prior probability

I concluded my previous post with a question, Doesn’t the government need to maintain a positive balance of trade as well as a large amount of gold and silver reserves for national security reasons, i.e. to finance naval fleets and raise armies in the event of invasion or war? As it happens, Smith devotes most of the second half of Book IV, Ch. 1 of The Wealth of Nations (see especially paragraphs. 20-30) to this very question, and his answer is an unequivocal NO: “It is not always necessary to accumulate gold and silver in order to enable a country to carry on foreign wars, and to maintain fleets and armies in distant countries.” (WN, IV.i.20) Why not? Because it is a country’s purchasing power (i.e. the amount of goods and services it is able to make or buy), and not its reserves in precious metals, that determines its ability to finance a war:

“Fleets and armies are maintained, not with gold and silver, but with consumable goods. The nation which, from the annual produce of its domestic industry, from the annual revenue arising out of its lands, labour, and consumable stock, has wherewithal to purchase those consumable goods in distant countries, can maintain foreign wars there.” (WN, IV.i.20)

According to Smith, gold and silver can be “accumulated or stored up” in one of three different ways — “first, the circulating money; secondly, the plate of private families; and, last of all, the money which may have been collected by many years’ parsimony, and laid up in the treasury of the prince” (WN, IV.i.22) — but none of these methods of piling up precious metals, standing alone, will ever be enough to pay for a war because wars are expensive. Based on his careful review of the available evidence, Smith concludes: “The funds which maintained [Britain’s] foreign wars of the present century, the most expensive perhaps which history records, seem to have had little dependency upon the … the circulating money, or of the plate of private families, or of the treasure of the prince.” (WN, IV.i.26)

But this observation, in turn, poses a puzzle: if Britain’s wars were expensive, and if they were not financed by taking gold and silver coins out of circulation or by melting down private hoards of precious metals or by shipping gold and silver reserves out of the country, then how were these expensive wars paid for? For Smith, the answer is not gold and silver; it is commerce and commodities. Taking the Seven Years’ Was as his prime example, Smith concludes: “The enormous expense of the late war [i.e. the Seven Years’ War] … must have been chiefly defrayed, not by the exportation of gold and silver, but by that of British commodities of some kind or other.” (WN, IV.i.27) More specifically, Smith tells us that it was “the annual produce of the land and labour of the country” that were “the ultimate resources which enabled us to carry on the [Seven Years’] war.” (WN, IV.i.28)

As an aside, Smith also explains why trade in manufactured goods — more than trade in agricultural goods — is the best way to finance a foreign war:

“The commodities most proper for being transported to distant countries, in order to purchase there either the pay and provisions of an army, or some part of the money of the mercantile republic to be employed in purchasing them, seem to be the finer and more improved manufactures; such as contain a great value in a small bulk, and can, therefore, be exported to a great distance at little expense. A country whose industry produces a great annual surplus of such manufactures, which are usually exported to foreign countries, may carry on for many years a very expensive foreign war without either exporting any considerable quantity of gold and silver, or even having any such quantity to export.” (WN, IV.i.29)

“No foreign war of great expense or duration could conveniently be carried on by the exportation of the rude produce of the soil. The expense of sending such a quantity of it to a foreign country as might purchase the pay and provisions of an army would be too great. Few countries produce much more rude produce than what is sufficient for the subsistence of their own inhabitants. To send abroad any great quantity of it, therefore, would be to send abroad a part of the necessary subsistence of the people. It is otherwise with the exportation of manufactures. The maintenance of the people employed in them is kept at home, and only the surplus part of their work is exported.” (WN, IV.i.30)

Furthermore, free trade not only makes it easier for a country to finance its foreign wars; free trade also promotes economic growth and development in the aggregate:

“The importation of gold and silver is not the principal, much less the sole benefit which a nation derives from its foreign trade…. By opening a more extensive market for whatever part of the produce of their labour may exceed the home consumption, it encourages them to improve its productive powers, and to augment its annual produce to the utmost, and thereby to increase the real revenue and wealth of the society…. To import the gold and silver which may be wanted into the countries which have no mines is, no doubt, a part of the business of foreign commerce. It is, however, a most insignificant part of it. A country which carried on foreign trade merely upon this account could scarce have occasion to freight a ship in a century.” (WN, IV.i.31; my emphasis)

To simplify, the best way to make war is to allow people to make money (not just store money), and the best way to make money is to allow free trade. But if free trade is so great, why is it so maligned in politics and so rare in practice? That is, why does almost every country in the world still engage in futile and self-defeating mercantilist and protectionist politics? (To be continued …)

“It would be too ridiculous to go about seriously to prove that wealth does not consist in money, or in gold and silver; but in what money purchases, and is valuable only for purchasing.” (WN, IV.i.17)

In a letter Adam Smith wrote four years after the publication of his Wealth of Nations, the Scottish philosopher describes his magnum opus as “the very violent attack I had made upon the whole commercial system of Great Britain.” (Corr. No. 208, letter from Adam Smith to Andreas Holt dated 26 October 1780) This figurative “very violent attack” begins in earnest in Chapter 1 of Book IV of of The Wealth of Nations (available here), where Smith explodes the most dominant economic theory and policy of his time (and, alas, ours): mercantilism/protectionism (M/P). In summary, M/P is a nationalist economic policy that aims to maximize a nation’s wealth and power through the accumulation of bullion (gold and silver) and a positive balance of trade, i.e. by promoting exports and restricting imports. But as Smith shows, M/P is based on a ridiculous, fruitless, and absurd theory: that money and wealth are the same things.

In a word, Smith calls bullshit! Among other things, he draws a simple analogy, comparing the total amount of gold and silver in circulation at any given moment in time to the total amount of pots and pans and other utensils in kitchen cupboards: “Gold and silver, whether in the shape of coin or of plate, are utensils, it must be remembered, as much as the furniture of the kitchen.” (WN, IV.i.19) As a result, any government policy that would try to artificially increase the total amount of kitchen utensils in a country would be patently absurd (“ridiculous”) as well as counterproductive because the number of pots and pans in a country is a function of the demand for kitchen utensils:

“But it readily occurs that the number of such [kitchen] utensils is in every country necessarily limited by the use which there is for them; that it would be absurd to have more pots and pans than were necessary for cooking the victuals usually consumed there; **** that to attempt to increase the wealth of any country, either by introducing or by detaining in it an unnecessary quantity of gold and silver, is as absurd as it would be to attempt to increase the good cheer of private families by obliging them to keep an unnecessary number of kitchen utensils.” (WN, IV.i.19)

More fundamentally, Smith shows how gold and silver are commodities that are subject to market forces, just like any other article of commerce. Consider what happens, for example, when the demand for gold and silver exceeds the supply of such precious metals. When this happens, there are many ways that a free country — i.e. a country with free markets — is able to overcome this shortfall:

“If … gold and silver should at any time fall short in a country which has wherewithal to purchase them, there are more expedients for supplying their place than that of almost any other commodity. If the materials of manufacture are wanted, industry must stop. If provisions are wanted, the people must starve. But if money is wanted, barter will supply its place, though with a good deal of inconveniency. Buying and selling upon credit, and the different dealers compensating their credits with one another, once a month or once a year, will supply it with less inconveniency. A well-regulated paper money will supply it, not only without any inconveniency, but, in some cases, with some advantages. Upon every account, therefore, the attention of government never was so unnecessarily employed as when directed to watch over the preservation or increase of the quantity of money in any country.”

In other words, barter, credit transactions, and paper money will pick up the slack when the supply of gold and silver is too small relative to demand. Next, consider the more interesting situation when a country has too much gold and silver: “When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation.” (WN, IV.i.13) Why? Because when a country has an excess supply gold and silver relative to demand, the value of these precious metals will drop: it thus makes more sense for people with large amounts of gold and silver to export these precious metals abroad in exchange for consumable goods, and no amount of mercantilist government intervention will be able to stop this outbound flow of precious metals, since gold and silver are easy to smuggle across borders. (WN, IV.i.14)

In short, the total amount of gold and silver in a country is a function of supply and demand. But that said, what about national defense, which Smith describes as the “first duty” of government in Chapter 1 of Book V of The Wealth of Nations? Doesn’t the government need to maintain a positive balance of trade as well as a large amount of gold and silver reserves for national security reasons, i.e. to finance naval fleets and raise armies in the event of invasion or war? I revisit Smith’s original reply to this mercantilist point in my next post. (To be continued …)

My wife Sydjia and I are huge Bad Bunny fans and can’t wait to watch his halftime show at this year’s Super Bowl (Super Bowl LX). In the meantime, check out this preview of Bad Bunny’s halftime show as well as his Tiny Desk Concert from last year (7 April 2025). IMO, Spanish is just as much a part of our North American heritage as the English language is — especially considering that Florida, Texas, and California, along with Cuba and Puerto Rico, were all Spanish-speaking territories before they were acquired by the United States. It’s about time that Puerto Rico be admitted into union as the 51st State! 🇵🇷🇺🇸

In the fourth and final chapter of Book III of The Wealth of Nations (Bk. III, Ch. 4, available here), Adam Smith explains how commerce and trade in urban areas ended up planting the seeds of feudalism’s destruction. According to Smith, the rise of free and prosperous cities and towns in Europe contributed to the demise of feudalism in three ways:

1. New markets. First off, cities and towns provided “a great and ready market” for “the two greatest and most important articles of land produce, bread and butcher’s meat.” (WN, III.iv.2 & 20) In other words, feudal lords now had a powerful economic incentive to manage and improve their lands in a more productive and efficient manner instead of allowing their lands to remain uncultivated.
2. New landlords. Next, as towns and cities became more prosperous, many urban merchants decided to become landowners themselves and put their lands to productive use: “the wealth acquired by the inhabitants of cities was frequently employed in purchasing such lands as were to be sold, of which a great part would frequently be uncultivated. Merchants are commonly ambitious of becoming country gentlemen, and when they do, they are generally the best of all improvers.” (WN, III.iv.3)
3. Liberty and security. Lastly and — for Smith — most importantly, towns and cities were safe spaces that were free:

“Thirdly, commerce and manufactures gradually introduced order and good government, and with them, the liberty and security of individuals, among the inhabitants of the country, who had before lived almost in a continual state of war with their neighbours and of servile dependency upon their superiors. This, though it has been the least observed, is by far the most important of all their effects.” (WN, III.iv.4)

But most ironic of all, Smith tells us, it was the great feudal lords themselves who committed collective suicide, so to speak! According to Smith, these men were so vain, so selfish, and so short-sighted that they readily and cheerfully pissed away their power and privilege in exchange for expensive and exclusive luxury goods. Smith’s stinging analysis is worth quoting in full:

“But what all the violence of the feudal institutions could never have effected, the silent and insensible operation of foreign commerce and manufactures gradually brought about. These gradually furnished the great proprietors with something for which they could exchange the whole surplus produce of their lands, and which they could consume themselves without sharing it either with tenants or retainers. All for ourselves and nothing for other people, seems, in every age of the world, to have been the vile maxim of the masters of mankind. As soon, therefore, as they could find a method of consuming the whole value of their rents themselves, they had no disposition to share them with any other persons. For a pair of diamond buckles, perhaps, or for something as frivolous and useless, they exchanged the maintenance, or what is the same thing, the price of the maintenance of a thousand men for a year, and with it the whole weight and authority which it could give them. The buckles, however, were to be all their own, and no other human creature was to have any share of them; whereas in the more ancient method of expense they must have shared with at least a thousand people. With the judges that were to determine the preference this difference was perfectly decisive; and thus, for the gratification of the most childish, the meanest, and the most sordid of all vanities, they gradually bartered their whole power and authority.” (WN, III.iv.10; my emphasis)

Smith then closes the circle: the vanity of the feudal lords, combined with shrewd self-interest of city merchants and manufacturers, ended up igniting a fortuitous “revolution” — the self-destruction of feudalism and the expansion of order and good government as well as liberty and security — an unexpected but socially beneficial coup du système (if I may be permitted to say) that no one intended or planned on ahead of time:

“A revolution of the greatest importance to the public happiness was in this manner brought about by two different orders of people who had not the least intention to serve the public. To gratify the most childish vanity was the sole motive of the great proprietors. The merchants and artificers, much less ridiculous, acted merely from a view to their own interest, and in pursuit of their own pedlar principle of turning a penny wherever a penny was to be got. Neither of them had either knowledge or foresight of that great revolution which the folly of the one, and the industry of the other, was gradually bringing about.

“It is thus that through the greater part of Europe the commerce and manufactures of cities, instead of being the effect, have been the cause and occasion of the improvement and cultivation of the country.” (WN, III.iv.17-18)

Nota bene: I will proceed to Books IV and V of Smith’s Wealth of Nations on Monday, Feb. 9.

“The [feudal] lords despised the burghers, whom they considered not only as of a different order, but as a parcel of emancipated slaves, almost of a different species from themselves. The wealth of the burghers never failed to provoke their envy and indignation, and they plundered them upon every occasion without mercy or remorse. The burghers naturally hated and feared the lords.” (WN, III.iii.8)

In Chapter 3 of Book III of The Wealth of Nations (available here), Adam Smith surveys the rise of cities and towns in Europe after the collapse of the Roman Empire and explains why so many inhabitants of these urban enclaves, i.e. the burghers, became more and more wealthy over time while the vast majority of their counterparts in the countryside remained impoverished and subservient.

To begin, Smith tells us that, after the fall of Rome, “The towns were chiefly inhabited by tradesmen and mechanics, who seem in those days to have been of servile, or very nearly of servile condition.” (WN, III.iii.1) Nevertheless, despite their servile status — especially when compared with the great lords of the countryside — these humble artisans enjoyed a major advantage: they were outside the legal jurisdiction of the despotic feudal lords. In short, they were free! Or in the immortal words of Adam Smith: “But how servile soever may have been originally the condition of the inhabitants of the towns, it appears evidently that they arrived at liberty and independency much earlier than the occupiers of land in the country.” (WN, III.iii.3; my emphasis)

Among the freedoms (the adult male) inhabitants of towns and cities enjoyed were the right to marry off their daughters without a feudal lord’s permission, the right to dispose of their property by will (again, without a lord’s permission), and the right of appointing their own rulers and of making their own laws. (WN, III.iii.3-7) And furthermore, they were free to trade with whomever they pleased! For Smith, it was these economic and legal freedoms that led to the economic growth and development of the cities and towns of Europe in marked contrast to the despotic and feudal economic stagnation of the European countryside. On this note — the Smithian connection between freedom and economic growth and between the lack of freedom and economic stagnation — the wisdom of the Scottish political economist is worth quoting in full:

“Order and good government, and along with them the liberty and security of individuals, were, in this manner, established in cities at a time when the occupiers of land in the country were exposed to every sort of violence. But men in this defenceless state naturally content themselves with their necessary subsistence, because to acquire more might only tempt the injustice of their oppressors. On the contrary, when they are secure of enjoying the fruits of their industry, they naturally exert it to better their condition, and to acquire not only the necessaries, but the conveniences and elegancies of life. That industry, therefore, which aims at something more than necessary subsistence, was established in cities long before it was commonly practised by the occupiers of land in the country. If in the hands of a poor cultivator, oppressed with the servitude of villanage, some little stock should accumulate, he would naturally conceal it with great care from his master, to whom it would otherwise have belonged, and take the first opportunity of running away to a town. The law was at that time so indulgent to the inhabitants of towns, and so desirous of diminishing the authority of the lords over those of the country, that if he could conceal himself there from the pursuit of his lord for a year, he was free for ever. Whatever stock, therefore, accumulated in the hands of the industrious part of the inhabitants of the country naturally took refuge in cities as the only sanctuaries in which it could be secure to the person that acquired it.

“The inhabitants of a city, it is true, must always ultimately derive their subsistence, and the whole materials and means of their industry, from the country. But those of a city, situated near either the sea coast or the banks of a navigable river, are not necessarily confined to derive them from the country in their neighbourhood. They have a much wider range, and may draw them from the most remote corners of the world, either in exchange for the manufactured produce of their own industry, or by performing the office of carriers between distant countries and exchanging the produce of one for that of another. A city might in this manner grow up to great wealth and splendour, while not only the country in its neighbourhood, but all those to which it traded, were in poverty and wretchedness.” (WN, III.iii.12-13; my emphasis)

If I could therefore sum up the main takeaway of Smith’s Wealth of Nation in a few words, I would say: “Legalize Freedom and Protect Property Rights.” But at the same time, Smith’s formula — his ringing defense of liberty along with his call for good government — poses a political paradox: governments enact and enforce laws, but laws, by definition, limit liberty. (To be continued …)

In Chapter 2 of Book III of The Wealth of Nations (available here), Adam Smith surveys the most dominant social, political, and economic system that arose in Western Europe after the collapse of the Roman Empire: feudalism. But Smith doesn’t waste any time on trivial matters, like knights, jousts, or the feudal code of chivalry. Instead, his focus is on the economics of feudalism, on why this medieval system stunted economic growth and development for centuries. For Smith, feudalism is synonymous with concentrated power and slavery. Indeed, both of these features of the feudal system — large landed estates, most of which is uncultivated, and slave labor — are closely connected, if not intertwined.

According to the Scottish political economist, feudalism is an economically inefficient system for two reasons. One is feudal law: institutions like primogeniture and entails prevent land from being freely sold or divided into smaller plots. As a result, land — the most valuable capital asset of all in Smith’s day — is not only concentrated in the hands of a small cabal of powerful landowners or lords; these rigid legal restrictions also prevent the land from being put to its highest-valued use. (See WN, III.ii.2-7.) Worse yet, the power and wealth of feudal landowners are built on slave labor, and as Smith explains in Paragraphs 9-13 of Chapter 2 of Book III of The Wealth of Nations, slavery is an inefficient and unjust system that impedes economic growth and development. Smith’s economic critique of slavery and coercion is timeless and thus bears repeating in full:

“But if great improvements are seldom to be expected from great proprietors, they are least of all to be expected when they employ slaves for their workmen. The experience of all ages and nations, I believe, demonstrates that the work done by slaves, though it appears to cost only their maintenance, is in the end the dearest of any. A person who can acquire no property, can have no other interest but to eat as much, and to labour as little as possible. Whatever work he does beyond what is sufficient to purchase his own maintenance can be squeezed out of him by violence only, and not by any interest of his own. In ancient Italy, how much the cultivation of corn degenerated, how unprofitable it became to the master when it fell under the management of slaves, is remarked by both Pliny and Columella. In the time of Aristotle it had not been much better in ancient Greece. Speaking of the ideal republic described in the laws of Plato, to maintain five thousand idle men (the number of warriors supposed necessary for its defence) together with their women and servants, would require, he says, a territory of boundless extent and fertility, like the plains of Babylon.” (WN, III.ii.9; my emphasis)

In other words, incentives matter! Enslaved persons are less productive and efficient than freemen and proprietors not because they are morally or genetically inferior but because their labour is coerced — slaves do not get to keep the fruits of their labour — or in the immortal words of Adam Smith: “Avarice and injustice are always short-sighted ….” (WN, III.ii.16) But Smith’s timeless critique of slavery — and of feudalism more generally — begs the question, How did some parts of Europe transition from the feudal system to the Age of Enlightenment? (To be continued …)

Why are some nations stagnant and poor, while others are vibrant and prosperous? We now turn to Book III of Adam Smith’s Wealth of Nations. As it happens, Book III, the third of five “books” or thematic sections in all, is subtitled “Of the different Progress of Opulence in different Nations”, and it is the shortest part of Smith’s magnum opus: it contains four chapters that together span a mere 60 pages of the Glasgow edition of The Wealth of Nations. (By comparison, Smith’s “digression” on the value of silver at the end of Book I is almost twice as long as the entirety of Book III!)

In Chapter 1 of Book III (available here), Smith compares and contrasts the “great commerce of every civilised society … between the inhabitants of the town and those of the country.” (WN, III.i.1) What does this commerce between town and country consist of? The Scottish political economist tells us right off the bat:

“It consists in the exchange of rude for manufactured produce, either immediately, or by the intervention of money, or of some sort of paper which represents money. The country supplies the town with the means of subsistence and the materials of manufacture. The town repays this supply by sending back a part of the manufactured produce to the inhabitants of the country. The town, in which there neither is nor can be any reproduction of substances, may very properly be said to gain its whole wealth and subsistence from the country.” (WN, III.i.1)

Smith then lowers the boom (so to speak) by taking aim at one of the most “absurd speculations” regarding the balance of trade between town and country: “Among all the absurd speculations that have been propagated concerning the balance of trade, it has never been pretended that either the country loses by its commerce with the town, or the town by that with the country which maintains it.” (WN, III.i.1) Why is the Trumpian doctrine of the balance of trade — in this case, domestic or internal trade between town and country — so “absurd” (to borrow Smith’s own term)? Because the world is not a zero-sum place. There are gains from trade:

“We must not, however, upon this account, imagine that the gain of the town is the loss of the country. The gains of both are mutual and reciprocal, and the division of labour is in this, as in all other cases, advantageous to all the different persons employed in the various occupations into which it is subdivided. The inhabitants of the country purchase of the town a greater quantity of manufactured goods, with the produce of a much smaller quantity of their own labour, than they must have employed had they attempted to prepare them themselves. The town affords a market for the surplus produce of the country, or what is over and above the maintenance of the cultivators, and it is there that the inhabitants of the country exchange it for something else which is in demand among them. The greater the number and revenue of the inhabitants of the town, the more extensive is the market which it affords to those of the country; and the more extensive that market, it is always the more advantageous to a great number.” (WN, III.i.1; my emphasis)

Adam Smith thus makes what I would describe as his single-most important contribution to the world of ideas: he presents a positive-sum view of the world. And even more importantly, Smith not only explains why trade is a positive-sum game (not a zero- or negative-sum one); he also begins to lay the intellectual groundwork that will allow us to answer the key question I posed above, Why are some nations poor, while others are wealthy? (To be continued …)

Adam Smith concludes Book II of his magnum opus with a bang. First off, he recaps his epic survey of capitalism by describing the main ways in which capital assets can be put to productive use — agriculture, manufacturing, and commerce:

“A capital may be employed in four different ways: either, first, in procuring the rude produce annually required for the use and consumption of the society; or, secondly, in manufacturing and preparing that rude produce for immediate use and consumption; or, thirdly, in transporting either the rude or manufactured produce from the places where they abound to those where they are wanted; or, lastly, in dividing particular portions of either into such small parcels as suit the occasional demands of those who want them. In the first way are employed the capitals of all those who undertake the improvement or cultivation of lands, mines, or fisheries; in the second, those of all master manufacturers; in the third, those of all wholesale merchants; and in the fourth, those of all retailers. It is difficult to conceive that a capital should be employed in any way which may not be classed under some one or other of those four.” (WN, II.v.2)

Next, Smith breaks ranks with François Quesnay and the French Physiocrats, the leading school of political economy of Smith’s day. In brief, the Physiocrats claimed that the wealth of nations is derived solely from agriculture. Smith, by contrast, expands the notion of productive activities to include manufacturers, wholesalers, and retailers. Although Smith concedes that agricultural production adds the most value to a nation’s total wealth or GDP — “The capital employed in agriculture …. is by far the most advantageous to the society” (WN, II.v.12) — he explains why all four sectors of the economy — not just agriculture but also manufacturing and wholesale and retail commerce — contribute to GDP. (See WN, II.v.3-11.)

Last but not least, Smith makes his most important contribution to political economy: he shows how capitalism and freedom — i.e. free markets and free trade, both inside a country and among nations — promote prosperity. According to Smith, when markets and people are free, the owners of capital will allocate their resources to their highest-value uses:

“The consideration of his own private profit is the sole motive which determines the owner of any capital to employ it either in agriculture, in manufactures, or in some particular branch of the wholesale or retail trade. The different quantities of productive labour which it may put into motion, and the different values which it may add to the annual, produce of the land and labour of the society, according as it is employed in one or other of those different ways, never enter into his thoughts.” (WN, II.v.37)

In addition, Smith not only rehearses his famous “invisible hand” argument (sans the hand) in the quoted passage above; he also rehearses the case for international trade and globalization more generally. Borrowing a wide variety of real-world examples — from the flax and hemp of Riga, to the tobacco of Virginia, to the sugar and rum of Jamaica — Smith explains how trade restrictions obstruct national prosperity:

“Were the Americans, either by combination or by any other sort of violence, to stop the importation of European manufactures, and, by thus giving a monopoly to such of their own countrymen as could manufacture the like goods, divert any considerable part of their capital into this employment, they would retard instead of accelerating the further increase in the value of their annual produce, and would obstruct instead of promoting the progress of their country towards real wealth and greatness.” (WN, II.v.21)

As a result, governments should not try to protect their domestic markets (the “home trade”) by imposing restrictions on foreign markets (the “foreign trade”) or by otherwise impeding the free flow and movement of goods and services (the “carrying trade”):

“The riches, and so far as power depends upon riches, the power of every country must always be in proportion to the value of its annual produce, the fund from which all taxes must ultimately be paid. But the great object of the political economy of every country is to increase the riches and power of that country. It ought, therefore, to give no preference nor superior encouragement to the foreign trade of consumption above the home trade, nor to the carrying trade above either of the other two. It ought neither to force nor to allure into either of those two channels a greater share of the capital of the country than what would naturally flow into them of its own accord.” (WN, II.v.31)

In short, the fifth and final chapter of Book II of The Wealth of Nations (available here) is an intellectual tour de force, and it is still a must-read, even after all these years later. (To be continued …)

Happy Groundhog Day! Now, let’s pick up where we left off, with Chapter 4 of Book II of The Wealth of Nations (available here). More specifically, should lenders be allowed to charge high interest rates? Or should the government impose a ceiling on interest rates? In short, should usury be legalized? Adam Smith’s answer to this key question, which appears in Book II, Chapter 4, is both subtle and surprising:

“The legal rate, it is to be observed, though it ought to be somewhat above, ought not to be much above the lowest market rate. If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it. Where the legal rate of interest, on the contrary, is fixed but a very little above the lowest market rate, sober people are universally preferred, as borrowers, to prodigals and projectors.” (WN, II.iv.15)

In other words, Smith identifies an “interest rate selection bias” of sorts: low interest rates attract credit-worthy borrowers who invest in solid low-risk projects, while high rates attract dicey borrowers who speculate in high-risk projects, like the ill-fated South Sea Company or Mississippi Company. As a result of this interest rate selection bias (so to speak), Smith concludes that the government should impose a floating cap or flexible ceiling on interest rates, one that is “not … much above the lowest market rate.” (WN, II.iv.15) Otherwise, if banks were allowed to charge high interest rates, risky pie-in-the-sky projects (most of which, by definition, are doomed to fail) will crowd out more solid or low-risk ones and endanger economic development.

Smith’s surprising conclusion (i.e. interest rates should be regulated) is nevertheless subtle for two reasons. One is the flexibility or pragmatic nature of his proposed regulation. Smith’s legal ceiling on interest rates is a flexible one, since it is based on whatever the lowest market rate happens to be at any given time. The other is the macro-rationale of his proposed regulation. Smith’s motivation for imposing a legal cap on interest rates is not to protect individual borrowers or consumers but to protect lenders as a class as well as economic growth and development as a whole!

And last but not least, although Smith supports a floating cap on interest rates (i.e. one that moves with the lowest market rate), he further observes that any attempt to prohibit lenders from charging any interest on loans would produce more harm than good:

“In some countries the interest of money has been prohibited by law. But …. [t]his regulation, instead of preventing, has been found from experience to increase the evil of usury; the debtor being obliged to pay, not only for the use of the money, but for the risk which his creditor runs by accepting a compensation for that use. He is obliged, if one may say so, to insure his creditor from the penalties of usury.” (WN, II.iv.13)

Yet again, we see two qualities of Adam Smith shine through, even after 250 years since the publication of The Wealth of Nations: (i) his intellectual originality — e.g. what I am calling his “interest rate selection bias” idea — and (ii) his open-minded pragmatism — his willingness to entertain some form of flexible government regulation for the greater good, i.e. to reduce suboptimal speculation, which might endanger economic growth and development. [1] Nota bene: I will conclude my survey of Book II of Smith’s magnum opus in my next post.

[1] Likewise, in a previous post (see here) we saw how Smith make the case for another pragmatic restriction on natural liberty: the elimination of small-denomination bank notes.

Yo, why not kick off Black History Month with my all-time favorite protest ballad from the musical legend himself, Bob Marley?