Adam Smith "The Father of Capitalism"
What better way to understand capitalism than to read what Smith said about it.
One day, I decided to read Smith’s famous “wealth of nations” (any of the quotes throughout this article can be searched for here). I haven’t yet finished it back to front, but I am over halfway through the second book. I still think it’s one of the best things to read if you want to understand modern capitalism (though I’ve hardly read a lot of it out there, but have for example read Piketty’s “Capital”.), and part of the reason is Smith is writing from a time before economics became its own isolated field. Instead Smith, I think rightly, is describing it from the point of view of politics as a whole; while he does go into specific economic detail, he never deigns to imagine that it is ongoing in a vacuum, independent of the political machinations going on around it. This, I think, is the appropriate way to view economics, for a variety of reasons.
Firstly, some myth busting. Many people have heard the phrase the “invisible hand” of the market, which is attributed to Smith. It’s talked about as if it’s some justification for letting any economic actors, pursue their own self interest, and it will always lead to the common good. Smith did coin the phrase, but the issue with attributing this modern reading to Smith is two fold. Firstly, the term only appears once in Wealth of Nations (which you can confirm for yourself in the link at the top), so it is hardly some central thesis of his. Instead, Smith appears to use the term as a bit of a throwaway to describe something that falls outside of his model: a kind of anomaly or exception. This is consistent with his usage in other works of his, where the term also appears, including one on astronomy. Secondly, the context in which it does appear in Wealth of Nations, both immediately and more broadly, is one that goes against its modern usage. The immediate context is Smith is arguing why people tend to avoid interacting with foreign markets, when it appears it should be of benefit to them. He says that part of the reason is the “invisible hand”:
He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.
So it is interesting, that in its original usage, Smith is saying that the Invisible hand leads people to avoid globalisation, and prefer domestic industry; the exact opposite as how it is often used today as a defence of globalisation. But, the phrase is still clearly used in a context of self interest leading to the common good, Smith just concluded that the common good was not capital globalisation (he argued for an equal globalisation of capital and labour, and was against laws that gave capital holders special freedom of movement, where it simultaneously blocked such freedom of movement for labourers. Perhaps I’ll expand on this in a later post).
The broader context is Smith does argue pursuing self interest can lead to the common good as part of his core thesis, but the explicit argument given is actually far more narrow than how it’s treated today. Smith divides people into 3 groups: those that live primarily by rent, those that live primarily by wages, and those that live primarily by profit. Smith argues that, the self interest of the first and second group, does align with the common good. But he argues that those who live by profits — by which he means, those who live by employing others — their self interests are often at odds with the common good.
His employers constitute the third order, that of those who live by profit. It is the stock that is employed for the sake of profit, which puts into motion the greater part of the useful labor of every society. The plans and projects of the employers of stock regulate and direct all the most important operations of labor, and profit is the end proposed by all those plans and projects. But the rate of profit does not, like rent and wages, rise with the prosperity, and fall with the declension, of the society. On the contrary, it is naturally low in rich, and high in poor countries, and it is always highest in the countries which are going fastest to ruin. The interest of this third order, therefore, has not the same connection with the general interest of the society as that of the other two. Merchants and master manufacturers are, in this order, the two classes of people who commonly employ the largest capitals, and who by their wealth draw to themselves the greatest share of the public consideration. As during their whole lives they are engaged in plans and projects, they have frequently more acuteness of understanding than the greater part of country gentlemen. As their thoughts, however, are commonly exercised rather about the interest of their own particular branch of business, than about that of the society, their judgment, even when given with the greatest candor (which it has not been upon every occasion), is much more to be depended upon with regard to the former of those two objects, than with regard to the latter. Their superiority over the country gentleman is, not so much in their knowledge of the public interest, as in their having a better knowledge of their own interest than he has of his. It is by this superior knowledge of their own interest that they have frequently imposed upon his generosity, and persuaded him to give up both his own interest and that of the public, from a very simple but honest conviction, that their interest, and not his, was the interest of the public. The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow citizens. The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.
Quite a devastating criticism of profit seeking, by the “Father of Capitalism” there; and I think his words hold true. Marx built on this observation of Smith, and formalised it as “the tendency of the rate of profit to fall”. That is, in a naturally productive and competitive market, or what Smith calls a “rich country”, profit margins must fall, because of two factors at either end. As more capital is invested in a competitive and healthy way, a larger amount of the population is employed, and as more of the population is employed, workers tend to have more job security, as there is less of an oversupply in waiting to take their jobs. Because workers have more job security, they tend to have higher wages, reducing the profit margins of companies. Now, companies can and do increase prices to avoid this, and they are supposed to be able to get away with this, as workers have more money to spend, and this is often called a “wage-price spiral”, a kind of inflation. But as Smith noted, this should not happen in a “rich” country. In such an economy, individual companies should not be able to so freely increase prices, as competition means that there will always be someone there to undercut. And so, as economies mature, profits tend to drop. Smith noted this in real-time. And in retrospect, historians like Eric Hobsbawm have supported his claim, pointing out that in the 1880s, this reached a sort of pinnacle all throughout the world, and that “what was at issue was not production, but its profitability.”
Hobsbawm pulls on many sources, and paints a picture of an interesting paradox that exemplifies Smith’s point. During this time, objective measures showed a thriving global economy. Production was at an all time peak, there was huge amounts of trade benefitting many and the “common good”, but, important businessmen everywhere were complaining about an economic downturn. As Smith says, these complaints were coming from “an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.” So what they were really complaining about, was an economy not serving their interests. A modern example of one of these “deceptions” Smith mentions, I think is the term “wage-price” just mentioned.
Why not “profit-price” spiral; somehow its the workers fault, not the companies increasing their profits? The Investopedia definition of the term, doesn’t even mention profit margins as an active mechanism, instead, it’s just treated as something as natural and inevitable as the surface of water reacting to a pebble (wages): “As rising wages increase disposable income, demand for goods rises, triggering prices for goods to move higher.” The entire entry does not mention “profit” once, leading the curious reader, to wonder how the hell prices are increasing? By some magic? Or perhaps, “invisible hand”? Prices are increasing because a group of people in some board room are deciding to increase them, and knowing they can get away with it, because they are either in direct cahoots with the competition, or because there simply isn’t enough of it. Of course, wages are mentioned many times, and there appears to be no entry on Investopedia for anything called a “profit-price spiral”. Smith is already one step ahead of Investopedia, expecting this kind of disingenuous framing.
In raising the price of commodities, the rise of wages operates in the same manner as simple interest does in the accumulation of debt. The rise of profit operates like compound interest. Our merchants and master-manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their goods both at home and abroad. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people.
Investopedia is silent about the effects of profit on inflation. So, how does this group continue to “impose” its own self interest on the rest of us? Ensuring that we are not allowed to have a healthy free market economic interaction, and that instead profits are maintained at odds with this. As Smith has already pointed out, part of this is that this group just often has a better understanding of their own self interest than others, and so works to make sure that, for example, competition is minimised. But this can’t be all, how do they do it? Well, by combining with each other:
It is not, however, difficult to foresee which of the two parties must upon all ordinary occasions have the advantage in the dispute, and force the other into a compliance with their terms. The masters, being fewer in number, can combine much more easily; and the law, besides, authorizes, or at least does not prohibit their combinations, while it prohibits those of the workmen. We have no acts of Parliament against combining to lower the price of work; but many against combining to raise it. In all such disputes the masters can hold out much longer. A landlord, a farmer, a master manufacturer, or merchant, though they did not employ a single workman, could generally live a year or two upon the stocks which they have already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment. In the long run the workman may be as necessary to his master as his master is to him; but the necessity is not so immediate.
…
We rarely hear, it has been said, of the combinations of masters; though frequently of those of workmen. But whoever imagines, upon this account, that masters rarely combine, is as ignorant of the world as of the subject. Masters are always and everywhere in a sort of tacit, but constant and uniform, combination, not to raise the wages of labor above their actual rate. To violate this combination is everywhere a most unpopular action, and a sort of reproach to a master among his neighbors and equals. We seldom, indeed, hear of this combination, because it is the usual, and one may say, the natural state of things which nobody ever hears of.
Again, this is reflected well in the world today. We are constantly hearing about workers unions, and scandals they are involved in etc. But rarely, for example, of groups like The Australian Energy Producers, who just recently held a private event, hosting many major politicians, in my own city. In Australia too, there are many laws restricting what unions are allowed to do, but no similar laws restricting what The Australian Energy Producers can do. For example “The Australian Council of Trade Unions (ACTU) stated that existing provisions of the Fair Work Act ‘unjustifiably interfere with the right to freedom of association and should be reconsidered’. These included restrictions on the right to strike, the duration of industrial action and union access to workplaces.” In fact, corporations, which in and of themselves examples of privileged “tacit” combinations of “masters” that Smith refers to, are often allowed special legal privileges through misnamed “free trade agreements”, which have very little to do with trade, and most everything to do with giving corporate entities special legal advantages and rights (remember, corporations do not like free trade, and they are the ones that push these through).
For example, in allowing companies to shop around for their preferred legal jurisdictions when taking action against the Australian Government, as Phillip Morris did when it legally moved its base of operations to Hong Kong, just to sue Australia through our Hong Kong trade agreement, leaving the Australian government millions of dollars out of pocket, even when Phillip Morris lost.
And then we get to the politicians hosted at the Gas event. As Smith notes
Whenever the legislature attempts to regulate the differences between masters and their workmen, its counsellors are always the masters. When the regulation, therefore, is in favor of the workmen, it is always just and equitable; but it is sometimes otherwise when in favor of the masters.
And such events are an important mechanism of how the modern “Masters” council the legislature.
Civil government, so far as it is instituted for the security of property, is in reality instituted for the defence of the rich against the poor, or of those who have some property against those who have none at all.
Things have changed a bit since Smith, Civil government, through the welfare state, does take many more measures to protect the poor than it once did. Much of these measures were won by combinations of workers, defying Smith’s betting odds. Though at the same time, the rise of the corporation has probably made such protection far more necessary than it once was, to stop the system eating itself.
It’s for all these reasons, and many more, that I think Smith’s “wealth of nations” is still the best description of modern capitalism that one can find. Because Smith understands, that while there is some ideal market out there, which he characterises as
The whole advantages and disadvantages of the different employments of labor and stock [read capital] must, in the same neighbourhood, be either perfectly equal or continually tending towards equality.
he also understands that combinations of masters, acting on their own, and through the legislature, as its council, will do all they can to make sure such an equality is not allowed, and in doing so, often driving whole nations “to ruin”. Or, perhaps in the context of having just gone through the hottest year we’ve ever record, and this year looking like it will beat last, entire worlds.