Some think he called for unfettered capitalism. They’re wrong. Here are 3 lessons from the founder of free markets on how to save capitalism from itself.
Political economists are trained to describe the world as it is. But sometimes events unfolding out the window force us to sit back and imagine the world as it could be.
Looking back on the ten years since the Great Recession, I see mixed signals. US stock markets are at all-time highs, and the unemployment rate is near an all-time low. Yet, the job creation that accompanied this economic recovery has been matched by stagnant or shrinking wages for most Americans. Who’s to blame?
Some politicians point to China and Mexico, talking about currency manipulation and trade deficits, or the effect of cheap migrant labor on the paychecks of American workers. Others point to a system that favors shareholders over workers when it comes to distributing company profit.
Either way, while paychecks aren’t getting bigger for the average American, prices for basic goods like housing and health care are rising. We often hear about corporations abusing their market power by raising prices on essential medicines like insulin.
These trends force us to ask some serious questions. Just how free should our markets be? What role, if any, should government play in protecting us from the downsides of global capitalism?
How free should our markets be? What role, if any, should government play in protecting us from the downsides of capitalism?
These are not new questions. When Adam Smith published The Wealth of Nations in 1776, he was also discontented with the world he saw out the window. Accordingly, he put forward a series of ideas about how society could nurture a market economy that works for everyone.
Voices on both sides of the debate over “big government” remember Smith as the original champion of unfettered capitalism. They remember him wrong.
Here are 3 lessons from the founder of modern political economy that are as relevant now as when Smith first derived them, more than two centuries ago.
Lesson 1: Capitalism for the people.
Smith fought to liberate markets because he believed that the economy should work for all of society, not for the narrow interests of a wealthy few. From his vantage point in eighteenth-century Scotland, this sentiment was quite aspirational.
In 1776, the British people faced private monopolies at every turn. Firms regularly conspired to limit competition between one-another so they could charge consumers inflated prices for inferior products. These monopolies were often sustained by favorable government policies, including those that restricted foreign trade.1 Under the prevailing economic wisdom of mercantilism, it was believed that every imported bottle of French perfume meant fewer jobs and less silver for Britain.
Judging a nation’s wealth by counting the amount of silver amassed in the treasury was a mistake, in Smith’s view. The true measure of wealth, he argued, was whether the common person could consume those goods and services that alleviate their daily stresses and bring them joy.
The true measure of wealth, Smith argued, was whether the common person could consume those goods and services that alleviate their daily stresses and bring joy.
But how to promote a more prosperous society?
Instead of monopolies and trade protectionism, Smith imagined a world of economic liberalism where markets were set free. If firms and nations engaged in open and fair competition with one-another, and if individuals were free to vote with their purse as to who offered the best product at the best price, everyone could be made better off.
Adam Smith on the invisible hand
“…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.”
Common wealth through free markets and individual self-interest, all guided by the invisible hand of the price mechanism. This is the Adam Smith that everyone remembers. But there was another side to his story.
Lesson 2: When it comes to markets, freedom isn’t free.
Smith wrote at great lengths about the dangers that government intervention, however well-intentioned, may pose to economic efficiency. Often, his call for free markets is mistaken for an endorsement of self-regulating markets: Take government out of the way, and let firms be governed by the laws of economic survival.2
Smith trusted individuals. He did not extend that trust to big business.
There is one problem with this laissez faire interpretation. Smith trusted individual consumers. He did not extend that trust to big business.
Adam Smith cautions us about merchants and manufacturers:
“The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens. The proposal of any new law or regulation of commerce which comes from this order, ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.”
Without an attentive society that defends both government and markets from capture by the narrow interests of big business, Smith believed, economic freedom and prosperity would be lost.
While Smith’s project was utopian in its vision for commercial society,3 it was not entirely naïve. He understood that economic competitors could not be expected to regulate the competition. In order to level the playing field and protect capitalism from itself, Smith warned us, society must referee the market game with great care.
Lesson 3: Sometimes the market just ain’t enough.
Smith also understood that self-organizing markets fail in predictable ways. When it comes to investing in the infrastructure and basic services that a prosperous commercial society requires, government intervention is needed.
Smith also understood that self-organizing markets fail in predictable ways.
Accordingly, an entire portion of The Wealth of Nations – Book 5 – is dedicated to the different forms that government intervention should take, and the various taxes required to fund them. These government functions include institutions like national defense, domestic justice, and public education, as well as public works such as roads and bridges. In his preview of Book 5, Smith tells us why markets so often fail in the provision of these public goods.
Adam Smith on market failures
“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 interests of the society. According to the system of natural liberty, the sovereign has only three duties to attend to; three duties of great importance, indeed, but plain and intelligible to common understandings: first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and, thirdly, the duty of erecting and maintaining 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; because the profit could never repay the expense to any individual, or small number of individuals, though it may frequently do much more than repay it to a great society.”
Government should be limited in its intrusions into private life, Smith cautions us. But without public intervention, he goes on, who would invest in those basic goods and services that benefit all of society?
Answers and lingering questions:
The oft-forgotten fact is that even the ‘founding father’ of free markets saw a role for government in defending market freedom:
- Regulate economic competition to prevent excessive profit and the abuse of market power through monopolies.
- Provide basic services that commercial society requires, but that private markets cannot deliver.
Adam Smith understood that these measures of market governance were the only way to ensure that society was not sacrificed on the altar of economic competition.
Market governance is the only way to ensure that society is not sacrificed on the altar of economic competition.
Therein lies the great paradox within The Wealth of Nations. On the one hand, government intervention is to be avoided because it can distort markets and undermine economic competition. Especially when the state becomes captured by narrow private interests. On the other hand, government intervention is also necessary to correct for market failures— dynamics that are as common-place now as they were back in the 1700s when Smith first theorized about them.
How can a society be reasonably expected to strike the right balance? To arrive at the Goldilocks solution where market governance is ‘just right’?
In his defense of public education, Smith leaves us with one potential solution to this paradox.
Adam Smith on public education and governance
“A man without the proper use of the intellectual faculties of a man, is, if possible, more contemptible than even a coward, and seems to be mutilated and deformed in a still more essential part of the character of human nature. Though the state was to derive no advantage from the instruction of the inferior ranks of people, it would still deserve its attention that they should not be altogether uninstructed. The state, however, derives no inconsiderable advantage from their instruction. The more they are instructed, the less liable they are to the delusions of enthusiasm and superstition, which, among ignorant nations frequently occasion the most dreadful disorders. An instructed and intelligent people, besides, are always more decent and orderly than an ignorant and stupid one. They feel themselves, each individually, more respectable, and more likely to obtain the respect of their lawful superiors, and they are, therefore, more disposed to respect those superiors. They are more disposed to examine, and more capable of seeing through, the interested complaints of faction and sedition; and they are, upon that account, less apt to be misled into any wanton or unnecessary opposition to the measures of government. In free countries, where the safety of government depends very much upon the favourable judgment which the people may form of its conduct, it must surely be of the highest importance, that they should not be disposed to judge rashly or capriciously concerning it.”
Only an informed and attentive citizenry, Smith concluded, might be expected to strike the right balance—avoiding policies that would distort markets unnecessarily, while embracing those those that keep the competition fair, provide public goods, and intervene when it is in the public interest.
One American, a contemporary of Adam Smith and an ardent disciple of his work, ultimately came to a similar conclusion.
“I know no safe depository of the ultimate powers of the society but the people themselves; and if we think them not enlightened enough to exercise their control with a wholesome discretion, the remedy is not to take it from them, but to inform their discretion by education.”
Thomas Jefferson
Notes
- A classic example is the British East India Company, which managed to carve out a near-monopoly position on the tea market within the British Empire. In part thanks to favorable tax rates granted by the English crown. It was these unfortunate circumstances that inspired the Boston Tea Party in 1773.
- https://www.cato.org/publications/commentary/tao-adam-smith, https://www.wsj.com/articles/SB10001424052702303561504577494382148546066, as cited and discussed at length here.
- Gocmen, Dogan. 2005. “Adam Smith’s Utopia: Society as an Open and Progressive System of Mutual Sympathy.” University of Edinburgh.
