Thursday, October 02, 2008

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)’.

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]



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