THE IMMORTAL ADAM SMITH, PART 2

In my previous post, I walked us through the first two paragraphs of Book IV, Chapter 2 of Adam Smith’s Wealth of Nations. To recap, Smith concedes that restraints on foreign trade will benefit domestic producers, but at the same time, he leaves open an important question: what effect will trade barriers have on a country’s overall level of wealth? Today, I want to focus on the third paragraph of Book IV, Chapter 2, for it contains a crucial observation: wealth is a function of capital — an insight I like to call “Smith’s First Law“.

The father of economics defines “capital” as those things, such as tools, animals, land, etc., that can be used by workers to generate revenue. (See Book II, Chapter 1 of Smith’s magnum opus.) And for Smith, a country is only as rich or wealthy as the amount of productive “capital” she has: “The general industry of the society never can exceed what the capital of the society can employ” (Wealth of Nations, IV.2.iii). This simple yet profound observation is the essence of Smith’s First Law, but is it true? To prove this assertion, Smith draws a direct analogy between a small firm and a “great society” like the Kingdom of France or the Britain of his day:

“As the number of workmen that can be kept in employment by any particular person must bear a certain proportion to his capital, so the number of those that can be continually employed by all the members of a great society must bear a certain proportion to the whole capital of that society, and never can exceed that proportion.” (ibid.)

In other words, the number of employees a profitable firm can hire depends on the amount of “capital” that firm has under its control. But does this logic apply to a country’s economy as a whole? More specifically, what effect do protectionist laws and trade restrictions have on the use and accumulation of “capital”? Put another way, can the government make the country it rules more wealthy by restricting foreign imports? Smith’s First Law says no, for wealth is a function of capital: “No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain. It can only divert a part of it into a direction into which it might not otherwise have gone …” (ibid.). [See also the paragraphs 13 & 14 of Book IV, Chapter 2 of The Wealth of Nations.]

What the Scottish philosopher-economist is saying here is that the government cannot increase a country’s wealth by restricting trade. Why not? Because the government cannot make its people more wealthy above and beyond the amount of capital they already have. To appreciate the timeless logic of Smith’s First Law, consider the following analogy: the wealth of a country is like the level of water in a reservoir, while protectionist trade policies are like a levee or dike. At most, according to Smith, government regulation of commerce can control the flow of water, but it cannot increase the overall level of water in the reservoir.

But Smith saves the best for last! He concludes the third paragraph of Book IV, Chapter 2 of his magnum opus by making the following offhand observation: “… and it is by no means certain that this artificial direction [i.e. regulation of commerce by the government] is likely to be more advantageous to the society than that into which it would have gone of its own accord” (ibid.). Stay tuned! I will continue my survey of Smith’s scathing and still-relevant critique of trade barriers in my next post …