ADAM SMITH’S CASE FOR FREE TRADE
ANY COMPARISON of the economics literature in the decades before and after the publication of Adam Smith’s Wealth of Nations in 1776 reveals a sharp break in the treatment of commercial policy. Although “all the important elements in Smith’s free-trade doctrine had been presented prior to the Wealth of Nations,” Jacob Viner (1937, 108) rightly notes that “these were often, however, to be found only in isolated passages not wholly consistent with the views expounded in the surrounding text.” While drawing upon the work of others, Smith created such a compelling and complete case for free trade that commercial policy could no longer be seriously discussed without contending with his views, and herein lies one of Smith’s foremost contributions to economics. That “the Wealth of Nations does not contain a single analytic idea, principle, or method that was entirely new in 1776,” as Joseph Schumpeter (1954, 184) put it, is less important than what Andrew Skinner (1990, 157) has described as “the presence of system; the fact that Smith gave political economy a distinctive analytical shape which was a dramatic step forward.” Smith achieved what others before him had failed to do: present a systematic, coherent framework for thinking about the economics of trade policy.1
Early evidence of Smith’s support of free trade comes from compilations of his lectures at Glasgow University in the 1760s. Smith (1978, 391–92) stated that all countries engaged in trade benefited from such exchange and he repeated the cosmopolitan viewpoint prevailing among intellectuals: “All these national jealousy(s) which prompt them to spite and ill-will each other, and refuse to be supplied by them in any convenience of life, must lessen the exchange of commodities, hurt the division of labour, and diminish the opulence of both.” Smith unequivocally supported free trade and concluded that “it appears that Britain should by all means be made a free port, that there should be no interruptions of any kind made to foreign trade, that if it were possible to defray the expences of government by any other method, all duties, customs, and excise should be abolished, and that free commerce and liberty of exchange should be allowed with all nations and for all things” (268).2
But the cursory discussion of trade in these lectures was just a sketch of what was to come. The economic analysis of commercial policy was fundamentally changed with the publication of An Inquiry into the Nature and Causes of the Wealth of Nations on March 9, 1776. Smith’s discussion of trade policy is concentrated in Book IV, “Of Systems of Political Oeconomy.”3 Smith first described “the great object” of mercantilist policies as “to diminish as much as possible the importation of foreign goods for home consumption, and to increase as much as possible the exportation of the produce of domestic industry. Its two great engines for enriching the country, therefore, were restraints upon importation, and encouragements to exportation” (IV.i.35, 45). Smith then set out to “examine chiefly what are likely to be the effects of [such policies] upon the annual produce of [a country’s] industry,” because “according as they tend either to increase or diminish the value of this annual produce, they must evidently tend either to increase or diminish the real wealth and revenue of the country.” In other words, Smith set up a specific criterion to evaluate the effects of various commercial policies in a consistent way. In assessing such policies, Smith argued that one must examine the economy-wide impact of such a policy on the real value of a country’s national income (or output), or what he called the real annual revenue of society (or produce).4 Simply by stating and then consistently applying this standard, Smith had already established a seminal contribution to the theory of commercial policy: no longer was it sufficient to conclude that an import tariff was beneficial simply because employment and output increased in the sector receiving such protection.
Smith first considered protection of domestic industries from foreign competition, or “restraints upon the importation from foreign countries of such goods as can be produced at home.” He contends that high duties or prohibitions on imports diminished competition and gave domestic producers a monopoly of the home market, enabling them to charge higher prices and leading to sloth and mismanagement. Agreeing with mercantilists that a tariff would expand domestic output in the import-competing sector, Smith posed a more penetrating consideration rarely raised by earlier writers:
That this monopoly of the home-market frequently gives great encouragement to that particular species of industry which enjoys it, and frequently turns toward that employment a greater share of both the labour and stock of the society than would otherwise have gone to it, cannot be doubted. But whether it tends either to increase that general industry of the society, or to give it the most advantageous direction, is not, perhaps, altogether so evident. (IV.ii.2)
To evaluate the impact of trade restrictions on real income, one needed a way of thinking about how real income was determined. To address this point, Smith clarified the philosophical underpinnings of his views of commerce and the economic interactions of individuals in the marketplace. Smith started with the proposition that individuals always direct their labor to their best possible advantage; that is, they “endeavour to employ it in the support of that industry of which the produce is likely to be of the greatest value, or to exchange for the greatest quantity either of money or of other goods” (IV.ii.8). “Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society” (IV.ii.4). This led to Smith’s classic statement:
As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. 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. (IV.ii.9)
That self-interested individuals perform a beneficial service to society had, of course, been noted early on by the Greeks and scholastics, who contended that profit-seeking merchants in carrying grain from low to high price regions transported it from abundant to scarce markets to the general benefit, and among his contemporaries, as indicated in the previous chapter. Smith made this point the cornerstone of his economic framework. With clarity and persuasiveness he maintained that the natural liberty of individuals interacting in the economic realm, each seeking their own betterment by providing goods and services to others, would lead to an efficient allocation of resources from the standpoint of society; the wants and desires of individuals would be met, if it was profitable to do so, and the annual revenue of society (real national income) would be raised to its highest level. Both for this reason, and because respect for the natural liberty of citizens dictated it, the competitive market (rather than the government) was the best mechanism for determining profitable lines of activities and allocating resources to those ends.
Although Smith did not envision much of a role for government in directing market processes or in dictating market outcomes, he was far from a full-fledged adherent to the laissez-faire doctrine. Smith believed that government did have an important role in supporting the market mechanism as a social institution.5 He outlined many circumstances in which government policies, such as the provision of certain public goods and the establishment of a system of law and justice, could allow the “invisible hand” of the market to operate more effectively. Thus, unlike what some critics would later charge, Smith’s case for free trade did not rest upon the case for laissez-faire. At the same time, the existence of circumstances in which there might be a productive role for government policy did not justify or necessitate any departures from free international trade.
In this general context, Smith argued forcefully that the key concept in assessing economic policy is the notion of opportunity costs, or the trade-offs between alternative activities under resource constraints. Stated simply, because the amount of capital and labor was fixed in an economy at any given point in time, increasing the output in one sector could only come at the cost of using resources already employed elsewhere in the economy. This had clear and immediate implications for policies that aimed to promote certain industries or sectors. “No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain,” Smith wrote (IV.ii.3). “It can only divert a part of it into a direction into which it might not otherwise have gone; and it is by no means certain that this artificial direction is likely to be more advantageous to the society than that into which it would have gone of its own accord.” This fundamental principle of Smith’s work departed entirely from mercantilist doctrine which implicitly held that government interference could either produce a more desirable mix of output than the free market, or produce a greater volume of total output, or both.
Thus far Smith’s reasoning was not based on any particularly new ideas about trade, but rather was derived from a different conception of the economic organization of society and the role of natural liberty in promoting national wealth. Finally, Smith linked these ideas to commercial policy:
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, employed in a way in which we have some advantage. . . . It is certainly not employed to the greatest advantage, when it is thus directed towards an object which it can buy cheaper than it can make. The value of its annual produce is certainly more or less diminished, when it is thus turned away from producing commodities evidently of more value than the commodity which it is directed to produce. According to the supposition, that commodity could be purchased from foreign countries cheaper than it can be made at home. It could, therefore, have been purchased with a part only of the commodities, or, what is the same thing, with a part only of the price of the commodities, which the industry employed by an equal capital, would have produced at home, had it been left to follow its natural course. The industry of the country, therefore, is thus turned away from a more, to a less advantageous employment, and the exchangeable value of its annual produce, instead of being increased, according to the intention of the lawgiver, must necessarily be diminished by every such regulation. (IV.ii.12)
This is a powerful and bold conclusion. Employing the concept of opportunity cost in terms of national income, Smith asserted with unwavering confidence that free trade permits the best allocation of society’s resources and that protective tariffs interfere with this allocation and consequently reduce national income. (Note, however, that Henry Martyn was more explicit about the efficiency of free trade than Smith is in this paragraph.) Furthermore, the statement is backed up by a systematic framework of economic reasoning which, however flawed or subject to qualification, proved (not surprisingly) to be much more compelling than the exceedingly loose statements that characterized much of the mercantilist literature. This particular conclusion about trade policy actually pushed Smith’s logic farther than he previously implied. Earlier he wrote that “it is by no means certain” that government interference “is likely to be more advantageous to the society than that into which it would have gone of its own accord.” But in the context of trade policy he wrote that the annual produce “must necessarily be diminished by every such regulation.” This certitude perhaps came from the demonstrable fact that certain goods could be acquired more cheaply from imports than through domestic production.
Establishing this static notion of economic efficiency was clearly compelling, but it was by no means the sole or even the principal gain from trade, according to Smith. “Between whatever places foreign trade is carried on, they all of them derive two distinct benefits from it.” The first is the exchange of superfluities which “satisfy a part of their wants, and increase their enjoyments.” The second, and more powerful force, was that “by opening a more extensive market for whatever part of the produce of their labour may exceed the home consumption, it encourages them to improve its productive powers, and to augment its annual produce to the utmost, and thereby to increase the real revenue and wealth of the society” (IV.i.31). The division of labor, which Smith emphasized in Book I on “the Causes of Improvement in the Productive Powers of Labour,” spurred productivity improvements such that a given amount of capital and labor could produce more output. This force was particularly potent in the context of international trade. Because “the division of labor is limited by the extent of the market,” free trade widened the extent of the market and permitted a more refined division of labor. In addition, free trade facilitated the exchange of knowledge about new methods of production and new business practices: “Nothing seems more likely to establish this equality of force than that mutual communication of knowledge and of all sorts of improvements which an extensive commerce from all countries to all countries naturally, or rather necessarily, carries along with it” (IV.viii.c.80). The worldwide division of labor brought about by international trade stimulated additional improvements in production that fueled the productivity of domestic labor and capital and thereby advanced the well-being of individuals.
Smith’s exposition of the static gains from free trade and dynamic effects of the division of labor and technology transfer were outstanding for the period in which he was writing. However, critics could argue that tariffs could alter the incentives to accumulate new capital and thus lead to higher output, although they would have to specify precisely the mechanism which would generate this result to make their argument compelling. Smith dismissed the likelihood that growth could increase by pursuing a policy of protection:
The industry of society can augment only in proportion as its capital augments, and its capital can augment only in proportion to what can be gradually saved out of its revenue. But the immediate effect of every such regulation is to diminish its revenue, and what diminishes its revenue, is certainly not very likely to augment its capital faster than it would have augmented of its own accord, had both capital and industry been left to find out their natural employments. (IV.ii.13)
Smith also attacked the balance of trade motive for government interference with trade:
There is no commercial country in Europe of which the approaching ruin has not frequently been foretold by the pretended doctors of this system, from an unfavourable balance of trade. After all the anxiety, however, which they have excited about this, after all the vain attempts of almost all trading nations to turn that balance in their own favour and against their neighbors, it doest not appear that any one nation in Europe has been in any respect impoverished by this cause. Every town and country, on the contrary, in proportion as they have opened their ports to all nations; instead of being ruined by this free trade, as the principles of the commercial system would lead us to expect, have been enriched by it. (IV.iii.c.14)
Smith conceded two cases in which, to his mind, import duties were justifiable. “The first,” he wrote, “is when some particular sort of industry is necessary for the defence of the country” (IV.ii.23). The reason, quite simply, is that “defense . . . is of much more importance than opulence.” This statement implicitly recognizes that national security could be purchased only through the material sacrifice of other desirable goods. By accepting this trade-off in principle, Smith believed that protecting defense-related industries justified tariff protection against import competition, although this constituted a noneconomic argument for tariffs rather than one arising from economic analysis.
The second exception concerned cases in which domestic goods were subject to taxes not levied on foreign goods. Imposing equivalent import duties would then equalize the tax treatment of domestic and foreign goods and, according to Smith,
would not give the monopoly of the home market to domestic industry, nor turn towards a particular employment a greater share of the stock and labour of the country, than what would naturally go to it. It would only hinder any part of what would naturally go to it from being turned away by the tax, into a less natural direction, and would leave the competition between foreign and domestic industry, after the tax, as nearly as possible upon the same footing as before it. (IV.ii.31)
Smith also mentioned two other practical considerations “in which it may sometimes be a matter of deliberation” about how import duties should be eliminated. The first concerned reciprocity, or “when some foreign nation restrains by high duties or prohibitions the importation of some of our manufactures into their country” (IV.ii.38). “Revenge in this case naturally dictates retaliation, and that we should impose the like duties and prohibitions upon the importation of some or all of their manufactures into our,” Smith wrote, adding that “[n]ations, accordingly[,] seldom fail to retaliate in this manner.” But Smith’s own advice was characteristically practical:
There may be a good policy in retaliations of this kind, when there is a probability that they will procure the repeal of the high duties or prohibitions complained of. The recovery of a great foreign market will generally more than compensate the transitory inconveniency of paying dearer during a short time for some sorts of goods. To judge whether such retaliations are likely to produce such an effect, does not, perhaps, belong so much to the science of a legislator, whose deliberations ought to be governed by general principles which are always the same, as to the skill of that insidious and crafty animal, vulgarly called the statesman or politician, whose councils are directed by the momentary fluctuations of affairs. When there is no probability that any such repeal can be procured, it seems a bad method of compensating the injury done to certain classes of our people, to do another injury ourselves, not only to those classes, but to almost all the other classes of them. (IV.ii.39)6
Smith essentially states that reciprocity (temporary retaliation to reduce foreign trade restrictions) is a noneconomic question. If trade policies are interdependent, in the sense that the policies of one country can affect the policies of another, then a tactical issue is introduced that complicates the basic free trade issue. Economic analysis in itself is of little guidance because it cannot indicate the circumstances under which a given retaliatory action will or will not reduce a foreign trade barrier. Smith clearly viewed retaliation as a question of tactics, not of strategy. The fundamental principle was still clear: free trade should be pursued independently of other countries’ policies.
The second “matter of deliberation” concerned the speed of introducing free trade. If lower duties promise to bring about a severe dislocation of domestic labor and capital (which is “much less [a problem] than is commonly imagined”), then “freedom of trade should be restored only by small gradations, with a good deal of reserve and circumspection” (IV.ii.40).
Smith then briefly turned to consider export policies such as bounties or subsidies, scoffing at such artificial efforts to increase exports:
We cannot force foreigners to buy their goods, as we have done our own countrymen. The next best expedient it has been thought, therefore, is to pay them for buying. It is in this manner that the mercantile system proposed to enrich the whole country, and to put money into all our pockets . . . if the bounty did not repay to the merchant what he would otherwise lose upon the price of his goods, his own interest would soon oblige him to employ his stock in another way. . . . The effect of bounties, like that of all the other expedients of the mercantile system, can only be to force the trade of a country into a channel much less advantageous than that in which it would naturally run of its own accord. (IV.v.a.1,3)7
Smith closed out his discussion of trade policy in Book IV of the Wealth of Nations with a broad statement that put his case into perspective. “The laudable motive of all these [mercantilist] regulations,” he declared, “is to extend our own manufactures, not by their own improvement, but by the depression of those of all our neighbours, and by putting an end, as much as possible, to the troublesome competition of such odious and disagreeable rivals.” The problem with mercantilism was not the laudable motive of encouraging economic progress, but the way in which that end was achieved. That motive became distorted by special business interests to the detriment of the national welfare. Smith held that
consumption is the sole end and purpose of all production; and the interests of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer. . . . But in the mercantile system, the interest of the consumer is almost constantly sacrificed to that of the producer; and it seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce. In the restraints upon the importation of all foreign commodities which can come into competition with those of our own growth, or manufacture, the interest of the home-consumer is evidently sacrificed to that of the producer. It is altogether for the benefit of the latter, that the former is obliged to pay that enhancement of price which this monopoly almost always occasions. (IV.viii.48–50)
In a later passage, Smith summed up his case for natural liberty in commerce:
It is thus that every system which endeavours, either, by extraordinary encouragements, to draw towards a particular species of industry a greater share of the capital of the society than what would naturally go to it; or, by extraordinary restraints, to force from a particular species of industry some share of the capital which would otherwise be employed in it; is in reality a great subversion of the great purpose which it means to promote. It retards, instead of accelerating, the progress of the society towards real wealth and greatness; and diminishes, instead of increasing, the real value of the annual produce of its land and labour. All systems either of preference or of restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord. Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of any other man, or order of men. The sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of society. (IV.ix.50–51)
To understand just how sharp a break Smith’s approach was with mercantilist thinking, one also needs to consider what is not in his writings. Smith does not exaggerate the role of trade in the domestic economy.8 He ridiculed barriers to the importation of the luxury goods that mercantilists abhorred.9 Most strikingly, stark judgments about the desirability of a particular commodity composition of trade are absent. The commodity composition of a country’s external trade reflected its stage of economic development and the natural conditions (such as factor endowments) in which it operated.10 Smith took a more balanced position than either the mercantilists, who magnified the importance of manufacturing, or the physiocrats, who embellished the importance of agriculture. In his discussion of the domestic economic relationship between town and country, which exchanged manufactured goods and raw produce with each other, Smith denied that “the gain of the town is the loss of the country.”
The gains of both are mutual and reciprocal, and the division of labour is in this, as in all other cases, advantageous to all the different persons employed in the various occupations into which it is subdivided. . . . The inhabitants of the town and those of the country are mutually the servants of one another. The town is a continual fair or market, to which the inhabitants of the country resort, in order to exchange their rude for manufactured produce. It is this commerce which supplies the inhabitants of the two both with the materials of their work, and the means of their subsistence. The quantity of the finished work which they sell to the inhabitants of the country, necessarily regulates the quantity of the materials and provisions which they buy. Neither their employment nor subsistence, therefore, can augment, but in proportion to the augmentation of the demand from the country for finished work; and this demand can augment only in proportion to the extension of improvement and cultivation. (III.i.1, 4)
Like the town and country, different countries specialize in the export of different goods based on natural advantages that came from their factor endowments and stage of economic development. Countries exporting raw produce did so to their advantage but were not necessarily destined to continue forever in that state as long as stable governance was conducive to freedom and commerce and accumulation, thereby enabling individuals to invest in physical and human capital. This was best achieved not through the artificial contrivance of commercial policy, which merely shuffled resources from one sector to another and which Smith thought distorted incentives and was unlikely to succeed in increasing national wealth. Instead, private individuals seeking to better their condition would naturally engage in the types of activities and improvements that would enrich the economy if only government had the wisdom not to stifle the process.11 Smith’s policy of free trade, therefore, applied to all countries regardless of their state of economic development.
Other writers had stated free trade conclusions before Adam Smith, but none (with the possible exception of Henry Martyn) had provided a firm conceptual framework in which to sustain such a conclusion. In so doing, Smith inflicted substantial damage on mercantilist doctrines and irrevocably changed the economic analysis of commercial policy.
1 For an overview of Smith’s contribution to trade theory in general, including many topics not covered here, such as the vent-for-surplus description of trade, see Arthur Bloomfield (1975).
2 Smith (1978, 534–35) also argued that export taxes were more pernicious than import tariffs because the “motives to industry are diminished” with the former, a contention he did not repeat in the Wealth of Nations.
3 All references will be to the Glasgow Edition of the Works and Correspondence of Adam Smith, edited by R. H. Campbell and A. S. Skinner. Quotations will be referenced using the Glasgow convention of citing the book, chapter, and paragraph in the Wealth of Nations.
4 Thus, Smith’s case for free trade was based on its being in the national economic interest, not on some cosmopolitan ideal as he was later accused by Friedrich List (see chapter 8) and others. As Smith ([1759] 1976, 229) put it in the Theory of Moral Sentiments: “The love of our own country seems not to be derived from the love of mankind. . . . France may contain, perhaps, near three times the number of inhabitants which Great Britain contains. In the great society of mankind, therefore, the prosperity of France should appear to be an object of much greater importance than that of Great Britain. The British subject, however, who, upon that account, should prefer upon all occasions the prosperity of the former to that of the latter country, would not be thought a good citizen of Great Britain. We do not love our country merely as part of the great society of mankind: we love it for its own sake, and independently of any such consideration.”
5 The two classic articles on this theme are by Jacob Viner (1927) and Nathan Rosenberg (1960).
6 “When our neighbours prohibit some manufacture of ours, we generally prohibit, not only the same, for that alone would seldom affect them considerably, but some other manufacture of theirs. This may no doubt give encouragement to some particular class of workmen among ourselves, and by excluding some of their rivals, may enable them to raise their price in the home-market. Those workmen, however, who suffered by our neighbours’ prohibitions will not be benefited by ours.”
7 “Bounties upon the exportation of any home-made commodity are liable, first, to that general objection which may be made to all the different expedients of the mercantile system; the objection of forcing some part of the industry of the country into a channel less advantageous than that in which it would run of its own accord; and, secondly, to the particular objection of forcing it, not only into a channel that is less advantageous, but into one that is actually disadvantageous; the trade which cannot be carried on but by means of a bounty being necessarily a losing trade” (IV.v.a.24).
8 In several places in the Wealth of Nations, Smith ranks domestic trade as being more useful than international trade. But as George Stigler (1976) points out, this is one of Smith’s “proper failures.”
9 “It is the highest impertinence and presumption, therefore, in kings and ministers, to pretend to watch over the oeconomy of private people, and to restrain their expense either by sumptuary laws, or by prohibiting the importation of foreign luxuries. They are themselves always, and without any exception, the greatest spendthrifts in the society. Let them look well after their own expense, and they may safely trust private people with theirs. If their own extravagance does not ruin the state, that of their subjects never will” (II.iii.36).
10 In the words of Hla Myint (1977, 240), who considers Smith’s views on economic development, free trade in developing countries was, for Smith, “a method of bringing out more fully the longer-run productive potentialities of countries provided by an increasing division of labour, capital accumulation and changing supplies of factors of production.”
11 According to Smith, “The uniform, constant, and uninterrupted effort of every man to better his condition, the principle from which publick and national, as well as private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things toward improvement, in spite both of the extravagance of government, and of the greatest errors of administration.” England’s success was in allowing this process to operate unchecked: “When we compare, therefore, the state of a nation at two different periods, and find, that the annual produce of its land and labour is evidently greater at the latter than at the former, that its lands are better cultivated, its manufactures more numerous and more flourishing, and its trade more extensive, we may be assured that its capital must have increased during the interval between those two periods. . . . In the midst of all the exactions of government, this capital has been silently and gradually accumulated by the private frugality and good conduct of individuals, by their universal, continual, and uninterrupted effort to better their own condition. It is this effort, protected by law and allowed by liberty to exert itself in the manner that is most advantageous, which has maintained the progress of England towards opulence and improvement in almost all former times. . . .” (II.iii.31–32, 36)