Adam Smith and the Financial Crisis – Part 1

Adam Smith and the Public Purpose

Adam Smith, the great Kirkcaldy-born philosopher and economist, observed plenty of banking activity, including crises, in his career. What can we draw from his thought in this time of economic troubles? If Adam Smith were the free-market fundamentalist the guys and girls at the Adam Smith Institute (ASI) would have us believe, then we would not expect much. More recently, however, careful scholarship such as that by Iain McLean in ‘Adam Smith: Radical and Egalitarian’ (Edinburgh University Press, 2006) has sought to show that the right-wing Adam Smith is a convenient figment of the imaginations of Margaret Thatcher and others.

McLean convincingly shows how Smith’s economic thought links with his background and experience in 18th century Scotland. This was as a free-thinking contemporary of David Hume and Robert Burns, an advisor to various government officials, and as the author of ‘The Theory of the Moral Sentiments’ (TMS). In the latter Smith identifies an innate sense of morality arising from our sympathy with the feelings of others. McLean demonstrates that there is no ‘Adam Smith Problem’ as to how the sympathetic Smith of the TMS becomes the selfish Smith of the Wealth of Nations (WN). In part, McLean argues that, in economic jargon, TMS and WN are ‘positive’ rather than ‘normative’ works, describing how things are rather than how they should be. But in any case, it is not true that Smith of the WN is extolling selfishness. Being a realist, Smith appreciates that self-interest is a prime motivation for human beings, and that in an interdependent society self-interest can frequently be served by making yourself useful to your fellow-humans, whether at the individual, community or national level.

The aspect of Smith’s message that is genuinely libertarian is that the obstruction of this natural tendency by taxation, by tariffs or quotas on free trade, or by the attempt to pre-empt individuals’ interests with centralised planning will frequently have unintended consequences in making us behave in less useful ways. Is it then true, as Professor Edwin West in an imaginary interview with Adam Smith would have us believe, that the Wealth of Nations advocates the abolition of all of ‘minimum wages, tariffs, export subsidies, agricultural marketing boards, taxes on capital, free education and central banking’? This is the full economic libertarian agenda of the Adam Smith Institute. While it is certainly true that Smith did argue vehemently against import tariffs and other restrictions on international trade, Smith also went to great lengths to point out that a well-paid worker is a much better worker, and will provide more workers in the future! So as a pragmatic measure (quite apart from the sympathy that surely would be deduced from TMS), if the free-market cannot provide an adequate living wage there is justification for social intervention to achieve it.

McLean draws attention to Smith’s rather more nuanced view of education. Smith makes it clear that education is both a ‘private good’ of value to the individual, and a ‘public good’ of value to society as a whole, and so there arise arguments for both private expenditure and public expenditure on education. The concept of ‘public goods’ is, as McLean rightly argues, central to why Adam Smith cannot really be used to advocate complete ‘laissez-faire’ economics as the ASI and others of their ilk would like to claim. The 20th century theory of ‘public goods’ describes ‘goods’ (broadly defined) that are ‘non-rival’ in that consumption by one individual does not reduce the availability for consumption for others, and ‘non-excludable’ in that once produced no-one can be prevented from benefiting from them. This makes their market provision problematic. Smith was thus ahead of his time in understanding that there were many ‘goods’ that while they were of benefit to all were not in the interests of any one individual to provide and so ought to be collectively financed. While Smith, writing in the 18th century presents quite a limited list of public goods: defence, (individual and national), justice, and ‘those that support commerce in general’ such as roads and bridges, advances in technology have now greatly expanded this list.

Moreover, what the economic libertarians ignore is that the problem of determining what should be privately/publicly provided is not primarily an economic one, but a democratic one. This because the cost-benefit balance of, for example, guaranteed healthcare versus the lottery of having to finding your own healthcare is different for each individual at different times. And once the decision has been taken that healthcare should be mainly funded collectively the problem of funding it is an inevitable corollary, as Smith clearly recognised.

Smith analyses the various methods of extracting collective funding at length. He arrives at eminently sensible maxims, that as McLean reports, were claimed by a Labour Prime Minister and Chancellor, Gordon Brown:

1. Subjects of a state should contribute towards the support of government in proportion to the revenue ‘they enjoy under the protection of the state’.
2. The tax due from each individual should be certain and not arbitrary.
3. Tax ought to be levied when most convenient to pay it, such as at the time of payment for taxed consumption.
4. Taxation should not be expensive to administer, should not obstruct ‘the industry of the people’, excessively encourage avoidance or be oppressive in its collection.

Do these maxims support the ASI rejection of income tax as a source of government funding? While it is true that Smith was not keen on income tax to ‘labourers’ because the ultimate burden would fall upon the consumer’ or ‘occasion a considerable fall in the demand for labour’ and therefore conflict with maxim 4, he is less concerned about such an effect for professionals and believed that the ’emoluments of offices’ are ‘in most countries higher than required’ and so their recipients can ‘very well bear to be taxed’. It seems likely that he would include the executives of modern limited liability corporations and government-backed financial institutions in these categories. In any case he makes it clear that if a public expense is required, once the preferred taxes are fully utilised the less preferred must suffice.

Of course the topical issue is that of banking. Edwin West’s Smith apparently rejects central banking on the basis that ‘the failure of one company, an accident which, in the course of things, must sometimes happen becomes of less consequence to the public’ when banking is more or less free to enter, with the proviso that there be a limit on the lowest denomination of paper money that could be issued. McLean disputes this on the basis of Smith’s account of the troubles of the ‘Ayr Bank’, but what were his real views on banking?

© 2010 Dr Diarmid J G Weir

Go to Adam Smith and the Financial Crisis Part 2