Thursday, October 17, 2013

Adam Smith's Support for Regulatory Financial Firewalls

In the Oxford English Dictionary, the origin of the term "fire-walls" is traced to a comic play published in 1799 by G.E. Lessing, called "School for Honor." One character is booted out of his hotel room for the arrival of a beautiful lady, and given an inadequate replacement room, which is described as "behind the pigeon-loft; with the prospect between the neighbor's fire-walls."

But for those who care about such matters, Adam Smith has a reference to fire-walls in The Wealth of Nations. Even better, Smith's reference draws an explicit parallel between the "obligation of building party walls, in order to prevent the communication of fire," and his support of a certain kind of financial regulation. In the OED, the origin of using the word "firewall" in the sense of "any structure, device, or procedure designed to protect the security or integrity of a system, process" is only dated back to a use in Business Week in 1975. The Adam Smith passage is from Book II, Chapter II, and I quote here from the ever-useful version of TWN available on-line at the Library of Economics and Liberty website. Smith writes:

"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."
What is Smith talking about here? At this time, money took two main forms. There was gold and silver money, which held its value because of its content of precious metals, and there were bank notes--that is, a note issued by a bank that could be used as a medium of exchange because it could be redeemed for gold or silver at the bank. The difficulty is that anyone could start a bank and begin issuing "bank notes" to pay for goods and services, which led to difficulties. Smith wrote:
"Where the issuing of bank notes for such very small sums is allowed and commonly practised, many mean people are both enabled and encouraged to become bankers. A person whose promissory note for five pounds, or even for twenty shillings, would be rejected by everybody, will get it to be received without scruple when it is issued for so small a sum as a sixpence. But the frequent bankruptcies to which such beggarly bankers must be liable may occasion a very considerable inconveniency, and sometimes even a very great calamity to many poor people who had received their notes in payment. It were better, perhaps, that no bank notes were issued in any part of the kingdom for a smaller sum than five pounds. Paper money would then, probably, confine itself, in every part of the kingdom, to the circulation between the different dealers, as much as it does at present in London, where no bank notes are issued under ten pounds value ..."
Thus, Smith was essentially arguing that financial sector firms should not be allowed to issue promises to pay unless they had actual assets, and that undercapitalized financial firms--"beggarly bankers"--should not be allowed to operate. Smith goes on to a discussion of how in  North America, paper money was often issued by governments who then tried to require others to accept the paper as legal tender. The British Parliament banned such actions, and although the colonists complained, Smith defended Parliament's financial regulatory action (and offered a present discounted value calculation along the way):

"The paper currencies of North America consisted, not in bank notes payable to the bearer on demand, but in government paper, of which the payment was not exigible till several years after it was issued; and though the colony governments paid no interest to the holders of this paper, they declared it to be, and in fact rendered it, a legal tender of payment for the full value for which it was issued. But allowing the colony security to be perfectly good, a hundred pounds payable fifteen years hence, for example, in a country where interest at six per cent, is worth little more than forty pounds ready money. To oblige a creditor, therefore, to accept of this as full payment for a debt of a hundred pounds actually paid down in ready money was an act of such violent injustice as has scarce, perhaps, been attempted by the government of any other country which pretended to be free. It bears the evident marks of having originally been, what the honest and downright Doctor Douglas assures us it was, a scheme of fraudulent debtors to cheat their creditors. ... Notwithstanding any regulation of this kind, it appeared by the course of exchange with Great Britain, that a hundred pounds sterling was occasionally considered as equivalent, in some of the colonies, to a hundred and thirty pounds, and in others to so great a sum as eleven hundred pounds currency; this difference in the value arising from the difference in the quantity of paper emitted in the different colonies, and in the distance and probability of the term of its final discharge and redemption. No law, therefore, could be more equitable than the Act of Parliament, so unjustly complained of in the colonies, which declared that no paper currency to be emitted there in time coming should be a legal tender of payment."