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 …)