Modern readers meet Adam Smith, if at all, as a caricature: on neckties, in op-ed articles, as a critic of government, a prophet of markets and laissez-faire. This think-tank version grossly distorts his significance. Like his friend Benjamin Franklin, Smith was astoundingly wide and deep: founder of a modern social science, moral philosopher, a man of affairs, and a superb writer as well. Thomas Jefferson, John Adams, Alexander Hamilton read his books. He was, if not a founding father of the American republic, a favorite uncle. His very universality makes it difficult to isolate his specific contributions as the originator of modern political economy.
Los primeros teóricos trataron los problemas del ajedrez y razonaron que ellos podrían ser usados para conseguir dar la luz sobre una amplia variedad de los problemas de la estrategia, incluyendo el comportamiento económico. Como Robert Leonardo, de la Universidad de
Ver tambien http://www.librosdeeconomiayempresa.com/r001/articulo1.aspx
Montreal, ha mostrado, en Von Neumann, Morgenstern, y la Creación de Teoría de juegos: Del Ajedrez a la Ciencia Social 1900-1960, el tablero de ajedrez estaba el camino a la teoría de juegos y, más allá, a la economía conductual..
… seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess–board. He does not consider that the pieces upon the chess–board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess–board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse [sic] to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must at all times be in the highest degree of disorder.
Those few words, written near the end of a long life of successful theorizing, spelled out the central fact that makes the problems of economics – of the social sciences in general – so much harder than those in physics. In returning to work on The Moral Sentiments, Smith was emphasizing the problem of human consciousness and will. Barely a hundred years would pass before the first theorists took up the problems of chess and reasoned that they could be abstracted and used to shed light on a wide variety of problems of strategy, including economic behavior. As Robert Leonard, of the University of Montreal, has shown, in Von Neumann, Morgenstern, and the Creation of Game Theory: From Chess to Social Science 1900-1960, the chess board was the path to game theory and, beyond, to behavioral economics..
There are a few things we know about human beings. They are alert, inquisitive, forward-looking (that is, they form expectations about others’ actions), volatile, highly imperfect, eager to cooperate (or not) in varying degrees; and, in circumstances that also may differ greatly, they may be eager to improve their lot, that is, often, to “make money.”
More than a few times over the years, economists have ignored or overlooked or forgotten these most basic facts, which together add up to a principle of conditional autonomy, in hopes of making easy gains. In invoking the player of the game of chess, Smith wasn’t repudiating the effort to make a social science; he wasn’t even making the case for caution. He was, near the end of his life, stating the obvious: that the subject invited further work.
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The way economics is today has much to do with the way the discipline got its start. Economists call this overall effect “path dependence,”meaning that its interpretations of the world today are determined by choices that others made in the past. This has to do with the various inquiries that economists have adopted over the years.
It’s in the nature of things that Adam Smith should be remembered for one great book, An Inquiry into the Nature and Causes of the Wealth of Nations, and one great insight contained in it – the counterbalance of the forces of supply and demand, animated by competition, productive of a high degree of spontaneous order when governed by suitable rules. In plain English, this is the price system of decentralized capitalism. Economists called it value theory for many years, until they clarified their thinking; today they speak of the existence of general equilibrium.
In fact Smith pursued two other lines of inquiry in the book which were only slightly less inviting. The first of these had to do with the growth of knowledge, which Smith discussed in terms of the division of labor. The second zeroed in, none too successfully, on the characteristics of the rapidly-growing system of paper money. Meanwhile, the success of The Wealth of Nationscaused subsequent generations to forget altogether about Smith’s earlier treatise on psychological and behavioral principles, The Theory of Moral Sentiments, even though it clearly had prepared the way.
What happened is fairly simple. The Wealth of Nations constituted, in a way that The Theory of Moral Sentiments did not, what we now recognize as a paradigm, in both main senses of Thomas Kuhn’s elusive term. That is, it was both a foundational book, and it conveyed a distinctive way of seeing and addressing a particular set of problems – or, rather, it conveyed three distinctive ways of viewing three particular problems, three different thinking caps. One of these was more appealing and ready-to-wear.
Each of the roads-not-taken was explored by others, with varying degrees of success, inside the community of those calling themselves economists and outside of it, by others aspiring to social science (political scientists, psychologists, sociologists, anthropologists and so on), as well as humanists of every sort.
Today all three prongs of inquiry in The Wealth of Nations are indispensable to understanding our twenty-first century world – and, of course, to understanding the present-day situation of economics. It helps to know something about the less tightly-focused agenda of The Moral Sentiments, too. Equipped with these four separate ideas, we’ll be better prepared when the story turns timely again, after 1936. Never mind the subtleties of paradigms, thinking caps, theorems; for simplicity’s sake, because their existence is so concrete, I will describe the metaphors Smith employed in The Wealth of Nations to convey them.
First, however, consider a little background the better to understand how Smith came to be a penetrating theorist.
. A man of parts
Smith was born in 1723, in Kirkaldy, a hardy little seaport on the North Sea, a dozen miles across the Firth of Forth from Edinburgh. The east of Scotland was still very poor. Union with England in 1707 had taken a toll on the region’s centuries-old trade with Holland, France and the Baltic nations. Glasgow, Scotland’s bustling Atlantic port, had more in common with London than with Edinburgh. Its trade with North America was booming, thanks to the union with England. Its merchants, it was said, imbibed free trade with the punch. And it was Glasgow where Smith went off to school at fourteen.
The intellectual excitement was intense. Isaac Newton had died just ten years before; knowledge of how his physics has “overturned or changed all ideas….” was slowly spreading, mostly through Scottish universities. In addition to lectures on Newton during his third year in Glasgow (and two sessions a week of experiments with air pumps, barometers and balances)+, Smith read Thucydides, Herodotus, Plato and Euclid, in Greek; Cicero and Seneca, in Latin; Descartes, Montesquieu and Rousseau, in French; Machiavelli, in Italian; and, of course, Hobbes, Locke and Bacon. His favorite teacher, Francis Hutcheson, lectured in English instead of Latin. By enquiring into human nature, Hutcheson argued, “the same way we enquire into the structure of an animal body, of a plant, of the solar system,” a science could be built on so firm a foundation “as would be satisfactory to every candid observer.”
Three years later, Smith left Glasgow on horseback for Oxford in 1740, on a scholarship designed to produce Episcopalian ministers. He would remain there for six years, reading extensively in history, politics and science. (Smith bought his own copy of Newton’s Principia; Colin Maclaurin’sTreatise on Fluxions, the first systematic exposition of Newton’s methods, appeared in 1742.) Smith disliked Oxford intensely.* The professors there were living complacently in the past, he found, still teaching Aristotelian physics.
*He diagnosed a lack of competition. The university was one of those places that “have chosen to remain, for a very long time, the sanctuaries in which exploded systems and obsolete prejudices found shelter and protection, after they had been hunted out of every other corner of the world.”
Smith returned to Kirkaldy in 1746. He was 23, again living with his mother. Two years later, as a way of launching a secular career, he was invited to offer a series of lectures in Edinburgh. He would eventually give three of these: first rhetoric, then a history of natural philosophy (what we now know as science was called in those days), and finally jurisprudence.
Hard as it is to recall in these days of YouTube and overnight delivery from Amazon, in the eighteenth century new views were disseminated mostly by lectures. Books intended for the citizen who wished to be well-informed had only just begun to find a market. Far more common, at least in cities like Edinburgh and Glasgow, were series of talks by university professors, independent scholars and itinerant showmen. They would hire a hall (or invite auditors into their lodgings), advertise the topic, and hope that a sufficient number of subscribers would show up and pay a guinea apiece to make a success of things – £100 a year or more in Smith’s case, a respectable living.
The lectures on rhetoric were a great success. Smith presented the ancient writers, and discussed the modern classics that he had read at Oxford as well: works by Addison, Steele and Pope. The greatest of them all, he declared, was Jonathan Swift, who had died in 1745. Smith called special attention to the “close, naked, natural way of speaking” that was advocated by members of the Royal Society, “bring[ing] all things as near the Mathematical plainness.” It was natural that the next year he should offer a course in “the New Science of Newton.” It is this essay that deserves our attention.
Later Smith would describe his lecture programs as part of a “juvenile project” and insist that all the manuscripts but one be destroyed. He spared “The Principles which Lead and Direct Philosophical Enquiries; Illustrated by the History of Astronomy,” the one on which he had worked the hardest and with which he was most pleased. Two hundred years later, the economist Joseph Schumpeter, who never had a high opinion of Smith in other respects, wrote that “were it not for the undeniable fact, nobody would credit the author of The Wealth of Nations with the power to write it.”
Since Smith’s ideas about the history of science bear a striking resemblance to those of Thomas Kuhn (who developed his ideas in a book on the Copernican Revolution), Smith’s history of astronomy is the place to start in understanding what he accomplished in economics, and what happened next.
. A historian of astronomy
The advances in astronomy were a source of great excitement in Edinburgh in the autumn of 1749. Confirmations of Newton’s laws were being reported on every front. Newton’s work on comets in The Mathematical Principles of Natural. Philosophy had been incomplete, but his friend and editor Edmond Halley had confirmed many of his views, and predicted that Newton’s spectacular comet of 1680 – it had passed so close to Earth that its long tail had been visible during the day – would return in 1758. Rarely has the outcome of a prediction been so eagerly awaited. In the meantime, eclipses were a matter of great interest to astronomers. Two eclipses visible in Edinburgh had occurred during the summer the year before; a distinguished French astronomer had visited to observe them, and to relate his experiences a dozen years before as a member of the French astronomical expeditions to Lapland and Peru. Thus it was not surprising that, a year later, a good-sized audience was willing to pay to hear the 26-year-old recently returned from Oxford expand on what had been learned.
They were not disappointed. Smith not only knew his Newton; he had mastered the Greeks. He began by giving them credit for the “thoroughness with which they had investigated the cosmos.” Smith carefully described the system of the flat Earth as it evolved from Eudoxus to Aristotle to Ptolemy. Originally it was contained within a system of eight crystalline spheres, the moon attached to one; the sun to another, higher sphere; five more for the “wandering stars” (the known planets, Saturn, Jupiter, Mars, Venus and Mercury) and a eighth for the fixed stars. This system was capable of explaining many eclipses, Smith noted, with a certain amount of residual mystery concerning the motions of the planets.
New observations meant more spheres. By Aristotle’s day the number was up to 56. Five centuries later, Ptolemy added eccentric spheres and epicycles. By the thirteenth century, astronomy had become an intricate system of wheels and circles, periodically contradicted by the facts. And it was in these circumstances of the extreme embarrassment of existing theory, in 1537, that Copernicus undertook to arrange the heavenly bodies differently.
Smith then led his listeners through the main chapters of the Copernican Revolution: Copernicus, writing in Latin so that his ideas would spread slowly; great Galileo, who bore out Copernicus, with his telescope and observations of the phases of Venus, which resembled those of the Earth’s moon; Tycho Brahe, the meticulous Danish astronomer and record-keeper; Johannes Kepler, the mystical German theorist who abandoned the idea of perfectly circular orbits in favor of ellipses; Descartes, with his “mechanical philosophy” of an infinitude of small spinning cubes, filling all of space; and, finally, Newton, who “relieved the last embarrassment” of the Copernican system and tied it all together with the law of gravity:
so familiar a principle of connection which to completely remove all the difficulties the imagination had hitherto in attending them.… the discovery of an immense chain of the most important and sublime truths, all closely connected together, by one capital fact [gravity], the reality of which we have daily experience…
In Smith’s parlance, these chains of truths were “systems” – terminology he inherited from Galileo, who titled his comparison of the Ptolemaic and Copernican cosmologies Dialogue on the Two Chief World Systems. Such systems resembled machines in many respects, Smith wrote. They were “invented” in order to “connect together those different movements and effects which are already in reality performed.” They had possessed the property of being immediately persuasive, without the need to spell out all the details. We might say that they were intuitively obvious As Smith put it, “Who wonders at the machinery of the opera house who has once been admitted behind the scenes?”
Today cosmologists call their systems “models.” Considerable refinement of the standards of rigor has occurred. The principles, however, remain the same, Their properties must be measurable, that they might be critically assessed.
Smith showed the pains Newton had taken to persuade his audience that the earth really was rotating on its axis. There was obviously no direct experience of this; but if it were so, then, by the laws of motion that Newton had adduced, the Earth should bulge a little at its equator and be slightly flattened at its poles. (Ancient cosmologies held just the reverse.) This was precisely the appearance that the planet Jupiter presented when viewed through a telescope – a proportion of thirteen at its equator to twelve at its polar diameter.
But what about the dimensions of the Earth? That had been the purpose of those French expeditions. They found that identical pendulums would swing more slowly in Peru than in Lapland, showing the equator to be farther from the center of the earth than the North Pole. It was the most solid and satisfactory evidence of all that the Earth in fact turned daily on its axis.
If this sounds strangely modern, that’s because it is. Smith was describing the psychology through which one paradigm displaces another. Like Kuhn, Smith was concerned with what constituted a satisfactory explanation. It was not enough that the models be systems, elegant little mathematical machines; they had to be such that their properties could be measured and tested against the world it was seeking to explain.
If they were serious about their work, astronomers, would have no alternative but to choose between competing models, on the basis of the rules of their science. If they were persuaded by one paradigm, they couldn’t entertain the other, and, having chosen, they could forget altogether about the model they had discarded. This all-consuming quality is the “mapping Africa” effect (well-known features of the everyday world disregarded or even forgotten until established by “scientific” methods) It turns out to play an important role in the history of economic thought.
Smith’s lectures were a considerable success. And so the eclipses that Smith’s auditors in Edinburgh had witnessed that first summer, once mysterious, were shown now to be completely and unalterably understood. The lecture series made him £100 or more; he would give another course in each of the next two years. There was no surprise among his colleagues when he was hired fr the vacant chair of logic at Glasgow University in 1751. He was 27.
. A student of human nature
Smith set to work on a book. The Theory of Moral Sentiments wasn’t finished until 1759. It is a curious work – part psychology text, part colloquy with a band of brother philosophers who had gone before. They are Hobbes, Mandeville and Rousseau, each of whom supposed that man possessed “no powerful instinct which necessarily determines him to see society for its own sake.”
Smith disagreed. The very first sentence specifies the indissoluble social aspect of human nature, the existence of fundamentally contradictory motives in everyday life: – “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” There follows extensive examination of human virtues as seen by various authorities – Cicero; Epictetus; the Iroquois confederation of native American tribes, whose customs had aroused great curiosity among Europeans – almost as though he were employing data on his way to constructing a system based on a few simple principles. Chief of these was the argument that the sense of justice was the foundation of social life, “the main pillar that upholds the whole edifice.”Fellow-feeling (beneficence, he calls it, the word altruism would not be coined for another hundred years) was the ornament, Smith wrote, not the core. Emulation is set forth as the single strongest motive force: the anxious desire that we ourselves should excel, is originally founded in our admiration of others.
He summarized the mainspring of his argument in a letter to a friend:
We learn, therefore, to sett up in our minds a judge between ourselves and those we live with. We conceive ourselves as acting in the presence of a person quite candid and equitable…merely a man in general, an Impartial Spectator who considers our conduct with the same indifference with which we regard that of other people.
Again, this strikes a distinctly modern-sounding note. Not much different from Kant’s categorical imperative, Freud’s superego, or, in everyday language, the conscience, “the self performing on a public stage,” in the intellectual historian Roy Porter’s phrase. From the vantage point of the present day, it looks like the beginnings of ego psychology.
Today a lot of people are interested in The Moral Sentiments, with good reason. It is a splendid book, as absorbing on the topic of human nature as anything of William James or Freud and seems to point directly to the “behavioral” economists of the present day. Smith seems to have hoped to found a science of “sympathy” and conscience.
Hume, who had become his friend, hailed him as a “moral Newton,” but this was wishful thinking. There was no “imaginary machine” to be found in the book, no mechanism capable of generating the kinds of insights we have come to expect from models. So at the time, and for many years after, The Moral Sentiments seemed one more among many such books of moral questioning, a “swansong,” as Smith biographer James Buchan put it, in a tradition that went back to the English civil war. It received a polite, even enthusiastic reception, a good deal of criticism and disagreement.There were six editions, but, rather than creating a discipline, it would be mostly forgotten within twenty years. Smith had become a celebrated professor within his university, but he was not yet an economist.
The Moral Sentiments did produce an invitation from Charles Townshend to serve as traveling companion and tutor to his step-son, Henry, then just leaving Eton, on an extended tour of the continent. Townshend was a rising politician (and author of the Townshend Acts, reviled in Britain’s North American colonies); his 20-year-old ward, approaching his majority as the Duke of Buccleuch. Smith thought about the offer briefly and, in 1763, resigned his professorship.
For the next three years, the pair visited France and Switzerland, sojourning in Toulouse, Geneva and Paris, despite the inconvenience of war between Britain and France. Smith met a great many interesting figures along the way, including Turgot and Quesnay, early proponents of a scientific economics, and returned to London with the young duke at the end of 1766. Buccleuch became involved with the Ayr Bank, as we have seen, and Smith returned to his native village, and began to write. It took six years to finish his next, better-known book.
…and, as a “conjectural historian,” founds a social science
The Wealth of Nations appeared in the autumn of 1776. It was overshadowed by the appearance of another book on publisher William Strahan’s list – The Decline and Fall of the Roman Empire, by Edward Gibbon. Wealth was highly successful, too, and for good reason: The Decline and Fall was a specimen of the sort of cyclical history that had been dominant since the Greeks; it was designed to be read as a kind of memento mori for the inevitable decline of Great Britain.
Wealth of Nations told a very different story – a story of what had happened in the years since the fall of Rome, and what was likely to happen in the future. Smith’s student, Dugald Stewart, called the book “theoretical” or “conjectural” history, to distinguish it from the more philosophic C narrative of the sort associated with Gibbon or Hume. There was, in fact, even more to it than that. It was a bold and self-conscious attempt to create a new science.
Smith divided his tome into five books. He set up his analytic scheme in the first two. The third takes his theory to the data, in this case the history of the known world, starting well before classical Greece. The fourth compares his system with what he describes as the dominant system of political economy, a world-view he designated “mercantilism.” The fifth book is a manual of public finance and a discussion of the responsibilities of government. Forty years later, David Ricardo structured his text, The Principles of Political Economy and Taxation, along similar lines, rendering in sturdy form the plans the architect had sketched.
. A pin factory
On the first page of the first chapter of The Wealth of Nations, Smith flatly declared that the division of labor had been the source of “the greatest improvement in the productive powers of humankind.” There was, of course, nothing new about the principle of specialization. Plato had devoted several pages to it in The Republic. setting out an account of the economic growth that, as four-stages theory, had great currency in eighteenth-century Scotland: hunting, herding, agriculture and commerce. Smith (and Sir William Petty, who had begun the modern discussion of the division of labor a century before Smith took it up) had the advantage of more than two thousand years of subsequent experience.
He illustrated the advantages of the division of labor with an extended example of a pin factory. A single man, setting out to make a pin from scratch, might spend a year making a single pin, Smith wrote in an early draft, He would have to find the ore, dig it up, refining the metal, forging it, splitting it into small rods, drawing a rod into wire, and, finally, drawing the wire into a pin. In a modern factory, he noted, ten men or more were involved in specialized operations. Thanks to their dexterity, the saving of time between operations and the invention of specialized pin-making machinery, they could make twelve pounds of pins a day – around 48,000 in all.
Nor was it just pins that were made this way. The best wire, for example, came from Sweden, where just as many hands had been involved in its manufacture, as many more in transporting it across the Baltic and North Seas, and only then did modern pin-making commence. Iron-mining, steel-making, shipbuilding, rope-spinning, worker-nourishing – the division of labor was so widely employed that the number of person involved in producing some small slice of the comforts of life was, Smith wrote, beyond counting. Many thousands cooperated in making the simplest good, and because the gains often were on the scale of those in pin manufacture, everyone had become better off. The lowliest peasant in Europe lived better than an African king, Smith wrote, thanks to the ubiquity of the division of labor.
Smith listed three explanations for the efficiency of specialization: the dexterity accumulated when workers dedicated themselves to a single task; the time saved by performing one instead of many tasks (“a man commonly saunters a little in turning his hand from one sort of employment to another,” he wrote); and the gains to be had from the introduction of machines. His discussion of the contribution of mechanization is very brief, consisting of two sentences. “Everybody must be sensible of how much labour is facilitated and abridged by the proper application of machinery. It is unnecessary to give any example.”
Instead he turned to a discussion of the roles of theory and practice. Who is better suited to invent some new item of machinery? The common worker who is most familiar with the means and ends of manufacture? Or the philosopher acquainted with its principles? Many improvements had been made technologists and businessmen, he wrote; and “some by those who are called philosophers or men of speculation, whose trade is not to do anything but to observe everything…” Speculation itself thus was becoming a trade, subdivided into many branches, and in science, as in every other business, specialization saved time and buttressed skill.
Subsequent thinkers, especially John Stuart Mill, would re-label the division of labor the practice of “cooperation.” What were its motive forces? Smith answered in chapter two. The division of labor arose from a simple principle: the “propensity to trade, barter and exchange one thing for another.” It seemed to have to do with reason and speech. Nobody ever saw a dog make a fair and deliberate exchange of one bone for another. But humans engaged in nearly constant trade with one another, based on the principle of fair exchange. “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” This was the “system of natural liberty”: the economy as a series of markets, for bacon, beer, bread.
The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle, that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations; though the effect of these obstructions is always more or less either to encroach upon its freedom, or to diminish its security.
Meanwhile, back at the pin factory, Smith addressed the limits on specialization in chapter three– “That the division of labor is limited by the extent of the market.” Making 48,000 pins was one thing; selling them was another. In a small village, or on a farm, no one could afford to specialize. Every highlander baked his own bread, The market was too thin to support a bakery. Only in a city could a porter expect to make a living. Even a city might not be enough: in reaching a truly broad market, transportation was often the key. That’s why cities were located on rivers and oceans. Not even pins could bear the cost of land transport to Calcutta.
But notice that Smith’s maxim is true backwards as well as forward. The size of the market is limited by the extent of the division of labor. With a single pin-maker whittling a few pins a day, there will hardly any market for pins. But eighteen pin-making specialists, with their machines, embedded in a worldwide system of division of labor, means an enormous (though not unlimited) market, because pins have become so inexpensive. Nor is it just pins. Fast forward 135 years to the market for Model T Fords. When Henry Ford decided in 1909 that his company would produce only its Model T, it took twelve and a half hours to make one car, which sold for $900. Over the next five years, he cut the price of the basic car to $440, reinvesting his profits in mines, mills, ships, railroads, metal-bending and cutting machines of every conceivable type, as long as they served the Model T. He sold 2 million in the peak year of 1923, fifteen million altogether before switching over to the Model A, in 1927.
Adam Smith never used the phrase “mass production,” but he anticipated many of the most important developments of the nineteenth and early twentieth centuries with his pin factory in 1776. As transportation became more efficient and new products came to require more know-how – think of pharmaceuticals, computer chips, and software – rail lines, airports, highways and universities and became more important to cities than rivers, but Smith’s insight remain as revealing as before: the division of labor is limited by the extent of the now global market.
. An Invisible Hand
All this unfolded in the first three chapters of The Wealth of Nations. Smith hurried on; he had greater excitement to communicate. He dropped the topic of specialization after three chapters and turned to a series of essentially housekeeping matters. The role of money had to be described, for instance. He discussed its history In chapter 4. The ancient Greeks had traded oxen for armor. Coins emerged: easy to weigh and, once stamped, hard to fake. Money had in due course become “the universal instrument of commerce in all civilized nations, by the intervention of which goods of all kinds are bought and sold, or exchanged for one another” (though workmen in certain remote villages in Scotland still carried nails in their purses instead of coins).
Then there was the distinction between the money price of a commodity (its “nominal” price) and the amount of work it takes either to make it or earn the money to buy it. That was the business of chapter five. Smith treats lightly the question of the purchasing power of money, what we now call “inflation”; mostly reserved for the lengthy digression on silver in chapter eleven. Often the corn price was more revealing of the cost of living, he wrote, since it fluctuated less than the prices of gold and silver.
All this in order to say something about why prices were what they were – to establish what would come to be known as the labor theory of value – the doctrine that the exchange value of all things depended on the amount of labor involved, originally labor alone; then capital; then, when lands has become private property, rent. Here Smith was describing the factors of production: the three component costs, into which the price of any item may be separated: the rent of land, wages of labor and profit of capital. All this nomenclature had been worked through before by others. But he zeroed in on the tendency of the rates of return to adjust, to become equal. And with this much housekeeping in place, Smith asserted the existence of a system of relative prices, in which goods exchange for one another in proportion to the effort by which they were acquired or created (one beaver for two deer, and so on).
Finally, in chapter 7, Smith introduces something completely new: the distinction between the natural price of a commodity in a system of prices, meaning the cost of bringing it to market (which in turn depends on the natural rates of wages, profit and rent); and its market price, meaning that for which it may be selling at any particular time. What is “natural” will vary from place to place, Smith says, depending on the neighborhood and the fertility of the land. Market conditions will vary, too: there will be bad weather, blights, wars, shortages and glut. Fashions will change. But competition will do the rest. The natural price is “the central price, to which the prices of all commodities are continually gravitating.”
If the market price of, say, wheat is high, farmers will hire more workers, plant more land with wheat, and bring more of it to market; meanwhile, purchasers will buy less wheat and more barley: before long the price will fall back. If, on the other hand, wheat is selling below its natural price, purchasers will buy more of wheat and farmers will take land out of production until the price returns to normal. As in one market, so in all: not just wheat, but corn and oats; not just food, but all the other headings of consumption; wages, profits and the rent of land. “The natural price is, as it were, the central price, to which the prices of all commodities are continually gravitating.” Markets would return to normal – would equilibrate – thanks to that elemental principle of self-interest.
Smith’s literary model implied a vast interrelated system among market participants which no one controlled, yet which generally behaved in an overall orderly fashion, in such a way that people would be fed, housed, clothed, etc., without coordination beyond that which was signaled by constantly changing market prices. As long as free entry between doing one thing and another were maintained (much of the rest of the book had to do with the variety of blockages that were interposed to defeat competition), the price system would do the rest. No foresight or planning or overall knowledge would be required.
His “system of natural liberty” – of competition – wasn’t set out in so many words as a “machine.” In fact its persuasive power stemmed from the verb he chose to describe its operation. “Gravitating” is employed twice in chapter 7, each time to suggest interdependence and order. Ninety years had passed since Isaac Newton broached the proposition that the paths of bodies of the heavens depended on a certain kind of force to attract one another at great distances: to wit, the law of universal gravitation. By now, the animating principle behind celestial mechanics was fairly widely understood.
Smith furnished a figure of speech for the mechanism he was describing. It was hardly the first time the notion of an unseen hand was used by British writers. Often the operation of “invisible hand” signified little more than Providence. In Wealth of Nations, however, it goes straight to the heart of the argument of the book: selfish ends constrained by certain rules to produce unexpected order.
As every individual, therefore, endeavors as much as he can both to employ his capital in the support of domestic industry that its product be of the greatest value. Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it…. [H]e 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 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 promoter it. I have never known much good done by those who affected to trade for the public good.
Smith wasn’t simplistic about any of this. He wrote in natural language, not, as Newton had, in the mathematical language of proof. If a town has two groceries, Smith argued, they’d both sell cheaper than if there were one, and if there were twenty, it was less likely that they could collude. If one employment were more advantageous or disadvantageous than the others, people would either crowd into it or stay away, thus all tending to equality, depending on the circumstances. The fluctuations would continue indefinitely, never coming to rest. Interdependence was the meaning Smith attached to “equilibrium,” not static balance — one thing depending on all the rest. “Gravitating” was just a verb, but “the Invisible Hand” would turn out to be uncommonly powerful.
. A set of Daedalian Wings
Little-noticed in The Wealth of Nations was a third figure of speech. Smith began his discussion of money in Book One, with a chapter on its origin and use, and inserted a little further on a 60-page “Digression concerning Variations in the Value of Silver during the Course of the Four last Centuries” – the phenomenon we call inflation. His thoughts on paper money and banking were to be found in Book II, where he discussed the nature of capital. It is here that he dealt with the scandal of the Ayr Bank and the banking crisis of 1772.
That nature of money was an important part of his argument with the mercantilists, for whom the mere possession of gold and silver was an end in itself, a way of national scorekeeping. Smith argued that money was useful only for what it would buy. It was best understood as a kind of infrastructure. It was a “wheel of circulation,” he wrote, something like a system of highways over which capital traveled from place to place. Like any other sort of infrastructure, the cost of its creation and maintenance was to be considered. That meant thinking about paper money.
Bank notes had begun replacing gold and silver coins throughout much of Britain in the eighteenth century. Smith took the system mostly for granted, because its origins were complicated. Two hundred years later, the economic historian Charles P. Kindleberger put it this way:
The usual textbook view is that banking developed from goldsmiths who issued receipts for gold left with them which later circulated from hand to hand and that observation of this circulation ultimately induced goldsmiths to issue receipts without previous deposit. The story is well told but inaccurate. Goldsmiths evolved into bankers only in the middle of the seventeenth century in England. . Banking developed much earlier and was connected especially with foreign trade.
Medieval fairs, bills of exchange, the usury laws and government finance banks are all important for understanding the debt markets of today, but for our purposes, it is enough to accept that gradually the goldsmiths invented private banking. They discovered they could issue more receipts – more bank notes – than they had gold in their vaults.
Such was the origin, long ago, of “fractional reserve banking.” The practice is more familiar today from Jimmy Stewart’s explanation of it in It’s a Wonderful Life than from introductory economics texts. Banks raise capital, accept deposits, and make loans, keeping only a fraction of the money deposited with them in the till, in reserve, in anticipation of the predictable flow of depositors who wish to withdraw their money. The loans are purchasing power. They become money.
Smith offered a sober discussion of history of fractional reserve banking, and a cautious defense of paper as an alternative to gold and silver coin. if gold and silver were a highway, carrying corn and grass to market but producing none itself, then banking system creating pape money was , “a wagon-way in the air,” enabling a nation to convert its supply of precious metal highways into pastures. Circulating money was had been estimated to be 18 million pounds. Only a fifth as much gold and silver would be required to support as much commerce. Or 18 million pounds of specie again could support five times as much revenue.
But paper money was dangerous, because it could be issued too freely. The system amounted to a set of “Daedalean wings.” he wrote, invoking the Greek myth of Icarus, who, using wings of feathers and wax that had been fashioned by his father Daedalus, flew too near the sun and perished in the sea when the wax melted. The metaphor wasn’t his Smith’s own. The great satirist Jonathan Swift had broached it a few years before Smith was born.
In “The Bubble,” written towards the end of 1720, Swift mocked the events surrounding the establishment of the South Sea Company, which had crashed and taken many London fortunes with it earlier that year, This was a major skeleton in Britain’s closet, a financial crisis whose impact on the society of its day was comparable in many ways to, perhaps, that of the Great Depression, or at least the Crisis of 2008.
The story is a complicated one. It involves a Scottish banker, John Law, who was the first advocate of paper currency and managed money. Money and Trade Considered: with a Proposal for Supplying the Nation with Money, published in Edinburgh l705, failed to persuade the British but brought an invitation to Paris in 1715. Law set up a bank to finance economic development in Louisiana, which was then a French colony. The soaring returns on shares of the Mississippi Company persuaded the British to try something similar in hopes of straightening out the nation’s exploding war debt. The South Sea Company and the Sword Bank also enjoyed spectacular run-up in share prices, then crashed the same month as did the Mississippi Company in in France. Swift wrote.
There is a gulf, where thousands fell,
Here all the bold adventurers came
A narrow sound, though deep as Hell.
[Ex]’Change Alley is the dreadful name.
Smith barely mentions the South Sea Company, except to assert that the English episode had been a “trifle” compared to the French affair – “the “the most extravagant job both of banking and stock-jobbing that, perhaps, the world ever saw.” The word bubble doesn’t appear in Wealth of Nations, despite Parliament’s adoption of the Bubble Act. (The measure designed to prevent it from ever happening again, chiefly by keeping other banks out) The incident that had riveted the attention of well-to-do Londoners, Swift, was judged to have been “adequately treated” by De Verney and Du Tot. Sir James Steuart, who seventy years before had given a long and sympathetic account of Law’s career in his Principles of Political Oeconomy (which had mostly to do with money and credit) wasn’t mentioned.
The chapter on banking includes Smith’s defense of his pupil, the Duke of Buccleuch, and the misadventures of the Ayr Bank. It concluded on an assertive note. Banks just need to be a little more prudent, issuing fewer large denomination circulating notes and none in small denominations. The more banks, the less likely is an accident (which must periodically occur) to affect the public, Smith wrote. More competition meant that banks are likely to treat their customers better, for fear of losing them to the next.
The late multiplication of banking companies, in both parts of the united kingdom, by which many people have been much alarmed, instead of diminishing, increases the security of the publick… the freer and more general the competition, it will always be the more so.
. What happened next?
These are, I think, the three most fundamental ideas in The Wealth of Nations – in any event, they are three most powerful metaphors. What remained for Smith was to take his model to the data. In Book Three, “On the different Progress of Opulence in different Nations,” he sketched an economic interpretation of the history of Western Europe since the collapse of the Roman Empire designed to illustrate the working out of his four-stage system: hunting, pasturage, farming and commerce.
In Book Four, “Of Systems of Political Economy,” he presented a dialogue between his own system and another that Smith labelled the mercantilist system. Mercantilism was in fact a hodge-podge of conceptions about the natural order of society, subsequently recognized as a combination of Greek, ecclesiastical, and monarchist doctrines. Smith set it up in order to shoot it down. It worked. Compared to the hierarchic traditions of the ages of the past, the idea of a decentralized system of markets was a model of parsimony and, eventually, clarity. The Wealth of Nations was a great success when it appeared in 1776.
What happened next? Three groups gradually coalesced around Smith’s book, in the early nineteenth century, began calling themselves political economists, thinking of themselves as scientists.
Price theorists quickly became the dominant tribe. They familiarized themselves with the thinking cap whose motif was the Invisible Hand. They became comfortable with its blinders and, like surveyors determined to map a newly-discovered continent with modern methods, began their investigations at a rapid pace.
They more or less ignored the growth theorists and the monetary theorists in the other groups, treating the others’ concerns as peripheral, dealing with them in chapters towards the ends of their books, often waving their arms and pretending to understand more than they did. They forgot The Moral Sentiments altogether.
Their excitement, which in disciplinary terms lasted around 175 years, is easy to understand, at least in Kuhnian terms. As the modern saying has it, when you’re a kid with a hammer, the whole world looks like a nail.
‘ A game-theoretic postscript
Most of Smith’s contemporaries were not interested in the least in the scientific ambitions of economics, theoretical or empirical. These tended, then as now, to be practical men, politicians and businessmen. One voice in particular stood out in the years after 1776, that of Edmund Burke, author, parliamentarian, and, though he never became Prime Minister, perhaps the most eminent statesman of the age.
It was Burke who sponsored a bounty on the export of grain to which Smith had objected. The criticism chafed. Shortly after Wealth appeared the two men began a ten-year private correspondence/conversation in which Burke regularly reproved the economist thus, at least according to an account of the matter by Burke’s eminently practical friend Thomas Jefferson (as recounted by twentieth-century Smith expert Jacob Viner):
You, Dr. Smith, from your professor’s chair, may send forth theories of freedom of commerce as if you were lecturing upon pure mathematics, but legislators must proceed by slow degrees, impeded as they are in their course by the friction of interest and the friction of preference.
Smith softened his criticism in the next edition of The Wealth of Nations by inserting these sentences at the end of the section:
So far, therefore, this law seems inferior to the ancient [former] system. With all its imperfections, however, we may perhaps say of it what was said of the laws of Solon, that, though mot the best in itself, it is the best which the interests, prejudices, and temper of the times could admit of. It may perhaps in due time prepare the way for a better.
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