Smith did not invent economics. Joseph Schumpeter observed that “The Wealth of the Nations” did not contain “a single analytic idea, principle or method that was entirely new”. Smith’s achievement was to combine an encyclopaedic variety of insight, information and anecdote, and to distil from it a revolutionary doctrine. The resulting masterpiece is the most influential book about economics ever published. Remarkably, much of it speaks directly to questions that are still of pressing concern.
The pity is that Smith’s great book, like most classics (of 900 pages), is more quoted than read. All sides in today’s debates about economic policy have conspired to peddle a conveniently distorted version of its idea. If his spirit is still monitoring events, it will undoubtedly have celebrated the collapse of communism. But it must also long to meet the politicians who have taken charge of a fine reputation and not so fine profile. And put them right on one or two points.
Today Smith is widely seen as intellectual champion of self-interest. This is a misconception. Smith saw no moral virtue in selfishness; on the contrary he saw its dangers. Still less was he a defender of capital over labour (he talked of the capitalist’s “mean rapacity”), of the rising bourgeoisie over the common folk. His suspicion of self-interest and his regard for the people as a whole come through clearly in one of his best-known remarks: “People of the same trade often meet together, even have merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Far from praising self-interest as a virtue, Smith merely observed it to be a driving economic force. In “The Wealth of Nations” he explained how this potentially destructive impulse is harnessed to the social good. What is to prevent greedy producers raising their prices until their customers can afford to pay no more? The answer is competition. If producers raise their prices too high, they create an opportunity for one or more among them to profit by charging less and thus selling more. In this way competition tames selfishness and regulates prices and quality. At the same time it regulates quantities. If buyers want more bread and less cheese, their demand enables bakers to charge more and obliges cheese-mongers to charge less. Profits in bread-making would rise and profits in cheese-making would fall; effort and capital would move from one task to the other.
Through Smith’s eyes, it is possible to marvel afresh at this fabulously powerful mechanism and to relish, as he did, the paradox of private gain yielding social good. Only more so, for the transactions that deliver a modern manufactured good to its customer are infinitely more complicated than those described by Smith. In his day, remember, the factory was still a novel idea: manufacturing meant pins and coats.
Amodern car is made of raw materials that have been gathered from all over the world, combined into thousands of intermediate products, sub-assembled by scores of separate enterprises. The consumer need know nothing of all this, any more than the worker who tapped the rubber for the tyres knows or cares what its final use will be. Every transaction is voluntary. Self-interest and competition silently process staggering quantities of information and direct the flow of good. Services, capital and labour– just as in Smith’s much simpler world. Far-sighted as he was, he would surely have been impressed. Mind you, modern man has also discovered something else. With great effort and ingenuity, and the systematic denial of personal liberty, governments can supplant self-interest and competition, and replace the invisible hand of market forces with collective endeavour and a visible input-output table. The result is a five-year waiting list for Trabants.
Because Smith was convinced that the market would, literally, deliver the goods, he wanted it, by and large, left alone. He said that governments should confine themselves to three main tasks: defending the people from the “violence and invasion of other independent societies”; protecting every member of society from the “injustice or oppression of every other member of it”; and providing “certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain.” Each of these jobs arises because the market in some ways fails. In the first two cases collective defence and the administration of justice– the failure is the so-called free-rider problem. People disguise what they are willing to pay for a service that must be provided to everybody or not at all; they want to consume it and let others meet the cost. However the third job– the provision of “certain public works and certain public institutions”– goes much wider. Indeed, to modern minds, it threatens to be all encompassing. It recognizes not only the free-rider problem but also other species of market failure notably, the effects of private transactions on third parties, or “externalities”. Smith has in mind roads, public education, and help for the destitute. As it turned out, millions of teachers, nurses, firemen, postmen, rubbish collectors, bus drivers and 57,000 varieties of civil servant have since marched through this opening.
Smith’s thinking already seems to permit a great deal of government intervention. Add some modern economics and the floodgates open. For instance, theorists have shown that if just one price in an economy is different from price under competition, efficiency may require other every price to be somewhat distorted as well. Less government intervention, it seems to follow, cannot be assumed to be better. Competition itself has changed out of recognition. Modern economies, it is said, are driven not by countless small producers, but by handful of giant enterprises and monopolistic trade unions. And the rapid pace of industrial change has made the externality of pollution far more obvious than before. Smith, admittedly, is a bit thin on global warming.
Above all, many have forgotten something that Smith saw clearly: that every advantage granted by government to one part of the economy puts the rest at a disadvantage.
Accordingly, he talked not of “intervention” at a too-neutral word-but of “preference” and “restraint”. Modern governments offer preference as though it costs nothing: the beneficiaries demand it as of right.
But Smith went further than revealing the penalty in every preference. He also understood that ministers, like markets, fail. A great virtue of unfettered competition, he said, was that “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.” Many of the reasons why markets fail are also reasons why governments fail at the same task. If the consumer refuses to reveal his preferences in a market setting, how are governments to discover them? All too often, moreover, government intervention is itself a cause of the market breaking down which becomes the reason for further rounds of intervention, and so on. In Britain think of tax preferences for housing, rent controls, planning, regulations; American think of tax preferences for borrowing, deposit insurance, leverage buy-outs, financial-market regulation. In one crucial respect, Smith’s arguments are even more powerful now than in his day. Naturally, he favoured free trade to prevent market failure: “By means of glasses, hothbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them 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?” Two centuries later, free trade is not just a matter of the cheapest supply; it is also the best way to force producers that might otherwise be near-monopolies to compete. It is perfect folly to complain that today’s big companies render the invisible hand powerless, and to conclude that barriers to trade must go up: trade and competition need each other more than ever before.
Smith was a pragmatist. The principles he expounded on the proper role of government are flexible if anything, too flexible. They are a remainder that imperfect markets are usually cleverer than imperfect governments, but they cannot draw a line to separate good intervention from bad. If governments and voters could be guided by two Smithian precepts, however, the market system that has worked so well would work even better.
First, the competitive clash of self interest against self-interest, however imperfect, has built-in safeguards. Before governments exert their monopoly power to displace it, they must justify themselves. Let the burden of proof always be on them. Second, when preference or restraint are judged to be necessary, use market forces to apply them. Tariffs are better than quotas; taxes are better than bans or direct controls; allocating resources by price (e.g. in health or education) is better than allocating them by fiat, even if the services are then provided “free” (but never forget those inverted commas) to their consumers.