🐎 Happy Lunar New Year! 🐎 Tucked in between Parts 1 and 2 of Chapter 3 of Book IV of The Wealth of Nations is Adam Smith’s “Digression concerning Banks of Deposit, particularly concerning that of Amsterdam” (available here). But why does Smith discuss the inner workings of a foreign bank in a chapter otherwise devoted to trade restrictions based on balance-of-trade arguments? Simply put: because the Bank of Amsterdam is central to Smith’s critique of the balance-of-trade doctrine. To see why, let’s compare and contrast the Bank of England with the Bank of Amsterdam:

In brief, although the Bank of England was created in 1694 by an Act of Parliament and Royal Charter, it was a privately-owned bank, i.e. a joint-stock company (corporation), and its original purpose was to finance the “Nine Years’ War” (1688 to 1697) between France and England. The Bank of Amsterdam (Amsterdamsche Wisselbank), by contrast, was publicly-owned. It was founded in 1609 by Amsterdam’s municipal council and housed in the Town Hall (pictured below).

That is, while the Bank of England was a private for-profit institution created to contribute to a public purpose (fund a war), the Bank of Amsterdam was a publicly-owned entity established to promote private commerce!

In summary, Dutch merchants were often paid in foreign and local trade coins (gold and silver). The problem, however, was that many — if not most — of these coins were “worn, clipt, or otherwise degraded below [their] standard value.” (WN, IV.iii.b.1) The Bank of Amsterdam solved this pesky problem by creating a uniform and standard form of accounting currency called “florins”. That is, the Bank of Amsterdam acted as a central repository where Dutch merchants deposited their foreign and local coins in exchange for “florins”. But here’s the rub: these fictional florins were not a physical currency; florins were merely a unit of account on the bank’s ledgers, and the Bank of Amsterdam charged a fee for converting this bank-account money back into physical coins (Dutch guilders).

So, what incentive did Dutch merchants have for doing business with the Bank of Amsterdam? In a word: security. The city government assumed full and direct liability for all deposits, thus guaranteeing that every “florin” or “guilder” on deposit was fully backed by physical gold or silver bullion kept in the vaults of the bank in City Hall. In other words, as Adam Smith points out in his digression, the Bank of Amsterdam operated as a 100% reserve bank:

“At Amsterdam, … no point of faith is better established than that for every guilder, circulated as bank money, there is a correspondent guilder in gold or silver to be found in the treasure of the bank. The city is guarantee that it should be so.” (WN, IV.iii.b.15)

Smith, however, is skeptical about the true amount of gold and silver reserves being held in the bank’s coffers: “What may be the amount of the treasure in the bank is a question which has long employed speculations of the curious. Nothing but conjecture can be offered concerning it.” (WN, IV.iii.b.16) But for Smith that is precisely the point! Simply put, Amsterdam was a wealthy city not because of the large amounts of reserves in the city’s coffers. She was prosperous because the city-owned bank facilitated commerce by offering safe and secure accounts for Dutch merchants!

This digression thus supports one of Smith’s main insights in Book IV of his magnum opus: the idea that balances of trade don’t really matter. What matters is having a stable and solid currency, which in turn facilitates trade, and that is precisely what the Bank of Amsterdam provided: a stable and solid currency. Nota bene: I will proceed Part 2 of Chapter 3 of Book IV The Wealth of Nations (available here) in my next post.