Under the rule of English monarchs, before the seventeenth century British civil war, anyone who sought to open finance and interfere with the ability of the crown to fund its whims faced the possibility of horrific punishment and death. It was treason to undermine supreme rulers. In England, treason could be punished by public hanging, disembowelment, decapitation, and just about every other torture conceived by man.

Then came the Glorious Revolution and the Scottish Enlightenment.

By a confluence of unusual events, as the middle of the eighteenth century approached, a small group of gifted thinkers in the Scottish capital of Edinburgh (theretofore a rather dreary regional capital dominated by a hilltop castle) was suddenly allowed to say just about anything that was well-reasoned in regard to the rule of recently crowned Hanoverian kings in London.

In the seventeenth century, Charles I, a Stuart and a Scot, became the king of England. His assassination led to a civil war. After the dictatorial rule of Oliver Cromwell, Charles II was for a time the king of England, Scotland, and Ireland. Then came the Glorious Revolution. In 1688, William of Orange and his wife, Mary (both Stuarts, descended from Charles I), came to England from Holland. William deposed James II and became King William III of England.

Parliament refused to tax citizens to allow William to make war with France. In 1694, however, it borrowed a concept from Sweden and Holland. Parliament created the Bank of England. The BOE allowed William to take in deposits, which were borrowed by the government to make war with France. This was rather like the United States using war bonds to finance World Wars I and II and the later deficit funding of wars in Vietnam, Afghanistan, and Iraq.

In Holland, having a central bank enabled the government to control lending and lower the cost of long-term government borrowing. That allowed Holland to build dikes and fund the land recovery needed to convert the bottom of the North Sea to farmland.

The process of turning salty sea beds into arable land can take decades or even a century. Using a central bank allowed for development of a farm infrastructure with limited risk (aside from a tulip mania) of disrupting the means of funding normal commerce. The same process, in the hands of militarist rulers, permits high-risk gambles on the success of war.

In England’s case, William’s war with France and a series of conflicts with Spain proved economically imprudent (as is usually the case). The lesson of history is that no nation can afford war. William died in 1702 and was succeeded by Anne, the last of the Stuarts. When she died in 1714 with no surviving offspring, the Stuart reign ended as its other potential successors were barred from ascending to the throne as Roman Catholics.

George I, the elector of Hanover, Germany, succeeded to the British throne in 1714. The Hanover family (who later changed their name to Windsor when Germans became notably unpopular) has reigned in England since 1714.

Rather than tax their subjects to pay for past errors, Parliament embarked on a series of schemes by which they sought to hide incurred losses. These gambles backfired.

One idea created the infamous South Sea Bubble. In 1711, Parliament approved the creation of a company with a monopoly on British trade with South America. It was capitalized with British government liabilities, and shares were sold to citizens based on expected returns from the bonds and prospects for favorable trading. It was a Ponzi scheme.

Investors, lured in by the promise of quick returns, rarely stopped to ponder the problem Spanish and Portuguese control of South America posed to the firm’s trading prospects. England was often at war with Spain. The company failed, of course, and a decimating financial crisis followed.

In addition to destroying firms in London by its perceived need to increase revenues, the Bank of England felt compelled to charge high rates on advances made to Scottish banks that used the money for investments in and around Edinburgh. At least one of the Scottish banks was owned by friends of Adam Smith. With no means to collect more interest from customers, the Scottish banks and their owners went broke.

In short, the first 50 years of British central banking were grim for English and Scottish investors alike. One benefit of this debacle, however, was the thinking generated in the mind of Adam Smith by his friends’ losses. The result was an analysis of how banking should be conducted that remains as relevant today as when Smith wrote it in 1776.

In 1745, despite financial losses and the city’s capture by an army supporting a Scottish claimant to the throne of England (Bonnie Prince Charles), Smith and other intellectuals in Edinburgh remained loyal to the Hanoverian King of England, then George II. These intellectuals did not challenge the Scottish Highland clans that joined forces with Prince Charles to seize Edinburgh and fight the English army (which soundly defeated them) but neither did they join the clans.

Perhaps the English saw a need to encourage loyal Scots who could serve as a buffer while they resolved issues with the clans that fought to enthrone Charles. The intellectuals of Edinburgh, in any event, became a loyal opposition recognized for enlightened thought, even in dissent.

The Scottish Highlands suffered as British policy gave the land to clan heads that proceeded to depopulate tribal areas, replacing tenants with sheep. The chiefs were encouraged to gain wealth by the same policies of austerity that some people profess today as the means for recovering from the bubbles and crises of 1998–2008. The insanity of seeking to create wealth by starvation can still be seen in the clan country of Scotland, which remains beautiful, desolate, lacking in infrastructure, and notably poor.

In Edinburgh, however, the group of loyal intellectuals guided the city in building infrastructure, education, housing, health care systems, bridges, roads, ports, and centers of production. Blessed by the freedom of thought and action that their loyalty to the crown gave them, they created a vibrant and beautiful city, along with a body of independent thought comparable to what is found in the world’s much larger population centers.

The Scottish Enlightenment produced great thinkers that became a powerful influence on the American colonists. The books they wrote in Edinburgh were read by America’s founding fathers. The interplay of religions in and around Edinburgh supported the American concept of absolute separation between church and state—that is, no government support and no government interference with a citizen’s right to worship as he or she chooses. Roger Williams first applied the concept to government in Rhode Island, then had it ratified by the British Parliament.

In 1776, Adam Smith set forth an outline of reserve banking on which the U.S. Federal Reserve System is likely based. Smith not only outlined how—and how not—to conduct banking and commerce within and between nations, he showed the British, by undeniable logic, that trading with the former colonies was economically better for England than seeking to tax them by force. When colonial American separatists faced execution for treason by revolting against the throne, Smith led a commission that advised the king to give up the fight.

Smith’s last revision (in 1790) of a philosophical treatise he first published before The Wealth of Nations includes a demonstration that benevolence is the sole driving force by which the invisible hand of economics can produce optimal benefits. His work supports the approach of the post-World War II Marshall Plan and explains the illogic and necessary failure of nations that seek to punish actual and potential trading partners by reparations, like those applied to Germany under the Versailles Treaty after World War I.

Smith also lays a foundation that explains how international imbalances, which were the driving force behind the bubble of the first decade of the twenty-first century, led to the subprime collapse that started in 2007. Though often cited as an inspiration for conservative and even libertarian policies, taken as a whole Smith’s economic and moral philosophy is consistent with a broad range of thoughtful modern economics that is the essence of classical liberalism.

Answers for most economic questions are far more consistent than the experiences that create the questions. As discussed throughout this book, almost anyone unrestrained by loyalty to a particular line of thought or other bias sees the formula for financial stability. It was as consistently espoused in eighteenth century Edinburgh as in the twenty-first century United States. It is learning the factors that cause stability and instability that has presented difficulty, not recognizing the solution.

Once the problem of financial crises was understood in the eighteenth century, the solutions were first applied in London shortly after the U.S. Civil War. But first let’s consider the early development of banking in the United States.