Legislating Instability : Adam Smith, Free Banking, and the Financial Crisis of 1772

From 1716 to 1845 Scotland's banks were among the most dynamic and resilient in Europe, effectively absorbing a series of economic shocks that rocked financial markets in London and on the continent. Legislating Instability explains the seeming paradox that the Scottish banking system achieved this success without the government controls usually considered necessary for economic stability. Scottish banks operated in a regulatory vacuum: no lender of last resort, no monopoly on currency, no capital reserve requirements, and no limits on bank size. These conditions produced a robust, competitive banking system. Despite large speculative capital flows, a fixed exchange rate, and substantial external debt, Scotland navigated two financial crises during the Seven Years' War. The exception was a severe crisis in 1772, seven years after the imposition of the first regulations on banking-the result of lobbying by large banks to weed out competition. While these restrictions did not cause the crisis, Tyler Beck Goodspeed argues, they undermined the flexibility and resilience of Scottish finance, thereby elevating the risk that another economic shock might threaten financial stability more broadly. The crisis of 1772, far from revealing the shortcomings of unregulated banking, as Adam Smith claimed, exposed the risks of ill-conceived regulation.