Classical Economics: Adam Smith
What is generally called the classical economics or classical political economy covers more than one hundred years from about 1776 to circa 1890. Classical economics was almost exclusively produced in Britain.
The three major treatises, economic masterworks of the classical period were:
1. Adam Smith (1723-1790), Inquiry into the Nature and Causes of the Wealth of Nations, 1776 (we shall use the shorter version of the title, the Wealth of Nations; almost nobody uses the full title).
2. On the Principles of Political Economy and Taxation by David Ricardo (1772-1823), 1817.
3. Principles of Political Economy by John Stuart Mill (1806-1873), 1848.
Smith, Ricardo and John Stuart Mill ruled economic thought from 1776 until almost the end of 19th century; Smith from 1776 until about 1820, Ricardo from roughly 1820 to 1850s, and Mill from 1850s until the 1890s.
There were of course many other minor thinkers, who belong to classical economics, but these three authors are the representative economists of the period.
There are two main characteristic features of the classical economics.
First, classical economists found in the economy a basic harmony; they had a positive attitude to the economic phenomena, which were induced by natural forces in the economy. They held a view that markets automatically, at least in the long run, bring a harmony in the economy and the society, that markets harmoniously resolve conflicts over the scarcity of economic resources, that markets always operate at or near full employment, that economic depressions are short-lived and that the markets automatically recover from slumps and the like.
This led them to advocate a governmental policy of laissez-faire, policy of governmental non-interfering in the economy. This was a very optimistic view about the functioning of the markets.
The second widely shared assumption or interest within classical economics is that classical economists were mainly interested in dynamic issues, long-term, long-run economic processes. The classicals were very interested in the forces determining the economic growth and the distribution of income over time. Adam Smith focused on the economic growth, while David Ricardo was interested in long-run changes in the distribution of income that would take place under capitalism.
After the decline of classical economics in 1870s, the long-term economic problems like the economic growth or the distribution of national income over time disappeared from economic theory for about 80 years in case of economic growth (the interest in growth reappeared in 1950s) and about 100 years in case of distribution of income over time (the interest in this problem has been brought back to economics only in recent let’s say 20 years).
The interest in long-run economic processes is the second characteristic feature of classical economics.
Two other seminal thinkers of the period deserve mention in this introduction to the classical thought.
Thomas Robert Malthus (1766-1834) and Karl Marx (1818-1883) were in part classical economists, they shared some views of Smith and Ricardo, but they should be considered as serious and important critics of classical economics.
Malthus formulated first population theory in the history of ideas, which is in accordance with classical economic theory. But he deviated significantly from the orthodox classical economics in his analysis of certain macroeconomic aspects of the economy.
A little digression here, classical economics and its reformulation neoclassical economics, which followed classical economics, is often called orthodox economics – as the views of classical and neoclassical economics were accepted as right or true by the most economists during the 19th and 20th century.
In accordance with this view, we have many heterodox economic currents or schools, Marxian economics, institutional economics, historical school of economics, Austrian economics and many others. Everything beside classical and neoclassical economics is non-orthodox, unorthodox or heterodox economics since it differs from the economics, which is considered right or true.
Malthus claimed that the market economy has no ability to automatically achieve full employment of resources. According to Malthus there are considerable difficulties in maintaining full employment of resources in the market economy,
Classical economists, Smith, Ricardo, thought that the underemployment of resources in market economy can happen only during relatively short periods and that in the long run there is an automatic tendency to a full utilization of resources.
Malthus’ claim to heterodoxy was his macroeconomic belief that there is no inherent, essential stability in market economy.
Karl Marx borrowed some elements from classical economics but he reformulated them completely and drew radically different theoretical conclusions and implications for economic policy.
We should add here that it was Karl Marx who coined the term ‘classical economics’.
Marx incorporated into his analysis several classical ideas – the so called labor theory of value, for example, and in the first place the interest in dynamic questions, especially the questions of the distribution of income over time in capitalism, the course of the rate of profit over time, and the prospects for the level of well-being, welfare of the labor class over time in capitalism.
So Marx can be considered as classical economist on the methodological level, he used the scientific tools of classical economics, but for completely different purposes.
While classical economists found that the profit motive of the capitalists led to an efficient allocation of capital in the economy and to savings, which promoted growth, Marx saw the activities of capitalists as harmful to the labor class and the society, he thought that labor class was exploited in the capitalism, that capitalism is unjust economic system and that it is doomed to failure.
Classical economists were the advocates of capitalism; Marx was a harsh critic of capitalism.
So much on the introduction to the classical economics and we can start with the discussion of Adam Smith’s economics.
Adam Smith was born in 1723 and died in 1790. He came from an influential Scottish family.
Smith was typical of early economic writers in that he was not exclusively an economist. He was an academic, and this allowed him a degree of detachment from various particularities and objectivity that was lacking in the mercantilist writers, who were generally businessmen.
As a professor of Moral Philosophy at Glasgow University from 1752-1764, he was giving a series of courses that encompassed what we now call the social sciences and humanities. He was interested in Moral Philosophy, which has many connections with his economics.
Smith was not a narrowly technical theoretician but a careful scholar with a grand vision of the interrelatedness of the society and the economy. Although we pay particular attention to his vision of the interrelatedness of the economy, Smith dealt with the important connections across many areas of society – things that are today studied by economists, political scientists, sociologists and philosophers.
Smith was influenced by his teacher Francis Hutcheson (1694-1746) and by his friend philosopher-economist David Hume (1711-1776). We touched on some views of Hume, while discussing mercantilism; we said that Hume was half-mercantilist, half-classical economist.
We discussed Hume’s famous argument, price-specie flow mechanism and concluded that Hume did not believed that single rise in money supply could contribute do the economic growth. Smith shared this view of Hume.
In case of Hutcheson, Smith shared Hutcheson’s strong disapproval of the mercantilist ideas of Bernard Mandeville. We discussed Mandeville’s views some weeks ago.
Mandeville, in his poem The Fable of the Bees, claimed that pursuit of individual self-interest by the members of society would generate many undesirable social and economic consequences and therefore there is a case for government intervention in the economy.
Hutcheson and after him Smith argued that egoistic actions do not necessarily lead to bad outcomes for the society, so the government do not have to undertake actions to channel private activities for good public effects.
Many of the attitudes toward knowledge and science during Smith’s time differ sharply from those of today.
First, no clear distinctions between various areas of inquiry existed: philosophy, science, social science and ethics were treated not as separate disciplines, but as a single body of knowledge. Smith wrote not only on economics, but also on rhetoric, law, and even on astronomy.
One of the consequences of this interdisciplinary approach was that Adam Smith believed that the scientific rigor of natural sciences, and especially of physics, could also be attained in social sciences, and in economics also.
He believed that just as Isaac Newton through rigorous scientific analysis had found order and harmony in the physical world, so he may discover the natural laws governing society and the economy.
This Smith’s preconception enabled him, when he examined the economy, to see not chaos but harmony and order, produced by individual self-interests interacting in competitive markets.
Smith has often been called the father of economics. Although each of the precursors of classical economists, that is mercantilists and physiocrats writers, saw bits and pieces of the puzzle (puzzle of how market economy is functioning), none had been able to integrate into a single volume an overall vision of the forces determining the wealth of nations, the appropriate policies to foster economic growth and the way in which millions of economic decisions are effectively coordinated by market forces.
Smith is called often the father of economic not because he discovered independently some important economic laws, but because he was able to synthesize his and previous developments into one, coherent, integrated system, explaining how markets work and how economic growth operates.
Smith’s major economic work is titled An Inquiry into the Nature and causes of the wealth of nations, published in 1776, the year of the American Declaration of Independence also.
In Smith’s lifetime, however, his reputation as a scholar was based not on this book, but on The theory of Moral Sentiments, published in 6 editions between 1759 and 1790.
Smith regarded both books as part of his broader inquiry into social science.
The main concern of the theory of moral sentiment was with the criteria on which moral judgments can be based - so this is the book on philosophy and ethics. However, since it creates a context for the Wealth of Nations, few words on the Smith’s theory of moral sentiments.
In this work, Smith was exploring the question of what makes it possible for people to live in society. How it is that selfish by nature people can be restrained in order to prevent form injuring one another?
Smith answer was that people are held together by mutual affection that is desire to please others because of the ability to see things from someone else’s point of view (they feel sympathy for each other). Nevertheless, this feeling is not strong enough for the society to flourish, to be peaceful and prosperous.
Further guidance for people is needed and this is provided by moral rules, generalizations from our experience of what types of action are approved of and disapproved of. Still moral rules are in themselves insufficient and need to be backed up, in some cases, by positive, legal laws.
So, in general, feelings of mutual love or affection, moral rules and positive laws are needed for society to flourish, to be prosperous.
However, Smith argued that sympathy and feelings of mutual love, affection, or friendship are not necessary for a commercial society. A commercial society can flourish, be prosperous, even though people do not have strong affections for each other.
This is the context for the Wealth of Nations – in this book Smith is exploring how a commercial society can prosper, even though men and women are pursuing their own interests.
What is important here, he assumes a framework of justice; people are assumed to be guided by morality (but not by love or sympathy for others) and restrained by a just legal system. Without such a framework of justice, society would be destroyed.
Within this framework, Smith in Wealth of Nations explains the benefits that arise from a system of liberty, where government is severely limited and people are allowed to pursue their self-interest.
As the title of his main economic work suggests, Smith was interested in explaining the nature and causes of the wealth of nations that is, using modern language, he was interested in macroeconomics, and tried to discover the forces of the economic growth. But the forces that Smith examined were much broader than those studied in modern economics, and he filled his economic model with political, sociological and historical material.
He gave some attention to the microeconomics, to the determination of relative prices, but his main interest was in the theory and practice of promoting economic growth.
A few statements on Smith’s methodology.
He used a combination of deductive reasoning and historical description.
Deductive reasoning is inference in which the conclusion is of lesser or equal generality than the premises, as opposed to inductive reasoning, where the conclusion is of greater generality than the premises. In deductive reasoning if the premises are true, it would be impossible for the conclusion to be false. For this reason, deductive arguments are usually limited to inferences that follow from definitions, mathematics and rules of formal logic
Smith did not use mathematical expressions, he used deductive reasoning in informal mode, descriptively.
His models, if we can use this word, lack rigor and elegance, but his descriptions of interrelationships within the economy are unmatched in history.
A modern mathematical economist could condense the theoretical propositions contained in the nine hundred pages of the Wealth of Nations into a very short paper, probably a few pages long paper. However, the Smith’s times were different and the modes of scientific reasoning were at the time different too.
We will now examine the overall theoretical structure of the Wealth of Nations and the policy conclusions that flow from Smith’s theory. After that, we will discuss some specific theoretical Smith’s achievements.
We start with the overall look at the Smith’s theory and its’ policy conclusions because we was not an economist in the narrow sense of the word, but rather a philosopher who pointed the way toward economic development and affluence. Smith is still read today for his insights in economic policy, not for his contributions to the technical part of economic theory.
So, let’s start with smith’s economic policy.
Smith’s economic policy from a methodological point of view is often called contextual economic policy. This means that his conclusions in economic policy were not only based on abstract, non-contextual, theoretical arguments, but that they were contextual, that is, they are based also on Smith’s observations of the existing historical, political and institutional circumstances.
Non-contextual economic policy is based only on abstract economic models; an example of non-contextual reasoning would be argument that laissez-faire, not intervening in the economy is the best policy, because in the long-run firms produce at the lowest possible average cost. There is a single, theoretical, separated from historical or institutional context reason for promoting laissez-faire in this reasoning.
Smith also used theoretical arguments in guiding economic policy, but his advocacy of laissez-faire is rooted in a methodological approach that asks the following question: Does experience, historical observations show that government intervention will produce better results than will the free working of the markets?
He advocated laissez-faire not only because of the theoretical, abstract arguments, but also he believed that in the context of history and the institutional structure of the England of his time, markets usually produced better results than did government intervention.
So he formulated contextual economic policy.
Later economists varied in their approach.
David Ricardo advocated laissez-faire policy based on abstract, non-contextual, ahistorical model. He did not used mathematical notation, but he formulated very abstract, non-contextual model of the economy.
Ricardian approach, the approach of David Ricardo, that is building abstract economic models and drawing policy conclusions from these models, became very influential in economics, especially in the 20th century with the rise of mathematical economics.
However, we should remark here, recently there are many new currents in economics which for the purposes of giving policy advice at least, are moving away from abstract theorizing, and examine how governments and governmental policies actually work in historical and institutional context. Public choice school in modern economics is one example of such a school.
Returning to Smith. What are his main policy prescriptions?
Let’s start with the assumptions of his analysis. He assumed that human beings are rational and calculating and in their economic matters are largely driven be economic self-interest.
He also assumed that, for the most part, competitive markets exist in the economy, and that within these markets the factors of production move freely to advance their economic advantage, he assumed free movement of the factors of production.
He also claimed that there is a natural process at work in the economy, which can resolve conflicts more effectively than any arrangements devised by human beings.
Smith expressed the nature and the effects of this beneficial process in market economy in the following passage from the Wealth of Nations (it deserves to be quoted at length):
As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes interest of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.
The reasoning in this passage is very simple.
Humans are rational, calculating, and driven by self-interest. If left alone by the government, each individual will follow his or her own self-interest, and thanks to the so-called invisible hand, in promoting self-interest he or she unintentionally promotes the interest of society.
Government should not interfere in this process and should therefore follow largely a policy of laissez-faire.
Private self-interest by means of invisible hand will lead to the public good in a non-regulated market economy. However, what is this natural process – an invisible hand – which leads from private interest to public interest?
“Invisible hand” is Adam Smith’s famous metaphor, which is present in the economic, scientific and public discourse from his times until today. This is probably the most famous, most well known, economic metaphor and idea of all times, invisible hand, invisible hand of the market.
In the most popular interpretation by the invisible ...
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