7 ADAM SMITH (1723–1790)

Greatness and illusion

If one figure is synonymous with capitalism, it is Adam Smith. To the subject’s practitioners, he is known as the “father of economics”. He may be the only economist who is also a household name. In 2006 officials at the Bank of England deemed him famous enough for his portrait to feature on the £20 note. “Smith’s insights into human nature, the organisation of society, the division of labour and the advantages of specialisation remain at the heart of economics,” announced the then Bank of England Governor, Mervyn King. Smith’s most important contribution, An inquiry into the nature and causes of the wealth of nations (or the Wealth of Nations, for short) of 1776, is the most famous economics book ever written. It is said that Margaret Thatcher used to carry a copy in her handbag. What exactly did Smith do to enjoy such pre-eminence?

He was born in 1723 in Kirkcaldy, on the eastern cost of Scotland, near Edinburgh. His father died when he was a baby; his mother raised him. Happily, his childhood was a fairly prosperous and intellectual one. His father had moved in rarefied circles, and Smith matured as a thinker at an exciting time. The industrial revolution had started in the 1760s with the invention of the spinning jenny. France and America were both stirring towards revolution. Scotland was an especially exciting place to be. At the time it had no fewer than four important seats of learning (the universities of St Andrews, Glasgow, Edinburgh and Aberdeen), compared with a meagre two in England (Oxford and Cambridge).¹ The clan system was being dismantled.² Glasgow was turning from a small provincial town into a great commercial capital. Ships from the city spread out across the world; its merchants had won the lead in the West India tobacco trade. As Alan Macfarlane puts it, “He lived in a boom-town and watched a feudal, Calvinist, world dissolving into a commercial capitalist one.” Smith’s works, especially the Wealth of Nations, were in Macfarlane’s words “almost autobiographical attempt[s]” to describe and explain the structural changes happening around him.

An enlightened life

While only a boy, Smith enrolled at Glasgow University. There he was taught by Francis Hutcheson, a liberal philosopher, whose writings influenced the American constitution. At the age of 17 he moved south, to Oxford, to attend the university on a Snell exhibition (a scholarship still in existence today). He hated it. The Scottish universities were superior to the English ones,³ where Smith complained that “the greater part of the public professors have, for these many years, given up altogether even the pretence of teaching”. Such comments caused some offence among his Oxford contemporaries, including Samuel Johnson. He made few friends, and before long he made the long ride back up to Scotland.

But his academic career was just getting started. By 1752 he held the chair of moral philosophy at Glasgow University (the chair of political economy was not created until 1892). Having quit the university in 1764, to travel around Europe as the private tutor to the Duke of Buccleuch (where he met François Quesnay), he returned to Kirkcaldy, where he wrote the Wealth of Nations. He saw out the latter part of his life as a customs officer in Edinburgh.

It is easy to have a soft spot for Smith. He was the archetypal absent-minded professor. A contemporary described his “air of vacancy, and even of stupidity”. It is said that once he went out walking in his dressing gown and, deep in thought, ended up miles out of town before coming to his senses. He supposedly brewed for himself a beverage of bread and butter, proclaiming it the worst cup of tea he had ever tasted. He never married, spending the majority of his life in the company of his mother. And his demise was dramatic. On his deathbed in 1790, he ordered that his unfinished papers be burned in front of his eyes.

Capitalism for the world

Smith’s first big book, The Theory of Moral Sentiments, came out in 1759 (though it subsequently went through many revisions, right up until his death). Like all of his contributions, this book cannot be reduced to a single argument. It presents a way of thinking about the world. As Dugald Stewart (1753–1828), a Smith biographer, says, it is a “study of human nature in all its branches”.

The book explores how people make decisions. (It is not called a “theory of moral sentiments” for nothing.) Its most important device is the notion of an “impartial spectator” (the term appears over 50 times in the text). According to Smith, people think about how their actions would be understood and judged by a neutral person looking in on them. Though the spectator is imaginary, it guides our behaviour. We seek to win its approval, Smith argues, and also look to it to help us judge the actions of others.

Readers often misunderstand what the notion of the impartial spectator really stands for. It may seem, at first glance, that the impartial spectator is really a stand-in for God: a being that hands down universal moral rules from which people deduce logical consequences. But that is not in the end its function. Rather the metaphor tries to get at something else. Trying to work out the right course of action can be a tricky matter, says Smith. Yes, there may be objective rights and wrongs, but it can be difficult to decipher which is which. So when someone needs to make a decision they try to put themselves in other people’s shoes. “Is that the right thing to do?” we ask ourselves, and imagine defending our course of action to some hazy combination of peer and judge and interviewer. The notion of the impartial spectator nicely captures the “feel” of how people make decisions. “We endeavour”, Smith says, “to examine our own conduct as we imagine any other fair and impartial spectator would examine it.”

In invoking this ghostly projection, Smith presents people as fundamentally social beings. As he puts it: “Were it possible that a human creature could grow up to manhood in some solitary place… he could no more think of his own character, of the propriety or demerit of his own sentiments and conduct.” Moral judgement is rooted in what surrounds the individual: conversation, friendships, family. Smith argues that all morality has a worldly foundation; norms are socially determined.

This of course was a radical argument–one, even, that appeared to stray close to moral relativism. Conservative opinion held that morality came from an unworldly being (namely, God) and was not socially determined. Though Enlightenment Scotland was a relatively liberal place, blatant blasphemy was sure to attract social ostracism at the very least. Smith was therefore sure to phrase his argument carefully. But like his teacher Francis Hutcheson, who had years before been accused of heresy, Smith ended up proposing (in the words of Hutcheson’s pupils) “a notion of moral goodness prior in the order of knowledge to any notion of the will or law of God”. Something is good because it is good, Smith believes–not because God says that it is good.

The pin factory

It was Smith’s economic writings, most famously the Wealth of Nations, which cemented him as one of the all-time greats. It came out in 1776, the year of the American Revolution and of Edward Gibbon’s suavely irreligious The Decline and Fall of the Roman Empire. In that year the world seemed on the cusp of something different.

Many commentators have summarised Smith’s vision of capitalism as a free-market one. He was averse to government intervention in any form, the argument goes. The phrase “invisible hand” is all many people know about him. In the popular telling, the phrase implies that the free operation of markets leads to the best possible outcome. Smith’s supposed glorification of selfish, bourgeois values appears to reach its climax in a passage of the Wealth of Nations. Journalists love quoting it: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.”

Homo economicus on the ropes

Yet Smith’s outlook was more complex than the pithy quotations above suggest. It is here that one must do what Smith wanted us to do, and read the Wealth of Nations in conjunction with Moral Sentiments.⁴ If the Wealth of Nations is a blueprint for how the economy works, Moral Sentiments is a guidebook for how people navigate it. The remainder of the discussion will discuss both books at once, to give a fuller picture of what Smith really meant.

First things first. The “peace and easy taxes” line is not necessarily Smith’s own. It comes via Dugald Stewart, Smith’s biographer. In 1793 Stewart delivered a eulogy on Smith to an Edinburgh discussion group. He reports on a lecture that Smith had given in 1755, in which Smith made that apparently very libertarian statement. Unfortunately, Stewart does not give the context, and as we will see, context really matters when it comes to understanding Smith.

Let’s focus, then, on work that is definitely his. It becomes quite clear that Smith does not believe that selfish behaviour always ends up benefiting society. For instance, he worried that businesspeople were always ready to club together and form cartels–which is certainly in their interest, but not the interests of society as a whole. “People of the same trade seldom meet together, even for merriment and diversion,” he wrote, “but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Indeed, Smith’s whole opposition to what he called the “mercantile system” is based on the idea that “merchants and manufacturers” had shaped the economy to suit their own interests. The guild system, which was prevalent in Europe until the 19th century, cartelised entire industries, causing prices for consumers to rise and quality to fall. Restrictions on imports resulted in higher prices for ordinary people, while ensuring bumper profits for domestic producers. “In the mercantile regulations… the interest of our manufacturers has been most peculiarly attended to; and the interest, not so much of the consumers, as that of some other sets of producers, has been sacrificed to it.” It is clear from such statements that Smith most certainly does not think that greed will always lead to a good outcome.

Fortunately, however, he does not believe that humans are entirely selfish by nature: he has a more complex account of human behaviour than the Gordon Gekko stereotype would allow. To be sure, he believed that people often do look out for themselves, but he maintained that this does not or should not come at the cost of disregarding others’ interests completely. This point is explored in the Lectures on Jurisprudence, the raw material for the Wealth of Nations. Here is the relevant passage. Note that Smith uses the example of brewers and butchers once again. “When you apply to a brewer or butcher for beer or for beef,” he says (with emphasis added), “you do not explain to him how much you stand in need of these, but how much it would be in [his] interest to allow you to have them for a certain price.”

Smith is making a subtle argument here. He is saying that in practice, you often serve your own self-interest by serving the self-interest of another party–by putting yourself in their shoes. The objective of one party must be mediated by consideration of the concerns of the other. We are close to the impartial observer again: rather like moral conduct, success in business turns out to require seeing oneself from an outside perspective. Two entirely selfish madmen could not reach a bargain (nor, for that matter, would two homines economici). As Smith quips, “Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog.” Humans, by contrast, have what is almost a natural tendency to “truck and barter”.

This may sound like a fairly weak argument; one needs only to feign interest in the wellbeing of someone else in order to get what you want. (As we saw earlier, Bernard Mandeville did not like this aspect of capitalism.) On the other hand, it shows that Smith does not believe that self-interest and greed are equivalent.

If people are not motivated purely by self-interest, what else are they motivated by? Smith certainly has something in mind. Consider the very first sentence of the Theory of Moral Sentiments: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.”

Let’s probe that idea further. One passage in the Theory of Moral Sentiments looks at what would happen if China were “suddenly swallowed up by an earthquake”. Smith wonders: how would the average man in Europe feel about it? No doubt he would “express very strongly his sorrow for the misfortune of that unhappy people”. But “when all these humane sentiments had been once fairly expressed, he would pursue his business or his pleasure, take his repose or his diversion, with the same ease and tranquillity as if no such accident had happened”.

That same day, however, if some “frivolous disaster” befell the man–say, “[i]f he was to lose his little finger”–he would react viscerally. He would be able to think of little else for weeks afterwards. One might therefore conclude that “the destruction of that immense multitude [the Chinese people in the earthquake] seems plainly an object less interesting to him than this paltry misfortune of his own”. In this passage, Smith appears to be endorsing the idea that people are heavily biased in favour of themselves. It is a depressing account of human selfishness.

But there is more. He asks the question: if that man were asked whether he would sacrifice his little finger in order to save the “immense multitude” from death, what would he do? Why, he would sacrifice his little finger, Smith says. When someone has the power to effect change, he reasons, they see their actions through the eyes of the “impartial spectator”. This, in Smith’s words, “is reason, principle, conscience, the inhabitant of the breast, the man within, the great judge and arbiter of our conduct”. When push comes to shove, we recognise “that we are but one of the multitude, in no respect better than any other in it”. People are not inherently selfish, according to Smith, but inherently social.

Thy bloody and invisible hand

The true meaning of that famous phrase, “invisible hand”, is also interesting. Many pundits use the phrase to encapsulate a supposed “greed is good” philosophy. That argument rests on a number of profound misunderstandings. First things first: Smith mentions the phrase “invisible hand” just three times in his entire published output. On each occasion the phrase is used in a completely different context–and never to mean what it means in the popular understanding.

Bear in mind the original source of the image–Macbeth, where the protagonist talks about “thy bloody and invisible hand”. Many of those reading Smith would have known that Macbeth utters the phrase when he is planning to murder Banquo, whom he sees as a rival to be King of Scotland. It is hard to believe that Smith would choose such a metaphor to describe something he viewed favourably.

So what does Smith mean when he uses the term? Emma Rothschild provides the best analysis of the multiple meanings of “invisible hand”. In Smith’s History of Astronomy he uses “invisible hand” to refer mockingly to the naivety of people in polytheistic societies. In the Theory of Moral Sentiments the term is used to refer to the spending habits of feudal lords. And in the Wealth of Nations it is used to describe how people prefer to have their capital close to where they live (as opposed to abroad, where it is hard to keep an eye on it). Nowhere does Smith give the impression through his use of the term “invisible hand” that a complete free market will lead to the best possible outcome. It’s just not what he has in mind.

Indeed, Smith believed that free markets sometimes led to bad outcomes. He looked around him, and saw the spread of capitalism and the division of labour. And there was a lot that worried him. He was in particular concerned by those who worked in factories their entire lives. “The man whose whole life is spent in performing a few simple operations”, he says, “has no occasion to exert his understanding [and] loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to become.”

To be clear, it does not follow from this that Smith wishes that the division of labour had never happened in the first place (an interpretation of Smith’s argument that is common among some of the left, especially Noam Chomsky). Smith is perfectly clear: the working classes are in a better position under a system where the division of labour led to improvements in material wealth than in a situation where there was no division of labour but also no economy. Smith also believed in “doux commerce”, an idea floating around in the 18th century which held that “commerce was the motor force behind the growth of manners and the progress of society” (this, of course, is squarely against the Mandeville critique).⁵ As the division of labour created increasingly complex social relations, people came to realise that they all depended on one another for their livelihoods, and that encouraged people to behave civilly towards each other. If you grow your own food, make your own furniture and build your own house, you can get away with being nasty to others. If you need to cooperate with people, that becomes more difficult.

Despite being generally in favour of the system of free-market, capitalist production, Smith acknowledges the downsides, and thinks that the situation of the working classes can and should be improved further. “[I]n every improved and civilised society,” he argues, “this is the state into which the labouring poor… must necessarily fall, unless government takes some pains to prevent it.” To stop people being totally sucked in to the mind-numbing factory system, in his view, the state needs to step in, providing “public diversions” for the poor including “painting, poetry, music, dancing”, to educate those whose lives would otherwise be devoid of intellectual stimulation. Smith also wanted England to adopt the “little schools” movement to spread literacy and numeracy among the population at large.⁶ (The movement had been in existence in Scotland since the 17th century.) Was a basic education not the least that anyone could expect to receive from a civilised society?

State intervention in education was one of Smith’s less controversial recommendations. In sharp contrast with the vast majority of modern economists, he advocated laws banning usury. He also favoured government regulations in the Mint, the Post Office, and hallmarks for gold and silver.⁷ In a word, he was a long way from a laissez-faire zealot.⁸

Discoveries of Smith, discoveries by him

Smith also contributed to the theories and practices underlying economic analysis. And it is for these contributions that he is most famous. In the 1850s Henry Thomas Buckle, an English historian, said that “innumerable absurdities, which had been accumulating for ages, were suddenly swept away” by the Wealth of Nations. Ronald Coase, a Nobel-prizewinning economist, called Smith “perhaps the greatest economist who has ever been”. A recent book by the economist Mark Skousen, The Big Three in Economics, says that “the story of modern economics begins in 1776”, the year of the publication of the Wealth of Nations. Some historians even link the beginning of the industrial revolution in the late 18th century to the publication of Smith’s most famous work.

Does he live up to his billing? Pinning down Smith’s precise contributions to economics as a discipline is not easy. For many, the Wealth of Nations achieves something that no other work had quite done before. It clearly brings out the idea of an “economy”–a self-regulating system of exchange, which is subject to its own natural laws.

Let us examine that idea more closely. Running through the book is a sense that things inexorably move towards balance (or “equilibrium”, in the jargon). This concept is central to modern economics. The prevailing wage rate in an economy is one example of equilibrium: at a certain level of wages, enough workers are willing to work, and enough employers are willing to employ. The same applies to the price of bread in a shop: the price of bread will rise until enough bakers are willing to bake it. Government intervention can change that equilibrium, either in a good or a bad way. But the tendency of society, almost naturally, is to reach some sort of balance. (Contrast this with the radically different approach that Marx and Engels take to history and society, which they see as being in a state of constant evolution.) Smith himself does not use the term “equilibrium”. Even so, throughout the book, there is a sense that he is trying to understand what will produce a “stable balance of forces [from] which there is no tendency to deviate”, as Glory Liu and Barry Weingast, two historians, put it.

To understand what all this means more precisely, consider Smith’s discussion of the English Poor Laws. This most bare-bones version of a welfare state had been introduced in the early 17th century. The system worked in such a way that people were only entitled to “relief” (that is, government handouts of food or money) within their local parish. This “law of settlements”, naturally, encouraged them to remain there rather than look for work further afield. Smith argued that the system resulted in an equilibrium in which wages in one part of the country could be much higher than in another. Because workers rarely moved away from parts of the country where wages were low towards parts where they were high, wages could not balance out. As he puts it: “The very unequal price of labour which we frequently find in England in places at no great distance from one another, is probably owing to the obstruction which the law of settlements gives to a poor man who would carry his industry from one parish to another without a certificate.”

There are two underlying arguments here. First, Smith implies that in a world free from government obstruction, wages would converge across England (ie, wages in the north-east and wages in the south-west should end up at roughly the same level). This is because of the tendency of wages to reach equilibrium. Second, government intervention prevents such a state of affairs. When Smith seeks to explain why wages differ from one region of the country to the next, he does not say “just because”, or “God wills it”. In Smith’s view, rather, there is a good, rational reason.

To modern readers, it may seem quite natural, obvious even, to analyse the world in this way.⁹ Even in Smith’s time, the idea that the economy and society was self-regulating was not entirely novel. Sir William Petty had compared the economy to the human body, suggesting that following some sort of disturbance it would tend to go back to its original state (in the same way that a human becomes ill and then recovers). Quesnay’s Tableau Economique of 1754 also gets at the idea of equilibrium. Yet in Smith the argument is laid out in a more comprehensive fashion–and is certainly easier to understand than Quesnay’s complex table.

That’s not all

Another important theoretical development credited to Smith concerns a theory of “value”–to be precise, what came to be known by all economists as “the labour theory of value”. But before proceeding with an explanation of what Smith said and why it was important, it is worth taking a step back. Just what is “value”, and why, as we will see in subsequent chapters, were so many economists obsessed with trying to understand it?

John Stuart Mill’s definition of “value” is probably the most useful: “Value is a relative term. The value of one thing means the quantity of some other thing… which it exchanges for.” In other words: why is stuff worth what it is worth? For instance, why is one kilogram of strawberries worth the same as many kilograms of flour? Why is a Ferrari worth more than a Fiat? The question of what constituted value was hugely controversial: not only Smith but David Ricardo, Thomas Malthus, Karl Marx and William Stanley Jevons all had different ideas. Economists today don’t really talk about value, but back then the debate sometimes got rather heated.

What makes matters annoying for outsiders is that none of the participants bothers to explain why the question of value is important–why it is a worthwhile discussion to be having. One can point to perhaps three reasons.

The first reason relates to the development of capitalism. At the time that the people in this book were writing, more and more goods and services were being sold on the open market for cash (and fewer and fewer goods and services were being bartered or produced solely for subsistence). In other words, markets were becoming a more important part of society. The question naturally arose as to why, for instance, nuts were more expensive than apples. Bear in mind that few of the people discussed in this book considered themselves “economists”, or even “political economists”–they were political theorists or philosophers interested in explaining the world around them.

A second reason for the early economists’ obsession with value concerns the sort of markets that they encountered in their everyday life. These days prices for goods and services are fairly predictable. You know that a pair of shoes today will cost pretty much the same as a similar pair of shoes next year. Over the past 20 years the annual rate of consumer-price inflation in Britain hit a high of about 5% in 2011 and a low of 0% in 2015. Not much variation, in other words. It was not like that in centuries past. During Adam Smith’s lifetime inflation jumped all over the place. The maximum annual rate of inflation Smith experienced was 28%, the minimum–14%.

This led people to believe that the price of stuff in money terms was too volatile to be an accurate gauge of a product’s value. A chair might be worth £1 one year, but ten shillings the next,¹⁰ but does that chair really give the sitter half as much value in the second year as in the first? Perhaps, the political economists reasoned, each product had a “market price” expressed in money, which moved around the product’s “natural price”.¹¹

Third reason. The obsession with value is a political one. Around the time the early economists were writing, industrialists and businesspeople were gradually gaining power at the expense of the landed gentry. The landed gentry lived off the land or hoarded gold; the ascendant bourgeoisie bought big machines and put ordinary people to work. The group that could lay claim to be the true creators of value had a better claim on political power. If the landed gentry could prove that they were the true creators of value, then they deserved to hold on to power. At the other extreme, if the workers could prove that they were the sole creators of value, that called for more radical redistribution.

Enough of the context. What do we mean by Adam Smith’s “labour theory of value”? H. M. Robertson and W. L. Taylor argue that Smith’s contribution to economists’ understanding of value represents “a major turning point in the history of economic thought”. And not in a good way. Francis Hutcheson taught Adam Smith much of what he knew. Hutcheson had a theory of value that we might call “subjectivist”–a “nuts-are-more-expensive-than-apples-because-they-are-nicer” theory. Hutcheson’s theory of value had pretty much been copied from Samuel von Pufendorf and Hugo Grotius, two earlier legal scholars, who in turn were influenced by Aristotle. Pufendorf had made interesting observations about economic value, noting, for instance, that “we generally find the most necessary things are cheapest.”¹² Hutcheson added that the cost of producing a good might also affect its cost; truffles are pricey in part because they are hard to find.

In other words, demand and supply. This sounds very modern. If you were to ask someone in the street why one thing cost more than another, they would probably give an answer similar to the one that Hutcheson gave in 1755. In some of his earlier works, Smith also seems to subscribe to the Hutchesonian idea of value. Yet by the time of the Wealth of Nations Smith disagreed, proposing in its place a new conception of value–and, in the process, set economic thought in a completely different direction.

Smith argues that Hutcheson has erred in his theory of value. In particular, “utility” or “value-in-use” cannot be a necessary ingredient of value since things “which have the greatest value in exchange have frequently little or no value in use”. Diamonds and water, according to Smith, are a good example. Diamonds cannot be used for anything. The theory goes that “their real use seems not yet to be discovered”, as Smith puts it in the Lectures on Jurisprudence. Water is the basis of all life. Yet diamonds are costly and water is not. Hence, “value-in-use” can have no impact on value. (This is known as the “diamond–water paradox”.)

Where to begin with this nonsense? As Hutcheson anticipated, diamonds do indeed have a use. They make people feel special, for instance. In addition, however, they are really hard to find and process. Water also has an extremely important use–a more important use than diamonds, to be sure. Yet water is easy to obtain. That is surely a good explanation of why water is cheap and diamonds costly. The diamond–water paradox is not really much of a paradox.

Still, Smith ploughed on. The labour theory of value goes that what really determines value is how much labour time has gone into it.¹³ The price of a good or service will be determined by how much labour it embodies. The “use-value” of a commodity does not really matter. So a computer is worth more than a pen purely because a computer has more labour time in it. As we shall see in Chapter 9, these ideas were taken up and formalised by David Ricardo and then Marx. The significance of this, as far as the development of economic thought is concerned, is hard to overstate.

Paul Douglas may have put it most eloquently. “Smith”, he says, “helped to divert the writers of the English Classical school into a cul-de-sac from which they did not emerge, insofar as their value theory was concerned, for nearly a century, while he also helped… to give rise to the economic doctrines of nineteenth-century socialism.” Marxist economic thought cannot exist without the labour theory of value.¹⁴ Marx, as we shall see in Chapter 15, got into all sorts of intellectual tangles as he tried to explain it. Yet the original sin, so to speak, may have been Smith’s. Emil Kauder, in his History of Marginal Utility Theory, bemoans Smith’s influence, saying that “[w]ith these few words Adam Smith had made waste and rubbish out of the thinking of 2,000 years. The chance to start in 1776 instead of 1870¹⁵ with a more correct knowledge of value principles had been missed.” Robertson and Taylor say that this judgement is “unreasonably harsh” yet they also acknowledge that “Smith certainly did know the ideas on value of Hutcheson and Carmichael, which also had roots two thousand years old in Aristotle.”

Completely baffling

There is a body of literature which argues that Smith’s view of value is more complicated than I have just outlined. Some people claim that Smith does believe in a labour theory of value in primitive societies, but not in more advanced capitalist societies. There is also a body of literature in opposition to that argument, which says that actually Smith really did believe in a labour theory of value applying to mature capitalist societies too.

What we can say for sure is that the discussion is unclear. And paying so little attention to the role of utility does seem odd. From our perspective, centuries later, it is inexplicable that someone who today is known as the “father of economics” could have made such an oversight. Of course the utility of something influences how much that thing is worth! Unfortunately, it is impossible to explain satisfactorily why Smith made such an error.

Perhaps the best reason is that Smith was trying to turn economics into a science. One might accuse Hutcheson, Pufendorf and others of offering “vague generalisations” as they sought to explain value, as Robertson and Taylor put it. Smith wanted an objective answer to the big questions in economics: why water was valued less than diamonds, and why some countries were richer than others. A bit like Richard Cantillon, Smith was trying to strip out the noise and focus on the fundamentals. The theory was a failure, but perhaps a grand one.

Smith is perhaps better known for his ideas on the division of labour. The basic idea is that, by getting each worker to focus on just one task, a given amount of labour time creates a lot more value.¹⁶ “The division of labour increases the work performed from three causes: dexterity acquired by doing one simple thing, the saving of time, and the invention of machines which is occasioned by it,” he says in the Lectures on Jurisprudence. His discussion of the pin factory in the Wealth of Nations is a particularly famous passage. Smith demonstrates the huge productivity improvements that can result from the division of labour. The passage is so famous that alongside Smith’s portrait on England’s £20 banknotes, there is an illustration of the division of labour in the factory and a caption from the treatise alongside.

(A quick aside. There is a mistake, or at the very least a statement liable to mislead, on the English £20 note. The caption under the illustration of Smith talks of “[t]he division of labour in pin manufacturing [and the great increase in the quantity of work that results]”. This is not a quotation from Smith, and it risks misrepresenting Smith’s point. The whole point of the division of labour is to reduce the amount of work that is required to produce a given unit of output, rather than increase it.)

Were Smith’s views on the division of labour revolutionary? Perhaps not. Smith was hardly the first person to recognise its beneficial effects. Plato discussed the issue. William Petty, who also has a claim to be the “father of economics” (see Chapter 2), did too in the 17th century (he looked at the example of a watch factory). An almost unknown German theorist, Ernst Ludwig Carl (1682–1742), is credited by some as having provided the first systematic account of the division of labour, way back in the 1720s.¹⁷ (And, by definition, the division of the labour within that pin factory existed before Smith noticed it!) There is even some evidence that Smith lifted the example of the pin factory from Denis Diderot’s Encyclopaedia, which was published in the 1750s and 1760s. Smith was not a full-blown plagiarist: he himself acknowledges that the practice of dividing labour “has been very often taken notice of” by other people (though he does not refer to the Encyclopaedia).¹⁸ Others, however, have been less careful, giving him more credit than he deserves.

Smith’s real contribution as far as the division of labour was concerned was somewhat more modest, though still important. He emphasised that the division of labour really was central to all economic activity: indeed, “practically the only factor in economic progress”, as Joseph Schumpeter put it. As Smith himself said: “The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is anywhere directed or applied, seem to have been the effects of the division of labour.” That, more than anything else, accounted for “the superior affluence and abundance commonly possessed even by [the] lowest and most despised member of civilized society”.

This was an important step forward. Economists today accept that the clearest way of raising living standards is to improve productivity (as Paul Krugman puts it, “productivity isn’t everything, but in the long run it is almost everything”). Productivity growth is achieved by making an individual worker do something specialised, very well. In our understanding of this, all are indebted to Smith.

Home economics

Smith is also known popularly for his writings on free trade. He is generally in favour of it, of course. “It is the maxim of every prudent master of a family”, he wrote in 1776, “never to attempt to make at home what it will cost him more to make than to buy… If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry.” (You’ll notice the difference with the mercantilists here. The mercantilists liked exports because they helped to increase employment. Smith likes imports because they can help to save on labour costs.)

Smith argued in opposition to the “mercantile system”, as he put it. As we saw in Chapter 1 on Jean-Baptiste Colbert, some mercantilists argued that the ultimate economic objective was a positive trade balance (ie, where exports exceeded imports). But what Smith is arguing here is that imports can be a good thing. He reserved particular scorn for Colbert. “Mr. Colbert… notwithstanding his great abilities, seems… to have been imposed upon by the sophistry of merchants and manufacturers” who demanded protection from foreign competitors. As well as being economically inefficient, the mercantile system was cosy and corrupt, working to the benefit of a few.

In general, Smith reasoned, trade allows for a more developed and bigger market, which encourages a deeper division of labour. It also allowed domestic producers to focus on activities at which they were more productive. To drive home his argument that free trade held many advantages, Smith explored the idea of making wine in Scotland. “By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland,” he reckoned, perhaps a little optimistically, “and very good wine too can be made of them.” But, he went on, that would be achieved “at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland?”¹⁹

Smith’s views on trade are popularly understood to have been revolutionary. By the 1780s he was almost certainly the most cited political economist in the world, overtaking Sir William Petty in the early 1780s.²⁰ Yet was Smith’s thought as novel as his almost instant celebrity suggests?

The first problem is that he seems to have exaggerated the damage done by the so-called “mercantile” system in order to make his argument seem fresher and more devastating. Data from the Bank of England suggest that in the century before the publication of the Wealth of Nations the value of imports to Britain had more than doubled in real terms. Meanwhile, Richard Grassby, a historian, suggests that the rate of profit had probably been falling over roughly the same period. In other words, businesses were making worse and worse returns on their investments. So was British society really afflicted with as much protectionism and cronyism as Smith made out? Donald Coleman puts it eloquently: “How was it that of all periods in the history of England that which, according to Smith, had seen this deplorable mercantile system come into being… had also seen a substantial increase in the ‘annual produce of the land and labour of England’… so much so that he could call it ‘the happiest and most fortunate period of them all’?” Reading Smith, it may seem as though he is proposing a radical rupture from the status quo. But the status quo may have been closer to Smith’s preferred system than he would like to admit.

Historians have also exaggerated Smith’s influence on economic debates. The intellectual tide had turned in favour of freer trade before Smith was writing, not after. Henry Martyn’s Considerations of the East India Trade (1701) very clearly stipulated that imports as well as exports could be good for the economy.²¹ From the 1740s onwards, a steady stream of pamphlets in Britain attacked the Corn Laws on the grounds that they raised the price of food for the poor (which they did). Smith was a big part of the debate, but to see it as originating with him is misleading, argues Salim Rashid. The writings of economists like Josiah Tucker and Sir Matthew Decker had tried to push public opinion in favour of free trade long before Smith published his magnum opus.²² As Rashid points out, eight years after the Wealth of Nations had been published John Adams, the second American president, singled out Tucker and François Quesnay (see Chapter 5) as the primary advocates of free trade–not Smith. On Smith’s death in 1790 the Times noted that “Dr Smith’s system of political oeconomy is not essentially different from that of Count Verri,²³ Dean Tucker,²⁴ and Mr Hume.” Smith’s writings on the subject tapped into the spirit of the times, but was he proposing something completely revolutionary?

In any case, Smith was not a free-trade purist. This is clear when one reads his discussion of the Navigation Acts, regulations that among other things ensured that English ships had a monopoly on English trade. From an economic perspective this was a highly inefficient arrangement: surely whichever country’s ships could carry goods most cheaply should be allowed to do so. Yet Smith was in favour of the Navigation Acts. He did of course recognise that their effect was damaging in economic terms. However, for an island nation constantly under threat from its European rivals, having a good supply of ships to hand was essential. And Smith believed that “Defence [was] of much more importance than opulence.” It was therefore necessary to protect their trade, no matter its short-term economic costs.

Linen shirts and leather shoes

So was Smith bereft of any original ideas at all? Far from it. One of his lesser-known but genuinely original contributions concerns our understanding of what it means to be poor. For generations a debate has raged about whether poverty is an absolute or a relative condition. Some people say that anyone who cannot afford to eat properly is absolutely poor. Kinder souls might argue that anyone with less than, say, £400 a week might be considered so. Others maintain that it’s purely a question of how others in society are doing. Perhaps the bottom 10% of the population should always be considered poor.

Roughly speaking, people on the right of the political spectrum prefer absolute measures. That’s because they tend to show improvements over time. Those on the left, however, prefer relative measures. These show smaller improvements because the poverty threshold rises as living standards rise.²⁵ (This debate will no doubt rumble on for ever.)

Smith, however, took a somewhat different approach. Rather than viewing poverty as either a relative or an absolute concept he said that it was both. At first glance this seems impossible. But it is not. To make his point, he refers to two different items of clothing: leather shoes and linen shirts. In the Wealth of Nations Smith says that

[a] linen shirt… is, strictly speaking, not a necessary of life. The Greeks and Romans lived, I suppose, very comfortably, though they had no linen. But in the present times, through the greater part of Europe, a creditable day-laborer would be ashamed to appear in publick without a linen shirt… Custom, in the same manner, has rendered leather shoes a necessary of life in England.

This quotation is significant, and has been much analysed by contemporary economists, in particular Amartya Sen. Smith says that poverty is relative, insofar as what is considered to be inadequate is liable to change over time. Europeans living in the 18th century thought that a linen shirt was an indispensable item of clothing. The Romans and Greeks did not. But at the same time he says that poverty is absolute. The experience of not having a linen shirt in the 18th century was a shameful one–and shame is an absolute experience. In plain English, you are not ashamed relative to someone else; you are simply ashamed. (Just as with the notion of the impartial spectator, Smith emphasises the impact of social judgement on people’s lives.)

This is an important distinction. People who disagree with the notion of relative poverty may say, for instance, that no one in Europe is “really poor” since their standard of living is much higher than it is in poor countries. Yet some Europeans’ relatively inferior position can land them in an absolutely worse one too, since they may be deprived of some basic opportunities of material wellbeing. Perhaps they might be ashamed, as in the example of the linen shirts and leather shoes. Or, if they do not have access to the internet they may end up excluded from political debate (again, an absolute condition; they are not “relatively excluded”, they are simply excluded). For that notion of poverty, which is now generally accepted among people who study poverty, Smith offers genuine insights.

An enlightened life

Smith, then, is a more complex figure than he might have seemed at first glance. To be sure, he had some novel ideas–but in some respects he is not quite the trailblazer he is commonly portrayed as. It is absolutely clear that economics did not “start with” Smith. So why, then, is he seen by both economists and the general public as a figure without equal?

Part of Smith’s attraction is the mythology that surrounds him. His life and his works, in particular the Wealth of Nations, have an air of momentousness about them. That work, published in a year of revolution, is in five books and over 350,000 words of dense prose. And just as with Marx’s Capital (1867), many people (including Margaret Thatcher) have a deeply emotional relationship with the Wealth of Nations. Even if they do not actually read it, they see it as a bible of sorts. Within it, somehow, somewhere, lie the secrets of capitalism.

Another explanation for Smith’s success lies in his writing. To be fair, he is often difficult to read. The sentences are sometimes impenetrable and he uses too many commas (way too many commas). But he also has a knack for brilliant phrases. Just look at the eloquence of the “butcher, baker” passage or the playfulness of the discussion of Scottish wine. What modern economist would quote from Macbeth? Smith studied rhetoric closely–indeed, he delivered a lecture, “Rhetoric and Belles Lettres”–and employed these techniques to convince the reader of his arguments. Even some of Smith’s biggest fans, including Jacob Viner, call him (somewhat exaggeratedly) a “propagandist”, so persuasively did he write. We have already seen, in the case of David Hume, that Smith was liable to ignore cautious theories, perhaps because they did not give his prose enough oomph.

Yet all this is not to argue in favour of dismissing Smith as all style and no substance. Joseph Schumpeter definitely overstates the case when he asserts that “the fact is that the Wealth of Nations does not contain a single analytic idea, principle, or method that was entirely new in 1776… it cannot rank with Newton’s Principia or Darwin’s Origin as an intellectual achievement”. Smith made important contributions towards a non-religious understanding of morality. His ideas about the structure of the economy are clearly and convincingly formulated. He had an important political role, too, galvanising opposition to the most heavy-handed and destructive forms of government intervention and support for free trade. That counts for a lot. Knowing about Smith is essential, even if he may not be as much of a genius as some people believe.

²⁵