What Would Smith Say?
The financial meltdown, through the eyes of the father of capitalism
In the middle of the nineteenth century, Robert Owen, a British mill operator who sought to overturn the nascent capitalist system, found his collectivist schemes crumbling. He turned for support to the dead, proclaiming that he had the backing of Benjamin Franklin, Thomas Jefferson, Shakespeare, Shelley, Napoleon, the Duke of Wellington, and the prophet Daniel — not to mention the dearly departed Duke of Kent, whom Owen complimented for never being late for a seance.
Owen was an important figure in the development of anti-capitalist sentiment. Marx and Engels were among his early fans. The fact that he was actually a capitalist is not as peculiar as it might seem; so was Engels. Many capitalists have claimed to be exceptional in being motivated by more than the desire to make money, elevating themselves by impugning the motives and short-sightedness of their competitors, and in the process supporting the claim that capitalism is a system based on greed and exploitation. This demonic characterization would perhaps surprise Adam Smith, the kindly eighteenth-century bachelor frequently dubbed “the father of capitalism.” His great book, An Inquiry into the Nature and Causes of the Wealth of Nations, is widely regarded as the seminal work on economics, his master metaphor the market- guiding “invisible hand.”
If you go to the museum in Smith’s birthplace of Kirkcaldy, Scotland, which lies across the Firth of Forth from Edinburgh, you will find displayed, in the inconspicuous nook devoted to him, a quote from the economist John Kenneth Galbraith. “With Das Kapital and the Bible,” it says, “The Wealth of Nations enjoys the distinction of being one of the three books to which people may refer at will without feeling they should read it…There is so much in the book that every reader has full opportunity for exercise of his own preference.” Galbraith, who rejected Smith’s market-oriented world in almost every way, was on this point gallingly correct.
As an iconic figure, Smith tends to be as much channelled as quoted. His ideas are often twisted, much as Owen mangled Shakespeare and Jefferson. Even his fans are guilty of the charge. For example, Smith made only one reference, itself tangential, to the invisible hand in The Wealth of Nations. It was later free-market enthusiasts who embraced and glossed the term.
In the wake of the international credit crisis, Smith has often been recalled either as the face of a system that doesn’t work, or as a fan of more extensive government regulation. On one side, for instance, a headline in BusinessWeek last October read, “Forget Adam Smith, Whatever Works.” On the other, disgraced New York governor Eliot Spitzer — who, as the state’s attorney general, had been the grand moralizing scourge of Wall Street — wrote, in a self-exculpating piece in the Washington Post, “Those who truly understand economics, as did Adam Smith, do not preach an absence of government participation. A market doesn’t exist in a vacuum. Rather, a market is a product of laws, rules and enforcement. It needs transparency, capital requirements and fidelity to fiduciary duty. The alternative, as we are seeing, is anarchy.”
Canada’s finance minister, Jim Flaherty, took a more nuanced approach when he wrote in the Financial Times, “The open market system did not fail in this crisis. However, some forgot Adam Smith’s maxim that the invisible hand needs to be supported by an appropriate legal and regulatory framework.” But what does “appropriate” mean? And is the present crisis the result of market anarchy, or of counterproductive regulations pursued by grandstanding and often-hypocritical politicians such as Spitzer? There’s the rub.
Will the real Smith please stand up?
Adam Smith was born in 1723, less than two decades after Scotland entered into commercial and political union with England. Smith’s father, who died before his birth, was a prominent lawyer and public official. Smith had an extended education, even by today’s standards, first at the University of Glasgow and then at Oxford, where he spent six unhappy years. He returned to Edinburgh to begin the life of a public intellectual, and was soon appointed to a professorship at the University of Glasgow; he taught there for thirteen years. In 1759, he published a well-received book, The Theory of Moral Sentiments, which led him to a three-year tutorship of the Duke of Buccleuch. The position came with a life pension, enabling Smith to return to his mother’s house in Kirkcaldy to work on his magnum opus. When it was published in 1776, it made his name.
The Wealth of Nations is long and discursive, and promotes the critical, controversial, and counterintuitive view that the pursuit of commercial self-interest without government interference yields the greatest improvements in the general welfare. “It is not,” he famously wrote, “from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” Smith wasn’t suggesting that butchers, brewers, and bakers lacked the milk of human kindness, or a sense of family or community. It was just that we should recognize that arm’s-length commercial exchange benefits all participants, and that enormous good is done by allowing self-interest free rein under the rule of law.
Two human tendencies — to trade and to specialize — serve as the engines of productivity growth in Smith’s system. He used the famous example of the pin factory to demonstrate how specialization within an organization could also enormously boost output. A single unskilled worker, he pointed out, would have trouble making a single dress pin in a day, but ten people coordinating their activities with fairly rudimentary equipment could produce 48,000. Widespread and free trade was desirable, he argued, because larger markets spurred specialization and thus further productivity increases, although he expressed concern about the mind-numbing work to which the division of labour might lead.
Smith became an important voice in the debates of the day, greatly influencing the policy climate that facilitated the Industrial Revolution, which was just taking off when he published his great book (James Watt, whose refinements of the steam engine led to the Industrial Revolution’s big bang, was a young instrument maker and acquaintance of Smith’s at the University of Glasgow). Smith also sympathized with the rebellious American colonists, stressing the excessive cost of controlling North America rather than simply trading freely with it.
His concerns about colonial policy reflected a more general skepticism about the character of politicians and the competence of governments. Above all, he considered it a mistake to imagine that governments could promote economic growth or compensate for the alleged shortcomings of the market, which represented a complex natural order. Such an authority, he noted, “would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.”
But folly and presumption die hard.
If Adam Smith were brought back to life today, he would not likely regard current economic problems as worthy of the greatest attention. He would find it perhaps far more astonishing that tens of millions had died in the previous century at the hands of regimes whose primary justification was the alleged evils of the Smithian system. Moreover, he might note that the term “capitalism” (which he never actually heard) appeared to be unpopular even in the countries that had flourished under it. This was largely because its image had been crafted by its enemies, as some of Smith’s most brilliant successors had pointed out. Joseph Schumpeter, for example, wrote that “capitalism stands its trial before judges who have the sentence of death in their pockets.” Friedrich Hayek also noted that the trial was rigged. “With its modern connotations,” he wrote, “[capitalism] is itself largely a creation of [the] socialist interpretation of economic history.”
But socialism wasn’t capitalism’s only enemy. Where markets had bloomed, they had tended to promote one-person/ one-vote systems of representative democracy (inconceivable in Smith’s day). Smith had noted the self-interested nature of businessmen, but believed that competition would prevent them from excess. Yet democratic governments had constructed a huge edifice of rules and regulations whose fundamental assumption was that the invisible hand was feckless and potentially dangerous. Their guiding principles were that workers would be exploited, consumers would be ripped off or poisoned, organizations would grow dangerously large, and that the natural world would be despoiled by capitalist “greed.”
Smith would no doubt find it astonishing that the fruits of the market system seemed to be so taken for granted. In The Wealth of Nations, he pointed to the stunning market coordination reflected in the most basic commercial items. A simple woollen coat, he observed, “as coarse and rough as it may appear, is the produce of the joint labour of a great multitude of workmen.” He concluded that “without the assistance and co-operation of many thousands the very meanest person in a civilized country could not be provided, even according to what we very falsely imagine the very easy and simple manner in which he is commonly accommodated.”
What would Smith think of the infinitely more complex specialization and co-operation involved in producing automobiles, jet aircraft, telecommunications, computers, or modern pharmaceutical products? What would he think of the absorption of his butcher, brewer, and baker into “supermarkets” that sported literally tens of thousands of products from all over the globe? Hadn’t we noticed, he might ask, just how sensationally rich we were compared with the benighted eighteenth- century denizens of Kirkcaldy, whose oatmeal-fed lives tended to be nasty, brutish, and short? If we wanted some perspective, Smith might suggest, what about starting there?
I asked Scots-born Harvard historian Niall Ferguson, an academic superstar whose recent book, The Ascent of Money, puts the current crisis in long-term historical perspective, what Smith might think of the state of the world. “If we imagine Adam Smith joining us now,” said Ferguson during a visit to Toronto, “he would say, ‘Well, it’s just as I said: the division of labour and comparative advantage [i.e., international trade] have generated extraordinary wealth. I’m not surprised to find opulence in a place that, when I lived, was a barren wasteland. But I’m also not surprised to find that the problems I identified in The Wealth of Nations have persisted. Governments continue to distort and disrupt the invisible hand’s work. Imperial policies still get pushed as they were in the eighteenth century, and there are still — even more so than in the eighteenth century — all kinds of parasitical groups who are a dead weight on the economy.’”
We need reminding that economic growth and improvements in general welfare were virtually unknown until the Industrial Revolution, which has increased per capita income in the West (and Japan) by factors of twenty or more. By every objective measure, from life expectancy through food availability, infant mortality, literacy, and access to consumer goods, the lot of humans in capitalist systems has improved, even if — as Ferguson points out — the path has been far from smooth. Why, Smith might ask, would we fret about a mere growth slowdown, or temporary contraction, in enormously rich economies?
Turning his eye to these troubles, Adam Smith would see culpable imprudence on the part of giant financial institutions. He was concerned about potential problems with the separation of management and ownership. He wrote of the directors of limited-liability companies that “being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own…Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”
Despite Smith’s skepticism, public companies have been largely successful as drivers of economic growth. Nevertheless, some see the roots of the present Wall Street debacle in the decision by giant investment banking partnerships to go public. For example, Michael Lewis, author of the Wall Street exposé Liar’s Poker, recently wrote, “The shareholders who financed the risks had no real understanding of what the risk takers were doing…No investment bank owned by its employees would have levered itself 35 to 1” (i.e., loaded itself with debt thirty-five times its owners’ capital). Lewis was pointing out, in an echo of Smith, that when executives began working with shareholders’ money, they lost their motivation for vigilance.
Whatever Smith’s reservations about the structures of private enterprise (and he would surely think potential conflicts should be the concern of any enterprise’s owners, not the government), however, he would have been more concerned about the dangers of co-operation between the public and private sectors. He had studied the eighteenth century’s most significant example of such folly, the Mississippi Scheme, which was hatched by a Scots adventurer named John Law. Law partnered with the French government to combine monetary expansion with massive stock promotion as a way of boosting the economy. The resulting bubble proved disastrous for France. Smith would similarly find the clumsy and visible hand of government monetary manipulation and economic management all over the current crisis. Monetary systems today are everywhere based on government-created fiat money (whose value is based solely on the judgment of the state — as opposed to in Smith’s day, when paper money was backed by gold). The great danger of such control is that governments will simply debauch the currency, either via the printing press (as in Zimbabwe right now), or by promoting “credit expansion” by artificially lowering interest rates, widely acknowledged as one of the roots of the present problems.
Our present woes, Smith would discover, were also promoted partly by China’s policy of holding down its exchange rate to boost exports, which led to a huge trade surplus that was invested in the US, thus promoting excessive American borrowing. (This was the exact kind of mercantilist measure he opposed.) Then there were US policies that pressured bankers and mortgage companies to make sub-prime loans to the disadvantaged. Key to this suicidal exercise were two “government-sponsored enterprises” known as Fannie Mae and Freddie Mac. The mortgage dross they supported was bundled, sliced up, and sold off around the world as collateralized debt obligations to investors who took comfort in credit ratings inflated by the assumption that the government would cover any defaults and salvage any foundering giant institution (which it has indeed done, at huge taxpayer cost). The collapse of the US housing market led to a wave of defaults, which in turn undermined those elaborately sliced-and-diced cdos and other exotic instruments peddled and/or held by financial institutions, which caused massive credit contraction. The real problem was surely all those government-sponsored pigs in elaborately concocted pokes.
Was this the end of capitalism, or of governments’ anti- Smithian belief that they should, and could, fine-tune markets and promote system-wide economic security? The idea that governments could stimulate economic activity by spending taxpayers’ or lenders’ money might strike Smith as a con job on a par with the Mississippi Scheme. He would recognize calls for bailouts as typical mercantilist special pleading, and point out that indulging them could only sap the economy in the longer term.
The notion that the very presumption of attempting to regulate markets comprehensively might be the root of the problem was beyond the thinking of most people, and in particular of the individual referred to by Smith as “that insidious and crafty animal, vulgarly called a statesman or politician, whose councils are directed by the momentary fluctuations of affairs.”
Capitalism’s political opponents, meanwhile, continue to probe for flaws and market failures to justify greater government control. One such area is the threat of manmade climate change, now accepted as fact by virtually every government on earth. Adam Smith had a rather intriguing connection to carbon dioxide: the substance was first identified and studied by his close friend and dining partner, the scientist Joseph Black. Now its release is said to be threatening life on earth, and demanding yet more government action. Among Smith’s philosophical works is a treatise on astronomy noting that scientific theories are designed to cater to our desire for simple explanations, and are always and inevitably provisional. He would thus treat with the greatest suspicion pervasive claims that climate change science was settled, and would be troubled by the extension of government controls to address it.
The world has changed greatly since Smith’s day, but his principles remain intact because they are rooted in human nature, which has not changed a whit, particularly when it comes to the urge to power. Some suggest that Smith has been made redundant by stunning technological and institutional advances he could not possibly have foreseen. But complexity, if anything, bolsters his argument about the fundamental inability of governments to enhance the free economy, except by protecting property rights and guarding their citizens from real, tangible threats.
Robert Owen’s grandiose, socialistic schemes typically ended in disaster, including a model community in New Harmony, Indiana, that collapsed after a couple of years. Strangely, though, perhaps the most spectacular preserved site of the British Industrial Revolution — the mills at New Lanark, Scotland, which Owen took over from his future fatherin- law — is dedicated to Owen’s garbled good intentions. By contrast, it was only last year, after two centuries of neglect, that a significant statue of Adam Smith was finally raised in Edinburgh, and it went up by private subscription. At the Kirkcaldy museum, meanwhile, there is another quote, from an essay collection titled A Hotbed of Genius. “Smith,” it says, “is often misrepresented as an uncritical advocate of a free economy. In fact, he believed that the government should be responsible for major public works…he warned against the evils of industrialization.”
While it stresses Smith’s qualms about free markets and industrialization, this government-run museum makes no reference to his much greater reservations about government. Channelling Adam Smith continues to be a contentious business.