by Bobby Akart
The realisation that services have value, as well as manufactures or agricultural products, is another Smith innovation, and one we recognize today, when service industries have grown enormously important. But the fact that they add value makes it rather misleading to call them 'unproductive'. It might be that the menial servants of the rich landowner are a pure consumption. But the services of teachers, writers, composers, doctors, and even lawyers can last and be enjoyed for some time after the service is performed. It may be that the knowledge, ideas, music, health and laws they produce are intangible and cannot be sold, but today we would hardly call that 'unproductive'.
Once again, Smith is breaking new ground, so the fact that he struggles to pin down these concepts is understandable. The more such services are consumed, the less income and capital are we left with for future investment. And therefore, the lower will be the next year's national product. Future income depends on the extent of our capital, and the only way to accumulate capital is by saving. Indeed, just to maintain capital we need to save, because materials and equipment must be repaired and replaced all the time. If instead of saving, we consume our current revenues on unproductive hands, then we are eating into our capital for the purpose of current consumption. This is prodigality, and if it persists, must lead to ruin.
The mercantilist view is that such dis-saving does not matter provided all the spending is done at home in the domestic economy, and that no gold or silver is therefore sent abroad. If the quantity of money in the country has not fallen, they say, then no wealth has been lost. But in fact, even though the quantity of money in the country does not change, real damage is being done.
Capital is being consumed instead of maintained. Since future income growth depends on the accumulation of capital, future income will necessarily be lower.
Capital can also be wasted through bad investment decisions. Again, this does not affect the nation's gold and silver deposits, but it certainly reduces its future productive capacity. Every failed project in agriculture, mining, fisheries, trade or manufactures uses up some of the country's productive funds.
However, nations are never ruined by the prodigality or injudicious investment of private individuals: only by that of public institutions. Ordinary people know that they must save and invest if they are to improve their condition and boost their future incomes. But most of government's income is spent on maintaining unproductive hands – a numerous and splendid court, the religious establishment, great fleets and armies – all of which subsist on the product of taxpayers' labour. Governments see little reason to save and invest for themselves. Unfortunately, when such public spending becomes so large that taxpayers have to eat into their capital in order to continue to pay for it, then future incomes are necessarily diminished. Even so, the free economy is remarkably robust. People's constant effort to better themselves, the mainspring of progress, is often enough to keep the economy growing, despite the extravagance and errors of government.
It is the highest impertinence and presumption…in kings and ministers, to pretend to watch over the economy of private people…. They are themselves always, and without any exception, the greatest spendthrifts in the society…. If their own extravagance does not ruin the state, that of their subjects never will.
The total national product can grow only through a growth in the number of productive workers, or through a rise in their productivity. Productivity can be increased only through better management of labour and capital resources, or through the use of more or better machines and equipment – each of which usually requires new capital investment. Greater production, therefore, usually indicates that a greater quantity of capital has been invested. If we see a country's lands becoming better cultivated, its manufactures more numerous, and its trade more extensive, we can be sure that its capital has increased. And that increased capital accumulation can be attributed to the private saving and investment of individuals, together with the legal security that enables them to accumulate their capitals without fear of them being stolen, and the liberty that encourages them to save, invest, and so better their own condition.
Interest
People lend to others in the expectation that the capital they advance to the borrower will eventually be returned to them, and that the borrower will pay a kind of rent for the use of it. Borrowers expect that they can use this capital for productive uses that will be so profitable that they can more than repay both capital and interest. Again, though, we should remember that what the borrower wants is not the money, but what the money will buy. The loan, in other words, represents some small part of the national product being assigned over from the lender to the borrower. When there is more capital available in any country, there is more competition between its holders, and borrowers can offer a lower price for it. In other words, the more capital there is, the lower the rate of interest that can be charged. The growth of capital, and its lower cost, will boost productive industry: more labour will be hired, and wages will be bid up. So employers will be paying less for their borrowed capital – though they will see their profit rates being eroded too.
Some people argue that it is the increase in the quantity of gold and silver, which resulted from mining discoveries in the Spanish West Indies, that has lowered interest rates. But this cannot be true. If everything else stays the same, then an increase in the quantity of silver has no effect other than to diminish the value of that particular metal – like every other commodity that is in plentiful supply. The effect of this is that money prices would appear to rise. But this rise in prices is purely nominal, rather than real. Prices would rise, but nothing, including interest rates, would really have changed.
Here, Smith is countering the mercantilist view with a quantity theory view of money – that the more money there is in circulation, the less it is worth. In other words, inflation. His intuitive view is that all prices are affected, and that nothing real changes. Today we recognise that inflation does have some distorting effects because the new money enters the economy in particular places and that price rises spread out from there, with the differences causing real misallocations on the way.
Some countries have attempted to outlaw the lending of money at interest. But this has simply increased the evil of usury, rather than preventing it. People still want to borrow money, but now they have to pay not just the interest, but a premium for the risk that the creditor runs in lending illegally. Government efforts to peg interest rates below their market price have the same effects. Creditors will not lend their money for less than the use of it is worth: so borrowers have to offer them a risk premium in order to get it at its full value.
This is a classic example of price controls leading to a black market. Where prices are artificially held down below market rates, suppliers may simply turn to other markets where they can make more money, creating shortages. Or they may continue to deal illegally: but in this case, customers will have to pay even more than the market price to compensate sellers for their risk. The same arguments apply to rent controls, wage controls and other price restrictions.
Further reflections on capital
Capital can be used in four different ways. Some assets (such farms or fisheries) yield raw produce for immediate consumption or for processing. Some (such as machinery and equipment) are used to prepare raw materials for consumption. Some (such as carts and ships) are used to transport raw or manufactured products to market.
Lastly, capital is used in retailing – to divide raw or manufactured goods into smaller amounts that match consumers' needs. If there were no butchers, for example, people would be obliged to purchase a whole ox or sheep at a time, which would be an inconvenience to the rich and an impossibility to the poor.
Smith here is taking on a view common in his time that retailers contributed nothing, and that they required regulation because competition was cut-throat, causing some to fail as others pushed customers into buying what they did not need.
The current political p
rejudice against shopkeepers is therefore misplaced. They do add value, and they serve the public. The competition between them might force some out of business, but it can never hurt the consumer. Competition pressurizes them to keep down their prices – a pressure which monopolists do not experience. The argument that, without regulation, some retailers might dupe customers into buying things they do not need is a specious one. For example, it is not the widespread prevalence of alehouses that causes people to drink to excess. Rather, it is the disposition to drink that gives employment to the alehouses. Retail trades, like any other, follow the demand.
The capital that is employed in agriculture seems to be the most productive. That is because nature works alongside the human labour, bringing the crop to fruition. The American colonies have grown rapidly largely because their capital is focused on this highly productive sector. They let others provide the capital for the (less profitable) trading and manufacturing sectors they need. America's manufactures are almost entirely imported, in a trade financed by the capital of merchants in Great Britain. Even the Virginia and Maryland stores and warehouses employed in this transatlantic trade are British owned. If, as a result of the present disagreements, the Americans were to call a halt to this trade and divert their capital into domestic manufacture, the effective monopoly that would be given to their domestic producers, and the increased costs they faced, would make them worse off.
Economic progress stems only from countries producing a surplus that they can then exchange with others. Countries are better off if they do not try to remain self-sufficient and raise trade barriers against others.
Book III: The progress of economic growth
The principal commerce of an advanced society is that which takes place between the country and the towns. In a sense, the towns acquire their whole wealth from the country. But that does not mean that their wealth comes at the expense of the country. Both sides benefit. Farmers need town artisans to make their tools and household goods, and towns need markets for their produce. The greater the wealth and population of a town, the bigger is the market, and the more the country benefits.
Priority of agriculture
Since subsistence is prior to convenience and luxury, the cultivation and improvement of the country must have taken place prior to the growth of towns; and towns could only grow insofar as the country produced surpluses. If the profits were equal, people would generally prefer to live from land, rather than manufactures or foreign trade. Land, and rent, seems much more secure than manufactures or trade, which are liable to many accidents and uncertainties, and landowners enjoy the beauty and peace of the countryside. Yet farmers still need artificers such as smiths, carpenters, wheelwrights and ploughwrights, masons and bricklayers, tanners, shoemakers and tailors. These people in return need food and raw materials. The inhabitants of the town and the country are mutually dependent; nevertheless, the towns could only grow in proportion to the prosperity of and the demand from the countryside.
When people are allocating their capital, therefore, they prefer to put it first into land, then into manufactures, and only then into foreign trade, with its many risks. Where land is extensive and fertile, such as the North American colonies, capital goes predominantly into agricultural improvement. In countries where the land is fully improved, more capital is diverted into manufacturing. In either case, the import-export business is generally left to other countries, where manufacturing is advanced. In fact, North America has grown fast precisely because its capital has gone into agriculture, while its trade has been financed by British merchants. The wealth of ancient Egypt, and of China and Indostan, demonstrate that nations can prosper even though their trade is financed mostly by foreigners.
The rise of the towns
The towns may depend on the country, but they also help to improve it. First, they provide large markets for the produce of the country. Second, rich people in the towns buy and improve land in the country. Wealthy merchants fancy themselves as country gentlemen – though they are also businesslike improvers of agriculture. Thirdly, the commerce of the towns promotes order and good government – principles which spread out to the country.
Townspeople achieved their freedom and independence before those in the country. Gradually they won privileges and self-government – helped in part by the desire of weak kings to make them allies against the rich landowning barons, who despised both kings and merchants. Order and government, security and liberty thus arose in the towns, and manufacturing and trade expanded.
In the age before manufactures, however, great landowners had nothing for which they could exchange their surplus. All they could do was use their wealth to maintain a large following of retainers and dependants. This gave them a vast authority, and they – rather than any distant king – naturally became the chief lawgivers and administrators. But such power can be arbitrary, and the introduction of the feudal law was an attempt to restrain it by creating a comprehensive system of rights and duties, from the king down to the smallest landholder.
The feudal law still could not curb the arbitrary power of the great lords. But the rise of manufacturing and commerce did. Once manufactured goods became available, the lords at last had something for which they could exchange their surplus. They started to spend their wealth on comforts and impressive luxuries, rather than on maintaining thousands of retainers.
As a result, however, the great landlords lost the source of their whole power and authority. For merchants are not as dependent on their customers as retainers are on their lord. They have other customers too: their loyalty is more divided.
For a pair of diamond buckles perhaps, or for something as frivolous and useless, they exchanged the maintenance, or what is the same thing, the price of the maintenance of a thousand men for a year, and with it the whole weight and authority which it could give them.
As the number of retainers diminished, farms were enlarged and became more efficient and productive. This prompted landlords to raise their rents, but in return the tenants demanded more security. Tenants became more independent, landlords lost their arbitrary power, and an orderly system of justice developed. The commerce and manufactures of the cities had been the cause of the improvement and cultivation of the country.
This history is speculative, and yet the breakdown of the traditional feudal power of the great Scottish chiefs may have given Smith real examples from his own time.
Tenancy law and agricultural efficiency
In England, the considerable security that is given to tenants has contributed to the agricultural success and grandeur of the nation. In other parts of Europe, leases have been too short to encourage improvements, or entailed unspecified services to be delivered to the landlord, or invited taxes (French farmers who produce a surplus find it almost all confiscated in the taille).
Small proprietors have a much more direct interest in managing their land than large ones, and so are more successful and productive. But in Europe, the persistence of primogeniture has still prevented the division of great estates. Land was considered, not just as a source of income and enjoyment, but as the basis of power, patronage, and protection: so in the dangerous times that followed the fall of Rome, it was thought better for land to be kept intact. This tradition has persisted, and as a result, land rarely comes to market – perhaps a third of the land area of Scotland is entailed under this system – and where it does come to market, it is sold only at a high, monopoly price. The system makes land use inefficient: cost-effective improvement of land takes the same close attention to detail and to profit as any other business, but the grand proprietors of large estates have much less interest in these things than those who cultivate their own small landholdings. Such is the inefficiency of this system that in Europe it takes over five hundred years for the population to double.
In North America, where primogeniture does not prevail, the population doubles every twenty-five years. There is an open market in land, and fifty or sixty pounds is en
ough to begin a plantation. If European landholdings were divided equally among the children on the death of the proprietor, the estate would generally be sold, more land would come onto the market, prices would moderate and the productivity of the land would rise.
Slavery, however, is another factor that limits agricultural efficiency. In Russia, Poland, Hungary, Bohemia, Moravia and other parts of Germany, serfs are tied to the land and can be bought and sold with it. But a serf or slave who can acquire no personal property has no interest other than to eat as much, and to labour as little as possible: productive work has to be forced out of them. Though slave labour looks cheap it is therefore the least cost-effective sort of labour. Slavery is common in the sugar and tobacco plantations of the British colonies, but only because the extent and fertility of the land makes the expense of slavery affordable.
Book IV: Economic theory and policy
Economics is about how to generate income for the people and to supply a revenue for the state. There are presently two principal theories, the mercantile system and the agricultural system.
The mercantile system
The mercantile system holds that wealth consists in money – gold and silver. A rich person, or a rich country, is one with plenty of money. Under this view, therefore, policy should focus on heaping up large quantities of money, seeking it out from colonies, welcoming it into the country, but preventing it from leaving.
As an illustration of this attitude, when the Spaniards discovered America, their first question was whether gold or silver could be found locally, such was the prevalence of this view and the assumed importance of these metals. For the same reasons, Spain and Portugal have severe prohibitions, or heavy taxes, on the exportation of gold and silver. Even some old Scottish laws prevented their exportation.