Determinants of the Wealth of a Nation

machines and instruments which facilitate and abridge labour; or of a more proper division and distribution of employment. In either case an additional capital is almost always required.¹⁴

For Adam Smith there was no question that capital accumulation required an institutional framework of free markets and private property. In a system of free markets operating without government direction, a given level of investment spending would be allocated so as to ensure the highest rates of economic growth. In a system of private property, a further requirement for high rates of capital accumulation is an unequal distribution of income.

INTERNATIONAL TRADE

One of the major aims of Smith's Wealth of Nations was to demonstrate the falsity of the rather extensive set of ideas now called mercantilism—about 25 percent of his book is devoted to an examination of mercantilist doctrine and practice. Some mercantilists argued that government regulation of foreign trade was

¹⁴Ibid., p. 326.

I

necessary in order for a country to have a so-called favorable balance of trade—exports greater than imports—and, therefore, an increase in the quantity of bullion, as other countries paid in precious metals for the home country's excess of exports over imports. Interestingly, we still use the term "favorable balance of trade" to describe a situation in which a country gives others more goods than it gets in exchange, the difference being settled through payments of gold or IOUs. A favorable balance of trade, however, is favorable only if one incorrectly believes that the wealth of a nation depends upon its holdings of precious metals and IOUs.

Smith, on the contrary, argued for unregulated foreign trade, reasoning that if England can produce a good, e.g., wool, at lower costs than France, and if France can produce another good, e.g., wine, at lower costs than England, then it is beneficial to both parties to exchange these goods, with each trading the good it produces at lower costs for the good it produces at higher costs. In the language of economics, this became known as the absolute advantage argument for foreign trade. This argument, moreover, is not limited to international trade. It applies to trade within a country as well.

Embedded in Smith's analysis of how markets develop dynamically over time, one finds another argument for free international trade. Although Smith never fully developed this argument, later economists were able to infer it from the Wealth of Nations. We have already seen that Smith held that a key determinant of the wealth of nations was the productivity of labor and that labor productivity depended primarily upon the division of labor. As labor becomes more divided and specialized, he pointed out, its productivity increases dramatically. Smith held that differences in individual abilities, and hence productivity, were largely the effects of the division of labor, not its cause. At birth, Smith asserted, we are all similarly talented; it is only after we begin to specialize in various activities that we become more proficient relative to others who do not so specialize. We learn by doing, becoming progressively able to produce our goods more cheaply as we get more efficient in our specialized tasks.

In the language of modern economics, there are increasing returns (decreasing costs) as labor becomes more and more specialized. Part of Smith's argument for the advantages of foreign trade was broadly based on this dynamic notion of increasing returns. He realized that if two individuals are equally talented at birth and their talents remain unchanged, it follows that there are no advantages to either of them if they specialize and trade their goods. (The nationality of the individuals makes no difference to these arguments—i.e., whether one person is English and the other French.) If, however, two individuals become more proficient by labor specialization, the costs of producing both their products decrease and both benefit by specializing and trading. Out of this insight of Smith's arose the recognition, pivotal for the development of free trade, that dynamically over time any nation might achieve absolute cost advantages in the production of certain goods through specialization and division of labor, and that all nations could gain from the resulting international trade.

Smith, who was very policy-oriented in his analysis of international trade, criticized, in particular, mercantilist jjplicies that had restricted the quantity of trade, concluding that those policies erroneously assessed the wealth of a nation

T

he revolutions that brought into being the former Soviet Union and the Communist Chinese regime, the at­tempts by less developed countries to achieve growth through planned econo­mies, and the dramatic changes now taking place in the countries that for­merly made up the Soviet Union have restored the relevance of many ques­tions Adam Smith raised concerning the appropriate mix of private and pub­lic sectors. Smith maintained that the primary determinant of growth was capital accumulation. The distribution of the yearly output between capital and consumer goods, according to Smith, determines the rate of growth of national output: the slicing of today's pie determines the size of tomorrow's. Smith's conclusion has never been more assiduously applied than in the Soviet Union and, more recently, in Japan. But what Smith envisioned was that capital accumulation would take the form of private, not state-owned, property. Re­cent experience in the United States has revived economists'interest in these issues.

Smith's less abstract, more institu­tional perspective on and approach to economic analysis, within its broad framework of the social sciences and his­tory, is also attracting increasing atten­tion today. The term political economy was absent from economic jargon for nearly one hundred years, but a number of economists are now urging a return to the more Smithian breadth of eco­nomics that the term suggests. Public choice theory and the new institutional economics, both of which have roots that extend back to Adam Smith, have been growth industries in economics.

Generations continue to ask how we should judge those who have the power to alter our national economic des­tiny—those in high finance, for exam­ple, who are changing the face of corporate America through mergers and acquisitions. Should we examine the mo­tives for their activities, or the conse­quences? Smith responded forcefully to such queries in his time, asserting that the consequences of action should be our touchstone for judging the appropri­ateness of economic activities.

as consisting of the bullion the nation held, rather than correctly defining a nation's wealth as a flow of goods. The proper governmental policy toward international trade, Smith held, should be the same as that toward domestic trade—one of letting voluntary exchanges take place in free-unregulated mar­kets. A policy of laissez faire, he believed, would lead to ever higher levels of well-being in all countries.

Modern economics, in assessing the dominant ideas of this period, has discovered another difference between the classicals and the mercantilists that significantly influenced their views concerning the relative importance of free markets versus government regulation. These differences, though never fully articulated in either Smithian or subsequent classical economics, are fundamental to classical views on the consequences of economic activity and remain funda­mental even today. They have to do with the fact that if one holds that the total

quantity of resources on our planet is fixed, then a process of exchange between two individuals or nations must require that one gain and the other lose. In the language of some modern economists, an economic exchange is a "zero-sum game," in which there is a winner and a loser. Thus, when Britain trades with France, if one gains by this exchange, the other must lose. An opposing perspec­tive holds that economic exchanges are not zero-sum games, that both parties can benefit from the exchange. To rigorously prove that all countries can benefit from foreign trade, one must show that there are more goods in the world after the exchange than there were before. While this sort of book is not the place to demonstrate such a proof, some introductory economics texts do show how foreign trade benefits both parties and that the total amount of goods in the world is greater after the exchange.

This insight of Smith and other classical writers that, contrary to the beliefs of many mercantilists, all parties might gain from trading provided a tremen­dously powerful argument for voluntary exchanges, whether between individu­als within a country or between different countries.

An aspect of foreign trade that did not interest Smith—no doubt partly because his forte was economic policy, not theory—but that bears on this discussion is the question of the price at which exchange occurs and, therefore, of what determines how the gains from trade are divided between the traders. We will address these issues when we examine David Ricardo and John Stuart Mill.

VALUE THEORY

Certain questions regarding value, or price, that should be kept separate were sometimes confused by early economists. (1) What determines the price of a good? In the language of modern economics, what determines relative prices? (2) What determines the general level of prices? (3) What is the best measure of welfare? The first and third questions are part of modern microeconomics; the second, although it defies the usually simple micro-macro dichotomy, is generally included under the broad umbrella of macroeconomics. Smith did not provide an unambiguous answer to any of these different questions. His treatment of them is, in places, confusing in this regard because he intermingled his discussion of what determines relative prices with his attempt to discover a measure of changes in welfare over time.

It is not surprising that historians of economic ideas have argued over Smith's true opinion. One group of writers holds that Smith had three theories of relative prices (labor cost, labor command, and cost of production) and a theory explaining the general level of prices. Another group maintains that he settled on a cost of production theory of relative prices, a theory measuring changes in welfare over time, and a theory of the general level of prices. The latter group denies that Smith had a labor theory of relative prices. We believe that Smith experimented with all these theories: a theory of relative prices consisting of

labor cost and labor command for a primitive society and cost of production for an advanced economy; the formulation of an index measuring changes in welfare over time; and a theory explaining the general level of prices. We first consider his theory of relative prices.

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