One of the unintended consequences of the 2008 financial crisis has been to bring what until then had been a backwater of academic research, financial history, into a mainstream topic of the reading public. So it will pique readers’ interest that Jonathan Conlin in Adam Smith (Reaktion Books, 2016, £11.99) covers an intriguing episode from the life of the great economist when he was working on The Wealth of Nations. In 1772, Smith witnessed the collapse of a major Scottish financial institution, Ayr Bank, and since one of the bank’s principal shareholders was Smith’s principal patron, the Duke of Buccleuch, its demise affected him in more ways than one.
In 1769, when Ayr Bank opened doors, Scotland was booming. Investing in Edinburgh’s New Town seemed a one-way bet and substantial sums were raised for property there and for infrastructure in the region. When the managers Ayr Bank came to grief they did much as have bankers before and since, namely by kidding themselves that loans could not sour and even if they did, savers were unlikely to care enough to pull their deposits., David Hume wrote to his economist friend after Ayr Bank collapsed, “we are here in a very melancholy situation … Do these Events any-wise affect your Theory?”
Smith in Wealth of Nations had two points to make.
The first was banks ought to lend to create real value in an economy and help build highways rather than highways through the air. Such common sense advice was in keeping with conventional thinking. But there was another comment Smith offered, regarding the imprudence of depositors, that evinces Smith had an intuitive understanding of the psychology of risk where he was well ahead of his time.
This is what Adam Smith had to say about depositors whose mind-set conduced to financial crashes: “The house is crazy, says a weary traveller to himself, and will not stand very long; but it is a chance if it falls to-night, and I will venture, therefore, to sleep in it to-night.” Depositors, in other words, share some of the blame for a collapse in market confidence because they are not as vigilant as they ought to be.
Just how perspicuous is this insight we can see from debates over the benefits of deposit insurance, today unquestioned as an indispensable prop of financial market stability. But less thought is given that once monitoring bank solvency becomes a regulator’s job, this not only adds to cost of regulation but also tempts reckless depositors to act as free-riders to the system.
In Jonathan Conlin’s biography, Smith’s reaction to Ayr Bank’s default is only one of many incidents in the life of Adam Smith that are sets against his works. As Conlin shows, it is often Smith’s asides and throwaway observations with which his Theory of Moral Sentiments and Wealth of Nations abound that illustrate his almost limitless capacity to prod readers into looking at things from an unexpected angle; for more of this see my full review of Adam Smith.