"All truth passes through three stages.
The Wealth of Nations by Adam Smith appeared in 1776. The book was at once a resounding success and founded both the new science of economics and the political reform agenda of liberalism. This page explains how he did it.
Contents: Liberating markets Re-ushering everybody in his social role Setting labour as sole economic energy Assigning an assistance-only role to government Making labour the standard of value measurement Neutralizing metal money Putting centre stage the business entrepreneur Defaming the land owners Explaining the free market mechanism Determining wages Determining Profits Determining land rent Making the agenda for price formation analysis Catching the prodigals Predicting the long term future Setting the political agenda of his day
People in Western countries, nowadays, are taught to regard as self evident the idea that free trade is a good thing unless it leads to undesirable situations. We are not taught to list commodities that can safely be freely produced, transported and sold, but we are confronted with a relatively short list of exceptions, products that need prohibitions or restrictions. Trade in people and hard drugs are almost world wide considered to deserve total prohibition - nowadays. At some times and places the same held, and holds for alcohol, prostitution, certain books, images and other information. For loads of other products, selling and buying is discouraged by special fees: fuel and tobacco are usually heavily taxed. Luxury goods are often taxed higher than necessities. In international trade, effective foreign competitors of home products often face high tariffs. And finally, there is the prohibition of products that do not satisfy government imposed design rules. Prohibition is costly to the government. But with tax there's a hitch: handsome arguments for tax as a "discouragement" of the market may hide the natural need for the government to meet its expenses. And the handsome arguments for legally requiring of a new product specific features purported to assure technical quality, safety, and effectiveness may hide the interests of competitors with influence in government. Political and moral hypocrisy, to the detriment of the general public, is around the corner, and one can only hope for democracies to be working well enough for the voter not to be fooled into paying too much and getting too little on his markets. To feed this hope, free news media and free speech are widely considered vital. Freedom is everybody's buzzword, even dictators love it.
This was not yet the world, nor the social and moral philosophy when, in the 18th century Adam Smith founded economics and coined the agenda of liberal reform. At that time, that now almost self evident philosophy got invented and the world was on its way to the modern commercial state. From where?
2000 years ago, when the German
tribes still regularly were on the move to escape being subdued or to conquer better
land, their leadership actively prevented attachment
of their subjects to a plot. This was done by redistributing land every year. That
prevented excessive luxury of the houses built, which would lead to flabbiness,
weariness to move and the immobilizing effects of too much agriculture to the
detriment of cattle breeding. Also, holding and enriching land was thought to be decadent
and leading to inequality: the smart and strong would deprive the simple and
weak from their acres or bind and extort them in other ways. This would result
in inequality, greed and factitious intrigues between nobles endowed with power
based on land. In the eyes of the
rulers of the German tribes of Antiquity that was a danger to the tribe's
survival and should be avoided.
As true proto-Stalinists the Germanic kings combated evil by chasing their
subjects around over their tribe's territory of the moment. Men did military service every other
year, to keep up their skills and hardness. Coming out of service, you had to
ask the whereabouts of you family this year. In Antiquity, Germanic societies
were not split into
a rich nobility and a large number of poor, like the Roman and the Celtic
of the time.
All this is told in Caesar's book
Gallico. And more:
Trade, a widespread, well known activity of a tiny, lowly reputed class of Roman and Celtic society, was neither desired nor even understood by Germans. At times when war left them a booty, Celtic and Roman traders could come to buy it. Germans would not start selling themselves.
A Germanic tribe was a unity with a strong sense of community and highly kept values, little cheating among tribesmen, no usurpation, and distrust of private property and trade. If they fought, or stole anything among one another, it was women. Such acts were performed under strict rules and considered honourable.
In the Middle Ages the Germanic tribes got sedentary and the evil foreseen by their old kings realized itself: the introduction of long term individual property rights for land, as exemplified by the Edictum Chilperici, left to us from the 6th century. It says that the death of a land owner (that means nobility!), if it is childless, his land will go to his brother (and not to the neighbours or anyone else who liked to use it). The very existence of "heritage" issues makes clear that in the meantime some kind of recognition of long term land property had come about, and that family relations had moved up in priority among property claims. The whole process led to the feudal system: a hierarchically ordered nobility owned the land formally as loan from the king but with rights of heritage. Working farmers were simply seen as part of the property. The lord decided how much of the crop the working farmer could keep to feed his family, the rest was considered the "yield" of the lord's "property". With it, he fed soldiers, courtiers etc. It was a matter of "skimming off" the natural agricultural surplus produce.
This was a power society, quite remote from the ideas of markets, supply, demand and prices, but sea, river and overland transport and trade started to yield classes of craftsmen and merchants forming towns at places strategic for trade and transport. Such towns were culturally quite different environments. This process of town formation dramatically accelerated in the 11th and 12th centuries, the start of extensive brick use, the times of the "Gothic" cathedrals and the founding of universities everywhere in Europe. The bulk of trade was between a town and its surrounding farm land, but there was also trade between towns, especially those with sea connections. In that period markets gained social significance, but they were in no way free markets in the modern sense. Towns acquired power in their own right but initially the internal division of power in towns looked more like a feudal system in that - not a nobility, but - a town elite of masters (guild heads) and magistrates decided on policy issues, which included
which products would be made
by which guild,
how they were to be produced.
Universities simply were one of the guilds, in fact the only one that survives until today, and its professors like Thomas Aquinas, wrote about "just price", as a matter of morality and (town) politics. Town economy was a meticulously maintained system of monopolies, and clearly no climate for a free entrepreneur working out his own commercial plan.
One gets the idea once one realizes how present day universities, the last remnants of the guild system, naturally set, by their system of ranks and careers to maintain academic tradition, have not exactly been the places of the major ground breaking technical innovations of the past century.
Such was the atmosphere in towns generally: products from outside were
barred as soon as the inside masters of the competing guild thought this to be in
their advantage. Artisans from outside a town would not be allowed to work (or
even live) in the town unless they, like the Huguenots fleeing for religious
persecution in the 15th century reformation,
came with a lot of money and made things nobody else could. In
short, to modern Western standards, policy makers did everything God forbids and
thought it was good!
Gradually, the rich of the towns infiltrated the power elite of (rural land owning) nobility surrounding the king or prince, who started to feel he had to balance country and town interests. Meanwhile society began more and more to rely on the technical products and industry of the town artisans. Speech and thoughts about social and political matters became issues of a wider public. The first ever newspaper, The Boston News Letter, appeared in 1704. In 1760 the first ever shoe factory started in Massachusetts, and five years later James Watt presented the first steam engine that could efficiently move industrial machines. Theories of "free" markets had started to sound all around, rather utopian, because except in the American colonies - where Europe's nobility did not feel the need to go, and that were too big and moved too fast to be controlled by anyone else - no one had ever seen free markets at work. The new "liberal" ideas were rejected by the conservative majority of existing power elites in the towns, country and government of old Europe. The conservative stance: God, Motherland and the King, brutally laming taxation as the "right" of the ruling class, the "fathers of the nation", to live off the nation as their "property", was well documented and spread over the part of the population that traditional power brokers felt dependent upon. Intellectuals discussing and writing about liberal ideas (of citizens being free, choosing their economic activities and their leaders) were looked upon as parvenu (new rich), not yet capable to understand the proper organization of a nation. In 1766, Anne-Robert-Jacques Turgot, Baron de Laune, Intendant of Limoges wrote Formation et distribution des richesses, a manifesto of liberalization of markets. He did not consider the liberalization of governments, because he looks for an absolute monarch to implement the liberalization. It would involve introducing less brutal and smarter taxes, designed to stimulate economic activity and lead to more riches, ultimately also to more tax income. But the price, a tax reduction, had to be paid first. Turgot's book was frowned upon, a true member of the traditional French elite would not even read it, after all the author was only a baron and provincial intendant. But 8 years later, in a failed attempt of Louis XVI, justly fearing he was not in a sustainable situation, to get things on the move a bit, Turgot became a state minister, and not much later the head of France's finances. He did not fit and it took the conservatives only eight years to get him out again. In that same year, 1776, Adam Smith's Wealth of Nations, an even thicker and more academic liberal manifesto by a Scottish university professor, reached France. After some study, the Journal des Savants of February 1777, wrote that "gens des lettres" had said a translation would be too costly for the expected sales.
France would get 4 competing translations in the 20 years to come, and a bloody revolution, which should make clear indeed that the 18th century European economies were in bad need of liberators of whom Adam Smith became the intellectual leader par excellence. Adam Smith's Wealth of Nations is a peaceful book, but in his private correspondence Smith wrote about "the very violent attack I had made upon the whole commercial system of Great Britain". Great Britain listened better than France, and the experiment of unfettering the markets and observing whether the promises made by the "economists" would realize did not need bloodshed there. In Holland, the old fossilized Dutch elite sought and got protection from the Prussian army at first, but when the Dutch liberals got help from the French revolutionaries, the fate of the old guards got sealed, and the new "Batavian Republic", got modernized under French revolutionary power backing.
How did Adam Smith's Wealth of Nations help liberating the 18th century economies? This is summarized by the section headers below.
Re-ushering everybody in his social role
Properly conducting the social intercourse between the sovereign, the land lords, the entrepreneurs and the labourers will make sure everybody has abundant income, at least enough to live off, and it will enable the sovereign to derive enough taxes to do what is needed for governance once it will be understood what is the proper task of government and the great amount of present mistaken thoughts and actions will be avoided. The art and prescriptions of "political oeconomy" show the way.
The sovereign is unproductive. His contribution to wealth is indirect: to guard the maintenance of the proper conditions for free markets to fully open up for the fuel of labour, the energy of the economy and the sole source of the value created.
The entrepreneur (elsewhere master, merchant, undertaker) is led by his search for profit to strike this energy source and direct it to applications contributing to the wealth of the nation.
The landlord is totally and hopelessly unproductive. He "reaps where he never sowed" and land rent is nothing but an unfortunately unavoidable drag on wealth creation.
The traditional British land owning nobility will not have liked the message. In circles of businessmen however liberal ideas were heard all around more and more. They must have appreciated the systematic founding on academic principles of what still were disconnected liberal slogans. Especially now this was done by a professor like Adam Smith, not shy of classifying political oeconomists like himself in the unproductive classes. The working class was no party in the issue at all: "about you without you". Yet within a few pages of the book, labour was to replace gold in the definition of value.
Labour, and labour alone, raised the the status of economic energy
Making a comprehensive list of all items contributing to and
going into what we need and like to have in our life would be a boring thing to
do: animals, plants, fertile soil, ploughs, rain, sun, insects (for
pollination), mines, wood, trade, war, God...but Adam Smith starts like this:
"The annual labour of every nation is the fund which originally supplies it with
all the necessaries and conveniences of life". Labour! All
the necessaries and conveniences of life! Quite a daring statement.
In classical Greece, labour was done by slaves whose social status normally was close to that of cattle: bought, fed, and under orders. Then why not include cattle too?, the Greek would certainly have asked. And as soon as cattle is in, the leak seems big enough for most of the rest to follow: plants are like cattle in all aspects except being fixed to the ground, etc. The Greek of antiquity would not have swallowed it. Piracy and war would top his list.
Christians love labour. But as service to God, not to create wealth. You labour for your place in heaven. Putting labour in the framework of the creation of earthly wealth means taking the path to hell. The strict Christian, whether catholic or protestant, is weary of Adam Smith's teaching because he does not, like any eager reader of Smith's book, accept wealth as a self evident desirability warranting recommendations of political reform.
And yes, the dislike was on both sides: Smith was opposed to both slavery and fundamentalist Christianity. He considered them a drag on the liberal reform of society. The conservative ideas in Smith's time, especially among land owners, still leaned on the remains of the late middle age feudal variant of Christianity: That was the image of God the father ruling his flock of humble servants through His noble and clerical sovereigns, sent round to teach the gospel and collect the produce of the land, kindly leaving what a servant minimally needs in order to reach heaven while on the way healthy enough to keep producing, in short, from the modern liberal perspective: organized crime laming agricultural business.
Government is a drag on wealth creation unless properly conducted as fringe operation
In traditional works on "yconomy", or "howsolde keepyinge", known from the times of Aristotle, the author typically instructed the head of a household, pater familias, how to run it. Adam Smith attacks the common idea that a nation is just the same thing, only on a bigger scale, with a king as pater familias. He explains that political oeconomy has to proceed from the different principles: under conditions set by government, like tax and regulations, millions of individuals independently take decisions according to their interests, disregarding, yes usually even unaware of the intentions the sovereign had in introducing them. A pater familias is able to keep track of his family and correct an individual if necessary. Not so a sovereign of a nation! One needs a moral philosopher, a political economist, to work out the consequences of different types of taxation and regulation on the activities of the masses of the nation. Do do so, an economists starts with studying the situation where there is no government at all! Even without government, people's activities will be coordinated by markets where they can sell what they profitably can make, and buy what they need, by a complicated mechanism that they do not necessarily have to be aware of. It is sufficient that they act purely in their own interest. Smith replaces the traditional idea of government as the nation's backbone wothout which it would immediately collapse, with the idea that a market system without government, that is: totally free!, would be a viable and the most natural state of a commercial society supplying all needs to everybody. Any consideration of government tasks should, we are taught, start with a thorough understanding of the automatic wealth creating system of free markets. Then it will transpire that some fringe effort is needed to keep them free and enhance their benefit. These would be tasks of government in its new, proper, modest, assisting role. Thus Smith's claims concerning the working of free markets clearly were based on philosophical reasoning, not on scientific observations. There were no examples, no real free markets to be observed: markets were yet to be made free.
Making labour the standard of value measurement
If two hunters use very simple tools only and have equal skills, and if one beaver takes the same time to hunt as two dear, if both hunters need both types of animals, they may exchange beaver for dear, and this will always be in the ratio 1:2. If any one of the hunters would ask more for his animal, it would be time saving for the other to go and hunt it himself. Thus in this simple case products naturally exchange exactly according to the ratio of the labour time of their production. If you possess something, you possess power over other people's labour: you can make them sell you a product in which they invested their labour, which essentially is a sale of that labour itself. But the labour time as measurable with clocks is not the only thing: ""there may be more labour in an hour's hard work than in two hours easy business". People know and consider this when bargaining. So, the standard is labour time corrected for differences in "disutility per hour".
As a result of this disutility corrected time standard, Smith was to be considered the father of both labour value theory as developed and used by the classical economists like Ricardo (who inspired Marx) and Mill, and the late 19th century neoclassical revolution in economics Jevons, Walras, Cassel, Menger, and Marshall, who founded economics on the positive and negative "utilities" of all options available to economic actors, and started to leave it altogether to the actor whether or not to employ clocks to help them determining the utilities that enter market models as data to determine prices and quantities bought and sold.
Neutralizing metal money
"Labour alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price;" This ends with a semicolon. After the semicolon it continues: " money is their nominal price only" (full text econlib): gold and silver money have a true price like any other commodity: it goes up and down with the labour necessary to produce them, that is: to dig them out and mould them into objects suitable for exchange. In practice, money value depends on very whimsical forces: its price may plunge, not only by a blow in the reputation of the authority stamping it for weight and quality, but even by a false rumour that gold or silver is found and will flood markets. Apart from coming in quite handy as a means of exchange and saving, that is: for exchanging and saving labour, gold and silver are among the least useful commodities.
Putting centre stage the entrepreneur
A capital owner is someone whose past revenues exceeded his consumption. There are many types of capital owners. The wealth of the nation is only profiting from one of them: the entrepreneur (elsewhere master, merchant, undertaker). Such a person is distinguished by the way he decides how to spend his capital: he considers the alternatives he has for employing workers to produce a commodity and sell it on the market. And he chooses the most profitable options. Once products are sold and his capital has returned, he reevaluates the situation to see whether the profitability order of his options has changed or he shall do the same investment again. One may, even justly, frown a bit upon the businessmen's morals and habits, they are not exactly sticking most faithfully to traditions, but these are the men who know how to steer the nation's wealth machine. They should be stimulated to do what is natural to their character. Fortunately they have already made a firm start with it! To make it the interest of the entrepreneur to put himself centre stage, prices should be a bit higher than the labour incorporated in the product, to allow for a profit. Wherever such conditions arise we will see entrepreneurs coming in action creating wealth. These conditions are stimulated by reducing laming tax rates and regulations.
Land owners: land rent is parasitism
Not only the sovereign, also the land owning nobility should vacate the centre stage of society. They have capital and gain more by receiving land rent, but this usually is a drag on wealth creation because land owners tend not to behave like entrepreneurs: they waste their capital to unproductive uses: "feeding dogs, horses and servants". Since land rent is unavoidable in an economy as long as land ownership is protected, which unfortunately, considering the odds, is best after all, one may only hope sooner or later to successfully teach the land owner the mind set of the entrepreneur. Even if they try a bit, look how they spend more on the land just around their castle than could in any way be returned by its produce, and how they neglect the far ends, where a little investment could yield enormous profits! Land, apart from the labour spent to make it arable, is the only thing the price of which does not originate from labour value. Hence is it not a commodity and it does not count as capital. By nevertheless receiving a rent, the landlord "reaps where he never sowed".
Explaining the free market mechanism
Every commodity has a natural price, which changes if
circumstances change such that it becomes less or more difficult to produce.
This means: as soon as its production starts to require less or more labour. But even
when nothing of the sort happens, one might see market prices differ from
natural prices. One day, demand might be higher or lower than foreseen, another
day there may be unforeseen impediments, or stimulants to supply (rain, a
passing army, a contagious disease in town etc. or: an unexpectedly good
harvest, too many ships arriving with too much of some commodity, etc.). There may
have been over-optimistic or over-pessimistic plans to supply goods which need a specific time to
finish (like animals and crop), hence will
take time to correct. All this and more will create differences
between to actual market price of a commodity and its true, natural price,
that is, its labour value. The differences will not last, because of the
market mechanism: too high supply of a commodity will lower the price and
thus suppress the profit on
it to a rate below that of other commodities. Entrepreneurs will shift any capital
returning through their sales to more profitable commodities. Supply will sink
and price will restore to the natural level, at which the profit on it will be
average again. Under-supply of a commodity, on the contrary, will result in
above average profits and motivate any entrepreneur to invest capital returning
through his sales in the production of it. That will lower the market price
until the profits on it are back to average and the price has returned to
The natural price is the centre of the balance. Whenever human error, unforeseen circumstances or governmental incompetence pushes the market price off the natural level, it immediately starts again gravitating towards its equilibrium point, by actions of suppliers and consumers who amazingly enough are not in the least concerned with it, totally concentrated as each of them is his individual interests.
Though it might not be directly relevant to teach the morals
of the free market economy, understandably one might ask a teacher of such
morals to be
told how prices should be calculated. Smith was not shy of making an elaborate
attempt, though he got in a bit of a mess. He was not only forgiven for it, but his
attempt was greatly appreciated and hailed as an excellent source of employment
for the class of economists newly, quickly and eagerly establishing itself after
the appearance of the Wealth of Nations.
Determining wages: If the capital available to pay and otherwise employ workers would remain constant in the long run, increase of the working population would gradually suppress the wage rate to the subsistence level. Simply think of the total wage fund available in the nation as a certain stock of wheat. Its value is the amount of agricultural labour that went into the production of this grain. Would capital decrease this would lead to proportional starvation of the labouring population: the employed can only just feed themselves, there simply is no food for the unemployed. Would capital grow faster than the working class population, then negotiations on the labour market would lead to wages slightly higher than subsistence.
Determining profits Smith regards profits as an addition to the value of the labour that goes into the product, but all the same it is to be estimated in terms of its labour value. Smith introduces average, ordinary, good, moderate, common, usual, neat and clear profits, and never uses the term natural profits! Though he bravely keeps up his head, he clearly is in nasty troubles (read it for more details: Wealth of Nations Chapter IX). He does not reach any definite conclusion, but:
Profits are not below the level which allows the entrepreneur to survive.
Profits contain a risk premium for the investment
Profits can not be higher than the level where there is nothing left of land rent and workers barely survive
Profits should at least be a little bit higher than what is necessary to cover incidental losses
Profits can be unnaturally raised by creating monopolies and price conspiracies
Smith does not try explain profits as future enjoyment in exchange for the suffering of the entrepreneur while he is working for this future.
Determining land rent. After crossing this dark field Smith determines land rent by writing as if he has already determined the prices of commodities, especially crops. Think of wheat: its revenue on the market is used to return wages paid, and to provide the agricultural entrepreneur with profit and a refund if his non wage costs. The rest is simply skimmed off as rent!: the worst land in use yields no rent. Any better land requires less labour per kilo of wheat than the worst, and the surplus, not necessary for paying market wages and (average) profits, acceptable to any entrepreneur, goes to the land owners.
Making the agenda for price formation analysis
Determining commodity prices by adding the "natural" wages, profits and rent components (section above) is not possible since, first, we got no guideline to calculate profits, and second, rent calculation requires the commodity price as given, hence is circular. The system is undetermined, but few readers can escape the thought that quietly sitting some hours might yield a full determination of prices along the lines set out by Smith.
It had an effect similar to Fermat's Last Theorem in mathematics: it is easy to understand what we want, and, given the conditions set, the desired result looks attainable by pure abstract analysis. But for more than a century the puzzle would break the teeth of a growing number of bright and persistent minds that got a taste for it. One hundred years later, mathematical whiz kid L�on Walras, on the wave of mounting feelings one could not solve this while at the same time preserving the labour value principle, would scoop the prize. Again 20 years later Karl Marx made an almost thousand page attempt to save price determination by calculating labour values (Capital Volume III, 1894). That retriggered the issue in academic circles and resulted in disproof of Marx's sophisticated claims with sophisticated math. Thus, Marx succeeded in becoming the economic anti hero and pastime for academic mathematicians up to Paul A. Samuelson again more than another half century later. Meanwhile the mathematics of general equilibrium prices got cleared up completely, an interesting and gratifying achievement, though void of consequences for economic practice or policy..
Smith made the idea of attainability of a proper price theory look so obvious that he felt he could continue the lines of his thoughts as if this cornerstone had been firmly placed, and proceed to teach how the wealth of nations is enhanced:
Catching the prodigals
In the course of one year, people receive capital in the form of wages, profit and rent. The value of all this capital is measured in labour. Wages can be considered to be consumed totally. What is done with the rest of the capital? Some, the prodigals, simply spend their annually received capital on "servants, dogs and horses". Others, prudent entrepreneurs set labour to work to produce, for a profit, new capital. That profit hence is, by definition, the yearly addition to the total amount of capital in the nation. And that addition is what Adam Smith calls wealth. Prodigality, that is unproductive use of labour, leads to poverty: a decline of the capital of the nation. Frugality, productive use of labour, adds, during a year, more to the capital of the nation than it consumes, and this annual net addition is the wealth of the nation. In the picture below, capital in Smith's definition is everything that
has required labour to produce,
is a tangible object (services are not, a servant is unproductive)
is useful to somebody
Examples of capital in Smith's definition transpiring from the picture below are ships, houses, mills, grain, ploughs, oxen. Castles, horses and dogs are capital too, though they are used unproductively. Land is no capital, though it bears some capital in the form of labour used in making it arable
Predicting the long term future
After thus firmly pinning down future and past, good and evil, Smith turns to what the long term future will be if frugality prevails. There will be positive annual wealth, that is, an annual growth of the nation's stock of capital. Workers will be paid slightly above minimum subsistence wage if that annual capital growth remains higher than the annual growth of the working population. More and more land will have to be cultivated to feed the population. Unfortunately, there is an end to that. Cultivation of new land can only continue until only such bad quality of land is left that it only produces the wheat to maintain those who cultivate it, leaving no excess to sell on a market, so no profit (and no rent). That will be the end of the possibilities for growth of a nation. It is very far away.
Setting the political agenda of his day
For now, we should make the prodigals (read: the traditional land owning nobility) realize that capital should be employed productively, and we should teach government not to lame industry with strangling taxes and silly regulations, and not to protect the interests of those who try to gain capital in order employ it unproductively. We all want wealth, don't we? Then everybody disposing of capital should produce it, and those who don't should not idly use their power to scoop some undeserved and unproductive benefit.