Tuesday, May 06, 2008

Adam Smith's Advice on Banking Regulations

Nicholas Gruen, CEO of Lateral Economics, and a long time friend of Lost Legacy (a couple of his articles on Adam Smith are on our home page under ‘articles’), writes a readable and sensible piece ‘Preserving liquidity a valuable option in mortgage market’ for The Sheet (‘better business journalism’; Melbourne, Australia) (6 May) HERE:

"It’s a tired cliche – but no less true for that – that generals fight the current war according to the lessons learned in the last.

The current generation of policy pundits have grown up on a simple diet of deregulation. This fact is itself unremarkable given the general good sense behind tidying up the detritus of the best part of a century’s ad hoc favouritism in Australia — a policy that was once sold under the nonsensical title of “protection all round”.

But unfolding events remind us of something that was just as integral a part of Adam Smith’s message to humanity as the bit we remember about the invisible hand.

Private competition only works well to transform self-interest into social good in a properly functioning market.

And that makes the functioning of markets themselves a public good par excellence.

The rules according to which market participants interact are a public good as is the liquidity and price discovery that the growth of the market provides.

That’s why Smith offered these comments on prudential regulation of credit:

“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.” [Original punctuation restored, GK]

Liquidity is a notoriously fickle public good within a financial market.

Each of the players is happy participating in a liquid market, and in doing so they further deepen its liquidity.

But because most of the players are risk averse, that liquidity can dry up with frightening speed.

That’s why, in the wake of the Great Depression, we built public institutions to vouchsafe this crucial public good.”

I shall pass over ‘the bit we remember about the invisible hand’ and commend the references to the need for regulation of aspects of banking business (Wealth Of Nations, II.ii.94:p 324) because this is a most important statement by Adam Smith.

It demonstrates his non-ideological approach to matters of public policy where the circumstances required breaches of Natural Law philosophy, to which he subscribed as a moral philosopher.

Extreme anarcho-libertarians and extremist free-market ideologues sometimes confuse Smith’s many statements about Natural Law and Liberty with what they allege, wholly erroneously, as his support for ‘laissez-faire’. He never used the words laissez faire once in over a million words of writing, though he knew the French Physiocrats and conversed with them in Paris and understood their laissez-faire recomendations, which gained currency way beyond its original meaning in the 19th and 20th centuries.

Nick Gruen is worth reading, and not just on banking regulations, but on literary aspects of Adam Smith too.


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