Mervyn King: Trusting in money - from Kirkcaldy to the MPC
Speech by Mr Mervyn King, Governor of the Bank of England, delivering the Adam Smith Lecture
2006, St Bryce Kirk, Kirkcaldy, Scotland, 29 October 2006.
I am indebted to Alex Brazier, Chris Salmon, Morten Spange and Tony Yates who have worked closely with me and are
effectively co-authors. I am also grateful to Charlie Bean, Tim Besley, Iain McLean, Mark Cornelius, Andrew Hauser, James
Proudman and Peter Rodgers for their helpful comments and to Kath Begley for valuable research assistance.
* * *
My Lord Lieutenant, Chancellor, My Lords, Ladies and Gentlemen,
In June 1767, Adam Smith wrote from Kirkcaldy to his dear friend David Hume:
"My Business here is Study in which I have been very deeply engaged for about a Month past. My
Amusements are long, solitary walks by the Sea side. You may judge how I spend my time. I feel
myself, however, extremely happy, comfortable and contented. I never was, perhaps, more so in all
my life".1 There is more wisdom in that remark than most busy people would ever care to admit, and it
was perhaps that contentment which allowed his mind to wander far and wide - across the sea by
which he walked - to imagine a society and an economy very different from the one in which he lived.
Last year I was in the audience when Alan Greenspan delivered the Adam Smith Lecture. Now I too
share the privilege of speaking in the Kirk where Gordon Brown's father used to preach to the people
of Kirkcaldy. Double trouble, you might think. I am particularly mindful of the controversy which
Greenspan's lecture stirred in the world of Smith scholars: "an unseemly battle is being fought over the
soul of Adam Smith", as one remarked. It is a sign of the resurgence of interest in Adam Smith that at
almost every point on the political spectrum one can find people who claim Smith as their own. But, in
a lecture in 1926 to commemorate the 150th anniversary of the publication of The Wealth of Nations,
the economist Jacob Viner wrote, "Traces of every conceivable sort of doctrine are to be found in that
most catholic book, and an economist must have peculiar theories indeed who cannot quote from the
Wealth of Nations
to support his special purposes".2
My intention today is certainly not to propose "peculiar theories", but to examine the importance of
social institutions in a market economy. Self-interest explains many economic decisions. But a market
economy also requires social institutions.3 They represent collective agreements about how to
constrain our actions. Some social institutions constrain our individual actions. For example, a market
economy cannot flourish in a world of anarchy in which we suspect that everyone else will cheat. If I
lend you money it is in both our interests that there be some mechanism by which repayment can be
enforced. So property rights, and courts to enforce contracts and adjudicate competing claims are
examples of some of the social institutions required to support a market economy.
But there are other, and for my purposes more interesting, social institutions which constrain our
actions, both now and in the future. In particular, it is on the need to constrain our
collective future
collective decisions on which I shall focus this evening. Such constraints are necessary to support the
willingness to make transactions. For example, if people believe that there is a high probability that
investment made today will be confiscated by the government in the future, they are not likely to make
that investment. It would be beneficial if we could constrain ourselves not to confiscate in future.
Constitutions can be rewritten, property rights revoked, and revolutions have been known to occur,
illustrating the point that, as a society, we can never commit future generations - or even our future
selves - to collective decisions. There is no way of enforcing that commitment. But we can try to find
ways of making it more or less credible that we will, collectively, act in a way that is conducive to our
long-run prosperity. So one of the most important ingredients of a successful market economy is the
set of institutions that constrain our future collective behaviour. Such institutions have cultural and
political roots, but they have economic effects. My focus tonight will be on money: money as a social
institution that, in the words of Joel Gray in the 1972 film of Cabaret, makes the world go round. And I
shall try to relate the origins of money as a social institution to the role of the Monetary Policy
Committee today.
Let me begin, though, with Adam Smith himself. Despite a rather solitary life, much of it here in
Kirkcaldy, and shunning invitations to join friends in Edinburgh, let alone London, he wrote two great
The Theory of Moral Sentiments An Inquiry into the Nature and Causes of the Wealth of
works - and
Nations - that owe much to careful observation of the world and contain numerous practical examples
of how industry and society worked. They are no dry academic treatises but commentaries on the
world around him. They contain many insights, two of which are particularly relevant to my theme.
First, to reap the benefits of the division of labour requires social institutions that give confidence to
people to take up specialised employment. Social institutions and market economies go hand in hand.
Second, people who, for the most part, pursue their own self-interest, are also prepared to stand back
and ask how their actions should be constrained by social institutions. Such institutions arise because
we build them.
On the first, The Wealth of Nations begins with the most famous example of Smith's commentary. He
explains the idea of the division of labour by looking at a "very trifling manufacture", namely "the trade
of the pin-maker":
"a workman not educated to this business ... could scarce, perhaps, with his utmost industry, make
one pin in a day, and certainly could not make twenty. But in the way in which this business is now
carried on, ... it is divided into a number of branches ... One man draws out the wire, another
straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; ... the
business of making a pin is, in this manner, divided into about eighteen distinct operations".4
Smith describes seeing a small factory of this kind in which the daily output of pins was almost 5,000
for each person employed. Specialisation increases productivity. The division of labour permits "this
great increase of the quantity of work".5 But the higher living standards which the division of labour
permits require institutions that allow us to exchange what we each produce. Smith described how "in
a nation of hunters, if any one has a talent for making bows and arrows better than his neighbours he
will at first make presents of them, and in return get presents of their game".6 But a man who spends
all day making arrows to swap them for meat gives up the chance of hunting himself for the chance of
sharing in a larger catch. For the group to specialise, the hunter who turns arrow-maker has to be sure
that his partner in trade will deliver the "present" of meat. When the timing of these exchanges is not
coincident, there is a need for social institutions to prevent one party reneging on the transaction, and,
in particular, for money - an issue that I will return to later.
Smith's second insight was that the social institutions necessary to exploit the full potential of a market
economy were not derived from the relentless pursuit of selfinterest, but from the recognition that we
Theory of Moral Sentiments
all benefit from what he described in as the exercise of "sympathy". In
other words, we step back from our immediate situation and ask: how do my actions affect others?
Answering that requires an ability to imagine ourselves in others' shoes - "sympathy". That sympathy
in the hunter, for example, might mean feeling the pain of a starving arrow-maker.
Smith argued that we "are endowed with not only a desire of being approved of, but with a desire of
being what ought to be approved of...".7 He talked about an "impartial spectator" whose judgment we
imagined and imposed as a constraint on our behaviour. Smith thought the "impartial spectator"
fundamental to an orderly and prosperous society. It is what stops the hunter from breaking his
promise to share his meat and, knowing that, it is what gives the arrow-maker the confidence to stop
hunting. It was the "main pillar that upholds the whole edifice. If it is removed, the great, the immense
fabric of human society... must in a moment crumble to atoms".8
But Smith recognised our own frailty. The temptation to follow our immediate selfinterest could
sometimes be overwhelming, and our own 'selfish passions' would take precedence over the judgment
of the "impartial spectator". As commercial society evolves, and we exchange with those much more
remote from us, our human frailties matter more. We need a mechanism to help us exhibit the
"sympathy" that is both desirable and necessary.
We need social institutions to bolster our often erratic ability to see things from the perspective of the
impartial spectator. These social institutions are not just given to us. We choose to build them as a
framework for collective decisions that constrain individual behaviour. We make them, and sometimes
we break them.
These two points from Smith's commentary - the importance of institutions and our desire to build
them - are closely related to the role of trust in a modern economy.9 How could we drive, eat or even
buy or sell unless we trusted other people? It is surely trust not money that makes the world go round.
Indeed, we shall see that money works only when it is trusted. But human frailty implies that trust can
be placed more easily when it is supported by institutions. Those institutions may well require trust, but
equally trust requires institutions.
Many economists - including Viner in the essay I have already quoted - have regarded Smith's
The Wealth of Nations
analysis of self-interest in as inconsistent with his discussion of "sympathy" in
his Theory of Moral Sentiments. In one of the best-known sentences from The Wealth of Nations,
Smith points out "It is not from the benevolence of the butcher, the brewer, or the baker, that we
expect our dinner, but from their regard to their own interest".10 Smith, so the critics argue, failed to
integrate the thinking in his two great works.11 It would not, to coin a phrase, be a sensible division of
labour for me to enter the debate about whether his two great works form a consistent whole or
represent two different and inconsistent viewpoints. Smith was a cautious and often obscure author.
What we know of his theory of law and government is through the notes of two students who attended
his lectures on jurisprudence. His failure to produce the projected third great work means that we do
not know what institutions he thought would best support a market economy. But irrespective of what
Smith thought, two things are clear. History is littered with failed attempts to order society without
reference to individual incentives. And we understand the need for social institutions to constrain our
actions.
Since Smith, economists have underplayed the importance of institutions, although there have been
notable exceptions such as Douglas North and Ronald Coase. Over the centuries, theories of a
competitive market economy have been refined. From these theories flows the remarkable result that,
under certain conditions, the pursuit by each person of their individual self interest leads to a more
efficient outcome for society as a whole. That work reached its apogee in the post-war work by
Kenneth Arrow and Gerard Debreu. Those economic models are, however, silent about many of the
institutions that are fundamental to the results.12 But without the appropriate institutions we tend to
anarchy not prosperity. The challenge facing us is to design and maintain the right set of institutions or
8
Theory of Moral Sentiments, II,ii,3.3,p86.
9
In her 2002 Reith lectures "A Question of Trust", Onora O'Neill argued that in order to interact with others, both as
individuals and institutions, trust plays a crucial role.
10
Wealth of Nations, I,11,2,p26.
11
Rothschild (2001) puts Smith's writings in the context of the Enlightenment and, while pointing to the complexity of Smith's
views and his caution in expressing them in public, paints an overall picture of a man who is not best described as a split
personality.
12
Economists have grappled with the challenge of understanding worlds in which there are not markets for everything. Coase
understood the existence of firms to be a manifestation of how market based exchange between employers and employees
was not efficient (see his 1991 Nobel lecture, for example). More recently, economists like Kiyotaki and Moore (an example
is their 2002 paper) and many others have built models in which debt markets are incomplete because it is costly to enforce
contracts, and which constrain the amount individuals can credibly borrow and pay back. These models can also be used to
explain how money comes to exist, as I discuss below. Another body of work that seeks to study the institutions that
underpin market exchange is the subject that has come to be known as 'law and economics'. Scholars in this field study the
economic origins and consequences of the legal system. See, for example, many works by Gary Becker, Ronald Coase and
Richard Posner.
BIS Review 102/2006
laws, and to abolish the unhelpful ones. And it is that challenge of institutional design to which I now
want to turn.
As Governor of the Bank of England, you will not be surprised to learn that money is a social institution
close to my heart. It is crucial in facilitating exchange and therefore, in allowing the division of labour.
Smith explained that "when the division of labour first began to take place, this power of exchanging
must frequently have been very much clogged and embarrassed in its operations."13 He was referring
to the absence of what economists call a 'double coincidence of wants': the hunter wants arrows and
the arrowmaker wants meat. Without that double coincidence exchange cannot take place through
barter.
Promissory notes, or 'IOUs', can act as promises to deliver in the future. And they could, in principle,
circulate - we could then exchange with people whose own produce we don't actually want. Imagine
Smith's primitive arrow-maker doesn't want meat. He can still exchange his arrows for a promise of
meat from the hunter. But he will do so only if he is sure that others, whose output he does want, will
accept the hunter's IOU. And that depends on whether the arrow-maker believes that others will trust
the hunter's promise to pay. Once future delivery is part of the exchange, trust is essential.
So we need to be able to trust in the promises of others to pay. In large commercial societies, where
the 'I' is remote from the 'U', relying on our own human "sympathy" is unreliable - debtors would be
tempted to default with those they have never met. We recognise that we need a social institution.
One such is a legal system that can be used to enforce IOUs. But enforcement is costly. These
problems encouraged us to build another institution - money. This recognition that money is
necessary because of our own frailty in honouring IOUs suggests that "evil is the root of all money".14
Smith had seen how commodities like "dried cod at Newfoundland; tobacco in Virginia; sugar in some
of our West India colonies" had been used as money and how there was even "a village in Scotland
where it is not uncommon,..., for a workman to carry nails instead of money to the baker's shop or the
alehouse."15 These commodities guaranteed a double coincidence of wants - most people smoked,
needed to preserve meat with salt, and ate fish. And because these commodities have intrinsic value,
the trustworthiness of our trading partners was not an issue. Salt is salt whether offered by an honest
trader or not.
But it is costly to produce and hold large stocks of these commodities. Salt kept to one side for use as
money has to be mined, and cannot be used to preserve meat. And the quality and quantity of the
commodity is not easily verifiable. In fact, this was a pressing concern for Smith as a university lecturer
because he would have been paid in person, in coin or specie, by his students before the lectures
began, something which I regret I forgot to do this evening. Smith's close friend, the chemist Joseph
Black, said that he was "obliged to weigh when strange students come, there being a very large
number who bring light guineas, so that I should be defrauded of many pounds every year if I did not
act in self-defence against this class of students."16
And so we reach paper money. I have here a £20 note. What is it? Money you say. Surely it is just a
piece of paper. What is the difference between a piece of paper and money? You can "buy stuff with
it".17
Why can we get anything in exchange for these intrinsically worthless pieces of paper? It is because
those to whom we give the paper expect that they will, in turn, be able to get something for it. That
rests on the expectation that whoever they pass the paper to will in their turn be able to get something
for it, and so on, ad infinitum. In short, the value of money depends on trust.
But it is not easy to trust paper money unless we trust the issuer. Much of the financial history of the
past 150 years is the story of our collective attempts to manage paper money. In a democracy, we
can't force people to use paper money, although after the French Revolution the Jacobins had a try.
They made it a capital offence to use commodities as money! This was a desperate and unsustainable
action resulting from the Jacobin policy of debasing their paper money - the Assignat - to make up for
a collapse in tax revenues and to finance a war against Prussia.
A more sensible solution is to create institutions in which we can have trust. On the front of this Bank
of England £20 note is written "I promise to pay the bearer on demand the sum of Twenty Pounds". In
essence, the promise is that the "stuff" that you can buy with this note does not change much from one
year to the next. In other words, the general purchasing power of the note is broadly stable - we have
price stability. Our ability to maintain price stability depends upon an institutional framework which is
expected to persist. That depends on all of us acting collectively - the value of a nation's money is
inherently a political choice. Inflation arises when the collective political commitment to maintain price
stability weakens.
When high rates of inflation are anticipated, people wisely avoid holding paper money. As I said in my
Ely lecture in 2004, "the demand for money today depends upon expectations of our collective
decisions about the supply of money tomorrow." In the twentieth century Germans saw their savings
wiped out by hyperinflation. And as recently as 1990, Argentina experienced hyperinflation. I have
been told that when people gave up using paper money in Argentina, they resorted to IOUs which
were taken to the local Catholic priest for endorsement. Those IOUs were trusted because to renege
on a promise endorsed by the priest would have very serious consequences, whether in this life or the
next.
It is sometimes tempting - as the examples of the Jacobins, Germany and Argentina show - for
issuers of money to issue too much of it: cheap money and plenty of it, as the saying goes.18 A public
monopoly of paper money raises the question of how can we prevent the institution managing that
money from abusing its issuing power. We cannot commit future generations - or even ourselves - to
a particular policy. So how can we design an institution to create the reasonable expectation that
money will retain its value?
In 1997 a new institution - the Monetary Policy Committee of an independent Bank of England - was
set up. And for the past decade inflation has been low and stable and economic growth more stable
than at any time in living memory. Just as importantly, yields on government bonds indicate that
inflation is expected to remain low over the next fifty years. Gordon Brown deserves great credit for
taking the time to design the institutional arrangements so carefully in advance. This was not a
traditional "make it up as you go along" approach to British economic policy.
In fact, the design is a good example of how to overcome the fundamental constraint faced by social
institutions. That constraint is that it is both impossible and undesirable to enforce binding
commitments on the collective decisions of our successors. It is impossible because there can be no
outside enforcer. It is undesirable because we cannot imagine or articulate every possible future
development.
As such, institutions must have, and be likely always to have, widespread support. Their design must
meet three principles. First, in order to maximise the breadth and permanency of support, the objective
should be as clear as possible. Second, the institution must have the appropriate tools and
competence to meet those objectives and be held accountable for doing so. Third, for the institution to
command widespread support, the design must reflect history and experience.
How do our current monetary arrangements meet these requirements?
First, the objective - the inflation target - is clear. It is 2% for CPI inflation.
Second, responsibility for setting interest rates has been delegated to a group of people - the
Monetary Policy Committee - with the appropriate technical competence and who face incentives
focussed on meeting the target. Expert judgment is needed because changes in the way the world
works mean that monetary policy cannot be run on autopilot.19 The members of the MPC are able to
exercise their own discretion over how to meet the target. Members of the Committee are held publicly
accountable for their individual votes.
Third, these arrangements reflect both our experience of previous monetary failures and the nature of
accountability in our political system. The separation between the elected government which sets the
target and the Monetary Policy Committee which makes the month-to-month decisions on the level of
interest rates necessary to meet the target is natural in our Parliamentary system. Since countries vary
in their political constitutions it is not surprising that their monetary constitutions also differ.
The apparent success of the MPC has led many to ask whether aspects of its design could be carried
over to other areas of public policy. The principles of widespread support for the objective of policy, the
incorporation of the lessons of history, and the need to ensure technical expertise have general
applicability. In the case of monetary policy, there is widespread agreement on the objective of low
inflation, the design has taken on board the lessons from our post-war experience about the difficulty
of targeting monetary aggregates or the exchange rate, and the MPC has been set up to include
appropriate expertise. Moreover, the MPC has to set only a single instrument - Bank Rate.
It may not be easy to find other areas of policy to which the MPC example can be immediately applied.
But it is certainly worth thinking imaginatively about the possibilities for in other areas in which trust in
future collective decisions is necessary. Pensions policy, for example, has for years been bedevilled
by a combination of extraordinary technical complexity, which means that decisions take a long time to
reach, and the reversal of policies adopted by earlier generations. This is very much an area where we
have been unable to constrain future collective decisions. And it is one that would benefit from greater
stability of policy.
At the international level, the importance of constraining future behaviour can be seen in such diverse
areas as trade policy and climate change. The difference in the degree of agreement on the objectives
of policy can be seen in the difference between the institutions that have been set up to deal with
those issues. But even the World Trade Organisation, despite the critical importance to the world
economy, and especially its poorer citizens, of opening up trade, has found it difficult to arouse
sufficient "sympathy", to use Smith's word, to get agreement on constraints on our future behaviour.
But let us not be pessimistic. The three principles of institutional design may be helpful in thinking
about future collective decisions in areas as diverse as health, education, pensions and taxation, just
as they were in constructing a new monetary policy framework. But that is for others to take forward.
Conclusions
I recognise that the success of central banks in keeping inflation low and stable over the past decade
may owe something to good fortune as well as to good policy. But, as the legendary football manager
Bill Shankly used to say, "it's strange, but the better we play, the luckier we get". What really matters,
however, is that we as central bankers acknowledge that we owe everything to the design of the
institutional framework. As I have argued this evening, a central part of Adam Smith's legacy is an
appreciation of the essential role played by social institutions. So it is appropriate that it was another
son of Kirkcaldy who, over two hundred years later, created the new institutional framework for the
The
Bank of England in 1997. As Niccolo Machiavelli wrote in Prince, "Nothing brings a man greater
honour than the new laws and new institutions he establishes". A Scotsman founded the Bank of
England, and it took another to reform it. Next year we celebrate the tercentenary of the Act of Union,
an Act strongly supported by Adam Smith. And we now have a successful and prosperous union
between our two countries with a common monetary institution which embodies the ideas not only of
Adam Smith and his great friend David Hume, but also of the key principles that should govern
institutional design.
From the division of labour in the pin factory to the need for our mutual "sympathy" to be embodied in
carefully designed institutions, Smith's writing is remarkable by its comprehensive and eclectic
examination of ideas and facts. So it is appropriate that tonight here in Kirkcaldy, where Adam Smith
found contentment in study and reflection, I can announce that tomorrow the Bank of England will
reveal its new £20 note. And the figure celebrated on the new note will, of course, be Adam Smith -
the first economist and the first Scotsman to appear on a Bank of England note. From next spring,
when visitors to our country look carefully at their new £20 notes, they will be able to see an engraving
showing the division of labour in pin manufacturing with the words "and the great increase in the
quantity of work that results". I hope they will absorb the lesson that specialisation in production and
trade across the world are the way to improve living standards in all countries - rich and poor alike.
And perhaps when they return home they will press their own politicians to support the opening up of
trade which has been at the heart of the British Government's efforts to reform the world economy.
So you should be proud of your famous son who, despite being "an absent-minded professor" who led
a "quiet, uneventful life", influenced the way the whole world thinks about the route to economic
prosperity.20
Let me conclude by returning to the words of Jacob Viner:
"In these days of contending schools, each of them with the deep, if momentary, conviction that it, and
Wealth of
it alone, knows the one and only path to economic truth, how refreshing it is to return to the
Nations with its eclecticism, its good temper, its common sense, and its willingness to grant that those
who saw things differently from itself were only partly wrong".21
Truly, Adam Smith was a man of the Scottish Enlightenment, and I am delighted that from next year
his face will look out at us from our banknotes.
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21
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