Legislating Instability

Adam Smith, Free Banking, and the Financial Crisis of 1772

Tyler Beck Goodspeed

• Publisher: Harvard University Press
• Year: 2016
• Print ISBN:
  9780674088887
• eBook ISBN:
  9780674969018
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

From 1716 to 1845, Scotland's banks were among the most dynamic and resilient in Europe, effectively absorbing a series of adverse economic shocks that rocked financial markets in London and on the continent. Legislating Instability explains the seeming paradox that the Scottish banking system achieved this success without the government controls usually considered necessary for economic stability.

Eighteenth-century Scottish banks operated in a regulatory vacuum: no central bank to act as lender of last resort, no monopoly on issuing currency, no legal requirements for maintaining capital reserves, and no formal limits on bank size. These conditions produced a remarkably robust banking system, one that was intensely competitive and served as a prime engine of Scottish economic growth. Despite indicators that might have seemed red flags—large speculative capital flows, a fixed exchange rate, and substantial external debt—Scotland successfully navigated two severe financial crises during the Seven Years' War.

The exception was a severe financial crisis in 1772, seven years after the imposition of the first regulations on Scottish banking—the result of aggressive lobbying by large banks seeking to weed out competition. While these restrictions did not cause the 1772 crisis, Tyler Beck Goodspeed argues, they critically undermined the flexibility and resilience previously exhibited by Scottish finance, thereby elevating the risk that another adverse economic shock, such as occurred in 1772, might threaten financial stability more broadly. Far from revealing the shortcomings of unregulated banking, as Adam Smith claimed, the 1772 crisis exposed the risks of ill-conceived bank regulation.

1

A Very Melancholy Situation

ON 27 JUNE 1772, as the city of Edinburgh reeled from its worst financial crisis since the collapse of the Darien Company in 1700, David Hume posted an anxious letter from the Scottish capital to Adam Smith, in Kirkcaldy, then working on An Inquiry into the Nature and Causes of the Wealth of Nations. To his friend, Hume noted that

We are here in a very melancholy Situation: Continual Bankruptcies, universal Loss of Credit and endless Suspicions. There are but two standing Houses in this Place, Mansfield’s and the Couttses … Mansfield has pay’d away 40.000 pounds in a few days; but it is apprehended, that neither he nor any of them can hold out till the End of the next Week, if not Alteration happen. The Case is little better in London … even the Bank of England is not entirely free from Suspicion. Those of Newcastle, Norwich and Bristol are said to be stopp’d: The Thistle Bank has been reported to be in the same Condition. The Carron company is reeling, which is one of the greatest Calamities of the whole; as they gave Employment to near 10.000 people.

He concluded by inquiring of Smith whether “these Events any-wise affect your Theory? Or will it occasion the Revisal of any Chapters?”¹

Two weeks earlier, on 10 June, the London banking house of Neale, James, Fordyce, and Down, of Threadneedle Street, had been issued a commission of bankruptcy upon news that one of their partners, Alexander Fordyce, had racked up a staggering £300,000 in trading losses (see Figure 1.1). Fordyce, the brilliant but brash youngest son of an Aberdeen hosier who had worked his way up from outdoor clerk to partner in one of London’s most prominent banking firms, had for months been shorting some £1,000,000 (approximately £114,200,000 in 2014 prices) of East India Company stock.² But with East India share prices flat since late 1771, and facing an additional margin call of 10 percent, Fordyce absconded to France, leaving his partners liable for an estimated £243,000 in debts.³ Days earlier, in reply to a desperate plea from Fordyce for an emergency line of credit, one London banker, a Quaker, had replied, “Friend Fordyce, I have known many men ruined by two dice, but I will not be ruined by Four-dice.”⁴ Realizing the extent of their liability, the remaining partners immediately suspended payments in a futile attempt to safeguard creditors from a disorderly liquidation, yet the damage was already done. Runs quickly formed against several of their principal counterparties in Exchange Alley, and by Wednesday following, no fewer than ten London banks had failed, with even the eminent houses of Drummonds and Coutts coming under severe pressure.⁵

FIGURE 1.1. A “Four dice” macaroni gambler. The four dice in the title indicate that this is Alexander Fordyce. In his right hand the man holds a money bag and in his left a Scotch bill for £10,000. Image from Matthew Darly, Macaronies, Characters, Caricatures & designed by the greatest personages, artists &c graved & published by MDarly, 39 Strand, vol. 3 (2 July 1772), British Museum. Photo reproduction courtesy of the British Museum via Creative Commons Attribution Non-Commercial Share Alike 4.0 International (CC-BY-NC-SA 4.0) license.

The worst, however, was yet to come. It took just forty-three hours for a rider to carry word of the collapse to Edinburgh, where several leading banking firms had been relying heavily on Neale, James, Fordyce, and Down, the largest buyer of Scottish bills in London, to roll over short-term debt. Fordyce himself being a Scotsman, and with two Scottish houses in London having already stopped payment owing to his failure, the fear was that the sudden evaporation of liquidity for Scottish bills, which had lately been flooding the London discount market, would render it nearly impossible for Scotland’s banks to obtain vital refinancing as outstanding drafts came due.⁶ As one Scottish banker thus put it, Fordyce’s downfall “set fire to the mine,” blowing up “the whole traffic of circulation” of Scottish bills in which the city had for some years been intensely engaged, with the result that “all those houses in London who had largely accepted bills drawn on them from Scotland … finding it no longer possible to discount the remittances that had been made to them for their reimbursement, were instantly compelled to stop payment.”⁷

Another contemporary observer, the eminent English historian Horace Walpole, likewise wrote at the time that “it is now thought Fordyce was rather the handle than the cause of this ruin,” and that he “only advanced the crash,” which “would have happened without his interference, for the Scotch bankers have been pursuing so deep a game by remitting bills and drawing cash from hence.”⁸ With the news arriving late Friday afternoon, Edinburgh’s bankers were largely spared for the weekend, but upon reopening Monday morning, panic set in. By the end of the day, the small private bank of Fordyce, Malcolm & Co. had been forced to stop, followed, on Tuesday, by Arbuthnot and Guthrie.⁹ Pressure was particularly intense, however, on Douglas, Heron & Co., the “Ayr Bank,” who on Tuesday evening distributed advertisements throughout Edinburgh offering a reward of £100 to anyone who discovered the source “of some ill-grounded reports raised by foolish or malicious persons” respecting the bank’s solvency.¹⁰

In private, however, the banking behemoth, whose balance sheet accounted for an estimated 25 percent of Scottish banknotes in circulation, 25 percent of deposits, and 40 percent of total bank assets, was scrambling to shore up an increasingly desperate internal position. Already the day before, they had approached directors of the Bank of Scotland and Royal Bank of Scotland to insist that, though the extent of their exposure to Neale, James, Fordyce, and Down did not exceed £22,000, they required an immediate six-month loan of £20,000 from each bank to resolve what they claimed was a temporary lack of liquidity.¹¹ The directors of the two chartered banks sensed a bluff, and the Royal Bank promptly responded that although they were “exceedingly sorry for the Bankruptcys that have happened in London,” they were “at the same time extremely pleased to be Informed that Messrs Douglas Heron & Company are entirely Covered on their Engagements with the Houses that have failed,” and therefore were “of Opinion that it would be Improper for them to Agree to the Proposals” made to them by the bank.¹²

Nevertheless, Douglas, Heron & Co. somehow managed to struggle through till the end of the week. But the following Monday, 22 June—“Black Monday,” as it came to be known—their head office at Ayr, where notes could previously be redeemed for specie, did not reopen after the weekend.¹³ Two days later, a second entreaty to the chartered banks for an emergency line of credit was refused, with the Bank of Scotland and Royal Bank of Scotland further informing Douglas, Heron & Co. that they could no longer accept the latter’s notes in payment.¹⁴ Within twenty-four hours, the largest bank in Scotland finally capitulated, announcing via public advertisement that “the Company of Douglas Heron & Company Bankers in Air, taking into their consideration the present state of the credit of this country, and the uncommon demands that have been made upon them for specie,” had resolved to “give over, for some time,” the payment of specie for their notes.¹⁵ Total liabilities amounted to nearly one and a quarter million pounds sterling.¹⁶ They assured their creditors, however, that “the country, who have received the most liberal aids from this company, cannot entertain the smallest doubt of the solidity of its foundation,” and further pledged that “in order to give full satisfaction to the public, that no person will be a loser who is in possession of their paper,” 5 percent interest would be paid on all outstanding Douglas, Heron & Co. notes, until paid, and duly registered a bond to that effect with the Court of Session.¹⁷

Evidently, the Scottish public was unassuaged. By week’s end, just four of Edinburgh’s eighteen private banks remained standing. Outside the capital, in addition to Douglas, Heron & Co., the Glasgow Merchant Banking Company and Simson, Baird & Co. both fell, while Dunlop, Houston & Co. (the “Ship Bank”), the oldest bank in Glasgow, was rumored to be on the brink. Of the country’s eleven provincial banks, just eight reopened for business on the following Monday morning, of which three—the Ship, Arms, and Thistle Banks, all in Glasgow—were already seeking assistance from Edinburgh.¹⁸ In Perth, the General Bank of Perth would soon wind up. The editors of The Scots Magazine were thus by no means dramatizing when they reported that the ongoing crisis was “said to be the greatest that ever happened in Scotland,” worse even than the aftermath of the South Sea Bubble or the collapse of the Darien Company.¹⁹ Horace Walpole concurred, writing that “scarce the bubble of the South Sea occasioned greater consternation.” As “one rascal,” he declared, could thus “shake the mighty credit of such a nation as Great Britain,” yet twenty years would be insufficient to “remove the prejudice that men will contract against bankers.”²⁰

Among those contracting such prejudice was, in fact, none other than Adam Smith, for whom the events of June 1772 did indeed seem to “occasion the revisal” of at least one chapter of the still incomplete Wealth of Nations, perhaps not coincidentally, as several of his intimate friends and associates were financial casualties of the Ayr Bank’s demise, as well as shareholders in the failed bank itself. In a letter to close friend William Pulteney, Member of Parliament for Cromartyshire, on 3 September 1772—less than three months from Black Monday—Smith admitted that, “tho I have had no concern myself in the Public calamities, some of the friends for whom I interest myself the most have been deeply concerned in them; and my attention has been a good deal occupied about the most proper method of extricating them.”²¹ Of the bank whose spectacular collapse bankrupted 114 of 226 shareholders and similarly threatened to ruin his pupil and patron, Henry Scott, 3rd Duke of Buccleuch, Smith later wrote that, ultimately, “This bank increased the real distress of the country which it meant to relieve,” insisting, moreover, that such calamity served as a stark reminder that “the commerce and industry of the country … cannot be altogether so secure, when they are thus, as it were, suspended upon the Daedalian wings of paper money, as when they travel about upon the solid ground of gold and silver.”²²

To be sure, it was not that Smith wished for credit and banking to be rigidly bound by gold and silver manacles; indeed, “The judicious operations of banking” he likened to “a sort of wagon-way through the air,” enabling a country to convert its “highways” of gold and silver “into good pastures and cornfields, and thereby to increase very considerably the annual produce of its land and labor.” It was rather, he feared, that “over and above the accidents to which they are exposed from the unskilfulness of the conductors of this paper money,” the industry and commerce thus suspended “are liable to several others, from which no prudence or skill of those conductors can guard them.” Therefore, just as violations of natural liberty are justified where the “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,” so too, Smith argued, are “regulations of the banking trade” likewise justified. Such regulation was, he suggested, introducing yet another metaphor, rather like the “obligation of building party walls, in order to prevent the communication of fire.”²³

But the “party walls” Smith advocated to fireproof the banking trade—prohibition of small-denomination banknotes, a maximum legal rate of interest, and prohibition of contingent liability banknotes—could hardly have been expected to deliver effective protection against what Smith called the “accidents” of both the “unskilfulness” of bankers as well as causes against which no amount of “prudence or skill” on their part, but only public regulation, might guard, for the simple reason that all three regulations were already law seven years before the crisis of 1772 and the collapse of Douglas, Heron & Co. More curious still is the realization that these restrictions, far from constituting the bequests of enlightened philosophers or prudential public administrators, were in reality the products of intense political lobbying by none other than the very bankers—many of them intimate and lifelong friends of Smith’s—whose trade they were intended to regulate. Perhaps oddest of all, however, is that close analysis of the available historical and statistical evidence reveals that, far from attenuating financial sector instability, the banking regulations championed by Smith actually exacerbated the risk of that for which they were purportedly the cure; Smith’s financial “party walls,” in other words, belong among the contributory causes of the 1772 crisis, not among its mitigators.

That the “Ayr Bank Crisis” in Scotland should be seen, at least in part, as a consequence of bank regulation is ...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Contents
• List of Figures
• 1. A Very Melancholy Situation
• 2. Beggarly Bankers
• 3. Procuring an Act
• 4. Prodigals and Projectors
• 5. Upon Daedalian Wings
• Notes
• Bibliography
• Acknowledgments
• Index