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September 2012 Policy Study, Number 12-9

   

A Short History of Economic Theory

   

Adam Smith: Laissez-Faire and the Beginning of Economic Thought

   

 

As Benjamin Franklin said, “All mankind is divided into three classes: those that are immovable, those that are movable, and those that move.”[1] Among those that history remembers as “those that move,” one of its greatest is the Scottish moral philosopher Adam Smith. Through his magnum opus, An Inquiry into the Origin and Causes of the Wealth of Nations, Smith imparted the principles of laissez-faire capitalism to generations of producers, economists, and governments. Eventually, the publishing of The Wealth of Nations led to an avalanche of prosperity that engulfed the entire world. In The Wealth of Nations, Adam Smith brilliantly shaped the principles of the division of labor, nature of money, “invisible hand,” political economy, and taxation, but ignored the fundamental role that entrepreneurship plays in the creation of wealth.

 

Understanding the division of labor is critical to Smith’s free-market model, since it embodies the ideas of production, exchange, and self-interest. At the foundation of the division of labor theory is the idea that the production of goods and services is most efficient if each worker specializes in some specific task, rather than an entire manufacturing process. Rather than have each citizen be a “jack of all trades,” a town might have a baker, a tanner, a brewer, a carpenter, etc., each of whom specializes in a certain product. Since each producer can generate far more than is necessary for his private consumption, the division of labor naturally leads to exchange among the various producers for items that they require but cannot produce.[2] The self-interest of each producer to acquire material necessities can be fulfilled through a simple barter economy where all citizens exchange their excess produce for the excess produce of others. Smith readily admits to the limits of the division of labor, acknowledging that some trades and manufactories can only exist inside of towns and cities, due to the low population of the countryside.[3] The ability to specialize in certain skills and exchange the products of labor with others would be impossible without the use of money as a medium of exchange.

 

Although many regard the acquisition of money as wealth, Smith debunks this notion with an explanation of money as nothing more than a tool of exchange or measurement of value. Prior to the advent of capitalism, the predominant economic theory was mercantilism, which held that wealth was measured in precious metals, and a nation could only become wealthy by stockpiling gold and silver. Smith demonstrated that money, whether gold, silver, or paper, is merely a medium of exchange between producers, not an actual form of wealth. Money is immensely preferable to barter, since it allows large products (like cattle) to be broken into numerous pieces (money), and be used to purchase a small quantity of another product (such as salt or flour).[4] According the Smith, true wealth merely equates to the purchasing power possessed by an individual, not the amount of currency that that individual owns.[5] Additionally, money provides a convenient way to measure the value of labor, and brings about the conclusion that wealth is really a measure of the power to purchase labor.[6] By firmly establishing that the creation and exchange of wealth is most efficient under a system utilizing money and the division of labor, Smith demonstrates how the free market will distribute goods and services.

 

In his defining thesis, Smith explained that as individuals sought their own self-interest, they would benefit society through an efficient distribution of resources. The key to understanding the “invisible hand” is Smith’s underlying worldview that individuals, not statesmen, know best how to spend the proceeds of their labor. He argued that as citizens sought their own self-interest through production and exchange, they would inevitably benefit society as a whole by efficiently distributing goods and services throughout the economy. At its core, the “invisible hand” is a liberty-based philosophy that advocates minimum interference in the personal lives of producers and consumers. Smith claimed that any interference in free trade harms all involved, from the most distant consumers or producers to those that the interference was designed to help.[7] Smith applies this concept to the international level with his arguments against mercantilism and in favor of free trade.

 

Adhering to his principle of division of labor, Smith expounds on the dangers of tariffs to productivity and exchange, as well as the economic principles behind colonial empires. Tariffs, or a tax on imports, would always harm the economy of the nation imposing them, Smith stated, because it promoted economic inefficiency and forced consumers to pay higher prices.[8] Tying this idea to Britain’s enormous empire, Smith defined colonies as attempts to form monopolies over resources and consumers in North America.[9] Colonies were economically inefficient, according to Smith, because of the fact that they constituted a vast tariff, doomed to fail because of the nature of the “invisible hand.” He lamented the fact that this principle was not understood by the Empire’s leaders and would lead to war with the colonies (already rebelling against unjust taxation) in an attempt to dominate North America.[10] Following his arguments on the political economy, Smith examined the role that a sovereign nation should play in the taxation of its citizens.

 

While readily admitting certain necessary expenses that an independent nation must incur, Smith warns against a large public debt that diverts valuable labor away from production. He acknowledged the necessity of a defensive military force to protect citizens against an aggressive enemy, as well as courts to maintain the domestic peace.[11] Of utmost importance to Smith were public institutions, from bridges and harbors to roads and libraries, whose costs were exorbitantly high and would deter private investors.[12] Because the division of labor rarely provides opportunities for the worker to challenge his mental faculties, Smith trumpeted the value of a universal, basic education funded by the government.[13] Finally, Smith conceded certain “ceremonial costs” that governments must bear to maintain the “dignity of the sovereign.”[14] After listing justified uses of tax revenue, a stern warning is issued against large public debts, since they draw wealth away from the productive economy, in direct opposition to the “invisible hand.”[15]

 

Although Smith brilliantly explained the principles of production, he ignored entrepreneurship, a vital component of the free market. Entrepreneurship leads to dynamic growth, a factor that Smith did not consider when describing the production and exchange of goods. Although Smith briefly mentioned it during his description of the “components of price,” entrepreneurship allows risks to be taken for a profit to be made, sparking investment into new industries. Last, entrepreneurship moves resources from unproductive areas into highly productive ones, as explained by the French economist Say, himself a pioneer of cotton manufacturing.[16] In spite of Smith’s disregard for entrepreneurship, The Wealth of Nations laid the groundwork for centuries of free markets and prosperity.

 

Although it ignored the role of entrepreneurship, Adam Smith’s The Wealth of Nations is a vividly conceived explanation of taxation, political economy, the “invisible hand,” money, and the division of labor. Without a doubt, Smith was one of the great “movers” of history, and gave a foundation to all future economists. The Wealth of Nations, published in 1776, helped disseminate the ideas of freedom to the world, prepare it for the onset of the Industrial Revolution, and ultimately contribute to the founding of the United States.

 

   

 

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