prior probability

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 …

I concluded my discussion of Adam Smith’s theory of economic development in Chapter 1 of Book II of The Wealth of Nations (see my previous post) with this observation: “a poor or developing nation does not make progress by accumulating or hoarding money and other assets; a nation becomes wealthy when her capital assets are put to productive use.” But this conclusion, in turn, begs the $64 question, how does a nation actually go about putting her capital assets to productive use? As it happens, this question is what this part (Book II) of Smith’sWealth of Nations is all about!

To the point, for Smith two ingredients are essential for economic growth and development: law and liberty. In summary, if people are free to make their own choices and if property rights are more or less secure and the legal environment is stable (what Smith refers to as “tolerable security”; see the passage quoted below), capital assets will not only be put to good use; they will gravitate to their best or most productive uses! I have already commented on Smith’s resounding and timeless defense of liberty (see here, for example) [1], today I will focus on the “law” side of Smith’s economic equation, for the Scottish philosopher himself compares and contrasts two different types of legal environment in the last two paragraphs of Chapter 1 of Book II of The Wealth of Nations:

“In all countries where there is tolerable security, every man of common understanding will endeavour to employ whatever stock he can command in procuring either present enjoyment or future profit. If it is employed in procuring present enjoyment, it is a stock reserved for immediate consumption. If it is employed in procuring future profit, it must procure this profit either staying with him, or by going from him. In the one case it is fixed, in the other it is a circulating capital. A man must be perfectly crazy who, where there is tolerable security, does not employ all the stock which he commands, whether be his own or borrowed of other people, in some one or other of those three ways.

“In those unfortunate countries, indeed, where men are continually afraid of the violence of their superiors, they frequently bury and conceal a great part of their stock, in order to have it always at hand to carry with them to some place of safety, in case of their being threatened with any of those disasters to which they consider themselves as at all times exposed.” (WN, II.i.30-31; my emphasis)

Nota bene: I will resume my survey of Book II of The Wealth of Nations on Monday (26 January)!

[1] Cf. WN, I.x.1, where Smith extols the advantages of “a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to choose what occupation he thought proper, and to change it as often as he thought proper.”

Adam Smith is often referred to as “the father of economics.” Although my colleague and friend (and co-author) Salim Rashid has questioned whether Smith is deserving of this title, [1] one thing I can say for certain is this: Smith presents a nascent theory of development economics in Book II of his magnum opus, The Wealth of Nations. Why, for example, are some nations poor, while others are opulent? The five chapters in Book II (“Of the Nature, Accumulation, and Employment of Stock”) are all devoted to this key question. Smith begins by defining the concept of “stock” or capital assets in Chapter 1 of Book II. [2] For Smith, capital can be used in one of two ways:

“First, [capital] may be employed in raising, manufacturing, or purchasing goods, and selling them again with a profit. The capital employed in this manner yields no revenue or profit to its employer, while it either remains in his possession, or continues in the same shape. The goods of the merchant yield him no revenue or profit till he sells them for money, and the money yields him as little till it is again exchanged for goods. His capital is continually going from him in one shape, and returning to him in another, and it is only by means of such circulation, or successive exchanges, that it can yield him any profit. Such capitals, therefore, may very properly be called circulating capitals.

“Secondly, it may be employed in the improvement of land, in the purchase of useful machines and instruments of trade, or in suchlike things as yield a revenue or profit without changing masters, or circulating any further. Such capitals, therefore, may very properly be called fixed capitals.” (WN, II.i.4-5)

Adam Smith thus compares and contrasts fixed capital, e.g. long-term assets like buildings, tools and machines, and people(!) [3], with circulating capital, e.g. short-term assets like raw materials, inventory, and wages. More importantly, Smith’s distinction is not only relevant today — modern accounting concepts like fixed assets (“Property, Plant, and Equipment” or PP&E) and working capital (Current Assets minus Current Liabilities) can be traced back to Smith — it also goes to the core of his most enduring and original idea, the seed of which he already planted in his lengthy “Digression on the Value of Silver” in Book I of The Wealth of Nations: wealth is not about money; wealth is about economic growth via the production and consumption of goods and services, [4] or in the immortal words of Smith himself:

“To maintain and augment the stock which may be reserved for immediate consumption is the sole end and purpose both of the fixed and circulating capitals. It is this stock which feeds, clothes, and lodges the people. Their riches or poverty depends upon the abundant or sparing supplies which those two capitals can afford to the stock reserved for immediate consumption.” (WN, II.i.26)

In other words, a poor or developing nation does not make progress by accumulating or hoarding money and other assets; a nation becomes wealthy when her capital assets are put to productive use. (To be continued …)

[1] See generally Salim Rashid, The Myth of Adam Smith, Edward Elgar 1998.

[2] When Smith uses the word “stock”, he isn’t referring to securities or shares in a company (like today’s meaning of “stock”); instead, he has a broader meaning in mind: “stock” refers to capital or all the accumulated wealth or resources of a nation, including such assets as raw materials, provisions, machinery, and money.

[3] Later in this same chapter, Smith includes “human capital” in his definition of fixed capital, thus creating a whole new branch of economics. Referring to “the acquired and useful abilities of all the inhabitants or member of the society,” Smith observes: “The acquisition of such talents, by the maintenance of the acquirer during his education, study, or apprenticeship, always costs a real expense, which is a capital fixed and realized, as it were, in his person. Those talents, as they make a part of his fortune, so do they likewise of that of the society to which he belongs.” (WN, II.i.17)

[4] Cf. WN, IV.viii.49: “Consumption is the sole end and purpose of all production.”

After his lengthy digression on the value of silver, Adam Smith concludes Book I of The Wealth of Nations with an important and original observation about the three major classes or “orders of people” in any economic system — i.e. landlords or “those who live by rent” (I.xi.p.8), workers or “those who live by wages” (I.xi.p.9), and capitalists or owners of capital or “those who live by profit” (I.xi.p.10). According to Smith, the rents of landlords and the wages of workers will rise when the economy as a whole is expanding, and by the same token, rents and wages will fall when the economy is stagnant or in decline. The profits of the capitalist class, however, are a different story:

But the rate of profit does not, like rent and wages, rise with the prosperity and fall with the declension of the society. On the contrary, it is naturally low in rich and high in poor countries, and it is always highest in the countries which are going fastest to ruin. (I.xi.p.10)

The Scottish philosopher then anticipates Karl Marx’s critique of capitalism by concluding Book I with the following ominous warning: the private economic interests of the capitalist class are diametrically opposed to the interests of the general public, or in the immortal words of Adam Smith:

“The interest of the [capitalists] … in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the [capitalists], by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.” (I.xi.p.10)

As a result, Smith urges people to exercise extreme caution anytime business firms propose a new law or regulation:

“The proposal of any new law or regulation of commerce which comes from this order [i.e. the capitalists] ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.” (I.xi.p.10)

In short, Book I of The Wealth of Nations poses something of a puzzle, maybe even a paradox: on the one hand, Smith thus far has been a vocal champion of laissez faire capitalism as an economic system — i.e. “a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to choose what occupation he thought proper, and to change it as often as he thought proper” (I.x.1) — but at the same time, he is deeply suspicious of capitalists as a class! Does this Smithian paradox have a solution, or is this contradiction inherent to capitalism? I will begin my survey of Book II of Smith’s magnum opus in my next post.

Adam Smith concludes Book I of The Wealth of Nations with a lengthy detour titled “Digression concerning the Variations in the Value of Silver during the Course of the Four last Centuries.” (WN, I.xi.e-p) Although it is tempting to just skim or even skip this seemingly tedious subsection, I agree with my colleague and friend Maria Pia Paganelli [1] that doing so would be a terrible mistake, a reckless omission, for Smith’s “digression” is no mere appendage or afterthought; it is a must-read for two reasons.

One is that Smith’s subsection on silver consists of “new” material. By Smith’s own admission, he wrote this part of his great book in February 1773 (see WN, I.xi.m.10), that is, a few years after his extended visit to France (1764 to 1766) and a decade (if not more) after writing his “early draft” of The Wealth of Nations. The other reason Smith’s lengthy detour is worth reading is that it explores what I like to call the “three-body problem” in economics — namely, what is the relationship between (i) a nation’s wealth, (ii) the price of precious metals like silver, and (iii) the price of consumer goods like corn and cattle? In the course of exploring this complex three-body conundrum, Smith exposes no less than three mercantilist miscues or economic errors:

• Fallacy #1: nominal prices are same as real prices. To begin, most of Smith’s 100-page-plus digression on the value of silver can be summed up in a tweet: We need to look at real prices (measured in terms of others goods and services), not just nominal prices (measured in money).
• Fallacy #2: correlation is causation. In addition, mercantilists confuse correlation with causation: they claim that the long-term increase in the nominal prices of most goods was caused by an increase in the amount of silver after the discovery of Spanish America. Smith, however, explains why this correlation is just a coincidence: the real price of silver and other goods (corn, cattle, etc.) is not only a function of changes in supply and demand but also of changes in overall economic prosperity. (WN, I.xi.n)
• Fallacy #3: money is wealth. Smith’s main punchline: the true wealth of a nation lies in its capacity to produce and consume useful goods and services, not just the amount of gold or silver it possesses. (WN, I.xi.n.1 & I.xi.n.9)

To recap, it is here — in his lengthy digression on the value of silver — that Smith’s debunks classical mercantilism, the idea that national wealth consists of gold and silver. But does Smith’s powerful rebuttal extend to modern mercantilism (e.g. Trumpism), the idea that national wealth consists of positive trade balances? (To be continued …)

[1] See Maria Pia Paganelli, “Adam Smith’s Digression on Silver: The Centerpiece of The Wealth of Nations.” Cambridge Journal of Economics, Vol. 46, No. 3 (2022), pp. 531-544, preprint available here.

What is the relationship between rent, profit, and wages — the ostensible subject of the second half of Book 1 of The Wealth of Nations — or between rents and prices more generally? Adam Smith grapples with these difficult theoretical and practical questions in Chapter 11 (available here) of his magnum opus. [1] Unlike the wages of workers and the profits of owners, however, one often gets the feeling from Smith that landlord rents are a necessary evil! In a previous chapter (Ch. 6), for example, Smith takes a direct swipe at landlords:

As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce. The wood of the forest, the grass of the field, and all the natural fruits of the earth, which, when land was in common, cost the labourer only the trouble of gathering them, come, even to him, to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces. This portion, or, what comes to the same thing, the price of this portion, constitutes the rent of land, and in the price of the greater part of commodities makes a third component part. (WN, I.vi.8)

After devoting three chapters to wages and profits (Chs. 8-10; see here, here, and here), Smith returns to the subject of landlords and rents in Chapter 11. Here, although Smith’s tone is less judgmental and more analytical, he goes to great lengths to point out how rents generally bear little to no relation to the skill or foresight of landlords. In the preamble to this lengthy concluding chapter (I.xi.a.1-9), for example, Smith defines rent as “the price paid for the use of land” (I.xi.a.1 & I.xi.a.5); then he asserts the following general principle:

Rent, it is to be observed, therefore, enters into the composition of the price of commodities in a different way from wages and profit. High or low wages and profit are the causes of high or low price; high or low rent is the effect of it. It is because high or low wages and profit must be paid, in order to bring a particular commodity to market, that its price is high or low. But it is because its price is high or low; a great deal more, or very little more, or no more, than what is sufficient to pay those wages and profit, that it affords a high rent, or a low rent, or no rent at all. (I.xi.a.8)

In other words, while the price of any given good or service is a function of profits and wages — i.e. the higher these profits or wages are, the higher the price of the good or service will be — rent, by contrast, is a function of price: the higher the price of any given good or service is, the higher landlord rents will be as a general rule. The key phrase here, however, is “as a general rule,” for Smith devotes the remainder of this chapter to describing three different scenarios regarding rents:

1. Scenario #1: Positive Rents (I.xi.b) — i.e. the circumstances under which landlords (like monopolists) are able to charge high rents;
2. Scenario #2: Negative or Zero Rents (I.xi.c) — i.e. the circumstances under which landlords are in no position to charge high rents; and
3. Scenario #3: Fluctuating Rents (I.xi.d) — i.e. the circumstances under which landlords’ position to charge high rents is unstable or in flux. It is here, when describing this third scenario, that Smith inserts a lengthy digression. [2] (To be continued …)

[1] As an aside, Chapter 11 is by far the most lengthy and tedious chapter of Book 1 of The Wealth of Nations: it spans over 180 pages of the Glasgow edition of Wealth and includes a protracted “Digression concerning the Variations in the Value of Silver during the Course of the Four last Centuries.” (I.xi.e-o)

[2] Smith’s “digression” takes up two-thirds of this lengthy chapter, or 119 pages of the Glasgow edition!

I will resume my series on The Wealth of Nations in my next post; in the meantime; check out this homage to another great economist: Thomas Sowell.

In Part 2 of Chapter 10 of Book I of The Wealth of Nations (I.x.c; available here), Adam Smith identifies three types of “absurd” laws and regulations — absurd because they restrict our natural liberty and distort markets:

• Laws and regulations that “restrain[] the competition in some employments to a smaller number than would otherwise be disposed to enter into them”; i.e. laws and regulations that artificially reduce the supply of workers in certain markets (see Paras. 3 to 32);
• Laws and regulations that “increas[e] the competition in some employments beyond what it would naturally be”; i.e. laws and regulations that artificially increase the supply of workers in certain markets (see Paras. 33 to 40);
• Laws and regulations that “obstruct[] the free circulation of labour and stock both from employment to employment”; i.e. oppressive laws like immigration restrictions and capital controls that artificially restrict or impede the free flow of capital and labor across borders (see Paras. 41-67).

Smith then surveys (and rightfully condemns!) many examples of specific laws and regulations that distort labor markets and obstruct capital flows, especially mandatory apprenticeship laws, education subsidies, and the infamous Poor Laws. But what is even more remarkable about this chapter is the fact that Smith’s diagnosis and critique of “those absurd laws” (I.x.c.43) are just as relevant and stinging today as they were in 1776! For what are occupational licensure laws but oppressive and wasteful and artificial restrictions on labor? What are federal student loan programs but subsidies to higher education that artificially inflate the number of college students? And what are immigration restrictions and taxes on capital flows but artificial restrictions to the free circulation of labour and stock?

But my favorite quote from Chapter 10 is Smith’s scathing critique of rent-seeking and business conspiracies:

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.” (I.x.c.27)

Here, Smith introduces what is to my mind a radical idea and a tension that will haunt the rest of his great work, for he implies that business can be just as detrimental to the public good as the government! (To be continued …)