------of allof thoseformal rules, governmental support, The The book addresses in depth the institutional structure thehistorical case reviewed could also be broadly inter preted as factual evidence the of real possibilities robust of institutional heterogeneity in banking, voluntary and how forms decentralized of self-governance, liability contracts, and polycentric structures are robust private means ef of ficientlygoverning banking matters without need for the centralizing banking services (Paniagua 2017). stability financial of markets. Scotlandoperated in a highly competitive and lightly regulated environment that had no central bank act to last as of a lender resort, monopo no list issuer currency, of legal no restrictions ex no entry, on ante binding limits the on number and size banks, of and fi nally despite capital no and Yet reserve 7). requirements (p. the lack institutions, the Scottish bank state-created explicit and ingsystem was remarkably stable and more robust than the English system. Scottishof banks and the wide forms bank of competition during the Scottish free-banking period, both which of helped the banks the resilient become to system) more (and than their English counterparts. also It explores in depth the regulatory environment in which banks operated, and thehow ‘regulatory quality’ that of environment devolved interest to due groups More and involvement. government critically,discusses it the and endogenous collaborative in stitutional and contractual arrangements that banks gen themselveserated (among and with their to shareholders) andattempt endogenously to such privately problems solve as last of lack a lender of resort, volatile capital outflows, and banking crises without needing Indeed, an agency. outside effectively absorbed several shockseconomic that affected the economies Scotland of and England and threatened the ------by Tyler Beck Goodspeed Beck Tyler by

INTRODUCTION INTRODUCTION Approximately from 1716 to 1845, Scotland’s 1845, to bankingApproximately from 1716 Despite the fact that Goodspeed’s book does address not

petitive banking systems in Europe. The Scottish system (or at least at illuminate(or the dangers ill-conceived of reform). system was among the most dynamic, resilient, and com scrutinize history find to successful banking experiences and compare them institutionally with our existent ones, so thatthey might illuminate the path institutional to reform shaping the reforms of financial and sector, the fragilityor resilience alternative of banking systems. in Conceivably, build to resilient order more banking systems, should we ry Scotland, has it substantial but contemporary relevance and invaluable insights policy for makers in regards the to perils banking of regulation, the interest of groups role in role of banks of role and regulation in economic crisis and where pursue to institutional reforms. Goodspeed’s book is revia the of sion history banking of episodes in eighteenth-centu ing the Scottish free-banking period and his interpre novel tation the bank (Douglas, of Ayr & Co.) crisis Heron are a fresh contribution that has relevance understanding to the inherent fragility banking of systems. the current financial crisis, his historical analysis concern This emphasison banks hasobviously ledgovernments to speciallay focus banking on and reform banking restric tions, and a severely pessimistic adopt to view regarding the Recession literature attribute to the to banking sector and itsfragilities the causes and length the of economic crisis and its capacity rapidly to the to spread economy. whole makers and economists are still discussing should we how our reform bankingsystems so that they canresil be more has become It ient. conventional wisdom in the post–Great 1. after Years recent economic the bankingand crisis, policy Goodspeed, Tyler Beck. Cambridge, MA: Harvard University Press, 2016, 224 pages, $39.95 pages, 224 2016, Press, University MA: Harvard Beck. Cambridge, Goodspeed, Tyler PABLO PANIAGUA PABLO https://www.pablopaniaguaprieto.com Web: Legislating Instability:Crisis Adam of 1772Smith, Free Banking, and the Financial REVIEW: VOLUME 5 | ISSUE 3 + 4 2018 5 | ISSUE VOLUME

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Before 1765, the collapse of a bank did not entail any sub- tions to ‘free banking’” (p. 7). Hence understanding how stantial threat to the stability of the system, mainly because the Scottish system actually functioned, and identifying its no single bank acquired sufficient size, interconnectedness, contractual and market mechanisms and how well it dealt and systemic importance that its failure would constitute a with crisis, is a valuable way of understanding how a real severe menace to counterparties and credit markets. Even (close to an ideal) free banking system could actually func- if a bank had done so, the system had contractual mecha- tion. nisms, such as optional clauses and unlimited liability, Second, the system suffered in 1772 a financial crisis that for mitigating systemic shocks (p. 137). The biggest threat severely threatened the system. This crisis has been con- to the Scottish system occurred during the financial crisis sidered by banking scholars an indication of how fragile a of 1772, in which sixteen banks failed. Goodspeed revisits banking system would be in the absence of other institu- this experience in detail, arguing that prior regulations and tional features such as stronger regulation, a lender of last impositions from seven years earlier severely undermined resort, or even a central bank. Hence understanding the banks’ resilience and flexibility to deal with the crisis. The timing and legal context of the 1772 Ayr crisis, particularly fact that Scottish free banking and the Ayr crisis occurred in light of the recent drastic changes in the regulatory en- during the time Adam Smith was working on The Wealth of vironment in 1765 and the political and macroeconomic Nations makes this historical episode particularly remark- context in which it occurred, would help to clarify mis- able. Goodspeed revises Adam Smith’s arguments concern- conceptions and doubts concerning the resilience of real ing free banking and regulation, concluding, contrary to free-banking systems and their vulnerabilities in the face of Smith’s claims, that the crisis, far from revealing the weak- regulatory changes. nesses of free banking, actually supplies important lessons Finally, the third reason concerns the unique role that on ill-conceived and ill-implemented banking reform aris- regulations and restrictions play—both directly and, indi- 79 ing when banks as interest groups engage in regulatory cap- rectly, by interacting among themselves—in the evolution ture. and erosion of the institutional structure of banking and finance. The Scottish experience offers a unique opportu- 2. THE BOOK ITSELF nity to identify the first- and second-order systemic and institutional effects of banking regulation, and how they COSMOS + TAXIS + TAXIS COSMOS The nearly 130 years of success of the Scottish free-banking can interact and unintendedly undermine other existent in- period is of particular interest, not only for the history of stitutional features that are relevant to sustaining banking banking, but also to understand alternative and plausible resilience. In addition, it sheds light on how additional and institutional banking arrangements that could be more unforeseen regulatory complexity and interventions emerge resilient and stable than contemporary ones based on cen- from the unintended interactions among restrictions, and tral banks. If we are indeed interested in reforming bank- how that complexity is created from regulatory capture and ing systems so that we could avoid or at least ameliorate vested interests. Particularly, it illuminates how top-down the damage of economic crisis, then we should seriously or ill-conceived and politically-led regulations can—even analyze all the real institutional possibilities or structural when well intended—interact among themselves, with prior liability reforms that we have available. The case of free existing restrictions, and with institutions, exacerbating the banking in Scotland is particularly important for us today fragility of the entire system and bringing severe costs to in a post–Great Recession world, especially in understand- society in ways that are impossible to foresee. Regulatory ing contemporary debates on banking reform, which type interventions therefore might not only have direct adverse of regulations to undertake, and more broadly how sound effects, but more critically, as the case of the Ayr Bank and resilient a free-banking arrangement would be com- suggests, they can have severe unexpected destabilizing pared to a centrally controlled one. I consider this case rel- interaction effects, undermining the whole institutional evant for three reasons. structure. First, the Scottish system has been one of the closest (if Thus there is a complex nonlinear relationship between not the closest) banking systems to that proposed in the politics, regulatory changes and the institutional develop- theory of free banking: “Scotland from 1716 to 1845 is ment and fragilities that such regulations and their interac- widely considered by economic and financial historians tions will generate. In other words, there is vital aspect of to have been one of the closest ever historical approxima- institutional and governance structures related to their en-

REVIEW: Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772 by Tyler Beck Goodspeed ------the crisis crisis the before Chapter 1 also reviews the crisis how Ayr is a great ex Whenregulations and restrictionsare largely designed Chapter 1, “A Very Melancholy Situation,” starts Melancholy Situation,” Very with “A a Chapter 1, to satisfyto concentrated interests, there is a substantial un perceived“institutional-fragility cost” that is shifted from the key institutional the into society, rest onto players or theof institutional structure. In other words, the dynam ics regulatory of capture entail substantial concentrated monetary benefits for interest at groups, the expenseof the transfer and dispersal institutional of fragility and its costs: the transmission institutional of fragility and financial risk tion small-denomination on banknotes, a maximum legal rate interest, of and contingent-liability of a prohibition banknotes—“were already seven law years curious More 1772. of still is the realization that these re strictions in … were reality the products intense of political lobbying” 6, emphasis in (p. original). whatampleGeorge of Stiglerdesignated the “theory ecoof regulation”—specifically,nomic dynamicsthe regulatoryof capture.In the Scottish case, Goodspeed that shows have we a great example in which agency a government a regula or tory body designed and intended serve to the public interest “in instead fact serve[d] mainly advance to private concerns withconcentrated interests in the regulated sector … The crisisitself presents starka warning the of risks posed by regulatory capture, particularly in financial markets” (p. this Perhaps is the most relevant argument21). Goodspeed givescrisis as the why to espe 1772 is relevant us today, for ciallyin the context the of international banking reforms such as Dodd-Frank among others, since sheds it light on bankinghow regulation and restrictions do not necessar ily in work the public interest and build to resilience in our systems. In fact, quite the could opposite occur. Despite those the system changes remained however, stable and responded relatively well in the face such a severeof crisis. global short introduction the to historical context in which the crisis occurred. Goodspeed brieflyreviews the unfolding crisis—in theof 1772 particular,the liquidity problems Scottishfor bills in the discount London market, and how that affectedrefinancing and short-term ofrollover the Scottish of debt banks. The crisis affected several banks’ liquidity and soundness, most importantly but ruinedit the “banking behemoth” Douglas, & Co., the Heron Ayr Bank.Goodspeed reviews Adam how Smith, during 1765 and1772, advocated more regulation and restrictions on banks deal to with the The contradiction problem. however is that the reforms Smith advocated—mainly, a prohibi ------the 1772 crisis,the 1772 rather but that caused

Despite these conclusions, Goodspeed clarifies that “it is Goodspeed’s central argument is“that the salient [1772]

undermined during the regulatory changes 1765–72. of ity”(Ibid., emphasis in original). The historical evidence suggests that the institutional and systemic resilience of the Scottish system drastically changed and was severely previously exhibited Scottish by finance, and el thereby evatedthe risk that adverse financial economic or shocks might metastasize threats into broader financial to stabil not my contention that contention the my not introduction legal of restrictions into Scottish banking they critically undermined the flexibility resilience and banking,and therefore, ultimately, amplifying the levelof systemic risk” (Ibid.). restrictions banking; on regulations that had the effectsof raising barriers loweringentry, to competition in the pro vision credit, short-term of increasing the efficient scale of Goodspeed notices that this be should sur not conclusion prising, acknowledge we once that “the oldest, largest, and most established banks in Scotland … legal for … lobbied Smith, rather made more than less likely precisely by those regulated “unfree’ or Scottish of elements banking which Wealth8). thepromoted”Nationsof The (p. of author financial crisisof the Scottish free banking period, the obtrusive exception the to hypothesis greater of financial stability underfree banking inScotland, was, paceAdam banking systems that regulations could bring, should be vi tal theoretical aspects economic regulation. of regulation a very difficultand dangerous task. Recognizing those potential institutional and erosions fragility costs, alongside the dangers enlarging of the systemic fragility of the system” (p. 22). Therefore, regulatory Therefore, 22). the matters system” (p. cannot be dissociated from institutional dynamics and changes, sys temic risk, and making complexity, the art politically-led of connected financialnetworks—can exacerbate the risk that adverse shocks are amplified propagated and throughout banking fragility and its negative spill effects over into other markets in ways that are unforeseeable.“add Thus ing complexity systems—such complex to as highly inter restrictions in implemented a nonlinear highly complex environment, might actually the have tendency reinforce to severely eachincreasing other negatively, both systemic imposed political legislative or means. In fact, Goodspeed’s analysis actually demonstrates that ill-conceived and in terest-group-captured regulation in concomitance with dogenous changesdogenous and their evolutions, that is significantly attempt regulate to we related how to and alter their envi ronments and legal context; either through exogenously VOLUME 5 | ISSUE 3 + 4 2018 5 | ISSUE VOLUME

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to the rest of the system and the enlargement of systemic misapprehensions around the freedom to issue small notes risks. Hence “capturing agents are essentially incentivized and the use of optional clauses. to produce negative externalities … [T]hese negative exter- The Scottish economy was a small open and fast-grow- nalities can be especially costly when reduced competition ing emergent economy with a fixed exchange rate, open to gives rise to systematically important financial institutions” large, volatile capital inflows and outflows that contributed (p. 22). to generating a balance-of-payments crisis and immense The core insight here is that, institutionally speaking, pressure on the financial system. Since the economy expe- regulations and restrictions are not only not positive sum, rienced large capital outflows due to international political but also, quite certainly, negative sum. Banking regulation events, the issuance of small notes was a rational endoge- not only may not work to satisfy the public interest, but nous response of the system to provide liquidity and credit through time it can also undermine and deeply damage in the face of an acute shortage of circulating media, par- the public interest and their well-being, through destroying ticularly when big banks curtailed credit to attempt to ride and eroding the long-term existent institutional resilience out a real exchange rate depreciation. This 1760–65 period of a given system, making it more fragile and increasing its of relatively higher issuance of notes cannot be considered systemic risk. This is a relevant contribution to the theory “manic” since it did not produce any marked difference in of economic regulation and institutional analysis since it inflation rates in Scotland when compared to England (pp. suggests that the social cost of regulatory capture is quite 45–47). Furthermore, regarding the privately issued notes, difficult to measure in quantitative terms. Its greater cost is a secondary and very dynamic market developed in which increasing: regulatory complexity, long-term institutional “there was certainly no shortage of willing bankers and erosion, and a gradual enlargement of the systemic risk and agents to exchange them … [A] considerable ecosystem of the spill over effects of banking failures into the rest of the quasi banking and clearing institutions formed around the 81 economy, which amounts to more than a single shift in the issuance of small commercial banknotes” (p. 52). cost-benefit equilibrium of the system. It seems the biggest The optional clauses, on the other hand, were rarely used welfare cost of regulatory capture resides in its capacity to and exclusively applied against “high-volume English spec- undermine through time the resilience and the welfare-en- ulators and arbitrageurs.” The clauses were “essentially a hancing properties of a system as a whole. private application of capital controls on large ‘hot money’ COSMOS + TAXIS + TAXIS COSMOS Chapter 2, “Beggarly Bankers,” analyzes—contra Smith— outflows” (p. 30). The optional clauses therefore, were useful the positive role that the emergence and proliferation of the also to allow illiquid but solvent banks to liquidate assets so-called “beggarly bankers,” or the small-scale note issu- without precipitating fire-sale losses and to form an orderly ers, played in actually bringing greater credit competition, backstop against bank panics, and emerged endogenously diversification of risk, and macroeconomic stability; ele- from the oldest and biggest Scottish banks around 1730, ments that contributed to building a remarkably resilient which were originally trying to defend themselves from banking system that withstood severe adverse economic hostile note raids by rival banks. In addition, they eventu- shocks prior to 1765. Goodspeed reviews here the tumul- ally developed mainly as a useful and selective way around tuous years between 1760 and 1765, which comprehended banks’ inabilities to respond to massive international capi- a severe balance-of-payments crisis in 1762, and how these tal outflows and external drains of specie, in turn because events and the proliferation of small issuers affected Smith’s existing usury laws prohibited them to increase their de- theoretical views on banking. Goodspeed also challenges posit rates above 5 percent (p. 43). The optional clauses then Smith’s convictions that this period was marked by a “small were crucial to impose temporary and selective capital con- note mania” attributable to the freedom of banks to issue trols that “allowed time for the current account deficit to banknotes for sums below £1 in addition to the free use of sort itself out through nominal adjustments in the bills of dilatory optional clauses in banks’ notes. Goodspeed finds exchange market” (p. 128), while small-note issuers helped “not only little evidence of a ‘mania,’ but also that the al- to avoid a contraction in the money supply and additional leged banking offenses—namely, the issuance of notes deflation. in denominations bellow £1 and the adoption of optional These two features, though criticized by Adam Smith and clauses—were in fact rational and effective market respons- banking scholars, were the product of competition and vol- es to the very real challenges confronting the Scottish econ- untary freedom of contact, and both contributed deeply to omy” (p. 30). Indeed, this chapter severely challenges the the resilience and flexibility of the system (pp. 45–47). They

REVIEW: Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772 by Tyler Beck Goodspeed ------Setting aside the litigation among the Bank’s Ayr unlim In chapter 4, “Prodigals and Goodspeed Projectors,” Goodspeed exhibits a case here regulatory of capture, resilient the Scottish banking system remained, mainly unlimited to due shareholder liability, rules appropriate for rapidly sequestering shareholders’ assets and providing for their equitable distribution among creditors, and robust co partnery 100). agreements (p. itedly liable shareholders, the creditors and the depositors of bank fully were through restituted and 1786 between 1774 restrictions and limitations Scottish on banking enacted the “elevated systemic level of 1772 before risk in Scottish financial markets,” concluding “attemptsregulate that to specific categoriesof financial activity gen cantherefore simply offsettingerate not changes in bank but behavior, changes that interact in often unpredictable ways with ex isting institutions, as well as with unanticipated changes in economic circumstances” 138). (p. addresses the crucial that role unlimited legal liability of shareholders in Scottish banks in played increasing system stabilityic the of banking system and in securing a rapid recovery1772. afterHe also convincingly argues it that was actually theunlimited liability banks’ of partners that asworked an efficient of market-based lender last resort that disrupting avoided credit markets. Despite the regula tory changes explored in chapter 3 that severely damaged the overall institutional structure and resilience inherent in the Scottish system, Goodspeed recognizes that “Scottish banking nonetheless retained its resilience” of 25). much (p. This fact is particularlyrelevant since restrictions the on small-note issuance and optional clauses had a significant negative effect loweringin competition in Scottish credit markets. Nevertheless, Goodspeed sheds new light how on risk, and created a rare institutional environment charac the to terizedexit small-noteof vacuum” “credit a (due by thatissuers) increased the likelihood that the institutional banking of evolution would lead the to establishment a of difficult-to-oversee, larger, much more and systemically important institution, as eventually did occurred when the BankAyr was actually 89). established (p. in 1769 a substantial vested interest in the legislative process, and the extreme unintended negative consequences, “high or effects,”legalof er-order restrictions given the complexity and opacity banking of and financial markets. This case illustrates differentrestrictions how might actuallyrein each force other unpredictably and undesirably, producing nonlinear impacts banks’ on size, counterparty and sys temic risk, and institutional fragility. finds he Here that the ------direct consequences the of

The The act,prohibiting by both the issuancesmall of notes Chapter 3, “ProcuringChapter 3, an reviews Act,” the “high major

exit small-note of issuers, elevated the counterparty level of quence, banks “getting intercon were more bigger [riskier, act 1765 The 78). and them” (p. nected], of there fewer were therefore increased the efficient scale of banking,forced the from gold andfrom gold silver rivals’ toward big bank notes, and an increase in the frequency bank of failures less than (from In per decade conse 75–84). one than more to (pp. eight) tiallycompetition and lower bankfewer formations, drastic shifts in the composition and riskinessof banks’ assets and loan portfolios, shifts in reserves of the composition away specifically finds historicaland statistical of sub evidence stantial institutional changes as act, including an increase in the average bank size, substan “should hardly“should underly act] as [the come a surprise … [I]ts ing purpose was achieve to precisely did what it achieve … raiseto barriers He entry to and limit 61). competition” (p. operations exited the having market), the effect double of amplifying the risk assumed individual by banks and also the system-level risk. Goodspeed notices that this result and the optional inclusion of clauses, increased the efficient scalebanking. of Banks then substantially got bigger in size competition and(quasi-bankinglowered informal or bank previouslyenabled theScottish bankingsystem absorbto such volatility” 129). (p. tem to adverse shocks” (p. 61). Unfortunately, the Unfortunately, act “did adversetem to 61). shocks” (p. nothing resolve the to fundamental … while problem the at same time undermined it the of some strengths that had posed small-note mania. The act “did indeed curtail the is suance private of banknotes did … [T]hey so the at cost of exacerbating the vulnerability the of Scottish financial sys restrain the paper profusion currency of experienced dur ing and 1760–65, was it thereforelegal a response the to exaggeratedviews policy makers the had at time the on sup the insistence pressure of groups, the had on com prior petitive systemreviewed earlier. The act was to intended 1765 Bank Act,1765 reviews the details regulatory of capture in its formation and serves contrast to the drastic institutional effects that new act,the which was largelyat implemented aleffects restrictions 1765 that played the in dynamicsthe bankingof and the stability the of overall Scottishsystem. This chapter traces legislative the history origins and of the mission the to real economy. effects,”or er-order the unintended complexity-institution also allowed the system absorb to and contain international financial shocks whilereducing their capacitymetastato size into systemic banking panics and limiting their trans VOLUME 5 | ISSUE 3 + 4 2018 5 | ISSUE VOLUME

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the issuance of tradable eight-year, coupon-bearing bonds ing in” and making responsible and accountable the bank that were also secured by the Ayr shareholders’ personal owners and directors for the misbegotten bank behavior, assets and wealth (p. 113). With that mechanism, the Ayr the system also protected note holders, depositors, and Bank was converted into a sort of “bad bank” whose sole creditors and arrested the crisis and facilitated a rapid cred- function was to slowly work off its toxic assets and gradu- it and economic recovery. ally pay its creditors, while the assets and property of the Goodspeed shows that the unlimited liability of share- bank’s owners functioned as a financial backstop. This holders of the bankrupt banks essentially served the ho- particular market-based contractual solution to reassure, mologous role of a private decentralized lender of last resort pay, and protect creditors is a valuable example of how a since the sequestration of shareholders’ personal assets decentralized free-banking system could provide credible, “bailed them in” for more than their subscribed capital. organized, and legally enforceable private solutions to liqui- Moreover, even if shareholders transferred their shares, dations and bank failures. the partners still remained indefinitely liable for all debts This case illustrates how—even if a big bank fails in a incurred during their ownership (p. 116). This form of vol- free-banking environment, which is as plausible an out- untarily contracted lender of last resort, being market based come as in any other banking system—there are still sev- (apolitical) and free of interest groups, might actually be a eral liability regimes and financial mechanisms to provide more institutionally robust alternative financial mechanism credibility and security to creditors and mitigate counter- to provide stability and liquidity compared to a lender of party risk through endogenous and voluntary forms of con- last resort as represented by a government agency bailing tracting equity bail-ins. These forms of equity bail-ins have out banks by socializing losses and using taxpayers’ money. the positive effect of “unfreezing” and restoring calm and A key difference between the Scottish lender of last resort transparency to the credit and interbank lending systems, and its more common form today resides in the fact that 83 diminishing counterparty risk. They mitigate financial banks were indeed allowed to fail, and the cost of bankrupt- shocks that otherwise could have spread and affected the cy was borne by the banks themselves without inflicting real economy, while simultaneously allowing mismanaged losses on the rest of society. This should invite us to reflect banks to deservedly fail, in turn discouraging long-term more critically on how we allocate financial liability today “too big to fail” problems and moral hazard. Furthermore, (p. 139). COSMOS + TAXIS + TAXIS COSMOS the issuance of tradable bonds backed by the Ayr Bank en- These properties allowed the Scottish system to recover abled all its counterparties to quickly resume lending and quickly and to avoid a severe credit contraction that would discounting bills after 1773, as these bonds were used by the have affected the rest of the economy. Indeed, the recovery remaining banks as collateral for loans (p. 112). of the Scottish economy after the Ayr collapse is particu- Hence through unlimited liability of banks’ sharehold- larly telling concerning the comparative macroeconomic ers and the issuance of bonds to creditors linked to those recovery effects of alternative financial systems and differ- shareholders’ assets, the Scottish system had a built-in pri- ent liability regimes. During its collapse, the Ayr Bank was vate contractual mechanism to restore and unfreeze credit allowed to issue transferable bonds to its creditors in order markets whenever a banking crisis occurred. Through an to fully restitute its claims. The bond issue also allowed the expedient legal process of transparent, publicly advertised, bank to satisfy through time the creditors while providing and predictable sequestration and equitable distribution of an orderly liquidation of the company’s assets and those the banks’ and owners’ liquidated assets, the system miti- of its partners. From that time (1773–74), credit markets gated widespread bank panics and fire-sale liquidations (pp. thawed and the Scottish economy rebounded sharply (p. 100–102). 111). The 1772 crisis was, no doubt, severe. However, compara- This historical case suggests that systems that possess tively speaking and unlike the Great Recession, most of the sound, incentive-aligned, and market-based mechanisms social and economic losses and distress eventually ended for liquidating banks, in addition to “liability regimes that up being borne solely by the owners and directors of the (unlike static, technical rules) automatically generate vol- bankrupted banks themselves, which had done, after all, a untary contracted, countercyclical equity bail-ins, may in negligent job in securing sound banking practices, respect- fact challenge Reinhart and Rogoff’s conclusion that deep ing the principles of copartnery, and enforcing managerial financial crises necessarily entail long, slow economic re- rules (pp. 117–21). Simultaneously and positively, by “bail- covery” (p. 26, emphasis in original).

REVIEW: Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772 by Tyler Beck Goodspeed ------be

an financial ongoing crisis and in the middle of CONCLUSIONS FOR AN ANTIFRAGILE AN ANTIFRAGILE FOR CONCLUSIONS AGENDA RESEARCH the causes that of crisis are sufficientlyunderstood” (p. As evidenced throughout Goodspeed’s book, Scottish Finally, Goodspeed interprets the lessons from the 1772 institutional properties encourage the systemas to a whole evolve, learn, and gain from economic stressors. banking certainly resembled an antifragile system. The antifragility of notion resonates also with the concepts of institutionalrobustness and with polycentricity in political would be certainly It (Paniaguaeconomy 2017). notewor thy undertake to an antifragile research agenda develop to regulate fore 24, emphasis in original). seems It that not today have we taken that cautionary tale again once seriously, rushing to regulate banking without yet understanding the origins of the crisis. perhaps today are Hence we adding further com plexity and planting the regulatory seeds that will make the next severe. crisis more but likely, only not more 3. As suggested, the Scottish system and free banking in gen eral, possessed institutional and learning properties that greatly resemble systems that Nassim has designated Taleb antifragile. In other words, free banking possesses incentive and competitive structures, feedback mechanisms, and in stitutional properties that allow the system become to more robust from macroeconomic shocks It (Paniagua 2017). also has the discipline markets of and lacks bailout policies, which aligns the incentives individuals of in the system and incentivizes private bankers and customers their improve to behavior and market develop and contractual mechanisms based past on experiences. These incentives and virtuous disruptive” (p. 132). By increasing the disruptive”averagesize 132). banks, of (p. also it undermined in partthe benefits of unlimited liability in effectivelymonitoring management, thus making lackof managerial accountability severely problematic. crisis and the institutional and evolution demise the of Ayr Bank as ways think to thoroughly more “the about poten tial implications particular of types regulatory of change and institutional arrangements in financial markets” (p. This case137). is an illustrative banking examplehow of practices, systemic risk, and management are oversight severely shaped, limited, and times at undermined the by constitutional context and legal complex system in which banks see also 142; operate With Paniagua (p. the 2017). RecessionGreat in mind, Goodspeed considers the Scottish experience cautionary as “a tale the of risks rushing of to ------. The . The

institutionally contextualized

The 1765 legislation 1765 interacted The severely negatively and In chapter 5, “Upon DaedalianIn “Upon chapter 5, Goodspeed Wings,” ac This point is particularlyrelevant today for diagnosing

the likelihood that future financial shockswould more be practices, lack managerial of accountability, and eventual The act not solve did the perennial 123). demise problem (p. theof balance payments, of furthermore but “increased it with the existent usury restrictions, affecting the institu tional banking of evolution and severely contributing the to Bank’sAyr formation, massive size, risky insider-lending was a general confusionin regards the to true sources of Scotland’s complicated troubles. the complexity the in of a context problem multifaceted of bankingregulation—ill directed.They led a to superficial interpretation and misdiagnosis the since of there problem an effort that, from their perspectives, was complicatedby unrestricted entry smaller of banks and notes issuers” (p. Nevertheless,137). those impulses were—due reform to for knowledges that the act was partly a genuine attempt of Scotland’s largest banks “to impose a highly on order dif ficult and poorly understood macroeconomicsituation, regulatory capture behalf on Scotland’s of biggest banks, “and ought caution therefore to us against too a simple conception regulatory of Goodspeed capture” 23). ac (p. knowledges that the reforms and the regulatory changes simply and not were and in for implemented 1765 lobbied entirely anticompetitive an of outcome seeking rent or conditioned outcome of fragile, of conditioned outcome (yet inefficient, overly and regulatedinadequately) banking systems. nomic recoveriesnomic are inherent, not of unavoidable outcomes any banking systems failing inherent or maladies capi of talistic economies. They rather seemto be an institutionally shareholders and bank managers, and the rules banking of liabilitymatter considerably in determining the severity of and recovery from banking crisis. Painful and eco slow need impose to a severe, long, and recoveryslow whenever a banking crisis occur. Institutional context, incentives for the unavoidable “inherentdrag” imposed recoveries on by banking crises be to have Scottish experience suggests that all not banking systems to financialto intermediation(Reinhart Rogoff and 2009). if take we Goodspeed’s However, insights the seriously, con drawnclusions Reinhart by (2009) regards andin Rogoff to affecting to acknowledge we have recovery, the sig a that nificant part of the explanation comes from substantialthe damage that the banking system did credit to marketsand and understanding the and recovery slow long sufferedby the States. United Whereas there might be other factors VOLUME 5 | ISSUE 3 + 4 2018 5 | ISSUE VOLUME

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a framework of institutional analysis that incorporates all NOTES three concepts in order to analyze systemic risk and the macrostability properties inherent in different banking sys- 1 Indeed, of the sixteen banks that failed in 1772, only tems. three failed to pay their creditors in full. However, their Evidence suggests that free-banking regimes possess biggest creditor was actually the Ayr Bank, meaning a great degree of antifragility. In contrast to Goodspeed’s that the losses were ultimately borne by the sharehold- historical case, contemporary societies have followed an ers of the Ayr (ibid., 98). The other thirteen banks, in alternative approach that, in fact, has driven us ever fur- fact, transparently and in an orderly manner settled ther away from antifragility into severe and ever-growing their debts in full, with stable expectations and con- systemic fragility. Now that we are reflecting on the Great fidence in the security and wealth of their proprietors Recession, and looking for ways to fix our banking mala- to render them able to pay and be liable for more than dies, perhaps we should take a closer look at what banking enough to cover the liabilities. history might tell us concerning the dangers of legislative 2 I am grateful to Harry David for editing assistance. reforms, complexity, and the alternative, robust institution- al structures that we should consider more seriously.2 REFERENCES

Goodspeed, T. B. 2016. Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772. Cambridge, MA: Harvard University Press. Paniagua, P. 2017. The Institutional Rationale of Central Banking Reconsidered. Constitutional Political Economy, Vol. 28, Issue 3, 85 pp. 231-256. Reinhart, C. and Rogoff, K. 2009.This Time Is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press. COSMOS + TAXIS + TAXIS COSMOS

REVIEW: Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772 by Tyler Beck Goodspeed