A severe financial crisis unfolded in 1772 when the London banking house of Neale, James, Fordyce, and Down went under, after a rogue partner ran up massive trading losses. Ten London banks subsequently failed, and the contagion quickly spread to Scotland, causing the collapse of the country's largest bank, Douglas, Heron & Company. Tyler Beck Goodspeed analyzes the regulatory intervention that, in his view, destabilized the Scottish banking system and set it up for failure. An act of Parliament passed in 1765 to regulate banking in Scotland had the unintended consequence of reducing the resiliency of the Scottish banking system, he argues. The Bank Act banned bills in denominations under £1 and prohibited “optional clauses,” which had allowed note issuers to defer redemption in specie for six months at 5 percent interest. The act was intended to raise barriers to entry in Scottish banking, and it succeeded. Between 1749 and 1765, the average starting capital of new banks was just over £9,000, but jumped to more than £84,000 between 1765 and 1772. The shock emanating from London in the latter year hit a banking system with a smaller number of bigger banks—banks that lacked the failsafe previously offered by optional clauses.

The Bank Act, Goodspeed argues, was based on a misdiagnosis of the ills of the Scottish monetary system. Scottish bankers—and Adam Smith—were concerned in the early 1760s about “an acute scarcity of coin, an adverse exchange rate [with London, and] a chronic drain of specie” (p. 29). The larger banks, with Smith's support, viewed the excessive issue of paper money, especially in small denominations, and the proliferation of small-time bankers as the root cause of the problem. The Bank Act, which struck at these perceived weaknesses, was an instance of regulatory capture, Goodspeed suggests. The larger banks solicited it, and directors of these institutions who sat as MPs shepherded it through Parliament. But in fairness to these actors, the legislation was also a genuine effort to grapple with real problems in Scottish banking, the origins of which neither Smith nor the bankers fully grasped.

The true problem, Goodspeed argues, was Scotland's vulnerability to large, hot money flows. Between 1745 and the late 1760s, the country “resembled a typical fast-growing emerging economy, with a current account deficit balanced by large capital inflows” (p. 30). When the Seven Years’ War (1756–1763) began, investors rushed to take advantage of attractive opportunities in the British public debt. The resultant outflows of money were mostly offset by higher wartime demand for Scottish goods, but poor harvests in 1756 and 1762 triggered severe balance-of-payments crises. Large quantities of specie were drained out of the Scottish economy to London and, to defend their reserves, Scottish banks selectively invoked the optional clause against English speculators. Optional clauses thus functioned as informal capital controls in a context where usury laws prevented Scottish banks from raising deposit rates. The proliferation of small-denomination bills was a response to the outflow of specie, not a cause.

Legislating Instability is a model of tight arguments, expressed clearly, supported by a well-chosen conceptual apparatus and deft use of both quantitative and qualitative evidence. This is economic history of a high caliber. Where the book seems a little less compelling is in its treatment of Adam Smith and his views on the problems of Scottish banking. Goodspeed argues convincingly that Smith misunderstood the monetary problems of Scotland in the 1760s and contributed to the misguided regulatory decisions embodied in the Bank Act. He explains Smith's stance by reference to his closeness to the world of Scottish banking—for example, to the Duke of Buccleuch, one of his chief patrons and a partner in Douglas, Heron & Company. Smith is part of what was “captured” in this instance of regulatory capture.

This is a reasonable argument, and an interesting one. But it is unsatisfying, or at least incomplete, as an explanation of Smith's attitude. Smith's propensity to link Scottish monetary problems in the early 1760s to an excessive issue of paper money seems consistent with a long-standing suspicion he shared with his friend David Hume that it might be difficult to keep paper money within judicious limits. It is striking that Smith immediately follows his discussion of Douglas, Heron & Company in The Wealth of Nations with a paragraph on John Law's “Mississippi scheme”—which was inspired by ideas about money that, Smith feared, “still continue to make an impression upon many people, and have, perhaps, in part, contributed to that excess of banking, which has of late been complained of both in Scotland and in other places” (book 2, chap. 2, sec. 78). Smith was primed intellectually to worry about the over issue of paper money and anxious to inoculate his countrymen against extravagant faith in its potential. Situating Smith's response to Scottish monetary problems in a broader intellectual frame would have complemented Goodspeed's perceptive analysis of the role Smith played in legislating instability.