Adam Smith and the discovery of modern economics

The Invisible Hand.

Adam Smith and the discovery of modern economics

By the middle of the last century England was unchallenged as the world's great eco­nomic power. The first phase of the first industrial revolution was over. By substituting machines for human skill, steam for human and animal force. English entrepreneurs brought about a shift from handicrafts to mass manufacturing, and in so doing gave birth to a modern economy. Within two lifetimes English society had been transformed: an Englishman of 1750 was closer to one or Caesar's legionnaires in material things than to his own great­grandchildren.

The problem was that England in the 1840s was also a country in crisis. A series of bad harvests had reduced demand for the goods being churned out by the new industries. Their producers could not find enough foreign markets to sell excess production, so were forced to sack their workers. Unemployment was made worse by the fact that England's population rose by one-third between 1801 and 1831. Despite all its economic achievements, the mass of England's people were living in abject poverty. England's ruling elite was split by a fierce debate on how a country could be so rich but its people so poor, and how to solve this problem before it set off a revolution. For support and ideas, the leaders of this debate turned to a group of thinkers, known as "economists".

Today, most people have a hard time understanding what economists are talking about, but everyone knows what an economist is - a specialist in a recognised branch of academic knowledge. At the beginning of the nineteenth century the term was nothing like as specific. In England it was applied to anyone who approached problems by putting every argument and doctrine, on whatever subject, to the rest of facts.

It was no coincidence that England gave birth to the first industrial revolution and what has since become known as the classical school of economics at the same time. The three most important, gospels of this school are Adam Smith's "Wealth of Nations" (published in 1776), David Ricardo's "Principles of Political Economy and Taxation" (1817), and James Mill's "Political Economy" (1821). Together these books set out a view of political economy based on three ideas: while their predecessors had seen agriculture and land as the sole source of wealth, the classical economists emphasised manufacturing and labour; they believed that free competition benefited society as a whole; and they opposed government interference in the economy as, more often than not, it only upset the natural process of wealth creation.

Of these books, the most important is that by Adam Smith. It is the first great classic of economic theory and one of the first known attempts to describe economic life as a whole.The genesis of "The Wealth of Nations" exactly mirrors the industrial revolution. Adam Smith was born in 1723, and was a student at Glasgow University in Scotland from 1737 to 1740, when John Kay invented the flying shuttle. Between 1764 and 1766, Smith toured Europe as the tutor of the Duke of Buccleuch, the ancestor of the man who is still Britain's largest private landowner. While in France Smith met Voltaire and was greatly influenced by a group of philosophers known as the physiocrats, who believed that governments should not interfere in the natural course of things, that it was better for them to leave well alone - laissez faire, laissez passer. Meanwhile, back in England, James Hargreaves was inventing the spinning jenny and James Watt built the first condenser, which made it possible to harness steam power. On his return from France, Adam Smith sat down to write his great book. The year before it was published in 1776, Richard Arkwright invented the spinning frame, the final invention needed to make the mass production of textiles possible.

The full title Adam Smith gave to his book was. "An Inquiry into the Nature and Causes of the Wealth of Nations." Its stated aim was to discover the causes of an increase in national wealth (i.e., what drives what we now know as economic growth).

The first key question the book addresses is what is wealth? When Smith was writing, wealth equalled bullion gold and silver. The conventional aim of government policy was to create the largest possible trade surplus through manipulating tariffs on imports and subsidies on exports, so that the nation's surplus of money increased. This approach Smith called the mercantile system of political economy." He then went on to explain, forcefully, why the supporters of this system were wrong-headed.

The fundamental mistake of mercantilism, Smith wrote, was the view that national wealth consists in money. Real wealth is measured by the availability of consumable goods and the labour which produces them. An increase in wealth equals an increase in goods, and plenty means cheap goods. Anything that restricts the availability of goods reduces a nation's wealth. National wealth can only increase as trade does between and within nations. For trade to grow you need a market, and how the market works is the core of Smith's book.

What makes markets such formidable creators of wealth is that they encourage the division of labour and specialization. Smith illustrates this point with an example "from a very trifling manufacture" - making pins. Working in a subsistence economy, where each person is forced to make everything he or she will use, one person "could scarce make one pin a day, and certainly could not make 20."

But in a modern economy the whole process is divided into a number of stages: "One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about 18 distinct operations." Working together in this way, ten men equipped with poor machinery could make 48,000 pins in a day.

To anyone from a modern industrial society, this description of elementary mass production may sound like pretty obvious stuff. In 1776 it was a revolutionary first attempt to explain how a tribal chief could have absolute power over 10,000 men but live in primitive conditions, while a labourer in a modern economy has power over no-one but owes his greater comfort to the co-operation of thousands of workers.

An effective market economy - and the civilised society that it supports - depends on a network of co-operation that is neither planned nor directed by a political power. The operation of market forces, like the division of labour, brings great benefits to society and raises the standard of living, but this benefit cannot be planned. Buyers and sellers in a market are motivated almost solely by self-interest, but serve the public interest without having intended it. If the seller is the sole producer of a popular product, he will push its price up as high as the market will bear. But a high price will attract rival producers. Once their goods are available in the market, the price will naturally fall. Thus the market is a self-regulating mech­anism guided not by a government, but by what Smith called "the invisible hand."

The wealth of a nation, Smith concluded, depended on trade, a market to make that trade possible, and the division of labour. Each of these is natural, unplanned and best left alone to act without political interference, for as Smith noted, "A great trader purchases his goods

always where they are cheapest and best". And yet "nations have been taught that their interest consists in beggaring all their neighbours." The example of such folly which was closest to Smith was the trade war raging between France and England while Smith was writing.

One of the bedrocks of Smith's philosophy is that no government or group of men is wise enough to do a better job at managing trade than a market, which reflects the guesses and knowledge of millions. However, he was not as Utopian as his critics have sometimes made out. Smith did not believe that governments would ever allow trade to be completely free and he wrote that the interests of national defence are always "more important than opulence".

Nor was Smith a believer in pure laissez faire. In his view the proper functions of government were limited but essential. They were, he wrote, to defend the country; to provide justice; and to carry out some projects which could not be left to individuals or the market, because they offered no immediate return. Under the final heading Smith was thinking of infrastructure projects like roads, bridges, canals and harbours, which are expensive and often unprofitable to build but lead to an increase in trade and hence of national wealth.

While Smith's great book is not as crudely laissez faire as its critics have sometimes claimed, it is true that it is a far from perfect work. The chapters on how markets set prices are the weakest in the book. But to criticise these details is to miss the real point, which was best described by Walter Bagehot, England's greatest writer on constitutions: "What Smith did was much like the rough view of the first traveller who discovers a country. He saw some great outlines well, but mistook others and left much out. It was Ricardo who made the first map, who reduced the subject into consecutive shapes and constructed what you can call a science." Smith's achievement was still immense: the country Smith discovered was called the modern economy.

Andrew Cowley is correspondent for the Economist in Moscow

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