Sunday, March 06, 2011

Book Review, Wealth of Nations Book 2

(Continuing from Book One) Book Two of WoN focuses on the role of money and banking in the economy, with particularly interesting stories from Scotland. I found this book to be much more fun and quotable than I had expected.

Ekelund and Hebert describe Book Two as "problematic," focusing on Smith's "unfortunate" use of terminology that divides workers into "productive" and "unproductive" groupings. We would call service sector workers as "unproductive," and Smith lumped his own profession--teaching--into the "unproductive" category. If you produce something, like a play, that expires as soon as it is finished, instead of something, like furniture, that exists on into the future then you're "unproductive." It's easy to understand the label, so I don't find it so problematic-- he's not making a judgment about laziness.

But perhaps this is where Marx (and later, Lenin) got his basic emphasis on manufacturing being the only important part of the economy.

"Productive" workers produce things that potentially add to the capital stock. A worker that manufactures a machine has contributed to the future wealth of his country. Smith contrasts this with "unproductive" government workers that perform services or defend the country militarily:
"The labour of some of the most respectable orders in the society is, like that of menial servants, unproductive of any value...The sovereign, for example, with all the officers both of justice and war who serve under him, the whole army and navy, are unproductive labourers."

This leads to a wonderful critique of the government. "Crowding out" is modernly considered to be a phenomenon of government borrowing driving up interest rates making it more expensive for firms to borrow for capital accumulation. Increases in our government's current deficit are justified on the basis of interest rates not (yet) rising. Smith simply sees increases in the government's sector as being more devotion of resources to unproductive uses-- diminishing future capital accumulation and wealth.
"Great nations are never impoverished by private, though they sometimes are by public prodigality and misconduct. The whole, or almost the whole public revenue is, in most countries, employed in maintaining unproductive hands. Such are the people who compose a numerous and splendid court, a great ecclesiastical establishment, great fleets and armies, who in time of peace produce nothing, and in time of war acquire nothing which can compensate the expense of maintaining them, even while the war lasts. Such people, as they themselves produce nothing, are all maintained by the produce of other men's labour. When multiplied, therefore, to an unnecessary number, they may in a particular year consume so great a share of this produce, as not to leave a sufficiency for maintaining the productive labourers, who should reproduce it next year. The next year's produce, therefore, will be less than that of the foregoing; and if the same disorder should continue, that of the third year will be still less than that of the second."

As Mitch Daniels critiqued President Obama's speech at the University of Michigan for more students to forgo private enterprise and work for the government (ie: at the expense of the taxpaying entrepreneurs), "The host can only stand so many parasites."

As such, Smith makes a good point about wars as destructive enterprises. Government consumes the produce of private enterprise in such a way that it does not get replaced:
"But had not those wars given this particular direction to so large a capital, the greater part of it would naturally have been employed in maintaining productive hands, whose labour would have replaced, with a profit, the whole value of their consumption."

Nonetheless, the stream of private enterprise finds a way around government obstruction:
"But though the profusion of government must undoubtedly have retarded the natural progress of England towards wealth and improvement, it has not been able to stop it. The annual produce of its land and labour is undoubtedly much greater at present than it was either at the Restoration or at the Revolution."

But much of Book Two is related simply to banking. First, fractional reserve banking allows more commerce and capital accumulation to take place than would have otherwise:
The judicious operations of banking, by providing, if I may be allowed so violent a metaphor, a sort of waggon-way through the air, enable the country to convert, as it were, a great part of its highways into good pastures, and corn fields, and thereby to increase, very considerably, the annual produce of its land and labour."

However, excessive issue of bank notes puts banks, and the entire economic system, at risk of a bank run. The scene Smith recounts has been repeated often through the centuries. What will curb the risk-taking by banks? Competition among the banks:
The late multiplication of banking companies in both parts of the united kingdom, an event by which many people have been much alarmed, instead of diminishing, increases the security of the public. It obliges all of them to be more circumspect in their conduct... This free competition, too, obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away. In general, if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so."

While Smith bemoans price ceilings in general, he seems oddly to maintain that some government-mandated interest rate ceiling is necessary:
If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent. the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it."

That is a very problematic statement contradicting the earlier statement about free competition and contradicts his statements on the harm of other price ceilings.

Smith discusses a situation in the U.K. a lot like our recent financial crisis vis-a-vis the repo market. Apparently, borrowers either kept rolling over their debts to one another, or they repaid their debts simply by taking on more debt from third parties. Once it became clear one person couldn't repay, the system collapsed and banks failed. The Bank of England played some role in bailing out banks, at great expense to the government.

Austrian-school economists take issue with this statement:
The quantity of money, on the contrary, must in every country naturally increase as the value of the annual produce increases. The value of the consumable goods annually circulated within the society being greater, will require a greater quantity of money to circulate them."

They would argue that no increase be necessary, simply allow deflation to happen...less money chasing more goods. They also dislike the fact that Smith apparently ignores the monopoly that the government has in producing currency.

Smith discusses how interest rates have fallen in Europe over the previous century. He argues, correctly, that it can't be because the quantity of gold/silver have increased. But he doesn't argue this in the way someone would today-- if nominal interest rates are falling either expected inflation is falling or the real rate is falling (perhaps due to an increase in saving). Smith's own argument is kind of odd and unconvincing, IMO, not worth posting here.

Onto Book 3.


John Nelson said...

I have also been struggling with Smith's distinction between productive and unproductive labor. I assume he picked those labels himself and he does come across as favoring "productive" labor. He talks about intellectual capital in book 1, but I wonder if he didn't give it as much weight as I would. I also found it interesting that he thought loans for fixed capital investments were beyond the purview of any prudent bank; that they should restrict themselves to funding the circulating capital in the economy. I guess I think he is far too conservative on that point. And finally, a big reason I decided to read this book was to get a better handle on money. My instincts tell me that there are some contradictions among his observations on money. He notes that money is "a wheel" that allow value to move through an economy and he even excludes it from his definition of capital. He also thinks paper money makes sense for funding circulating capital. But he is opposed to broader use of paper money and would certainly be again fiat money. If money is just a "wheel", then why not paper money?

JDTapp said...

I agree-- Smith's views on banking seem odd and underdeveloped. Why he trusts citizens and entrepreneurs to be good judges of ordinary economic transactions, but not when it comes to borrowing & lending is a little unclear. I guess it's just from his observations of bank runs. Same with his interest rate ceiling comment.

I think his views on money are what the Austrians like Murray Rothbard found so problematic.

I think he is opposed to paper money because of how it was created. Bank notes as paper money work only if the bank is prudent in how much it holds in reserve. (Book IV contains info on banking back then that I wish I knew more about). Paper currency can always be multiplied for the advantage of the creator, as he talks about in the American colonies. I hear him saying "paper money has advantages and disadvantages."

My understanding has been that David Hume was the more insightful on the role of money, but I've never read his works. My plan was to read him before I read Smith, but it didn't work out that way.