Adam Smith

An Inquiry Into the Nature and Causes of the Wealth of Nations

Introduction

• Recall: Ethics, economics as part of a broader system of social science– Theory of Moral Sentiments: An exercise in

moral, social philosophy– Wealth of Nations: Extends this to provide a

working model for social interaction: the “System of Natural Liberty” as a vehicle for directing our self-regarding propensities

– A response to to the challenge directed toward Smith’s moral theory: Will the Impartial Spectator be sufficient to control “the passions”?

• Is the available information sufficient?

• Is that information really always interpreted impartially?

• Our claim: society needs institutional structure

• But TMS does not tell us where this comes from

Links to Kuhn: Smith’s Disciplinary Matrix

• A systematic– Exploration of the natural order underlying the

social world– Application of that understanding to social and

economic issues

• A unified system of explanation

• A definitive technique of analysis

• Provided economics (political economy) with its first generally accepted system of theories, concepts, analytic techniques: its first disciplinary matrix

• Part of his general theory of society

• That is: he gave it– An organized structure of assumptions– A problem orientation– A value system– An analytic framework– (later) a self-conscious intellectual community

• Much popular appeal of this paradigm– Relevance to immediate policy problems

• Population explosion; concern for Poor Relief; economic growth issue

• Corn Laws; and commercial policy

– Belief that political economy could provide• A simple, effective method of analyzing these

complex problems

• A reasoned approach to useful policy recommendations

– Ricardo, Malthus, others, as puzzle-solving: doing normal science

Fundamental Issue

• Under what conditions will society operate so as to maximize human happiness?

• TMS: Human happiness promoted by obeying the moral virtues under the observation of the Impartial Spectator; grounded in need for social approval

• WN: – More explicit recognition of the problem of

opportunistic behavior– Implications for the kinds of reforms necessary

to bring society closer to the system of natural order that would maximize happiness

– Note Smith’s location in time and space

• The machine metaphor: under what conditions does it operate best?

• The importance of policy

• WN as probably the first unified socio-economic model

The Major Themes

• Economic growth, development: society’s laws of motion

• Social coordination: How does a society in which each individual follows own self-interest keep from falling apart?

Economic Growth

• What’s the “wealth” of nations?– Mercantilist presumption– Smith: “Wealth”, from “weal”, well-being– What’s necessary for the “good life”?– For whom?

• Growth measured in terms of output per person

• Sources of productivity: where does growth come from?– Now: Focus on

• Technology

• Capital per worker

• Institutions

• Incentives

• Smith: Source of productivity growth in specialization, division of labor– The pin factory– Why does this happen?

• Improved dexterity: learning-by-doing

• Time saved moving from operation to operation

• Inventing labor-saving machines

• Who benefits?

• Origin of division of labor? “Propensity to truck, barter, and exchange . . .”

• We need the cooperation of many others to survive; do we get that cooperation by appealing to their benevolence?

• The social division of labor as important

• What affects the degree of specialization? The importance of the extent of the market

• Examples

The Importance of Money

• Specialization as implying exchange

• Barter, and the problem of transactions costs

• Commodity vs. fiat money

• The diamond/water paradox: a scientific puzzle

The Policy of Europe

• A first look at Smith’s argument for the “system of natural liberty”

• A way for Smith to talk about the consequences of interference with free exchange

• Examples: exclusive privileges; restrictions on labor mobility; the threat of monopoly

The Importance of Capital Accumulation

• Smith’s problem: How do we support ourselves until we produce and sell our own output?

• In our language: – Capital stock as necessary for more division of

labor– Capital, thus, as a major source of productivity

growth

• Productive vs. unproductive labor: What’s going on here?

• Distinction between output produced for

– Current consumption (consumer goods)– Future consumption (capital goods)

• How does society increase productive labor (capital accumulation)?– Parsimony: saving– Link to TMS, and saving as a dimension of

prudence/self-love

• The importance of good public policy– Smith’s warnings against a large public sector:

why?

• The direction of spending matters: Spending for luxury goods in a poor country as blocking economic development

The System of Natural Liberty

• Book IV, and further discussion of mercantilist legislation

• The trade balance: – Do we need to worry about trade deficits?– Are gains to one trading partner matched by

losses to the other?

– Why see restraints on trade?– Contemporary versions

• The basic idea: The competitive market as reconciling private, social interests; the social mechanism for regulating the economy

• Imposes orderly rules of behavior on economic agents

• Thus: The “Invisible Hand”– As working automatically to coordinate

people’s individual decisions– As working best with minimum interference

• Potential problems:– Desire to monopolize– Tendency for protectionism– Grounded in self-interest?

• Where’s government in all this? To provide– Legal system: Administer justice– Anti-monopoly protection– Military security– Provide certain public works

In the End: The Central Theme of the Invisible Hand

• Under certain social arrangements private and social interests can be harmonized

• Market forces assure a social result that is independent of individual intentions

• Self-interest works for general welfare only under appropriate set of rules

• Does a market economy guarantee the “best of all possible worlds”? Is Dr. Smith really Dr. Pangloss in disguise?

• Is government without fault? The incentives facing politicians, bureaucrats

The Evolution of Social Institutions

• Unresolved issue: Where do social institutions (including government) come from? Why are they necessary?– TMS, and their necessity; but not how they

come to be– WN, and a story about their origin (Books III

and V): a “philosophical history”

• How does human society begin? The propensity to “ . . . truck, barter, and exchange . . . “

• Necessity of defining, monitoring, enforcing property rights

• Security, order as necessary for society; and social order requires system of law

• So: how do institutions evolve?– Brief definition: Institutions as rules (explicit; or

implicit)– Origin with the evolution of property– Sources of authority:

• Age

• Fortune

• Birth

• Personal qualifications

– Stages of society• Subsistence (hunting, fishing)

• Pasturage

• Agriculture

• Commercial

– Evolution of differences in property ownership; and associated evolution of property rights

– Importance of preconditions for growth

• Why does Smith do this? To show how changes in the nature of the economy are reflected in institutional changes

– The basic argument:• Humans are self-regarding is all spheres of society

• Helps us understand the pursuit of wealth, security

• Economic development creates different stages of society, each with its own characteristic institutional structure

• Two case studies:– Western Europe after the fall of Rome

• The manor as the basic unit of society– Disorder; conflict

– Provided security

– Mutual claims, lords and serf

• Changes in system of property rights: entail; primogeniture

• Limited growth possibilities

• Emergence of a market economy– Links, town and country

– Political alliances, monarchs and towns

– Role of foreign trade

– Decline in lords’ feudal power• Conversion of feudal obligations into cash

• Dissipation of fortunes: buying goods and services

• So: Commerce brought about what feudal violence could not: a decreased power for nobles

In the End . . .

• “Whenever a person seeks to serve his own ends, he invariably serves the ends of society”

• Did Smith provide a solution to this problem? Did he suggest the conditions (social arrangements) under which this can happen?

• Self-interest makes the market system go

• But benevolence (a moral sentiment) makes the market system possible

• Social institutions important in harnessing, channeling, pecuniary motives

• A set of policy prescriptions grounded in– The existing institutional structure– His analysis

• Is the free-market economy the “best of all possible worlds”? Is Dr. Smith really Dr. Pangloss in disguise?

• Another issue: Is market society (capitalism) civilizing or self-destructive? What’s the effect of capitalism on the social and moral order?

– The “Doux-Commerce” hypothesis: Favorable effects of capitalism

• Limitations on the powers of monarchs

• A moralizing agent: people are useful to each other

• Smith, and frugality, integrity, industriousness

• The influence of continuing relationships

– The “Self-Destruction” hypothesis: Capitalism as undermining the moral foundations on which any society must rest

• Influence of the Industrial Revolution

• Emphasis on individual advantage: atomism as corrosive of social cohesion

• Rationalism undermines religious belief

• “Commercial spirit” replaces “higher values”

– Can both be held at the same time?– Is there an inevitable outcome for capitalism?