In 1772, at the height of Scotland's worst banking crisis in two generations, David Hume wrote to his close friend Adam Smith. After recounting the bank closures, industrial bankruptcies, spreading unemployment, and even growing "Suspicion" of the soundness of the Bank of England, Hume asked Smith, "Do these Events any-wise affect your Theory?". They certainly did. Smith's analysis of the role of banking in The Wealth of Nations, published just four years later, clearly reflected the lessons he took away from the 1772 crisis. In contrast to the doctrinaire antiregulatory ideology with which he is usually associated by today's economists, Smith favored such measures as usury laws-- specifically, no lending at interest rates above 5 percent - and restrictions on the obligations that banks could issue.
Published Fall 2010
The lessons learned from the recent financial crisis should significantly reshape the economics profession's thinking, including, importantly, what we teach our students. Five such lessons are that we live in a monetary economy and therefore aggregate demand and policies that affect aggregate demand are determinants of real economic outcomes; that what actually matters for this purpose is not money but the volume, availability, and price of credit; that the fact that most lending is done by financial institutions matters as well; that the prices set in our financial markets do not always exhibit the “rationality” economists normally claim for them; and that both frictions and the uneven impact of economic events prevent us from adapting to disturbances in the way textbook economics suggests.