prior probability

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?

I concluded my previous post on Chapter 3, Book II of The Wealth of Nations by asking, Does Adam Smith’s distinction between so-called productive and unproductive labour — i.e. between the production of goods and the provision of services — still make sense today? The answer is a qualified yes!

Why “qualified”? Because Smith equates economic development with the production and accumulation of physical assets like crops, cattle, and machines, but today — 250 years after the publication of The Wealth of Nations — the provision of intangible services is just as essential to economic growth as the production of physical goods. By way of example, consider caregivers like housewives and nurses, or educators like college professors and elementary school teachers, or tech bros like software engineers and web page designers. They may not grow crops, rear cattle, or manufacture finished goods, but no one doubts whether health care, education, and the Internet contribute to GDP (either in total or at the margin).

But that said, Smith’s distinction between goods and services nevertheless makes perfect sense in an 18th-century or historical setting, especially if what you’re trying to do is explain why commercial societies like Britain and Holland are becoming wealthy and prosperous while feudal societies like Poland and Russia aren’t, which is precisely what Adam Smith is trying to do in The Wealth of Nations. Remember, when Smith uses the terms productive and unproductive he does not mean useful and useless. What he really means is this: “Does X or Y form of labour create new capital or make better use of existing capital?” Labour is thus either productive or unproductive in the Smithian sense depending on whether it creates new capital assets or enhances the use of existing capital.

Today, however, the concept of “capital” is no longer limited to the production of physical assets or tangible goods (as it was in Smith’s day). Today, capital includes intangible assets like trade secrets, brands, and algorithms as well as human capital (skills, know-how, etc.). But once we expand the concept of capital to include intangibles, Smith’s distinction between productive and unproductive dissolves. So, why is Smith’s distinction still relevant? Because however the concept of capital is defined, Adam Smith is making a fundamental and timeless point that remains just as relevant today as when he was writing his magnum opus: not all economic activities contribute to economic growth and development! Some activities are zero-sum or rent-seeking: they merely redistribute existing wealth rather than create new forms of wealth.

In other words, once we take a step back and probe the inner logic of Smith’s distinction, we see a fundamental qualitative difference between value-creating activities (i.e. productive labour) versus value-extracting activities (unproductive labour), between zero-sum rent-seeking and positive-sum trade and wealth creation. And this is yet another reason why Adam Smith’s magnum opus is a timeless classic that is still worth reading today! Nota bene: I will resume my survey of Book II of The Wealth of Nations on Monday (2 February) and then push into Book III by the end of next week.

After introducing Adam Smith’s distinction between so-called “productive” and “unproductive” labour from Chapter 3 of Book II of The Wealth of Nations (available here), I concluded my previous post by asking why this distinction is so crucial for Smith. Why does it matter how workers are classified, especially when (as Smith himself concedes) both productive and unproductive pursuits are “useful” and in demand? In two words, the reason why this distinction matters for Smith is this: it is his “secret sauce” (so to speak), for it explains why some nations become rich while others remain poor.

Let’s begin with poor countries. According to Smith, too much government spending and corruption causes countries to become poor: “Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct. The whole, or almost the whole public revenue, is in most countries employed in maintaining unproductive hands.” (WN, II.iii.30) How does government spending keep nations poor? By subsidizing unproductive labor, which, in turn, crowds out productive pursuits:

“Such are the people who compose a numerous and splendid court, a great ecclesiastical establishment, great fleets and armies, who in time of peace produce nothing, and in time of war acquire nothing which can compensate the expense of maintaining them, even while the war lasts. Such people, as they themselves produce nothing, are all maintained by the produce of other men’s labour. When multiplied, therefore, to an unnecessary number, they may in a particular year consume so great a share of this produce, as not to leave a sufficiency for maintaining the productive labourers, who should reproduce it next year. The next year’s produce, therefore, will be less than that of the foregoing, and if the same disorder should continue, that of the third year will be still less than that of the second. Those unproductive hands, who should be maintained by a part only of the spare revenue of the people, may consume so great a share of their whole revenue, and thereby oblige so great a number to encroach upon their capitals, upon the funds destined for the maintenance of productive labour, that all the frugality and good conduct of individuals may not be able to compensate the waste and degradation of produce occasioned by this violent and forced encroachment.” (WN, II.iii.30; my emphasis)

Now, let’s talk about wealthy countries. In order to become prosperous, Smith explains, a country must devote more of its GDP to economically productive pursuits: “The annual produce of the land and labour of any nation can be increased in its value by no other means but by increasing either the number of its productive labourers, or the productive powers of those labourers who had before been employed.” (WN, II.iii.32) But what is Smith’s secret sauce? How do we make this switch from “unproductive” to “productive”?

Adam Smith’s answer: by investing in “additional capital”! (ibid.) According to Smith, a society becomes rich when technological innovations or good management (or both!) allow firms to supply markets with a greater amount of goods using the same amount of existing capital assets (in the case of good management) or using a smaller amount of new capital assets (in the case of innovation), or in the immortal words of the Scottish political economist:

“The productive powers of the same number of labourers cannot be increased, but in consequence either of some addition and improvement to those machines and instruments which facilitate and abridge labour [e.g. technological innovations]; or of a more proper division and distribution of employment [e.g. good management]. In either case [innovation or good management] an additional capital is almost always required. It is by means of an additional capital only that the undertaker of any work can either provide his workmen with better machinery or make a more proper distribution of employment among them.” (WN, II.iii.32; my emphasis)

Either way (technological innovations or good management), the wealth of nations of requires new and more efficient capital assets or a better use of existing capital assets. Any questions? I have one: does Smith’s distinction between productive and unproductive labor still make economic sense today? (To be continued …)

In Chapter 3 of Book II of The Wealth of Nations (available here), Adam Smith draws yet another fundamental distinction, [1] this one between so-called “productive” and “unproductive” professions or pursuits. Smith does not use these terms in a judgmental or normative sense. Both types of labour are, for Smith, “useful” but only one produces durable goods with a definite lifespan (like cars, furniture, houses, etc.), while the other type, by contrast, produces transitory services that are consumed on the spot (like a play or puppetshow, to borrow two of Smith’s own examples).

In brief, Smith’s paradigmatic example of a productive worker is “the labour of the manufacturer”: his labor is productive in a literal sense because it “fixes and realizes itself in some particular subject or vendible commodity, which lasts for some time at least after that labour is past.” (WN, II.ii.1) Consider, for instance, Smith’s famous pin factory example in Chapter 1 of Book 1 of The Wealth of Nations: the workers on the floor of the pin factory are “productive” (again, in a literal sense) because they are manufacturing long-lasting products that can then be used for sewing and other productive activities.

By the same token, Smith’s textbook example of an unproductive worker is “the menial servant.” (WN, II.ii.1) His work is “unproductive” in the Smithian sense because it “does not fix or realize itself in any particular subject or vendible commodity.” (ibid.) Instead, the work product of domestic servants (butlers, cooks, maids, etc.) are transitory and ethereal; their efforts “generally perish in the very instant of their performance, and seldom leave any trace or value behind them for which an equal quantity of service could afterwards be procured.” (ibid.)

But aside from “the menial servant”, who else is unproductive (in the Smithian sense)? Although Smith begins with “the menial servant”, he doesn’t stop there. He classifies all government officials — from the king on down! — as unproductive. Although Smith concedes that government officials like judges and police provide an essential public service (law and order), they are nevertheless “unproductive” in a literal sense since they do not produce durable goods:

“The sovereign, for example, with all the officers both of justice and war who serve under him, the whole army and navy, are unproductive labourers. They are the servants of the public, and are maintained by a part of the annual produce of the industry of other people. Their service, how honourable, how useful, or how necessary soever, produces nothing for which an equal quantity of service can afterwards be procured. The protection, security, and defence of the commonwealth, the effect of their labour this year will not purchase its protection, security, and defence for the year to come.” (WN, II.ii.2)

Indeed, Smith goes even further. He puts “churchmen, lawyers, physicians, men of letters of all kinds; players, buffoons, musicians, opera-singers, opera-dancers, etc.” into the unproductive category because “the work of all of them perishes in the very instant of its production.” (WN, II.ii.2; my emphasis) But why does it matter how a worker is classified? Why is this distinction between productive and unproductive labor so crucial for Adam Smith? And regardless of how these questions are answered, does this distinction still make economic sense today? (To be continued …)

[1] By way of example, some of the previous distinctions we have seen made by Adam Smith thus far include the distinction between value in use and value in exchange (WN, I.iv.13), between real and nominal prices (I.v.7), between actual and natural prices (I.vii.7), between fixed and circulating capital (II.i.4-5), and between money and revenue (II.ii.14).

In my previous post, we saw the pivotal role that banks play in promoting economic growth and development. By issuing bank notes (paper money), discounting bills of exchange (check cashing), and providing cash accounts (lines of credit), banks facilitate trade and the financing of capital assets. But at the same time, as Adam Smith himself points out in the second half of Chapter 2 of Book II of The Wealth of Nations (Paras. 48-106), bad banking practices can endanger economic development. The collapse of the infamous Ayr Bank (Douglas, Heron & Co.) in 1772 is a case in point. According to Smith (see WN, II.ii.73-77), the Ayr Bank issued far too many bank notes than it could convert into gold and silver and was way too liberal in “discounting” bills of exchange and in granting “cash accounts” to borrowers. As a result of these practices, the Ayr Bank produced an over-supply (so to speak) of paper money.

But why is an oversupply of paper money so dangerous? Because when there are too many bank notes in circulation, for example, excess notes will be returned to the issuing banks (the banks that issued those notes) for their face value in gold and silver, but some banks will not have enough gold and silver on reserve to honor their notes. These banks thus run the risk that they will run out of cash and become insolvent. This danger, in turn, can destabilize the entire economy because a run on one bank can spread to others, especially if too many depositors fear their accounts are at risk and try to withdraw their holdings at the same time.

To counteract this danger, Smith calls for … (wait for it!) … aggressive government regulation! Among other things, he proposes the elimination, by law, of small-denomination bank notes: “It were better, perhaps, that no bank notes were issued in any part of the kingdom for a smaller sum than five pounds.” (WN, II.ii.91) Say what?! Doesn’t this heavy-handed approach — a complete and total government ban on small bank notes — contradict Smith’s ringing defense of “natural liberty” and economic freedom in the rest of his Wealth of Nations? [1] To his credit, Smith acknowledges this contradiction and explains why some restrictions on liberty are morally and legally justified:

“To restrain private people, it may be said, from receiving in payment the promissory notes of a banker, for any sum whether great or small, when they themselves are willing to receive them, or to restrain a banker from issuing such notes, when all his neighbours are willing to accept of them, is a manifest violation of that natural liberty which it is the proper business of law not to infringe, but to support. Such regulations may, no doubt, be considered as in some respects a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments, of the most free as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty exactly of the same kind with the regulations of the banking trade which are here proposed.” (WN, II.ii.94)

In other words, Smith is a pragmatist, not an ideologue: restrictions on one’s natural liberty are justified when those restrictions are designed to promote the general welfare or otherwise protect a larger group of people from harms caused by a few. (To be continued …)

[1] As an aside, the irony of Smith’s hard-line position against small bank notes is not lost on me: from 2007 to 2020 the Bank of England issued a beautiful £20 note with Adam Smith’s portrait! (Perhaps £20 does not count as “small”?)

Picking up where we last left off, Adam Smith surveys three important substitutes for money and metal currencies in the next part of Chapter 2 of Book II of The Wealth of Nations (specifically, Paras. 26-47): (a) bank notes, (b) bills of exchange, and (c) cash accounts. The first two money substitutes — bank notes and bills of exchange — are what lawyers call negotiable instruments: transferable and unconditional promises or orders to pay a specific sum of money, either on demand or at a set time, as the case may be. A bank note, for example, is a form of paper money consisting of a promise to pay a specific amount (including interest) upon demand. According to Smith, the main advantage of bank notes is that they lower transaction costs; bank notes are little pieces of paper that effectively replace expensive and cumbersome metal currencies (like gold and silver). In fact, Smith explains how banks can circulate up to five or even ten times more money in bank notes than they actually hold in gold and silver reserves! (WN, II.ii.26-42)

A bill of exchange, by contrast, is a credit document on which one party (the drawer) instructs another party (the drawee) to pay a specified sum of money to a third party (the payee) at a future date. By way of example, suppose a merchant in Glasgow wants to sell some goods to a merchant in London. Instead of demanding an immediate payment from the buyer in London, the seller in Glasgow can draw a bill of exchange on the London merchant, payable at a certain future date (say, 30, 60, or 90 days). During this interval of time (i.e. before maturity), the Glasgow merchant can do one of three things: (i) he can keep the bill of exchange until it becomes due; (ii) he can transfer or “endorse” it to a third party (this third party will then have the right to receive payment from the London merchant upon maturity); or (iii) he can “discount” or cash it with a banker for immediate cash at less than its face value. (see, e.g., WN, II.ii.43)

In addition to bank notes and bills of exchange, there is yet another method by which banks inject money — or what today we refer to as “liquidity” — into the economy: a bank can open a “cash account” in the merchant’s name, extending to the merchant a direct line of credit. (see, e.g., WN, II.ii.44-46) Once the merchant opens a cash account at his bank, the merchant may then draw money from this account up to a set limit. The bank charges interest only on the utilized balance, i.e. on the amount of money actually drawn from the account. (ibid.)

But how do these types of financial transactions — promissory notes, bills of exchange, and cash accounts — promote economic growth and development? In a word, these finance instruments do so by making it easier for merchants to trade and finance capital assets. How so? By acting as convenient and perfect substitutes for gold and silver: merchants no longer need to keep large sums of cash on hand in order to do business; instead, they can use bank notes, bills of exchange, and cash accounts to acquire capital assets and invest in productive activities right now. Furthermore, bank notes, bills of exchange, and cash accounts not only replace the need for hoarding gold and silver; these finance instruments also allow the same quantity of metal currency already in circulation to support a much larger volume of trade!

But that said, Smith also has a lot to say about the dark side of banking and finance in the second half of this chapter (Paras. 48-106). Among other things, he describes a real-world banking failure that occurred in Scotland (the spectacular collapse of the Ayr Bank in 1772; see WN, II.ii.73-77), explains why banking is such a risky activity (namely, the oversupply of bank notes), and proposes some ways of reducing this peril. (To be continued …)

To my friends “down under”, 🇦🇺 Happy Australia Day 🇦🇺! And to my friends in the twin cities of Minneapolis and Saint Paul, keep resisting and keep on fighting for our freedoms! The heavy-handed and lawless Gestapo tactics by masked federal officials — extrajudicial murders and warrantless home invasions — must stop immediately!

Now, as promised, to the business at hand: Chapter 2 of Book II of Adam Smith’s Wealth of Nations. It is here, in this prolonged and protracted chapter — it contains more than 100 paragraphs and spans over 75 pages of the Glasgow edition of Smith’s magnum opus! — where the Scottish philosopher explains the pivotal roles that money, banking, and finance play in promoting (and in potentially destroying) economic growth and development. To begin, Smith makes three contributions to our understanding of finance and economics in the first part of this chapter (Paras. 1-25):

1. Contribution #1: What is “money”? Smith points out two possible meanings of the word “money” — money as a unit of accounting, and money as purchasing power: “When we talk of any particular sum of money, we sometimes mean nothing but the metal pieces of which it is composed; and sometimes we include in our meaning some obscure reference to the goods which can be had in exchange for it, or to the power of purchasing which the possession of it conveys.” (WN, II.ii.16)
2. Contribution #2: Smith’s money wheel metaphor. Smith’s focus, however, is not on mere accounting; it’s on the function of money. At several points in this chapter (WN, II.ii.14, II.ii.23, & II.ii.39), for example, Smith describes money as “the great wheel of circulation.” What Smith means by this memorable metaphor is that money is a means to an end: it is an instrument of commerce, just like a turnpike or navigable river, which facilitates trade by making it easier for goods to reach their respective markets.
3. Contribution #3: Smith’s distinction between money and revenue. Smith also draws a fundamental distinction between “individual” and “aggregate” revenue, i.e. between the revenue generated by each individual landlord, worker, or capital owner and the aggregate revenue produced by a nation or other collective:

“The great wheel of circulation is altogether different from the goods [and services] which are circulated by means of it. The revenue of the society consists altogether in those goods [and services], and not in the wheel which circulates them. In computing either the gross or the net revenue of any society, we must always, from their whole annual circulation of money and goods, deduct the whole value of the money, of which not a single farthing can ever make any part of either.” (WN, II.ii.14)

Put another way, money ≠ revenue:

“Though the weekly or yearly revenue of all the different inhabitants of any country, in the same manner, may be, and in reality frequently is paid to them in money, their real riches, however, the real weekly or yearly revenue of all of them taken together, must always be great or small in proportion to the quantity of consumable goods which they can all of them purchase with this money. The whole revenue of all of them taken together is evidently not equal to both the money and the consumable goods; but only to one or other of those two values, and to the latter more properly than to the former.” (WN, II.ii.20)

Next, after clearing up what he means by “money”, Adam Smith turns his attention in the remainder of this chapter to banking and finance. (To be continued …)

Like a meteor flashing in the night sky, the Spice Girls, the best-selling girl group of all time (see here), were a bright but relatively brief phenomenon …