Adam Smith's Simplified Wealth of Nations, Book 2, Chapter 2d: Overtrading
Chapter 2d: Overtrading
57"The overtrading of some bold projectors in both parts of the United Kingdom was the original cause of this excessive circulation of paper money. "
58 With propriety, a bank can advance to a merchant the capital he would otherwise have unemployed as ready money for answering occasional demands.
A bank should not advance the whole or any big part of his capital to the merchant.
If the paper money the bank advances never exceeds this value, it can never exceed the value of the gold and silver circulating in the country if there was no paper money.
It can never exceed the amount needed by the national circulation.
59 A bank only advances to the merchant the ready money that he needs for answering occasional demands:
when the bank discounts a real bill of exchange to a real merchant, and
when the real merchant pays it to the bank as soon as it becomes due
The payment of the bill replaces to the bank the value it had advanced, with interest.
When the bank deals with real customers, its coffers resemble a pond.
The stream from the pond continually runs out while another is continually running in.
The amount running in is equal to what runs out.
Without any further care or attention, the pond is always full.
Little or no expence is needed to replenish the bank's coffers.
60 Without overtrading, a merchant may frequently need ready money, even when he has no bills to discount.
A bank entirely frees the merchant from needing to keep ready money unemployed for answering occasional demands, when:
it discounts his bills,
advances him a cash account, and
accepts a piecemeal repayment on easy terms.
When the merchant actually gets such demands, he can answer them from his cash account.
The bank should check whether the sum of the repayments is equal to the advances given to its customers within 4-8 months.
It may safely continue to deal with them if the repayments are equal to the advances within such short periods.
The stream continually running out from its coffers may be very large.
But the stream continually running in must be at least equally large.
Those coffers will be likely equally full, without further attention.
It would not need any extraordinary expence to replenish them.
On the contrary, if the sum of the repayments falls commonly very short of the advances, it cannot safely continue to deal with such customers in this way.
The stream running out from its coffers is much larger than the stream running in.
Unless they are replenished by some great and continual expence, those coffers must soon be exhausted.
Advantages of Prudence
61 For a long time, Scottish banks were very careful to require frequent and regular repayments from all their customers
They did not care to deal with any person of any fortune or credit who did not make frequent and regular operations with them.
By this attention, they saved the extraordinary expence of replenishing their coffers.
They also gained two other very considerable advantages:
62 They could tolerably judge the thriving or declining circumstances of their debtors.
The only evidence they needed was what their own books gave them.
Men are regular or irregular in their repayments, as their circumstances are thriving or declining.
A private man who lends to a dozen debtors, may observe and inquire constantly and carefully into each of the debtor's situation by himself or his agents.
But a bank which lends to 500 people can have no regular information on the conduct and circumstances of most of its debtors beyond what its own books provide.
In requiring frequent and regular repayments from all their customers, the Scottish banks had probably this advantage in view.
63 They could avoid issuing more paper money than what the national circulation needed.
When they observed that a customer's repayments were equal to their advances, they knew that the paper money they advanced did not exceed the gold and silver money he needed.
It meant that the paper money which the bank circulated through their customers did not exceed the amount of metal money needed to circulate in the country had there been no paper money.
The frequency, regularity, and amount of his repayments would demonstrate that their advances did not exceed his ready money for answering occasional demands.
His repayments meant that all his capital was constantly employed.
The money part of his capital is continually returning to and leaving from every dealer in the form of paper or coin money.
If the advances of the bank exceeded the money part of his capital, his ordinary repayments would be insufficient to pay the ordinary advances.
Because of his dealings, the stream running into the bank would be less than the one running out.
With the commerce the same, the excessive amount of paper might soon exceed the total amount of gold and silver needed to circulate in the country, had there been no paper money.
The excessive paper money would immediately have returned upon the bank to be exchanged for gold and silver.
This second advantage was not perhaps well understood by the Scottish banks as the first.
64After creditable traders receive discounted bills and cash accounts to free them from needing to keep ready money unemployed, they should not expect any more assistance from banks.
In this case, the banks cannot lend more without endangering its own interest and safety.
A bank cannot advance to a trader the whole or even most of the money with which he trades.
Because, though that money is continually returning to and leaving from him:
the whole of the returns is too distant from the whole of the outgoings
the sum of his repayments could not equal the sum of its advances in a timely manner for the bank.
A bank could still less afford to advance fixed capital to the merchant, examples of which are:
The smelting-house, workhouses, warehouses, dwelling-houses needed by an iron forge undertaker
The capital employed by a mine undertaker in sinking his shafts, getting engines to draw out water, making roads, etc.
The capital employed by land improvers in clearing, draining, enclosing, manuring, and ploughing uncultivated fields and in building farm-houses with stables, granaries, etc.
The returns of the fixed capital are much slower than the returns of the circulating capital.
Such expences, even done with the greatest prudence and judgment, return to the undertaker only after many years
Many years is too far to suit the conveniency of a bank.
Such undertakers or projectors may, with great propriety, carry on most of their projects with borrowed money.
The capital of the undertakers should be sufficient to ensure the capital of those creditors.
The projectors should ensure that those creditors would not incur any loss, even if the project's success should fall very much short of the projector's expectation.
Even with this precaution, the borrowed money which would not be repaid for several years, should not be borrowed from a bank.
It should be borrowed upon bond or mortgage of private people who can live on the interest of their money without taking the trouble to employ the capital themselves
Such private people should be willing to lend that capital to creditable projectors who will keep it for several years.
A bank which lends its money without the expence of stamped paper or attorneys' fees for drawing bonds and mortgages and accepts the easy repayment terms of Scotish banks, would be a very convenient creditor to such traders and undertakers.
But such traders and undertakers would surely be most inconvenient debtors to such a bank.
Credit Derivatives: Drawing and Redrawing
65 It is now more than 25 years since the paper money issued by the Scottish banks was more than fully equal to what the national circulation could easily absorb and employ.
Those banks gave more than all the assistance possible to Scottish traders and undertakers.
The traders and undertakers had overtraded a little.
They brought themselves either a loss or a profit reduction which always results from the smallest degree of overtrading.
Those traders and undertakers wanted to get more assistance from the banks.
They thought that those banks could extend their credits to whatever sum the traders wanted, with only a few reams of paper as expense.
The traders complained of the contracted views and dastardly spirit of the bank directors who did not extend their credits relative to the extension of the country's trade.
The traders equated the extension of national trade to the extension of their own private trade, which was being limited by their available capital or by what they could borrow from private people through bond or mortgage.
They thought the banks were honour-bound to supply the deficiency and provide all the capital they wanted.
The banks, however, thought otherwise and refused to extend their credits.
Some of those unfortunate traders who were near bankruptcy had recourse to the well-known shift of drawing and redrawing
It was an expensive way to extend credits.
This practice of raising money had been long known in England.
It was done to a very great extent during the recent war, when the high profits of trade afforded a great temptation to overtrading.
From England, it was brought into Scotland, where it was carried on to a much greater extent than in England, because of Scotland's very limited commerce and capital.
66 The practice of drawing and redrawing is so well known to all businessmen that it may be unnecessary to explain it.
But I shall still explain it because:
This book might be read by non-business people.
Its effect on banking might not be understood even by businessmen.
67 The customs of merchants were established when the barbarous laws of Europe did not enforce the performance of contracts.
During the last two centuries, the customs of merchants have been adopted into the laws of all European nations.
Extraordinary privileges were given to bills of exchange to the point that money is more readily advanced on them than any other species of obligation.
Money is advanced especially when the bills are made payable within a short period as 2-3 months.
If the acceptor* does not pay the bill as soon as it is presented and becomes due, he becomes a bankrupt from that moment.
The bill is protested and it returns to the drawer.
If the drawer does not immediately pay it, he likewise becomes a bankrupt.
The bill passes through other drawers who successively advance the money or goods in the bill to one another.
All the drawers write their names on the back of the bill confirming the receipt of the money or goods, becoming endorsers.
Each endorser-drawer becomes liable to the owner of the bill for those contents.
This is done before the owner presents the bill to the acceptor for payment.
If the endorser-drawer fails to pay, he too becomes a bankrupt.
The drawer, acceptor, and endorsers of the bill can all be persons of doubtful credit.
The shortness of the due date gives some security to the owner of the bill.
Though all of them may become bankrupts, there is little chance that they all become bankrupt in so short a time.
A weary traveler says to himself:
"This house is crazy and will not stand very long.
But there is little chance that it will fall tonight, so I will sleep in it tonight."
* seller = drawer = maker = receiver of bill = creditor = receiver of promise
* buyer = drawee = acceptor = giver of bill = debtor = promiser
68 The interest on bills was 5% in the year.
The commission was never less than 0.5% on each draft.
Let us suppose that Trader A in Edinburgh draws a $100 bill upon Trader B in London on January 1, payable two months or on March 1.
In reality, B in London owes nothing to A in Edinburgh.
B agrees to accept A's bill on condition that on February 28, B shall redraw another $100 bill upon A payable two months or on April 28, with interest and a commission or $105.5
Before April 28 or on April 27, A draws a second bill upon B, to be due on June 27 for $111.3.
Before June 27 or on June 26, B draws another bill upon A, payable two months on Aguust 26 for $117.4
This practice has sometimes gone on for several months and years.
The bill always returning upon A with the accumulated interest and commission of all the former bills.
This commission was repeated more than six times in the year.
Whatever money A might raise must have, cost him something more than 8% in the year and sometimes a great deal more:
when the price of the commission happened to rise, and
when A was obliged to pay compound interest on the interest and commission of former bills.
This practice was called raising money by circulation.
69 In a country where most ordinary profits in mercantile projects run between 6-10%, it was pure speculation to be able to earn a good profit after paying the enormous expence of borrowed money.
Many vast projects were carried on for several years with only drawn and redrawn bills.
The projectors had golden dreams of great profit.
Upon their awaking at the end of their projects or when they could not continue them, they very seldom found great profits.
70 Trader A in Edinburgh regularly discounted with some Edinburgh bank the bills he drew upon B, two months before they were due.
Trader B in London regularly discounted with some London bank the bills he drew upon A, two months before they were due.
Scottish paper money was advanced in those bills discounted with the Edinburgh banks
English paper money was advanced in those bills discounted with the London banks
The bills upon which this paper had been advanced were all repaid as soon as they became due
The value really advanced upon the first bill, was never really returned to the banks which advanced it
Because before each bill became due, a new bill was always drawn to a greater amount than the bill being paid
The discounting of this new bill was needed to pay the old bill.
This payment was altogether fictitious.
The stream which ran out of the coffers of the banks by means of the bills of exchange, was never replaced by any stream which run into them.
71 The paper issued upon those bills of exchange amounted to the whole fund destined for some vast project of agriculture, commerce, or manufactures.
The paper issued was not merely the small part of the ready money for answering occasional demands.
Consequently, most of this paper was in excess of the national circulation, had there been no paper money.
It immediately returned to the banks to be exchanged for gold and silver.
It was a capital which those projectors very artfully contrived to draw from those banks without the bank's consent or knowledge that they had really advanced it.
72 When two people continually drawing and redrawing upon one another, discounting their bills with the same banker, the banker must immediately discover that they are trading with the capital he advances to them and not with their own capital.
But this discovery is not easy:
when they discount their bills with other banks, and
when the same two persons draw from a great circle of projectors.
The projectors find it for their interest to assist one another.
They make it as difficult as possible to distinguish between:
a real bill of exchange which is drawn by a real creditor and debtor, and
a fictitious bill of exchange, which:
has no real creditor but the discounting bank,
has no real debtor but the projector who used the money.
Even if a banker discovers this, he might be too late
He might find that he had already discounted the bills of those projectors so much that, by refusing to discount any more, he would bankrupt them all and ruin himself by ruining them.
For his own interest and safety, he might go on, withdrawing gradually.
Everyday, he would make discounting harder, so that those projectors would be forced to go to other bankers or other methods of raising money so that he could get out of the circle.
Those projectors were extremely enraged by the difficulties created by the Bank of England, London banks, and Scotch banks in discounting.
The projectors equated their distress, caused by the prudence of the banks, to the country's distress.
They said the country's distress was caused by the banks' ignorance, pusillanimity, and bad conduct.
The projectors blamed the banks for not aiding them in their spirited undertakings to beautify, improve, and enrich the country.
They thought that it was the banks' duty to lend as much as they wanted to borrow, for as long as they wanted.
By refusing to give more credit to those who were already given too much, the banks saved their own credit or the country's public credit.