1776: The Debut of Adam Smith

1776 was an important year in history. The Declaration of Independence was enacted in July, establishing political independence for the United States. Months earlier, however, an influential book was published which established economic independence and finally laid out a plan for economic success and substantial wealth accumulation and progress. This book was called An Inquiry into the Nature and Causes of the Wealth of Nations by the world's most famous economist, Adam Smith. Well known for the concept surprisingly hardly mentioned, the "invisible hand," this book was intended to dismantle mercantilism.

Mercantilists believed in protectionism because encouraging exports and heavily restricting imports maximized the nation's specie(wealth, according to mercantilists), but these policies, Smith noted, benefited only the producers and the monopolists and hindered economic progress. Any policies which did not benefit the consumer, Smith deemed anti-growth and shortsighted.

Smith defined wealth, not as gold and silver, as the Mercantilists did, but rather as production and exchange. Wealth encompassed both agricultural goods(which the Physiocrats associated with wealth) and manufactured goods. Money served less as a store of value and more as a medium of exchange. Using this new definition of wealth, Smith proposed no trade restrictions, no wage laws, and an emphasis on saving, investment, and capital accumulation.

Adam Smith introduced the idea of specialization of labor(aka division of labor), which increases microeconomic and macroeconomic productivity in three ways: 1) Division of labor increases the skill of each worker, 2) Workers waste less time in switching from one task to another, and 3) The narrow focus of each worker's attention on his/her task results in the invention of improvements in task technology. The resulting increased productivity from division of labor leads to higher wages and increased output. Greater income means greater consumption and greater savings, both of which spur economic growth. The larger the portion of income that goes into savings, the greater the potential for economic growth(because savings can be invested; investment keeps economic growth going). The ultimate constraint on economic growth, therefore, is the increasing difficulty of finding new and profitable outlets for investment. Cessation of economic growth delivers the economy into what Smith termed a stationary state.

Smith also differentiated between value and utility in his diamond-water paradox. Water has a high value in use but a low value in exchange. Meanwhile, diamonds have a low value in use yet a high value in exchange.

The value in exchange can be described by the market price(short run), which is determined by supply and demand or the natural price(long run), which is determined solely by the cost of production.

The competitive process aids economic growth and is characterized by the following:

• a large number of sellers
• resource owners who are knowledgeable on the wages, rents, and profits within the economy
• freedom of movement of resources between industries 

The Real Bills Doctrine was yet another contribution from Smith.  Operating under the assumption that paper money was convertible into specie, the doctrine stated individual banks should only provide loans when collateral was "real bills." In this manner, banks could not overissue loans.

Smith disagreed with the Mercantilists on many topics-the most important of which was international trade. He viewed international trade as a "positive-sum game," in which all parties benefit. Nations  would specialize in goods they had advantage(s) in producing and exporting. He supported tariffs only in two cases: for national defense and to offset taxes on domestic goods. Some tariffs had been used to protect infant industries but Smith disagreed with this practice because he doubted this protection would be removed once the industry breached maturity. And while in theory, legislators could strategically impose tariffs in retaliation against foreign tariffs, they would be unsuccessful in practice, according to Smith.

Although Smith advocated minimal government intervention, he recognized government was necessary to carry out the following functions:

• national defense
• administration of justice
• provision of public works
• universal public education

Smith's ideas were accepted very slowly for a few reasons. First, he was presenting his ideas to all of Parliament, many of whom were much older. Additionally, France was fighting the Napoleonic Wars at this time, which made the French wary of any change(s). And finally, many people thought Smith's ideas were too speculative and not practical.

Today, we recognize the contributions of Smith, while noting his major omission: Smith did not recognize services as wealth. National wealth is modernly defined as both goods and services.