Download An Introduction to the Wealth of Nations

Adam Smith Legacy Lecture
‘An Introduction to the Wealth of Nations’
Ronald MacDonald
• Today I’m going to talk about Adam Smith’s Wealth of Nations
(WN): what’s its central message and what do the 5 books
within the WN say?
• Along the way I’ll try and relate what Smith has to say with
contemporary economics and, if time allows, conjecture what
he might have to say about the recent financial crisis.
• Fair to say that WN strongly influenced by so-called French
Physiocratic school, lead by François Quesnay. Smith said
that the teachings and beliefs of the Physiocrats were: ‘the
nearest approximation to the truth that has yet been
published on the subject of political economy’. A lot of their
ideas in the WN, but Smith takes these further and does not
agree with them on everything.
• First what is the central message of the Wealth of Nations
(WN)?
•
It depends on whether you are a Classical or Neo Classical
Economist. Quick recap of their respective positions.
• Classical economists are the group that follow on from Smith
and include Jean Baptiste Say, David Ricardo, Thomas
Malthus and John Stuart Mill.
• Key assumptions: Micro: flexible prices in both goods and
labour markets. Macro: ‘Say’s law’ that in the aggregate
supply creates its own demand central to this. Savings and
investment equalised because real interest rates flexible and
coincide with the natural rate of interest. Combination of
these assumptions provides a full employment economy
• Neo classical can be seen as taking their microeconomics
from the Classical guys and their macro from Keynesian guys
(so called neo classical synthesis).
• Neo classical micro: general equilibrium in which prices,
outputs and income distributions determined in markets
through demand and supply by utility/profit maximising
individuals and firms with rational preferences and full
information;
• Neo classical macro: Aggregate Demand may not always
equal Aggregate Supply due to a deficiency of aggregate
demand which could arise from the failure of national savings
to equal national investment at the full employment level.
• Neoclassical economists emphasise Smith’s concept of the
invisible hand in bringing about microeconomic equilibrium.
Given this phrase has been portrayed in many different ways
it is worth reading the original from WN:
• ‘….every individual necessarily labours to render the annual
revenue of the society as great as he can. [But] indeed
he neither intends to promote the public interest, nor knows
how much he is promoting it…he intends only his own gain,
and he his own gain, and he is in this, as in many other
eases, led by an invisible hand to promote an end which was
no part of his intention ….. By pursuing his own interest he
frequently promotes that of the society more effectually than
when he really intends to promote it’.
• Eg Samuelson, in his the multi million selling neo-classical
synthesis principles Economic textbook sees the invisible
hand mechanism as a central mechanism in achieving
general equilibrium although neoclassical economists
articulate the idea, as we have said, in a more sophisticated
way to Smith.
• In contrast, Classical economists see the essence of the
Wealth of Nations as that contained in the first few sentences
of the book; i.e. as its title proclaims, the book represents a
programme to promote the wealth of nations, or as we would
say today, it is a book on how an economy can develop and
grow. Central to this, in Smith’s view, is the division of labour.
• ‘The annual labour of every nation is the fund which originally
supplies it with all the necessaries and conveniences of life
which it annually consumes…[T]his produce …bears a
greater or smaller proportion to the number of those who are
to consume it…[B]ut this proportion must in every nation be
regulated by two different circumstances:
• First, by the skill, dexterity, and judgement with which its
labour is generally applied and
• Secondly, by the proportion between the number of those
who are employed in useful labour and that of those who are
not so employed.’
• In these first few sentences are contained some of the
elements that become the great themes of the WN.
• In essence, Smith represents the economy as a circular two
period process (from Quensay): if the economy is to grow the
inputs to the production process – labour and capital – in
period 2 must be greater than the inputs of period 1. Any
outputs from period 1 that are not usable as input in period 2
are regarded as unproductive.
• Therefore to ensure maximum growth labour should be used
as productively as possible. To this, Smith added his own
insight that productive labour should be made even more
productive be deepening the division of labour. The pin
factory story gives a good example of this.
• ‘One man draws out the wire, another straights it, a third cuts
it, a fourth points it, a fifth grinds it at the top for receiving the
head; to make the head requires two or three distinct
operations; to put it on, is a peculiar business, to whiten the
pins is another; it is even a trade by itself to put them into the
paper; and the important business of making a pin is, in this
manner, divided into about eighteen distinct operations.’
• Smith estimated that in this way one man working on one or
two of these functions could make approx four thousand
eight hundred pins in a day. But leave it to one man to do all
operations then he may be unable to make more than 20 and
perhaps not even one.
• Smith argued that in a competitive market framework,
deepening the division of labour meant lower prices that
would make the goods more appealing to a wider market.
• To him extended markets and increased production would, in
turn, generate new ways of organising production and
inventing new ways of production which leads to a further fall
in prices and so the process goes on.
• It is this dynamic that produces a growth machine which
ensures the Wealth of Nations.
• Smith’s ideas in many ways were seen as the antithesis of the
prevailing doctrine of Mercantilism (important link with the
Physiocrats). Indeed in many ways WN was a treatise against
the economic doctrine of Mercantilism which dominated
western European economic policy and discourse from the
late 16th to late 18th centuries. Hence WN political economy.
• Recap of Mercantilism: government control of foreign trade of
key importance to ensure military security for a country. To
achieve this a plethora of actions taken such as the
introduction of tariff barriers, export subsidies, non tariff
barriers to limit domestic consumption in the form of antidumping measures and countervailing duties, building a
network of overseas colonies.
• Smith wanted all of these restrictions to be swept away since
this would maximise the market available to the nation and as
we have seen maximise wealth creation. I’ll return to the
relevance of mercantilism in today’s world below.
• The WN has within it 5 Books, which I guess today we would
simply refer to as parts. My plan today is to give a brief
flavour of each of the books and draw out what the books
message is for today.
Book 1
• Key focus on the division of labour. [argued that the concept
of the division of labour is to the WN what sympathy is to
TMS] often taken as a new creation of Smith. But other 17c
thinkers, such as Sir William Petty, recognised that
specialisation increased the productive powers of human
work.
• The novelty in Smith’s work was that such specialisation
would not lead to improvements in productivity if the workers
were slaves whose labour and innovations belonged to their
masters. So people need to be free to work.
• In essence what he is refereeing to is well defined property
rights for both workers and capitalists and this is something
that is a central element in recent growth theory. He also
indicates that workers also find it important to be safe and
feel safe and again this has an important resonance with
modern growth theory i.e. a standard modern growth model
would include for countries the legal framework, well defined
property rights, existence of corruption, efficient police force,
how democratic, etc.
• As noted, the division of labour cannot function without a
market for its specialities and Smith recognised that such
markets can only operate efficiently with money of some
form, rather than a barter system.
• Rather than give an historical account of money Smith gives a
philosophical account in terms of the key and important
distinction between real and money, or nominal, prices. He
clearly understood it was real purchasing power that
mattered. This is a distinction which economists take for
granted nowadays but it was not a common place distinction
in the 18c. So an important contribution.
•
Additionally, he very clearly understood the famous
monetary exchange equation (MV=PY) that increases in the
money supply, after perhaps a period of disruption, do not
affect real quantities. He made this point in the context of the
French monarchy and their debasement of the French
currency. In Smith’s original thinking the quantity of goods is
just a synonym for the work put into them.
• Smith seems therefore to be in the Classical monetarist
tradition. He would therefore probably not approve of what is
happening today, in terms QE and especially not moves to
target a country’s GDP.
• Smith argued that a commodity or item had two different
prices for sale – the market price and the natural price.
• The natural price was originally based on a labour theory of
value (i.e. supply side) but in the WN the natural price also
includes rent and profit in addition to the wage (the natural
price in terms of labour value is something Marx ran with and
the Ricardo/ Sraffa schools also ran with this which became
the so-called Cambridge controversy).
• The market price is determined by how many people want the
good and how badly (i.e. demand side).
• Smith thought the market price would usually be above the
natural price because of restrictions to labour mobility (i.e.
apprenticeship restrictions, settlement laws) and
monopolistic restrictions. In todays economic jargon the two
prices coincide in a perfectly competitive model.
• The first book ends with a warning against the sectional
power of merchants and manufacturers. ‘The proposal of any
new law or regulation of commerce that arises from the
merchant class therefore, ‘ought always to be listened to with
great precaution.’ Since this he thought would ultimately not
be in the consumers interests.
Book 2
• This returns to the division of labour but moves this away
from labour per se towards capital, which enters as the third
player on the scene (after specialisation and freedom of
occupation) (again strongly influenced by French thought).
• Smith makes a distinction between circulating capital – the
goods that earn revenue by changing hands – and fixed
capital – warehouses, factories, machines and tools that earn
revenue without changing hands.
• More generally, fixed capital is any investment that increased
the productive powers of capital and that included ‘useful
abilities’ acquired by the workman through education and
apprenticeship – what we now call human capital.
• The interaction between circulating and fixed capital is at the
heart of Smith’s tableau economique – in its daily purchases
the public withdraws from the circulating capital of society,
which must then be replaced through additional raw materials
from agriculture and finished goods from manufacture.
• How is capital accumulated? To answer, Smith makes a
distinction between productive and unproductive labour. In
the French school this was simply a distinction between
farmers and manufacturers.
• But for Smith it is between those who produce work that
perpetuates itself and those who, while producing something
of value, must be maintained by the work of others.
• In the unproductive class, Smith includes ‘churchmen,
lawyers, physicians, men of letters of all kinds, players
buffoons, musicians, opera singers, opera dancers etc’.
• As an aside he argues that labour of an artist, for example, is
seen to ‘perish in the very instant of its production’. But
perhaps not so true today with cds and dvds etc?
• For Smith productive and unproductive individuals are united
in the desire of ‘bettering our condition’ which occurs ‘in
spite of the extravagance of government and of the greatest
errors of administration’. This can be achieved by saving and
accumulating some part of what they acquire. The principle of
frugality / thrift is at the heart of this.
• So capital is ‘silently and gradually accumulated by the
private frugality and good conduct of individuals’ despite ‘all
the extractions of government’. We see in these quotes a
none too flattering picture of the role of government.
• The book continues with a discussion of the relative
productivities of capitals, beginning with agriculture, followed
by manufacturing and then the wholesale and retail
businesses.
• Smith gave special emphasis to agriculture which may seem
perverse to us today but in his day, pre the existence of
machines, agriculture was a dynamic activity and farmers
saw dramatic increases in yields through the application of
novel methods of cropping and animal husbandry.
Book 3
• In the third and fourth books of WN Smith changes tack,
much as he did in the TMS, and swaps his analytical
approach for an historical approach.
•
He observed some countries being more advanced in their
division of labour and richer in invested capital and Smith
tries to account for what he labels the ‘progress of opulence’.
• He draws on both Roman and feudal history to demonstrate
that since the fall of the Roman empire the towns in Europe
had come to dominate the country and not vice versa –
agriculture had suffered under the feudal system of short
leases, primogeniture, and the violence that occurred in the
countryside.
• In contrast, the free cities were secure behind their walls and
became sanctuaries for capital, markets for manufactured
refinements and foreign luxuries, and homes of good
government. In time these spread out into the countryside
(these historical facts seem to be an inversion of what his
own plan or nature intended).
Book 4
• The differing degrees of what Smith referred to as opulence in
different countries led to different theories of political
economy. In the fourth book Smith distils these down to two
main systems: one that advocates the priority of commerce,
the other agriculture. The first is essentially a mercantile or
commercial system.
• Here Smith again has a swipe at the mercantile notion that a
country becomes wealthy from a positive trade balance which
is manifested in gold and silver.
• He is highly critical of artificial policies that attempt to
improve the balance of trade through the restrictions,
bounties on corn, the re-export preferences known as
drawbacks, subsidies and other limits to the free movement
of capital and working people. In vivid language he portrays
the mercantile interest that dominated the House of
Commons at that time as ‘like an overgrown standing army
always poised to intimidate the legislature’.
• But interesting that what is essentially a Mercantilist
approach has seemed to work for East Asian countries
starting from Japan through to the recent Chinese
experience. Does this counter Smith’s claim, or is it because
the rest of the world is following his free trade rules?
• If such constraints on trade are removed and natural liberty is
established then the role of government should only have 3
duties: the protection of society from foreign invasion;
establishment and exact administration of justice; certain
public works that would be unprofitable for private citizens,
either individually or in small groups to provide.
• The 4th book has the last appearance, or should it be nonappearance, of the Invisible Hand. Here it is with respect to
the merchant who, other things being equal, prefers to deploy
his capital under his eye at home rather than overseas (Home
bias effect? ) and this has the unintended consequence ‘to
render the annual revenue of society as great as he
can’…..’he is in this, as in many other cases, led by an
invisible hand to an end which was no part of his intention.’
Book 5
• This provides a discussion of how revenues should be raised
and spent on defence, justice and public works.
• In terms of the latter, he argued that public investment to
facilitate commerce should be provided only where private
individuals have failed and they should be paid for by those
that use them so that the bridge or road will be built where it
is needed and to a suitable scale. Night watchman role for
government.
• Smith very interested in public education and particularly the
education of the poor. He argued that even if public education
brought the state no advantage, it makes people less open to
the political contagion of faction and sedition, fanaticism and
superstition. In other words it produces positive externalities.
He therefore advocated compulsory education for all children.
• Smith of course recognised that public services could not be
maintained without some general taxation and its anticipation
in borrowing. Interestingly, Smith did not view taxation as a
badge of slavery but of liberty but only if it was collected on
principles of equality, certainty, convenience and economy.
• Smith believed that taxes should be levied without impinging
on the freedom and privacy of the subjects.
• Although taxes and other duties should not interfere with the
allocation of capital and work he makes sufficient exceptions
that would please even a modern chancellor – duties to
discourage ale shops and strong drink, taxes on luxury items
rather than necessities, subsidies on the transport of coal .
• Taxation should be progressive the rich should pay a higher
proportion of their income than the poor.
• Monopolists should be taxed on their monopoly profits.
• Smith and the recent financial crisis.
• Recap of sources of crises.
• Origins in US with attempts to reduce inequalities by allowing
wider access to cheap mortgages.
• Inflation targeting a key element. In targeting inflation,
nominal and real interest rates were kept artificially low in the
period of the great moderation (1987-2007) by ECB, BofE and
the Fed. Also excess money supply and liquidity as a result.
• Light touch regulation in Anglo Saxon countries and highly
risky assets (i.e. sub prime mortages) became rebundled and
sliced as triple A by the regulators – a form of financial
alchemy. Collusion Tacit or otherwise between governments,
central banks, regulators and commercial banks.
• As someone in the Classical tradition, Smith believed that
with market forces the real interest rate would equalise
national savings with national investment at a high level of
employment. The kind of policies underlying the great
moderation would have interrupted this process as they
clearly did and so he would not have advocated this.
• Also as we have seen he was very suspicious of powerful
groups colluding to the detriment of the consumer he would
have bee against the tacit collusion I have described.
• A second key element in the recent crisis in the UK was the
annual build up in real public expenditure in the noughties.
This expenditure appeared affordable at the time since the
liquidity inspired property boom / consumer spending
generated GDP growth and tax revenue.
• But once the boom ended the new higher levels of real public
spending were not sustainable.
• From what we have seen Smith would have been against such
dramatic rises in public spending especially the non
sustainable elements.
• So suggest that had Adam Smith been Gordon Brown’s chief
economic advisor the UK economy would perhaps not be in
the mess it is in today.
Concluding Comments
• In sum, creation of wealth about the interplay between
specialisation, liberty and saving and the conversion of the
latter into capital.
• Clearly Smith did support an economic structure which is
more in the free market mould than the mixed economy
prevalent today, but had a clear role for government in terms
of the classic public good (light house) and externalities
(education) arguments.
• The free market should be extended to international markets
and against the bullionist /mercantilist idea that countries
should run balance of payments surpluses for the sake of it.
• With respect to macroeconomic issues I see Smith very much
in the classical monetarist tradition and would presumably
take the side of the leading exponent of that view today - Alan
Meltzer - position that the debasement of the currency we see
in the US and UK is undemocratic and unwise.
• At the end of the day it is probably just a bit of fun to think of
what Smith would have made of the current financial crises
and the Great Recession since the current economic
structure today is very different to his day.
• But it would seem that the central ideas from the Wealth of
Nations about how countries become wealthy or opulent and
grow are as relevant today as they were then and the political
economy of free trade versus mercantilism is as alive an