SMITH AND HIS TIMES

To understand the book it is useful to know the milieu of 18th century Scotland and something of Smith’s life.

Smith grew up in a time in which it took six weeks for a horse-driven goods wagon to ply its way from London to Edinburgh and back again, and in which the industrial revolution was barely underway. The first steam engines were being invented, America was just a colony of Britain, and Australia was yet to become one. Across Europe the old feudal structures were eroding, while manufacturers and merchants were on the rise.

Though Scotland was poor and quite backward compared to the England it had recently united with in a last ditch attempt to achieve prosperity and stability, in Smith’s lifetime it would make remarkable strides. Glasgow’s port would make it one of the fastest growing cities in the world, servicing Britain’s Indian and American colonies, and the philosophers Henry Home, David Hume and Adam Ferguson, and natural scientists James Hutton and Joseph Black, were all Smith’s contemporaries or friends in what became known as the Scottish Enlightenment.

Born in 1723 in Kirkcaldy, across the Firth of Forth from Edinburgh, Adam Smith was of a respectable lineage. His father had been a lawyer and a customs official who died a few months before his son was born. As a result, Adam and his mother remained extremely close throughout her long life, and for most of it they lived under the same roof.

At only 14 he was sent to Glasgow University where he enjoyed the instruction of Francis Hutcheson, the philosopher whose concept of “benevolence” or “the greatest happiness for the greatest numbers” would be a significant influence on the utilitarian Jeremy Bentham. Hutcheson’s emphasis on liberty would also have a major effect on Smith’s developing mind. As one of the star students at Glasgow, Smith, well versed in Greek and Latin, won a scholarship to Oxford. He would spend six years there based at Balliol College, but he found the university overly conservative and the teaching poor, and as a Scot he felt an outsider.

Back in Edinburgh, over the next three years Smith was paid to give a series of lectures on rhetoric. These in turn helped him gain an appointment to Glasgow University, in 1751, to the chair of logic and rhetoric, followed by moral philosophy. He stayed at Glasgow for the next thirteen years, a time he regarded as the most useful and happiest of his life.

Moral philosophy in his time also covered legal and economic issues and matters of public policy, and Smith’s lectures on jurisprudence, or “Policy, Revenue and Arms” set out the proper role of the state in regards to keeping order and national defence, and also addressed how these roles should be funded. Even from these early lectures we can see his distrust of regulation. He notes, for instance, that the best way of reducing street crime is to make sure that commerce is flourishing, or that there is “public opulence”: “Nobody will be so mad as to expose himself upon the highway, when he can make better bread in an honest and industrious manner”, he remarks.

THE WEALTH OF NATIONS: ORIGINS AND INFLUENCES

Yet Smith’s focus in his twenties and thirties, like many of his contemporaries, was on decoding human nature and attempting to establish general laws which govern it. His first great work, The Theory of Moral Sentiments, isolated “sympathy”, that is benevolent feeling towards one’s fellow man, as the strongest motivating factor in human action - along with love of self. The Theory is Smith as a pure moral philosopher, dissecting humanity’s inner and social life. Written in an accessible style, it sold well and was influential, and Smith could easily have rested on his laurels as a philosopher.

But Smith’s mind was too wide-ranging to stick to matters of perception and motivation. He also wanted clarity on some of the big political questions of his day. What was the proper level of taxes, and how should they be levied? Were trading monopolies and colonies a financial boon or a drain on states? Should agriculture make way for industry?

French thinkers such as the royal physician François Quesnay (Tableau Economique, 1758) and Anne-Robert-Jacques Turgot (Reflections on the Formation and Distribution of Wealth, 1776), later to be France’s senior finance minister, had already created a foundation in economic matters, and Smith would come to know and be strongly influenced by both. His library also included Adam Anderson’s Origin of Commerce (1762), and Malachi Postlewayt’s Universal Dictionary of Trade and Commerce (1757). He was therefore hardly the first to enter the field.

Moreover, in Britain James Steuart’s An Inquiry Into the Principles of Political Economy had been published in 1767, and was the first comprehensive treatise on political economy, analyzing most of the issues that Smith was also interested in, including labour, price, rents from land and the mechanism of demand and supply. As a fellow Edinburghian Smith knew Steuart, but they were poles apart on many issues. Where Steuart essentially supported the status quo on barriers to free trade to shore up state power and finances, Smith was developing a strong critique of this “mercantilist” system, instead looking to an economic model based on individual power and liberty.

But Smith was a slow worker. Unlike fellow system-builder Charles Darwin, who would hurriedly publish his magnum opus, The Origin of the Species, eighty years later after being prompted by the publication of a paper on natural selection by fellow naturalist Alfred Wallace, Smith seems to have been unworried by Steuart’s book. Indeed, it was another nine years, in 1776, before the first volume of An Inquiry into the Causes of The Wealth of Nations was published.

Yet given Smith was by no means the first writer on matters of political economy, why did his work become the standard one in the new field of economics? Apart from its keen, balanced analysis of the modern market economy, an important factor was the writing itself. The Theory of Moral Sentiments had had an audience that went well beyond academia, and his friend David Hume had once sniffed that Smith’s circle of readers was too wide. Yet Smith evidently wanted to create an impact, and so made sure The Wealth of Nations was accessible to any educated reader. It assumes no prior knowledge of economic matters, and as Edwin Seligman suggested, is more of a work of literature than a textbook. Get past the antiquated phrasing and you realize that the tone of much of the book is surprisingly informal. Smith does not stint on using the “I” pronoun in the work, or withhold from including anecdotes which, though hardly scientific, have rhetorical power.

A final reason for the success of the book must be the genius of the title. Smith shared the same London publisher as Steuart, so could not have brought out a book that also had “Political Economy” in the title. It was a blessing in disguise. By bringing together the alluring “Wealth” and the grandeur of “Nations”, Smith created a phrase that was both timeless and powerful.

The title would seem to suggest that the book is about the wealth of states, and of course large parts of the book are about government policy. But in fact it makes the point that the wealth of a nation is really the wealth of a people, which should be allowed to grow regardless of the government or sovereign ruler of the day. This did not mean that Smith was anti-government completely, and in fact he calls for a strong, if light, framework of laws primarily for the physical protection of the individual and the protection of commercial contracts. Furthermore, in contrast to Margaret Thatcher’s famous remark that “There is no such thing as society”, Smith believed strongly in the power of cohesive social relations, envisioning a peaceful, prosperous and stable society resting on individual freedoms. It was only in this sort of political and social organization, he believed, that we would see a high degree of “benevolence” exhibited between one human being and another.

Below is a discussion of themes from The Wealth of Nations covering: specialization through the division of labour; the principle of self-interest; the role of capital; the law of price and demand; the function of money; the benefits of trade; and the correct role of government.

These themes loosely follow the order of the five Books that make up the greater work.

SPECIALIZATION, THE PROSPERITY KEY

“It was not by gold or by silver, but by labour, that all the wealth of the world was originally purchased”.

Book 1 is a superb analysis of how a “modern” market economy works, and central to this is Smith’s understanding of the role of labour. The wealth of a country, he writes, depends on the skill and judgement of its workers and on what proportion of the population is employed in such productive work.

How much a good or service costs generally depends on the amount of labour that has gone into its making, or the “toil and trouble” that the buyer saves by not having to make it or do it himself. “What is bought with money”, he notes, “is bought by labour”. Even if a transaction is facilitated with money, what we are really exchanging is the value of our own labour for someone else’s.

What marks an advanced nation from a poorer one is the “division of labour”. Smith mentions the people of his time who lived in the remote Scottish highlands, who, because they were far from any town, had to be their own “butcher, baker and brewer”, providing all their own needs. In contrast, highly developed cities and towns are characterized by a strong division of tasks and roles. A person concentrates on making one thing only, but does it so efficiently that the return from selling the thing is more than enough to buy commodities which they otherwise would have had to make themselves. In a well-governed society, the division of labour thus leads to “universal opulence”, allowing even the lowliest workers to cover all their needs. Indeed, Smith notes, such workers can enjoy “conveniences” that kings of less developed lands could only dream of.

Smith’s famous example of the division of labour is a pin factory that existed near his home in Scotland. Instead of one person making each pin from scratch, he observed, the workshop divided their manufacture into several stages, with each worker responsible for one stage. One man performs the operation of drawing out the wire, another straightens it, another cuts it and so on. The result is counterintuitive: one would expect perhaps a doubling of productivity, but in fact the effect is exponential. Many thousands more pins can be made in a week compared to a workshop where one person has to perform all these tasks, since the specialized worker gets very good at a particular task, and does not waste time moving from one job to another. Summing up the power of specialization to transform the economic prospects of a society, Smith remarks that, “Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things.” Moreover, when an economy becomes highly specialized, products become not only better and more uniform but cheaper because the same amount of labour can produce more goods. The division of labour makes everyone better off.

The bigger and more developed the economy, the more specialized the workforce, and the greater the necessary trade in, and demand for, goods and services. Big cities are wealthy precisely because of their increased division of physical and mental labour, where we can find not only factory workers and labourers, but inventors, philosophers and lawyers. That is, with most people busy earning a living in other ways, they can afford to pay someone else to “design”, “think” and “speak” for them. “This subdivision of employment in philosophy”, Smith writes, “as well as in every other business, improves dexterity, and saves time. Each individual becomes more expert in his own peculiar branch, more work is done upon the whole, and the quantity of science is considerably increased by it.” Smith thus portends the rise of the knowledge society and the “creative class”, who enrich themselves and their countries through their ability to make connections, provide insights and increase knowledge. Other than the ability to type or speak, the work of these “symbolic analysts” as Peter Drucker would call them in our time, involves no manipulation of physical objects.

Given that people are better suited to one kind of work and not another, in a highly specialized society they can usually find an outlet for their talents. Smith notes, for instance, that where once people might have entertained themselves by campfire, in a rich country we pay expert actors and singers to amuse us. By choosing work that best suits us and gives us a greater chance of gain, society wins by having access to our refined and unique skills or creations. Though Smith believed that human beings did not fundamentally differ much from each other, it was in what they produced that set them apart.

This conception of man as producer, whose efforts could be boiled down to a monetary value, offended many. The English art critic and social thinker John Ruskin portrayed Smith as being responsible for sidelining God and making money the measure of all things. To this Smith must plead guilty, and yet it can also be said that by giving a monetary value to invention, uniqueness and originality, Smith’s ideas helped increase the quantity of each. Through the division of labour, a premium is paid for difference, so naturally forcing people to produce the new and the valuable. Smith admitted that the modern factory system could easily lobotomize workers, who must perform the same function hour after hour, day after day, but on the other hand the division of labour allowed for singular work to be recognized and rewarded.

SELF-INTEREST AND THE BEST ALLOCATION OF RESOURCES

The division of labour came about, Smith says, through the natural human propensity “to truck, barter and exchange”. We act simply from the motive of getting something of value in exchange for what we have produced. However, what no one expected, he notes, was just how much wealth such a self-interested system could produce in a nation.

In his idea that self-interest could lead to the greater good Smith was influenced by British satirist Bernard Mandeville, who in The Fable of the Bees (1723) argued that “private vices lead to public benefits”. But how could Smith reconcile this scandalous notion with his ideas of “sympathy” and “benevolence” as expressed in The Theory of Moral Sentiments? Being concerned with how economies actually work, and how people actually act in an economic setting, in The Wealth of Nations he was perhaps forced to admit that self-interest, not regard for others, was the essential engine of prosperity. Smith notes that, unlike most other animals, “man has almost constant occasion for the help of his brethren”, yet he can’t depend on their natural benevolence. To get what he wants, he must frame his wants in terms of their self-interest. Thus, in an advanced economy, we all get what we need by working out what others may need or want, and providing it. Book 1 contains the famous lines:

“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. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities, but of their advantages.”

We do not generally act for “society’s best interests”, but rather are always looking for the greatest advantage that we can get from our capital. But by seeking our greatest gain we in fact assure the best allocation of capital for society. The citizen, Smith famously says, is “led by an invisible hand to promote an end which has no part of his intention”. When millions of individuals are left to determine their own destinies, through trial and error they tend to make good decisions, and the collective outcome is much better than if a society had been planned from the centre. In a graphic contrast between the health of the people and the quackery of state policies designed to “help” a country towards wealth, Smith writes:

“The uniform, constant, and uninterrupted effort of every man to better his condition, the principle from which public and national, as well as private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things towards improvement, in spite both of the extravagance of government, and of the greatest errors of administration. It frequently restores health and vigour to the constitution, in spite not only of the disease, but of the absurd prescriptions of the doctor.”

THE CRUCIAL ROLE OF CAPITAL

While the division of labour was the mechanism by which national prosperity occurred, for it to happen in the first place required the accumulation of capital. As Smith explains in Books 2 and 3, the number of people involved in useful work in a society, their productivity and the technology at their disposal, can never reach a state greater than the amount of capital available to achieve these things. A weaver, for instance, cannot expand unless he has a sufficient stock of materials, or money to pay for wages, to keep the whole operation going until revenue comes in from the sale of previous work:

“A weaver cannot apply himself entirely to his peculiar business, unless there is before-hand stored up somewhere, either in his own possession, or in that of some other person, a stock sufficient to maintain him, and to supply him with the materials and tools of his work, till he has not only completed, but sold his web.”

In a manufacturing operation, a virtuous circle is set into motion when the significant sums of capital invested lead the owner to want to maximize his investment through the most efficient use of materials and labour. This leads to greater specialization of work tasks and the use or development of machines that help to produce a greater quantity of quality, uniform product in the shortest time. This desire to make the most of capital, naturally leading to greater specialization and technical innovation, allows a particular company, or city or country, to within a few years become the world leader in the particular good that it makes. Yet the greater the complexity of a manufacturing operation, the more capital is needed in the first place. Today’s aircraft makers, for instance, depend on the extremely specialized skills and machinery of thousands of component makers to produce a single aircraft. This extreme division of labour requires enormous initial and circulating capital, plus very long lead times between the taking of an order for a new plane, and its final delivery.

Smith observed that a society’s combined stock or capital is divided into three portions:

1. That which is immediately consumed, which includes housing. People erroneously consider their home as “capital”, Smith notes, but if it is not actively being rented out it cannot be described as such, since it is generating no revenue or profit. In fact, it is a cost.

2. Fixed capital, which produces a revenue or profit irrespective of who owns it. Fixed capital includes: machines or instruments or trade; houses or commercial buildings rented out; improved land which can yield a saleable crop or product; and skilled or educated workers, whose knowledge can be put to profitable use. The size of the pool of such workers can determine the wealth of a nation as much as its quantity of arable land.

3. Circulating capital, which includes: money, by which means other forms of capital can easily change hands; provisions, or those of goods that are ready for sale; materials, or the things needed to make the goods that are currently in the hands of suppliers; and products made, which are sitting in the showroom or shop or yard available to be purchased.

All fixed capital is originally derived from circulating capital, and fixed capital continually needs the injection of more circulating capital to maintain it. That is, you cannot earn money from a farm unless you can buy seeds to sow crops and people to plant them; you cannot make a profit from machinery unless you can buy oil to power it and a person to operate it.

Whatever savings can be made in the outlay of fixed capital, Smith noted, was not only good for the farmer or manufacturer, but good for society since the saved capital could be productively expended elsewhere. Everybody wins from a more productive use of capital. It is only when there is government interference in this natural process that the growth and development of a society falters.

Smith admitted that the average person does not have much capital, but must work by the hour or week to meet their needs; subsistence comes from their labour, not something they own. This, he remarks, “is the state of the greater part of the labouring poor in all countries”. Today, it might be argued that not much has changed. Most people - even if they live in a rich country and do not dream of thinking of themselves as the “labouring poor” - still earn a salary based on having to go to a place of work and do certain tasks in a certain number of hours. Although they may have a pension fund or an investment property, were they to stop working, in a matter of weeks or months they would have nothing to live off. Yet if the logic of The Wealth of Nations is followed, individuals through their frugality could become capitalists themselves, living increasingly off the profits of a business, or rent from property or interest on money invested, instead of daily wages from the simple sweat of their brow.

THE DIFFERENCE BETWEEN MONEY AND WEALTH

Smith makes an important distinction between the real wealth of a nation, which consists of its productive output, and the system of money which is needed as a means of easy exchange and a symbol of value. “The great wheel of circulation”, he says, “is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them.”

That is, how much money is in a society (a plank of mercantilist thinking) matters much less than the purchasing power of that money, or how well the inhabitants can live with what they have, including what they can buy from other nations. That money is an expression of value but of limited value itself went against the view of Smith’s time that a nation’s wealth consisted of the amount of gold and silver it was able to amass in its treasuries. In contrast, he suggested that it was more important to keep money flowing so that it could be put to work in developing farms and creating businesses.

In a section on banking, Smith shows how its development benefits society, particularly in the way that paper money, representing actual gold and silver, makes the wheels of an economy turn more easily and at less cost. He praises the innovation of cash bank accounts, which saves people having to keep money in their own coffers, and which make business transactions much easier, and overdraft facilities, which allow manufacturers to always have enough money to buy materials when needed, and pay suppliers, before their receipts come in. Smith observes that a society using paper money builds itself a “highway” above the actual economy, which speeds up commercial activity. The easier the flow of money, and the quality and depth of the banking system in serving society, the more prosperous a nation will be.

PRODUCTIVE AND UNPRODUCTIVE LABOUR

In chapter 3 of Book 2, Smith presents his controversial distinction between productive and unproductive labour.

He suggests that only labour which results in a tangible “thing” can be considered truly productive. The labour of a manufacturing worker is “wrapped up” in the thing he has made, therefore his labour is a commodity of real value. In contrast, the labour of a domestic servant will “perish in the very instant of their performance”, leaving no trace of value which can afterwards be redeemed in terms of purchasing someone else’s labour. Smith notes: “A man grows rich by employing a multitude of manufacturers; he grows poor by maintaining a multitude or menial servants.”

But Smith also perceives the labour of clergymen, lawyers, opera singers and soldiers as being “unproductive” because what they produce also vanishes the moment it is made, i.e. the words of the priest or lawyer, the song of the singer, the security provided by the soldier. It might be argued, even though such people might not produce a physical thing, they do provide something nonetheless (e.g. moral uplift, entertainment, domestic ease, security) which people are willing to pay for, and which in turn can purchase the product of other people’s labour? Smith’s point is that all monies paid to “unproductive” labourers must originally come from capital invested either in manufacturing, or rents from land. That is, we can afford to pay the wages of the lawyer, singer, soldier or servant only because there is money around in the first place from revenues from truly productive use of capital. In other words, if there were no farms or factories, a society could not afford national security, or entertainments, or to pay for cleaners.

In the case of soldiers, they are maintained through taxes on productive output, and naturally, the more money a government spends on unproductive things such as security or luxuries of state, the less that is available in a society for genuinely productive uses. Smith mentions the various wars that Britain had engaged in in his era which amounted to an outlay of £200 million. If Britain had chosen not to engage in such obviously unproductive ends, he imagines, “to what height the real wealth and revenue of the country might by this time have been raised”. This aversion to war runs throughout The Wealth of Nations, principally because Smith felt it was a shocking waste of a society’s resources.

Smith highlights the fact that cities and towns which are maintained by national revenue (for example, Fontainbleau outside Paris, the site of a royal court), tend to be unentrepreneurial and even corrupt. In contrast, cities such as Rouen and Bordeaux, great trading entrepots of his era, had sober and industrious populations, since they were engaged in the productive use of capital, not simply relying on state or royal revenue. One could draw the same conclusion today. Washington DC and Canberra in Australia exist on armies of bureaucrats serving the national government. Neither are great centres of productive output because they do not need to be. As Smith neatly puts it, “Wherever capital predominates, industry prevails; wherever revenue, idleness.”

PRICE AND DEMAND IN A MARKET ECONOMY

Smith observes that all sources of revenue can be boiled down to three elements: wages, profit or rent. The natural price of any product will be a direct reflection of the costs born in bringing that product to market, including land or property rental, labourer’s wages, and the profits demanded of the capitalist who has invested in a business.

In any given enterprise, the rewards of labour do not just go to the labourer, or even to the “projectors” and “inspectors” (i.e. the managers), but must go to the owner of the capital on which the whole operation depends. This was, of course, Marx’s problem with capitalism, that a person who does not put in the labour, who often does not even provide significant direction in the creation of a product, gets a large portion of the produce of the labour. But in Smith’s mind this was fair, since without the stock or capital provided in the first place, the wages of the labourer could not be paid.

Smith notes that capital is naturally directed into the raising or manufacture of commodities that will fill demand and in the process bring a good price, and therefore return on capital for the investor. In a free economy, this constant adjustment of output to meet public needs or wants was a fairly reliable process which came to be known as the law of supply and demand.

Smith notes the many factors that affect the demand and supply of labour itself. He observes the comparatively high price of labour in the America, even though it was not as rich a country as Britain during his lifetime. Wages depend not on the wealth of a nation per se, he argues, but how fast it is growing and its demand for workers. In America, the lack of skilled labour had an interesting side effect: rapid population growth. A farmer might not be able to afford employed farm hands, but he could grow a large family as his own “stock of labour”.

The price of labour also depends on factors such as the level of hardship or ingenuity involved in the creation of something. For instance, something which takes only an hour to create by a master, who has spent twenty years perfecting his task, may be worth more than something produced, “in a month’s industry, at an ordinary and obvious employment”. Another factor is ease: a tailor earns less than a coal-worker because the latter’s job is difficult and dirty, so its performance commands a premium. A public executioner is highly paid because his work is ghastly and hardly anyone would want to do it. Other professions are paid well, Smith notes, because of the trust factor: “We trust our health to the physician, our fortune, and sometimes our life and reputation, to the lawyer and attorney”.

Smith also offers an explanation as to why a few people in some fields earn huge amounts:

“In a profession, where twenty fail for one that succeeds, that one ought to gain all that should have been gained by the unsuccessful twenty. The counsellor at law, who, perhaps, at near forty years of age, begins to make something by his profession, ought to receive the retribution [i.e. reward], not only of his own so tedious and expensive education, but of that of more than twenty others, who are never likely to make any thing by it.”

It is fair, then, that in free market economies it can seem as if the winner takes all. The price of a top lawyer’s or entertainer’s labour perfectly reflects the public demand for the service provided. Yet should they fall out of favour, or should others emerge who offer something better or different, the law of supply and demand will naturally adjust their compensation. Though such an observation may seem obvious, The Wealth of Nations was one of the first books to put into writing, using colourful examples, this kind of streetwise logic.

Finally, Smith makes a very sensible case for the freeing up of labour markets of his time, which particularly in the system of guilds in the cities created unnecessary barriers to people being able to move around Britain seeking an outlet for their skills. An efficient labour market, he very persuasively argues, depends on the ability of an individual to sell their services based on the highest bidder, and should have nothing to do with membership of an exclusive organization.

OF WEALTH FROM TRADE

Despite its popular image as a guide for the dawning industrial revolution, readers of The Wealth of Nations soon notice its “agrarian bias”. National wealth follows a “natural” path, Smith notes in Book 3, from agriculture to manufacturers to trade, and he constantly argues for the benefits to a country of developing its agriculture first. He is simultaneously critical of merchants, who in chasing the best returns on their money are drawn to foreign markets without regard for the development of their own country. Yet they could only be blamed so much, since the whole mercantilist system of his era was based on the power of states and their drive for new sources of wealth from colonization. Through state monopolies on trade with these colonies, governments could gain much of the benefits of foreign trade. Smith writes scathingly of Britain’s East India Company, which used government mandates to make fortunes for its members, and he actually advocates that Britain withdraw itself from its American colonies. Britain’s rulers, he writes, had always imagined America to be a gold mine, but it had, in fact only ever been “the project of a gold mine”. It had cost the British taxpayer more than it was worth.

As a result of such adventures, Smith observes, the “natural” way of individuals and communities developing the land had been corrupted, with the resources that might otherwise have gone into agriculture going towards often fruitless overseas expansion. As Laurence Dickey suggests, despite his reputation as a cosmopolitan free trader, Smith was first and foremost a patriotic Scot, and believed that a country should develop its home turf first. A frugal and intelligent custodianship of the land was, he believed, the original source of national wealth. Good returns here could be ploughed back into manufacturing and, only lastly, foreign trade.