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Book 5, Chapter 2
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
In societies without much trade or manufacturing, wealthy people cannot buy luxuries, so they either buy necessities for others or hoard money. So does the sovereign. But in commercial societies, sovereigns and the wealthy buy luxury goods, often to excess. Instead of amassing treasure, such countries incur debts—especially during wars, which require massive and immediate spending.
In this final chapter of The Wealth of Nations, Smith will analyze how and why nations take on debt. For him, writing in the 18th century, this was a relatively new and troubling development. It enabled irresponsible leaders to spend far beyond their means, using the government to pursue their own short-term interests and forcing the people to pay for it in the long term.
Themes
Merchants and manufacturers will lend this money to the sovereign because they generally have access to lots of capital. If they already trust the government to protect their property, they will certainly trust it to pay them back, which makes government debt a secure investment. As the sovereign usually borrows in times of crisis, it generally offers its creditors favorable terms, and those creditors can often sell its debt at a premium. Since the government knows that it will be easy to borrow, it has no need to save. This is why, by 1776, most European countries are heavily indebted.
The government’s incentives align closely with private creditors’. Namely, the government can easily get away with living off loans, and creditors see it as the most desirable borrower. Accordingly, the government gets access to practically unlimited credit, while its creditors get a very secure and profitable investment. But Smith clearly views this model as unsustainable, and he hopes to end his book with a clear warning about its perils.
Themes
At first, governments offer unfunded debt, without any collateral. Later, they start dedicating certain funds to repay their debt, whether for a limited period of time or perpetually. For instance, the Bank of England loans the crown the expected value of land and malt taxes at the beginning of every year, and the crown pays it back with interest as it collects the taxes.
The government can get away with offering unfunded debt because of the great trust people place in it. Indeed, since the end of the gold standard in the 1970s, all modern paper money is just unfunded government debt. But the government can also leverage its various assets and powers—including the power of taxation—to guarantee creditors repayment.
Themes
This system began when the crown issued and repeatedly extended a series of temporary taxes in order to cover its interest payments between 1697 and 1710. The taxes became perpetual in 1711, then were consolidated into a fund to cover the crown’s interest payments in 1715 and 1717. Most European countries have done the same thing, repeatedly taking out temporary loans to pay their other loans before eventually resorting to “the more ruinous practice of perpetual funding.” Interest rates fell in the early 1700s, so Britain put all the money it saved in a new fund, which it spent taking out new debts.
The Bank of England’s practice of lending to the crown is the foundation of modern central banking. This keeps monetary and fiscal (spending) power separate, while ensuring that the government can pay its bills. Smith points out how the crown introduced taxes specifically to pay for its debts—in other words, it borrowed money first, and then figured out how to pay for it later. This approach helps explain why he finds government debt so troubling. Specifically, it shows that governments don’t set tax policy by carefully analyzing its advantages and drawbacks, like Smith did in the last chapter. Rather, it too often spends what it can get away with, and then scrambles to find new ways to pay for it after the fact.
Themes
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The crown also offers fixed-term and lifetime annuities, meaning it pays creditors their interest every year either for a certain number of years or until the creditor dies. Its long-term annuities, lasting 90 to 100 years, are financially equivalent to perpetual annuities. But they appear less attractive than perpetual annuities, so have become less common. Creditors particularly like tontines, or lifetime annuities organized in lots so that longer-surviving lenders receive higher payments. This is because people are overconfident, and everyone tends to assume they will live longer than average. Lifetime annuities are more common in France than England. This is because most of the English crown’s creditors are London merchants, who prefer perpetual annuities because they are easier to sell. But most of the French crown’s are wealthy farmers, tax collectors, and bachelors who care more about living luxuriously than passing on a fortune.
These annuities are the precursor to modern government bonds, which guarantee creditors consistent income at relatively low interest rates year after year, while funding government operations with their capital. Once again, overconfidence is the most consistent bias in human economic decision making. The government can easily raise additional revenue by taking advantage of this; in fact, modern government-run lotteries depend on exactly the same principle. Lastly, the difference between English and French annuities reflects the countries’ fundamental differences in the late 18th century. England’s commercial society and Parliamentary system encourage the elite to seek status through profit. In contrast, France’s rigid aristocracy only guarantees status based on rank. This gives elites little incentive to seek profit and holds down the whole economy. Indeed, Smith’s analysis of the French economy can help modern readers understand the popular motivation for launching the French Revolution.
Themes
If the people had to pay directly for war, they would hate and protest it, but perpetual funding allows governments to spread the cost of wars over many years. As a result, European city-dwellers even enjoy reading about wars in the newspapers and fantasizing about national glory. Their taxes don’t fall in peacetime—instead, the government constantly finds new ways to tax them. In fact, since Britain started using perpetual funding to pay for the war of 1688–1697, it has never even gotten close to paying off more debt during a period of peace than it borrowed in the previous war. Thus, Britain’s debt has consistently increased, and since the American colonies are just starting a new war, there is no reason to think it will stop.
In the first chapter of Book V, Smith explained how the division of labor can lead to longer, more violent wars. Agricultural societies can send all their men to war between harvests, but complex societies develop a class of professional soldiers who are paid to fight and train for war full-time. As he explains here, once the government figures out how to pay them, this fundamentally transforms the population’s relationship to war. In fact, Smith’s analysis even suggests that the availability of unlimited debt was one of the main reasons European states colonized the world, then fought so many pointless wars over their colonies. He paints a picture of European colonialism emerging more from governments’ arrogance and financial impunity than their economic self-interest.
Themes
Some have defended England’s national debt by suggesting that this brought more capital into the country, but they are wrong. British creditors already had this capital—they just chose to lend it to the government, which wasted it on economically unproductive war expenses, instead of investing. Thus, while paying for public expenses with taxes merely diverts revenue from one economically unproductive activity to another, paying for these expenses with credit actually diverts capital from productive activities to unproductive ones.
War may be the most unproductive economic activity of all, because even if it funds certain kinds of manufacturing, it mainly just spends immense sums of money to destroy people, resources, and infrastructure. And as Smith points out here, paying for war with debt amounts to siphoning capital stock out of the rest of the economy, then spending it destroying that economy. Of course, the alternative to war is respecting other countries’ sovereignty and engaging in free trade with them. Needless to say, Smith considers this a far superior alternative.
Themes
Paying for wars with debt prevents sudden tax increases during wartime. But such increases would cause the people to oppose war, so they would make wars shorter, less frequent, and less serious. In fact, Britain currently pays more in peacetime to service its old war debts than it would cost to directly fund a war through taxes.
Again, debt is pernicious because it insulates the population from war’s true effects. This allows the government to keep fighting without facing immediate political or economic consequences. But the consequences still pile up slowly and imperceptibly in the long term, until they are constantly putting immense pressure on the nation’s economy.
Themes
Since war debt shifts some of the nation’s land and capital from private to public ownership, it reduces landlords’ investment in land improvements and encourages capital owners to invest in other countries. Thus, every state that has funded itself with debt has become weaker: Genoa, Venice, Spain, France, and now Britain. The British tax system may be Europe’s best, but each new war will weaken it by forcing Britain to impose foolish and oppressive new taxes. As of 1776, these taxes haven't stopped the British economy from growing, but they may yet. Every country that accumulates massive debts will eventually go bankrupt.
Debt undermines the whole economy’s health and discourages the investment that drives long-term growth. So it’s no exaggeration to say that Smith thinks war debt could cause Britain’s political and economic system to collapse. Unfortunately, Britain wouldn’t heed his advice, and it would keep fighting ruinous colonial wars continually for more than a century. Today, while historians still debate debt’s precise effect on the American Revolution success and the Britain’s colonial empire’s collapse after World War II, few doubt that it played a significant role.
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Some nations try to disguise these bankruptcies by redenominating their currencies, so that the government can pay its creditors less than it really owes. If Britain tries to do this, it will defraud countless innocent people out of their wealth and cause a disastrous loss of confidence in the government. Nations should openly declare bankruptcy rather than resorting to this evil “juggling trick.” Rome once did this by cutting a primary coin’s value by five-sixths (and then again by three-fourths). But this was a popular move because, in Rome, most debts were owed by the poor to the rich. Many nations have performed this trick secretly by debasing their currencies at the mint. This always causes popular outcry.
Redenomination is like an even more brazen, shocking, and damaging form of currency debasing, because the government doesn’t even try to hide it. This causes a massive loss of investor confidence, which is devastating because capital investment in productivity improvements is the primary factor that drives long-term economic growth. Declaring bankruptcy is a better option: it amounts to admitting the problem and promising to change, rather than lying to cover it up. Bankruptcy demonstrates the government’s commitment to transparency and eventually giving investors their due.
Themes
Britain can only pay off its national debt by massively increasing the general revenue, massively decreasing expenses, or both. Smith’s proposals for reforming the land, house, customs, and excise taxes would help. But they wouldn’t be nearly enough. Taxing Ireland and the colonies would make a far bigger difference, but that would require giving all those territories representation in Parliament. Powerful interests at home would never accept that. But it’s worth explaining how this would work.
Smith gives some important context to his proposals from the last two chapters: they are specifically designed to help Britain become financially solvent once again, after disastrous wars and the colonial empire all but bankrupted it. His proposals will likely remind 21st-century readers of the American revolutionaries’ complaints about “taxation without representation.” While the revolutionaries demanded an end to taxation, Smith proposes that the real solution is representation.
Themes
Britain’s tax system has four parts: “the land-tax, the stamp-duties, and the different duties of customs and excise.” Landowners in Ireland, America, and the West Indies can certainly afford to pay the land-tax. Indeed, they can afford it more easily than British landowners can because church tithes consume a massive portion of British land rents, but there are no tithes in the New World. Extending the stamp-duties would be easy. Extending British customs rules to the colonies, while permitting free trade within the Empire, would hugely benefit everyone (and more than pay for itself). But excise rules would have to change, as the colonies produce different commodities from Britain, and in different ways. For instance, the rules for taxing English beer cannot apply to America, where every family brews its own. Yet excise taxes on sugar, rum, and tobacco would be easy to implement.
Smith clearly demonstrates that Britain could easily extend its taxation system to the colonies, if Parliament had the political will to do so. Yet merchants and manufacturers used their disproportionate political power to prevent a fairer, more economically sound system from taking hold. True economic competition with the colonies would have threatened their profits, so they instead did everything in their power to maintain their monopolies—and led the colonies to revolt as a result. While British beer taxes may not function smoothly in America, this is just another reason to switch to a malt tax, as Smith proposed in his previous chapter.
Themes
In 1776, Britain currently collects 10 million pounds in tax revenue annually from eight million people. By taxing the two million people in Ireland and the three million in America and the West Indies at the same rate, it could earn another six and a quarter million pounds annually. One million would go to pay for the colonies’ government, and the rest would go to Britain’s debt, which it could completely pay off within a few years. Meanwhile, the new, fairer tax system would help the poor and fuel economic growth.
Smith’s numbers may be approximate, but they clearly demonstrate his point about the economic benefits of bringing the colonies into the United Kingdom as equals. Of course, modern readers will know that Britain refused to do so—and may be tempted to ask themselves how history would have been different if Parliament had heeded Smith’s advice. Britain was already Europe’s preeminent power—and remained as such except during Napoleon’s rule—but it would have been far stronger still if it had managed to pay off its war debt (and avoided taking on more).
Themes
Of course, not all people will produce the same tax revenue. The working masses are much poorer in Scotland than England, and they are even poorer in Ireland. The poorest white people in America and the West Indies are still much wealthier than the poor in England, while enslaved Black people in the colonies have the worst lives of all—even if they do consume commodities. Smuggling would be easier in America but simplifying the excise rules (and particularly taxing malt) would reduce it.
The British Empire’s class system is structured by the economic opportunities in each colony, proximity to the power center of London, and race. Smith has already explained why North America’s abundant fertile land and the Caribbean’s efficient (if brutal) sugar colonies provided greater opportunities for poor white people than in Britain. Scotland and Ireland face the worst conditions within the Empire largely because they lack capital investment. And Smith doesn’t take India into account, as it’s still being run by the East India Company (and so is not formally part of the Empire).
Themes
The American colonies use paper money instead of gold and silver. This is not because they’re poor, but rather because they’re growing so fast that buying up gold and silver seems like a waste of capital. For foreign trade, Virginia and Maryland mainly pay in tobacco, while the northern colonies use gold and silver as necessary. The West Indian sugar colonies export far more to Britain than they import from it, but most of their landlords live in England and simply receive their rents in sugar and rum. The northern colonies’ gold and silver payments have been the most reliable, while payments from sugar colonies with significant uncultivated land (like Jamaica) have been the least reliable because planters prefer to invest in land improvements rather than paying their debts. So while America can afford to pay taxes in gold and silver, Britain could collect them in rude produce instead.
The North American colonies’ monetary system contributes to their economic success. Mercantilists would assume that Americans use paper money because they don’t have gold and silver, but it’s really because they are some of the first to build policy around a more accurate understanding of money. As Smith explained in Book II, Chapter 2, paper money allows far more investment than gold and silver, so it grows the economy much faster. Gold and silver are only necessary for certain kinds of foreign trade, when a country cannot find other goods to import in exchange for its exports. And the global gold and silver market will always be willing to supply a country that truly needs them, since their price will rise and merchants will rush to sell them.
Themes
It’s only fair that America and Ireland should help pay for Britain’s debts, as they have Britain to thank for their religious freedom and military defense. By forming a union with Great Britain, Ireland could shake off its oppressive religious aristocracy, and the American colonies could avoid the violent internal divisions that are already tearing them apart.
Smith’s view of the situation in North America and Ireland scarcely resembles the way those former colonies now remember their history under the British. But readers must recall that Smith is imagining a scenario in which the crown incorporates Ireland and the North American colonies into the United Kingdom as equals. Of course, his arguments are strongly influenced by the experience of his native Scotland, which saw its economy boom (and the Scottish Enlightenment emerge) in the decades after its union with England in 1707.
Themes
Lastly, not only do the East India Company’s territories rightly belong to the crown, but they are also much wealthier, more populous, and more fertile than Britain itself. The Company already overtaxes India, but by better administrating this tax system, Britain could pay off its debts.
Rather than truly incorporating India into the Empire, the crown simply let the East India Company govern it as a monopoly. This devastated India’s people and economy, to the point that India went from being one of the world’s richest regions to one of the absolute poorest—its standard of living didn’t recover to precolonial levels until the 1970s. It also deprived Britain of all the benefits that colonization was supposed to achieve. The East India Company would collapse in the mid-1800s, and the crown would finally step in to govern in its place.
Themes
If Britain cannot increase its revenue, it has to reduce its expenses. Its tax collection system and military are both less expensive than its neighbors’ and couldn’t shrink much more. But its government and wars in America have been very costly, and they haven’t even turned the colonies into a proper taxpaying province. Even the colonial trade is a money-losing monopoly that hurts the people. Thus, if it really wants to cut costs, Great Britain should give up her colonies and “accommodate her future views and designs to the real mediocrity of her circumstances.”
In historical perspective, these famous concluding remarks are often seen as a haunting prediction of Britain’s loss in the American Revolution and eventual colonial decline. Of course, the British Empire would continue growing before it would finally decline nearly two centuries later. But Smith’s fateful last warning still captures the essential dynamics behind it: colonialism is as economically untenable for the colonizer as for the colonized. It’s massively expensive, and it focuses on extracting wealth and resources from colonies for the sake of short-term profits, without investing in their long-term growth. And today, Britain’s national consciousness arguably remains stuck between its pride in its colonial past and a growing recognition of “the real mediocrity of [its] circumstances.”
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