Lecture Notes: History of Thought

• I. Intro
  • A. "History of Economic Thought" can be a course in history (names, dates, who affected whom) or in thought. This is a course in thought.
    • 1. Because we don't really know why people believed what they believed
    • 2. And even if we did, there is no reason for economists to spend large amounts of time and effort on intellectual history.
    • 3. And even if we wanted to, one cannot do a respectable job of explaining people's beliefs without first understandingthem--and in the case of the founders of economics, understanding their ideas is hard work, and more than enough to fill the quarter.
    • 4. So that the other sort of course is likely to end up with superficial knowledge of the ideas, much of it wrong.
    • 5. By the end of the quarter, you can decide for yourself whether this highly biased view of how History of Thought should be taught is correct or not.
    • B. Three people: Smith, Ricardo and Marshall
      1. We will mostly rely on three books they wrote
      2. I may put a few other short things on reserve.
    • 3. The course has a web page, I have an EMail address, both arein the syllabus .
    • 4. Office hours T 4:00-5:30, Wed 3-5, and by arrangement. rm 204 5732
  • C. Handouts.
    • 1. You will get handouts consisting of a collection of quotes from the book we are reading, along with a few questions.
    • 2. Their primary purpose is to help you tell whether you are really reading the book--i.e. absorbing the ideas, which is the point of the exercise--or merely passing words through your mind, which is easy to do, especially when you are tired and the ideas are hard.
    • 3. If the quotes don't make sense, you are missing the ideas.
    • 4. Some of the quotes will also be on the exams, as short essay questions--explain what they mean.
    • D. Two midterms, a final. They are weighted roughly 25/25/50
      1. Mostly essay questions, explaining the quotes.
    • 2. Might be a few numerical questions.
    • 3. No historical questions.
    • 4. But I hope you will remember that the important event of the year 1776 was the publication of the Wealth of Nations
    • 5. That Ricardo was a generation or two later
      6. And Marshall at the end of the 19th century, beginning of the 20th.
  • E. A few homework assignments, but most of the work is reading and understanding. First assignment: Roughly estimate the ratio of national income to national debt in England in the 18th century, entirely from information in Smith. Compare to the current figure. Due just before the first midterm.

• II. Who they are:
  • A. Smith
    • 1. The man who first assembled economics, although there were precursors.
    • 2. Tryed to understand questions such as:
      • a. Why are some nations richer than others.
      • b. What determines prices
        c. What determines wages, profits and rent
        d. Nature of money
        e. How can you compare standards of living across time and space.
    • 3. But also economic imperialist questions, such as:
      • a. Why were barbarians dangerous to civilized nations in antiquity, and the reverse now?
      • b. Why did feudalism end?
      • c. What are the advantages or disadvantages of an established religion.
    • 4. And policy questions such as:
      • a. Should there be tariffs, export subsidies, etc.? His analysis was not up to modern academic standards, since Ricardo had not yet invented the theory of comparative advantage, but was well ahead of modern newspaper discussions of such issues.
      • b. Should schooling be public or private?
      • c. How should universities be organized? Compulsory attendance? Faculty run?
      • d. How should taxes be collected?
    • 5. Enormous range of knowledge.
      • a. Many of us us have a prejudice towards our own superiority over people of the past.I know of no evidence of improvement in intelligence over the long term.
      • b. Not only was Smith smarter than most of us, he knew more.
      • c. Not about physics and mathematics, but ...
      • d. About history and contemporary institutions.
    • 6. His book opens a window on a different world.
      • a. If you want to know about the past, read primary sources--books written then (selecting, of course, the interesting ones)--not just modern historians.
      • b. The Wealth of Nations is a good one.
      • c. My other favorite for the 18th century is Casanova's Memoirs.
      • d. And it turns out there is a connection between them. The advertisement to Smith's 4th edn thanks a Mr. Henry Hope of Amsterdam for information about the bank of Amsterdam. He is related to a woman Casanova pursued (unsuccessively).
    • 7. 18th century prose. If something doesn't makes sense, check how he is using words. Usually the same meaning, but not always.
  • B. Ricardo: In Marshall's words "His exposition is as confused as his thought is profound."
    • 1. He invented general equilibrium theory--without mathematics. He did it by a c ombination of:
      • a.Simplifying assumptions
        b. simple numerical examples
        c. and very good mathematical intuition.
      • d. Marshall comments in one of the appendices that it is risky to reason via numerical examples, because you may, without realizing it, assume away part of the problem in drawing up your example. "Ricardo himself had no mathematical training. But his instincts were unique; and very few trained mathematicians could tread as safely as he over the most perilous courses of reasoning." (Principles, Appendix L)
    • 2. Disagreement with Smith: How prices are determined.
      • a. Price of money: Smith says that the price of a good is the sum of the price of the inputs. So if one input, say labor, goes up, the price of all goods must rise. But money itself is a produced good, and its (money) price cannot rise--it is one by definition (the price of a dollar is--a dollar). Something is off--Smith has his (implicit) general equilibrium theory wrong.
      • b. Separate technological change from factor price change. Consider, for the moment, only price changes due to changes in factor prices.
      • c. Therefor when wages go up (measured in money), technology held constant, profits must go down--in order that the price of money, which must be the sum of the cost of its (unchanged) inputs, can stay the same.
      • d. Implicitly, this is a world where money can be produced instantly at a fixed input cost--not because the world is like that, but because that makes it easier to think through the logic of this particular problem..
    • 3. Disagreement with Smith: Rent
      • a. Is rent a cost? Not on marginal land.
      • b. Marginal land must just cover production cost, so ...
      • c. Rent on other land is the value of its output above the output from the same inputs applied to marginal land.
      • d. So rent is not a component of price. Rather price is determined by labor + capital on marginal land.
      • e. Or on the intensive margin--how much grain does one more dose of labor and capital produce.
      • f. This is not only the modern theory of rent ( "Ricardian" but invented by Malthus)
      • g. It is the first step towards the marginal revolution.
      • h. Going from a constant returns world, to a constant returns except for land world.
      • i. Note that there are two "technology" changes implicit in the model: changes in how we produce goods (what we think of as technological change), and changes in what land is marginal.
      • j. Which is ultimately determined (geography held constant) by population.
    • 4. Contrast with Smith:
      • a. Smith is drawing on all the richness of his real world knowledge, thinking through the logic somewhat imprecisely, and applying it broadcast.
      • b. Ricardo knows a lot about the real world--he was disowned by his parents at age 21 for marrying a woman of the wrong religion (Quaker--his parents were Jewish) and in the next four years made a fortune on the stock exchange, retired, and lived on it. but...
      • c. He is interested in an abstract logical structure.
      • d. Thus, for example, he finds it useful to hold technology and capital fixed while letting population go to equilibrium. Then he lets capital go to equilibrium--with the population at any instant at the level implied by that amount of capital. Then ...
      • e. While Smith is interested in how taxes can and should be collected, Ricardo is using them to put his analytical engine through its paces. If you impose this tax, what happens?
      • f. Here and elsewhere, he uses brutal simplification to see through to the fundamental relationships.
      • g The first true economic theorist.
  • C. Marshall
    • 1. A number of different people invented the marginal approach to economics at about the same time. Marshall is the one from whom the main line of modern economic theory is chiefly descended--at least micro.
    • 2. So reading him shows you both the original derivation,the big picture, and ...
    • 3. Someone wrestling with the underlying problems--the sort of criticisms that a very intelligent non-economist would make.
    • 4. For example--how to define economic improvement.
    • 5. I think Marshall's answer to that question is better than the Paretian answer that is normally taught; for reasons see my Price Theory textbook.
    • 6. What assumptions about rationality do we need to do economics?
    • 7. In a way he combines the strengths of Smith and Ricardo--interested in real world institutions and tryingto create a fully coherent theoretical structure--built on the work of both Smith and Ricardo.

• III. Common issues considered by all three:
  • A. Explaining relative prices.
  • B. Measuring changes in human welfare.
  • C. Solving the coordination problem. "Invisible hand."
  • D. Designing optimal institutions.

• IV. Hints on reading Smith:
  • A. 18th century prose style. Words sometimes have different meanings.
  • B. Fixed and circulating capital.
    • 1. Fixed capital is what we think of as capital--machinery and the like.
    • 2. A farmer must pay his employees as they work, but only gets the crop at the end of the year. So he needs capital with which to advance them their wages, with which to buy fertilizer and seed corn, etc. Similarly for a manufacture. This is the "circulating capital."
  • C. Smith is Scottish, not English.
  • D. Money in his world is government issued coinage, plus privately issued paper convertible into government coinage on demand.

• V. Wealth of Nations, Book I
  • A. Question: Economic growth and distribution of income.
    • B. Division of labor
      1. Inside the firm vs outside the firm (trifling vs not)
      • a. Smith uses the example of a trifling manufacture (pin making) because
        b. Its division of labor is all under one roof, inside the firm, where it is easy to see
        c. While division of labor in more elaborate manufactures is largely outside of the firm.
    • 2. The possibility of improved output through division of labor is greater in manufactures than in agriculture, hence ...
    • 3. Output differences between more and less developed countries are less, and poor nations specialize in agriculture.
    • 4. The division of labor produces output increasse for three reasons:
      • a. Greater desterity
        b. Eliminates changeover time
        c. Tends to produce inventions
        5. How many people does it take to make a woolen coat?
    • a. Many--to herd sheep, shear them, process the wool, spin it, weave it, make the tools that do all the things, produce the iron and wood used to make the tools, ...
    • 6. Or a pencil? Ditto.
    • 7. Result--ordinary British peasant better off than African king. Bigger difference than between European peasant and European prince!
    • 8. Consider modern equivalent: Is the average worker today better off than the rich of Smith's time? Is the difference more than between the average now and the rich now?
    • 9. Possibly true for material goods. Not for flattery, status, service, ... .
  • C. Division of labor arises from propensity to trade:

    • 1. Situation among animals? Smith says no trade
      a. But property exists without trade in the form of territory in some species.
    • b. And some trade of services (grooming) apparently occurs among primates. "I'll scratch your back, you scratch mine."

  • 2. Among humans, trade lets us exploit self interest of others. "Even a beggar." "It is not from the benevolence ... ."
  • 3. Smith Argues for nurture over nature. He was not a parent.
  • 4. Trade makes diversity an asset to the group, since individuals can specialize and exchange their product or services--unlike the situation for animals.
• D. Division of labor is limited by the extent of the market.
  • 1. To have division of labor requires either:
    • a. Low transport costs or
      b. High population density.
  • 2. Hence civilization starts on coasts, rivers.
  • 3. Nature of medieval economy--
    • a. wheat doubles its price in 20 miles
      b. The silk road from China across central asia.
• E. Money:
  • 1. The problem with barter is the double coincidence problem. The spontaneous solution is to use some good in part as a means of exchange
    2. The money solution. Metal turns out to be the best good to use, and almost all societies end up with some sort of metal money.
    • a. It is easily subdividable, recombinable (try doing that with a cow). Fairly high value to weight ratio, especially for precious metal.
    • b. Those were important characteristics in the past. But today, we can exchange claims to goods rather than the goods themselves. Commodity traders trade large quantities of pork bellies, wheat, etc. without ever handling the real goods. If you are exchanging claims, these characteristics of the goods don't matter much.
    • c. A second crucial characteristic, so far, is that the money you use is the money your neighbors use--otherwise you have to keep going to the money exchange every time you want to buy anything.
    • d. But that is changing to. I can put my money card into a Canadian money machine and draw Canadian dollars from a U.S. dollar account. As more and more transactions occur through computers, which can do exchange calculations very fast and very inexpensively, the importance of using the same money as your neighbor declines.
  • 3. Pound--started out (France c. 800 A.D.) not as an actual coin but as a money of account--the number of silver pennies that weighed a pound (240).
    • a. When the silver penny got debased, they could either
      b. Keep redefining the number of pennies in a pound, or ..
    • c. Use "pound" to mean "240 pennies, however much they now weigh."
    • d. They did the latter.
    • 4. Debasing benefits debtors, esp the govt, at the expense of creditors
      a. Consider the modern case. Our government inflated at a time when it had large debts in the form of long term bonds--so it could inflate away a lot of what it owes.
    • b. Nowadays the debts are mostly short term--because lenders require big interest rate premiums if the government is borrowing long term and thus has a temptation to inflate. With short term debt, the government can't gain much by inflation, short of very high rates.
    • c. It is worth noting that Smith saw the logic of this--in the context of the debasement of silver money--two hundred+ years ago.
  • 5. Value has two meanings.
    • a. Use value
      b. Exchange value.
    • c. Diamond water puzzle--not resolved here.
  • 6. Three questions:
    • a. What is the real measure of exchange value.
    • b. The parts of which it is made up.
    • c. Why the market price sometimes deviates from the natural price.
    • d. Note that use value has dropped out of the discussion.
    • e. And he recognizes that he has not fully solved the question-- "obscure."
• F. Real and nominal price.
  • 1. Real price--number of hours to earn the money to buy. Why is that the real price?
    • a. Because ownership of something gives you command over the amount of labor you can hire with the money you sell it for, or ...
    • b. Because that is what it costs you in labor to buy the good.
    • c. Note that labor is the measure, not the determinant, of value. So this is not a labor theory of value in the ordinary sense.
    • d. He says that a good contains the value of a certain amount of labor, not that it contains the labor.
    • e. And he is going, in the next chapter, to argue that the natural price is actually the sum of the costs of labor, profit and rent.
  • 2. Nominal price: In money. That is what we actually buy stuff with--not goods or labor.
  • 3. But the real value of gold and silver vary--New World mines lowered it.
  • 4. "Equal quantities of labour, at all times and places, may be said to be of equal value to the labourer." So labor is the real price of commodities!
    • a. So what he is doing with "real price" is using prices of goods measured in terms of wages, where we would use "real wages" (wages measured in terms of prices of goods).
    • b. Meaning that a fall in the value of goods is an improvement! A fall in the value of goods means that you can get the goods with fewer hours of work.
    • c. One sort of "labor theory of value," but not Marx's.
    • d. Turning it around, labour has a high real price if it gets lots of commodities.
    • e. He is using the use value of labor--toil and pain--to measure the exchange value of commodities.
  • 5. Sale with reservation of a perpetual rent:
    • a. If the lease is set in nominal terms, it is vulnerable to debasement (which always goes in one direction) and to variation in the value of gold or silver, which currently, Smith thinks, is probably declining.
    • b. Better to set the rent in terms of corn.
    • c. Empirical evidence from college leases. Apparently Oxford et. al. had income from leasing land, and initially 1/3 was in Corn. Now (almost 200 years later) that has become 2/3. It follows that the price of corn has gone up four-fold [do the arithmetic yourself]--or, in Smith's terms, the value of the money rents fallen to a quarter. Almost entirely due to the change in value of silver.
    • d. All of this assumes the inflation was unanticipated --except by the clever guy who insisted on the corn rents.
  • 6. Corn has a roughly constant value (in labor). Why? But only in the long term.
    • a. It fluctuates in the short term because annual output, which varies, is large relative to the stock.
    • b. Constant in the long term because corn is the input to "producing" workers--an early version o f the "iron law of wages." He does not say this here, but stay tuned.
  • 7. Money has a roughly constant value in the short term, not in the long term. Why?
    • a. Roughly constant in the short term because annual production and consumption is small compared to stock.
    • b. But in the long term coins can be debased, the value (measured in labor, remember) of silver and gold can change.
  • 8. So short term fluctuations in the nominal price of corn are due to changes in its real price, long term changes are due to changes in the real price of money.
  • 9. So prices in corn or a better measure century to century, prices in silver year to year.
  • 10. Real and nominal price are always in exact proportion at a given time--the ratio being the wage rate!
  • 11. And nominal, not real, price is relevant to a trader--because silver is easier to transport than labor.
    • a. If a trader can buy goods in London for 100 ounces of gold, sell them in Calcutta for 200 ounces, and bring the gold back, he is better off--quite aside from what the real price of the goods (measured in local labor) may be.
    • b. Suppose Smith had taken the argument one step farther. Instead of bringing gold back, the trader (whose ship is coming back anyway, and might as well fill its holds) uses the gold to buy goods in Calcutta.
    • c. He would have discovered the principle of comparative advantage--that the gain from trade depends on the ratio of prices of the two goods (one transported London to Calcutta, one the other way) being different in London than it is in Calcutta.
  • 12. So people may more attention to nominal price--since few of them are comparing conditions of life over long periods of time.
  • 13. Corn is a proxy for wages in the long term, and better recorded than wages, so useful for measuring economic change over time.
  • 14. With two circulating moneys, we tend to think of one of them as defining value.
  • 15. With a fixed proportion, the value of the most precious metal regulates the other! No.
    • a. The one that is overpriced in the exchange is being determined by the other, assuming no free coinage of it but of the other.
    • b. And drives out the other if there is free coinage.
    • c. Note that gold is being coined without seignorage. Silver coinage is debased--and you can't coin debased coins, you have to coin full weight ones.
    • d. So debasement acts as rather like seignorage.
  • 16. Why French coin comes home again.
  • 17. Money price is defined by silver weight, not coins, in Smith's usage.

  G. An explanation of the economics of coinage.

  • 1. Smith seems to understand it, despite his "most precious." But he does not explain it clearly.
  • 2. Simplest case: One metal, free coinage and melting. You can convert silver freely into shillings, shillings into silver, so a shilling is worth exactly its weight in silver.
  • 3. Add seignorage, and some superior convenience of coin over bullion. Now a shilling is worth a little more than its weight. If its value gets up to the cost of having it coined (weight in silver plus seignorage), people bring silver to the mint to be coined. If it gets below the value of melting it--i.e. the value of its weight in silver--people melt shillings. So the value of a shilling is normally somewhere between the value of the silver in it and that plus seignorage.
  • 4. Suppose we want two coinages, one silver and one gold, with, free coinage (i.e. no seignorage) and melting (almost impossible to prevent) of both, exchanging at a fixed ratio.
    • a. We set their weights so that the value of the gold in one is (say) ten times the value of the silver in the other.
    • b. No problem--until the market ratio shifts.
    • c. If the government does nothing, the coins no longer exchange at 10:1, and their exchange rate changes from year to year with the price of gold and silver--which is inconvenient.
    • d. If the government guarantees the exchange rate--bring in ten silver coins, they give you one gold, or vice versa..
    • e. Now you can make a fortune (and bankrupt the mint) arbitraging the two ratios. Suppose the gold in a gold dinar is worth the silver in eleven silver dirhem. Start with 10 dirhem. Bring them to the government, exchange for 1 dinar. Melt it. Sell the gold for 11 dirhem weight of silver. Take it to the mint. Have it coined into 11 dirhem. You are now one dirhem richer. Repeat.
    • f. Seignorage reduces but does not eliminate the problem. It stabilizes the system as long as the price ratio is witha limited range, by (in effect) taxing the arbitrage loop described above, but it breaks down if the price ratio of the metals shifts too far.
  • 5. How do we solve this problem and keep both metals in circulation? Make one a token coin.
    • a. 21 shillings exchange for a guinea, whose gold is worth more than their silver.
    • b. You freely mint guineas from gold, but ...
    • c. To get shillings, you pay in guineas, and government mints dirhem as required and gives them to you.
    • d. If people are, on net, bringing in shillings for guineas the government melts (or hoards) the shillings, thus keeping them off the market.
    • e. So the supply of shillings false when their price drops below 21 to the guinea, rises when it goes above, ...
    • f. Maintaining the fixed exchange ratio.
    • g. And the value of both coins is determined by the value of gold.
    • h. And you have to worry about people counterfeiting silver coins.
  • 6. Further complication--worn coins. Start with the mint price slightly undervaluing silver.
    • a. If the circulating silver is worn, weighs less than its mint weight, then at a price where it doesn't quite pay to coin it (at mint weight) it also does not quite pay to melt it--all the full weight coins having already been melted.
    • b. So you have an equilibrium with worn coins serving as token coins.
    • c. The situation Smith describes.
    • d. I could take silver to the mint, have it minted, clip the new coins--but presumably the cost of deliberately "wearing" coins and reclaiming the silver is more than the small gain is worth.

  H. What determines the natural price?

  • 1. In a primitive society, with labor the only input, ratio of labor inputs--deer/beaver
    • a. Modified for unpleasantness of the labor.
    • b. And dexterity. Why? Esteem? Human capital input.
  • 2. As capital accumulates
    • a. Workers become employees, and part of the price goes to the capitalist.
    • b. The capitalist must get enough to "more than replace his stock"--remember that we are talking about circulating capital. What he gets at the end must replace what he spent during the year--his stock--with something over for profit.
    • c. Profit is not the same thing as managerial income, since it is determined by the amount of stock.
    • d. So profits of stock are a separate term from wages of labor.
  • 3. As land becomes scarce it becomes private property, must pay rent to the landowner.
  • 4. Labor still measures all three parts.
  • 5. What about seed corn, wear and tear on the plow, etc?
  • 6. That all goes back to rent, labor and profit input to produce seed corn, plows, etc.
  • 7. And sometimes (flour, linen), production involves layer on layer of all three inputs. Land, labor, and capital to group the wheat, then more to mill it, then ... .
  • 8. In the progress of the manufacture, every subsequent profit is greater than the forgoing, because the capital must be greater.
    • a. Explain the argument--again remember this is circulating capital. The company that spins the flax must advance both the price of the flax and the wages of its workers. But the price of the flax is what the grower of the flax got to replace his capital, plus provide profit. So the spinning company must have advanced more capital than the farmer who grew the flax.
    • b. The argument is wrong because it implicitly assumes a fixed turnover period. If growing flax takes a year and spinning it a week, the spinning company gets to use its capital 52 times a year, the farmer only once.
    • c. If we wanted to consider fixed capital--machines and such--we could incorporate it into the argument with a very long turnover period--the ten years (or whatever) it takes to wear out a plow.
  • 9. And from price you get distribution of income!
  • 10. Being careful to note that one person, even one activity, may draw income from two or three of wages/rent/profit.
    • a. A gentleman who farms his own estate receives rent and profit (he isn't doing the work). Note that a farmer, in Smith's terminology, is the "capitalist" who rents land, hires labor, sells the crop.
    • b. A common farmer, renting land, providing capital and also doing some of his own labor.
    • c. Gardener working his own land has all three.
  • 11. Annual product split between industrious and idle, which determines economic growth. Mandeville argued that vice and luxury were good for the economy; Smith is going to argue that they are bad.

  I. Natural and Market Price:

  • 1. Start with ordinary rates of wages, profit, and rent--which will be explained later.
  • 2. Natural price of a commodity is then the sum of input costs at their natural price.
  • 3. Opportunity cost is brought in to show that the cost to the seller must include his profit. Note that the war between the accountants and the economists has already started. Smith sees cost as a modern economist does but realizes that his readers may be thinking in terms of money actually paid out.
  • 4. This is the lowest price at which he will sell for a long period of time, if he is free to change his trade. In the short term, he may sell for less (quasi rents are looming over the horizon, but won't become clear until Marshall).
  • 5. Market price might be above, below, or equal to natural price.
  • 6. Depending on whether quantity demanded at natural price is more or less than supply. "Effectual demand." He is only using one point on the demand curve--which is all he needs for his purpose, which is ...
  • 7. A correct sign argument, which shows that market price will tend towards the natural price. He doesn't take it the next step to demand at other prices.
  • 8. Similarly for supply--iron vs oranges. He see swhy the price of oranges can drop much farther below its natural price than the price of iron, but does not know how to formalize the idea. Marshall does.
  • 9. So he shows why the price goes to its long term equilibrium--falls when above, rises when below.
  • 10. With fluctuations large or small according to incertainty of annual output.
  • 11. Fluctuations are mostly bsorbed by wages and profits, because rent is set by contract in advance, in money or output.
  • 12. Might stay out of equilibrium because:
    • a. People in the business conceal shortage so as to make money from it. Rarely for long.
    • b. Trade secret.
    • c. Rent on specially situated lands--good vinyard.
    • d. Government granted monopoly.
    • e. Apprenticeship, exclusive privilege, etc.
    • f. Can be below cost briefly with freedom, only for a generation at most with guilds, save in a caste system. Note his use of "police." It means, roughly, government activity regulating internal affairs (we will see the term again later). "Police" in our sense are not going to exist in England for about another sixty years.
  • 13. Next step: What determines the natural price of the factors of production?

  J. Wages

  • 1. If labor were the only input, wages would have risen--i.e. gsoods gotten cheaper--as productivity increased.
  • 2. Wages are determined in part by a successful implicit cartel of employers
    • a. Supported by the state
    • b. By the fact that employers can hold out longer
    • c. By the fact that there are fewer of them.
  • 3. Limited by what will maintain the laboring population.
    • a. Why? Common humanity?
    • b. Or--implicitly--because if population goes down, the capital must bid against itself for the inadequate supply of workers.
  • 4. But the employer monopsony cartel is broken by increasing demand for labor, forcing employers to bid against each other.
  • 5. Note that the amount of the capital is, roughly speaking, the demand for labor, given the circulating capital model here.
  • 6. It is the increase of wealth (stock) that gives high wages, not the amount.
  • 7. In North America wages are higher than in England.
    • a. Lots of evidence.
    • b. Widows with children are very marriageable--because wages are so high that children are a net asset.
    • c. People marry young. Because wages of children are valuable, making it easier to support a family.
    • d. Note that this is an early version of the work Becker got the Nobel prize for--applying economics to the family.
  • 8. In the stationary state, even ifa society is very rich (lots of output per acre), wages are low.
  • 9. In declining state it would be worse still.
  • 10. So welfare of workers depends on the first derivative of capital stock, wealth of country on level--roughly speaking.
  • 11. Evidence that in England wages are above subsistence, hence advancing economy.
    • a. Summer vs winter wages
    • b. Wages don't fluctuate with price of corn inthe short term.
    • c. Wages vary by place--and not with price of subsistance.
    • d. Grain was dearer and money wages lower in the previous century. Yet people survived.
  • 12. Are high real wages for the working class a good thing or a bad thing?
    • a. Consider what the fact that Smith has to ask that question tells us about the difference between his world and ours?
    • b. 18th c. England is a democracy, but with a limited franchise, and parliament is dominated by the upper classes--land owning gentry, aristocracy, etc.
    • c. Who naturally enough see such questions in terms of their self interest, not the workers' self interest.
  • 13. A good thing on general grounds, and grounds of equity--the sort of argument we would make.
  • 14. The relation between standard of living of the workers and population:
    • a. Poverty does not lower, may even raise, the birth rate.
    • b. No explanation of why. My suspicion is that the upper classes are using contraception of some sort or other, or possibly abortion. Both exist--see Casanova's memoirs.
    • c. But poverty drastically increases the mortality rate of children.
    • d. So increasing income increases the working population.
    • e. Implicitly, employers are paying the cost of maintaining the working class, just as slaveowners pay the cost of maintaining their slave population--in the former case through the equilibrium wage rate. If wages don't maintain the population, the population falls and wages go back up.
    • f. Maintanance of workers is cheaper than of slaves, because the worker manages his budget in his own interest better than the slave manager manages the slave's budget. Hence free labor is usually cheaper than slave labor.
  • 15. The relation between real wages and how long and hard workers work:
    • a. High wages make workers more productive, both for biological reasons--better fed and healthier--and for incentive reasons.
    • b. Smith is responding to arguments for what we would call a backward bending supply curve for labor--when wages go up, workers are richer, so choose to consumer more leisure.
    • c. The argument matters, because if increased wages reduce labor output, then it is in the interest of the employers to keep wages low (real wages--i.e. money wages low and/or corn expensive). Smith wants to persuade them of the opposite.
    • d. He offers a variety of empirical evidence and oratorical arguments, but can't eliminate the theoretical possibility of the opposite effect.
• K. Profits
  • 1. Increasing stock (but not high level of stock) raises wages; high level of stock lowers profits. Merchants are competing with each other.
  • 2. What has actually happened in England in recent centuries?
    • a. Measuring the rate of profit is hard, given the large random component, but we can use the interest rate as a proxy, since higher profits will result in higher market interest rates, ceteris paribus.
    • b. Smith doesn't have good historical data on market interest rates either, but he does have data on legal maximum rates and believes that in England they tended to be at or a little above the market rate. So he uses them to conclude that ...
    • c. While wages have been rising, due to economic growth at an increasing rate (i.e. the rate of growth of capital has been increasing), profits have been going down.

    3. What about variation over space?

    • a. There is more stock relative to labor in large towns than in villages, so rate of profit is lower, wages higher.
    • b. But why? "It generally requires a greater stock to carry on any sort of trade in a great town ..." Doesn't that reflect a greater demand for capital, because a larger demand for goods? So why is the profit rate lower? Not really explained.
    • c. Similarly, Scotland is less developed than England, interest rate higher, wages lower.
    • d. France has higher profits (higher interest rates, but hard to observe because of varying legal restrictions setting the interest rate below its market level, which people evade in various ways) and lower wages than England. French wages are lower than Scottish wages--because although France is richer than Scotland, it is growing more slowly.
    • e. Holland is richer than England, interest rate lower, wages higher. Why high wages? Smith seems to be arguing that Holland is not declining but not that it is growing faster than England, which is what should be required to make its wages higher.
    • f. In the colonies, profits are high because lots of land etc.--opportunities for investment--and not much capital. Wages are high because population is low relative to stock--and stock is increasing rapidly because of the high rate of profit.
    • g. So "rich" means something like "ratio of capital to land" or "ratio of output to land," with land apparently representing opportunities to invest capital.
    • h. In the colonies, the profit rate has been declining as stock accumulates--but wages are still high because stock is still accumulating.
    • i. Smith seems to be arguing that a large stock with low profits increases faster than a smaller stock with high profits. That might be true if it means "the derivative of the capital stock is higher." But isn't what matters the proportional growth rate--at how many percent per annum the capital stock grows? If so, it will be lower in the low profit case--independent of the amount of capital. But what matters is ultimately the population growth rate necessary to meet the growth of capital bidding for labor, since that determines how well off the workers are in equilibrium--so it is the proportional growth rate of capital that should matter.
    • j. If new investment opportunities appear (new colonies, for example) capital is pulled out of the old trades, and profits go up everywhere.
    • k. Smith has not yet explained why profits are not always the same everywhere, due to just this mechanism.

    4. In a fully developed country, wages should be low (no increase in demand for labor) and profits low (all productive opportunities for investment have been taken up). Lots of competition. But no known cases.

    • a. China seems a candidate, but ...
    • b. Bad laws (very limited foreign trade) and insecurity of property rights keep it down.
    • c. Which is supposed to explain why the interest rate in China is high. Smith is trying to explain away a datum that seem inconsistent with his theory--the fact that China is a very rich country with high interest rates.
    • d. But the bad laws don't explain that--they limit the opportunities for investment.
    • e. Insecurity of property rights would tend to keep down both the supply of capital and the demand for it--why save if your savings might get stolen, why invest if your factory/fertile field/whatever might be expropriated?
    • f. It is unclear to me exactly what Smith's theory here is--is "competition" of stock intended to mean "exhaustion of good investment opportunities?"

    5. If loans are risky because the contract is not enforceable, the market interest rate will incorporate a large risk premium, so overestimate the profit rate.

  • 6. If interest is illegal, the actual interest rates will be high to compensate for the risk.
  • 7. Note that profit rate is profit above losses due to risks.
  • 8. In a fully developed country, the interest rate would be so low that practically nobody could live on interest. Capitalists would also be businessmen--as seems to be true in Holland.
  • 9. Profit is normally more than the interest rate because
    • a. The borrower is insuring the lender--this assumes risk aversion (since Smith has already said that profit is net of loss from risks)
    • b. And the borrower is actually managing the investment.
    • c. But, as Smith already told us, the recompense for that isn't really part of profit but of wages.
    • d. In England, normal profit is about twice the interest rate.
    • e. But the ratio might change with the profit rate.

    10. High profits tend more to raise costs than high wages.

    • a. The argument is that an increase in the profit rate acts as compound interest, since you have to pay a higher rate on the higher amount from the earlier stage of production due to the higher rate on its capital.
    • b. So a one percent increase in the profit rate (from 10% to 10.1%, say) will increase the profit cost of goods by more than a one percent increase in the wage rate (from 100 pence a week to 101 pence a week).
    • c. Provided the production period is more than a year, so that the interest gets a chance to compound!
    • d. But so what? Smith is saying nothing about how much of the price is due to labor (most of it, given the interest rates he is describing and a one year production cycle in agriculture) in the first place, nor about how large the percentage changes in wages and profits are that we can expect to see.
    • e. So we don't actually know that the changes in profits we observe in the real world have a larger effect on prices than the changes in wages we observe in the real world.
    • f. So this is rhetoric, designed to attack people who blame high wages for the difficulty of selling their goods.

  K. Chapter X part I. Wages and profits across employments, where there is perfect liberty.

  • 1. The principle of equal net advantage applies to both wages and profits.
    • a. If one job is, all things considered, more attractive than another, people will move into the one and out of the other, driving down the wage of the former and up the wage of the latter until they are equally attractive.
    • b. Similarly if one line of business yields higher profits, all things considered, than another.
    • c. Note that this assumes that all workers are, in some fundamental sense, identical--there is no premium for special talents. All nurture, no nature.

    2. Differences in money wages arise from:

    • a. Pleasantness or unpleasantness of the employment.
      • i. Smith says that this affects profits as well, as in the case of a tavern keeper.
      • ii. But this is wrong. It affects the wages of the tavern keeper, which are being mistakenly included in his profit--a point Smith makes elsewhere.

      b. How hard the business is to learn--Smith quite explicitly introduces the idea of human capital here. He thinks that this has little effect on the profit rate in different businesses. Here again, if it did affect it, it would really be affecting managerial wages, not profits.

    • c. Constancy of employment. If you can only practice your trade half the year, you must make enough to make up for the days of idleness
      • i. Plus a little extra to make up for risk aversion (or fear)
      • ii. But this ignores the benefit of the extra leisure.
      • iii. He claims that this does not apply to profit--presumably because profit is being calculated annually anyway.

      d. Trust that may be reposed in the workmen.

      • i. He puts this in terms of a link between social status and reliability.
      • ii. The modern version ("efficiency wages") is that such people must get more than the opportunity cost of their labor, in order that ...
      • iii. Betraying their trust and losing their reputation will injure them.
      • iv. But sunk human capital can serve the same function--and produces a better product; we should prefer the highly trained surgeon over the less highly trained one who is getting an above market return on his human capital. Both are in trouble if they lose their reputation--and the former is a better surgeon.

      e. Uncertainty of success.

      • i. To first approximation, the expected return on all investments, including investments in human capital, should be the same. So a profession where many people fail should pay a very high salary to the successes.
      • ii. But Smith believes that people tend to overestimate their own ability and luck, especially young people at the point of choosing a career, with the result that the expected return in very uncertain professions is below that elsewhere.
      • iii. Also, success in uncertain professions results in status adn admiration, providing a non-pecuniary reward. Is this balanced by the nonpecuniary costs of failure? He doesn't say.

      f. Digression on opera singers, actors, and the like. These are highly skilled activities but practicing them for money is considered shameful--so they have to be paid enough extra money to make up for the nonpecuniary cost. Probably not true nowadays.

    • g. Evidence for risk preferring nature of people--aka optimism.
      • i. The fact that people buy lottery tickets. Are there alternative explanations? Is it true,as Smith claims, that the more tickets you buy, the more likely you are to be a loser?
      • ii. The fact that most houses and many ships are not insured (he hasn't thought about moral hazard). He does allow for self insurance by firms with lots of ships.
      • iii. People enlist in the army.

      h. What about the effect of risk on profit? He thinks it is less than fully compensated--but the evidence he offers doesn't show that. Even if it were fully compensated, there would still be more bankruptcies in risky lines of endeavor (his evidence)--compensated by arger profits for the firms that succeeded.

    3. Difference in profit is also a result of confusing profit with the wages of the proprietor.

    • a. If the amount of capital one man can manage is small (country grocer), including his wage in his profit results in a large overestimate of the profit rate.
    • b. Similarly if his labor is highly skilled and should command a high wage (apothecary--who also has a small capital stock).
    • c. This effect lowers the price of goods in big cities, since the proprietor can operate on a much larger scale, requiring a lower per unit markup to pay for his labor.
    • d. Grocery goods have the same wholesale cost ("prime cost") in cities (because they don't take a lot of land, being labor intensive, so can be grown near the city?), so a lower retail cost in cities than in towns.
    • e. Corn and meat have a higher wholesale cost in cities because they must be brought farther--and this is balanced by the lower markup, making the retail price similar in towns and in cities.

    4. In order for the principle of equal net advantage to hold at a given instant, we require:

    • a. That the employments are well known and long established. In a new manufacture, a wage premium is needed to make up for the risk that the job will vanish next year.
    • b. That wages (and profits) are at long term equilibrium.
    • c. That the profession is the chief employment of those doing it. People who make their living doing something that sometimes leaves them at leisure may be willing to spend that leisure working at something that pays below the ordinary wage. Of course, one could say that part of the net advantage of, say, spinning is that you can do it to fill in time when you can't farm.

  L. Chapter X part II. Inequalities due to government policy.

  • 1. Guild regulations, requiring a fixed apprenticeship, limiting the number of apprentices, etc.
    • a. The real purpose is to benefit those in the trade at the expense of their customers. In the short run the requirement of apprenticeship injures the apprentice--but it raises his wage later, when he becomes a journeyman or master.
    • b. The pretended purpose is to protect the customers, who are better protected by being free to buy from whom they please.
    • c. Apprenticeship has bad consequences for the apprentices; since they work for nothing during their apprenticeship they have no incentive to learn to be productive.
    • d. Each guild is willing to pay a high price for other guilds' products in exchange for getting a high price for theirs. There is a mistake in Smith's argument here. The high price reflects in part artificially high costs (the inefficiency of apprenticeship, due to apprentices not working hard). So the guildmaster produces less output per hour than otherwise, and exchanges at the same rate as he would without guild restrictions (both what he buys and what he sells being expensive because of guild regulations), leaving him worse off.
    • e. And the guilds together gain in their trade with the countryside, which has no such monopolies.
    • f. The argument may show that the towns are relatively better off but doesn't show that they are absolutely better off as a result of the restriction--you would have to know how much of the higher price they get reflects higher costs.
    • g. Note the wool-comber argument, which rebuts, a hundred and fifty years in advance, what used to be a standard argument in anti-trust---that if you had a monopoly in one stage of the production process you would use it to get a monopoly in other stages (vertical integration). As Smith points out, you don't have to.
    • h. In fact, Smith argues, husbandry (what we call farming) is a more skilled trade than most town trades, hence has more, not less, need for apprenticeship (although he doesn't want any such requirement for any trade).
    • i. And dumb yokels, in his opinion, are on average smarter than townies, due to the wider range of their activities--just less articulate.

    2. Conspiracies in restraint of trade.

    • a. "People of the same trade ... ."
    • b. We cannot prevent such meetings by any law consistent with liberty and justice (so presumably the Sherman act is inconsistent with liberty and justice--or doesn't work).
    • c. But should not encourage them--as we now do in a variety of ways.
    • d. Nor provide legal enforcement of cartel agreements which would otherwise be unstable.
    • e. This is not just a historical issue. Barbers, physicians, lawyers, and a host of less prominent professions currently use government restrictions on licensing in just the way Smith describes.

    3. Corporations (meaning here guilds, not joint stock corporations) are unnecessary, since the real discipline on a producer is exercised by his customers.

  • 4. A second way in which public policy distorts relative wages is by subsidizing the training of some professions, such as clergy, either privately (by charity) or publicly.
    • a. The result is not only to drive down the wages of the clergy, but ...
    • b. Of the learned professions, in large part populated by unsuccessful aspirants for clerical office.
    • c. In contrast, the top learned men in antiquity seem to have done very well for themselves--before schooling for such activities was subsidized.

    5. A third way is by keeping people from moving from one trade or location to another in response to differences in relative wages (or profits). Throughout Europe this is done by guilds

    • a. Both because they may not permit someone from another town to practice the craft in their town, and ...
    • b. Because they will not permit skilled workers to switch from a trade with a surplus of labor to one with a shortage--even if the trades are so similar that most of the skill carries over.

    6. In England, the poor laws create a further problem.

    • a. Support of the poor is a local responsibility, so, ...
    • b. Each parish is reluctant to allow people who might need assistance to move there
    • c. And has the legal right to send them away, unless they meet conditions which ordinary workers normally cannot meet.
    • d. Or have a certificate from the parish they came from making it responsible for them--which that parish has little incentive to provide.
    • e. With the result that labor mobility is seriously restricted.

    7. There are also occasional attempts at price and wage control, not very effective, and typically designed to favor of the employers, not the employees.

  M. Chapter XI part I: Rent

  • 1. What does Smith mean by describing "rent" as a monopoly price?
    • a. Ordinary prices are determined by cost of production
    • b. "Monopoly" prices are determined by demand--the highest price you can get.
    • c. Unlike our monopoly models, there is no Price vs Quantity tradeoff here--the landowner simply finds the highest price someone will pay.
    • d. Think of an ordinary price being determined by a horizontal supply curve.
    • e. And a monopoly price--at least rent--by a horizontal demand curve--correct model for a single landowner, precisely because he is not what we would call a monopoly.
    • f. But it is natural for Smith to think of a demand determined price as a monopoly price, since a monopoly controls entry and therefore blocks the mechanism that normally gives you a long run price equal to cost of production.

    2. Improved transport benefits almost everyone.

    • a. The town has better access to agricultural products.
    • b. The distant countryside has better access to town markets.
    • c. The near countryside? Not so clear. He thinks it benefits, partly because the competition makes people manage better. ??? This corresponds to the modern popular rather than the modern economic version of the benefit of competition.

    3. Meat vs bread.

    • a. Meat is land intensive, bread is labor intensive, so...
    • b. Relative price of meat to bread rises as population increases relative to land.
    • c. Currently meat worth about twice+ as much as bread by weight.
    • d. What is it now? Check your local supermarket.
    • e. Again a theory of equal net advantage--this time for the use of land, which must yield the same amount producing either wheat or meat.
    • f. The owners of land that is fit only for raising cattle ( "uncultivated moors") get a free ride in high rents when population expands enough so that some good land must be used for raising cattle.
    • g. Grass has a higher weight to value ratio, so if there is not enough land nearby you grow grass locally (for grazing) and import corn. Why not import the cattle?
    • h. Note "artificial grasses"--the second agricultural revolution is happening.
    • i. Note the way in which Smith is doing his own research--dredging through the surviving records to establish patterns of prices, wages, etc. A useful skill anytime you are researching a new area. Data mining.

    4. Determinants of rent.

    • a. Capital investment in land (improvement) raises its rent.
    • b. Some land (vineyards producing especially good wine) do not produce enough to equal effectual demand--what demand would be at a price determined by ordinary profit, labor, and rent. So they pay an extra high rent. Note that here again, he is using one point on the demand curve in order to make a sign argument--that the rent on such land will be higher than rent on ordinary land.
    • c. Similarly with sugar plantations in the West Indies--the land there doesn't get used to produce other crops (at least for export), so there is no land available to switch to sugar if sugar is more profitable (as it is).
    • d. In contrast, in Cochin China (Southeast Asia I think), land is used for sugar and other crops, and sugar is much less expensive than in Europe. Presumably the rent on sugar fields there is the same as the rent on other land.
    • e. Evidence of very high rent is that absentee owners can afford to cultivate the land, despite the incentive problem of controlling very distant managers.

    5. Rent is determined by the productivity of the crop that people mostly eat.

    • a. Non food-crop land determined by that, if it can substitute for food crop land, via equal net advantage--the rents must be the same. Otherwise land would change use until it was.
    • b. Food crop land determined by that, ultimately, because wages tend towards subsistence?
    • c. So a given output of food is worth more--in Smith's sense, measured by labor--the more people it will feed.
    • d. And, since agricultural labor is a subtraction from rent--a cost of production--the fraction of the produce that goes to rent should also be higher if calories per acre are higher (actually, if calories per hour of farm labor are higher).
    • e. Rice lands are not in equilibrium, because they are unsuited for corn, and vice versa.
    • f. In Smith's day, potatoes are the new miracle crop.
    • g. And his evidence that they are healthy (and oatmeal is not) is that Irish laborers and prostitutes seem to be healthy and beautiful--unlike Scottish peasants.

---

Correction

In Class Monday I said we were not covering Book II. I was wrong. It is book III that is omitted on the syllabus; Book II is included, you should read it, and you will be responsible for it.

Book II

• Chapter I
  • A. Division between capital and stock for immediate consumption.
    • 1. Isn't the latter a sort of a capital stock too? It saves the trouble of going to the store.
    • 2. But Smith tends to distinguish between things that produce services and things that produce goods, as we will see.

    B. Division between fixed and circulating capital.

    • 1. Circulating provides revenue only when it goes from him.
    • 2. Fixed only as he keeps it, and includes
      • a. Not just machinery, but
      • b. Improvement of land and
      • c. Human capital.
      • d. Seed corn. Odd case, but makes sense, since you keep running it from the barn to the field to the barn to the field ... without ever giving it up.

      3. Is this really a sharp distinction? Doesn't fixed capital "go from him" eventually too--with a much longer production period?

    • 4. The material that makes up his circulating capital goes from him in the same sense--is converted into something else that he sells.

    C. So stock divides into ...

    • 1. For immediate consumption, which includes the entire housing stock! Useful but not productive.
      • a. I might get a revenue by renting out my house, but ...
      • b. That comes from my tenant's production, not the house's production.
      • c. Following this through, am I an unproductive worker?
      • d. That depends, apparently, on whether this class is a consumption activity or a process for increasing your human capital.

      2. Fixed capital. Which includes buildings that are used in producing revenue--farmhouses, shops, warehouses, etc.

    • 3. Circulating capital.
      • a. Includes the money stock!
      • b. Which is the only part that is not being continually withdrawn from circulating capital as it becomes a consumption good or whatever.

      4. Every fixed capital requires a circulating capital to yield revenue.

    • 5. Circulating capital is replaced as it circulates.
    • 6. Fixed capital as it wears out--also money.
    • 7. But circulating capital can also "wear out"--via rats in the granary, for example.

    D. Where property rights are secure, people will always use their stock for something.

    • 1. Where insecure, they may conceal it
    • 2. Evidence that that was once the case is the importance of treasure trove in the past.

  Chapter II: Money

  • A. Distinction between gross revenue and neat (we would say net) revenue.
    • 1. Net is net of the cost of producing.
    • 2. Gross revenue is the whole annual produce (but does not include the flow of services from a dwelling house).
    • 3. Net subtracts the cost of maintaining it.
    • 4. For example, the cost of maintaining machinery, and of building it ... . Those are intermediate goods.
    • 5. Which matters, because when we discover a way of making the same improvement at lower cost, we are better off.
    • 6. But the "expense of maintaining" the circulating capital is not a subtraction--because that simply consists of replacing goods as you sell them, and selling them is the ultimate use.
    • 7. It would count if we were considering the expense of storing grain, loss to goods through rot and mildew, etc.--possibilities Smith does not consider.
    • 8. And it does count in the case of money, where we have to replace what is worn out.
    • 9. And money itself is not a part of the revenue of the society, but the wheel by which goods are circulated--in that respect like a fixed capital.
    • 10. Otherwise you would double count--count both my income and the goods it buys.

    B. Paper money

    • 1. The institutions: Private banks issuing paper money in Scotland, the bank of England, which is essentially a government maintained monopoly, in England.
    • 2. The questions:
      • a. How much paper money can be put into circulation?
      • b. What are the consequences for prices and output?
      • c. What institutions will put that amount (or less) into circulation?

      3. As paper money goes into circulation, it drives out an equal quantity of gold, which goes abroad.

      • a. In modern quantity theory terms (and Hume had already invented the quantity theory at this point), the increased money stock raises prices a little, at which point foreign goods are a little cheaper, so the balance of trade goes negative, so gold flows out.
      • b. The process continues until the money stock is back at its old level--as Smith says.
      • c. And the country is richer by whatever was bought with the gold.
      • d. Just as we are richer if we can make the same machine at lower cost.

      4. What happens to the gain from paper money?

      • a. If it goes to luxurious consumption, no general gain.
      • b. If it becomes part of the capital stock, general gain.
      • c. The latter happens, because banking does not increase the revenue of the idle, so does not, on average, increase their consumption.
      • d. Where does the new money appear? If people get cash accounts, it replaces their cash balance. Is Smith assuming that idle people don't hold much of the society's cash, or that they can't get cash accounts?

    C. Bills of exchange: Very short term loans

    • 1. Normally generated in commerce:
      • a.The grocer buys wheat from the wholesaler, doesn't have the cash, but will have it when he sells the wheat.
      • b. So he pays with a bill of exchange--essentially a postdated check.
      • c. The wholesaler takes it to a bank which discounts it--pays him a little less than the face value, and gets the check.

      2. Also used in international dealings:

      • a. I am a Venetian, going to Rome.
      • b. I go to my banker, he has a bill of exchange drawn on a Rome banker for two weeks from now which he discounted for someone. He sells it to me.
      • c. When I get to Rome, I go to the Rome banker and exchange it for money.
      • d. Or my Venetian banker writes a bill of exchange on himself, which I take with me to Rome and discount there.

      3. Widely used because very enforceable:

      • a. If the bank that allowed me to write a bill of exchange on it doesn't provide the money to cover the "check" by the date it is due, it is declared bankrupt.
      • b. If I then don't make my check good, I am declared bankrupt.
      • c. If it passed through multiple hands, the last endorser owes the money--and if he fails ...
      • d. And it is for a short term, so not much time in which all of those people could go bankrupt and be unable to pay.

      4. Could be misused by the equivalent of kiting checks. An expensive way of raising capital for someone without much credit.

    D. What mechanism regulates private issue of paper money?

    • 1. Bank can put the money into circulation by making loans, by discounting bills of exchange, by offering cash accounts (i.e. a line of credit).
    • 2. But if it puts into circulation more than people want to hold in its notes, the surplus keeps coming back to be redeemed for coin.
    • 3. Giving it the expense of continually turning assets into cash.
    • 4. It can prevent that if it somehow restricts its issue to what would have been the money balances of its customers--defined as the people who are willing to hold its notes instead of coin.
    • 5. One way is to issue only on cash accounts, and keep track to make sure the customers are continually repaying in a short interval. Thus the cash account plus the money issued are replacing the cash balance of the customer (Smith seems to miss the former part) as a "shock absorber," cushioning short run fluctuations in income and expenditure.
    • 6. Smith thinks that discounting real bills also qualifies, since there also, money would have been used instead. Maybe.

    E. What went wrong in Scotland?

    • 1. Banks were tricked into overissuing via circulating bills of exchange, by speculators--not in our sense, but people making speculative investments.
    • 2. Those who favored the idea thought that issuing money provided capital. But, as Smith sees, it only provides capital to the extent it replaces the gold and silver that would otherwise have been used.
    • 3. It is hard for a bank to get out, because if it refuses to issue the next bill of exchange the previous one doesn't get paid, lots of people go bankrupt, and the bank loses a lot of money.
    • 4. Luckily for them, the Ayr bank, apparently convinced by bad economics, went into business with lots of capital--and ended up going bust with all the bills of exchange drawn on it.

    F. Note that a bank might have two quite different, but easily confused, functions:

    • 1. Producing money.
    • 2. Acting as an intermediary in loans.
    • 3. But when it produces money it has that money as capital, so loans it out.
    • 4. Smith thinks that loans qua loans are a bad idea for a bank, because an individual can more readily monitor a few creditors than a bank can monitor a lot of creditors.
      
• Chapter III: Accumulation of capital, productive and unproductive use of labor.
  • A. The essential distinction between:
    • 1. Productive labor: Labor that produces some tangible value as output.
      • a. Includes not only farmer and merchant but ...
      • b. Trader and retailer
      • c. Because their labor (and their employees' labor) increases the value of the goods they handle.

      2. Unproductive Labor: Labor that produces services not used to produce output.

      • a. Most obviously, the labor of servants, but also ...
      • b. The King, courtiers, army, .... . How would Smith distinguish, if at all, between the army and private guards to prevent theft of good from a factory?
      • c. Singers, musicians, actors, ...

    B. The distinction matters because:

    • 1. Productive labor not only feeds the laborer but replaces the stock that fed him with a greater stock (labor plus profit).
    • 2. Unproductive labor, although it may be very useful, produces a stream of services, not embodied in the value of physical goods, so vanishes as soon as consumed.
    • 3. Someone who merely replaces his capital--i.e. consumes his profit--is neither increasing nor decreasing the capital stock. Some of his revenue goes to productive labor (to replace the circulating capital) some to unproductive (his own consumption).
    • 4. Someone who saves part of his profit and reinvests it is increasing the capital stock.
    • 5. Someone who spends the profit and part of the capital decreases it.
    • 6. Similarly, someone who consumes all of his rent keeps the capital stock constant, someone who saves some increases it, someone who borrows against his land and spends the money decreases the capital stock.

    C. And the capital stock matters because it is the fund that employs labor, and its increase leads to higher wages, more output, etc.

  • D. Rich v poor countries:
    • 1. Rent, with development, increases in quantity per acre but decreases as a fraction of total output. Is this merely a historical observation, or does Smith have an explanation? It is not clear.
    • 2. Profit, with development, increases as a proportion of the national income, but decreases as a proportion of the stock. In other words, the profit rate falls.
    • 3. Note that the number of acres is staying constant with development; the amount of capital is increasing enormously.

    E. Effect on society:

    • 1. People are more industrious the larger the fraction of the labor is productive.
    • 2. Why? Shouldn't a judge or a cook or an actor work just as hard as a weaver?
    • 3. Extensive anecdotal evidence, but no clear theory.
    • 4. Possible argument--the employers of weavers are professional employers and know how to make sure their employees work. The employer of a servant is a professional nobleman, the employee of the judge is the King, and neither is an expert at getting work out of his employees? Smith does not make this argument--or any that I can find.

    F. Prodigality and Parsimony:

    • 1. A prodigal reduces the capital stock, ultimately reducing the annual produce of the country and the wage rate. He eats up the capital that would have kept employing people forever.
    • 2. The argument does not depend on whether he consumes home or foreign commodities.
      • a. Smith is responding to people who think national wealth is the stock of gold and silver
      • b. Pointing out that as output falls, so will the money stock, for standard quantity theory reasons
      • c. So both the correct view of the real wealth and revenue of the country (annual output) and the incorrect (stock of gold and silver) lead to the conclusion that the prodigal, even if prodigal only at home, reduces national wealth.
      • d. This is not obvious, since the money he spends may be spent in England.
      • e. But it is correct, since eating up capital ultimately reduces national output, which reduces the demand for money, with the result that money flows out.

      3. But frugality is a more reliable and consistent pattern of behavior than prodigality, so private frugality generally wins out over private prodigality.

    • 4. Capital is also eaten up by imprudence--bad investments. But that is a fairly minor factor.
    • 5. Public prodigality is a much more serious risk, but even that ...
    • 6. Is usually outweighed by the effect of private frugality.

    G. Progress of England

    • 1. Can only come through capital accumulation, via
      • a. Increasing the number of productive workers (bidding them away from unproductive activities, or increasing the population, or both?)
      • b. Increasing their productivity via more fixed capital or ...
      • c. Increased division of labor
      • d. All of which depend on increasing the capital stock.

      2. And England has in fact been making progress, so far as Smith can tell, as far back as he has information--which is to Roman times.

    • 3. Note his description of the pamphlets etc. arguing that things are going to hell, when in fact the long term pattern is steady improvement. They are still coming out. Famine 1960, for example--now somewhat dated.
    • 4. Progress continues despite government prodigality.

    H. Two forms of personal consumption:

    • 1. Immediate consumption expenditures and
    • 2. Expenditures on capital goods (in our sense) that yield a flow of consumption services--fancy houses, gardens, art, ... .
    • 3. The latter is less damaging, since at least you have something for your money that continues giving you services, and ...
    • 4. Eventually gets passed down to poorer people.
    • 5. Also, it is easier to come to your senses and stop being prodigal with regard to the second category.
    • 6. If you stop your lavish consumption people conclude you either see you were acting foolishly or have run out of money.
    • 7. If you stop your lavish building, collecting, etc. people may conclude that you have gotten what you wanted.
    • 8. But the consumption version may betoken a more generous spirit, since you are feeding your friends as well as yourself.

  
  Chapter IV: Of Stock Lent at Interest

  • A. Money that is lent usually gets spent on productive not unproductive labor.
    • 1. The exception is where you lend to a prodigal.
    • 2. Which you avoid for fear that he will be unable to repay you.
    • 3. "Except in cases of gross usury."Which we would describe as a risk premium. What is wrong with risk loans at high interest rates? It is a subject we will return to.

    B. Money vs real stuff

    • 1. Loans are made in money but really consist of the goods you get with the money.
    • 2. Smith is answering a fallacy that remained common from then until now--the idea that if there is more money there will be more to lend-- "cheap money."
      • a. One version is responsible for the Social Credit Party of Canada--the Douglas Credit movement, which wanted the banking system to provide lots of cheap credit via the printing press.
      • b. Another appears regularly in press reports on the Fed--the idea that it can cause low interest rates by easy money--in the sense of expanding the money supply--and high by tight money.
      • c. True in the very short run, if it creates money and lends it out as capital, but ...
      • d. That is a tax on the money balance used for loans, and its long term result is to raise nominal interest rates, not lower them.

      3. Smith points out that the amount that can be lent is not limited by the money supply, since the same thousand pounds can be lent out over and over.

    C. Why the interest rate falls as capital accumulates (finally)

    • 1. Limited opportunities for capital investment, so have to find less and less productive ones, or ...
    • 2. Compete someone else out of what he is doing--which requires selling at lower prices and buying at higher prices, reducing the profit rate.
    • 3. Competition for workers drives up wages.
    • 4. And as profits fall, so does the interest rate people will pay to borrow money in order to use it to earn profits.

    D. Smith (actually Hume) answers those who believe that it is the increase in gold and silver from the New World that drove down the interest rate.

    • 1. The interest rate is a ratio of two amounts of money--interest paid (in money) divided amount borrowed in money.
    • 2. An increase in the amount of money that reduces the value of money reduces both terms, leaving their ratio unaffected.
    • 3. On the other hand, an increase in the total real output of a society would lower prices (assuming the quantity of money stayed the same) and lower the profit rate--because the real amount of capital would have increased.

    E. Smith's defense of a moderate usury law

    • 1. Prohibitting interest, or fixing it by law below the market rate for good risks, is a mistake--the law will be expensively evaded.
    • 2. Setting it equal to the market rate for good risks is a mistake, because slightly less good risks will be unable to borrow from law-abiding lenders.
    • 3. Setting it a little above the market rate for good risks is a good idea, because it keeps money out of the hands of risky borrowers--which is to say, profligates.
    • 4. But what is wrong with risky borrowers who are willing to pay for the risk? They may be people with projects that might not work but will pay handsomely if they do.
    • 5. And a profligate who wants to waste his inheritance can do so without bothering to borrow, by selling his inheritance bit by bit--it's just a little less convenient.
    • 6. Smith's position was attacked by Bentham, and Smith may (or may not) have conceded the justice of Bentham's attack.

    F. The price of land:

    • 1. Is the present value of the flow of rents, capitalized at the interest rate.
    • 2. Or a little more, because land is a more secure investment than most others and gives status etc.
      
• Chapter V: Of the different uses of Capital
  • A. Four different uses
    • 1. Agriculture
    • 2. Manufacture
    • 3. Merchant--wholesale and manufacturing
    • 4. Retail

    B. Their consequences: How much labor does each immediately put in motion?

    • 1. In all cases, the labor of the capitalist is itself productive
    • 2. Retailer adds only his labor and profits to the value of the goods, but also replaces the capital of the wholesaler
    • 3. Wholesaler (who also provides transportation of the goods) adds his labor, profits, and the labor of the sailors etc. that he employs to the value of the goods, and also replaces the capital of the farmer and manufacturer.
    • 4. Manufacturer puts immediately into motion the labor of lots of employees. He also replaces the capital of the makers of his fixed machinery, the farmers, the miners, etc.
    • 5. Farmer puts into motion even more than anyone else? Why?
      • a. He is at the bottom of the tree, so almost none of his expenditure is to replace other people's capital?
      • b. Nature labors with man.
      • c. Farmer produces both the cost of labor etc. and the rent.
      • d. So his labor results in more production than anyone else's.
      • e. But only point a above implies that he puts more labor into motion--the others merely imply that he produces more value.

    C. Mobility/immobility of capital:

    • 1. Underlying a lot of Smith's analysis, but so far not discussed, is the question of the mobility of capital.
      • a. A capitalist who invests his own money needs to know what is happening, to be secure, etc., which is easier in your own country.
      • b. And even a lender wants to know his creditors--which is easier if they live nearby.
      • c. So there is always some tendency for capital to stay near the capitalist.
      • d. To a degree varying with the activity.

      2. How does the immobility of the capital relate to which of the four uses it is in?

      • a. Farmers and retailers have to be present to run things, so usually must be resident members of the society they are doing business in.
      • b. The capital of the merchant can move around, since he is doing business in many places, so can easily shift from buying or selling in one place to buying or selling in another.
      • c. The manufacturer must be where the manufacture is carried on--but that is not tied to geography in the way farming and retailing are. You can buy goods from country A, manufacture in B and sell to C.

    D. The effect on the society of the different uses of capital and how it is related to whose capital it is.

    • 1. It doesn't much matter whether the capitalist doing international trade lives in England or not,
      • a. since the only difference is whether his labor and profits are English.
      • b. His employees may, either way, be English or foreign.
      • c. And he replaces the English capitals of the English farmers and manufacturers just as well whether he is English or foreign.

      2. It matters more whether the manufacturer is living in England.

      • a. If he is, the labor he puts in motion is English
      • b. But even if he is not, he may still be useful by absorbing English products (Baltic products being absorbed by English manufacturers in Smith's example).

      3. If there isn't enough capital, you should first use domestic capital in agriculture then in manufacture (he is ignoring retailing at this point for some reason), then foreign trade.

    • 4. Which is what the American colonies are doing, with great success.
    • 5. But is this really because agriculture is more productive or because it is harder to do it with foreign capital?
    • 6. The latter fits Smith's conclusion--laissez-faire--better than the former. Why would people want to use capital in the way that puts into motion the largest possible amount of domestic labor?

    E. How the amount of labor put into effect depends on the details of the use of capital.

    • 1. Domestic carrying trade replaces two domestic capitals.
    • 2. Foreign replaces one domestic, one foreign.
    • 3. And usually the foreign replaces much more slowly, because longer production period (farther to go)
    • 4. Why does this matter? He is ultimately getting at capital as a demand for labor, I think. Capital used in a distant trade buys fewer hours of labor per pound of capital, etc.
    • 5. Capital used to transport goods between two foreign countries puts in motion no domestic labor, other than the capitalist. It only happens when, as in the Dutch case, there is nowhere better left for the capital to go.
    • 6. Foreign trade is politically popular and the argument is that England's defense and security depends on lots of ships and sailors. But that can be provided just as well by coastal trade etc. So forcing capital into foreign trade does not necessarily increase the size of the merchant marine.

    F. Conclusion: Laissez-faire

    • 1. No adequate theoretical argument given here--why not subsidize farming?
    • 2. Smith concludes that the opposite has happened, that the policy of Europe has slowed the development of agriculture in order to subsidize trade and manufacturing, which shows that current policy is bad but not that all intervention is bad.

Book IV

• Chapter I: What is wrong with mercantilism
  • A. Note that most of what Smith is attacking--17th and 18th century economics--is still alive and well everywhere except academic economics.
  • B. The obvious mistake--to confuse wealth and money.
    • 1. Wealth is often measured in money, and if you have money you can get other things, so it is tempting to suppose that the more money a country has, the wealthier it is.
    • 2. The Tartar error of identifying wealth with sheep is closer to the truth than the Spanish error of identifying it with gold--sheep being more useful than gold
    • 3. Some people argue that money is crucial because a nation needs it to carry on foreign wars.

    C. Consequences of that mistake.

    • 1. Simple version: Make it illegal to export money.
      • a. But money is easily smuggled, so this doesn't work
      • b. And impoverishes the country by the cost of the smuggling.

      2. Fancy version: Try to maintain a "favorable balance of trade"

      • a. This term is still in use--what is favorable about it? "Problem" of the trade deficit--why is it a problem?
      • b. Sophisticated supporters of this position argue that the simple version is too simple, since sending gold out sometimes brings more in.
      • c. nice quote on page 434 "just as fruitless"
      • d. Worrying about the balance of trade is unnecessary, since a productive country will acquire gold and silver sufficient to its demand just as it acquires wine sufficient to its demand.
      • e. Indeed more easily, since value to weight is so much higher, making it easy to transport gold and silver.
      • f. And a country cannot keep in more than it has a demand for, since it is so easily smuggled.

    D. Why money is considered important.

    • 1. People who find it hard to borrow complain there is not enough money.
      • a. Sometimes spendthrifts, sometimes
      • b. Sober men with overambitious ideas for investing capital.
      • c. The problem is not that there is not enough gold but that there is not enough capital--or that the people who have it don't want to lend it to them.

      2. Idea that money is more important because more durable.

      • a. So is hardware.
      • b. Would we enrich the nation by making sure people had lots more pots and pans--which is to say, more than they actually want and can use?
      • c. Would that somehow give them more food to put in the pots and pans?
      • d. No more does having more money give you more goods for the money to circulate.

      3. Money is needed for carrying on foreign wars.

      • a. In primitive state of society, perhaps--when the king stores up a treasure for that purpose.
      • b. But in an advanced state, countries pay for their wars by exporting more than they import and spending the difference on supporting armies and fleets.
      • c. The "mercantile republic" means the world economy.
      • d. If you want to support foreign wars, you want an economy that produces lots of potential export goods--preferably good with high value to weight, so not too hard to export.

    E. Real gain from foreign trade:

    • 1. Not acquiring gold and silver--that job would take a ship a century--but ...
    • 2. More of a market for your produce and ...
    • 3. Greater opportunities for division of labor.
    • 4. The effect of the gold and silver of the New World on Europe was
      • a. To make gold and silver plates etc. cheaper, more widely used--a small gain.
      • b. To make money less valuable per weight, hence less convenient--a small loss.

      5. But an enormous gain in opportunities for trade.

      • a. Should have benefitted both sides, but ...
      • b. The savage injustice of europeans ...
      • c. Made it a bad deal for the American natives.

      6. No such enormous gain occurred with the discovery of the East Indies

      • a. Should have, since civilized nations are much better potential trading partners than savages.
      • b. But East Indian trade was almost all through national monopoly trading companies.

    F. The mercantilist error led to a lot of different sorts of restraints, which Smith is about to analyze in the next few chapters.

• Chapter II: On restraints on imports that compete with domestic produciton. (which we would call protective tariffs and quotas)
  • A. High duties or prohibitions give domestic industry a monopoly of the home market; is this a good or bad thing?
    • 1. Clearly it can benefit the protected industry, but ...
    • 2. It is diverting capital there from somewhere else.

    B. Why the national interest is usually best served by letting people decide for themselves where to employ their capitals.

    • 1. People prefer, for their own convenience, to employ capital as near home as possible, which (Smith argues) is also in the national interest.
      • a. A modern economist would want a quantitative, not just qualitative version of the argument
      • b. Which, on Smith's terms, is not going to work, because ...
      • c. The private incentives (easier supervision) for using capital at home also count in the national interest calculation, but ...
      • d. The national interest reason he believes exists does not count in the private calculation, so...
      • e. If the higher profit in foreign trade is just enough to cancel the greater difficulty of supervision, the capitalist will be indifferent between the two alternatives, but ...
      • f. It will be, by Smith's account, in the interest of the nation for him to invest at home.

      2. In investing at home, each person tries to pick the investments that produce the greatest value, which is good for both him and the nation. This argument does work, although it is being made in a simpler form than a modern economist would make it.

    • 3. "those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it."
    • George Stigler comments somewhere that Smith would have done us a great favor if he had written down those very few words, since Stigler finds dissuading businessmen from the belief that they are doing busineess in the public interest harder than Smith did.
    • 4. An individual capitalist is in a much better position thatn a statesman or lawgiver to determine how best he should invest his money. Great quote ending "and which 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."
    • 5. And giving the monopoly of the home market to domestic manfacturers is in some measure telling people how to direct their capital because ...
    • 6. Getting goods by importing them really means getting goods by producing something else that costs less to produce than what you are going to get, sending that something else abroad, and trading it for the foreign goods you want. Hence a tariff is telling people to produce the goods they would have imported in a more expensive way (at home) rather than a less expensive way at home (produce export goods at home to trade with foreigners for what they want).
    • 7. Hence using the industry of the nation in a less productive way, making us worse off.
    • 8. Infant industry argument: Perhaps temporary protection will result in an industry that can produce the goods we were importing as cheap or cheaper, but ...
      • a. In the meanwhile, we are making ourselves worse off, hence reducing the capital stock (not necessarily--the higher cost in the short run might be paid from reduced consumption), which makes us worse off in the long run.
      • b. This argument is inadequate, since if the new industry can really produce the goods more cheaply than we can import them (in the long run) that gain might be enough to make up for the loss.
      • c. Smith may be being fooled here by thinking of the value of output as proportional to the labor that goes into it (+capital and rent), and forgetting that if the same goods become cheaper, measured in labor, i.e. "less valuable," that is a benefit.

      9. Benefits of trade and division of labor are likely to be bigger in the international than interpersonal context, since nations differ in natural advantages (climate etc.) whereas people only in acquired advantages (again Smith assumes nurture is much more important than nature as a cause of human differences).

    C. Consequences of protection and of abolishing protection.

    • 1. Most of the gain from protection goes to merchants and manufacturers, since much of what they make has a high enough value to weight ratio so that transport costs are not prohibitive and thus faces potential competition from abroad.
    • 2. Farmers and country gentlemen (i.e. landlords) are at much less risk, since grain and cattle and butcher's meat all have a low value to weight ratio and are therefore expensive to transport.
    • 3. So only a very big price difference will result in substantial imports.
    • 4. A conclusion Smith thinks is supported by recent evidence, esp. with regard to imports of cattle from Ireland.
    • 5. And for a well developed country, raising cattle would be a wasteful use of land, so they would be better off importing them. Note the distinction between raising, which can be done at a distance, and fattening, which has to be done fairly close to where they will be eaten.
    • 6. Also, the bounty on exporting corn means that smaller stocks are carried over from year to year, so results in more imports in a bad year, hence ...
    • 7. The real gainers are the people who transport corn, not the ones who grow it.
    • 8. But doesn't the bounty also raise the price in both good years and bad ones, benefitting the growers? The larger carryover stocks without the bounty would keep down the price in bad years.
    • 9. Farmers and country gentlemen are good guys, led astray by the merchants and manufacturers into demanding trade protection.
    • 10. And one reason they are good guys is that they are dispersed, so cannot as easily organize against their customers. Note the mix of "generosity which is natural to their station" on the one hand and rational self interest arguments on the other.

    D. Exceptions to laissez-faire: When is government interference justified?

    • 1. When some industry is necessary for national defense.
      • a. In time of war, England needs ships and sailors (although in fact, in the next series of big wars, the English were perfectly willing to use foreign sailors in the navy when they could get them).
      • b. So subsidizing English shipping in various ways was justified.
      • c. This regulation makes England poorer--but that is a price worth paying for defense.

      2.To balance the effect of a domestic tax on the industry--impose the same tax on imports. Note that this can be justified in modern terms as dealing with an externality, since otherwise the import not only reduces the sales of the domestic industry but also the revenue of the government.

    • 3. Some people argue that this justifies general import taxes if the necessaries of life are being taxed, since that drives up the general cost of production and implicitly taxes everything. Smith disagrees ...
    • 4. Because it is not practical to calculate the proper amount of such taxes, and ...
    • 5. Because it is analogous to the case of a bad climate etc. making a country less productive.
    • 6. But this is wrong. If we tax the necessaries, and if encouraging labor intensive domestic industry results in more of the necessaries being bought, it also results in more taxes coming in, which is not true in the case where necessaries are expensive due to natural factors.

    E. When is government interference possibly justified--or possibly not?

    • 1. Retaliatory duties
      • a. if we really think they can be used to negotiate a mutual reduction in trade barriers.
      • b. If there is no likelihood of that, they merely add a second injury imposed by our government to a first imposed by someone else's.

      2. If we have high duties and industries have adjusted to them, and an immediate abolition will throw lots of people out of work and cause a lot of trouble. but ...

    • 3. Smith thinks this is less of a problem than generally imagined, because ...
      • a. In many industries, England is already an exporter without a bounty, hence produces more cheaply than it could import, so abolishing protection would have little effect--just a few imports by men of fashion who liked foreign goods.
      • b. The economy can absorb a lot of labor, as demonstrated by what happened when the war was over and lots of soldiers and sailors became unemployed.
      • c. Indeed, this is a harder problem than would result from abolishing trade protection, both because the numbers of people were bigger and because soldiers are less suited to be workers than workers (shifting from one industry to another) are.
      • d. And soldiers are more suited to be troublemakers. "more than a hundred thousand men, all accustomed to the use of arms, and many of them to rapine and plunder."

      4. And it would be an even smaller problem if they repealed guild regulations and the law of settlements, thus increasing labor mobility. Note that it is the law of settlements, not the poor laws, he wants to repeal.

    F. But it isn't going to happen--Smith thinks it is more likely that Utopia would be established than that England will abolish its trade restrictions (which in fact happened about seventy years after Smith wrote, in part due to his influence).

    • 1. Because the private interests of many (merchants and manufacturers) oppose it
    • 2. And they will fight to keep their privileges.

    G. But the abolition of protectionist laws should be done gradually.

    • 1. Which is an argument against creating them in the first place, or extending them, ...
    • 2. Since they are so hard to get rid of.
      
• Chapter III:
  
• Part i: Argues that the actual policies implemented do not make sense even on mercantilist principles--an important (public choice) point. "and smugglers are now the principal importers, either of British goods into France, of of French goods into Great Britain."
  
• Part ii. And unreasonable on other (i.e. correct) principles.
  • A. The argument assumes that a "trade deficit" means the country is losing by trade, which is absurd.
    • 1. If you believe that a country gains when it has a trade surplus and loses when it has a trade deficit, it seems to follow that a balanced trade is neither a gain nor a loss for either country. But it lets both gain by employing their capitals in a more advantageous way, increasing them
    • 2. Smith assumes the commodities exchanged to be of roughly equal value. He doesn't think about the ambiguity of his sense of "value" --how many hours of work it takes to buy something--when wages are different in the two countries.
    • 3. It is easier not to stumble over the principle of comparative advantage when you are in a gold standard world, where all prices are comparable, than in a paper money world, where it is not obvious how prices in yen can be compared to prices in dollars.
    • 4. Smith runs through gains of trade, pointing out that they apply if what is exported is gold just as if what is exported is something else.
    • 5. "Losing trade with the alehouse?" No. (this is apparently an argument about whether there should be import duties on wine--and leads in the direction of questioning sin taxes, such as our high taxes on alcohol and tobacco)
      • a. The opportunity to buy anything can be abused if someone acts foolishly, but ...
      • b. That is not a good argument against institutions that make it cheaper to buy things.
      • c. Any way, inhabitants of wine countries are sober people, being used to the stuff.
      • d. And taxing wine makes it a luxury good, which makes getting drunk a form of showing off.
      • e. If it was untaxed and cheap, people would get a drunk for a while, but once they adjusted to its being cheap would be as sober as Frenchmen or Spaniards.

    B. One implication of mercantilist doctrines is that everybody else's prosperity is a threat to us.

    • 1. The modern form of this dangerous mistake appears in the word "competitiveness," which suggests that what matters is not how well off we are, or how good at producing, but how well off relative to other countries.
    • 2. This makes commerce a source of international conflict when it should be a source of international amity.
    • 3. Quote on the "impertinant jealousy" of merchants and manufacturers.
    • 4. "And they who first taught it were by no means such fools as they who believed it."
    • 5. Because domestic manufactuers profit, and the rest of us lose, through trade restrictions.
    • 6. In fact, the wealth of our neighbors is a good thing in time of peace, since it makes them better trading partners--although it may be a threat to us when we are at war with them.
    • 7. And their manufacturers may be enemies to our manfacturers, but they are friends to the customers of our manufacturers--i.e. the mass of the population.
    • 8. Near neighbors are the best people to trade with because the turnover is fast. England and France should be trading with each other for their mutual benefit. And France is a much bigger economy than the New World as well as much closer.
    • 9. Predictions of national collapse due to unfavorable balance of trade are often made and never fulfilled (sounds familiar--except now it is due to overpopulation).

    C. The balance that really matters is not between exports and imports but between production and consumption--i.e. capital accumulation.

   

  Chapter V: Bounties

  • A. Export subsidies--not very common nowadays.
  • B. Only necessary for industries that cannot make money exporting without a bounty
    • 1. Which means that the returns for what they produce are less than the cost, so on net we are eating up capital by engaging in those industries.
    • 2. So we are forcing trade from a more to a less advantageous activity.

    C. Empirical evidence on the effect of the corn bounty.

    • 1. The amount England has gotten for exporting corn has exceeded what it has paid for importing it by more than the amount of the bounty.
    • 2. But this confuses revenue with profit--the exported corn cost something to produce.
    • 3. Consider the argument in a simpler world where there were no imports at all. If England exports £100,000 worth of corn while spending £50,000 subsidizing the export, does that represent a net gain?
    • 4. The fact that the corn would not have been exported without a bounty (if it is a fact--if not, we don't need the bounty) means that cost of production was more than the price it could be exported for-say a total production cost of £70,000-hence England lost by the bounty. They got £100,000 of revenue in exchange for £120,000 of taxes plus production cost.
    • 5. The price of corn in England has inded been falling, but that is in spite of the bounty.
      • a. Happened in France, which has export restrictions, not a bounty
      • b. And presumably reflects the inflow of gold and silver from the New World.

    D. Theoretical argument:

    • 1. A bounty tends to raise the price of corn in good years (by encouraging exports) and in bad years (because less is carried over from the previous good year).
    • 2. This is clearly true if we hold output constant ( "in the actual state of the tillage"). Is the argument changed if we allow for additional output due to the higher prices?
    • 3. The bounty double taxes the population--to pay the bounty, and to pay the resulting high price (a point the Agriculture department was still missing c. 1966, when I was in Washington. They calculated the cost of part of the farm program as equal to government expenditure on it, ignoring the cost to consumers of having to pay more for food).
    • 4. And the high home price reduces the population.
    • 5. Ultimately, wages are proportional to the price of corn, so the farmer is losing in higher wages what he makes in higher corn prices.
    • 6. And all prices rise accordingly.

    E. Spain and Portugal and restraints on the export of gold and silver.

    • 1. In equilibrium, as much is smuggled out as is imported--a flow always beats a stock (dam metaphor).
    • 2. But what drives the (very expensive) smuggling is the price difference between gold and silver in Spain and Portugal and elsewhere.
    • 3. The result is to make goods more expensive in Spain and Portugal than elsewhere. Every trade must pay the cost of smuggling.

    F. Applied to the corn bounty

    • 1. The bounty lets our competitors eat cheaper, ultimately makes their labor cheaper, ours more expensive.
    • 2. So we are exporting corn, turning it into workers, turning it into goods, importing the goods--and using a bounty to force that cycle when it would be cheaper to do it at home.
    • 3. Only the corn merchants clearly gain.
    • 4. "The nature of things has stamped upon corn ..."

    G. Bounties on production (subsidies to production rather than export) are much rarer.

    • 1. Subsidy to fishing is an exception, perhaps justified by considerations of national defense, but ...
    • 2. Herring buss bounty makes little sense because ...
      • a. Combining various subsidies, each barrel of herrings exported cost the govt ...
      • b. A tonnage bounty, not a herring bounty (paid in proportion to the tonnage of the ship, not the quantity of herring caught), so ships fit up to catch the bounty, not the herrings. Smith gives an extreme case for a year when few herrings were caught.
      • c. The bounty is subsidizing a shipping technology poorly adapted to the circumstances of Scotland, over the boat fishery better adapted.

    H. Justified bounties?

    • 1. To keep militarily important industries in existence in case of war.
    • 2. Drawbacks (refunds of taxes on the import of the inputs)
    • 3. Premiums--special prizes for artists, manufactuerers, etc. are useful and cheap.

     

Digression on the corn trade

• A. Inland dealer--Smith is giving the argument that shows speculation (in our sense) is a desirable activity. His inland merchant is, among other things, what we would call a corn speculator.
  • 1. A possible exception exists if there were a single monopolist, who might destroy corn so as to raise the price.
  • 2. Hirshleifer's stamp auction story: Someone buys the only three copies in existence of a rare stamp, then publicly burns one--on the theory that demand is inelastic, so the remaining two will be worth more than the three were before.
  • 3. But that can't happen with corn, since it is divided among many merchants.
  • 4. History of dearths and famines shows that dearths are always due to a real shortage, not a conspiracy by the corn merchants--although they often get blamed.
  • 5. And the famines are due to government attempts to interfere with a dearth.
  • 6. For example, by holding prices down--with the result that the corn is not produced or is consumed too fast.
  • 7. Or old laws prohibiting middlemen in the corn trade.
  • 8. Without middlemen, the farmer must provide the capital that would have been provided by the corn merchant--and charge for it--so eliminating middlemen doesn't save the customers money. The error he is pointing out here is still around.
  • 9. Indeed, by reduced division of labor, eliminating corn merchants actually makes corn more expensive--it takes more work for the farmers to do the corn merchants job, since they are not as good at it as the corn merchants were.
  • 10. And a merchant buys to sell--if he actually keeps corn off the market when it is dear, he loses money--so merchants can only cause famine if they make a mistake, in which case they are also losing a lot of money.
  • 11. The fear of speculators is like the fear of witchcraft.

  B. Importer. Makes corn cheaper, so makes farmers and landlords poorer in money, but not in value, since labor also gets cheaper. And the lower price expands home industry, demand for corn.

• C. Exporter increases supply of corn in bad years by providing a market for surplus in good.
• D. If all countries had free import and export of corn, famine would be less of a problem.
• E. The merchant carrier of corn, with warehouses in Britain, is a reserve in case of shortage.
• F. If the mercantilists were right, and prosperity occurred because of such restrictions rather than in spite of them, why are Spain and Portugal doing so badly?
  • 1. Smith's explanation is that they are duing badly because of the bad effects of importing gold and silver and trying to keep them in
  • 2. Plus insecurity of property rights.

Chapter 7 part i

• A. Gold mines are on average unprofitable for the same reason as being a lawyer--investors are overoptimistic.
  • 1. Hence should not be subsidized.
  • 2. Should they be discouraged? He never says so, but that is what the logic suggests.

...[the next bit is not in what you were assigned to read, but you may find my summary interesting, especially if you read part ii anyway]

• B. New colonies are the most successful societies
  • 1. Plenty of land, essentially no rent or tax, so settler gets his full output, has an incentive to produce lots.
  • 2. Population increases since there is an incentive to marry early, lots of food for kids, kids are very profitable.
  • 3. Greek colonies had independence and lots of land, did well
  • 4. Roman colonies were dependent on Rome, founded in areas already well populated (he is talking about Roman colonies in Italy), did much less well.
  • 5. New World colonies had lots of land, were dependant in theory but so far away as to be mostly independent in fact (Parkinson's argument that the telegraph killed the British Empire), did well.

  C. Differences among among New World colonies

  • 1. New World colonies that were governed by exclusive companies of merchants, including Canada, did badly.
  • 2. Santo Domingo did well because it was settled by pirates, and the French couldn't push them around.
  • 3. English colonies did especially well because:
    • a. The rules made it hard for one person to get control of all the land, and ...
    • b. Lack of primogeniture kept breaking up estates in some of the colonies.
    • c. And the rest at least were alienable, which had the same effect more slowly
    • d. The Spanish and Portuguese colonies had their version of entail--meaning that an estate stays together, cannot be broken up and sold off.

• part iii What did Europe get out of its colonies in the New World?
  • A. General advantages:
    • 1. New products
    • 2. Augmentation of European industry
      • a. Obviously for countries that have c olonies and trade with them, or ...
      • b. Trade with other people's colonies by exporting goods to them through the mother country.
      • c. Less obviously for countries that export nothing to the New World but import something from it--and must therefore be exporting to someone else who exports to the New World in order to pay for it.
      • d. Still less obviously, countries that neither export nor import to or from the New World may still be benefitted because the New World made other countries richer, so increased they amount they can buy and sell.

      3. But this effect is reduced by confining colonies to trading with the mother country--injuring the colonies and the rest of Europe for the benefit of the mother country.

    B. Benefit to mother country of its colonies.

    • 1. As of all its territory, provide military support and taxes.
    • 2. But the European countries have had to provide military to defend their colonies, not the other way around--net loss to them.
    • 3. And the British colonies usually cost Britain more in peace, and always in war, than they bring in.
    • 4. So the only benefit is the exclusive trade.

    C. Effects of English monopoly over the trade of English colonies

    • 1. Benefits England relative to other European nations, since English gets tobacco etc. cheaper, but ...
    • 2. Smith thinks it might injure England absolutely.
    • 3. Apparently he suspects tobacco production has a declining industry cost curve, although ...
    • 4. His own arguments about rent of specially suited lands imply the opposite--larger demand should put more pressure on the limited supply of special lands.
    • 5. Note how Smith qualifies this whole argument-- "may."
      • a. In judging how reliable a source of information is, one of the things to look at is
      • b. Whether it qualifies its statements carefully, so as never to claim more than it really knows or can prove.
      • c. Smith passes that test; many books and people fail it.

      6. English monopoly in trade with her colonies pulls English capital into that trade and out of domestic investment--which, Smith thinks, is a bad thing. Now we see where he was going back when he argued that investements closer to home were better for England. He was laying the groundwork to argue that mercantilism made England worse off, by forcing its capital out of home employments and into distant ones.

    • 7. His conclusion that the profit rate must have been higher as a result seems right, since foreign trade is a capital intensive activity.
    • 8. And the share of British capital in the colonial trade continues to grow, because the colonies grow faster than England, hence absorb an increasing amount of its capital.
    • 9. And a further result is the decay in other parts of English trade, as capital is pulled out of them into the colonial trade.
    • 10. England was already a great naval power before the legal restraints on trade with the colonies had had any effect, so they cannot explain its naval power. Remember that Smith believes that military strength is sometimes a legitimate basis for restrictions on trade.
    • 11. Raising the profit rate in England makes it "less competitive" in all other activities, since it raises costs.
    • 12. Merchants complain of high wages as making it hard to compete with foreigners, but ignore high profits.
    • 13. Furthermore, driving other countries' capital out of the British colonial trade lowers the profit rate in those countries and thus their costs--for competing elsewhere.
    • 14. And the long run effect is to move British capital into an area where the turnover is slow, and where it thus supports less British labor than it did before.
    • 15. Another source of long turnover is that the colonists pay their debts slowly, in order to, in effect, borrow capital.
    • 16. Also, one long run effect is to put British capital into the indirect carrying trade for other ultimate consumers--the worst thing of all from Smith's standpoint, since it employs essentially no British workers.
    • 17. Furthermore, English industry is dependant on one market when it could be on many, hence more at risk--like the risk of monocrop agriculture.
    • 18. What if the American colonies should revolt? As, of course, they are just starting to do as Smith is finishing the book.
    • 19. Conclusion: The colonial trade should be made free--but slowly.

    D. Effects of the American Revolution (early stages)

    • 1. The effects on the English economy were reduced somewhat because
      • a. Americans bought in advance what they would need from England, anticipating an interruption of trade.
      • b. A variety of temporary and accidental changes happened which increased demands for British goods elsewhere.

    E. Effects of the colony trade are good; effects of the monopoly of it are bad. Net effect is still good.

    • 1. Not so clear for Spain and Portugal, where a variety of bad effects, including insecure property rights, make things worse.
    • 2. But England has justice, secure property rights, freedom to export, so survives and prospers despite some impediments.
    • 3. Smith argues that the British monopoly on trade with the British colonies reduces capital accumulation, because it reduces national revenue, from which savings come--but it increases profits, which should increase capital accumulation, both because profits can be reinvested and because a higher profit rate makes saving and investing more attractive.
    • 4. The monopoly reduces rent, because high profit rate slows improvement of land.
    • 5. And the high rate of profit makes merchants into spendthrifts!
    • 6. And they set a bad example for everyone else.
    • 7. Compare Spanish merchants to Dutch.
    • p. 613 quote
    • p. 616 quote
  • F. What to do about the revolting colonies?
    • 1. Best solution is to turn the colonies lose, but it won't happen. How else might England resolve the matter--what terms might it reach with the colonies?
    • 2. England cannot expect the colonial legislatures either to be willing to vote to pay their share of the expenses of the empire or to know what it is.
    • 3. Parliament could set, colony by colony, how much each owed. Smith thinks they would set it low, not high, although he does not explain why they would do so.
    • 4. But that is not a reliable resource, because the colonies would not cooperate
    • 5. And if you did do it, that would wipe out the importance of the colonial assemblies, which the colonial politicians would not tolerate.
    • 6. But if you give the colonies representation in parliament in proportion to the taxes they pay, then colonial politicians will hope for imperial importance.
    • 7. If you don't do that, the war is going to be very difficult, because everyone in America feels himself important in consequence.

    G. Consequences of mercantilism

    • 1. British mercantalism may actually benefit foreign countries--by forcing their capital into investments with faster turnaround (so why not have government interference do the same thing for England? Doesn't this argument imply that a reverse mercantilism would be even better than laissez faire?)
    • 2. While it injures England by the opposite effect.
    • 3. Smith is struggling with the conflict between his support for laissez-faire and his theory that some uses of capital are more valuable to England than others. He tries to get out of the problem by arguing that we may need the distant capital to keep the local capital going. But at this point he no longer has a clear theory by which we can evaluate the different uses of capital.

    H. East India, Asia, ... The British East India Company started as a trading company with a monopoly of trade between England and India. It ended up ruling quite a lot of India. It was organized as a joint stock company.

    • 1. An exclusive trading company has a monopoly against other countries--French merchants cannot import Indian goods into England. That effect always attracts domestic capital into the monopolized activity, since the lack of competition drives up the profit rate.
    • 2. An exclusive company also has a monopoly against its countrymen--Englishmen who are not a part of the East India company are not permitted to transport Indian goods to England.
    • 3. The effect is to make foreign goods more expensive at home, and ...
    • 4. In the case of poor countries, to attract capital into the trade when none should be going there. Sweden should be doing its long distance trading with Dutch capital, and saving its scarce domestic capital to employ Swedish workers in Sweden.
    • 5. In the case of rich countries, an exclusive company reduces the capital in the trade because capitalists who are not part of the monopoly company cannot invest. Holland, for example.
    • 6. Argument for exclusive companies: Such a trade requires a monopoly company, because no single merchant could maintain all of the structure needed for it--not only ships, but agents in the different ports, etc.
    • 7. Smith's answer: The same argument implies that every industry should be run by a monopoly company--no single merchant can build coaches and make wheels and refine the iron and cut the wood and breed the horses ...
    • 8. Which is why we use the market instead--lots of merchants cooperating via trade.
    • 9. Similary for the East India trade--some merchants will live there and collect the goods that others will ship.
    • 10. European colonies in Africa and Asia have been much less successful than in America
      • a. Because the natives of America were mostly hunters, of Africa and East Indies at least shepherds, hence more populous and better able to defend themselves. [Smith is probably wrong here, since many of the Indian tribes were agricultural]
      • b. And exclusive companies are lousy colonial rulers.
      • c. Consider the Dutch, who maintain their spice monopoly not only by burning the surplus production of the areas they control, but by trying to wipe out the trees in the areas where they have no settlement
      • d. The British East India company hasn't gotten quite that bad--but may yet.

      11. An exclusive company of merchants functions both as sovereign and as trader.

      • a. As sovereign, it is in their interest to promote the economic growth of the areas they rule and can tax.
      • b. As merchants, they want to restrict economic growth to maintain their monopoly price.
      • c. As sovereigns, their interest is the same as that of the country--as merchants, the opposite.
      • d. And in practice, they have the habits of merchants, so rule badly.

      12. The administrators of an exclusive company are even worse than the company wants them to be.

      • a. The local officials are hard to control from thousands of miles away.
      • b. And they have an interest in monopoly, not only in the trade they are supposed to be monopolizing (there their interest is the same as the company's) but also a monopoly in other things as a way of extorting money from those they rule.
      • c. And they do not have secure property rights in the country, so no incentive not to ruin it in the course of enriching themselves.
      • d. Hence the administration is worse than the company wants it to be.
      • e. But all of this is not the fault of the bad character of the servants of the East India Company, and he doesn't mean to insult any of them. They are caught in a bad incentive structure, and have behaved if anything better than one might expect.
      • f. At least ometimes better--and sometimes: "exploits of somewhat a different nature."

Chapter VIII: Conclusion

• A. Reverse version of mercantilism: Encourage the import and discourage the export of raw materials, tools of trade, etc. ,
  • 1. The theory is that you gain gold by converting cheap raw materials into expensive finished goods and selling the latter.
  • 2. And you want to have domestic raw materials finished at home, so as to get as much gold as possible for them.
  • 3. When you limit yourself to giving imported raw materials low or zero duties, this is a fine idea, and should be extended.
  • 4. In the case of linen yarn, which is actually a produced material (intermediate good in making linen cloth), they made it duty free, because ...
  • 5. The spinning was being done by dispersed poor people, the weaving by concentrated rich people (i.e. the owners of the weaving companies), so making import duty free held down the price of the intermediate good, benefitting the (politically powerful) weaving companies at the expense of the (powerless) home spinners.
  • 6. While bounties on exporting the finished linen, and bans on importing it, held up the price of the finished cloth.
  • 7. Bounties on goods from the colony: Double mistake:
    • a. One bad argument is that they are part of England, so spending money on them costs nothing--the gold stays in the British empire and eventually comes back to England in its monpoly trade with the colonies. The error is being demonstrated as Smith writes.
    • b. And in any case, bounties on home manufacture are wasteful for reasons Smith has already pointed out.

  B. Woolen trade.

  • 1. An elaborate set of regulations existed to prevent the export of British wool, including keeping track of it, limiting its movement near the coast, etc.
  • 2. Also to prevent the export of British sheep, with capital punishment for the second offense--although it is not clear it was ever actually imposed.
  • 3. Smith mentions the problem that when punishment are too high juries won't convict.
  • 4. The whole system is justified by fairytales about the innate superiority of British wool, so that if only they could maintain their monopoly ...
  • 5. When in fact British wool is of rather low quality by international standards.
  • 6. The result is to greatly lower the price of English wool, but ...
  • 7. Not much effect on quantity, because wool and mutton are joint products, with the mutton paying most of the cost
  • 8. So lowering the price of wool simply raises the price of mutton.
  • 9. You might expect elasticity on the separable cost part--less effort to raising sheep with good wool, taking care of the wool, etc., but even that seems slight, because taking good care of the sheep so as to produce good mutton also produces good wool.
  • 10. The joint cost argument does suggest that you could have a substantial export duty on wool without very much effect on the industry, which might well be a sensible way of raising money.

  C. Restraints on emigration of skilled workers:

  • 1. Not allowed to emigrate, under severe penalties at home
  • 2. Trying to hire them to emigrateis a serious crime.

  D. Summary:

  • 1. The system is crazy--the interest on the war debt due to the colonies is enormously more than any plausible estimate of the gains from the trading monopoly.
  • 2. It exists for the benefit of the merchants and manufacturers, at the cost of consumers and (sometimes) other merchants and manufacturers.

Book V

Chapter 1a: Cost of defense

• A. How the cost varies among stages of development
  • 1. For hunters, every man has the relevant training, can go on war while feeding himself, but ... hunters cannot maintain an army of any significant size.
  • 2. For shepherds an army is similarly inexpensive, and since they routinely travel with their flocks, the whole people can go to war together.
  • 3. With the result that Mongols et. al. are a formidable threat, massing very large armies.
  • 4. With primitive agriculture,
    • a. The farmers are in good physical condition, many of their activities suit them to warfare.
    • b. And they can leave the farm once the crop is planted, until it is harvested, without much cost.
    • c. But must leave the rest of the population behind to care for the fields.
    • d. So can cheaply raise big armies, but only for a limited time.
    • e. Examples: The Germans vs the Romans, and the feudal armies
    • f. Both of which served at their own expense

    5. With further development, this becomes impractical, because:

    • a. Farmers do more, have less leisure, and craftsmen have almost none, so taking people out of their normal occupation is expensive.
    • b. Warfare gets more expensive in equipment, training, etc., so individuals on their own won't learn how to do it properly, or adequately equip themselves.
    • c. Campaigns get longer, so run past the time that farmers can afford to neglect their fields.
    • d. At which point you need paid armies.
    • e. With the result that the Greeks could field 20-25% of the population if they had to, and modern states only about 1%. The number is substantially higher in the 20th century--because we are a lot richer.

  B. Organizing armies in a developed society: Two alternatives

  • 1. Militia
  • 2. Professional standing army
  • 3. Smith thinks the latter is militarily much more effective, because
    • a. Better trained
    • b. Better disciplined
    • c. Although a militia that has foought for several years becomes a de facto standing army--which is happening to the colonial militia fighting the British.

    4. Militias are at their best among barbaric people such as the mongols, where their rulers in peace are their officers in war.

  • 5. Smith explains chunks of classical history, from Philip of Macedon on, as standing armies beating militias.
  • 6. He argues that a standing army is not a threat to civil society, providing that ...
  • 7. Its officers are the upper classes of the society, with an interest in civil well being.
  • 8. And with a loyal standing army, the King can afford to tolerate dissent, knowing his position is safe.

  C. Capital intensive military:

  • 1. The shift to firearms has made warfare much more capital intensive, both
    • a. Because guns are more expensive than bows.
    • b. Because gunpowder gets used up and
    • c. Because fortification becomes more expensive when it must defend against cannon.

    2. And the result is that rich nations are now dangerous to poor ones

  • 3. When it used to be the other way around.

• ii: Justice
  • A. Link between the accumulation of property and the development of status differences
  • B. and between accumulation of property and need for law enforcement.
    • 1. If there isn't much property, you can still kill people or beat them up.
    • 2. But although that injures them, it doesn't do you much good; incentives such as anger and hatred exist occasionally, but ...
    • 3. The desire for wealth is a much more consistent incentive, so ...
    • 4. When there is lots of property, and people can commit crimes that not only hurt the victim but also help them, the problem of preventing crime becomes much more serious.
    • 5. Consider the question of whether, today, there should be a free market in organs for transplant. The one good argument I know of against the idea is that it would create an incentive to kidnap and murder people so as to get their organs to sell. Mugging would be more common if the random victim was worth $50,000 on the hoof.

    C. Initially, justice provides the government a source of revenue.

  • D. The situation changes when the crown gets access to tax revenue. Justice become nominally free, although still expensive because of the lawyers etc.
  • E. Smith argues that competing court systems were a good thing.
    • 1. The different royal courts all wanted to attract business, since that is how they got their income, so ...
    • 2. Modified their legal rules in order to provide new solutions to legal problems that used to be out of that particular court's reach.
    • 3. He does not discuss what determined what court a case went to. It would seem as though the obvious way to get business would be to always rule for the plaintiff, thus giving plaintiffs an incentive to plead their case in your court. Obviously something was preventing that, but Smith does not explain what.

    F. And he suggests possible ways of giving courts incentives today.

  • G. And argues for separation of court and executive.

  Part III: Expense of public works and Institutions Article I

  • A. Facilitating commerce in general--roads, canals, ports, etc.
    • 1. Should be paid for by user fees, because
      • a. It is fair, if proportioned to weight pf vehicle, since the wear and tear on a road or bridge is roughly proportional to weight.
      • b. The price is ultimately paid by the consumer, who is a net gainer, since the savings in transport cost is more than the toll.
      • c. User fees can even be used to help the poor a little at the expense of the rich, by higher tolls per weight on luxury transport.
      • d. If roads are financed by user fees, they only get built where they are useful, instead of where some powerful person wants them--since if there is no traffic they are not going to pay for themselves.

      2. Canals can be maintained by giving someone the right to collect the tolls, in exchange for keeping up the canal.

      • a. This gives the proprietor a private interest in keeping up the canal
      • b. And thus may be better than having a disinterested commissioners in charge.

      3. It doesn't work for roads, because a road will still yield tolls even if badly kept up.

      • a. So roads should be under commissioners
      • b. But in practice, that method doesn't seem to be working very well.
      • c. Some people argue that by doing it better, government could get a big revenue from tolls, although there is considerable question how much.
      • d. But the result would be to impede inland commerce, since the tolls would keep being pushed up so as to collect more revenue.
      • e. And it is an unfair way of collecting taxes, since a per weight toll is chiefly paid by bulky commodities, not by expensive luxury goods, hence by the poor not the rich.
        • i. This is not inconsistent with his earlier argument. There he was saying that per weight tolls were a fair way of paying for the roads.
        • ii. Here he is saying that they are an unfair way of paying for general government.

        f. And the problem of people not repairing the roads is still there--the government being even harder to force to do its duty than the current trustees.

      4. International comparison

      • a. In France, where the central government is in charge of roads, the major roads are in good condition, the minor ones in terrible condition.
      • b. In China, the government is in charge of roads and canals, and it is said that they do it very well, although Smith is sceptical.
      • c. One possible explanation for why they might do it well is that in China, government revenue mostly comes from land tax, which is increased by maintaining good transport, so the sovereign has a direct incentive to keep up the roads,
      • d. Whereas in Europe, revenue may ultimately depend on land produce, but not directly or obviously.
      • e. So having roads run by the central executive, although it may perhaps work in China, certainly would not in Europe.

      5. Where public works cannot be paid for directly by a user charge (lighting the streets of London), at least they should be paid for by the local government, financed by local taxes, for both better management and greater fairness.

    B. Facilitating particular branches of commerce: forts in foreign countries, consuls, etc.

    • 1. It makes sense to pay for such expenses by a tax on that particular branch of commerce.
    • 2. Which ought to be done by the executive, as part of the defense of the nation, but often is entrusted to companies of merchants instead.
    • 3. Which has been a catastrophe.
    • 4. Two versions: regulated companies, whose members trade on their own stock, and joint stock companies. Both sometimes have exclusive privileges.
    • 5. Regulated company is like a town guild.
      • a. And has an obvious incentive to try to keep people out so as to reduce the competition.
      • b. Smith runs through the history of a bunch of them.
      • c. Cannot be trusted to maintain forts etc., because the interest of the directors is in their own trade, not the general good of the company--in this respect, a joint stock company is better.
      • d. And because the directors of a regulated company, controlling their own stock, and whatever dues are paid by the members, but not the general stock of all the other traders, don't have the resources to maintain forts etc.--again an advantage for a joint stock company.

      6. Joint stock company (our standard limited liability corporation) differs from a partnership in that:

      • a. Stockholders have no right to withdraw their investment--i.e. require the company to buy it back from them--as in a partnership, but ...
      • b. Stock is freely traded, unlike a partnership, which can control who joins it.
      • c. So the value of the stock is determined by the market, not by the obligations of the company.
      • d. And a joint stock company has limited liability, a partnership unlimited liability.

      7. A joint stock company can attract lots of capital from passive investors (stockholders in our sense).

      • a. Because their risk is limited.
      • b. So it provides a way of financing very costly projects
      • c. But joint stock companies are likely to be badly run, since they are run by people managing other people's money.
      • d. With the result that joint stock companies for foreign trade never succeed without exclusive privileges, and not always with them.
      • e. Being unable to withstand the competition of "private adventurers" (i.e. independent entrepreneurs).
      • f. History of unsuccessful joint stock companies.

      8. East India company

      • a. When it faced competition from private traders, it did badly.
      • b. It complained that the competition lowered prices at home (true) and raised them in India.
      • c. Smith doubts the latter, both because exports to Britain were a tiny part of the Indian market, and ...
      • d. Because he believes that average cost, in the long term, declines as quantity increases, due to increasing competition, division of labor, etc.
        • 1. Marshall, who we will read later in the quarter, describes this as an industry with economies of scale that are internal to the industry but external to the firm--thus explaining why it does not produce a natural monopoly.
        • 2. A similar argument is made by modern economists in the contexst of path dependency. They point out that the U.S. does most of its trading with economies rather similar to its own--Western Europe and Japan. The theory of comparative advantage would suggest that we should trade mostly with dissimilar countries.
        • 3. Their explanation is that if Germany started an optics industry (say) early, they are now much better at it than we are, even though the economies are in other respects similar.

        e. East India company eventually got not only a monopoly but rule over much of India--and ran it so badly that it still lost money.

      • f. Someone may buy stock in order to have a say in the appointment of "the plunderers of India" --i.e. the East India Company officials.
      • g. Terrible system of rule, since a mercantile company is indifferent to the long run prosperity of the land it rules.
      • h. Note that this argument depends on the company not representing the interests of the mass of stockholders--an agency problem--since otherwise it would want to rule the country well so as to raise the market value of their shares.

      9. Legitimate monopoly (in Smith's view).

      • a. Temporary monopoly to a trading company to reward it for opening up some new branch of trade.
      • b. Like a patent or a copyright.
      • c. But a perpetual monopoly taxes consumers by high prices, and potential entrepreneurs by keeping them out of the trade.
      • d. Without a monopoly, a joint stock company cannot compete in foreign trade, because it is a difficult activity, and joint stock companies are run much worse than private trading firms.

      10. Where can a joint stock company survive without special privileges?

      • a. Banking, insurance, making and maintaining a navigable canal, supplying water to a city.
      • b. Because all of these are easy to do, so do not raise large agency problems, and ...
      • c. Require a lot of capital, so require a joint stock company.
      • d. And are very important. Why does this matter?

  Article II: Education

  • A. General argument
    • 1. If you want teachers to do their jobs, their getting paid should depend on it
    • 2. Which means fees from the pupils, rather than ...
    • 3. Salary supported by government, endowment, etc.
    • 4. The glory of their objective is an inadequate incentive compared to material incentives.
    • 5. Fixed salaries give lazy teachers.
    • 6. And a faculty run university means each professor allowing the others to neglect their duty in exchange for their allowing him to neglect his. Oxford.
    • 7. If the authority is external--Board of Trustees in the modern U.S. case--they are probably incompetent to judge how the professor is doing his job, and being subservient to them degrades him--he must pay court to them.
    • 8. Limiting certain professions to people with certain degrees forces people into those universities, independent of whether the universities do a good job.
    • 9. So do scholarships that are tied to particular universities.
    • 10. It would be better to give scholarships that can be taken to any university, thus encourageing competition.
    • 11. i.e. a voucher system, at the higher ed level (such as the G.I. Bill after WWII).

    B. Incentives of teachers

    • 1. If students are not free to choose their teachers, then even if the teachers are paid by the students they have little incentive to do a good job.
    • 2. And will fall back on various expedients to evade it.
    • 3. Especially if the school discipline requires the students to treat the professors with respect whether or not they deserve it.
    • 4. Smith is against compulsory attendance beyond about the age of 13!
    • 5. And observes that entirely private branches of education are the best taught. Dancing and fencing.
    • 6. Public schools in England are better than the Universities.
      • a. Since the schoolmaster is paid by fees
      • b. Andgraduation is by examination, not attendance.
      • c. Like our High School Equivalency Exam?

    C. It might be argued that even if Universities do a bad job, they are better than nothing. Smith's response:

    • 1. European universities originated to teach priests
      • a. And thus wasted their efforts on theology, metaphysics, etc.
      • b. And in various ways were unsuited to the education of gentlemen, which is the job they ended up with.
      • c. To what extent is there a similar tension today between educating scholars (a tiny fraction of the population, but a lot of our system of higher education pretends they are the norm) and educating people in general?
      • d. Universities were not the sources of most of the progress in knowledge. Consider Smith's comments on p. 772( "... after they had been hunted out of every other corner of the world") and Marxism today, which survives in Cuba, North Korea, and American Universities.

      3. Nowadays, a lot of young men are instead educated by a few years travel abroad.

      • a. At that age, it is hard not to improve some in a few years.
      • b. He learns several languages--too badly to be of any use
      • c. Develops bad habits,
      • d. The custom only exists because universities are so bad.
      • e. And fathers want to get their sons out of their sight.

      4. Long history of the development of education.

    • 5. Offering evidence that the Greeks and Romans, without public institutions for education, did at least as well as the moderns.
    • 6. Nowadays (Smith), the private teacher is at a disadvantage, because he faces subsidized competitors--like the private school/public school at present (Us).
    • 7. If there were no public universities,
      • a. Nothing would be taught unless someone wanted to learn it.
      • b. Unlike the current situation, where exploded systems of real science (Ptolemy) or completely useless sciences (metaphysics?) get taught by people whose income is independent of their industry.
      • c. At present, women receive a more useful education than men--because entirely private.

    D. Should there be any public role in education?

    • 1. In some states of society, people will naturally learn the abilities and virtues proper to them.
    • 2. In others, not, in particular ...
    • 3 Lots of division of labor means that workers are doing very simple things, hence become stupid and ignorant, incapable of judging concerning the duties of private life (why doesn't the worker's experience outside of work take care of that? He has to court a wife, raise children, maintain his household, ...), judging the national interest, or defending the country.
    • 4. So unless government does something about it, the bulk of the laboring poor ends up almost subhuman.
    • 5. Unlike barbarous societies, where people do lots of things and are all warriors, minor statesmen, etc.
    • 6. But where nobody has as great understanding as that of the wisest people in a modern society, with so much more to know about.
    • 7. So there is an argument for public attention to the education of the common people, but not so much for people of rank.
    • 8. Both because their parents educate them, and because their jobs are more diverse, and because they have more leisure.
    • 9. Applied to us, that suggests that perhaps we should have public schools, at least for the lower classes, but surely no public universities or colleges.

    E. Possible public role in the education of the common people:

    • 1. Establish local schools, partly subsidized, but with the master largely paid from fees paid by the parents.
    • 2. With more attention to useful skills and less to Latin.
    • 3. And perhaps give prizes etc. to those who do well--like our National Merit scholarships?
    • 4. The government could force people to acquire a minimal education by requiring that before letting anyone set up a trade in a village or town, etc., he have some minimal education. (Doesn't this sound like bringing back the guilds--who is going to administer the tests, and decide what you need to know to be a tailor, other than the existing tailors?)
    • 5. What about maintaining martial spirit--i.e. making people good soldiers?
    • 6. And proper human beings
    • 7. And the state will be less threatened the better educated people are. In free countries, the safety of government depends in large part on the people approving of it.

  Article III: How to pay for schools

  • A. Religious schools
    • 1. Teachers of new religions have an advantage, because ...
    • 2. The opposition has salaries, therefore is lazy and ignorant of how to persuade the masses, making them
    • 3. Vulnerable to the competition of popular and bold enthusiasts.
    • 4. So the old religion must call on the government to persecute the new.
    • 5. The preachers of the old may be more learned and sophisticated, but ...
    • 6. The new are more competent at spreading their ideas, arts of popularity.
    • 7. Consider televangelists vs mainline religions--Iannacone argument. Once the television stations were permitted to charge for religious broadcasting while still counting it as public service, the fundamentalist preachers outbit the mainline protestant sects--because they were better at using preaching to raise money.
    • 8. When salaries are set up for the dissenters, they become more respectable--and less popular.
    • 9. The catholic clergy depend largely on voluntary gifts, can use confession to get them--tell sinners that they should make up for their sins by penance, in cash.
    • 10. Mendicant orders depend entirely on voluntary gifts
    • 11. So both are good at inspiring the people.
    • 12. The higher clergy consider themselves gentleman, and make no effort to instruct the populace.
    • 13. Smith quotes Hume on the desirability of preventing the diligence of the clergy, which can be done by giving them stipends--since diligence inspires intellerance, hostility to others, etc.
    • 14. Smith argues that that is not why established churches came into existent. They were an outcome of alliances between political factions and religious factions--with one such alliance winning and becoming the established church.
    • 15. It would have been better if politics and religion has stayed separate, all religions treated equally.
      • a. There would have been a great multitude of sects (sound like modern day America?)
      • b. But with lots of tiny religions, no one can be any serious danger to the public tranquility.
      • c. And since each is a tiny minority, it would have an incentive to be tolerant of others.
      • d. Ultimately leading to a pure and rational religion.
      • e. Competition on the religious market.
      • f. Pennsylvania being an example.

    B. Two systems of morality

    • 1. strict among the common people
    • 2. Loose among the upper classes
      • a. Accepting vices of levity, luxury, intemperance, male unchastity
      • b. But without falsehood and injustice
      • c. A pattern common people cannot afford.

      3. Religions start among the common people, and usually adopt the strict form.

    • 4. Upper class people are highly visible, subject to social pressure towards whatever pattern of morality prevails.
    • 5. Lower class people in small village may face similar pressures, but ...
    • 6. In a great city, not. So they are at risk of profligacy and vice
    • 7. But joining a small sect makes a worker more important, visible, provides a non-geographic equivalent of the village he came from.
    • 8. If such religions make people too rigorously moral, encouraging the study of science and philosopy is a means of making them less so.
      • a. Which the government could do by requiring some knowledge of such things before permitting people to exercise a liberal profession or hold office.
      • b. But wouldn't that rapidly degenerate into guild restrictions? Smith has just attacked such rules in the context of requiring a university degree.
      • c. He apparently thinks that an examination is safer--with a competitive market for producing the education needed to pass it.
      • d. And if the upper classes are reasonable, they will set a good example.

      9. Public diversions, gaity, etc. also subvert fanmatical sects.

    C. More on established religion

    • 1. A peril to the sovereign.
      • a. The clergy of an established church can act together, coordinate their behavior.
      • b. Their power depends on the people believing that they have the truth and nobody else does.
      • c. So if the sovereign isn't entirely orthodox, or even if he wants to defend subjects who are not entirely orthodox, they will attack him and use their religious power to replace him with a more orthodox alternative.

      2. So the sovereign needs some way of controlling the church.

    • 3. He is not competent to prescribe the content of doctrine, etc., so must have some way of influencing the clergy--fear or expectation.
    • 4. But the clergy have de facto or de jure tenure in their positions, and should, since if the sovereign could easily turn them out the people wouldn't take their preaching seriously.
    • 5. Trying to control them by fear is risky. It makes those persecuted more popular, and the react with even stronger opposition. Pushing people around rarely works (examples given).
    • 6. And especially not for the clergy of an established church, who have lots of status.
    • 7. So they should be managed instead. By controlling "preferment"--i.e. sources of income.
      • a. Initially, appointment to clerical position was controlled by the people and/or local clergy.
      • b. Eventually most were taken under the control of the pope.
      • c. Who thus had control of a powerful spiritual army throughout Euroope.
      • d. And a lot of employees and income.
      • e. Which latter they applied, as did the barons, in maintaining people, feeding the poor, etc.
      • f. And unlike the barons they were under a unified control.
      • g. Ending up with goodies such as benefit of clergy--the right to have clerics tried in church courts instead of royal courts.

      8. This immense power was eventually destroyed by economic development

      • a. Because the clergy, like the nobles, found they could spend their income on themselves rather than on others
      • b. Reducing their number of retainers, dependants, popularity with the masses.
      • c. And thus political power.
      • d. With the result that the sovereigns took over at least partial control of handing out the goodies.

      9. Making the Catholic Church, even before the reformation, somewhat more like an established church under control of the sovereign.

    • 10. And vulnerable to the Protestant reformers, who were less luxurious and knew more. And were better at selling their ideas.
    • 11. At which point sovereigns who were on the outs with the Pope or the local clergy converted to Protestantism.
    • 12. The Pope couldn't oblige Henry VIII without offending Charles V of Spain (and Germany--he was the Holy Roman Emperor as well as the King of Spain).
    • 13. So Henry retained most of the doctrines while taking control of the English church for himself.

    D. Outcome of the reformation.

    • 1. Lutherans and Church of England maintained the Catholic system of organization, with the sovereign replacing the Pope at the top of the (national) hierarchy.
      • a. A system that promotes peace and good order, which is to say
      • b. A church that supports the Crown.
      • c. And clergy who flatter to get preferment, but also make themselves into educated gentlemen so as to get the esteem and political support of the upper classes
      • d. Which includes being moderate and tolerant
      • e. And unable to maintain the respect of the masses.

      2. Calvinists gave each local congregation the power to elect their own clergy, and established equality among them.

      • a. Local election led to faction and fanaticism, schism and civil conflict.
      • b. So in small states local rulers took over the power.
      • c. In Scotland some popular control remains--and causes trouble.

      3. Equality under the Calvinist system reduced the tendency to flattery, etc., since benfices were all worth about the same amount. Ended up with learned, decent, respectable clergy (Holland, Geneva, Switzerland and Scotland)

      • a. None of the clergy very rich, so they must be moral to get respect
      • b. Levity and vanity look rediculous in men of moderate means, and are likely to be ruinous.

    E. Church vs University

    • 1. Whichever pays better gets the good learned men.
    • 2. Hence the Universities in Catholic countries and England have only the dunces
    • 3. In protestant Switzerland and Germany, Holland, Scotland, etc., the Universities have the most eminent academics.

    F. Church vs State

    • 1. They are drawing income from the same source (chiefly rent of land), so a rich church means a poor state.
    • 2. Scotland and Protestant Switzerland are the reverse.

  Part IV

  • A. National defense and supporting the sovereign's personal expenses are general expenses, should be paid by everyone.
  • B. Expense of justice could be paid that way, since it benefits everyone, but
    • 1. The expenses are occasioned by those who act badly
    • 2. And for the benefit of those who use the courts to defend themselves
    • 3. So the cost can be paid by those two groups
    • 4. And general money is needed only for the cost of convicting judgement proof criminals.

    C. Local expenses with local benefit should be paid locally.

  • D. User taxes were practical.
  • E. Expense of education beenfits all, so may without injustice be paid by the general taxes. but ...
  • F. It might, with equal propriety and even with some advantage, be defrayed entirely by those receiving the immediate benefit, or by voluntary contribution.

Chapter II: Sources of Revenue

• Part I: The Sovereign living of his own.
  • A. In primitive societies, the sovereign lives on the profit of his capital (herds etc.)
  • B. In some small modern societies, a mercantile project, such as a bank, is an important source of revenue.
    • 1. It has been suggested for Britain, which could borrow money cheaply to replace the Bank of England's capital, then get revenue from the difference between its cost of capital and what the Bank lends at.
    • 2. Smith thinks the English government is incompetent to run a bank.
    • 3. A post office has been run by many governments with success--a simple business.
      • a. Can't prove it by our Post Office, which has consistently lost money.
      • b. But what Smith is describing is not exactly the same thing.
      • c. An 18th c. Post Office, in addition to carrying mail (but not delivering it to houses, a 19th c. innovation, I think)
      • d. Also provided a network of stables, such that somebody "riding post" could keep changing horses.

    C. Princes have tried many other businesses, and rarely succeeded.

    • 1. Their agents act like the servants of the rich, with profusion
    • 2. Making it a losing business.
    • 3. Similarly, from the other direction, when the East India Company became a sovereign it stopped being a competent trader.

    D. States with a treasure may derive some income from interest.

    • 1. Typically lent to other states (because they operate on a large enoughs scale)
    • 2. Obvious risk in case of war between them.

    E. Pennsylvania got income by lending on created money--bills of credit backed by land.

    • 1. Which works only if they are no more than the gold and silver they replace
    • 2. Successful for that moderate state, a failure for other American colonies.

    F. Rent of the public lands a larger and more reliable source of income.

  • G. Worked for Greek states (citizen soldiers, little expense) and for medieval (King lived of his own).
  • H. Nowadays, the whole rent of the kingdom would roughly cover the peacetime revenue of government and be inadequate in wartime.
    • 1. Some rough calculations of total rent
    • 2. And the observation that it would be a fraction as great if it all belonged to the government, and was mismanaged accordingly.
    • 3. And in Europe there are typically large crown lands, badly managed, producing almost no income. Consider the Bay area, where land is very expensive, but most of the land is held out of use by government ownership, zoning regulations, etc.
    • 4. Government should sell off its land, both to get the money to pay some of its debts, and
    • 5. Because it would become much more productive as a result.

    I. Conclusion: These sources are inadequate for a modern society, so taxes are needed.

  Part II: Taxes

  • A. All revenue is ultimately rent, profit, or wages
    • 1. So all taxes ultimately fall on those.
    • 2. Smith will discuss them in order.

    B. General maxims of taxation.

    • 1. Contribution according to ability, i.e. income.
      • a. Equality of taxation.
      • b. Any tax that falls on only one of the three sources of revenue is necessarily unequal
      • c. Smith will mostly take that as given, and consider only any further inequality within the source being taxed.

      2. Amount of tax ought to be certain, not arbitrary. Otherwise tax collectors become insolent and corrupt .

    • 3. Tax should be collected in the most convenient time and manner.
    • 4. Taxes should minimize excess burden--cost as little as possible beyond the actual amount collected. Costs arise:
      • a. Cost of maintaining the tax collectors.
      • b. Obstruction of people--i.e. disincentives due to taxation, the "excess burden" triangle shown in a modern textbook.
      • c. Injury done in the process of imposing penalties.
      • d. Trouble, vexation, oppression
        • i. Not literally expense, but ...
        • ii. equivalent to what you would pay to avoid it
        • iii. Which insight may undercut Smith's distinction between productive or unproductive labor.
        • iv. And point towards a marginal utility version of economics.

  Article I: Taxes upon rent

  • A. Can be done as a fixed amount per year on any piece of property
    • 1. Fixed, as in Britain, becomes unequal over time.
    • 2. But fits the other maxims fine:
      • a. Is perfectly certain
      • b. Paid at the same time as rent is, which is convenient
      • c. Takes few tax collectors
      • d. And since it is fixed, it does not discourage improvement.

      3. Works fine, given economic growth, which means the tax is getting lower and lower as a fraction of rent. Would have been less pleasant if rents had been declining.

    • 4. Tax due is measured in money. If silver had been rising in value, this would have been a problem for the landlords, since their real tax would have been going up.
    • 5. So fixed money rents have worked, but might not under other circumstances, which is an argument against them.

    B. or proportioned to the real rent year by year.

    • 1. Which the physiocrats argue is proper.
    • 2. The Venetian system is to tax rented lands at 10% of the rent and self-farmed lands at 8% of the imputed rent.
      • a. More equal than the English system, but ...
      • b. Less certain
      • c. More trouble to pay
      • d. More costly to collect

      3. These problems could be alleviated if (Smith's proposed system for taxing rent):

      • a. All leases must be publicly registered, with bounties to either landlord or tenant informing on the other.
      • b. Fines for renewal of leases (i.e. fixed payment rather than annual) are a bad idea, could be discouraged by making the tax on them higher than on rent.
        • i. Bad for landlord, who is acting as a spendthrift
        • ii. For tenant, who is capital poor, and can now cultivate less.
        • iii. Why does it happen? Why doesn't landlord borrow from someone else on better terms?

        c. Restrictions on how the land is to be used should be counted as further rent and also taxed at a higher rate, to discourage them.

        • i. Because they are due to the foolish conceit of the landlord, who thinks he knows how the land should be farmed better than the farmer.
        • ii. Why should he care? He is getting a fixed rent anyway.
        • iii. Isn't a better explanation that the landlord wants his land farmed in a way that maintains its value? There is an incentive problem for the farmer, who can deplete the soil then go rent from someone else.

        d. Rent in kind are a bad thing (why?) and can be discouraged similarly.

      • e. Landlords should get a slightly lower tax if they farm the land themselves, but only up to a maximum amount of land, because.
        • i. Some cultivation by landlords, who have lots of capital, permits experimentation, with benefits to all, but ...
        • ii. Cultivating all of the land by landlords to get lower taxes means by bailiffs, who are likely to be less competent than farmers (if bailiffs are all that idle and profligate, will a moderate tax reduction be a sufficient incentive for the landlord to use bailiffs, i.e. employees, instead of renting out his land?)

        f. Note the dirigiste tone of this passage. Smith should reread his own discussion of people who think they are entitled to tell other people how to use their capital.

      4. Main argument against taxes proportioned to rent is that they discourage improvement by taxing it.

    • 5. The problem can be reduced by allowing a landlord, before making improvements, to have his land valued and freeze the tax at the old value for long enough to let him pay back the cost of the improvement
      • a. But this assumes that the gain from the improvement is known in advance.
      • b. Which is unlikely.

      6. Seen from the other side, the shift of part of the gain from improvement to the sovereign is an advantage--the sovereign gets a share in the gain from improving land, so has an incentive to encourage it, but ...

    • 7. Attention of the sovereign is a lot less important than attention of the landlord, so better too long a term without raising the tax than too short.
    • 8. Such a tax has the virtue of varying with the state of agriculture, value of money, etc. in an appropriate way.

    C. Or proportioned to a survey and valuation

    • 1. Might be equal at first, but ...
    • 2. Becomes unequal
    • 3. Unless you continually reassess
    • 4. Something governments are incompetent to do
    • 5. And a nuisance to the citizens.

    D. Or by taxing output, not rent.

    • 1. The tax will be passed on to the landlord.
    • 2. Such taxes are really very unequal, since the relation between output and rent is very different in rich and poor lands.
    • 3. And they discourage improvement, by taxing its result.
    • 4. And they discourage the growing of crops that are valuable but expensive to grow. Madder.
    • 5. When this is done by the sovereign rather than the church (tithes), it at least gives him an incentive to maintain roads, canals, etc. in order to keep up output. (would be true for the church if it acted as a single body, as Smith earlier argued it can).
    • 6. May be paid in cash or in kind
      • a. Kind might be convenient for a small proprietor living on his estate, but ...
      • b. Leads to neglect and fraud if it is done for the owner by agents, either of a rich gentleman or , still worse, a government.

      7. If in cash, either proportioned to the real value of the crop or at a fixed rate per bushel.

      • a. Former varies in real value only with output
      • b. Latter also with value of money.

      8. If a tax on produce is commuted for a fixed sum, we are back with the English land tax.

    E. Or by taxing the rent of houses.

    • 1. Which should be considered as made up of building rent and ground rent.
    • 2. The former is the interest of the capital spent building the house, regulated by the interest rate, since it must pay that plus repair or replacement costs.
    • 3. The rest of the rent is the ground rent.
    • 4. A tax on house rent cannot, in the long term, affect building rent. (But would discourage the building of valuable houses! And the long term for houses, as Smith pointed out earlier, is very long indeed.)
    • 5. The tax is in part paid by the tenant, in part by the landlord, because it reduces the demand for housing and so reduces its rent. Smith is assuming here that how much you are willing to pay for housing is fixed, independent of what you get for it, which seems implausible.
    • 6. To the extent it is paid by the tenant, it is a somewhat graduated tax, since Smith thinks rich people spend a larger fraction of their income on housing than poor
      • a. Which Smith thinks a virtue
      • b. But what of his earlier maxim of fairness?

      7. Tax on the tenant falls on all sources of income. Smith does not note that such a tax is in part a large capital levy on the return from houses built before the rent was imposed--since houses last a long time.

    • 8. Uninhabited taxes should pay no tax.
    • 9. Houses inhabited by the proprietor should be taxed by rentable value, not cost.

    F. Better still, taxing ground rent.

    • 1 Falls entirely upon the owner of the land.
    • 2. Ground rent of houses, and rent of agricultural land, come often with little attention by the owner, so taxing them does little harm--in modern terms, the supply of land is almost perfectly inelastic.
    • 3. And this is even more true of the ground rent of houses than of agricultural rents.
    • 4. Which is also fairer, since ground rents are due mainly to external causes--good government.
    • 5. Smith knows of no examples of straight ground rent taxes, perhaps because of the problem of measuring it, but thinks it should be doable.
    • 6. Various proxies for house value have been used, such as:
      • a. Hearth tax. Odious because collector had to enter every room. What would he think of modern building inspectors?
      • b. Tax on houses, increasing with number of windows. Could be counted from the outside.
      • c. Unequal taxes, since the rich man in the capital pays the same tax as the poorer man with the same number of windows in the countryside.
      • d. All such taxes tend to reduce rent.

   

  Article II: Taxes on profit

  • A. Profit is divided into interest and what remains--compensation to the entrepreneur.
    • 1. A tax on profit must be paid either by raising the profit or lowering the interest paid.
    • 2. In the former case it falls on rent if the profit is from agriculture, on consumers in higher prices if it is form manufacturing.
    • 3. The interest of money seems, at first glance, suitable for taxation for the same reason as rent.
      • a. It is what is left over after paying the cost of employing stock, and ...
      • b. With a fixed amount of stock, the interest rate is given, so the tax must come out of what the lenders receive, not what the borrowers pay.
      • c. But, although Smith does not mention it, this assumes that the savings rate is unaffected by the after tax interest rate!

      4. Two reasons why capital might not be a good thing to tax.

      • a. Capital is hard to measure, and ...
      • b. Is mobile, so can flee jurisdictions where it is heavily taxed.
      • c. Hence, in practice, taxes on interest are low and only roughly calculated.

    B. Taxes on general profit that Smith knows of:

    • 1. English land tax was supposed to include stock as well as land
      • a. It sounds as though towns got to decide just how they would raise their share
      • b. And the stock is very much undervalued in the tax--at perhaps 1/50th its actual value.

      2. In all countries, the tax was set in a way that avoided the need to inquire into the detail of individual circumstances.

      • a. In Hamburgh, the tax is 1/4th of 1 % of all you possess--self assessed, with the amount secret, hence really a voluntary tax.
        • i. It works in Hamburgh because
        • ii. The people trust the government and approve of the tax.

        b. Switzerland has various self-assessed taxes, with the amount of the assessment public.

        • i. On total assets in Underwald
        • ii. On income in Zurich
        • iii. On exports in Basil
        • iv. All of which are believed to be honestly reported.

        c. The reason the Swiss are willing to publicly declare their assets or revenue, and the inhabitants of Hamburgh are not, is that Hamburgh is a trading city:

        • i. Merchants don't want to have to make the state of their finances public, for fear
        • ii. That if they are doing badly, they will be unable to borrow, and their affairs will collapse.

        d. In Holland, immediately after the Dutch got their independence from Spain, they had a capital levy of 2%, self assessed. That was workable as a once and for all tax in an emergency, but would have been ruinous as a regular tax, since it amounts to about 2/3 of the income from the capital.

      • e. All of the other taxes were intended to tax the income from capital, the Dutch tax to tax capital itself.
        • i. Presumably Smith means that in the other cases, people were expected to pay the tax by reducing their expenditure accordingly, while
        • ii. In the Dutch case, they were expected to reduce their capital stock.
        • iii. But it is not clear why, save that the latter tax was substantially larger, so harder to pay out of current income.

    C. Taxes on profit in particular activities.

    • 1. Can never fall ultimately on the dealers in that good, since they must get their ordinary profit or they will go do something else.
    • 2. If proportioned to the amount sold, the tax ultimately falls on the consumer.
    • 3. If a fixed tax on all dealers (such as license fee for being in the business), it falls ultimately on consumers, but also gives big dealers an advantage over small dealers
    • 4. The tax on shops is the same amount on all shops; it could not be proportioned to how much each shop sells
    • 5. "without such an inquisition as would have been altogether insupportable in a free country." In other words, a sales tax cannot be collected in a free country, because it imposes an intolerable violation of the seller's privacy.
    • 6. If the tax was substantial (which it was not), it would have given a significant advantage to large retail dealers, leading to less competition and higher prices, so not only would the tax have been paid by the consumers, they would have paid more than the tax, with the extra going to increased profits to the dealers.
    • 7. France has a tax on profits in agriculture
      • a. The "real taille" was a tax on land held by ignoble tenure (meaning not held by someone who held it as a nobleman).
      • b. The "personal taille" was a tax on the (estimated) profits of people who rented other people's lands (farmers in Smith's sense), however the land itself was held.
      • c. The former is unequal but need not be arbitrary--you know by what tenure you hold the land, and may know the amount of taxes.
      • d. The latter is both unequal and uncertain, since the tax collector has no good measure of the farmer's profit.

      8. A tax on profits in manufacture falls on the consumer; a tax on profits in agriculture falls on the landlord--is paid by lowering the rent the farmer pays. Why?

      • a. Smith thinks the supply of agricultural output is perfectly inelastic, so far as the tax is concerned
      • b. Apparently because he believes that once you are renting the land, there is a particular amount of capital necessary to cultivate it properly.
      • c. But why doesn't the farmer pull stock out of the least profitable parts of cultivation--not hire quite as many people to weed the field, say, and accept a slightly lower output?
      • d. I suspect we will hear more on this subject from Ricardo.

      9. One effect of the personal taille is that, since the tax collector will estimate your profit from how rich you seem to be, farmers try to look poor--which sometimes means cultivating their land badly.

      • a. Smith thinks they over do it, and lose more by farming badly than they gain in reduced taxes.
      • b. The result is to make everyone worse off.

      10. Poll taxes in the New World are taxes on slaves, hence taxes on the profit of a particular form of capital.

    • 11. And should be distinguished from the kind of poll tax that is paid by free men--i.e. a fixed amount per person.
    • 12. Taxes on servants are really taxes on consumption. They fall most heavily on the middling rank, since they have the highest ratio of servants to income.
    • 13. Taxes on profits in particular employments cannot affect the interest rate (or so Smith thinks).
      • a. The interest rate will have to be the same in the taxed as in the untaxed industry, since otherwise nobody will invest capital in the former. True, but ...
      • b. That doesn't tell us if the overall interest rate is or is not changed by the tax.

    D. Taxes on the capital value of lands, houses and stock.

    • 1. These are transfer taxes and inheritance taxes.
    • 2. Inheritance, and transfers of lands and houses, are public transactions, so may easily be taxed.
    • 3. Transfer of moveable property, on the other hand, can be kept secret, so cannot easily be taxed directly.
    • 4. It can be taxed indirectly either by
      • a. Requiring that agreements to repay be made on paper that has paid a stamp duty in order to be enforceable.
      • b. By requiring that such transfers be recorded, either in a public register (i.e. one anyone can see) or a secret register (that only the tax collector gets to see?), in order to be valid, and then taxing them.

      5. The same method is also often used for inheritance and transfers of real estate, although they could have been taxed directly instead.

      • a. Smith runs through historical examples, Roman and medieval, in which
      • b. The amount of the inheritance tax sometimes depended on who was inheriting from whom.

      6. The tax may or may not be proportional to the value of what is being transferred. More historical examples.

    • 7. Taxes by stamp duties and registration are a new invention, but have spread very fast, since "There is no art which one government sooner learns of another, than that of draining money from the pockets of the people."
    • 8. Taxes on inheritance fall on the heir.
      • a. This sounds obvious, but it is neither obvious nor necessarily true.
      • b. suppose I want to make sure my children have a particular amount of money to support them, and so
      • c. I compensate for the tax by saving more and consuming less, thus making sure they will have enough after tax.
      • d. I am then paying the inheritance tax out of my consumption, and it is costing my children nothing.

      9. Taxes on the sale of land fall on the seller because (according to Smith):

      • a. People usually sell land when they have to, and will take whatever they can get (i.e. inelastic supply curve).
      • b. While buyers are more flexible. So the buyer is willing to pay a certain amount in tax plus price.
      • c. Could be--but why does it have to be?
      • d. Smith concludes that such taxes thus are often cruel and oppressive, since they are falling on someone who is selling property because he has to, and is thus presumably in a bad poisition already.

      10. Taxes on the sale of houses fall on

      • a. The buyer if the house is just being build, since the builder must get his ordinary profit, but ...
      • b. On the seller if it is an old house, for the same reason as with land.

      11. All of these taxes are unequal even if proportioned to the value of the property, since some lands and houses change hands, and thus get taxed, much more often than others.

    • 12. All taxes on the transfer of property tend to reduce the total amount of capital, shifting money from capital, which maintains productive labor, to the government, which maintains unproductive labor.
    • 13. Registering mortgages and other rights on real estate is very useful, since it gives security to purchasers (who know what they are buying, and whether it is encumbered) and lenders.
    • 14. But making other transactions public is often inconvenient, or even dangerous, to people (do you want everyone to know you bought lots of valuable diamonds?). That you are deeply in debt to the bank?
      • a. So registers of such transactions are kept secret.
      • b. But a register that must be kept secret should not be kept at all
      • c. Since the people who are keeping them cannot be trusted (do you want the IRS to know your secrets, and are you sure the local agent won't gossip?)

  Article III: Taxes on the wages of labor

  • A. Wages are determined by the demand for labor and the price of provisions, so ...
    • 1. While those things remain the same, the effect of a direct tax on wages is
    • 2. To raise them by somewhat more than the tax.
      • a. Suppose, for example, a tax of 1/5th and a ten shillings wage. In order for the after tax wage to be ten shillings, the worker must get 12.5 shillings, so his wage has gone up by 1/4th, not 1/5th
      • b. True, but it does not mean that the wage is increased by more than the tax--the tax being collected, after all, is 1/5 of 12.5 shillings, which is 1/4th of 10 shillings, which is the amount by which the wage is increased.
      • c. Smith is confusing the tax described as a fraction of wages with the tax described as an amount of money--and it is the latter that is relevant.

      3. The tax would really be advanced by the manufacturer (or farmer) and paid by the consumer (or out of rent).

    • 4. And the cost to consumers and landlords is more than with a tax on rent and goods producing the same amount.
      • a. Smith's argument is that it is more because the employer must get back not only the increased wages but his normal profit on those wages.
      • b. But he is forgetting that the reason he gets the profit is the time interval between when he pays the wages and when he sells the goods--he is collecting interest on having paid the tax earlier than he gets reimbursed.
      • c. But that means that a tax on labor which collects $100 today costs the consumers $100(1+r) next year, where r is the interest rate.
      • d. And a tax directly on consumers and landlords that produced $100 today but was paid a year from now would also cost them $100(1+r), since the government would have to borrow the money now and pay interest on it for a year while waiting for the taxes to come in.
      • e. In other words, Smith is forgetting that a dollar today and a dollar year from now are not the same thing.

      5. But all of this assumes that the demand for labor stays constant. That will not happen (same amount of stock, labor costs more, so the stock can employ fewer workers). So such a tax will actually cause economic decline, a drop in real wages, ... .

    B. Taxes on particular sorts of wages

    • 1. The wages of skilled labor have a certain relation to wages in general (Smith's explanation of equal net advantage back in Book I), so a tax on such wages would simply result in their going up enough to keep the same after tax wage as before.
    • 2. But government employees are often overpaid, so their wages can be taxed without driving the wages up to compensate.
    • 3. And government employees are unpopular, so such a tax is popular.
    • 4. Smith does not consider just what the political mechanisms are that result in government employees being overpaid, hence does not consider the possibility that those mechanisms, rather than the market, might result in a compensating wage increase.

  Article IV: Taxes intended to fall on all sorts of revenue.

  • A. Capitation tax (literally head tax, meaning a tax on people)
    • 1. If proportioned to wealth or income is wholly arbitrary, since
    • 2. Knowing what a taxpayer's wealth or income actually was would require "an inquisition more intolerable than any tax, and renewed at least once every year." Say about April 15th.
    • 3. So such taxes are set at the whim of the assessor.
    • 4. Taxes set by rank rather than fortune are unequal, since rank and fortune do not match that closely.
    • 5. So the tax is either arbitrary (if proportioned to wealth or income) or unequal (if set by rank).
    • 6. Inequality is tolerable in a light tax; arbitrariness is not.
    • 7. and English head taxes have mostly been by rank, and light.
    • 8. French capitations are by rank for the higher orders, by their supposed fortune for the lower.
      • a. The great are willing to put up with inequality in a light tax, but would not accept the arbitrary assessment of an intendant (i.e. tax collector).
      • b. Their inferiors have to put up with arbitrary assessment.

      9. Capitation taxes on the lower ranks are essentially taxes on wages, with the problems discussed earlier.

    • 10. Capitation taxes are cheap to collect, but don't provide much revenue, and are inconvenient to those paying them.

    B. Taxes on consumable commodities

    • 1. Intended as a tax on consumption, hence an indirect tax in income.
    • 2. Smith distinguishes between necessaries and luxuries, including in the former not only what you need to survive but what local custom makes it indecent for you to go without (a shirt in England then and California now, at least indoors).
    • 3. A tax on necessaries works like a tax on labor--it makes living and bringing up kids more expensive, which reduces the labor force, which drives up wages, so the tax is eventually paid in higher wages.
    • 4. Taxes on luxuries, even luxuries consumed by the poor (beer, for example), do not increase wages.
    • 5. This seems puzzling; one might think that if beer gets more expensive and poor people still drink it, they will have less money to buy necessaries, so the same sequence of events will occur and wages will again rise.
    • 6. But Smith has an answer. The laboring poor are divided into:
      • a. The sober and industrious poor
        • i. Who have an elastic demand for luxuries. If the price of beer goes up, they will buy less, spend less money on it, and have more left over for necessaries for themselves and their children.
        • ii. And they are the ones who bring up large families, and principally supply the demand for useful labor.

        b. The dissolute and disorderly poor

        • i. Who may keep consuming luxuries even when their price rises because of the tax.
        • ii. Thus leaving their families hungry.
        • iii. But such people don't bring up large families anyway, since their children perish from neglect, mismanagement, ...
        • iv. And any children who do survive are likely to end up as public nuisances, due to their bad upbringing, corrupted morals, etc.

      7. So taxes on necessaries raise wages, hence the price of all manufactures, while ...

    • 8. Taxes on luxuries are paid by the consumers of the taxed luxuries.
    • 9. The upper and middle class ought to oppose taxes on necessaries, and on the wages of labor, because they end up paying them, with a considerable overcharge.
      • a. His "overcharge" here seems to mean only that, since the taxes on the poor are passed along in higher wages, they all end up on the not poor--but so would any alternative tax, except for a tax on the luxuries of the poor.
      • b. He may also be thinking about his (mistaken) arguments that taxes on wages end up costing more than they bring in.

      10. He discusses actual taxes on necessaries in Britain: salt, leather, soap and candles.

    • 11. And abroad.

    C. Taxes on consumables may be collected either:

    • 1. As an annual fee for the right to consume certain things, or ...
    • 2. As a tax on the goods paid by the dealer before the consumer gets them.
    • 3. The former is more convenient for a good, such as a coach, that lasts a long time, since the tax is spread out over its useful life.
    • 4. But if such taxes were applied to all goods they would be very unequal, since people who used very different quantities of the taxed goods would all be paying the same amount of taxes for the right to use them.
    • 5. And would be less convenient for goods that were consumed quickly, such as beer, since you would be paying a lump sum each year rather than a little bit each time you bought beer.
    • 6. And such a fixed fee would be less effective as a sumptuary law--to discourage drinking, say--since the marginal tax on an additional drink would be zero.
    • 7. Of course, although Smith does not mention it, this is an advantage if you are only trying to collect money not discourage consumption, since it means that the dead weight cost of the tax is less.

    D. Excises and Custom duties

    • 1. Smith discusses the history of customs duties in England.
    • 2. And points out that when goods are prohibited from being imported, as part of mercantilist policy
      • a. With the result that either they are not imported, or ...
      • b. Are smuggled.

      3. or have such high duties as to encourage lots of smuggling

    • 4. The result is to reduce, not increase, the income the government gets from customs.
    • 5. Bounties on export and drawbacks (refunds of import taxes when the good are re-exported) are a source of fraud, via "smuggling" in which you pretend to export something then land it back in England.
    • 6. Smith notes that high taxes, by reducing consumption of the taxed commodities and encouraging smuggling, often reduce tax revenue--a point referred to nowadays as the "Laffer Curve."
    • 7. He thinks England could get the same revenue from customs by imposing them on a few imported goods of general use, with a moderate rate and better enforcement and no export bounties.
    • 8. And trade and manufactures would do far better.
    • 9. Total expenditure of the lower classes is larger than of the upper, because there are so many more of them, so getting a large revenue from a consumption tax requires taxing consumption of the poor--but it should be their consumption of luxuries not of necessaries.
    • 10. Smith proposes revising current taxes on malt, beer, and ale by replacing them with a single tax on malt--i.e. malted barley--(which is the chief ingredient for making beer and ale)
    • 11. One objection offered is that this would reduce the rent and profit of land growing barley.
    • 12. But since land can be shifted between that use and others, it must get the normal return...
    • 13. And putting all the tax on malt should not reduce demand any more than putting the same or greater tax on multiple stages of the production process, as is now done.
    • 14. The only losers by the change are those who brew for home consumption, who presently are exempt from part of the taxes. They are mostly rich people, whose servants are brewing beer and ale for the whole household--why should they get a special tax break?

    E. Taxes on transport--tolls etc.

    • 1. Presumably start as user fees for maintaining the road, but ...
    • 2. Get taken over by the sovereign and used as a source of revenue
    • 3. Increasing the toll, and decreasing the upkeep of the roads it was supposed to pay for.
    • 4. Where the toll is on goods carried from country A through B to C, they represent a tax B can collect that is paid by people in A and C.

    F. Taxes upon luxuries

    • 1. Fall on all sources of revenue (i.e. on revenue, whether from wages, rent, or profit) and are paid by the consumer of the luxury, but ...
    • 2. Not proportionally to revenue, since some people spend more of their revenue than others
    • 3. And someone whose revenue is in country A but who lives, and consumes, in country B contributes nothing to the government of A, which is protecting his source of revenue.
    • 4. Such taxes can be made certain (i.e. predictable) and convenient (we are back running through his four maxims of taxation, and have just covered 1-3).
    • 5. But they fail maxim 4--they cost the people much more than what the government gets, for four reasons.
      • a. Collecting them requires lots of customhouse and excise officers. In England, the salaries of the customs officers are about 10% of the net revenue of the customs, and their perquisites (non-cash benefits of the job) are much more than their salaries, so the whole expense is probably twenty or thirty percent.
      • b. Discourage industry.
        • i. Obvious if it is a domestic industry that is taxed, thus discouraged.
        • ii. If we tax import goods, since they are what producers get in exchange for producing export goods, we make producing export goods less attractive, so they produce fewer of them.
        • iii. More generally, the taxes force the direction of national industry in a different way than it would have naturally run.

        c. Smuggling results in forfeitures and other penalties, which ruin the smuggler

        • i. Who, it is true, is breaking the law, but ...
        • ii. A law that does not follow from natural justice, so he may well be a good person.
        • iii. And practically everyone is willing to smuggle when he is sure he can get away with it.
        • iv. And to claim scruples about buying smuggled goods would in most countries be considered hypocrisy, and make the person claiming it suspecedt of being a knave.
        • v. When Smith became a commissioner of the customs, he wrote one of his friends a letter saying that after checking the list of commodities that could not be legally imported he had concluded that practically everything he was wearing was illegal, and had destroyed his lace, etc.
        • vi. He suggested that his friend avoid checking over the list, for fear of having to do the same thing.

        d. Expose the dealers in taxable commodities to harassment by tax collection, vexation, trouble, ...

    G. Smith argues that although the English system of taxation is pretty bad, the taxation of most other countries is much worse, and gives examples.

  • H. Taxes on consumable commodities may be collected either by ...
    • 1. Government employees, in which case the revenue varies year by year according to how much comes in, or ...
    • 2. tax farmers, who agree to pay a fixed amount per year in exchange for being permitted to collect the tax.
    • 3. The latter is a mistake, because
      • a. The farmer must make a profit on his advanced capital. (But this is balanced by his paying earlier than he collects, which is why he must make a profit on his capital)
      • b. He must get paid for his expertise, work, etc.--but so must the government tax collector. Hasn't Smith already answered these arguments in his defense of the inland corn merchant some time back?
      • c. But Smith thinks the competition for tax farming is inadequate, due to the huge amount of capital (or credit) required, hence tax farmers get overcompensated.
      • d. And because the tax farmers are oppressive tax collectors, since once their contract is over they don't care what condition the country is in.
      • e. And they lobby for more and more severe laws to force people to pay taxes.

    I. Smith discusses how to reform other countries' taxation systems.

    • 1. And observes that France, although richer in towns etc. than Britain, collects only about half the per capita tax
    • 2. And yet the French are much more oppressed by taxes than the British.

    J. He points out that when a country is sufficiently desperate, and has imposed all the proper taxes, it may have to impose improper ones.

    • 1. For example a country that had to spend a lot on warfare to defend itself, or ...
    • 2. Holland and Zealand, which are largely below sea level and so have to spend a lot to simply stay in existence (dike repairs etc.).
    • 3. They survive in part because the great mercantile families have a share in the government and are therefore willing to stay in the country even though their capital brings them less, and prices are higher, than elsewhere.
    • 4. If Holland should lose its republican form of government, the capital would flee and the economy collapse.

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