Superphysics Superphysics
Chapter 2h

How Drawing and Redrawing Works

by Adam Smith Icon
8 minutes  • 1645 words
Table of contents

65 More than 25 years have passed since the paper money issued by the Scottish banks was more than fully equal to what the national circulation could easily absorb and employ.

Those banks gave more than all the assistance possible to Scottish traders and entrepreneurs.

The traders and entrepreneurs had overtraded a little.

  • They brought themselves either a loss or a profit reduction
    • This always results from the smallest degree of overtrading.
  • They wanted to get more assistance from the banks.
  • They thought that those banks could extend their credits to whatever sum they wanted, with only a few reams of paper as expense.
  • They complained of the contracted views and dastardly spirit of the bank directors who did not extend their credits relative to the expansion of the country’s trade.

The traders equated the expansion of national trade to the expansion of their own private trade, which was being limited by:

  • their available capital, or
  • what they could borrow from private people.

They thought the banks were honour-bound to:

  • supply the deficiency, and
  • provide all the capital they wanted.

The banks, however, thought otherwise and refused to extend their credits.

Some of those unfortunate traders who were near bankruptcy turned to drawing and redrawing.

  • It was an expensive way to extend credits.
  • This practice of raising money had been long known in England.
  • It was done often during the Seven Years’ war, when the high profits of trade afforded a great temptation to overtrading.

From England, it was brought into Scotland, where it was done on a much greater extent than in England, because of Scotland’s very limited commerce and capital.

66 The practice of drawing and redrawing is so well known to all businessmen that it is unnecessary to explain it. But I will still explain it because:

  • this book might be read by non-business people, and
  • its effect on banking might not be understood even by businessmen.

67 The customs of merchants were established when the barbarous laws of Europe did not enforce the performance of contracts.

During the last two centuries, the customs of merchants have been adopted into the laws of all European nations.

Extraordinary privileges were given to bills of exchange to the point that money is more readily advanced through them than any other kind of obligation, especially when they are made payable within a short period as 2-3 months.

Superphysics Note: Drawing and Redrawing a Cheque

An example of a bill of exchange is a cheque

  • Buyer “B” owes $100 to Seller “S” for some goods which B bought.
  • B writes a check or bill of exchange for $100 to S, payable in 2 months.
  • But S also owes $100 to Friend “F” so he endorses the bill to F so that B will pay F.
  • F owes money to Cousin “C” so he endorses it to C, too
  • B is the drawee or acceptor or payer
  • S, F, and C are the drawers or payees
  • S and F are endorsers
  • An unpaid bill is called a draft

If the acceptor does not pay the bill as soon as it becomes due, he becomes a bankrupt from that moment.

  • The bill is protested and it returns to the drawer.

If the drawer does not immediately pay it, he likewise becomes a bankrupt.

  • The bill passes through other drawers who successively advance the money or goods in the bill to one another.

All the drawers write their names on the back of the bill confirming the receipt of the money or goods, becoming endorsers.

  • Each endorser-drawer becomes liable to the owner of the bill for those contents.
  • This is done before the owner presents the bill to the acceptor for payment.
  • If the endorser-drawer fails to pay, he too becomes a bankrupt.

The drawer, acceptor, and endorsers of the bill can all be persons of doubtful credit.

  • The shortness of the due date gives some security to the bill’s owner.

All of them may become bankrupts, but there is little chance that they will all become bankrupt in so short a time. A weary traveler says to himself:

“This house is crazy and will not stand very long. But there is little chance that it will fall tonight, so I will sleep in it tonight.”

68 The interest on bills was 5% in the year. The commission was never less than 0.5% on each draft.

Let us suppose that Trader A in Edinburgh draws a $100 bill on Trader B in London on January 1, payable after two months or on March 1. In reality, B in London owes nothing to A in Edinburgh.

  • B agrees to accept or pay the bill of A on the condition that on February 28, B shall redraw another $100 bill on A payable after 2 months or on April 28, with interest and a commission at $105.5.
  • On April 27, A draws a second bill on B, to be due on June 27 for $106.03.
  • On June 26, B draws another bill on A, payable 2 months on August 26 for $106.56

This practice has sometimes gone on for several months and years. The bill always returning on A with the accumulated interest and commission of all the former bills. This commission was repeated more than 6 times in the year.

Whatever money A might raise must have, cost him something more than 8% in the year [5% + (0.5% * 6)] and sometimes a great deal more:

  • when the price of the commission happened to rise, and
  • when A was obliged to pay compound interest on the interest and commission of former bills.

This practice was called raising money by circulation.

69 In a country where most ordinary profits in mercantile projects run between 6-10%, it was pure speculation to predict a good profit after paying the enormous cost of borrowed money.

Many vast projects were carried on for several years with only drawn and redrawn bills*.

*Superphysics note: Nowadays, this is similar to venture capital werein the angel investor sells his shares to a venture capitalist who then sells it to another even if the business is running at a loss.

The entrepreneurs had golden dreams of great profit. After waking up at the end of their projects or when they could no longer continue them, they very seldom found great profits.

70 Trader A in Edinburgh regularly discounted with some Edinburgh bank the bills he drew on B, 2 months before they were due.

  • Trader B in London regularly discounted with some London bank the bills he drew on A, 2 months before they were due.
  • Scottish paper money was advanced in those bills discounted with the Edinburgh banks.
  • English paper money was advanced in those bills discounted with the London banks.

The bills on which this paper had been advanced were all repaid as soon as they became due.

  • The value really advanced on the first bill, was never really returned to the banks which advanced it.

Because before each bill became due, a new bill was always drawn to a greater amount than the bill being paid.

  • The discounting of this new bill was needed to pay the old bill.
  • This payment was altogether fictitious.
  • The stream which ran out of the coffers of the banks through the bills of exchange, was never replaced by any stream which ran into them.

71 The paper money issued on those bills made up the whole fund for some vast project of agriculture, commerce, or manufactures, and not just the ready money for answering occasional demands.

  • Consequently, most of this paper money was in excess of the national circulation, had there been no paper money.
  • It immediately returned to the banks to be exchanged for gold and silver.
  • Thus, those entrepreneurs very artfully used it to draw gold and silver from those banks, without the bank’s consent or knowledge that they had really advanced it.

72 Two people who continually draw and redraw on one another and discount their bills with the same banker are really trading with the capital that the banker advances to them and not with their own capital. This is difficult to spot when:

  • they discount their bills with other banks, and
  • the same two persons draw from a great circle of entrepreneurs.

The entrepreneurs find it for their interest to assist each other. They make it as difficult as possible to distinguish between=

  • a real bill of exchange, drawn by a real creditor and debtor, and
  • a fictitious bill of exchange, which=
    • has no real creditor but the discounting bank,
    • has no real debtor but the entrepreneur who used the money.

Even if a banker discovers this, he might be too late. Those bills might have already been discounted so much that, by refusing to discount any more, he would:

  • bankrupt them all, and
  • ruin himself by ruining them.

For his own safety, he might go on, withdrawing gradually. Everyday, he would make discounting harder, so that those entrepreneurs would be forced to=

  • go to other bankers, or
  • do other methods of raising money so that he could get out of the circle.

Those entrepreneurs were extremely enraged by the difficulties created by the Bank of England, London banks, and Scotch banks in discounting.

  • They equated their distress, caused by the prudence of the banks, to the country’s distress.
  • They said that the country’s distress was caused by the banks’ ignorance, bad conduct, and lack of courage.
  • They blamed the banks for not aiding them in their spirited undertakings to beautify, improve, and enrich the country.
  • They thought that it was the banks’ duty to lend as much as they wanted to borrow, for as long as they wanted.

By refusing to give more credit to those who were already given too much, the banks saved their own credit or the country’s public credit.

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