The Great Economists Read online

  For his system to work effectively, there must be competition in the marketplace. But Smith also stipulated that such operations must be within the legislation and rules set by the government. The banking sector serves as a telling example. Smith believed that there should be competition among banks to reduce moral hazard, for example the possibility that banks might behave badly knowing they will be rescued. Government regulation could force banks to be more careful ‘by not extending their currency beyond its due proportion to their cash’.17 In other words, banks should depend on their cash and deposits for their lending operations and not get themselves in trouble by leveraging themselves in complicated ways.

  More controversially, and reflecting his concern about banks, Smith supported setting a ceiling for interest rates, so that ‘prodigals and projectors’ could not take up the credit available and exclude the ‘[s]ober people’ who would use the loans more productively.18 (His fellow philosopher Jeremy Bentham considered this to be a betrayal of Smith’s free-market principles!)

  In this respect, Smith would agree with the need to reform financial services after a crisis. He would improve banking supervision and increase competition to ensure that credit flowed freely in the economy. Along these lines, Smith believed that some government intervention was warranted, but he was specific as to which areas. For instance, the state should maintain good transport facilities (roads, canals, navigable rivers), as that would break monopolies and encourage competition. His preference was to see such facilities regulated by local administration, or even deregulated if that lowered the cost of maintenance.19

  Smith also advocated government spending on education. He worried about the impact of the division of labour on people, particularly of repetitive assembly work: ‘[The worker] naturally loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to become.’20 In his view, government had an obligation to counteract this effect with some provision of universal education. Smith also favoured public examinations to maintain educational standards, and focused on science, a feature of the Scottish Enlightenment: ‘Science is the great antidote to the poison of enthusiasm and superstition; and where all the superior ranks of people were secured from it, the inferior ranks could not be much exposed to it.’21

  But Smith also makes clear that there are areas where governments should not intervene, among them placing limits on the mobility of workers and capital, and enacting policies that hinder competition. In particular, Smith believed that restraints on the freedom of trade and policies that favour some sectors of trade over others would force economic activity into unproductive channels. Government intervention to promote one sector against the market is bound to be less productive than if self-interested individuals were able to decide on merit which businesses to start or where to work or what to trade. Rebalancing the economy would fall foul of Smith’s admonitions about governments believing themselves to be capable of choosing the most productive sectors.

  The rebalancing argument cannot separate out the domestic sectors of the economy from a country’s trade position since specialization within an economy is affected by globalization. When Britain specialized in manufacturing as the earliest industrial power, it imported agricultural goods. Smith certainly saw the interconnections between trade and the structure of the British economy.

  In fact, Smith’s beliefs about a circumscribed role for the state were influenced by his deep-seated opposition to the mercantilist policies of that time. He strongly objected to mercantilists distorting international trade by seeking to run a surplus.

  In book IV of The Wealth of Nations, Smith criticizes the ‘Mercantile System’. He explains why the policy that tries to improve the trade balance through imposing restrictions was inefficient. He was particularly against the regulation of the British trade in grain. He wasn’t alone. It was a general preoccupation of Enlightenment economists to argue against protectionism. Smith viewed protectionist trade policies as diametrically opposed to an efficiently operating market. Smith reserved his severest criticism of mercantilist practices for the way that European merchants exerted their monopoly power in the American colonies, asserting that ‘[t]o prohibit a great people, however, from making all that they can of every part of their own produce, or from employing their stock and industry in the way that they judge most advantageous to themselves, is a manifest violation of the most sacred rights of mankind’.22

  Although Smith equated free trade with the exercise of economic freedom, a theme throughout his work, he did make allowances for customs to generate government revenue if necessary:

  From the above considerations it appears that Brittain [sic] should by all means be made a free port, that there should be no interruptions of any kind made to foreign trade, that if it were possible to defray the expences of government by any other method, all duties, customs, and excise should be abolished, and that free commerce and liberty of exchange should be allowed with all nations and for all things.23

  Unlike many economists, Smith had the chance to put his theories into action. As the Commissioner of Customs for Scotland, he advocated the removal of all trade barriers, which was qualified only by the need to raise revenue for what he considered to be the proper purposes of governing a country. He supported levying duties on imports and exports at a moderate level, but not so high that smuggling would be profitable. True to his beliefs about government policies not distorting the market, he would set duties to be equal for different producers and importers, so that one group or one country would not have an advantage over another. For instance, he saw the inequity of exempting the product of private brewing and distilling (which was imbibed by the rich) from excise duty, while taxing the preferred tipples of the poor.

  Having shown what the wealth of nations consists of, and how growth may be encouraged, or at least not discouraged, by governments, Smith in book V of The Wealth of Nations went on to discuss a necessary public expenditure: defence. But he was against the British going to war over its American colonies. He urged legislators to awaken from the ‘golden dream’ of empire and avoid ‘a long, expensive and ruinous war’.24 Smith had even advocated that colonists be given representation in Parliament. In correspondence with William Strahan MP (who was the publisher of both Smith and Hume) on 26 October 1775, Smith wrote that ‘a forced and every day more precarious Monopoly of about 6 or 700,000 Pounds a year of Manufactures, was not worth contending for; [and] that we should preserve the greater part of this Trade even if the ports of America were open to all Nations’.25

  Unsurprisingly, Smith stressed the economic gains from relinquishing the American colonies. In line with his view that markets operate efficiently, he saw the benefits of trading with America even if it was no longer a colony; indeed, he was willing to trade with anyone. Preferring one country over another was, after all, a product of government policy and distorted Smith’s freely competitive markets.

  In summary, then, Adam Smith would not have advocated that governments rebalance the economy if doing so meant introducing distortions into the operation of the market. He was particularly vehement when it came to trade, and he viewed such restrictive policies as not just inefficient for the market but also distortionary in terms of trading with other countries.

  Neither Britain nor the United States has managed either to rebalance the economy towards manufacturing or to close their trade deficits after the 2008 global financial crisis. Instead, a dominant services sector and a persistent trade deficit continue to characterize these post-industrial economies. Smith wouldn’t have been surprised. In his economic model, government cannot fundamentally change the economy; only add distortions to how the market functions.

  Smith didn’t suggest, however, that a nation’s economic strengths could not be shaped. He did believe in government regulation and policies designed to improve market efficiency. Britain during his lifetime underwent a significant structural shift that was possible
under the conditions set by the state. The advent of the Industrial Revolution itself is an example of how technological progress, which the state can influence, fundamentally altered the nature of an economy and a society. The digital revolution of the twenty-first century might even change the application of Smith’s views on the unproductive services sector, since services output doesn’t expire on use and we can now, for example, purchase and enjoy ad infinitum copies of our favourite musical performances.

  Finally, as for the reshaping of a nation’s advantage to be more competitive in a less than free trade system, Smith would certainly advocate for liberalization and opening up. But what if the global system failed to meet his standards? The next chapter explores how our second Great Economist, David Ricardo, would view the currently imperfect international trading regime and whether Britain and America should be worried about their large trade deficits under such a system.

  A giant among economists

  He may be the father of economics, but, like all economists, Smith was subject to criticism, and not just over advocating that colonists be given representation in Parliament! For instance, his friend and contemporary, David Hume, disputed Smith’s claim that the rent of farms would make up a portion of the price of produce. Hume believed that rent would not factor into the price of a good traded in the market because the price is determined solely by quantity supplied and customer demand.

  Nevertheless, Adam Smith was an influential if somewhat eccentric figure throughout his life. Among his known eccentricities was his banging his head against the wall while dictating The Wealth of Nations (he had to dictate because his handwriting was terrible). And although he had a designated heir, he gave away a great deal of his money, mostly in secret.

  His greatest bequest is, of course, to economics. Smith is unquestionably the father of the field whose ideas of a freely competitive market still shape our thinking today. And he believed in human endeavour above all:

  The natural effort of every individual to better his own condition … is so powerful a principle, that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations.’26

  CHAPTER 2

  David Ricardo: Do Trade Deficits Matter?

  Buying more from the rest of the world than a country sells – does it matter? It’s a concern for a number of countries, but most notably for the advanced economies of the US and Britain, which have some of the largest persistent trade deficits. As discussed in the last chapter on Adam Smith, trade is related to being deindustrialized. So, this is a challenge that other economies may well confront as they develop. But, for the UK and US, it is a pressing issue now with potential lessons for other countries. What does a large trade deficit say about the health of the economy?

  It’s a long-standing issue, but one that has come into the spotlight as Britain’s current account deficit, which is the broadest measure that includes trade and investment flows, rose to record highs after the 2008 financial crisis. There is no doubt that there are concerns about the UK’s trade deficit. The Bank of England has warned about the consequences if foreigners stop investing in the UK after it leaves the EU, which would make the current account deficit harder to finance.

  The United States also has a large trade deficit, but it enjoys the privilege of the US dollar being the world’s reserve currency. That means foreigners more readily lend money to America to finance its deficit. But, the dollar’s position has been questioned by the rise of currencies such as the Chinese renminbi (RMB).

  The heart of the issue is this: does it matter if the US or Britain has a large trade deficit? It’s been the case for decades. The geopolitical tensions may be higher, but has the economic sustainability of the deficit changed much?

  The question of trade has garnered much analysis over centuries, particularly for the UK. International trade was one of the first topics tackled by economists in the late eighteenth century. The rejection of the protectionist Corn Laws in favour of opening up to the world economy marked the start of an era of globalization which contributed to Britain’s prosperity.

  It was at that time that the seminal work on international trade was penned by David Ricardo. Ricardo’s On the Principles of Political Economy and Taxation is considered to be one of the classics in economics.

  So, what would Ricardo make of the persistent trade deficits experienced by the UK as well as other deindustrialized nations such as the US? Ricardo’s theory of comparative advantage, whereby countries gain from trade even if they are less efficient in all production than their trading partners, has transformed the thinking around international trade and showed why there are significant benefits from globalization. But to understand the context for Ricardo’s economic theory, we must first take a look at his life.

  The life and times of David Ricardo

  Although one of the most influential economists of all time, one whose ideas still permeate the profession today, David Ricardo never went to university. Born in 1772, he was later to be disinherited by his Jewish family when he married a Quaker, Ricardo nevertheless used his father’s connections at the London Stock Exchange to strike out on his own. He became one of the wealthiest men in Britain, as well as an economist, and late in life a parliamentarian.

  Unlike most economists, Ricardo was a successful investor. He was really a stockbroker, dealing mainly in government bonds like his father. Similar to his near contemporary Nathan Mayer Rothschild, he was what was then known as a ‘loan contractor’, whereby he contracted to take on large chunks of government-issued debt and then sold them to the market at his own risk. During the Battle of Waterloo he bet against a French victory by investing in British securities. With that one call he became one of the richest men in England. At the time of his death, he was worth around £700,000.1

  Another sign of his investment skills is that he was also a landlord. By the age of forty-three he had made £600,000 and purchased Gatcombe Park in Gloucestershire, which has been owned by Princess Anne since 1976. Ricardo’s decision to buy land might have had to do with wanting to turn himself in a country gentleman. His investments gave him an annual income of some £28,000: £10,000 from his estates, £10,000 from mortgages elsewhere and £8,000 from French stocks. Translated into today’s money, his estate was estimated to be worth £350–400 million, with an annual income of roughly £15 million. His wealth and standing contributed to his economic theories, which were based on three classes within a society.

  Once Ricardo became wealthy, he focused less on his businesses. He began writing about economics by happenstance. His interest in economics, or what was known then as political economy, was triggered unexpectedly when he happened to pick up Adam Smith’s The Wealth of Nations while visiting Bath in 1799. It wasn’t until a decade later that he would write his first essay on economics. In his late thirties, Ricardo published a series of economic articles in the Morning Chronicle. His writings were published a year later as The High Price of Bullion: A Proof of the Depreciation of Banknotes. Due to the war with France, England’s gold supply was under pressure so the Bank of England had stopped paying its notes in gold. Freed from this constraint, Ricardo argued that there was too much money printed by the central bank, which contributed to the high inflation of the time. This critique in his very first publication brought him to the attention of some of the leading thinkers of the time: Thomas Malthus, Jeremy Bentham and James Mill, father of the prominent philosopher John Stuart Mill.

  An increase in tariffs on imported wheat in 1815 under the Corn Laws prompted his next major work, Essay on the Influence of a Low Price of Corn on the Profits of Stock. The argument against the protectionist Corn Laws formed the foundation for his future and seminal work that set out the basis for trade models in economics. In 1817, On the Principles of Political Economy and Taxation was published. Not only did Ricardo’s argument
s lead to the repeal of the Corn Laws, he also became a lawmaker.

  By the time that he had published Principles, Ricardo was living both in Grosvenor Square in London and Gatcomb Park (the ‘e’ was added later). He was elected High Sheriff of Gloucestershire in 1818 and entered Parliament that year. He held his seat until his death a few years later.

  In 1823, at the relatively young age of fifty-one, he died unexpectedly of an ear infection. He was survived by his wife, Priscilla, and seven of their eight children. Two sons followed him into Parliament. Ricardo’s estate was divided among his family, and he also bequeathed some of his fortune to his friends Malthus and Mill.

  Ricardo’s career as an economist may have been brief but, during it, his theory of comparative advantage cemented his place in history as the father of international trade.

  Like Adam Smith, Ricardo lived during a time of vast change. Undoubtedly, his views on trade were shaped by the protectionist debates over agriculture.

  To give a sense as to how much the country had changed, less than one-fifth of the English population lived in the northern half of the country in 1751. By the early nineteenth century, that had risen to a quarter of the population owing to industrialization. A third of the population was urban, up from a quarter in 1751. England had become the most urbanized country in western Europe.