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Intro
Often considered the foundational text of modern economics, Adam Smith’s massive 1776 treatise The Wealth of Nations addresses a wide range of interconnected questions about how labor, consumption, trade, and good government can help societies grow wealthier over time. At the heart of this inquiry is Smith’s innovative theory of political economy, which he develops by exploring how the basic dynamics of the division of labor (Book I) and capital stock (Book II) drive economic growth. Book III examines Europe’s historical economic development, with a focus on the relationship between towns and the countryside, while Book IV addresses the serious flaws with the mercantile system, which was the dominant approach to political economy in Smith’s era. The fifth and final book focuses on how governments—and particularly Britain’s—can work in their people’s best interests and finance themselves.
Smith opens Book I with the famous example of a pin factory, which he uses to demonstrate how the division of labor dramatically improves productivity. Complex modern societies can achieve “universal opulence,” or raise everyone’s standard of living to a high level, by helping people sort themselves into thousands of different specialized jobs. The natural human propensity for trade takes care of the rest: people sell whatever they produce for money, then use that money to buy whatever they need. Yet people often confuse the money price (nominal price) of goods for their real price, which is measured in labor (or a close proxy: grain). Thanks to coin debasing and the discovery of new mines in the Americas, nominal prices fluctuate widely, along with the value of European gold and silver coins.
The price of goods (and thus the revenue of a person, firm, or nation) is made of three parts: wages, profit, and rent. These respectively come from work, capital stock, and land. And they respectively support laborers, investors, and landlords. The value of each of these three components depends on economic circumstances like the level of specialization, amount of fertile land, and overall wealth in a country. Similarly, the market price of each commodity depends on the balance between supply and effectual demand. When supply exceeds demand, prices and profits fall, and suppliers leave the market in favor of more profitable alternatives; when demand exceeds supply, prices and profits rise, so more suppliers enter the market. In this way, market prices usually drift toward the natural price, and investors’ profits drift toward an average rate. Wages and rents rise in proportion to the demand for labor and land. Wealthy commercial societies like Holland have high wages and rents but low profit rates, because they have already developed their agriculture and manufacturing to a high level. In contrast, the fastest-growing societies are places with abundant fertile land, like Britain’s colonies in America, where wages and profit rates are very high, but rents are very low.
Dirty, highly specialized, competitive, and seasonal jobs tend to pay better, as they have to compensate workers for these additional inconveniences. Institutions like guilds (corporations) and apprenticeship requirements artificially raise wages and prices by restricting labor supply. Meanwhile, rent is always a monopoly price: landlords raise it as high as farmers can afford, which gives them an incentive to improve their land and use it in the most profitable way possible. This further raises rents, driving the division of labor forward in a continuous cycle. While this cycle also affects prices, this dynamic varies for different kinds of goods and is harder to measure historically, because the Spanish mines increased nominal prices for everything between 1500 and the 1770s.
Smith begins Book II by explaining how people start accumulating and investing capital once society becomes complex and wealthy enough. To succeed in business, investors must pay for both fixed capital (like buildings and machines) and circulating capital (like the materials of manufacture that they use in production), then use their revenue to cover those capital costs (in addition to wages, rent, and the ordinary rate of profit). The faster this investment cycle runs, the faster an economy grows. The money supply is a form of circulating capital that supports the whole economy, and effective banking strategies (like the banknotes and cash accounts developed by Scottish banks) can make it circulate more efficiently. Farmers, manufacturers, wholesale merchants, and retail traders are productive laborers because they produce more revenue than they take in, while menial servants, soldiers, clergymen, doctors, and educators are unproductive laborers because they do not. The societies with the highest proportion of productive labor will grow the fastest, and agriculture is the most productive activity of all. Every society should invest first and foremost in improving its land, then in manufacturing, and only later in international trade.
Book III focuses on the relationship between the countryside, which generates raw materials (or rude produce), and cities, which turn those materials into manufactured goods. Property ownership structures largely determine whether a nation invests in its land and improves its agriculture. The fall of the Roman Empire left most of Europe’s land in the hands of a few noble feudal families, who managed it poorly and constantly fought against each other. This made cities safer, wealthier, and more productive. And once these cities grew prosperous enough, the feudal lords in the countryside could start spending their agricultural wealth on manufactured goods, instead of just feasts and war. They chose commerce over violence, started improving their land, and eventually lost their power—which brought Europe out of the Middle Ages.
After outlining his own system (or theory) of political economy in the first three books, Smith spends Book IV comparing it with the mercantile and agricultural systems. In his era, most European nations still follow the mercantile system: they define their wealth in terms of their gold and silver reserves and focus on improving the balance of trade in order to increase their reserves. But Smith has already shown that labor, not money, is the real measure of all economic value. International trade often depends on gold and silver as a medium of exchange not because they are inherently special, but simply because they are highly valuable by weight and easy to transport. International trade’s real purpose is not to accumulate more treasure, but rather to advance the division of labor by importing goods that other countries are better at producing, while exporting goods that the home country is better at producing.
Europe’s mercantilist policies—like import restrictions, drawbacks and bounties for exportation, and establishing exclusive trade with colonies and company monopolies—are all counterproductive at worst and wasteful at best. Indeed, Britain’s American colonies are the most successful because, even though trade is restricted there, it’s still freer than anywhere else. And these colonies still cost Britain more than they generate in revenue. In general, domestic trade and trade with nearby countries are simply more profitable than the colonial trade, which is slow and risky. Instead of trying to micromanage trade, nations should just eliminate all these barriers to it, even for critical goods like grain.
Ultimately, mercantilism is only the dominant system because merchants have significant political power, which they use to try and establish monopolies and raise prices. In contrast, French theorists have recently developed the agricultural system, but no country has adopted it. This system rightly views agriculture as the foundation of the economy, but wrongly treats manufacturers and merchants as unproductive laborers.
In Book V, Smith details how wise governments (or sovereigns) should operate and raise revenue to pay for their expenses. Any independent nation needs to defend itself, and military technology makes wealth a massive advantage in war. But war is also deeply wasteful, and wise commercial nations avoid it. Similarly, successful nations need effective justice systems. But these can pay for themselves by charging lawbreakers fines and fees—which should be structured carefully, so as to preserve judges’ independence. An effective government must also build public services like roads, canals, post offices, and mints, but all of these can pay for themselves if managed properly. Most European governments have established regulated companies and joint-stock companies, then granted them monopolies, to promote certain kinds of international trade, but these are wasteful and corrupt. Well-governed public schools and religious institutions, on the other hand, are essential.
To cover these expenses, the sovereign has to raise money (or a general revenue). Some governments earn this revenue by investing capital, lending out money, or renting out land, but private individuals usually outcompete them. This is why most governments prefer to raise revenue through taxes instead. But not all taxes are created equal. Taxes should be proportionate, predictable, easy to pay, and no higher than necessary. Land taxes should be proportional to rents and designed to incentivize land improvement, while house taxes proportional to the ground rent are even better, as they mainly affect landlords but still encourage renters to be frugal. However, England’s land tax system is poorly designed and needs reform.
When the government tries to tax profits, investors simply pass the cost on to farmers and consumers. Taxes on interest and wealth are simply too hard to calculate and administer. Proportional taxes on certain kinds of socially undesirable businesses (like pubs and plantations that utilize enslaved laborers) are perfectly fair, and real estate transfers and inheritances are an excellent source of revenue, particularly when the government charges stamp-duties and registration fees in exchange for managing a public property ownership registry. Taxes on wages, capitation taxes, and taxes on necessities are harmful, but taxing luxuries is very reasonable, if economically inefficient. Customs duties should be greatly simplified, limited to a few key commodities, and administered at centralized warehouses (like excise taxes).
No European tax system is remotely well-designed, Smith concludes, but Britain’s is the least bad. However, in a worrying development, countries like England have started financing their governments with debt instead of taxing their people effectively. They waste money on interest, spend recklessly on wars they can’t afford, and risk going bankrupt. The only way for Britain to eliminate its budget deficit, Smith concludes, is either by taxing its colonies to increase revenue (which would also require giving them representation in Parliament), or by simply granting them independence. But British leaders are too proud and stubborn to do either, and so they will keep wasting money on unnecessary wars—like the American Revolution, which has just begun.
