prior probability

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 …

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.

THE IMMORTAL ADAM SMITH, PART 4

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?

THE IMMORTAL ADAM SMITH, PART 3

“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 …

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 …

Among other things, Adam Smith devotes an entire chapter of The Wealth of Nations to “Restraints upon the Importation from Foreign Countries.” (See Book IV, Chapter 2 of his magnum opus.) To begin with, the Scottish philosopher-economist concedes right off the bat that “high duties” (i.e. import tariffs) or “absolute prohibitions” (total embargoes) on imports can work to the benefit of local producers: “By restraining, either by high duties or by absolute prohibitions, the importation of such goods from foreign countries as can be produced at home, the monopoly of the home market is more or less secured to the domestic industry employed in producing them” (Wealth of Nations, IV.ii.1).

The father of economics then provides several specific examples of “high duties” or “absolute prohibitions” on foreign trade–specifically, those imposed on the importation of live cattle, salt, corn, wool, and silk:

“Thus the prohibition of importing either live cattle or salt provisions from foreign countries secures to the graziers of Great Britain the monopoly of the home market for butcher’s meat. The high duties upon the importation of corn, which in times of moderate plenty amount to a prohibition, give a like advantage to the growers of that commodity. The prohibition of the importation of foreign woollens is equally favourable to the woollen manufacturers. The silk manufacture, though altogether employed upon foreign materials, has lately obtained the same advantage. The linen manufacture has not yet obtained it, but is making great strides towards it. Many other sorts of manufacturers have, in the same manner, obtained in Great Britain, either altogether or very nearly, a monopoly against their countrymen.” (Ibid.)

Also, Smith notes that these restraints on foreign trade are not just limited to cattle and corn or wool and silk: “The variety of goods of which the importation into Great Britain is prohibited, either absolutely, or under certain circumstances, greatly exceeds what can easily be suspected by those who are not well acquainted with the laws of the customs” (ibid.). And next, Smith further reiterates that restrictions on imports benefit domestic graziers (cattle ranchers), domestic corn growers, as well as domestic woollen and silk manufacturers:

“That this monopoly of the home-market frequently gives great encouragement to that particular species of industry which enjoys it, and frequently turns towards that employment a greater share of both the labour and stock of the society than would otherwise have gone to it, cannot be doubted.” (ibid.Wealth of Nations, IV.ii.2)

It is here, however, where Smith’s analysis starts to get interesting, for he then makes the following offhand observation: “But whether it [i.e. protectionism] tends either to increase the general industry of the society, or to give it the most advantageous direction, is not, perhaps, altogether so evident” (ibid.). In other words, are restrictions on trade good on balance? Are they beneficial overall? Stay tuned, for I will survey Smith’s scathing and still-relevant critique of trade barriers in my next few posts …

Although the text of Article I, Section 8, Clause 1 of the U.S. Constitution specifically empowers the Congress (not the president) to set import tariffs (“The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises …”), it turns out the legislative branch began delegating this power to the president during FDR’s quasi-dictatorship in the 1930s and 40s. (See here, for example, for an introduction to U.S. tariff policy.) As a result, the constitutional question we should be asking instead is this: Does the Congress have the authority to delegate any of its “Article I” powers to another branch of government in the first place? Perhaps it is time for courts to revisit the non-delegation doctrine, though good luck with that, since it turns out that Congress has also delegated most of its lawmaking powers to a plethora of regulatory agencies! (Bonus links: Ilya Somin, Adrian Vermeule, and William Funk.)

I will address some legal aspects of Trump’s executive order imposing tariffs on imports from our main trading partners (Mexico, Canada, and China) in my next post; in the meantime, today’s “Monday map” post is dedicated to my hometown: Los Angeles, California. Bonus link: Photographer Nicholas White surveys some of the most popular graffiti styles found on the streets of L.A. in this photo-essay.