The Wealth of Nations. The Theory of Moral Sentiments

“It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature, which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another.” 

Smith argues that the division of labor flows naturally from the propensity of humans to trade with each other to meet their needs, and consequently over time cultivate different skills, talents, and abilities. Because it is natural to humanity, in Smith’s reasoning, it must be a preferred course of action.

“As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market.” 

The size of the market determines the degree to which specialization can exist in the division of labor. In large towns, large populations and consequentially large markets allow for extremely nuanced specialization in the division of labor. In small towns, the division is less specialized and, in some situations, nonexistent, necessitating economic actors to perform all aspects of a given trade. 

“The real value of all the different component parts of price, it must be observed, is measured by the quantity of labour which they can, each of them, purchase or command. Labour measures the value, not only of that part of price which resolves itself into labour, but of that which resolves itself into rent, and of that which resolves itself into profit. In every society, the price of every commodity finally resolves itself into some one or other, or all of those three parts; and in every improved society, all the three enter, more or less, as component parts, into the price of the far greater part of commodities.” 

Smith posits that the price of any commodity is comprised of three elements: the wages of labor, the profits of stock, and the rent of the land. The profits of stock are not precisely what one might think of the term today, as a return on investment from a purchase of stock in a company. Smith uses the term stock to refer to tangible capital stock employed in a trade by laborers to generate profit. Smith recognizes that there are many situations in which the price of a commodity does not resolve itself neatly into one of the three categories. For example, a farmer may own the land, the capital used for production, and supply the labor. While in this scenario the three components are not neatly divided, they do still comprise the price of the commodity in the same manner.

“The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market, and the demand of those who are willing to pay the natural price of the commodity, or the whole value of the rent, labour, and profit, which must be paid in order to bring it together.”

This concept is commonly known as supply and demand. This now fundamental concept was first proposed by Smith in this seminal work.

“The five following are the principal circumstances which, so far as I have been able to observe, make up for a small pecuniary gain in some employments, and counterbalance a great one in others. First, the agreeableness or disagreeableness of the employments themselves; secondly, the easiness and cheapness, or the difficulty and expense of learning them; thirdly, the constancy or inconstancy of employment in them; fourthly, the small or great trust which must be reposed in those who exercise them; and, fifthly, the probability or improbability of success in them.” 

Smith posits that in a naturally free market, all work should receive equal financial compensation because the labor market naturally moves workers to required positions, creating a state of financial equilibrium. Smith explains that while this is theoretically true, several factors contribute to variation in pecuniary gain from different employments. All factors attribute increased pecuniary gain to some form of risk, whether physical or financial.

“Whatever obstructs the free circulation of labour from one employment to another, obstructs that of stock likewise; the quantity of stock which can be employed in any branch of business depending very much upon that of the labour which can be employed in it.” 

Regulations that prevent laborers from freely moving between industries also obstruct the movement of capital stock between industries. Such restrictions have profound economic effects because they prevent capital stock and labor from being employed where it is most productive. Freedom of labor to move between industries permits laborers to decide for themselves the most productive use of their labor, which will in turn direct capital to its most productive use.

“But though the low money price, either of goods in general, or of corn in particular, be no proof of the poverty or barbarism of the times, the low money price of some particular sorts of goods, such as cattle, poultry, game of all kinds, etc. in proportion to that of corn, is a most decisive one.” 

Smith explains that the price of corn regulates all other prices because corn is a staple. If the price of a commodity is low or high compared to the price of silver, it is ineffectual, but if the price of a commodity is low or high compared to the price of corn, it demonstrates the commodity’s abundance in relation to corn, and the low value of land used to produce that commodity in relation to corn.

“The quantity of industry, therefore, not only increases in every country with the increase of the stock which employs it, but, in consequence of that increase, the same quantity of industry produces a much greater quantity of work.” 

As a country’s domestic produce increases, its industry grows, first to fill its capacity for domestic trade, then to international trade when it has accumulated surplus stock. This also causes an increase in labor and a corresponding increase in a nation’s wealth. 

“The legal rate, it is to be observed, though it ought to be somewhat above, ought not to be much above the lowest market rate. If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.” 

Smith believes that a nation should regulate interest rates, but only slightly. While he believes the market will set an appropriate rate, he believes the sovereign should ban excessively-high rates because when rates are excessively high, the only borrowers will be extreme risk takers, who are unlikely to make prudent financial decisions and repay their loans. This will have a negative impact on the entire national economy. If interest rates remain reasonable, level-headed borrowers will use the money to increase their stock of productive capital, thus increasing productive labor and the value of land. With it, the wealth of the nation will increase.

“A capital may be employed in four different ways; either, first, in procuring the rude produce annually required for the use and consumption of the society; or, secondly, in manufacturing and preparing that rude produce for immediate use and consumption; or, thirdly in transporting either the rude or manufactured produce from the places where they abound to those where they are wanted; or, lastly, in dividing particular portions of either into such small parcels as suit the occasional demands of those who want them.” 

Smith discusses capital stock in great detail: its role in national economy, as a component of price, in trade, and the ways in which it is used. Consumption, while necessary, is the least economically productive use of capital. Consumption does not produce any greater value. Manufacturing produces the most value from capital. Transportation and dividing capital each produce value, but not as much as manufacturing.

“The home trade is employed in purchasing in one part of the same country, and selling in another, the produce of the industry of that country. It comprehends both the inland and the coasting trade. The foreign trade of consumption is employed in purchasing foreign goods for home consumption. The carrying trade is employed in transacting the commerce of foreign countries, or in carrying the surplus produce of one to another.” 

Smith believes a nation must first satisfy its home trade to capacity before endeavoring into international trade. Once a nation is producing surplus, Smith claims it can trade internationally. Further, Smith states that nations should not conduct the carrying trade until they are fully at capacity trading internationally.

“The great commerce of every civilized society is that carried on between the inhabitants of the town and those of the country. It consists in the exchange of rude for manufactured produce, either immediately, or by the intervention of money, or of some sort of paper which represents money. The country supplies the town with the means of substance and the materials of manufacture. The town repays this supply, by sending back a part of the manufactured produce to the inhabitants of the country. The town, in which there neither is nor can be any reproduction of substances, may very properly be said to gain its whole wealth and substance from the country. We must not, however, upon this account, imagine that the gain of the town is the loss of the country. The gains of both are mutual and reciprocal, and the division of labour is in this, as in all other cases, advantageous to all the different persons employed in the various occupations into which it is subdivided.”

Smith argues that the basis for all domestic trade is rural areas supplying raw commodities for towns to manufacture into specialized goods, to resell to inhabitants of both towns and rural areas. Smith posits that this cyclical relationship is natural, and that there are no winners or losers in such a relationship.

“A country that has no mines of its own, must undoubtedly draw its gold and silver from foreign countries, in the same manner as one that has no vineyards of its own must draw its wines. It does not seem necessary, however, that the attention of government should be more turned towards the one than towards the other object. A country that has wherewithal to buy wine, will always get the wine which it has occasion for; and a country that has wherewithal to buy gold and silver, will never be in want of those metals. They are to be bought for a certain price, like all other commodities; and as they are the price of all other commodities, so all other commodities are the price of those metals. We trust, with perfect security, that the freedom of trade, without any attention of government, will always supply us with the wine which we have occasion for; and we may trust, with equal security, that it will always supply us with all the gold and silver which we can afford to purchase or to employ either in circulating our commodities or in other uses.”

Smith’s arguments for free trade are like his arguments for free markets. Smith believes the best possible system is merchants freely bargaining with other merchants for the exchange of commodities, rather than sovereigns dictating which commodities are to be exchanged and under what terms. It is important to note that Smith’s free market and free trade ideas criticize only interference with the purpose of manipulating the economic exchange. Smith believes that regulations and interference with trade are appropriate when based not on economic grounds but instead are tailored to serve some other purpose, such as national security.

“The importation of gold and silver is not the principal, much less the sole benefit, which a nation derives from its foreign trade. Between whatever places foreign trade is carried on, they all of them derive two distinct benefits from it. It carries out that surplus part of the produce of their land and labour for which there is no demand among them, and brings back in return for it something else for which there is a demand. It gives a value to their superfluities, by exchanging them for something else, which may satisfy a part of their wants and increase their enjoyments. By means of it, the narrowness of the home market does not hinder the division of labour in any particular branch of art or manufacture from being carried to the highest perfection. By opening a more extensive market for whatever part of the produce of their labour may exceed the home consumption, it encourages them to improve its productive power, and to augment its annual produce to the utmost, and thereby to increase the real revenue and wealth of the society. These great and important services foreign trade is continually occupied in performing to all the different countries between which it is carried on. They all derive great benefit from it, though that in which the merchant resides generally derives the greatest as he is generally more employed in supplying the wants, and carrying out the superfluities of his own, than of any other particular country. To import the gold and silver which may be wanted into the countries which have no mines, is, no doubt part of the business of foreign commerce. It is, however, a most insignificant part of it. A country which carried on foreign trade merely upon this account, could scarce have occasion to freight a ship in a century.” 

Smith spends much of his work arguing against the mercantilist policy of accumulating gold and silver. Smith argues that all trade is equal and that nations are hurting themselves by prioritizing the accumulation of gold and silver over trade of other commodities. Such policies interfere with natural markets by directing resources away from where they can be employed most profitably and towards unprofitable endeavors.

“Nothing, however, can be more absurd than this whole doctrine of the balance of trade, upon which, not only these restraints, but almost all the other regulations of commerce, are founded. When two places trade with one another, this doctrine supposes that, if the balance be even, neither of them either loses or gains; but if it leans in any degree to one side, that one of them loses, and the other gains, in proportion to its declension from the exact equilibrium. Both suppositions are false. A trade, which is forced by other means of bounties and monopolies, may be, and commonly is, disadvantageous to the country in whose favour it is meant to be established, as I shall endeavor to show hereafter. But that trade which, without force or constraint, is naturally and regularly carried on between any two places, is always advantageous, though not always equally so, to both.”

Here, Smith argues that there are no winners or losers in trade; that is, trade is not like sport. The concept of trade as a balance with scales that can be tipped is ridiculous to Smith. If two parties freely and with reason endeavor to trade, then such a trade is advantageous for both parties.

“The wealth of neighbouring nations, however, though dangerous in war and politics, is certainly advantageous in trade. In a state of hostility, it may enable our enemies to maintain fleets and armies superior to our own; but in a state of peace and commerce it must likewise enable them to exchange with us to a greater value, and to afford a better market, either for the immediate produce of our own industry or for whatever is purchased with that produce.”

Smith believes in freedom of trade, without restriction or interference in any way. The best measure of a trade, Smith contends, is the voluntary bargain made between two merchants. He also believes, contrary to popular notions of his time, that it is in a nation’s best interests for neighboring nations to be wealthy, purely to facilitate trade, so the whole region of nations can grow wealthy together.

“Bounties upon exportation are, in Great Britain, frequently petitioned for, and sometimes granted, to the produce of particular branches of domestic industry. By means of them, our merchants and manufacturers, it is pretended, will be enabled to sell their goods as cheap or cheaper than their rivals in the foreign market. A greater quantity, it is said, will thus be exported, and the balance of trade consequently turned more in favour of our own country. We cannot give our workmen a monopoly in the foreign, as we have done in the home market. We cannot force foreigners to buy their goods, as we have done our own countrymen. The next best expedient, it has been thought, therefore, is to pay them for buying. It is in this manner that the mercantile system proposes to enrich the whole country, and to put money into all our pockets, by means of the balance of trade.” 

In the present day, bounties are referred to as subsidies. Bounties remain a common practice for most nations. In the United States, bounties exist for certain agricultural commodities and energy sectors, among others. Though bounties continue to be criticized for the same reasons Smith states, they remain popular for the same reasons Smith states: industry lobbying.

“Were all nations to follow the liberal system of free exportation and free importation, the different states into which a great continent was divided, would so far resemble the different provinces of a great empire.” 

In this argument for complete, unrestricted, untaxed freedom of trade, Smith argues that if free trade were implemented in Europe, the continent would grow into one great empire, more prosperous than any nation could ever become by itself through a system of boundaries, tariffs, and restrictions.

“Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer. The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it. But in the mercantile system, the interest of the consumer is almost constantly sacrificed to that of the producer; and it seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce. In the restraints upon the importation of all foreign commodities which can come into competition with those of our own growth or manufacture, the interest of the home consumer is evidently sacrificed to that of the producer. It is altogether for the benefit of the latter, that the former is obliged to pay that enhancement of price which this monopoly almost always occasions. It is altogether for the benefit of the producer, that bounties are granted upon the exportation of some of his productions. The home consumer is obliged to pay, first the tax which is necessary for paying the bounty; and, secondly, the still greater tax which necessarily arises from the enhancement of the price of the commodity in the home market.” 

Smith is arguing that while consumers of goods are their purpose of production, merchants have gained and used their influence to ensure an economic system for the complete and total benefit of the producer, at the expense of the consumer. For example, bounties benefit the producer by providing a payment and a market for goods where one would not naturally have existed. That same bounty, though, acts as a double tax on consumers.

“It cannot be very difficult to determine who have been the contrivers of this whole mercantile system not the consumers, we may believe, whose interest has been entirely neglected; but the producers, whose interest has been so carefully attended to; and among this latter class, our merchants and manufacturers have been by far the principal architects. In the mercantile regulations which have been taken notice of in this chapter, the interest of our manufacturers has been most peculiarly attended to; and the interest, not so much of the consumers, as that of some other sets of producers, has been sacrificed to it.”

Smith takes an almost accusatory tone in this passage. It is evident that he believes not only that the mercantilist system benefits manufacturers at the expense of consumers, but that he believes manufacturers brought this about knowingly and intentionally. 

“In a more advanced state of society, two different causes contribute to render it altogether impossible that they who take the field should maintain themselves at their own expense. Those two causes are, the progress of manufactures, and the improvement in the art of war.” 

Smith maintains that for modern societies, the cost of foreign wars must be maintained by the public revenue. Smith recounts the various stages of society in which inhabitants may abandon their civil pursuits for the cause of war with little societal cost. He contrasts such rudimentary societies with advanced, modern societies, in which farmers and manufactures must remain at work in order to keep the economy afloat while a nation is at war. Such considerations, combined with advancements in the art of war requiring professional soldiers, necessitate standing armies. Such standing armies do not produce value for the nation in a manner that adds to its wealth, so they must be maintained from public funds.

“When the judicial is united to the executive power, it is scarce possible that justice should not frequently be sacrificed to what is vulgarly called politics.” 

Here, Smith is arguing for a separation of judicial and executive power. Smith believes combining the judicial and executive institutions leads to corruption that threatens individual liberties.

“The third and last duty of the sovereign or commonwealth, is that of erecting and maintaining those public institutions and those public works, which though they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could never repay the expense to any individual, or small number of individuals; and which it, therefore, cannot be expected that any individual, or small number of individuals, should erect or maintain.”

Smith recognizes that certain expenses, such as infrastructure projects, are necessary and even economically advantageous for a nation, but cannot be expected to be completed by private funds alone. An example of such a project is a highway used to better transport goods from one town to another. Such a highway aids in the transport of commerce and is economically advantageous for a society, but cannot be expected to be completed solely with private funds (he does advocate the use of tolls in certain situations, but qualifies that toll roads are not reasonable in every situation). In such situations, Smith argues that the entire society or some subsection of a society (in the case of toll roads, those who use the road) should bear the cost of such projects.