Picking up where we last left off, Adam Smith surveys three important substitutes for money and metal currencies in the next part of Chapter 2 of Book II of The Wealth of Nations (specifically, Paras. 26-47): (a) bank notes, (b) bills of exchange, and (c) cash accounts. The first two money substitutes — bank notes and bills of exchange — are what lawyers call negotiable instruments: transferable and unconditional promises or orders to pay a specific sum of money, either on demand or at a set time, as the case may be. A bank note, for example, is a form of paper money consisting of a promise to pay a specific amount (including interest) upon demand. According to Smith, the main advantage of bank notes is that they lower transaction costs; bank notes are little pieces of paper that effectively replace expensive and cumbersome metal currencies (like gold and silver). In fact, Smith explains how banks can circulate up to five or even ten times more money in bank notes than they actually hold in gold and silver reserves! (WN, II.ii.26-42)

A bill of exchange, by contrast, is a credit document on which one party (the drawer) instructs another party (the drawee) to pay a specified sum of money to a third party (the payee) at a future date. By way of example, suppose a merchant in Glasgow wants to sell some goods to a merchant in London. Instead of demanding an immediate payment from the buyer in London, the seller in Glasgow can draw a bill of exchange on the London merchant, payable at a certain future date (say, 30, 60, or 90 days). During this interval of time (i.e. before maturity), the Glasgow merchant can do one of three things: (i) he can keep the bill of exchange until it becomes due; (ii) he can transfer or “endorse” it to a third party (this third party will then have the right to receive payment from the London merchant upon maturity); or (iii) he can “discount” or cash it with a banker for immediate cash at less than its face value. (see, e.g., WN, II.ii.43)

In addition to bank notes and bills of exchange, there is yet another method by which banks inject money — or what today we refer to as “liquidity” — into the economy: a bank can open a “cash account” in the merchant’s name, extending to the merchant a direct line of credit. (see, e.g., WN, II.ii.44-46) Once the merchant opens a cash account at his bank, the merchant may then draw money from this account up to a set limit. The bank charges interest only on the utilized balance, i.e. on the amount of money actually drawn from the account. (ibid.)

But how do these types of financial transactions — promissory notes, bills of exchange, and cash accounts — promote economic growth and development? In a word, these finance instruments do so by making it easier for merchants to trade and finance capital assets. How so? By acting as convenient and perfect substitutes for gold and silver: merchants no longer need to keep large sums of cash on hand in order to do business; instead, they can use bank notes, bills of exchange, and cash accounts to acquire capital assets and invest in productive activities right now. Furthermore, bank notes, bills of exchange, and cash accounts not only replace the need for hoarding gold and silver; these finance instruments also allow the same quantity of metal currency already in circulation to support a much larger volume of trade!

But that said, Smith also has a lot to say about the dark side of banking and finance in the second half of this chapter (Paras. 48-106). Among other things, he describes a real-world banking failure that occurred in Scotland (the spectacular collapse of the Ayr Bank in 1772; see WN, II.ii.73-77), explains why banking is such a risky activity (namely, the oversupply of bank notes), and proposes some ways of reducing this peril. (To be continued …)