prior probability

Adam Smith is often referred to as “the father of economics.” Although my colleague and friend (and co-author) Salim Rashid has questioned whether Smith is deserving of this title, [1] one thing I can say for certain is this: Smith presents a nascent theory of development economics in Book II of his magnum opus, The Wealth of Nations. Why, for example, are some nations poor, while others are opulent? Book II, which is titled “Of the Nature, Accumulation, and Employment of Stock”, contains five short but crucial chapters, all of which are devoted to this key question. Smith begins by defining the concept of “stock” or capital assets in Chapter 1 of Book II. [2] For Smith, capital can be used in one of two ways:

“First, [capital] may be employed in raising, manufacturing, or purchasing goods, and selling them again with a profit. The capital employed in this manner yields no revenue or profit to its employer, while it either remains in his possession, or continues in the same shape. The goods of the merchant yield him no revenue or profit till he sells them for money, and the money yields him as little till it is again exchanged for goods. His capital is continually going from him in one shape, and returning to him in another, and it is only by means of such circulation, or successive exchanges, that it can yield him any profit. Such capitals, therefore, may very properly be called circulating capitals.

“Secondly, it may be employed in the improvement of land, in the purchase of useful machines and instruments of trade, or in suchlike things as yield a revenue or profit without changing masters, or circulating any further. Such capitals, therefore, may very properly be called fixed capitals.” (WN, II.i.4-5)

Adam Smith thus compares and contrasts fixed capital, e.g. long-term assets like buildings, tools and machines, and people(!) [3], with circulating capital, e.g. short-term assets like raw materials, inventory, and wages. More importantly, Smith’s distinction is not only relevant today — modern accounting concepts like fixed assets (“Property, Plant, and Equipment” or PP&E) and working capital (Current Assets minus Current Liabilities) can be traced back to Smith — it also goes to the core of his most enduring and original idea, the seed of which he already planted in his lengthy “Digression on the Value of Silver” in Book I of The Wealth of Nations: wealth is not about money; wealth is about economic growth via the production and consumption of goods and services, [4] or in the immortal words of Smith himself:

“To maintain and augment the stock which may be reserved for immediate consumption is the sole end and purpose both of the fixed and circulating capitals. It is this stock which feeds, clothes, and lodges the people. Their riches or poverty depends upon the abundant or sparing supplies which those two capitals can afford to the stock reserved for immediate consumption.” (WN, II.i.26)

In other words, a poor or developing nation does not make progress by accumulating or hoarding money and other assets; a nation becomes wealthy when her capital assets are put to productive use. (To be continued …)

[1] See generally Salim Rashid, The Myth of Adam Smith, Edward Elgar 1998.

[2] When Smith uses the word “stock”, he isn’t referring to securities or shares in a company (like today’s meaning of “stock”); instead, he has a broader meaning in mind: “stock” refers to capital or all the accumulated wealth or resources of a nation, including such assets as raw materials, provisions, machinery, and money.

[3] Later in this same chapter, Smith includes “human capital” in his definition of fixed capital, thus creating a whole new branch of economics. Referring to “the acquired and useful abilities of all the inhabitants or member of the society,” Smith observes: “The acquisition of such talents, by the maintenance of the acquirer during his education, study, or apprenticeship, always costs a real expense, which is a capital fixed and realized, as it were, in his person. Those talents, as they make a part of his fortune, so do they likewise of that of the society to which he belongs.” (WN, II.i.17)

[4] Cf. WN, IV.viii.49: “Consumption is the sole end and purpose of all production.”

After his lengthy digression on the value of silver, Adam Smith concludes Book I of The Wealth of Nations with an important and original observation about the three major classes or “orders of people” in any economic system — i.e. landlords or “those who live by rent” (I.xi.p.8), workers or “those who live by wages” (I.xi.p.9), and capitalists or owners of capital or “those who live by profit” (I.xi.p.10). According to Smith, the rents of landlords and the wages of workers will rise when the economy as a whole is expanding, and by the same token, rents and wages will fall when the economy is stagnant or in decline. The profits of the capitalist class, however, are a different story:

But the rate of profit does not, like rent and wages, rise with the prosperity and fall with the declension of the society. On the contrary, it is naturally low in rich and high in poor countries, and it is always highest in the countries which are going fastest to ruin. (I.xi.p.10)

The Scottish philosopher then anticipates Karl Marx’s critique of capitalism by concluding Book I with the following ominous warning: the private economic interests of the capitalist class are diametrically opposed to the interests of the general public, or in the immortal words of Adam Smith:

“The interest of the [capitalists] … in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the [capitalists], by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.” (I.xi.p.10)

As a result, Smith urges people to exercise extreme caution anytime business firms propose a new law or regulation:

“The proposal of any new law or regulation of commerce which comes from this order [i.e. the capitalists] ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.” (I.xi.p.10)

In short, Book I of The Wealth of Nations poses something of a puzzle, maybe even a paradox: on the one hand, Smith thus far has been a vocal champion of laissez faire capitalism as an economic system — i.e. “a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to choose what occupation he thought proper, and to change it as often as he thought proper” (I.x.1) — but at the same time, he is deeply suspicious of capitalists as a class! Does this Smithian paradox have a solution, or is this contradiction inherent to capitalism? I will begin my survey of Book II of Smith’s magnum opus in my next post.

Adam Smith concludes Book I of The Wealth of Nations with a lengthy detour titled “Digression concerning the Variations in the Value of Silver during the Course of the Four last Centuries.” (WN, I.xi.e-p) Although it is tempting to just skim or even skip this seemingly tedious subsection, I agree with my colleague and friend Maria Pia Paganelli [1] that doing so would be a terrible mistake, a reckless omission, for Smith’s “digression” is no mere appendage or afterthought; it is a must-read for two reasons.

One is that Smith’s subsection on silver consists of “new” material. By Smith’s own admission, he wrote this part of his great book in February 1773 (see WN, I.xi.m.10), that is, a few years after his extended visit to France (1764 to 1766) and a decade (if not more) after writing his “early draft” of The Wealth of Nations. The other reason Smith’s lengthy detour is worth reading is that it explores what I like to call the “three-body problem” in economics — namely, what is the relationship between (i) a nation’s wealth, (ii) the price of precious metals like silver, and (iii) the price of consumer goods like corn and cattle? In the course of exploring this complex three-body conundrum, Smith exposes no less than three mercantilist miscues or economic errors:

• Fallacy #1: nominal prices are same as real prices. To begin, most of Smith’s 100-page-plus digression on the value of silver can be summed up in a tweet: We need to look at real prices (measured in terms of others goods and services), not just nominal prices (measured in money).
• Fallacy #2: correlation is causation. In addition, mercantilists confuse correlation with causation: they claim that the long-term increase in the nominal prices of most goods was caused by an increase in the amount of silver after the discovery of Spanish America. Smith, however, explains why this correlation is just a coincidence: the real price of silver and other goods (corn, cattle, etc.) is not only a function of changes in supply and demand but also of changes in overall economic prosperity. (WN, I.xi.n)
• Fallacy #3: money is wealth. Smith’s main punchline: the true wealth of a nation lies in its capacity to produce and consume useful goods and services, not just the amount of gold or silver it possesses. (WN, I.xi.n.1 & I.xi.n.9)

To recap, it is here — in his lengthy digression on the value of silver — that Smith’s debunks classical mercantilism, the idea that national wealth consists of gold and silver. But does Smith’s powerful rebuttal extend to modern mercantilism (e.g. Trumpism), the idea that national wealth consists of positive trade balances? (To be continued …)

[1] See Maria Pia Paganelli, “Adam Smith’s Digression on Silver: The Centerpiece of The Wealth of Nations.” Cambridge Journal of Economics, Vol. 46, No. 3 (2022), pp. 531-544, preprint available here.

What is the relationship between rent, profit, and wages — the ostensible subject of the second half of Book 1 of The Wealth of Nations — or between rents and prices more generally? Adam Smith grapples with these difficult theoretical and practical questions in Chapter 11 (available here) of his magnum opus. [1] Unlike the wages of workers and the profits of owners, however, one often gets the feeling from Smith that landlord rents are a necessary evil! In a previous chapter (Ch. 6), for example, Smith takes a direct swipe at landlords:

As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce. The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was in common, cost the labourer only the trouble of gathering them, come, even to him, to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces. This portion, or, what comes to the same thing, the price of this portion, constitutes the rent of land, and in the price of the greater part of commodities makes a third component part. (WN, I.vi.8)

After devoting three chapters to wages and profits (Chs. 8-10; see here, here, and here), Smith returns to the subject of landlords and rents in Chapter 11. Here, although Smith’s tone is less judgmental and more analytical, he goes to great lengths to point out how rents generally bear little to no relation to the skill or foresight of landlords. In the preamble to this lengthy concluding chapter (I.xi.a.1-9), for example, Smith defines rent as “the price paid for the use of land” (I.xi.a.1 & I.xi.a.5); then he asserts the following general principle:

Rent, it is to be observed, therefore, enters into the composition of the price of commodities in a different way from wages and profit. High or low wages and profit are the causes of high or low price; high or low rent is the effect of it. It is because high or low wages and profit must be paid, in order to bring a particular commodity to market, that its price is high or low. But it is because its price is high or low; a great deal more, or very little more, or no more, than what is sufficient to pay those wages and profit, that it affords a high rent, or a low rent, or no rent at all. (I.xi.a.8)

In other words, while the price of any given good or service is a function of profits and wages — i.e. the higher these profits or wages are, the higher the price of the good or service will be — rent, by contrast, is a function of price: the higher the price of any given good or service is, the higher landlord rents will be as a general rule. The key phrase here, however, is “as a general rule,” for Smith devotes the remainder of this chapter to describing three different scenarios regarding rents:

1. Scenario #1: Positive Rents (I.xi.b) — i.e. the circumstances under which landlords (like monopolists) are able to charge high rents;
2. Scenario #2: Negative or Zero Rents (I.xi.c) — i.e. the circumstances under which landlords are in no position to charge high rents; and
3. Scenario #3: Fluctuating Rents (I.xi.d) — i.e. the circumstances under which landlords’ position to charge high rents is unstable or in flux. It is here, when describing this third scenario, that Smith inserts a lengthy digression. [2] (To be continued …)

[1] As an aside, Chapter 11 is by far the most lengthy and tedious chapter of Book 1 of The Wealth of Nations: it spans over 180 pages of the Glasgow edition of Wealth and includes a protracted “Digression concerning the Variations in the Value of Silver during the Course of the Four last Centuries.” (I.xi.e-o)

[2] Smith’s “digression” takes up two-thirds of this lengthy chapter, or 119 pages of the Glasgow edition!

I will resume my series on The Wealth of Nations in my next post; in the meantime; check out this homage to another great economist: Thomas Sowell.

In Part 2 of Chapter 10 of Book I of The Wealth of Nations (I.x.c; available here), Adam Smith identifies three types of “absurd” laws and regulations — absurd because they restrict our natural liberty and distort markets:

• Laws and regulations that “restrain[] the competition in some employments to a smaller number than would otherwise be disposed to enter into them”; i.e. laws and regulations that artificially reduce the supply of workers in certain markets (see Paras. 3 to 32);
• Laws and regulations that “increas[e] the competition in some employments beyond what it would naturally be”; i.e. laws and regulations that artificially increase the supply of workers in certain markets (see Paras. 33 to 40);
• Laws and regulations that “obstruct[] the free circulation of labour and stock both from employment to employment”; i.e. oppressive laws like immigration restrictions and capital controls that artificially restrict or impede the free flow of capital and labor across borders (see Paras. 41-67).

Smith then surveys (and rightfully condemns!) many examples of specific laws and regulations that distort labor markets and obstruct capital flows, especially mandatory apprenticeship laws, education subsidies, and the infamous Poor Laws. But what is even more remarkable about this chapter is the fact that Smith’s diagnosis and critique of “those absurd laws” (I.x.c.43) are just as relevant and stinging today as they were in 1776! For what are occupational licensure laws but oppressive and wasteful and artificial restrictions on labor? What are federal student loan programs but subsidies to higher education that artificially inflate the number of college students? And what are immigration restrictions and taxes on capital flows but artificial restrictions to the free circulation of labour and stock?

But my favorite quote from Chapter 10 is Smith’s scathing critique of rent-seeking and business conspiracies:

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.” (I.x.c.27)

Here, Smith introduces what is to my mind a radical idea and a tension that will haunt the rest of his great work, for he implies that business can be just as detrimental to the public good as the government! (To be continued …)

Chapter 10 of The Wealth of Nations is the second-longest chapter in Book 1 of Smith’s magnum opus: it consists of two parts, contains 115 paragraphs (52 paragraphs in part one, followed by another 63 paragraphs in part two), and spans some 77 pages in the Glasgow edition. Among other things, this chapter addresses the following fundamental question: is it better to be an employee or a business owner, a worker or a “capitalist” (owner of capital)?

What is even more remarkable about this pivotal chapter is Smith’s surprising theoretical answer: the expected returns from labor and capital are in the long run equal! In fact, the Scottish philosopher-economist opens this chapter with the following general principle: “The whole of the advantages and disadvantages of the different employments of labour and stock must, in the same neighbourhood, be either perfectly equal or continually tending to equality.” (WN, I.x.a.1)

In other words, it does not matter whether you are a worker or a capitalist because the expected returns (in theory, at least) from labor and capital will either be “perfectly equal” or will be “tending to equality”! But that said, it is important to note that Smith qualifies his surprising conclusion with two important caveats. One is geographical. (Notice the qualification “in the same neighbourhood” in the quotation above.) The other caveat is legal/regulatory: the existence of free entry and exit into any trade, profession, or business, or in the immortal words of Adam Smith:

This [Smith’s surprising conclusion about equal expected returns from labor and capital] at least would be the case in a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to choose what occupation he thought proper, and to change it as often as he thought proper. (WN, I.x.a.1; my emphasis)

Alas, as Smith himself notes, this second condition rarely, if ever, holds, for “the policy of Europe … nowhere leaves things at perfect liberty.” (WN, I.x.a.2) The father of economics therefore devotes most of Chapter 10 to the “Inequalities occasioned by the Policy of Europe” (WN, I.x.c), i.e. to the distortions in the expected returns from labor and capital resulting from laws and regulations and other restrictions on liberty. (To be continued …)

Chapter 9 of Adam Smith’s Wealth of Nations (available here) is another intellectual and historical tour de force. Among other things, Smith not only compares and contrasts the levels of wealth of many different nations and regions of the world — England and Scotland, Bengal and China, and North America and Holland, just to name a few — Smith also formulates another general principle or general law regarding the relationship between profits and interest rates: “… as the usual market rate of interest varies in any country, we may be assured that the ordinary profits of stock must vary with it, must sink as it sinks, and rise as it rises. The progress of interest, therefore, may lead us to form some notion of the progress of profit.” (WN, I.ix4)

More importantly, Smith anticipates and refutes Karl Marx’s dire thesis in Das Kapital. According to Marx, the profits of the owners of capital come at the expense of the wages of the workers: as the wealthy acquire greater amounts of capital and produce more efficiently (i.e. hire fewer workers), the owners are able to exploit the working classes because of the existence of a large and ever-growing pool of unemployed men (Marx’s famous “reserve army of labor”). For Adam Smith, however, the opposite is true: it’s the workers who, in effect, “exploit” the owners of capital! In Paragraphs 6 and 7 of Chapter 9, for example, Smith writes:

“Since the time of Henry VIII. the wealth and revenue of the country have been continually advancing …. The wages of labour have been continually increasing during the same period, and in the greater part of the different branches of trade and manufactures the profits of stock have been diminishing.” (WN, I.ix.6)

“It generally requires a greater stock to carry on any sort of trade in a great town than in a country village. The great stocks employed in every branch of trade, and the number of rich competitors, generally reduce the rate of profit in the former below what it is in the latter But the wages of labour are generally higher in a great town than in a country village. In a thriving town the people who have great stocks to employ frequently cannot get the number of workmen they want, and therefore bid against one another in order to get as many as they can, which raises the wages of labour, and lowers the profits of stock….” (WN, I.ix.7)

Furthermore, according to Smith, the profits of the owners of capital will tend to decrease toward zero as the stock of capital increases! Why? Because an increase in profits in a given market attracts new entrants and new investments in capital by existing firms, and the resulting competition and investments in capital have the effect of increasing wages and decreasing profits. It suffices to say that history has vindicated Adam Smith and condemned Karl Marx.

Let’s pick up my survey of Adam Smith’s Wealth of Nations where we left off: with Chapter 8 on “The Wages of Labour” (available here). As it happens, this particular chapter is one of the lengthiest and most tedious chapters in Book I of the The Wealth of Nations — it consists of no less than 57 paragraphs and spans over 30 pages of the Glasgow edition of Smith’s magnum opus — but it is also one of the most intriguing and relevant chapters for our times, for buried deep inside (Para. 36) is the following immortal passage:

“Is this improvement in the circumstances of the lower ranks of the people to be regarded as an advantage or as an inconveniency to the society? The answer seems at first sight abundantly plain. Servants, labourers, and workmen of different kinds, make up the far greater part of every great political society. But what improves the circumstances of the greater part can never be regarded as an inconveniency to the whole. No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable. It is but equity, besides, that they who feed, clothe, and lodge the whole body of the people, should have such a share of the produce of their own labour as to be themselves tolerably well fed, clothed, and lodged.” (WN, I.viii.36; my emphasis)

We thus get to see a side of Adam Smith that is often overlooked or ignored: the Scottish philosopher as champion of the worker! He tells us that the working classes deserve their fair share of the overall wealth of society. But unlike Karl Marx, Thomas Piketty or John Rawls, Smith’s concern for ordinary working men (and women!) is grounded in economic reality:

“It deserves to be remarked, perhaps, that it is in the progressive state [i.e. expanding GDP],while the society is advancing to the further acquisition, rather than when it has acquired its full complement of riches, that the condition of the labouring poor, of the great body of the people, seems to be the happiest and the most comfortable. It is hard in the stationary, and miserable in the declining state. The progressive state is in reality the cheerful and the hearty state to all the different orders of the society. The stationary is dull; the declining, melancholy.” (WN, I.viii.43)

In other words, economic growth is more important than economic equality, or more simply put, for the working classes to prosper the economy as whole must be growing! (To be continued …)