prior probability

ADAM SMITH’S SECOND EXCEPTION TO FREE TRADE

“The second case, in which it will generally be advantageous to lay some burden upon foreign for the encouragement of domestic industry is, when some tax is imposed at home upon the produce of the latter. In this case, it seems reasonable that an equal tax should be imposed upon the like produce of the former.” (Wealth of Nations, IV.ii.31)

What Adam Smith is saying here is that “targeted tariffs” (my term) on specific imports are justified when equivalent domestically-produced goods (such as soap, salt, leather, and candles) are subject to local excise taxes, and the rationale for Smith’s second exception to free trade is to “leave the competition between foreign and domestic industry, after the tax, as nearly as possible upon the same footing as before it” (Wealth of Nations, IV.ii.31). Otherwise, certain imports would enjoy an artificial price advantage in the home market and “our merchants and manufacturers … will be undersold at home” (ibid.).

But at the same time, Smith limits the scope of this second exception in two ways. Specifically, (1) the tariffs allowed under this second exception should not be extended to all imports, only to the imports of those foreign goods whose local equivalents are taxed, and (2) the tariffs on those specific imports should not exceed whatever the local tax on domestic goods is. In the next four paragraphs of Book IV, Chapter 2 of The Wealth of Nations (paragraphs 32 to 36), Smith explains why his second exception to free trade should not be extended any further. These four paragraphs also contain a fascinating digression on the effect of local taxes on “the necessaries of life”, i.e. essential consumer goods like soap, salt, leather, and candles (see WN.IV.ii.33). Stay tuned: I will explore this important digression in my next post …

ADAM SMITH’S FIRST EXCEPTION TO FREE TRADE

“There seem, however, to be two cases in which it will generally be advantageous to lay some burden upon foreign for the encouragement of domestic industry.” (Wealth of Nations, IV.ii.23)

As I mentioned in a previous post, Adam Smith identifies several “exceptions” to free trade in the second half of Book IV, Chapter 2 of The Wealth of Nations. Alas, as we shall soon see, some of these “exceptions” are so sweeping in scope that they could end up sabotaging the case for free trade.

Take, for example, Smith’s first exception: national defense. To illustrate this exception, the Scottish philosopher-economist trots out the “act of navigation” (i.e. the Acts of Trade and Navigation or “Navigation Acts” for short), a series of shipping laws dating from 1660 that strictly regulated trade between Britain and her colonies and with other countries:

“The defence of Great Britain … depends very much upon the number of its sailors and shipping. The act of navigation, therefore, very properly endeavours to give the sailors and shipping of Great Britain the monopoly of the trade of their own country in some cases by absolute prohibitions and in others by heavy burdens upon the shipping of foreign countries.” (Wealth of Nations, IV.ii.24)

Worse yet, Adam Smith not only defends this shipping monopoly on national security grounds; he actually extols the Navigation Acts as, and I quote, “the wisest of all the commercial regulations of England” (WN, IV.ii.30).

What? Is Smith being serious here? The Navigation Acts were the linchpin of Britain’s mercantilist system; among other things, these onerous laws prohibited the use of foreign ships and required the employment of English and colonial mariners for 75% of the crews. (By the way, where have we heard this before? If the old Navigation Acts ring a bell, that’s probably because these onerous laws were the British equivalent of the Jones Act, a modern-day U.S. shipping law that many of my North American readers will be familiar with.)

To his credit, Smith concedes that the Navigation Acts make Britain poorer: “By diminishing the number of sellers, therefore, we necessarily diminish that of buyers, and are thus likely not only to buy foreign goods dearer, but to sell our own cheaper, than if there was a more perfect freedom of trade” (WN, IV.ii.30). But he nevertheless defends the Navigation Acts because “defence … is of much more importance than opulence” (ibid.). For Smith, national security trumps prosperity.

But the fatal flaw with Smith’s premise is that almost anything we do has some connection, however remote, to national security! In any case, it gets worse, for Smith’s next major exception to free trade is even more broad and sweeping than the first one, so stay tuned, I will consider Smith’s second exception in my next post …

President Trump signed an official memorandum on Thursday calling for “fair and reciprocal” trade tariffs on all major U.S. trading partners (you can read the presidential memo for yourself here), but as per my previous post, does Trump’s executive action fall into any of Adam Smith’s exceptions to free trade? Before we explore Smith’s exceptions and their scope (i.e. before we consider whether these exceptions swallow up the general rule in favor of free trade), allow me to post a compilation of my previous posts explaining step-by-step Smith’s critique of trade barriers:

1. The immortal Adam Smith
2. Adam Smith’s First Law
3. Adam Smith’s Second Law
4. The logic of the invisible hand
5. Adam Smith’s dire warning
6. Smith’s First Law Redux
7. Adam Smith and the conspiracy of the merchants

(THE REAL ADAM SMITH PROBLEM)

“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“!

THE IMMORTAL ADAM SMITH, PART 7

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 IMMORTAL ADAM SMITH, PART 6

“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 …

THE IMMORTAL ADAM SMITH, PART 5

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 …