Adam Smith on Systemic Risk, ca. 1776

Adam Smith is sometimes heralded as the foundational thinker of laissez faire economics. As many people have written before, Smith was not a doctrinaire proponent of laissez faire, but rather took a pragmatic approach that started with the principle of promoting natural liberty to the extent possible, but recognized times when government must encroach on that liberty to promote everyone’s welfare.

Smith’s chapter on Money (book 2, ch. 2) in The Wealth of Nations provides an excellent example. Smith has a lengthy discussion of bank notes and other forms of paper money as supplements to hard currency. Smith generally favors such notes, especially in relatively large denominations for use in transactions between businessmen or banks themselves. Smith worries about small denominations of paper money because such small denominations are much more likely to be accepted at first, even when issued by someone of questionable credit, and then end up going unpaid and causing lots of bankruptcies (Wealth 351-352). Smith concludes this discussion with a recommendation for government intervention:

To restrain private people, it may be said, from receiving in payment the promissory notes of a banker, for any sum whether great or small, when they themselves are willing to receive them; or, to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is manifest violation of that natural liberty which it is the proper business of law, not to infringe, but to support. Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed. (Wealth 353)

In other words, if your liberty could lead to a major negative consequence for many people who have no part in your actions, the government should step in to prevent such harm. Sounds like a pretty good justification for regulating derivatives and other financial instruments to me!

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