27 Sep 2010 | History

Economic Thinkers - Adam Smith 

Our second in a series of great economic thinkers throughout history takes a look at the author of The Wealth of Nations. Edward Russell-Walling discusses Adam Smith and his legacy.  

For years, he was the icon of the economic right, the stereotypical free market champion. More recently, those who have been able to see beyond the stereotype have embraced him. Few economists appeal across the political spectrum in this way, but then Adam Smith was no ordinary thinker. For many, he was the father of modern economics.

Adam Smith was born in 1723 in Kirkcaldy, in what is now Gordon Brown’s parliamentary constituency. The former prime minister is a great admirer of his posthumous constituent, and it may be no coincidence that, in 2007, Smith became the first Scot to grace a Bank of England banknote – in his case, the £20 note.

Although remembered as an economist, Smith would have described himself as a philosopher. His first great work, published in 1759, was The Theory of Moral Sentiments, which examined how we reach moral judgements and explored the notion of ‘sympathy’ – putting ourselves in another’s shoes.

An Inquiry into the Nature and Causes of the Wealth of Nations was published in 1776, during the time of the American Revolution. At heart it was a critique of mercantilism, the prevailing economic theory. Mercantilism held that a country’s wealth was measured by its store of gold and silver and that international trade was a zero-sum game in which a nation prospered only at the expense of other nations. A positive balance of trade increased the nation’s ‘wealth’, and so tariffs and protectionism were the order of the day.

TRUE MEASURE OF WEALTH

Smith argued that this system served the narrow interests of the capitalists – the merchants and manufacturers – but not those of the nation’s consumers. Economic growth – what we would call gross national product – was the true measure of a nation’s wealth and free trade made everyone better off. In explaining why, he elaborated on a number of ideas that have become economic staples.

One was the division of labour. With around 18 separate tasks involved in making a pin, one person could scarcely make a pin a day, he argued. But a team dividing the work into specialised, repetitive tasks, could make upwards of 4,800 per person per day. The same applied to nations, which shouldn’t try to produce everything for themselves. With elaborate glasshouses, for example, Scotland could make very good wine – at about 30 times the expense of buying it from France. Economists David Ricardo and John Stuart Mill would develop these ideas in their theories of comparative advantage.

In a marketplace where people were free trade with whoever they chose, an ‘invisible hand’ would direct resources to those goods and services that people wanted most. Smith pointed out that individuals would invest capital, land or labour where they could get the best possible return on it. Therefore, all uses of a resource must yield an equal rate of return, adjusted for the relative risk of the enterprise. George Stigler, the Nobel prize-winning US economist, described this as the central proposition of economic theory.

In matters of exchange, Smith said, we are motivated principally by self-interest – he called it ‘self-love’. We need to earn money and, in a competitive market, we can only achieve that by doing something others value. In this way, we are ‘led by an invisible hand to promote an end’ that was not part of our intention.

FREEDOM IN TRADE

Barriers to free trade and fair competition distort the efficient allocation of scarce resources. Tariffs and subsidies redirect resources to inefficient industries. The empire-building proclivities of the mercantilists were also inefficient, according to Smith, who argued that the cost of defending colonies such as America outweighed the preferential trade benefits they offered.

Smith was no libertarian. He believed that government had an important role in society – in defence, law enforcement and the provision of necessary services ignored by the private sector. He also believed the state should provide free education and poverty relief. Yet the ideas for which he is best remembered are free trade, free markets and minimal government interference.

His most influential modern heirs are the economists Friedrich von Hayek, who believed strongly in markets versus planned economies, and the Chicago School monetarist Milton Friedman. Both were heroes of Margaret Thatcher and the Adam Smith Institute, the UK think tank that propagates Adam Smith’s ideas in general and privatisation in particular.

Since the collapse of Soviet-style communism, Smith and his followers appear to have won the markets versus centralised economy war. Smith’s liberal economics replaced mercantilism and, at least in the developed world, have been strengthening their position ever since, as belief in free markets and (notionally) free trade has spread.

As a totem of free marketeers, Smith was once seen as an enemy of the left. But taken in tandem, Smith’s two great works reveal his belief that people are motivated by more than self-interest and that free markets alone cannot deliver a healthy economy. This more rounded Adam Smith has won a broader following as a moralist as well as an economist. As Nobel economics laureate, Amartya Sen, was moved to write earlier this year: “The continuing global relevance of Smith’s ideas is quite astonishing.”
 

Author: Edward Russell-Walling
Edward Russell-Walling is a finance and business writer and editor. He contributes to The Financial Times, New Statesman, The Banker and Director and is the author of 50 Management Ideas You Really Need to Know.