19 Banks and trust in Adam Smith
Introduction
One can see banking as a mediating institution based on trust. In a small pre-commercial society, trust is personal and credit markets quite limited and based on personal knowledge. In larger commercial societies, credit markets tend to expand, but this is not possible if they are based only on personal trust. This is because of the difficulties of getting to know every customer in a large and impersonal society. Institutional trust needs to supplement personal trust. One trusts a bank and/or the banking system more than the individual teller in the bank, and the bank trusts credit scoring and the legal system in the face of a lack of personal knowledge of individual clients. Yet personal and impersonal trust act generally as complements for one another rather than substitutes.
Adam Smith’s vision of banking may be interpreted as an example of an analysis of this mix of institutional and personal trust. Bankers in Smith’s time tended to be prominent public figures, with known reputation and known assets (personal trust), but bankers were also legally bound by unlimited liability (institutional trust). They gave credit to “men of credit” (personal trust), but when it became difficult to verify this credit, Smith argued, regulation was needed (institutional trust).
Banks and trust in Adam Smith
The lending market is a market based on trust. Trust is difficult to offer because trustworthiness is difficult to judge. How can we generate enough trust and trustworthiness to create and sustain a lending market?
Adam Smith lived in eighteenth-century Scotland, during a time of social and economic change when the economy began to grow significantly. As commercial interactions expanded, the frequency of interactions with individuals whom one did not previously know and with impersonal instruments of exchange expanded, too. The increased commerce brought about, among other things, new needs and new institutions, such as a credit market and a banking system. Adam Smith’s description of the banking system in Scotland in the eighteenth century in his Wealth of Nations ([1776] 1981) offers us some possible insights into the complex relationship between trust and trustworthiness and their relationship with personal and impersonal relations in a complex, growing commercial society.
The historical “Adam Smith Problem” (for an overview of the problem, see Montes 2003) held that there was a fundamental tension between Smith’s two great works, The Theory of Moral Sentiments ([1759] 1984) and The Wealth of Nations ([1776] 1981). Though most contemporary scholars reject the crude version of this problem (Montes 2004; Otteson 2002; Paganelli 2008), there nonetheless remains a lingering suspicion that Smith’s focus on socialization and communal life in his account of moral psychology and his focus on the “self-interest” of actors in an economic setting reveals an inconsistency in his analysis. In what follows, I want to use the example of what Smith has to say about banking to show not only that there is no tension here, but also that Smith’s account of a successfully operating banking system integrates communal experience, in the form of personal knowledge and relationships, with economic interaction through institutions in a competitive banking market. The resulting analysis shows that we can infer from Smith’s analysis an awareness of the problems that might arise in an extended commercial society where individuals interact with little personal knowledge of each other. But we can also infer that, for Smith, a combination of personal knowledge and interaction with institutional features such as the legal system and the discipline of the market allows for the growth of a stable banking system and a stable society.
Personal trust may be easily achieved with personal knowledge. Yet, in the presence of impersonal relations, personal knowledge may become excessively expensive to achieve. We therefore rely on other sources of knowledge, such as institutions, to generate and maintain trust. Institutional trust plays an important role in supplementing personal trust when personal trust is either weak or too expensive to achieve, such as in large impersonal environments.
Adam Smith realized the complexity of the interactions of personal and impersonal exchanges and of personal and impersonal trust. On the one hand, he is severely critical of personal relations; on the other hand, he is also severely critical of impersonal relations. Smith claims that personal relations are tyrannical in nature as they imply dependency, such as the relations typical of the feudal system. He welcomes the impersonal relations of commercial societies as they bring freedom and dignity to individuals (Paganelli 2013). Indeed, Smith tells us, “Commerce and manufacturers gradually introduced order and good government, and with them the liberty and security of individuals, among the inhabitants of the country, who had before lived [in] servile dependency upon their superior” ([1776] 1981, III.iv.4, 412). Yet too much impersonality may lead us to vices and debauchery (Paganelli 2010). Indeed, in The Wealth of Nations we hear that “a man of low condition,” moving from his small village to a great city, abandons an environment with close personal ties for an impersonal one in which he “is observed and attended to by nobody” (V.i.g.12, 795–796). So there is no check on his “low profligacy and vice.” Smith suggests the reintroduction of personal exchanges to reestablish balance with the guided “study of science and philosophy” (V.i.g.14, 796) and “publick diversions” (V.i.g.15, 796). Smith therefore views society not in terms of either–or but in terms of a complex web of interactions of personal and impersonal relations and exchanges. His description of the banking system is an example of his vision of integrated personal and impersonal trust.
Adam Smith’s description of the eighteenth-century Scottish banking system may not be the most accurate available to us (Checkland 1975a). Yet his description may be even more interesting because of this. His knowledge was certainly profound and almost first-hand (e.g., Gherity 1995; Skaggs 1999; Rockoff 2013), given that one of his benefactors (the Duke of Buccleuch) was involved in a major Scottish bank and its subsequent collapse (the Ayr Bank), and given that there are speculations regarding Smith’s involvement in the drafting of a banking bill abolishing some small notes and prohibiting the two major banks from creating a monopoly (Checkland 1975a). So if Smith’s account is not a perfectly accurate description of reality, as alleged, it may be considered as a description of an idea (see also: Hueckel 2009): banking is (should be?) a delicate game of trust and trustworthiness and the best way to avoid disaster is a delicate balance of competition and regulation.
So here is a problem that emerges with banking. Smith does not explicitly present it in these terms but the argument can be inferred from his words. Why would anyone accept as a form of payment a piece of paper that said that payment will come at a later moment? Why would anyone accept as payment “a shadow without a substance,” as Isaac Gervaise ([1720] 1954) would say? For anyone to accept that piece of paper as payment, that person needs to trust that that piece of paper will indeed be transformed into payment at a later date. This can happen in two ways (Frankel 1977). One way is to trust that it is possible to give it to someone else as a form of payment and have this other person accept it without problems. The other way is to trust that, by bringing it to the issuer, the issuer will redeem it for actual payment without problems. In both cases, trust depends either on the individual issuer or receiver, or on the institutions that guarantee that exchange, or on a combination of both. Smith helps us see how individual trust, institutional trust, and their combination generate and sustain a healthy banking system. Bankers in Smith’s time tended to be prominent public figures, with good reputations and known assets. The bankers’ personal reputation generated trust. Their known assets also contributed to their personal trust; but the fact that they were also legally bound by unlimited liability allowed institutional trust to enhance that personal trust. Individuals were comfortable accepting papers issued by these well-known bankers bounded by unlimited liability because they trusted that their promises to pay would be fulfilled either by their sound banking activities or by the extent of their estate. We can therefore infer from Smith’s work that it is not just personal trust or not just institutional trust, but an intertwined relation between personal and institutional trust that allowed this kind of paper money to be widely accepted as intermediary in exchange.
Banks in Smith’s time were not initially banks of deposit. They only came to accept deposits later in time when they ran into serious liquidity problems and were looking for ways to increase their cash. Banks would lend money, mostly in the form of paper certificates. And these papers would circulate as money (Munn 1981). As Smith explains, “It is chiefly by discounting bills of exchange, that is, by advancing money upon them before they are due, that the greater part of banks and bankers issue their promissory notes” ([1776] 1981, II.ii.43, 298). The bank advances the amount of the bill minus the legal interest rate until the bill is due. And when the bill is due, it collects it. But the advance that the bank gives is not in gold or silver, but in its own promissory notes, which allows the bank to make a higher profit from a larger sum advanced. It also allows banks to operate with an amount of gold and silver in reserves that is less than the sum of the amount stated in their notes, because it is expected that, under normal circumstances, not all the notes would come back to the bank for redemption at the same time. According to Smith, bankers need only about 20 percent of gold as reserve for immediate demands, the economy running on one-fifth of the gold and silver otherwise required (II.ii.29, 292–293). For Smith, this is one of the major advantages of banking: a country can have a paper money for domestic trade, freeing gold and silver for foreign investment where paper money cannot go.
It is interesting to note why paper money does not have the same reach as gold and silver. While gold and silver are an impersonal means of exchange, paper money is a fiduciary means of exchange. The quality of gold and silver is easily recognizable everywhere in the world. The quality of notes and of note issuers is recognizable only with the knowledge of them. And that knowledge is “personal,” in the sense that it is local. Gold and silver are accepted everywhere. Notes are accepted only within the sphere of reputation of the issuer. Indeed, Smith tells us: “paper cannot go abroad; because at a distance from the banks which issue it, and from the country in which payment of it can be extracted by law, it will not be received in common payment” ([1776] 1981, II.ii.32, 294). Corroborating this point, David Hume would call paper money “counterfeit money,” exactly because it would not be accepted abroad ([1752] 1985, 284).
But let’s go back to Smith’s account of banking. In addition to discounting bills of exchange, the Scottish banks
invented … another method of issuing their promissory notes; by granting, what they call, cash accounts, that is by giving credit to the extent of a certain sum … to any individual who could procure two persons of undoubted credit and good landed estate to become surety for him, that whatever money should be advanced to him, within the sum for which the credit had been given, should be repaid upon demand, together with the legal interest.
([1776] 1981, II.ii.44, 299)
With cash accounts, there is no need to “keep [any] money unemployed to answering such occasional demands. When they actually come upon him, he satisfies them from his cash account with the bank, and gradually replaces the sum borrowed with the money or paper which comes in from the occasional sales of his goods” (II.ii.46, 300).
There was a lot of paper in Scotland during Smith’s time. Indeed, as we saw above, most of the circulating money was paper. Smith even claims that the spectacular economic growth of Scotland in the eighteenth century is due to the presence of these papers:
by the erection of new banking companies in almost every considerable town, and even in some country villages … 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 all kinds are commonly made. … That the trade and industry of Scotland … have increased considerably during this period, and that the banks have contributed a good deal to this increase, cannot be doubted.
(Smith [1776] 1981, II.ii.41, 297)
But how is it possible to generate enough trust to sustain it?
Again, Smith does not present the problem in these terms but we can infer the answer from his work. He seems to imply that at least the following factors are responsible for the generation of trust in the credit market: the personal wealth and reputation of the bankers combined with the unlimited liability of the banks, and the convertibility of paper money into commodity money. In addition, to further support this trust, it seems to me, Smith supports free competition among issuing banks. But he also advocates two specific regulations while objecting to others. He favors a ban on small bills and on the option clause (a clause that allows temporary suspension of convertibility of notes into specie [precious metal]), while he objects to monopolistic privileges for the two public banks of Scotland, the Bank of Scotland and the Royal Bank of Scotland. The effective signaling of the trustworthiness of individuals remains more complex and problematic. The “men of credit,” the guarantees required for the cash accounts, and competition seem to be the mechanisms he describes to signal trustworthiness of the borrowers. Let us analyze each of these factors.
The first two are based on a sort of personal trust, backed by legal guarantees. The unlimited liability of the partners in a bank implies that its partners are personally responsible for all the debt of the bank. If a bank caves to the temptation to over-issue paper in the attempt to increase its profits, and there is a bank run and the bank fails, the partners will have to use their personal wealth to cover all the liabilities of the bank. This liability arrangement implies two things. First, that the bankers tend to be responsible and careful in their lending, as a bad loan, or a series of bad loans, can mean a loss of their family wealth. Having the bankers’ personal assets on the line lowers the chances that the bank will become insolvent and increases the trust one has in the bank. Second, that someone who knows that the partners of the banks are very wealthy would be more willing to accept a note from that bank. If the bank runs into problems, the personal wealth of the partners will kick in and cover its losses. This is indeed what happened in the case of the infamous Ayr Bank (Munn 1981). The partners were extremely wealthy and well-known property owners. People were happy to receive their notes because they could trust the extent and the wealth of their property. And when the bank eventually failed, the partners used their family assets to liquidate the obligations of the bank: none of their clients lost a penny, while a vast amount of land was redistributed through this sale. Yet, the popularity and success of the Ayr Bank before its bust and the success of most other provincial banks testifies to the fundamental role of personal trust and the reputation of bankers in a system of unlimited liability. Systems of limited liability, on the other hand, may tend to be less stable. Partners are not personally responsible for the actions of the bank for more than the amount they have originally invested. So their reputation and personal wealth cannot play the same stabilizing role as in the system of unlimited liability (White 1995).
The more complex society becomes, the more impersonal and the less face-to-face it becomes, the more there is need for mechanisms that can supplement personal trust. Personal trust is no longer able to do all the legwork because of the higher information costs in an impersonal society. Personal trust still remains, but where it cannot reach, another trust-generating mechanism needs to step in. Market competition is, for Smith, one of the most important of these mechanisms (see also Seabright 2010). Yet, market competition does not substitute for personal trust; it simply fills in where personal trust cannot reach and may enhance personal trust where it does reach. With the increasing costs of verifying information that characterize impersonal exchange, lenders may attract riskier borrowers and not be able to distinguish them from the more prudent ones. Borrowers tend to overestimate their probability of success and therefore tend to over-borrow (Bentham 1796; Paganelli 2003). They also tend to like promissory notes more than loans in precious metals because promissory notes free idle capital, and because they could be paid back a little at a time. This, all things being equal, would increase the amount of credit given and therefore the amount of paper money in circulation. For Smith, bankers, inexperienced bankers at least, have incentives to over-issue paper money because they gain from the interest on the notes. Since the interest on the notes is revenue to the bank, the more notes issued, the more interest collected, the more revenue generated, and, allegedly, the higher the profits for the bank. And if banks discount bills of exchange with promissory notes rather than with gold and silver, they could make even more profit (Smith [1776] 1981, II.ii.43, 298–299). Creditors, therefore, are tempted to ask for over-issuing of credit, and banks are tempted to over-issue credit.
This is a problem because it increases the risk of holding notes and the probability that a bank may be subject to a run and become not just illiquid but insolvent. The history of Scottish provincial banks includes many of these cases over time, especially in the early expansionary period of the provincial banks. But Smith and history see the benefits of competition over time, especially in terms of building trust in the fiduciary medium, which eventually is reflected in the increased use and acceptance of it (Munn 1981; Checkland 1975b).
If a bank over-issues, for whatever reasons, that bank most likely will not only not increase its profits, but would increase its probability of failure. For Smith, a bank may over-issue, but this does not imply that note holders are willing to hold these extra notes. The note holders would indeed think of these extra notes as extra and would not be willing to hold them. Rather than holding paper money, the merchant has incentives to go to the bank and redeem the paper money for specie and send that specie abroad for a more fruitful investment. The bank is under obligation to pay on demand and it will have to exchange the note for gold and silver, unless it is willing to face the risk of a bank run, which would increase the probability of bankruptcy (WN II.ii.48, p. 301). To pay for the incoming notes, the bank needs specie. But if the bank over-issues, it will not have all that specie readily available. The bank must get gold and silver by borrowing from another nearby bank or, more commonly, from other banks in London. This is expensive, not only because of the transaction and transportation costs (the precious metals have to be physically transported from a bank (say, in London) to the local bank that over-issued), but also because often the rate at which the over-issuing bank can draw from other local banks and/or London banks is higher than the interest it receives from its borrowers. Indeed, “The Scotch banks, no doubt, paid all of them very dearly for their own imprudence and inattention” (Smith [1776] 1981, II.ii.56, 304).
As Smith points out, borrowing precious metals from other banks (and transporting them to the bank in need) to redeem notes can be done on occasions but not regularly. If it is done regularly, the bank will eventually go out of business. To avoid losing profits or generating bank runs, the banks learn to decrease the amount of issuing (II.ii.49–56, 301–304). This means that, at least after the first period of adjustment, it is possible to trust the bank notes and therefore to increase one’s willingness to hold and use paper, because the bank is more likely to behave judiciously. In an impersonal banking system, trust can therefore be built via convertibility of paper into commodities and the discipline of the market.
Despite the personal reputation and responsibility of the bankers and the institutional checks of guaranteed convertibility, the development of an expanding banking system may generate a level of impersonality that may breed inefficiencies, crises, and injustice. This is where Smith calls for free competition in issuing as well as for state regulation – to attempt to reduce the effects of the dominance of impersonality. By analyzing his call for regulations, the fundamental role of competition will emerge. So let us look at the banking regulation that Smith favors. Smith calls for two banking regulations: he wants to see a ban on small notes and a ban on the “option clause,” a clause that allows temporary suspension of convertibility of notes into specie.
Smith justifies the ban on small notes because he claims that with small notes the competitive checks may not work well due to excessive impersonality. People will be less reluctant to accept a small note of dubious or unknown origins than a big note of dubious or unknown origins, as the stakes are minor and the options are fewer. In Smith’s day, small notes were commonly used to pay for the salary of day laborers, in face of an increasingly chronic and severe absence of coins. The impersonality of the notes, in the case of small notes, may prove dangerous as small notes would tend to be over-issued and may cause extreme financial distress to the small-income earners who would most commonly use them. Smith therefore advocates banning notes of less than five pounds. Smith tells us, indeed, that,
where the issuing of bank notes for very small sums is allowed and commonly practiced, many mean people are both enabled and encouraged to become bankers. A person whose promissory note for five pounds, or even for twenty shillings, would be rejected by everybody, will get it to be received without scruple when it is issued for so small a sum as a sixpence. But the frequent bankruptcies to which such beggarly bankers must be liable, may occasion a very considerable inconveniency, and sometimes even a great calamity to many poor people who had received their notes in payment.
(Smith [1776] 1981, II.ii.90, 323)
This ban would confine notes to transactions between dealers and dealers, and not extend them to transactions between dealers and consumers (II.ii.92, 323). The number of dealers is significantly smaller than the number of consumers. Limiting the circulation of notes to dealers also increases the chances of increasing personal trust, as dealers tend to know each other.
The role of market checks was already mentioned above: with the exception of small-denomination notes, the temptation of over-issuing notes that a bank may have is constrained by the presence of other banks and the ability of a person to redeem notes on demand. If one person does not want to hold the notes of a bank, he or she can redeem the notes for gold or silver or take his or her business to another bank. This ability to reject unwanted money generates trust in the system. The preservation of this competitive check in the formation and maintenance of the fiduciary means of exchange is so important for Smith that he calls for government intervention to stop a mechanism meant to short-circuit it: the option clause.
If a bank accepts and discounts a note of another bank, it increases the trust in and the circulation of a competitor’s notes, thereby strengthening the competitor. At the beginning, provincial and public banks would not accept and discount rival notes. But eventually they did accept and discount rival notes, especially the ones of close competitors. This was because they saw it as a means to damage the rival bank and hopefully put it out of business. A bank would discount a competitor’s notes but then would keep them, rather than bring them to the issuing bank for redemption. When a bank had collected enough of a competitor’s notes, it would bring them in to ask for their redemption all at once. The issuing bank must have enough reserve to honor the notes. If not, the bank would risk a run and failure. To try to prevent liquidity problems caused by their rivals, banks started to issue notes with an option clause: the option was that the bank would convert the note back to precious metals upon demand, but with a delay of up to six months, while paying interest for those months. The clause, when exercised, would buy the bank time to find the precious metals that it did not have in reserve (Checkland 1975b; Munn 1981; Gherity 1995). For Smith, the option clause ([1776] 1981, II.ii.98, 325), which seems to be an instrument of stability, is only superficially so. In reality, it dilutes the incentive to restrain over-issuing by suspending convertibility. Trust in banks is now threatened and Smith calls for a ban on the option clause to maintain the trust in the institution.
I believe my reading of Smith is also indirectly supported by the severe criticisms that Smith offers of most of the other regulations present in banking. For example, Smith objects to the attempts of the two public banks to monopolize issuing ([1776] 1981, II.ii.41–42, 297–298), and he may even have been one of the forces that blocked the public banks’ petition for privileges to the parliament (Checkland 1975b). Additionally, Smith points out that, in North America, paper money does not come from banks but from the government. Government paper is made into legal tender. And legal tender forces people to accept a particular form of money, even if they otherwise would not. Legal tender substitutes, crowds out, and destroys trust (Frankel 1977). Force does not integrate personal and impersonal trust but eliminates it; it substitutes for trust by taking its place. Smith seems to imply that the laws establishing legal tender should be abolished to let natural trust re-emerge. So Smith tells us:
But allowing the colony security to be perfectly good, a hundred pounds payable fifteen years hence, for example, in a country where interest is at six per cent. is worth little more than fourty pounds of ready money. To oblige a creditor, therefore, to accept of this as full payment for a debt of a hundred pounds actually paid down in ready money, was an act of such violent injustice, as has scarce, perhaps, been attempted by the government of any other country which pretended to be free. It bears the evident marks of having originally been, what the honest and downright Doctor Douglas assures us it was, a scheme of fraudulent debtors to cheat their creditors.
([1776] 1981, II.ii.100, 326)
And he continues: “No law, therefore, could be more equitable than the act of parliament, so unjustly complained of in the colonies, which declared that no paper currency to be emitted there in time coming, should be a legal tender of payment” (II.ii.101, 327).
Finally, as mentioned above, Smith’s description of the invention of the cash account is telling of the fundamental role of personal trust in the issuing of fiduciary means of exchange. Signaling personal trustworthiness is difficult and costly. Scottish bankers created a way to make the signal effective: “Any individual who could procure two persons of undoubted credit and good landed estate to become surety for him” (II.ii.44, 299). This seems a clever way to reincorporate the personal trust and trustworthiness of the traditional “man of credit” (Baroni 2002) with an expanding banking system that may not as easily verify the personal signaling of trustworthiness. With the expansion of society and of banking, the role of signaling the trustworthiness of the “man of credit” decreases, as it becomes too costly to gather information. Today we substitute this expensive personal knowledge with the cheaper impersonal knowledge of credit scores. But this is an indication of both the importance and the challenges of signaling trustworthiness effectively.
Another aspect of signaling trustworthiness that proves challenging, both for Smith and for us, is linked to the above: What happens when wise banks reject a too risky credit extension? Smith tells us that traders use “shift of drawing and redrawing” to raise the money to use to over-trade ([1776] 1981, II.ii.65). This is an interesting twist on the ability of personal and impersonal circumstances to generate or destroy trust. As we saw above, for Smith the over-issuing of credit is dangerous. Banks have to be ready to fulfill their obligation at all times or they might generate bank runs and the very expensive attempts to replenish their coffers to fulfill their obligations (II.ii.48). Yet, banks may still over-issue (41–87). And one of the reasons for which “the circulation has frequently been overstocked with paper-money” (II.2.56) is the banks’ difficulties in gaining knowledge regarding the trustworthiness of their creditors.
Smith explains that banks may not understand what they are doing because projectors fool banks when traders draw and redraw upon one another. If they do it from the same banks, the bank will eventually realize what is going on because personal knowledge can be built. But traders are well aware of the danger of personal knowledge in this case. In the attempt to increase impersonality and anonymity and break down personal knowledge, traders start using different banks, making it increasingly difficult for banks to gain that kind of personal knowledge required to give trust or not. Smith explains this tension by claiming that there are two different kinds of bills: “real bills of exchange” and “fictitious bills of exchange.” He tells us that
When two people, who are continually drawing and re-drawing upon one another, discount their bills always with the same banker, he must immediately discover what they are about, and see clearly that they are trading, not with any capital of their own, but with the capital which he advances to them. But this discovery is not altogether so easy when they discount their bills sometimes with one banker, and sometimes with another, and when the same two persons do not constantly draw and re-draw upon one another, but occasionally run round a great circle of projectors, who find it for their interest to assist one another in this method of raising money, and render it, upon that account, as difficult as possible to distinguish between a real and a fictitious bill of exchange; between a bill drawn by real creditor upon a real debtor, and a bill from which there was properly no real creditor but the bank which discounted it; nor any real debtor but the projector who made use of the money.
([1776] 1981, II.ii.72, 311–312)
When a banker realizes that he is discounting “fictitious bills,” it may be too late. “Real bills” can be trusted because they are based on personal knowledge. “Fictitious bills” are impersonal, and of a constructed impersonality meant to hide the personal details of the bill – they should not be trusted.
Whether Smith was an early promoter of the “Real Bill” doctrine or whether the Real Bill doctrine works or not has been discussed elsewhere (Arnon 1999; Glasner 1992; Santiago-Valiente 1988; Selgin 1989) and it is not relevant here. What matters in this context is to notice how, in Smith’s analysis, personal knowledge about the projectors helps maintain a healthy banking system, while the unscrupulous projectors try to dilute personal knowledge by attempting to create anonymity, which would maintain the fictitious facade of personal trustworthiness for them while eroding institutional trust. Yet Smith seems to trust the impersonal system of competition among issuing banks to readjust the circulating notes to an efficient and safe level (Cowen and Kroszner 1989; White 1995).
Smith’s analysis of banking may therefore be interpreted as an example of an analysis of this mix of institutional and personal trust. Complex commercial societies cannot thrive on an either–or system of trust. There is no opposition between personal trust and impersonal institutions. There is, on the other hand, a healthy interaction of personal and impersonal situations, where personal and impersonal trust act as complements for each other, not substitutes. The necessary presence of institutional trust does not replace personal trust. On the contrary, it enhances it and it fills in the spaces that personal trust, by its personal nature, cannot fill. Indeed, the banking system that Smith describes as generating prosperity is a system where the impersonal trust of unlimited liability and of banking regulations work together with the personal trust and trustworthiness of the bankers and of the “men of credit” to create a healthy and prosperity-generating banking system. The two forms of trust become integrated in a successful commercial society where bankers and customers are able to merge their reliance on personal and institutional forms of trust to form a more secure basis for banking activity.
We can therefore imply from Smith’s works that trust is possible in an extended, anonymous society and that his understanding of community is wider than that seen in small face-to-face societies. Smith was well aware that the sort of experience of trust that exists in a small community is very different from that which exists in a large commercial society. But rather than arguing in favor of a return to a more communal form of life, which he believed would necessarily limit the market and prevent the full exploitation of the division of labor, he instead sought ways to enhance the levels of trust and trustworthiness between individuals. Rousseau argued that mankind had been corrupted by the move from small-scale communities to larger societies. Smith, on the contrary, provides us with an analysis of the development of banking from which we can infer how the personal interactions of a small community can be supplemented by trust-generating institutional features such as the legal system and competition. Institutional bases of trust make up for a weakening of personal knowledge and allow for the enhanced exploitation of the division of labor.
Where Rousseau saw commerce in opposition to community and as a threat to the personal bonds of communal life, Smith instead sees the two as complementary and mutually reinforcing. Rousseau’s belief that the development of the impersonal institutions of a commercial society supplanted the genuinely human personal relationships of small-scale communities was comprehensively rejected by Smith. In Smith’s view, the two forms of relationship can be integrated in the behavior of commercial actors. His views on banking give one example of how this is the case. It is indeed possible to infer from Smith’s work that, in his view, there is no simple binary opposition between interactions that exist on a personal and an impersonal level.
In Smith’s account of banking, he depicts a system of competitive banks that are “kept” honest by the rigors of competition and the correct application of regulation. The result is a banking system where we are able to rely on others, not always because we know them personally as members of the same community, but because the sense of communal experience is extended to all of those whom we come to trust as bound together by the institutions of a commercial society. From Smith’s analysis of banking we can extract the point that the success of the economy is based on interdependence, and that this, in turn, is based upon the interaction of personal and institutional trust.
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