Book II, Chapter II, 3

An operation of this kind has taken place in Scotland during the past twenty-five or thirty years, with new banking companies established in almost every sizeable town and even in some country villages. Its effects have been precisely those described above. Almost all the country’s business is conducted with the paper issued by these companies, commonly used for purchases and payments of every kind. Silver rarely appears except as change for a twenty shilling banknote, and gold still more rarely. Although the conduct of these companies has not always been beyond reproach, and an act of parliament has accordingly been needed to regulate it, the country has plainly benefited greatly from their trade. I have heard it said that trade in the city of Glasgow doubled in about fifteen years after banks were first established there, and that trade in Scotland has more than quadrupled since the first establishment of the two public banks in Edinburgh. One, the Bank of Scotland, was established by act of parliament in 1695; the other, the Royal Bank, by royal charter in 1727. I do not claim to know whether the trade of Scotland as a whole, or Glasgow in particular, has truly grown by so much in so short a time. If either has, the increase seems too great to be explained by this cause alone. But there can be no doubt that Scottish trade and industry have grown substantially over this period and that the banks have contributed considerably to that growth.

The value of the silver coin circulating in Scotland before the Union in 1707 and brought immediately afterward to the Bank of Scotland for recoining amounted to £411,117: 10: 9 sterling. There is no account of the gold coin; but the old records of the Scottish mint show that the value of gold coined annually somewhat exceeded that of silver. Moreover, many people, unsure of being repaid, did not bring their silver to the Bank of Scotland, and some English coin was also in circulation and was not called in. The total value of gold and silver circulating in Scotland before the Union therefore cannot be estimated at less than a million sterling. This seems to have made up almost all its circulating money: although the Bank of Scotland, then without a rival, issued a considerable amount, its notes appear to have formed only a small part of the whole. Today Scotland’s total circulating money cannot be estimated at less than two millions, of which the gold and silver most probably amount to less than half a million. Yet despite this great reduction in circulating gold and silver, Scotland’s real wealth and prosperity do not appear to have suffered. On the contrary, its agriculture, manufactures, and trade—the annual produce of its land and labor—have plainly increased.

Most banks and bankers issue their promissory notes chiefly by discounting bills of exchange: advancing money on the bills before they fall due. From the amount they advance they always deduct the legal interest for the period until payment is due. When the bill is paid at maturity, the bank recovers what it advanced and earns the interest as clear profit. A banker who advances his own notes rather than gold and silver to the merchant whose bill he discounts can discount bills to an additional amount equal to the value of his notes that experience shows are ordinarily in circulation. He can thus earn interest as clear profit on a correspondingly greater sum.

Scottish commerce, not very extensive today, was even smaller when the first two banking companies were founded. They would have done little business had they confined themselves to discounting bills of exchange. They therefore devised another way to issue their notes: granting what they call cash accounts. This means extending credit up to a specified sum—two or three thousand pounds, for example—to anyone able to find two people of unquestioned credit and good landed property to guarantee that any money advanced within that limit would be repaid on demand, with legal interest. Banks and bankers in many parts of the world, I believe, commonly extend this kind of credit. But, so far as I know, the Scottish banks are distinctive in the easy terms on which they accept repayment; these may be the chief cause both of their extensive business and of the benefit the country has gained from it.

A person with such a credit from one of these companies who borrows a thousand pounds, for example, may pay it back in installments of twenty or thirty pounds. From the day each installment is paid until the entire loan is repaid, the company deducts the corresponding share of interest on the original sum. Merchants and almost everyone in business therefore find it convenient to maintain cash accounts with these banks. They consequently have an interest in encouraging the banks’ business: they readily accept their notes in payment and urge everyone they can influence to do the same. When customers ask the banks for money, the banks generally advance it in their own notes. Merchants pay those notes to manufacturers for goods, manufacturers pay them to farmers for materials and provisions, and farmers pay them to their landlords as rent. Landlords return them to merchants in payment for the comforts and luxuries they supply, and merchants return them to the banks to settle their cash accounts or repay their borrowings. In this way almost all the country’s monetary business is conducted with these notes. This explains the companies’ extensive trade.

These cash accounts allow each merchant, without acting imprudently, to carry on more trade than he otherwise could. Consider two merchants, one in London and the other in Edinburgh, who employ equal amounts of stock in the same trade. The Edinburgh merchant can prudently carry on more trade and employ more people than the London merchant. To meet the constant demands for payment on goods bought on credit, the London merchant must always keep a considerable sum of money idle, either in his own vaults or with his banker, who pays him no interest on it. Suppose this sum is normally five hundred pounds. The goods in his warehouse must always be worth five hundred pounds less than they could be if he did not have to keep the money idle. Suppose he generally turns over his entire stock of goods, or goods equal in value to his entire stock, once a year. Having to keep this sum idle means he sells five hundred pounds worth less goods over the year than he otherwise might. His annual profits fall by all the profit he could have earned by selling an additional five hundred pounds worth of goods, and he employs fewer people to prepare goods for market—by however many an additional five hundred pounds of stock would have supported. The Edinburgh merchant, on the other hand, keeps no money idle to meet occasional demands. When these arise, he meets them through his cash account with the bank, gradually repaying what he borrowed out of the cash or paper he receives from occasional sales of his goods. With the same stock, therefore, he can prudently keep more goods in his warehouse at all times than the London merchant. He can earn greater profits himself while continually employing more industrious people to prepare those goods for market. This explains the great benefit the country derives from this banking business.

It may be thought that the ease of discounting bills of exchange gives English merchants a convenience equivalent to Scottish merchants’ cash accounts. But Scottish merchants, it should be remembered, can discount bills of exchange just as readily as English merchants, and have the additional convenience of their cash accounts.

All the paper money of every kind that can readily circulate in a country can never exceed the value of the gold and silver it replaces—or, assuming trade remains the same, the gold and silver that would circulate there without paper money. If twenty shilling notes, for example, are the smallest paper money circulating in Scotland, the total paper that can circulate readily cannot exceed the amount of gold and silver needed to carry out the country’s customary annual transactions worth twenty shillings or more. Should paper in circulation ever exceed this amount, the surplus could neither be sent abroad nor used in domestic circulation and must immediately return to the banks for exchange into gold and silver. People would soon notice that they held more paper than they needed for their domestic business. Unable to send it abroad, they would at once demand payment from the banks. Once exchanged into gold and silver, the surplus could readily be put to use abroad, whereas it had no use as paper. The banks would therefore immediately face demands for payment of the entire surplus, and demands on a much larger scale if they showed any reluctance or difficulty in paying: the alarm caused by such behavior would necessarily intensify the run.

Besides the costs common to every business, such as rent, the wages of servants, clerks, and accountants, and the like, a bank has two principal expenses of its own. First, it must keep a large sum of money in its vaults at all times to meet occasional demands from the holders of its notes, forgoing the interest that sum could earn. Second, it must replenish those vaults as quickly as payments empty them.

A bank issuing more paper than the country can employ in circulation, with the surplus continually returning for payment, should keep more gold and silver in its vaults—not merely in proportion to this excessive increase in notes issued, but in a much greater proportion, since its notes return much faster than their number increases. Its first expense must thus increase not merely in proportion to this forced expansion of its business, but much more rapidly.

Moreover, though the bank’s vaults ought to hold far more money, they must also empty much faster than they would if its business stayed within reasonable limits. Replenishing them requires not only greater expenditure but expenditure that is more constant and unremitting. The coin continually drawn from its vaults in such large amounts cannot circulate within the country. It has replaced paper that exceeds what domestic circulation can employ, so it too exceeds that amount. Since nobody will let that coin lie idle, it must be sent abroad in one form or another to find a profitable use unavailable at home. This constant export of gold and silver makes it harder, and therefore still more expensive, for the bank to obtain fresh gold and silver for its rapidly emptying vaults. In proportion to the forced expansion of its business, then, its second expense must rise even more than its first.

Suppose that a particular bank can readily keep exactly forty thousand pounds in paper circulating in the country and must hold ten thousand pounds in gold and silver in its vaults at all times to meet occasional demands. If it attempts to circulate forty-four thousand pounds, the extra four thousand pounds, more than circulation can readily employ, will return almost as fast as the bank issues it. To meet demands the bank should therefore hold not merely eleven thousand pounds but fourteen thousand pounds in its vaults at all times. It earns nothing in interest from the four thousand pounds of excess notes, while bearing the entire expense of constantly collecting four thousand pounds in gold and silver, which leaves its vaults as quickly as it enters them.

If every banking company had always understood and pursued its own particular interest, circulation could never have been flooded with paper money. But banking companies have not always understood or pursued their own interests, and circulation has often been flooded with paper money.

Something like this has happened in Scotland over the past five-and-twenty or thirty years. New banking companies have opened in almost every sizable town and even in some country villages. The results have been just as described above. Business there is carried on almost entirely with the notes issued by these banks. People commonly use them for purchases and all kinds of payments. Silver is rarely seen except when changing a twenty shilling banknote, and gold is seen even less often. The banks have not all behaved beyond criticism, and an act of parliament was needed to regulate them. Even so, their business has clearly brought the country great benefits. I have heard it said that trade in Glasgow doubled in about fifteen years after banks first opened there. I have also heard that Scotland’s trade has more than quadrupled since the first two public banks opened in Edinburgh. The Bank of Scotland was established by an act of parliament in 1695, and the Royal Bank by a royal charter in 1727. I do not claim to know whether Scottish trade generally, or Glasgow’s trade in particular, really grew so much in so short a time. If either did, banking alone seems unable to explain such a large increase. But there is no doubt that Scotland’s trade and industry grew substantially during this period, and that the banks contributed a great deal to that growth.

Before the Union in 1707, Scotland had silver coins in circulation worth £411,117: 10: 9 sterling. Immediately after the Union, these coins were brought to the Bank of Scotland to be recoined. We have no accounting of the gold coins. But old records from the Scottish mint show that the value of gold coined each year was somewhat greater than the value of silver. Also, many people did not bring their silver to the Bank of Scotland because they doubted they would be repaid. And some English coins were circulating that were not called in. So the total gold and silver circulating in Scotland before the Union cannot have been worth less than a million sterling. This seems to have been almost all the money circulating there. The Bank of Scotland had no rival and circulated a considerable amount of its own notes, but these seem to have been only a very small share of the total. Today, the total money circulating in Scotland cannot be estimated at less than two millions. Of this, the gold and silver probably amount to less than half a million. Yet although the circulating gold and silver have decreased so much, Scotland’s real wealth and prosperity show no signs of suffering. On the contrary, its farming, manufacturing, and trade, and its land and labor’s yearly output, have clearly grown.

Most banks and bankers issue their promissory notes mainly by discounting bills of exchange. This means paying out money against a bill before it comes due. They always deduct the legal interest on the sum advanced for the period until the bill is due. When the bill is paid on its due date, the bank recovers what it advanced and earns the interest as a clear profit. A banker who gives the merchant his own notes rather than gold and silver when discounting a bill can discount more bills. The extra amount equals the value of his notes that, in his experience, ordinarily remain in circulation. This lets him earn interest on a larger sum.

Scotland’s commerce is not very large now, and it was even smaller when its first two banks were established. Those banks would have had little business if they had only discounted bills of exchange. So they found another way to issue notes: what they call cash accounts. A bank offers an individual a credit line up to a set amount, say two or three thousand pounds, if the person can find two reliable owners of landed estates to guarantee it. They guarantee that whatever he borrows within the credit limit will be repaid on demand, with legal interest. Banks and bankers around the world commonly offer this kind of credit, I believe. But as far as I know, the easy repayment terms offered by Scottish banks are unique to them. These terms may be the main reason both for the banks’ large volume of business and for the benefits the country has received from it.

For example, someone with such a credit line who borrows a thousand pounds may pay it back bit by bit, twenty or thirty pounds at a time. For each partial payment, the bank reduces the interest on the original sum by the corresponding amount from the date of that payment until the full sum has been repaid. So all merchants and nearly all other businesspeople find it useful to keep cash accounts with these banks. They then have an interest in helping the banks do business: they readily accept the banks’ notes in payment and encourage others they can influence to accept them too. When customers ask the banks for money, the banks generally give them their own notes. Merchants pay these notes to manufacturers for goods. Manufacturers pay them to farmers for materials and provisions, and farmers pay them to landlords for rent. Landlords pay them back to merchants for comforts and luxuries. Finally, merchants return them to banks to settle their cash accounts or repay what they borrowed. Almost all the country’s money business is handled with these notes. This explains the banks’ large volume of business.

Cash accounts let every merchant safely conduct more trade than would otherwise be possible. Take two merchants with equal stocks in the same line of business, one in London and the other in Edinburgh. The Edinburgh merchant can safely conduct more trade and employ more people. The London merchant must always keep a substantial sum of money on hand, either in his own safe or with his banker, who pays him no interest on it. He needs this money to meet constant demands for payment for goods bought on credit. Suppose he normally needs five hundred pounds for this purpose. His warehouse must then contain five hundred pounds less in goods than it could if he did not have to leave that money unused. Suppose he normally sells all the goods in stock, or goods worth the full value of his stock, once a year. Because he has to keep that money unused, he sells five hundred pounds worth fewer goods each year than he otherwise could. He loses all the yearly profit he could have made on those extra goods. He also employs fewer people to prepare goods for market: specifically, however many could have been employed with five hundred pounds more stock. The Edinburgh merchant, by contrast, keeps no money unused to meet occasional demands. When payments come due, he draws from his cash account at the bank. He gradually repays what he borrowed with cash or notes from sales of his goods. With the same stock, he can safely keep more goods in his warehouse at all times than the London merchant. He can thus earn more profit and give steady employment to more productive people who prepare those goods for market. This is why the country has gained so much from this banking practice.

One might think that English merchants’ ability to discount bills of exchange gives them a benefit equal to Scottish merchants’ cash accounts. But Scottish merchants can discount bills just as easily as English merchants can, and they also have their cash accounts.

The total paper money of all kinds that can circulate readily in a country can never exceed the value of the gold and silver it replaces. That is the amount that would circulate there without paper money, assuming trade stayed the same. Suppose twenty shilling notes are the smallest notes circulating in Scotland. Then the total paper money that can circulate readily there cannot exceed the gold and silver needed to carry out the yearly transactions worth twenty shillings or more usually made there. If paper money in circulation exceeds that amount, the surplus cannot be sent abroad or used in domestic circulation. It must immediately return to the banks to be exchanged for gold and silver. Many people would quickly see that they held more notes than they needed for business at home. Since they could not send the notes abroad, they would immediately demand payment from the banks. They could readily find a use for the resulting gold and silver by sending it abroad, but not for the paper notes. The banks would immediately face demands for payment covering all the surplus notes. If they were slow or reluctant to pay, the demands would grow much larger, because their reluctance would cause alarm.

Banks have ordinary business costs, including rent, wages for servants, clerks, and accountants, and so on. They also have two main costs of their own. First, they must always keep a large sum in their vaults to meet occasional demands from noteholders. They lose the interest they could have earned on it. Second, they must refill those vaults as fast as payments empty them.

A bank that issues more paper than the country can use in circulation will continually have the surplus returned for payment. It should keep more gold and silver in its vaults, not just in proportion to its excessive increase in notes, but by a much larger proportion. Its notes come back far faster than their increase alone would suggest. Thus its first cost, holding reserves, should rise by much more than the forced increase in its business.

Although such a bank must keep its vaults much fuller, they will empty far faster than if it kept its business within reasonable limits. Refilling them takes not only much heavier spending but a constant, unbroken effort. The coins continually taken from its vaults in such large amounts cannot circulate in the country. They replace paper in excess of what domestic circulation can use, so they too are in excess of what it can use. Those coins cannot be left idle, so they must be sent abroad in one form or another to find profitable use unavailable at home. This constant export of gold and silver makes it harder, and therefore more expensive, for the bank to find new gold and silver to refill vaults that empty so rapidly. As its business grows beyond reasonable limits, its second cost must rise even more than its first.

Suppose a particular bank can easily circulate exactly forty thousand pounds in notes and must always keep ten thousand pounds in gold and silver in its vaults for occasional demands. If it tries to circulate forty-four thousand pounds, the surplus four thousand pounds will come back for payment almost as quickly as it is issued. To meet demands, the bank needs not just eleven thousand pounds in its vaults, but fourteen thousand pounds. It gains no interest on the extra four thousand pounds in circulation. Yet it bears the entire cost of continually gathering four thousand pounds in gold and silver, which leaves its vaults almost as soon as it arrives.

If every bank had always understood and protected its own interests, there could never have been too much paper money in circulation. But banks have not always understood or protected their own interests, and circulation has often been flooded with paper money.