Adam Smith on fractional reserve banking

When I posted before on this subject, I wrote:

While [fractional reserve banking] might be inflationary, it also fuels growth. The alternative, so far as I can see, would be both deflationary and cause economic contraction.

Adam Smith lived throught he period when this system first became widespread in Scotland. Here’s what he had to say about it. At the time, paper currency was essentially promissory notes issued as receipts for deposits of precious metals (“I promise to pay the bearer on demand the sum of…”) and Smith, just before this passage, noted that the issue of paper money under this system freed up most (he said 80%) of the bullion for use in overseas trade, which further enriched the country. That’s the context, here’s the quote:

When, therefore, by the substitution of paper, the gold and silver necessary for circulation is reduced to, perhaps, a fifth part of the former quantity, if the value of only the greater part of the other four-fifths be added to the funds which are destined for the maintenance of industry, it must make a very considerable addition to the quantity of that industry, and, consequently, to the value of the annual produce of land and labour.

II.2.41

An operation of this kind has, within these five-and-twenty or thirty years, been performed in Scotland, by the erection of new banking companies in almost every considerable town, and even in some country villages.*12 The effects of it have been precisely those above described. The business of the country is almost entirely carried on by means of the paper of those different banking companies, with which purchases and payments of kinds are commonly made. Silver very seldom appears except in the change of a twenty shillings bank note, and gold still seldomer. But though the conduct of all those different companies has not been unexceptionable, and has accordingly required an act of Parliament to regulate it, the country,*13 notwithstanding, has evidently derived great benefit from their trade. I have heard it asserted, that the trade of the city of Glasgow doubled in about fifteen years after the first erection of the banks there; and that the trade of Scotland has more than quadrupled since the first erection of the two public banks at Edinburgh, of which the one, called the Bank of Scotland, was established by act of Parliament in 1695; the other, called the Royal Bank, by royal charter in 1727.*14 Whether the trade, either of Scotland in general, or the city of Glasgow in particular, has really increased in so great a proportion, during so short a period, I do not pretend to know. If either of them has increased in this proportion, it seems to be an effect too great to be accounted for by the sole operation of this cause. That the trade and industry of Scotland, however, have increased very considerably during this period, and that the banks have contributed a good deal to this increase, cannot be doubted.

(emphasis added)

So, I was ahead of Smith by, um… minus two hundred and thirty four years.