prior probability

Talk about the division of labor: large language models can write your term papers and grade them too!

Is American exceptionalism for real? With the recent news that the public debt of the United States has now surpassed $40 trillion (see here, for example), I want to take a moment to share my previous blog posts (from earlier this year) on Adam Smith’s thoughts on public debts:

1. “The last chapter of The Wealth of Nations: *Of Publick Debts*“
2. “Adam Smith, father of public choice theory“
3. “The real reason why nations fail according to Adam Smith“
4. “Adam Smith on the social cost of public debts“
5. “Adam Smith’s new Utopia (and his epic smack-down of politicians)“

Nota bene: I will conclude my comprehensive survey of Adam Smith’s 1784 digression on joint stock companies on Tuesday (18 August), but in the meantime below is a compendium of my recent blog posts on Adam Smith’s critique of joint stock companies:

General (three posts)

1. Adam Smith and the economics of corporate governance
2. Adam Smith’s rebuke of corporate boards
3. Adam Smith’s digression on joint stock companies (continued)

Royal African, Hudson’s Bay, and South Sea companies (one post each)

1. Adam Smith’s brief history of the Royal African Company
2. Adam Smith’s survey of the Hudson’s Bay Company
3. Adam Smith’s South Sea Company post-mortem

East India Company (five posts)

1. Adam Smith’s very long paragraph: part 1 of 3
2. Adam Smith’s very long paragraph: part 2 of 3
3. Adam Smith’s very long paragraph: part 3 of 3
4. Lessons from the rise and fall of the East India Company: public versus private government
5. Lessons from the rise and fall of the East India Company: Adam Smith’s Catch-22

Bonus link (via Wikipedia): List of chartered companies

If you are looking for any further evidence that Adam Smith is, deep down, a pragmatist, then check out paragraph 30 of the last part of Smith’s 1784 pamphlet, Additions and Corrections to the First and Second Editions of Dr. Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations. The first three sentences of this paragraph describe three examples of temporary monopolies that are perfectly justified: copyrights, patents, and … wait for it … overseas trading companies like the East India Company! Or in the immortal words of Adam Smith:

“When a company of merchants undertake, at their own risk and expense, to establish a new trade with some remote and barbarous nation, it may not be unreasonable to incorporate them into a joint stock company, and to grant them, in case of their success, a monopoly of the trade for a certain number of years. It is the easiest and most natural way in which the state can recompense them for hazarding a dangerous and expensive experiment, of which the public is afterwards to reap the benefit. A temporary monopoly of this kind may be vindicated upon the same principles upon which a like monopoly of a new machine is granted to its inventor, and that of a new book to its author.” (Smith 1784, pp. 74-75)

Smith further adds that any military bases (“forts and garrisons”) built by overseas trading companies to protect their foreign investments should be expropriated by the home government (Britain):

“But upon the expiration of the term, the monopoly ought certainly to determine; the forts and garrisons, if it was found necessary to establish any, to be taken into the hands of government, their value to be paid to the company, and the trade to be laid open to all the subjects of the state.” (Smith 1784, p. 75)

Despite Smith’s concession in favor of certain types of temporary monopolies, Smith is adamantly opposed to perpetual monopolies. Smith provides two reasons why perpetual monopolies are bad and are never justified:

“By a perpetual monopoly, all the other subjects of the state are taxed very absurdly in two different ways: first, by the high price of goods, which, in the case of a free trade, they could buy much cheaper; and, secondly, by their total exclusion from a branch of business which it might be both convenient and profitable for many of them to carry on. It is for the most worthless of all purposes, too, that they are taxed in this manner.” (Smith 1784, p. 75)

But wait, there’s more! There’s an additional reason why perpetual monopolies are so bad. According to Smith, giving a company a perpetual monopoly will end up subsidizing, in Smith’s words, “the negligence, profusion, and malversation” of the employees of the company protected by such a perpetual monopoly:

“It is merely to enable the company to support the negligence, profusion, and malversation of their own servants, whose disorderly conduct seldom allows the dividend of the company to exceed the ordinary rate of profit in trades which are altogether free, and very frequently makes it fall even a good deal short of that rate.” (Smith 1784, p. 75)

Smith concludes his survey of East India Company with a general point about all joint stock companies that are engaged in the business of overseas trade. According to Smith, such joint stock companies cannot survive without a monopoly: “Without a monopoly, however, a joint stock company, it would appear from experience, cannot long carry on any branch of foreign trade.” (Id.) Why not? Because the directors and managers of large joint stock companies can’t respond to market conditions as quickly or astutely as smaller competitors can:

“To buy in one market, in order to sell, with profit, in another, when there are many competitors in both, to watch over, not only the occasional variations in the demand, but the much greater and more frequent variations in the competition, or in the supply which that demand is likely to get from other people, and to suit with dexterity and judgment both the quantity and quality of each assortment of goods to all these circumstances, is a species of warfare of which the operations are continually changing, and which can scarce ever be conducted successfully without such an unremitting exertion of vigilance and attention as cannot long be expected from the directors of a joint stock company.” (Smith 1784, pp. 75-76)

Smith then applies this general lesson to the specific example of East India Company:

“The East India Company, upon the redemption of their funds, and the expiration of their exclusive privilege, have right, by Act of Parliament, to continue a corporation with a joint stock, and to trade in their corporate capacity to the East Indies in common with the rest of their fellow-subjects. But in this situation, the superior vigilance and attention of private adventurers would, in all probability, soon make them weary of the trade.” (Smith 1784, p. 76)

Notice what Smith is doing here. He is describing is a kind of political-economic paradox, a classic catch-22 or “damned-if-do, damned-if-you don’t” situation. On the one hand, monopolies are doomed to fail because monopolies tend to produce “negligence, profusion, and malversation” on the part of employees. But at the same time, a joint stock company engaged in overseas trade cannot survive unless it is awarded a monopoly over that trade. Hence the catch 22!

Does this paradox have a solution? What is the ultimate lesson of the East India Company? The Smithian solution is to grant “temporary” monopolies, just like the we do for copyrights and patents. But how long should these each of these “temporary” monopolies last? That is, how temporary is temporary? Alas, Smith does not say.

Nota bene: I will conclude my survey of Adam Smith’s digression on joint stock companies on Tuesday (18 August).

Thus far this week (see here, here, and here), we have reviewed Adam Smith’s tedious and painstaking reconstruction of the rise and fall of the East India Company. What lessons can we learn from this epic episode in the history of mercantilism? As it happens, two of the next three paragraphs of Smith’s 1784 pamphlet (namely, paragraphs 27 & 29) move from the specific (the East India Co.) to the general: how to align the interests of the East India Company’s “servants and dependants” (i.e. employees) with those of the proprietors” (shareholders). In paragraph 27, Smith writes:

“It might be more agreeable to the company that their own servants and dependants [i.e. the employees of the corporation] should have either the pleasure of wasting or the profit of embezzling whatever surplus might remain after paying the proposed dividend of eight per cent than that it should come into the hands of a set of people with whom those resolutions could scarce fail to set them, in some measure, at variance. The interest of those servants and dependants might so far predominate in the court of proprietors [i.e. the shareholders who have a controlling interest in the corporation] as sometimes to dispose it to support the authors of depredations which had been committed in direct violation of its own authority. With the majority of proprietors, the support even of the authority of their own court might sometimes be a matter of less consequence than the support of those who had set that authority at defiance.” (Smith 1784, p. 73)

Smith thus anticipates what economists today call “the principal-agent problem,” i.e. a conflict of interest between the employees of a large joint stock company and the shareholders who own the company. In short, why would the employees of a corporation ever act in the best financial interest of the shareholders? Moreover, Smith explains two paragraphs down (para. 29) why this internal conflict of interest is especially acute in the case of the East India Company:

“With the right of possessing forts and garrisons in distant and barbarous countries is necessarily connected the right of making peace and war in those countries. The joint stock companies which have had the one right have constantly exercised the other, and have frequently had it expressly conferred upon them. How unjustly, how capriciously, how cruelly they have commonly exercised it, is too well known from recent experience.” (Smith 1784, p. 74)

In other words, the principal-agent problem is not just a matter of dollars and cents, of maximizing shareholder value. It’s a matter of justice. That is why trade should be free and open, not controlled by state-sanctioned mercantile monopolies. Because when a firm like the East India Company acts as both a merchant and a government, an even deeper conflict of interest or principal-agent problem emerges, for the agents of the company only care about their own personal gain or, at most, the profits of the company. They do not care at all about the well-being of the local people they rule.

But what about “the regulations of 1773” — i.e. the two major changes in the East India Company’s corporate governance made by Parliament in 1773 that Smith highlights towards the end of his “very long paragraph” (see here)? Alas, Smith tells us in the next paragraph (para. 28) that “[t]he regulations of 1773 … did not put an end to the disorders of the company’s government in India.” (Smith 1784, p. 73) Why not? Because of the general “principal-agent problem” that bedevils joint stock companies with large numbers of shareholders.

By way of example, even when the English East India Co., “during a momentary fit of good conduct,” had amassed “more than three millions sterling” and had access to “a vast accession of some of the richest and most fertile countries in India”, the Scottish philosopher-economist-customs officer reports that “all was wasted and destroyed”:

“… during a momentary fit of good conduct, they had at one time collected into the treasury of Calcutta more than three millions sterling; notwithstanding that they had afterwards extended, either their dominion, or their depredations, over a vast accession of some of the richest and most fertile countries in India, all was wasted and destroyed. They found themselves altogether unprepared to stop or resist the incursion of Hyder Ali; and, in consequence of those disorders, the company is now (1784) in greater distress than ever; and, in order to prevent immediate bankruptcy, is once more reduced to supplicate the assistance of government.” (Smith 1784, pp. 73-74)

Adam Smith then closes this paragraph (para. 28) on a deeply pessimistic note. After observing that “[d]ifferent plans have been proposed by the different parties in Parliament for the better management of its [the East India Co.’s] affairs,” Smith highlights what all these corporate governance proposals have in common: the company is incapable of ruling its territorial possessions and must therefore hand those possessions over to the (British?) government. Or in the words of the Scottish scholar:

“And all those plans seem to agree in supposing, what was indeed always abundantly evident, that it is altogether unfit to govern its territorial possessions. Even the company itself seems to be convinced of its own incapacity so far, and seems, upon that account, willing to give them up to government.” (Smith 1784, p. 74, my emphasis)

Smith wraps up his scathing indictment of the English East India Company in paragraph 30 of the last part of his 1784 pamphlet (see my next post). Although paragraph 30 is not as protracted as Smith’s “very long paragraph” (para. 26), it’s still pretty long: it contains over 500 words and 10 sentences — the lengthiest of which consists of 119 words and the second-longest, 82 words). I will turn to Smith’s closing East India Co. paragraph in my next post. (To be continued …)

Alternate title: The Rise and Fall of the English East Indian Company

To sum up the first two-thirds of our survey of Adam Smith’s “very long paragraph” (see here and here), the English East India Company had accumulated massive amounts of debts over the course of the 18th century, but this mercantilist company had also generated tons of revenue — so much so that by 1773, the year its five-year bribe payoffs to the British government were set to expire (see my previous post), the firm was so flush with cash that it was poised to clear its massive debts. Instead, the company’s debts began to spiral out of control! Smith writes (sentence #47):

“In 1773, however, their debts, instead of being reduced, were augmented by an arrear to the treasury in the payment of the four hundred thousand pounds, by another to the custom-house for duties unpaid, by a large debt to the bank for money borrowed, and by a fourth for bills drawn upon them from India, and wantonly accepted, to the amount of upwards of twelve hundred thousand pounds.” (Smith 1784, p. 70)

The East India Company was now forced to take drastic measures. Among other things (sentence #48), the company had to take out a loan, beg the government for a moratorium on its bribe payments (again, see my previous post), and slash its dividend payments in half:

“The distress which these accumulated claims brought upon them, obliged them not only to reduce all at once their dividend to six per cent, but to throw themselves upon the mercy of government, and to supplicate, first, a release from further payment of the stipulated four hundred thousand pounds a year; and, secondly, a loan of fourteen hundred thousand, to save them from immediate bankruptcy.” (Smith 1784, pp. 70-71)

At the same time, Smith informs us in the very next sentence of this very long paragraph (sentence #49), the employees of the East India Company engaged in shady business practices in order to enrich themselves before the company’s imminent collapse:

The great increase of their fortune had, it seems, only served to furnish their servants with a pretext for greater profusion, and a cover for greater malversation, than in proportion even to that increase of fortune. (Smith 1784, p. 71)

The situation got so out of hand that the Parliament conducted a formal inquiry and made “several very important alterations” to the company’s corporate governance. In the immortal words of Adam Smith (sentence #50):

“The conduct of their servants in India, and the general state of their affairs both in India and in Europe, became the subject of a Parliamentary inquiry, in consequence of which several very important alterations were made in the constitution of their government, both at home and abroad.” (Smith 1784, p. 71)

What were these “alterations” or changes to the company’s constitution? First off, the operations of the company in India would now be subject to strict government oversight. Smith writes (sentences ##51-54):

“In India their principal settlements of Madras, Bombay, and Calcutta, which had before been altogether independent of one another, were subjected to a governor-general, assisted by a council of four assessors, Parliament assuming to itself the first nomination of this governor and council who were to reside at Calcutta; that city having now become, what Madras was before, the most important of the English settlements in India. The Court of the Mayor of Calcutta, originally instituted for the trial of mercantile causes which arose in city and neighbourhood, had gradually extended its jurisdiction with the extension of the empire. It was now reduced and confined to the original purpose of its institution. Instead of it a new supreme court of judicature was established, consisting of a chief justice and three judges to be appointed by the crown.” (Smith 1784, p. 71)

In addition to subjecting the operations of the company in India to government oversight, Smith describes two major changes to the internal corporate governance of the East India Company. One major change, Smith says (sentences #55 & #56), was to reduce the number of shareholders with voting rights:

“In Europe, the qualification necessary to entitle a proprietor to vote at their general courts was raised from five hundred pounds, the original price of a share in the stock of the company, to a thousand pounds. In order to vote upon this qualification too, it was declared necessary that he should have possessed it, if acquired by his own purchase, and not by inheritance, for at least one year, instead of six months, the term requisite before.” (Smith 1784, p. 71)

The other major change (sentences #57 & #58) was to increase and rotate the terms of the members of the company’s board of directors:

“The court of twenty-four directors had before been chosen annually; but it was now enacted that each director should, for the future, be chosen for four years; six of them, however, to go out of office by rotation every year, and not to be capable of being re-chosen at the election of the six new directors for the ensuing year. In consequence of these alterations, the courts, both of the proprietors and directors, it was expected, would be likely to act with more dignity and steadiness than they had usually done before.” (Smith 1784, pp. 71-72)

For Smith, however, these changes in the company’s corporate governance were merely cosmetic. They do not align the private incentives of corporate officers with the common good. Smith writes (sentence #59):

“But it seems impossible, by any alterations, to render those courts [i.e. boards of directors of joint stock companies doing business overseas], in any respect, fit to govern, or even to share in the government of a great empire; because the greater part of their members must always have too little interest in the prosperity of that empire to give any serious attention to what may promote it.” (Smith 1784, p. 72, my emphasis)

Adam Smith doesn’t hold back, for he does not limit this criticism to the board of directors of the East India Company. He extends his damning critique to the company’s shareholders. Smith writes (sentences ##60-63):

“Frequently a man of great, sometimes even a man of small fortune, is willing to purchase a thousand pounds’ share in India stock merely for the influence which he expects to acquire by a vote in the court of proprietors. It gives him a share, though not in the plunder, yet in the appointment of the plunderers of India; the court of directors, though they make that appointment, being necessarily more or less under the influence of the proprietors, who not only elect those directors, but sometimes overrule the appointments of their servants in India. Provided he can enjoy this influence for a few years, and thereby provide for a certain number of his friends, he frequently cares little about the dividend, or even about the value of the stock upon which his vote is founded. About the prosperity of the great empire, in the government of which that vote gives him a share, he seldom cares at all.” (Smith 1784, p. 72, my emphases)

Then, in what has to be one of the most strongly-worded and damning passages Smith would ever write (sentence #64), Smith makes the following indictment:

“No other sovereigns ever were, or, from the nature of things, ever could be, so perfectly indifferent about the happiness or misery of their subjects, the improvement or waste of their dominions, the glory or disgrace of their administration, as, from irresistible moral causes, the greater part of the proprietors of such a mercantile company are, and necessarily must be.” (Smith 1784, p. 72, my emphasis)

Worse yet, according to Smith (sentences ##65-67), the British government only made matters (this lack of alignment between the company and the common good) worse :

“This indifference, too, was more likely to be increased than diminished by some of the new regulations which were made in consequence of the Parliamentary inquiry. By a resolution of the House of Commons, for example, it was declared, that when the fourteen hundred thousand pounds lent to the company by government should be paid, and their bond-debts be reduced to fifteen hundred thousand pounds, they might then, and not till then, divide eight per cent upon their capital; and that whatever remained of their revenues and net profits at home should be divided into four parts; three of them to be paid into the exchequer for the use of the public, and the fourth to be reserved as a fund either for the further reduction of their bond-debts, or for the discharge of other contingent exigencies which the company might labour under. But if the company were bad stewards, and bad sovereigns, when the whole of their net revenue and profits belonged to themselves, and were at their own disposal, they were surely not likely to be better when three-fourths of them were to belong to other people, and the other fourth, though to be laid out for the benefit of the company, yet to be so under the inspection and with the approbation of other people.” (Smith 1784, pp. 72-73, my emphases)

I will conclude my survey of Smith’s stinging critique of the East India Company in my next post. (To be continued …)