Monday, March 01, 2010

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.

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4 Comments:

Blogger Reese said...

Thanks for reporting on the more complete and nuanced real views of Adam Smith. It is too bad that so few read these kinds of blogs. Whereas, a blog discussing the vapid and poverty-stricken "philosophy" of someone such as Ayn Rand will draw thousands of readers and commentators, like moths drawn to a flame.

5:48 am  
Blogger Jake Watson said...

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5:30 am  
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5:14 am  
Blogger Gavin Kennedy said...

Thanks to Jake and Jony for your comments which I received today, 22 October 2014 ...
In context, Smith's concerns for bad banking practices referred to the ruinous consequences when bankers make poor decisions -individually perhaps motivated by short-term benefits, like bonuses, that prove risky for the banks as institutions and those innocent customers uninvolved in high-risk scams.
If bank as institutions do not protect the general public, who but regulators can fill that role. I know that is a slippery slope but I am unimpressed with the potential consequences of an absence of regulation to protect in innocent.
Gavin

3:10 pm  

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