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.

59 A bank only advances to the merchant the ready money that he needs for answering occasional demands:

The payment of the bill replaces to the bank the value it had advanced, with interest.

60 Without overtrading, a merchant may frequently need ready money, even when he has no bills to discount.

Advantages of Prudence

61 For a long time, Scottish banks were very careful to require frequent and regular repayments from all their customers
  1. 62 They could tolerably judge the thriving or declining circumstances of their debtors.
  1. 63 They could avoid issuing more paper money than what the national circulation needed.

64 After 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.

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.

66 The practice of drawing and redrawing is so well known to all businessmen that it may be unnecessary to explain it.

67 The customs of merchants were established when the barbarous laws of Europe did not enforce the performance of contracts. * 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. 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.

This practice has sometimes gone on for several months and years.

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. 70 Trader A in Edinburgh regularly discounted with some Edinburgh bank the bills he drew upon B, two months before they were due. 71 The paper issued upon those bills of exchange amounted to the whole fund destined for some vast project of agriculture, commerce, or manufactures.

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.

Next: Chapter 2e: Bank collapse