Academic journal article Business Economics

Adam Smith and the Political Economy of a Modern Financial Crisis

Academic journal article Business Economics

Adam Smith and the Political Economy of a Modern Financial Crisis

Article excerpt

Financial crises have occurred periodically for hundreds of years, and Adam Smith had important insights into their causes. Although by no means all that we know about such crises has been derived from Smith, it is interesting and important to reflect on what he did know and how ignoring his warnings about the creation of excess liquidity has contributed to the current crisis. In addition to the complexity of contemporary finance and the role of central banks and other regulatory institutions, a major difference between Smith's day and ours is the emergence of "moral hazard" as an important policy issue and its corollary, "immoral results." It is important to realize that the risks of financial crisis, moral hazard, and immoral results cannot be avoided by financial and accounting gimmicks, and that there is no substitute for adequate capital in the creation of liquidity.

Business Economics (2009) 44, 3-16.

doi: 10.1057/be.2008.9

Keywords: financial crisis, Adam Smith, liquidity, moral hazard, immoral results, mortgage lending, derivatives


The United States is now in the midst of a major financial crisis that has spread to affect credit and equity markets and financial institutions all around the world. Many have characterized the present crisis as the worst since the Great Depression--a description that is becoming more apt with each passing day. Whatever the ultimate scale of the present crisis, it is not the only important financial crisis to beset the United States in the past 50 years; by my count there have been at least seven: 1971, 1974--75, 1980--82, 1987, 1991, 2000--2002, and 2007--?. Looking further back through the 19th and 20th centuries, the average frequency of crises has been roughly constant at about one per decade. Most other countries, both economically advanced and developing, also have histories of not infrequent financial crises. (1)

During my career as an economist, I have had a good deal of experience with financial crises, perhaps most dramatically as the macroeconomic member of President Reagan's Council of Economic Advisers during the stock market crash of October 1987. During the 10 years that I served as the chief economist of the International Monetary Fund, I witnessed about 40 cases of countries involved in financial crises, sometimes in isolation but often in combination. Once during this period a journalist asked, "What does the IMF do in financial crises?" "Well," I replied, "we help to manage them." "And, how are you doing at this job?" was the next question. "Well," I replied, "recently we have managed to have quite a lot of crises."

Because financial crises have been important and relatively frequent occurrences going back hundreds of years, it is not surprising that the greatest economist of all time, Adam Smith, has something relevant to say on the subject in his great book. An Enquiry into the Nature and Causes of the Wealth of Nations. (2) Because this lecture is presented in connection with the annual Adam Smith award by the National Association for Business Economics, it is appropriate to reflect here on what that great economist can still teach us about the causes and consequences of such crises and about what both private behavior and public policy might do to help avoid them or ameliorate their consequences.

I shall not argue that everything important that we might hope to learn about the political economy of financial crises is in Smith. Indeed, Smith's greatness as an economist derives from immense and detailed knowledge of operation of the economics of his day and earlier times, combined with ability to abstract (making use of the ideas of other thinkers) general theories that explained these operation. (3) Our economies and our monetary and financial systems are quite different and in most respects far more developed and complex than they were in Smith's day. Accordingly, it would be unreasonable to expect that any empirically grounded economist, even one with the intellectual caliber of Adam Smith, could have foreseen and understood all of the important issues that arise in modern financial crises. …

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