complicity in the creation of the mess is as big a secret as are the extent of toxic problem.

But let’s be clear. It is the risk-aversion of the players in the banking crisis that leads them to behave in this manner. They prefer to hold onto what real assets they have rather than commit their business to the uncertain fortunes of lending to both other banks and the wider business community.

Ironically, government borrowing creates an opportunity to buy bonds and earn some interest, though at lower rates than they were used to. But that won’t end the crisis. But banks carry debts owed to them by foreign banks, and what they fear about the risk of their bank lending in Britain is made much worse when considering the security of their loans abroad, where uncertainties caused by doubt and ignorance of the true state of affairs with foreign banks makes them ever more insecurity.

What is true for British banks is also true for foreign banks, all of which was made worse by the swift decision of the Prime Minister and the Chancellor, just when the crisis broke, to seize and confiscate the funds of the Iceland banks in London. Other foreign banks, seeing this treatment, were positively encouraged to disengage their banks situated in the UK. Likewise, British banks’ insecurity about lending abroad is another disincentive to lend.

Adam Smith shows in Wealth Of Nations an analogous situation when noting that some, but not all, domestic merchants preferred to invest their capital locally rather than join those merchants who sought higher profits from trading with the British colonies in North America.

The risk premium, plus long experience of some merchants in the Atlantic trade, was covered by the higher profits they could obtain while their monopoly trade, under the protection of the British Navigation Acts – originally an idea under Cromwell’s remit - and which were enforced by the Royal Navy and every British seaport at home and abroad.

But those merchants, who were risk-averse towards overseas trade, found that local investment, nearby where they operated, though less profitable, were also much less risky. Local courts were serviced by neighbours they knew and laws were clearly defined. These considerations led them to invest locally, which directly benefited the British economy and produced a higher national output of the ‘necessaries, conveniences, and amusements of life’, with a higher amount of employment than would otherwise have occurred. [The whole is the sum of its parts.]

Smith used the metaphor of ‘an invisible hand’ to explain how they were ‘led’ to do this, which has since taken on a life of its own, as if such an entity actually existed; some attribute the ‘invisible hand’ to the hand of God (presumably the hand of the Judaic-Christian God only) and some to ‘Providence’, maybe even to the ‘Intelligent Designer’ too.

The cold fact remains, the action of those, but not all, merchants who preferred to invest locally, was driven by their risk-aversion, and not by anything mystical at all. Likewise, today’s bankers, who hang on to their money rather than lend it out, are driven by their risk-aversion, and nothing else.

There is no invisible hand at work in the Banks. It’s a judgment about comparative risks made by those who run the banks. Change the personnel, but the risk-aversion remains while the causes of it remain on their books.

Meanwhile, the plethora of so-called ‘doing the right things’, in a stream of endless and empty sound bites, creates a complex web of suspicions, fuelled by failures, to have any real effect, and makes it more and more difficult, and unlikely, that the crisis will end for a long and longer time.

'Any Port in a Storm'

In Business Week, 16 October, HERE:

“Forget Adam Smith, Whatever Works” by Pete Engardio

"Federal Reserve Bank of Dallas President Richard W. Fisher addressed the high and mighty of global finance in Washington during pivotal meetings of the Group of Seven and the International Monetary Fund. The gravity and complexity of the 15-month-old credit crisis called for action that transcended familiar ideological categories, he hinted, such as free markets vs. state intervention. Fisher even borrowed a Chinese proverb popularized by the late Chinese leader Deng Xiaoping: "No matter if it is a white cat or a black cat, as long as it can catch mice, it is a good cat."

Comment
The reference to Adam Smith is in the headline alone, with nothing else about him in the text.

I agree, if the implied meaning about forgetting Adam Smith if this refers to his alleged, though false, views about the laissez-faire, zero government, invisible hand toting version of the mythical Adam Smith touted by Chicago trained or influenced economists.

However, I disagree if Pete Engardio refers to the real Adam Smith born in Kirkcaldy in 1723 and author of the Wealth Of Nations, who was never an ideologue, nor an extremist, nor even a single- issue exponent of moral philosophy and political economy.

The real Adam Smith was a pragmatist in all his policy advice. For example:

regulate those aspects of private banking services where the public were put at risk from the imprudent behaviours of individuals who borrowed or lent (Book II);

promote free trade and reduce or abolish tariffs slowly and gradually to prevent domestic employment being reduced suddenly; recognise that defence is more important than opulence, therefore keep the protectionist Navigation Acts in place, despite working against British commercial interests; leave some level of tariffs on foreign imports because they are necessary to fund government revenue (Book IV);

choose between public commissioners or private managers on grounds of which worked best; arrange where feasible for luxury users of publicly-funded roads to pay higher tolls than poorer people; charge small fees for parents sending their children to publicly-funded local ‘little schools’, and charge less or nothing at all for the most indigent (Book V).

‘Whatever works’ is sound advice, especially in emergencies and crises. 18th century Sailors used to say: ‘any port in a storm’.

There is of course a need, afterwards, to pay prudent attention to the detail, but the broad admonition should be entertained, rather than rigidly rejected in a fit of ideological purity.

Smith on Banking Interventions

‘Migeru’(?), 10 October, writing in European Tribune (HERE) quotes from Wealth Of Nations, without explanation of the context, a piece called ‘Adam Smith on Banking’ and risks giving a wrong impression of exactly what Adam Smith was discussing.

“In The Wealth of Nations, when discussing Banking reform in Scotland in the latter part of the 18th century, Adam Smith had the following to say
“To restrain private people, it may be said, from receiving in payment the promissory notes of a banker[,] for any sum, whether great or small, when they themselves are willing to receive them; or, to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is a manifest violation of that natural liberty which it is the proper business of law[,] not to infringe, but to support. Such regulations may, no doubt, be considered as in some respect a violation of natural liberty.”

[‘Migeru’ adds: ‘Just so it cannot be said that I take the consecutive paragraph out of context’ (which has the effect of doing precisely what he/she claims they are not doing):

“But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.”

Comments
Reading the two parts of the same paragraph (WN II.ii.94: p 324) with the break in between raises a doubt whether ‘Migeru’ quotes them to show that the current interventions in the affairs of the world’s banks is a violation of Natural Liberty and therefore worthy of opposition by supporters of Natural Liberty, or a justification for intervening on these occasions to curb some individuals who otherwise would/might ‘endanger the security of the whole society’.

To make sure about Smith’s message here check the context. Chapter II, Book II, is a long chapter on banking: ‘Of Money considered as a particular Branch of the general Stock of Society, of the Expence of maintaining a National Capital’, pp 286-329.

It discusses the role of money and the banking facilities in the economy. It is descriptive if how banks work and their role in facilitating the ‘great wheel of circulation’. It also discusses the foibles of bank customers and also those of some bankers and how they can threaten the prosperity of society.

In the particular case of banks issuing paper bills for small sums, as low as sixpence, the risks from over issuing paper are severe on the credit worthiness of others. Smith suggested that the legislature forbid such practices and show why, as well as answering a possible objection from those who support the general principle of Natural Liberty (which Smith espouses strongly in other pages) by acknowledging that it is indeed such a ‘violation of Natural Liberty’, but it is nevertheless justified.

Now what role does this have for today’s banking crisis? It’s not clear from Migeru’s posting.

Ultra-conservatives and extreme libertarians may use it to support letting the financial system collapse as the least of the two evils, one of which includes state intervention; remnant Marxists and extreme socialists and social democrats may use it as part of their disparagement of Adam Smith in the guise of the Chicago version of him.

The best antidote to both is to read Chapter II of Book II of Wealth Of Nations and judge for yourself. The failings of politicians and rogue bankers and some of their customers was sufficient to cause the current crisis.

Smith gives several mid-18th-century examples to show decisively he was a pragmatist, not an ideologue.

David Warsh's Economic Principals Gets It right

At last some sensible comment and analysis of the so-called ‘bail-out’, which too many serious economists are treating as a test of one’s virility as free-market economists, as if these irregular events are final proof of the need to call for government passivity and trust in markets to correct with all the brutal force of unforgiving militants for laissez-faire, while others from the left, the doomsday environmentalists (often with a marxist tinge), and the 'we are doomed' fringe, see their chance to extend government into ever greater roles in place of markets.

I refer to the article, The Enormous Bodkin, by David Warsh, of Economic Principals, (subscription) which gives an historical slant to the current problems, while showing that mostly the economics profession, as trained in the past thirty years, is not treated to any passing familiarity with the nature and causes of ‘the cycles of manias, panics and crashed that have been a familiar feature of global capitalism since its emergence in the seventeenth century’. Indeed, as David Warsh shows, leading introductory textbooks scarcely mention them.

I shall make one small quotation from Economic Principals (with apologies to David Warsh for doing so without his permission as the copyright owner):

“This is not the bankruptcy of modern economics, as my friend Robert Samuelson put it the other day in Newsweek, a shattering of the conceit that the problem of stability had been solved once and for all. Economists have done pretty well at stitching the global economy together these last thirty years, during a period of unprecedented growth. The failure to give recurring financial crises a more prominent place in its undergraduate texts is, however, somewhat embarrassing, or so it seems to me. Kindleberger was of the opinion that both Keynesian orthodoxy and monetarism were incomplete because they left out credit cycles altogether (he was writing in the mid ’70s, remember). He was right. Last summer, Olivier Blanchard, of the Massachusetts Institute of Technology, now serving a stint as chief economist of the International Monetary Fund, observed in a survey of macroeconomics that the New Keynesian orthodoxy that, for the past twenty years or so had constituted the mainstream textbook view, had, with respect to asset prices, fallen “short of the mark.”

It had become vividly clear, he wrote, that financial institutions do matter, and that shocks to their capital or liquidity positions can be potentially seriously damaging to macroeconomic health. Research on credit and financial markets was proceeding vigorously, though, Blanchard concluded, and “one can be confident that progress will happen rapidly.”

It can’t happen too quickly for the next editions of those introductory texts.”

Comment
If that doesn’t wet your appetite to subscribe to David’s weekly online sense on economics (from www.economicprincipals.com – 1.617.666.3365) you may be beyond saving from ideological paralysis – present but not involved in what’s going on around you.

Another Misuse of Adam Smith's Views

David Sogge, 3 October, writes in Casino Crash: ‘Adam Smith responds to Bank Bailout!’ (HERE)

“Many know the Adam Smith remark (1776): “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public…” But Smith wrote other things that Wall Street types would choke on, including some remarks pertinent to the bailout plan railroaded at high speed through the US Congress at their behest.

Here are last two sentences of Book I of Smith’s Wealth of Nations:

“The proposal of any new law or regulation of commerce which comes from this order [profit takers], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.”

Comment
Both quotations, in my view, are used without the necessary and prudent qualifications, which suggests that David Sogge, of the Transnational Institute, an organization ‘acting in the spirit of public scholarship’, which displays an unscholarly carelessness with Adam Smith’s ‘Wealth Of Nations’, a not uncommon feature of many of those who quote snippets from it.

The first quotation, shorn of its context, appear to be a general statement about ‘trades’, which today is easily taken by general readers to be applicable to modern businesses operating in a system of company laws, when in fact Smith referred to the behaviours of traders, journeymen, artificers, petty merchants, and members of the corporate guilds that managed the economic activities of towns which, by law, were privileged to make all kinds of decisions that could, and frequently did, restrict competition and raise prices against consumers.

The relevant context is found in Wealth Of Nations (WN I.x.c.14-32: pp 139-47).

Modern businesses are not analogous to Smith’s reference to ‘trades; indeed, today there are severe legal prohibitions and penalties on collusion of the kind identified by Smith in 16th-18th-century Britain. If anything, Smith’s reference to ‘trades’ in his context is more closer to the behaviours of modern trade unions – some still called ‘Guilds’ in the USA – than to modern businesses. Recently, the European courts fined heavily certain businesses that were found guilty of price collusion and even Hollywood was shut down by a 'Guild' for weeks.

The second quotation from Book I of Wealth Of Nations (WN I.x.p.1-10: pp 264-7) is part of a discussion about the three great orders: those who lived by rent (landlords), those who lived by wages (the employees), and those who lived by profit (18th-century merchants and manufacturers).

Smith felt that the [proprietors of land] were ‘inseparably connected with the general interest of society’ and ‘can never mislead [society]’ when it promotes its own interests ‘concerning any regulation of commerce or police’ (the latter an 18th-century word for providing society with the wherewithal to consume food – no food, no society).

The interests of labour were also strictly connected to society because wages arose from producing the ‘real wealth’ of society and rose or fell to reflect when society was healthy or in decline. Unfortunately, argues Smith, the labourer was ‘incapable of either comprehending his interests, or understanding [society’s interests] with his own’. This was part of Smith’s later notion that expenditure by government on the education of all children was justified in view of the prevailing ignorance among the majority of the population (Book V, Wealth Of Nations).

The third order, those ‘who live by profit’, put into motion ‘the greater part of the useful labour of society’, but the rate of profit is inversely related to the prosperity of society; high in the poorest and low in the richest. This gives them a peculiar role in that their interests are counter to those of a society because they do best when they restrict competition and when they promote monopolies. They tend to understand their interests, and accordingly they promote legislation that serves their interests. They oppose free trade in favour of restrictions, both monetary (tariffs and prohibitions) and strategic (jealousy of trade, hostility to foreign traders, military means, the Navigation Acts, and colonies.

Wealth Of Nations was not a textbook in economics; it is a critique of 18th-century mercantilist political economy (Books III and IV), using Britain as the prime example. It is in this context that the second quotation must be understood.

It was Smith’s intention that his readers, particularly legislators and those who influence them understood the consequences of their pursuing policies that served the interests of those merchants and manufacturers who stood the gain at the expense of the other two orders, and at the expense of growth of the commercial economy, particularly as faster growing economies were associated with higher wages and lower profits (though larger capitals produced greater absolute amounts of profit, albeit at lower rates), and, critically higher wages would raise the incomes of waged workers and their families.

Passing the quotation off as part of a critique of the ‘bailout’ of the debt-laden banks, which marketed high-risk loans at the behest of legislators, including republican and democratic presidents, senators and representatives, is disingenuous.

It is interesting that many participants in the debate use quotations from Smith (out of context) and myths about Smith (the so-called invisible hand) to criticise the so-called bailout and the so-called US ‘free market’ (actually a mercantilist economy in many ways), but seldom is any critic spelling out what should be done that will avert the early consequences of doing nothing.

The failure of credit availability among the banks will show up, fairly rapidly, in business failures, unemployment, and severe misery for millions in the famous ‘main streets’ across the USA, and it is this prospect that legislators (facing elections) will focus on quickly once they connect with their electorates (another aspect of 21st century circumstances not available to Adam Smith – he didn’t have a vote under the existing franchise).

Adam Smith Was Not Ideological on Banking Crises

Peter Boettke pleads “PLEASE, Just Say No!” on the authoritative Blog: “The Austrian Economists” (HERE):

“But IF we shut down our borders and if we raise the costs for domestic trade; and IF we make it very costly for innovators to think up new ideas and find the financing to bring those ideas to life in the market place, THEN a real crisis will result. If instead, we were to use the current financial mess to learn the right lesson and get government out of the business of doing business, and instead restrict government to the minimalist role of the "nightwatchman state" we will see market adjustment proceed ruthlessly and quickly cleaning out the malinvestments and redirecting resources to more efficient uses and people to more effective employments of their time and talents.

Get government out of the financial industry, let businesses fail, let reallocation of resources and people take place, and lets build effective restraints on government so that we don't end up in this mess again.

In my opinion, we ought NOT do the bail out, but even if for sake of argument I granted that we should, I would argue that there are insurmountable difficulties in the policy action proposed so that we cannot achieve what is intended with this bail out in terms of serving the public interest (it will definitely succeed in serving private interests).

Perhaps the best words ever written on this were in fact penned by Adam Smith himself, so I will leave you with those:

‘What is the species of domestick industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it’ (The Wealth of Nations, Vol. 1, p. 456)’.
VOTE NO.”

Comment
Of the economics of Peter Boetkke’s argument I am fairly sure he may be correct, but on the political economy of it I am less sure that he is being practical.

Academic economists, enjoying high salaries and tenure, may have a personal interest in being relaxed at the consequences of specific stances which pure economics dictates, but to be fair, politicians on higher salaries and with more tenuous tenure dependent on the vagaries of the narratives of their rivals, who seek to replace them in the electoral lottery, may legitimately be less sanguine about their electoral prospects if they vote in either way, for or against, the ‘bailout’ of easy to despise bankers.

Be clear, and admittedly, I am not taking a stance either way on the Bill’s merits, though as a pensioner I am aware of the personal risks if the entire edifice crumbles…

My interest is in the appropriate use of Adam Smith’s legacy which makes me uneasy about the actual quotation from Wealth Of Nations that Peter considers ‘the best words ever written on this’ subject. It comes, of course, from a set of passages referred to on Lost legacy many times each month – those related to the arguments around the use of the metaphor of ‘an invisible hand’ on the same page (WN: p 456).

As I understand the Bill, it does not seek to ‘direct private people in what manner they ought to employ their capitals’, which if it did it would indeed be a folly because ‘no council or senate whatever ... would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it’. It is proposing to use taxation revenue to add liquidity to the system.

The issue is not about directing ‘private people’ to ‘employ their capitals’; it is about ensuring that existing enterprises, teetering on the brink of a general bankruptcy for want of liquidity have the necessary capital to go about their ‘private business’. That is altogether different and comes from a situation completely unknown to Adam Smith in his day.

A single mid-18th-century bank (the Ayr Bank) that failed lost the capitals provided by its shareholders and the deposits of its customers which, while disastrous for those involved (shareholders, savers, creditors, employees, and customers trusting that the bank was managed by people of ‘fortune, probity, and prudence’ [WN II.ii.28: p 292]), it was not catastrophic for an entire society, as may be likely in the current financial crisis, not the least because of its global not local nature.

Smith’s entire chapter in Book II reveals his understanding of the emergence of banking as a force in a commercial economy. It pays modern economists to read it. They will see how troublesome considerations in the early days of banking led gradually and eventually to the weaknesses presently found in modern global banking. That ‘great wheel of circulation’, which is so critical for a growing economy before the industrialization of commerce, is always vulnerable to the ‘excesses’, which caused the current crisis.

Smith spends pages discussing the effects of a run upon banks, the fraudulent practices of ‘drawing and redrawing’ (this ‘ruinous resource’), ‘clipping of coins’, management of ‘debtors’, keeping an eye on the increase in customers and their ‘conduct’, the ‘discounting of bills’, ‘fictitious payments’, and the plausible blame for ‘distress’ due to the claims by those refused credit of the ‘ignorance, pusillanimity, and bad conduct of the banks’, when in fact they were attempts at prudent banking.

Bank ‘liberality’ in the issuing of bank notes beyond what was sensible (promises of quick and profitable repayments?), led to a ‘fatal cycle’ and caused ‘real distress’.

One small reform that Smith sought was that of the legislature restricting banks from issuing small-denomination notes. This practice led to ‘a very considerable inconveniency, and sometimes a very great calamity to many poor people’. Smith’s comment on what may be done to rectify the outcomes of these practices is revealing to ideologues revelling in their certainties about practical not utopian economics:

“To restrain private people, it may be said, from receiving in payment the promissory notes of a banker, for any sum whether great or small, when they themselves are willing to receive them, or to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is a manifest violation of that natural liberty which it is the proper business of law not to infringe, but to support. Such regulations may, no doubt, be considered as in some respects a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments, of the most free as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty exactly of the same kind with the regulations of the banking trade which are here proposed” ( WN II.ii.94: p 324).

I would have thought these words would be more relevant to the current debate than those Peter quotes from Book IV above, and very much contrasts with his general approach to who knows best about an individual’s circumstance – the individual or the government? As a general statement the knowledge of the individual is paramount over the government's is acceptable; as a practical question when the financial system faces a possible global collapse, the issue is no longer so clear cut.

Individuals also make private decisions to behave irresponsibly (or fraudulently, or ignore high risks). It’s not the bank that decides to behave recklessly, but the individuals employed in it. If they are not restrained by the bank’s rules of governance, they must be restrained by the justice system, i.e., the collective decisions of other individuals in the legislature and the executive. Competition both pushes bankers to be more circumspect and more liberal in their conduct. Which predominates is not a matter of theory; it is determined by the balance of their conduct and expressions of their self-interest as they see it.

‘The most urgent necessity’ argued Smith justifies the abrogation of a normally correct economic policy (WN IV.v.b. 39: p 539; in reference to the absurd interventions of governments in the corn trade, nominally to deal with ‘dearth’, but which often promote 'famine'). It may be that the global financial systems is approaching or has reached that point. That is something that political economists may have a legitimate viewpoint.

I am not convinced that pure theory is of much help in determining the answers and I much prefer that we approach our determinations in the manner that Adam Smith demonstrated: sound principles tempered by sounder applications of them to different and changing particular circumstances.

Adam Smith was never an ideologue.

[I am currently reading Riccardo Rebonato's Plight of the Fortune Tellers: why we need to manage financial risk differently, Princteon University Press, 2007]