“There seem, however, to be two cases in which it will generally be advantageous to lay some burden upon [imports] for the encouragement of domestic industry.” (Wealth of Nations, IV.ii.23)
Thus far (see here, here, here, here, here, here, and here), we have surveyed the first half (paragraphs 1 to 22) of Book IV, Chapter 2 of The Wealth of Nations, where Adam Smith builds the case for free trade. The second half of this chapter (paragraphs 23 to 45), however, identifies several possible exceptions, such as national defense, and we shall soon see when we resume our series next week, these Smithian “exceptions” are so sweeping in scope that they could end up sabotaging or crippling the original case for free trade, and to my mind, it is this internal contradiction in Smith’s analysis of trade that marks the real Das Adam Smith Problem.
“Is any resentment so keen as what follows the quarrels of lovers, or any love so passionate as what attends their reconcilement?” (Adam Smith, The History of Astronomy, Section 1)
Was Adam Smith speaking from personal experience when he posed the above questions? Either way, I will resume my series on the “Immortal Adam Smith” soon; in the meantime, what better way of celebrating Saint Valentine’s Day than by revisiting my 2021 Econ Journal Watch paper “Adam Smith in Love“!
To prohibit by a perpetual law the importation of foreign corn and cattle is in reality to enact that the population and industry of the country shall at no time exceed what the rude produce of its own soil can maintain. (Wealth of Nations, IV.ii.22)
Thus far, we have surveyed the first few paragraphs (1 to 16) of Book IV, Chapter 2 of The Wealth of Nations, including what I have christened Adam Smith’s “First” and Second” Laws, the invisible hand metaphor, and the idea of absolute advantage. In the next few paragraphs (17 to 22), Smith turns his attention to food markets and concludes that graziers, butchers, and farmers “can have nothing to fear from the freest importation” of cattle, salt, and corn (WN, IV.ii.20). Why not? Because the costs of transporting such goods from one country to another are high relative to whatever absolute advantage one country may have over another in cattle ranching or salt and corn production:
“If the importation of foreign cattle, for example, were made ever so free, so few could be imported that the grazing trade of Great Britain could be little affected by it. Live cattle are, perhaps, the only commodity of which the transportation is more expensive by sea than by land. By land they carry themselves to market. By sea, not only the cattle, but their food and their water too, must be carried at no small expence and inconveniency.” (WN, IV.ii.17)
“Salt provisions are not only a very bulky commodity, but when compared with fresh meat, they are a commodity both of worse quality, and as they cost more labour and expence, of higher price.” (WN, IV.ii.19)
“Even the free importation of foreign corn could very little affect the interest of the farmers of Great Britain. Corn is a much more bulky commodity than butcher’s meat. A pound of wheat at a penny is as dear as a pound of butcher’s meat at fourpence. The small quantity of foreign corn imported even in times of the greatest scarcity may satisfy our farmers that they can have nothing to fear from the freest importation.” (WN, IV.ii.20)
Next, Smith compares and contrasts two major groups of market participants and draws some generalizations about these two groups. According to the Scottish philosopher-economist, “farmers and country gentlemen … are the least subject to the wretched spirit of monopoly” (WN, IV.ii.21), but “merchants and manufacturers”, by contrast, “seem to have been the original inventors of those restraints upon the importation of foreign goods which secure to them the monopoly of the home-market” (ibid.), or in the immortal words of Adam Smith:
“Country gentlemen and farmers are, to their great honour, of all people, the least subject to the wretched spirit of monopoly…. Farmers and country gentlemen, on the contrary, are generally disposed rather to promote than to obstruct the cultivation and improvement of their neighbours’ farms and estates. They have no secrets such as those of the greater part of manufacturers, but are generally rather fond of communicating to their neighbours and of extending as far as possible any new practice which they have found to be advantageous.” (WN, IV.ii.21)
But even more importantly, Smith provides a proto-Marxist explanation for this stark difference between monopoly-loving “merchants and manufacturers” on the one hand and public-spirited “farmers and country gentlemen” on the other. For Smith, where you stand on the issue of the free trade depends on where you sit, so to speak, i.e. town or country:
“Country gentlemen and farmers, dispersed in different parts of the country, cannot so easily combine as merchants and manufacturers, who, being collected into towns, and accustomed to that exclusive corporation spirit which prevails in them, naturally endeavour to obtain against all their countrymen the same exclusive privilege which they generally possess against the inhabitants of their respective towns.” (ibid.)
I will resume my multi-part series on the “Immortal Adam Smith” in the next day or two. In the meantime, I can’t help but notice the irony of Smith’s analysis here: today, it is the farm lobby that has most-successfully lobbied the Congress for perverse subsidies and obscene quotas and tariffs on imports!
“The natural advantages which one country has over another in producing particular commodities are sometimes so great that it is acknowledged by all the world to be in vain to struggle with them. By means of glasses [i.e. windows], hotbeds, and hot walls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expence for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines merely to encourage the making of claret and burgundy in Scotland? But if there would be a manifest absurdity in turning towards any employment thirty times more of the capital and industry of the country than would be necessary to purchase from foreign countries an equal quantity of the commodities wanted, there must be an absurdity, though not altogether so glaring, yet exactly of the same kind, in turning towards any such employment a thirtieth, or even a three-hundredth part more of either. Whether the advantages which one country has over another be natural or acquired is in this respect of no consequence. As long as the one country has those advantages, and the other wants them, it will always be more advantageous for the latter rather to buy of the former than to make. It is an acquired advantage only, which one artificer has over his neighbour, who exercises another trade; and yet they both find it more advantageous to buy of one another than to make what does not belong to their particular trades.” (WN, IV.ii.15, emphasis added)
The 15th paragraph of Book IV, Chapter 2 of The Wealth of Nations (quoted in full above) deserves a blog post of its own. Here, the father of economics introduces the concept of “absolute advantage” to present one of the most powerful and irrefutable arguments in favor of free trade. Put simply, when firms in country A can produce goods X, Y, and Z at a lower cost than firms in country B, then both countries are better off when they allow free trade in X, Y, and Z.
But is this ingenious argument really true? Is it better for a country like Scotland to import cheaper claret and burgundy from France than to promote local industry by growing her own grapes and bottling her own wine at home? Or to borrow a more contemporary example, is it better for the European Union or the United States to import cheaper electric vehicles (EVs) from the People’s Republic of China than to manufacture them in Europe or in the U.S.?
Adam Smith openly acknowledges that free trade will harm local firms. (See specifically Book IV, chapter 2, paragraph 16: “If the free importation of foreign manufactures were permitted, several of the home manufactures would probably suffer, and some of them, perhaps, go to ruin altogether, and a considerable part of the stock and industry at present employed in them would be forced to find out some other employment.”) But at the same time, Smith’s resounding answer to both of the questions above is an unqualified and absolute “YES”!
Recall Smith’s First Law: wealth is a function of capital. When a country prohibits or otherwise restricts the importation of cheaper goods like foreign wine or Chinese-made EVs in order to promote the domestic production of such goods or to protect local firms, Smith’s First Law invites us to take a step back and look at the big picture: what will the overall or “macro” effect of such trade barriers be? In a nutshell, Smith’s First Law teaches us that the overall effect of trade restrictions is simply to divert the flow of domestic capital into the production of those goods that would have been imported into the home market but for the restrictions on trade. To see this, ask yourself the following counterfactual question: what would have happened had there been no trade barriers in the first place?
In the remainder of Book IV, Chapter 2 of The Wealth of Nations, the father of economics does two more things: (1) he devotes special attention to food markets, such as cattle, corn, and salt, and (2) he identifies two important exceptions to the general rule that trade barriers are bad. I will turn to Smith’s analysis of food and agriculture markets in my next post and then conclude this series next week by taking a closer look at Smith’s two exceptions to free trade …
In my previous post in this series, we saw that Adam Smith’s famous “invisible hand” mechanism in the economic arena will work only if two key conditions are met:
Condition #1: Owners of capital prefer local markets over more distant ones.
Condition #2: Owners of capital extract the most value from their capital.
But do either of these two conditions hold in the real world? More specifically, how can we say with any degree of confidence that the owners of capital will, in fact, extract the most value from their capital? As it happens, Adam Smith responds to this key question in the tenth, eleventh, and twelfth paragraphs of Book IV, Chapter 2 of The Wealth of Nations. For Smith, the reason why both conditions above are true is local knowledge:
“What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him.” (WN, IV.ii.10, emphasis added)
In addition, the Scottish philosopher-economist draws from this descriptive observation about local knowledge a normative claim about the outer limits of government power — or what I like to call “Adam Smith’s dire warning”:
“The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but [would also] assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.” (ibid., emphasis added)
In contemporary terms, Adam Smith is making two additional sub-claims in the above passage. One is that people are better judges of their own private interests than the government is. The other is that it is downright “dangerous” — Smith’s word, not mine — when politicians try to tell us what economic activities we can engage in. Wait; what?!? “Dangerous”?!? Why? Stay tuned: I will address this key question in my next post …
Last Sunday (2 Feb.) was the 66th Annual GRAMMY Awards show. Although I am a huge country music fan, it is puzzling how a compilation of mediocre songs like “Cowboy Carter” won the Best Album of the Year award. Unless the GRAMMYs are rigged, my theory is that Billie Eilish and Taylor Swift must have split the vote for first place, thus handing Beyoncé a default victory. Next time, the GRAMMYs should consider a more accurate “Bayesian voting” procedure instead.
Let’s pick up where we left off — with Adam Smith’s Second Law, i.e. the counter-intuitive claim that a group of people will be better off overall when each person keeps busy pursuing his own self-interest. To prove this claim, Smith makes two further sub-claims in Book IV, Chapter 2 of The Wealth of Nations:
Subclaim #1 — Owners of capital prefer local markets over more distant ones: “First, every individual endeavours to employ his capital as near home as he can, and consequently as much as he can in the support of domestic industry; provided always that he can thereby obtain the ordinary, or not a great deal less than the ordinary profits of stock.” (WN, IV.ii.5)
Pause. Why do the owners of capital prefer to employ their capital in domestic markets over foreign markets? The father of economics provides one major reason why “every individual” generally prefers local markets over more distant ones: the fear of being defrauded. In the timeless words of Adam Smith (WN, IV.ii.6), “In the home-trade his capital is never so long out of his sight as it frequently is in the foreign trade of consumption. He can know better the character and situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress.” In other words, capitalists can keep a close eye on their capital and can more quickly enforce their contract and property rights in local courts when they “employ [their] capital as near home as [they] can” (WN, IV.ii.5).
Subclaim #2 — Owners of capital want to extract the most value from their capital: “Secondly, every individual who employs his capital in the support of domestic industry, necessarily endeavours so to direct that industry that its produce may be of the greatest possible value.” (WN, IV.ii.7) In support of this sub-claim, Smith makes the following reasonable observation:
“The produce of industry is what it adds to the subject or materials upon which it is employed. In proportion as the value of this produce is great or small, so will likewise be the profits of the employer. But it is only for the sake of profit that any man employs a capital in the support of industry; and he will always, therefore, endeavour to employ it in the support of that industry of which the produce is likely to be of the greatest value, or to exchange for the greatest quantity either of money or of other goods.” (WN, IV.ii.8)
Adam Smith then combines these two sub-claims in the ninth paragraph of Book IV, Chapter 2 of The Wealth of Nations to postulate of the most surprising and original and controversial claims in all of social science:
“But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry …. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry [cf. sub-claim #1], and so to direct that industry that its produce may be of the greatest value [cf. sub-claim #2]; every individual necessarily labours to render the annual revenue of the society as great as he can [cf. Smith’s Second Law].” (WN, IV.ii.9)
The Scottish philosopher-economist then illustrates this surprising conclusion, a conclusion I have christened “Smith’s Second Law“, with a quasi-divine metaphor that would revolutionize our understanding of the world, the invisible hand:
“He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.” (ibid.)
In other words, by employing their capital in local markets and by trying to squeeze the most value out of their capital, the owners of capital end up indirectly benefiting the local economy as a whole! As an aside, Smith’s Second Law has important consequences for contemporary debates about “corporate social responsibility” (CSR). After all, if the pursuit of profits really “is most advantageous to the society” (WN, IV.ii.4), then the study of business ethics is not only a total waste of time; it is also a counter-productive diversion from activities that are far more beneficial to society overall!
What do you think of Smith’s Second Law or the invisible hand metaphor? We are now just four posts into my new series on Adam Smith and just nine paragraphs into Book IV, Chapter 2 of The Wealth of Nations, and we already have a lot of ideas to contemplate and digest. After a brief pause, I will further explore the “Immortal Adam Smith” when I resume my series on Tuesday, Feb. 11. In the meantime, check out the legendary Milton Friedman in the short video posted below. Does Professor Friedman’s explanation of the invisible hand mechanism accord with Adam Smith’s?
“Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to the society.” (Wealth of Nations, IV.ii.4)
The fourth paragraph of Book IV, Chapter 2 of Adam Smith’s Wealth of Nations (quoted above) contains one of the most original — and controversial — insights of all time, an idea that the father of economics would immortalize with his timeless invisible hand metaphor (cf. WN, IV.ii.9). In plain English, Smith is saying that a group of people will be better off overall when each person pursues his own self-interest — i.e., when each member of the group makes the best or most profitable use of the “capital” at his disposal — a proposition I like to call Smith’s Second Law. (For reference, I blogged about Smith’s definition of “capital” and his First Law in my previous post.) But is Smith’s Second Law true? How does promoting one’s self-interest work to advance the common good? Rest assured, I will further explore Smith’s controvertible and counter-intuitive claim in my next post …
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 …
prior probability 