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Book 1, Chapter 8
Themes
Key
LitCharts assigns a color and icon to each theme in The Wealth of Nations, which you can use to track the themes throughout the work.
Labor, Markets, and Growth
Capital Accumulation and Investment
Institutions and Good Governance
Mercantilism and Free Trade
Money and Banking
Summary
Analysis
While a growing economy tends to raise wages, it generally reduces profits because it forces merchants to compete. Exact profit rates are difficult to measure, but interest rates can be used as a proxy for them. The rates set by the British crown have fallen significantly since the 1500s, at the same time as Britain’s economy has grown at higher and higher rates.
It may seem counterintuitive that economic growth causes profit rates to fall. But what this really means is that workers and consumers are keeping more of the wealth society produces, while capital owners are keeping less. Interest rates, or the profit rate earned from lending out money, are a good indicator of overall profit rates because capital owners can always resort to moneylending if they don’t have other, more profitable options. For instance, it would make little sense for capital owners to run a business at 4% profit if they can simply lend out their money for 5% interest.
Themes
Trade is generally more expensive in cities than in villages, since more competition means higher wages and lower profit rates. The same dynamic applies to Scotland and England: although the legal interest rate is the same in both, the market interest rate is significantly higher in Scotland, and so is the rate of profit. Similarly, interest rates and profit margins are higher in France than in wealthier England (which is why many English merchants tend to invest in France). But the Dutch are even wealthier than the English. Dutch wages are high and profit rates low, which leads many Dutch merchants to lend money to foreigners.
A vibrant economy with low profit rates will still produce more overall profits for capital owners, simply because the total amount of capital invested is much higher. Dutch and English merchants invest their capital overseas to take advantage of the higher profit rates in less developed countries, much like investors in the Global North do today. But in the 18th century, unlike today, it took far longer for overseas investments to earn a return, because the capital literally had to be exported and reimported on ships. This discussion foreshadows Smith’s later focus on mercantilism, trade, and comparative advantage.
Themes
But Britain’s American colonies don’t fit this pattern. Wages are highest there, but so are interest rates and profit margins. This is because the colonies are still underpopulated, relative to their land and natural resources. Land is cheap and people are only farming the very best of it, which is highly profitable. In fact, North American planters simply cannot get as many workers as they want. But as the colonies’ population increases and their best lands get taken up, profit rates fall—which is why interest rates have steadily gone down in North America.
By the 18th century, virtually all fertile land in the Old World was already owned and inhabited, but this wasn’t true of America (or, at least, the native people living on the land didn’t count as far as Europeans were concerned). Thus, America enjoyed the high wages that come from fast growth along with the high profit and interest rates that come from underdevelopment (a society having not yet reached its full economic potential). These favorable economic dynamics explain the massive European migration to the Americas from the 17th through 20th centuries.
Themes
In general, countries will see their profit levels rise as they conquer new territories or absorb new industries, as their existing capital stock gets spread more thinly among a broader range of business opportunities. In this situation, people choose to allocate their capital and labor to the highest-profit sectors of the economy. Competition decreases, prices rise, profits increase, and so owners can afford higher interest rates. This happened across Britain’s colonies, like in Bengal, where interest rates often exceeded 50 percent.
Smith’s analysis of profit rates helps explain why capital owners have historically driven conquest and industrial innovation. Of course, Smith does not think that Bengal’s high profit rates are really good for Britain. On the contrary, as he will explain in Book IV, they’re really a result of the East India Company’s brutal monopoly policies, which foolishly suppressed the subcontinent’s economy in order to keep its own profit rates high.
Themes
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In contrast, a country that makes use of all its resources and achieves its maximum level of population will see both low wages and low profits, as there would be high competition among both workers and business owners. No country has ever been like this. While China has stagnated in some ways, it also limits its own economic growth by sharply limiting foreign trade and letting the wealthiest business owners suppress their competition. Interest rates there are still as high as 12 percent.
18th century China offered an example of a wealthy but stagnant country where an entrenched elite lived lavishly due to monopoly power, but workers only earned subsistence wages. In contrast, the perfectly-developed country that Smith imagines would have relatively free competition and an economic elite, rather than an aristocratic one. It would still have high levels of inequality. In such a country, there would be no more territory to conquer, so industrial innovation would have to drive productivity growth.
Themes
Often, merchants raise interest rates because their country’s legal system does not effectively enforce contracts and they need to compensate for the risk. Some countries outlaw lending with interest, but people still do it in secret—and at higher rates. At a minimum, interest and profit rates must be high enough to compensate for unexpected losses. So in a very wealthy country, these rates would be very low, and only the richest could afford to live off interest. For instance, in Holland, almost everyone is a merchant or tradesperson.
Interest compensates lenders for two things: the opportunity cost of lending their capital out, rather than investing it elsewhere, and the risk of losing their capital. In the 18th century, this risk was very real because investment often meant shipping gold bars overseas, dealing with thieves and pirates, and so on. The fairer a society’s economic institutions are, the lower this risk becomes, and the lower interest rates can fall. It’s good that such a society would enable relatively few people to live off interest, because this would force them to participate in more productive activities instead.
Themes
At the highest possible rates of profit, all revenue except workers’ subsistence-level wages go to profit. In Smith’s Britain, ordinary market profit rates are about double interest rates, but can vary within reason. This is why countries with high wages can compete by lowering profit margins. Lastly, high profits tend to drive prices up more than high wages do, as they make every transaction more expensive, and so their effects multiply in a way similar to compound interest.
In a nation with the highest possible profit rates, capital owners would run the economy on monopoly principles, and they would capture absolutely all the gains from economic growth. Smith’s explanation of how nations can compete with one another for market share again foreshadows his discussion of mercantilism and free trade in Book IV.
Themes
