Volumes 2 and 3 of Smith’s masterwork are in some respects easy to overlook. The intuitive framework of wages, profits, and rents is introduced and described in Volume 1. Smith applies his ideas to political economy and government finance more directly in Volumes 4 and 5. Stuck in between, the two middle volumes appear more mundane: Volume 2 explains different types of capitals in both individual and aggregate cases. This part of the work is packed with observations about the importance of frugality and prudence, ones which our present age would do well to remember. Volume 3 details the march of economic progress across different sectors of a nation’s economy, and is, in a sense, an abbreviated economic history of Europe.
A Stock is Not a Stock is Not a Stock
Volume 2: Of the Nature, Accumulation, and Employment of Stock
Part of the risk Smith runs here is the risk of being tedious—which he mentioned in Volume 1 that he was perfectly willing to hazard. Yet one could be generous and conclude simply that Volume 2 builds upon the foundation that precedes it.
Volume 2 opens with a basic description of how accumulation of stock is related to division of labor. This is a virtuous cycle: “As the accumulation of stock must, in the nature of things, be previous to the division of labor, so labor can be more and more subdivided in proportion only as stock is previously more and more accumulated.”
Fixed and Circulating Capital
Extremely tiny stocks are generally held only for consumption, and it is generally not until one “possesses stock sufficient to maintain him for months or years” that he seems to “derive a revenue from the greater part of it.” It is this portion of stock that is designated to provide a revenue, or income to its owner, that Smith refers to as “capital”. As Smith describes it, capital can be employed in two ways.
- In “raising, manufacturing, or purchasing goods, and selling them again with a profit.” Such a form a capital does not create value for the employer until it is sold—consider the case of an inventory of goods, which does not yield income until it changes hands and the seller receives payment. Smith: “His capital is continually going from him in one shape, and returning to him in another; and it is only by means of such circulation…that it can yield him any profit.” Smith calls this circulating capital.
- In “improvement of land, in the purchase of useful machines and instruments of trade…or in such like things as yield revenue or profit without changing masters…such capitals may very properly be called fixed capitals [emphasis mine]”.
For illustration, one may consider grocery store merchandise as circulating capital, and large mining machines as fixed capital. Most businesses require some proportion of both types, which vary greatly in different industries.
Smith furnishes examples of fixed capital such as “useful machines and instruments of trade…profitable buildings…such as shops, warehouses, work-houses, farm-houses…improvements of land…the acquired and useful abilities of all the inhabitants and members of the society.” With this final point, Smith touches on what we now call “human capital”, representing the value of skills both on the individual and societal levels. This is a concept which Marx, unsurprisingly, ignores.
Circulating capital likewise includes four categories: the money commodity itself, provisions (which Smith implies to mean perishable inventory such as meat, grain, or milk), durable goods, and raw/in-progress inventory.
It’s GDP, Kind Of
Smith moves on to apply this idea of fixed and circulating capitals to the annual produce of individuals and society as a whole. In the case of an individual landlord, his net rent (Smith consistently substitutes “neat” for “net”, but his meaning is clear) is the gross rent less the costs and expenses to maintain the land in its prior state of usefulness. It is likewise with individuals more broadly, that gross revenue is “the whole annual produce of their land and labor,” and their net revenue is “what remains free to them, after deducting the expense of maintaining first, their fixed, and secondly, their circulating capital.” Essentially, part of gross revenue is spent to replace any capital depreciated or consumed in the production of goods—what financial analysts today would often term “maintenance capital expenditures”.
In the aggregate, however, the maintenance of circulating capitals is less important, at least in Smith’s telling. This is because “whatever portion of those consumable goods is not employed in maintaining [fixed capital], goes all to [consumption], and makes a part of the neat revenue of the society.” Although difficult to intuit, this concept strikes me as a “cancelling out” of individual circulating capitals changing hands throughout an economy—milk passing from farm to distributor to grocer to consumer, for instance.
Where I suspect Smith has missed the boat a little bit is in the assumption that such circulating capitals do not require even on a societal level some costs of maintenance—for instance, storage and spoilage costs. Yet Smith does not go into this level of detail.
Money: Fixed and Circulating at the Same Time
Unlike other circulating capitals, the money commodity itself does require maintenance to replace itself. This is because “the stock of money which circulates in any country must require a certain expense, first to collect it, and afterward to support it.” In this way, fixed capital and money “bear a very great resemblance to one another.” The cost associated with establishing and maintaining a money supply of course varies greatly between monetary regimes—but the essential points remain the same.
Although money is the scorekeeper which regulates transfer of fixed and circulating capitals, it has no intrinsic value for the sake of being money. Gold, silver, or other money commodities may have intrinsic value as those commodities, but they possess this not at all because they are used as money. As Smith puts it: “The great wheel of circulation [money] is altogether different from the goods which are circulated by means of it…In computing either the gross or the neat revenue of any society, we must always, from the whole annual circulation of money and goods, deduct the whole value of the money.”
He provides a further illustration: “If a guinea [21 shillings] be the weekly pension of a particular person, he can in the course of the week purchase with it a certain quantity of subsistence, conveniences, and amusements…His weekly revenue is certainly not equal both to the guinea and to what can be purchased with it, but only to one or other of those two equal values, and to the latter more properly than to the former, to the guineas [sic] worth rather than to the guinea [emphasis mine].”
Because money is not in itself part of the revenue of society, it more closely resembles fixed capital than it does circulating capital. And as with other forms of fixed capital, any means by which it can be maintained or replaced more cheaply “is an improvement of the neat revenue of the society.”
We are Mostly Unproductive
Smith describes two broad categories of labor:
- One “which adds to the value of the subject upon which it is bestowed…[as] the labor of a manufacturer adds generally to the value of the materials which he works upon.” This is productive labor.
- Any labor that does not increase the value of the capital toward which it is directed is unproductive labor. Smith does not use this as a term of disparagement: unproductive labor includes the King, the army and navy, alongside “churchmen, lawyers, physicians…musicians, opera-singers, etc.” Of these, “like…the tune of the musician, the work of all of them perishes in the very instant of its production.”
Both groups of laborers are “equally maintained by the annual produce of the land and labor of the country.” Yet it is only productive labor, labor which augments a nation’s capital stock, that can be expected to increase that produce in the future. “Accordingly, therefore, as a smaller or greater proportion…is in any one year employed in maintaining unproductive hands, the more in the one case, and the less in the other, will remain for the productive, and the next year’s produce will be greater or smaller accordingly.” Basically: a trade-off between productive investment and unproductive consumption.
Further, the produce of the country is either destined for “replacing a capital” or “constituting a revenue.” Productive labor is paid by that portion which replaces capital—which makes sense, as this contribution is by definition the fruit of their labor. Unproductive laborers, on the other hand, “are all maintained by revenue.” The unproductive are most dependent upon “the rent of land and the profits of stock,” since “these are the two sorts of revenue of which the owners have generally most to spare.”
The ratio between productive and unproductive labor is, as we might expect, dependent on the national produce which replaces capital versus that which constitutes revenue. Capital replacement is a far higher proportion in rich countries than it is in poor ones. Perhaps this is a product of the advanced, capital-intensive forms of manufacturing. Perhaps it is a warning sign about the present “service economy”.
A Challenge to Keynes
Writing 150 years before John Maynard Keynes, Smith takes a strong “savings-first” approach to the economy. This contrasts heavily with Keynes’ emphasis on consumption as the lifeblood of the economy. Characteristically, Keynes ignores Smith’s arguments entirely in many of his greatest works—he was too busy reinventing economics in the image of science to have time for tedious debates.
Smith admits that a country’s produce is “no doubt ultimately destined for supplying the consumption of its inhabitants” but stops well short of making consumption the key indicator of economic health. If anything, saving, as a replacement to capital, is what enables greater consumption in the future.
Indeed the proportion of produce between capital and revenue “seems everywhere to regulate the proportion between industry and idleness…wherever capital predominates, industrial prevails; wherever revenue, idleness.” Further, “capitals are increased by parsimony, and diminished by prodigality and misconduct.”
And again: “By what a frugal man annually saves, he not only affords maintenance to an additional number of productive hands…he establishes, as it were, a perpetual fund for the maintains of an equal number in all times to come.”
Smith picks up this refrain again when critiquing mercantilism in Volume 4: the only balance of trade that can doom a nation is that between its production and its consumption. He includes a further warning against prodigality: “The prodigal…by not confining his expense within his income…encroaches upon his capital. Like him who perverts the revenues of some pious foundation to profane purposes, he pays the wages of idleness with those funds which the frugality of his forefathers had, as it were, consecrated to the maintenance of industry.” We therefore need not guess what Smith would think of America’s current state of government-sponsored debt-financed consumption—alas, some lessons may only be learnable the hard way.
Public Prodigality
As Smith continues, I imagine him talking almost directly to the post-New Deal United States.
As prescient as many of Smith’s comments appear, one misses the mark entirely—not because of Smith’s foolishness, but because he did not anticipate the foolishness of later generations. “The quantity of money, therefore, which can be annually employed in any country, must be determined by the value of the consumable goods annually circulated within it.” How naïve this appears to students of today, accustomed to fiat money and central banking, to suggest any natural constraint upon the supply of money. But Smith’s hard sayings don’t stop there. The paragraph below is worth quoting in full, and equally worth reading carefully.
“Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct. The whole or almost the whole public revenue is, in most countries, employed in maintaining unproductive hands. Such are the people who compose a numerous and splendid court, a great ecclesiastical establishment, great fleets and armies, who in time of peace produce nothing, and in time of war acquire nothing which can compensate the expense of maintaining them…Such people, as they themselves produce nothing, are all maintained by the produce of other men’s labor. When multiplied, therefore, to an unnecessary number, they may in a particular year consume so great a share of this produce, as not to leave a sufficiency for maintaining the productive laborers, who should reproduce it next year…Those unproductive hands who should be maintained by a part only of the spare revenue of the people, may consume so great a share of their whole revenue…that all the frugality and good conduct of individuals may not be able to compensate the waste and degradation of produce occasioned by this violent and forced encroachment.”
The TLDR: “[Governments] are themselves always, and without any exception, the greatest spendthrifts in the society.” And again: “It is the highest impertinence and presumption, therefore, in kings and ministers to pretend to watch over the economy of private people.” Put in today’s terms: Uncle Sam has no reason to criticize your daily Starbucks while being unable to track down their own multimillion-dollar fighter jets.
Different Employments of Stock
Borrowing, the Debt Multiplier, Real Estate
The stock lent at least “is always considered as a capital by the lender”, in that he expects a return thereupon. The borrower may either use it as a capital himself by employing it, or may use it for his own consumption. Smith minces no words about this: “The man who borrowers in order to spend will soon be ruined, and he who lends to him will generally have occasion to repent of his folly.” Thus it only makes sense in cases of “gross usury”, that is, punitive interest rates, like those seen upon credit cards and payday loans today. A notable except is “country gentlemen” who are able to borrow upon mortgage without being expected to make any productive use of their borrowings.
Through first principles, Smith gets very close to a concept that Keynes and his adherents would call the “money multiplier”. He gives the following example: “A…lends to W £1000, with which W immediately purchases of B £1000 worth of goods. B having no occasion for the money himself, lends the identical pieces to X, with which X immediately purchases of C another £1000 of goods. C, in the same manner, and for the same reason, lends them to Y, who again purchase goods with them of D. In this manner, the same pieces, either of coin or of paper, may, in the course of a few days, serve as the Instrument of three different loans, and of three different purchases, each of which is, in value, equal to the whole amount of those pieces.”
Regarding attempts to fix interest rates by law, Smith insists that creditors “will not lend…money for less than the use of it is worth…No law can reduce the common rate of interest below the lowest ordinary market rate at that time when that law is made.” Any attempts to do so will simply result in elaborate ways to circumvent the law.
Interestingly, Smith also suggests an inverse relationship between land prices and interest rates—not simply because higher rates should reduce asset prices in general (which is basic financial math), but because investment in land is a substitute for lending funds at interest. Therefore a higher return from interest should reduce the demand for land as a substitute, lowering its price.
Four Employments of Capital
Beyond lending at interest, capital can be employed in four ways. Each of these is dependent upon the others, and can be thought of as a different stage in the process of production (to use Hayek’s terminology).
- “Procuring the rude produce”, i.e. agriculture or mineral extraction.
- “Manufacturing and preparing that rude produce”: manufacturing.
- Transporting goods, whether raw produce or manufactured goods.
- “Dividing particular portions of either into such small parcels”: that is, retail.
How Development Occurs, Or Doesn’t
Volume 3: Of the Different Progress of Opulence in Different Nations
Every civilized society carries on commerce “between the inhabitants of the town and those of the country…The gains of both are mutual and reciprocal.” Yet the industry of the country—agriculture—is a precondition for the division of the labor that enables manufacturing and other industries to develop, just as “subsistence is, in the nature of things, prior to convenience and luxury.”
Smith further suggests that given equal rates of profit, “most men will choose to employ their capitals, rather in the improvement and cultivation of land, than either in manufactures or in foreign trade.” Therefore “the natural course of things” will direct capital “first…to agriculture, afterwards to manufactures, and, last of all, to foreign commerce.”
Blame Your Older Brother for the Dark Ages
After the fall of the Western Roman Empire, the leaders of the “barbarian” nations which conquered/settled this territory “acquired, or usurped to themselves, the greater part of the lands of those countries…no part of them, whether cultivated or uncultivated, was left without a proprietor.”
Smith laments this collapse into feudalism, but admits that it “might have been a transitory evil.” Alas, it was not, due to the law of primogeniture. By such a law, all estates and property were inheritable only by the firstborn surviving heir. This “hindered [estates] from being divided by succession.”
The rationale for primogeniture was the perception of land as the key to political power, rather than as a key to economic subsistence. To maintain a hereditary regime, it was unthinkable that the monarch’s possessions would be divided with each generation—especially when many jealous rivals to the throne enjoyed their own large estates.
The consequence of this was to delay any great improvements upon land, as “it seldom happens…that a great proprietor is a great improver.” Indeed, small proprietors are generally more diligent in improving their own holdings.
Types of Labor. Hint: Slavery is the Worst
Outside of the farmer who owns the land outright, Smith lists three different arrangements, in order from least to most productive upon the land.
- Slavery. In this category Smith also considers serfdom, which he rightly describes as a “milder kind” of slavery relative to that of the Romans, but slavery nonetheless. “If great improvements are seldom to be expected from great proprietors, they are least of all to be expected when they employ slaves for their workmen…A person who can acquire no property can have no other interest but to eat as much and to labor as little as possible. Whatever work he does beyond what is sufficient to purchase his own maintenance, can be squeezed out of him by violence only, and not by any interest of his own.” If slavery is so unproductive, why has it always existed throughout history? Simple human nature. “The pride of man makes him love to domineer, and nothing mortifies him so much as to be obliged to condescend to persuade his inferiors. Wherever the law allows it, and the nature of the work can afford it, therefore, he will generally prefer the services of slaves to that of freemen.”
- Share-cropping. This word has come to English through post-Civil War arrangements in the U.S., and has negative connotations of both exploitation and racism. Smith was not familiar with the word, but he describes a similar system. In such a system, “produce was divided equally between the proprietor and the farmer, after setting aside what was judged necessary for keeping up the stock.” Thus “such tenants…have a plain interest that the whole produce should be as great as possible.” Yet still it is not in the laborer’s interest to expend his own stock upon any improvements.
- Long-term leasing, or “farmers who cultivate the land with their own stock, paying a rent certain to the landlord.” These arrangements can incentivize farmers to expend their own stock upon improvement of the land, as they “may sometimes expect to recover it, with a large profit, before the expiration of the lease.”
The key in all this is simple: the closer the position of the country laborer is to that of true ownership, the greater the incentive to improve the land and it’s productive power.
How Feudalism Died
From the Dark Ages on, until the abolition of serfdom, the merchants and city-dwellers generally enjoyed a greater degree of freedom than did the serfs in the country. Yet the role played by cities and burgers in bringing about the decline of feudalism is stated wonderfully by Smith in the following passage:
“It must be remembered that, in those days, the sovereign of perhaps no country in Europe was able to protect, through the whole extent of his dominions, the weaker part of his subjects from the oppression of the great lords…The inhabitants of cities and burghs, considered as single individuals, had no power to defend themselves; but by entering into a league of mutual defense with their neighbors, they were capable of making no contemptible resistance. The lords despised the burgers, whom they considered not only as a different order, but as a parcel of emancipated slaves, almost of a different species from themselves. The wealth of the burgers never failed to provoke their envy and indignation, and they plundered them upon every occasion without mercy or remorse. The burgers naturally hated and feared the lords. The king hated and feared them too; but though, perhaps, he might despite, he had no reason either to hate or fear the burghers. Mutual interest, therefore disposed them [the burghers] to support the king, and the king to support them against the lords. They were the enemies of his enemies, and it was his interest to render them as secure and independent of those enemies as he could.”
Mutual Benefit Between Town and Country
We’ve established already that the manufacture and industry of cities is rendered possible only by the division of labor that presupposes a surplus of agricultural stock. This is the country’s great contribution to the cities.
Yet cities are no parasites; Smith lists three benefits that the industry of cities bestows upon the country/agriculture.
- Cities provide a “great and ready market for the rude produce of the country…they gave encouragement to its cultivation and further improvement.” In this sense, cities are a source of demand for agricultural produce.
- “The wealth acquired by the inhabitants of cities was frequently employed in purchasing such lands as were to be sold, of which a great part would frequently be uncultivated.” Thus the investment of city profits enabled more land to be improved and turned to agriculture.
- Finally, “commerce and manufactures gradually introduced order and good government.” This makes some sense given the history of feudalism Smith has just described. “This, though it has been the least observed, is by far the most important of all their [cities’] effects.”
In our next post, Smith will finally get political—18th-century style.
