Understanding the Economic Basics and Modern Capitalism: Market Mechanisms and Administered Alternatives

UNDERSTANDING

THE ECONOMIC BASICS

AND MODERN CAPITALISM

Market Mechanisms

and Administered Alternatives

DAN BLATT

UNDERSTANDING THE ECONOMIC BASICS AND MODERN CAPITALISM

MARKET MECHANISMS AND ADMINISTERED ALTERNATIVES

Copyright © 2014 Dan Blatt.

All rights reserved. No part of this book may be used or reproduced by any means, graphic, electronic, or mechanical, including photocopying, recording, taping or by any information storage retrieval system without the written permission of the publisher except in the case of brief quotations embodied in critical articles and reviews.

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Contents

Publisher’s Introduction:

THE WEALTH OF NATIONS BY ADAM SMITH

Introduction: Market Mechanisms and Administered Alternatives

1) Discretionary Resources

2) Government Economic Policy

Part I: Markets (Book I)

1) Division of Labor

2) Markets

3) Money

4) Value

5) Legal Tender

6) Profits

7) Market Price

8) Wages

9) Profit Rates and Interest Rates

10) The Mature Economy Fallacy

11) Restraints on Competition

12) Rent

13) Supply Curves

14) Inflation

15) Self Interest and the National Interest

Part II: Capital (Book II)

1) Capital Stock

2) The Mechanism of Exchange

3) Financing Mechanisms

4) Accumulation of Capital

Part III: Property Rights (Book III)

1) Agriculture

2) The Importance of Property Rights

3) Economic Impact of Freedom

Part IV: Mercantilism (Book IV)

1) The Mercantile System

2) Mercantilist Trade Restraints

3) Colonialism

4) Mercantile Trading Companies

5) Industrial Policy

Part V: The Proper Role of Government (Book V)

1) Defense, Justice, and Infrastructure

2) Regulatory Companies

3) Education

4) Established Religions:

5) Taxation:

6) The Public Debt:

PRINCIPLES BY DAVID RICARDO

Introduction: Comments on Smith, Malthus, Say and Others.

Part I: Value

1) Theories of Value

2) Money

Part II: Rent, Prices, Wages and Profits

1) Rent

2) Prices

3) Wages

4) Profits

Part III: International Trade and Comparative Advantage

1) The Benefits of Free Trade

2) Comparative Advantage

Part IV: Say’s Law and Inadequate Demand

1) Say’s Law

2) Automation Fears

3) The Savings Gap

Part V: Taxes and War Debts

1) Taxes

2) War Debts

CAPITAL (DAS KAPITAL)BYKARL MARX

Introduction to Book I: Creation of a Propaganda Myth

1) Economic Value

2) The Science Propaganda Ploy

Part I: The Labor Theory of Value

1) The Value of Commodities

2) The Money Commodity

3) Social Fictions

4) Impact of Economic Exchange

5) Money and the Circulation of Commodities

6) Creation of Capital

7) Wage Labor

8) Rate of Exploitation

9) Propaganda Magic

10) Spun Yarn Examples

11) Surplus Labor.

Part II: The Factory System

1) Who Needs the Capitalist?

2) Manufacturing and Industrial Workers

3) Worker Revolt

Part III: The Marxist Propaganda Myth

1) The Original Source of Capital

2) Supply and Demand for Labor and Capital

Book II: The Circulation and Expansion of Capital

Introduction to Book II: Nonfunctional Definitions, Inflexible Economics, and Criticism of Smith.

Part IV: Capitalism Without Flexibility

1) The Productive Circuit in Commodities Circulation.

2) Profits

3) Inventory Glut

4) Latent Money-capital

5) Profit Incentives

6) The Commodity Circuit

7) Process of Production

8) Costs of Commercial Circulation

9) Productive Capital

10) Exploitation

11) Money, Credit and Inflation

12) Aggregate Economic Flows

Part V: Differing Views of Capital and Exchange Values.

1) Smith’s Definition of Capital

2) Immaterial

3) Smith’s Reliance on Exchange Values

Book III: Profits, Interest, Rent, and Labor Use Values

Introduction to Book III: Making Value Disappear

Part VI: Profits

1) Influence of Labor Use Values on Profits

2) Cost-price

3) Rate of Profit

4) Immaterial

5) Internal Contradictions that Undermine Capital

6) Merchants

7) Defending Abstract Industrial Labor Theory

Part VII: Interest and Returns on Equity Capital

1) Financial Capital

2) Management and Superintendence

3) Interest-bearing Form of Capital

4) Irrelevance of the Ownership Interest

5) Money-capital and the Business Cycle

6) Banking System and the Business Cycle

7) Interest Rates and the Business Cycle

9) Bank Acts of 1844 and 1845

10) Usury

Part VIII: Rent

1) Property Interests in Land

2) Ground Rents

Part IX: Economics Based Only On Values Produced

1) Trinity Formula

THE GENERAL THEORY BY JOHN M. KEYNES

Introduction: Keynesian Theory

1) A General Theory

2) The Influence of Karl Marx

3) The Savings Gap

Part I: Labor Market Theory

1) Abandonment of Analysis of Fundamentals

2) Professor Pigou and Mathematical Analysis

3) The Problem With Savings

Part II: The General Theory

1) Effective Demand

2) Income

3) Savings and Investment

4) Psychological Propensities and Inducements

5) The Savings Gap

6) The Multiplier

7) Offsets

8) The Inducement to Invest

9) Prospective Yield

Part III: Interest Rates

1) The Impacts of Interest Rates

2) Monetizing the Debt

3) Savings and Capital

4) Interest and Money

Part IV: The Business Cycle

1) Variables

2) Wages

3) Aggregate Employment

4) Prices

5) Remedies for the Business Cycle

6) A Promise of Socialist Utopia

Part V: Trade Policy

1) Mercantilism

Capitalism, Socialism, and Democracy by Joseph A. Schumpeter

Introduction: The Broad Relevance of Schumpeter

1) The Government Directed Business Cycle

2) Socialist Expectations

Part I: Creative Destruction

1) The Power of Imperfect Competition

2) Can Capitalism Survive?

Part II: Socialism

1) Evaluation of Marx

2) Marx’ Propaganda Myth:

3) Schumpeter on Socialism:

4) The Road to Serfdom

5) The Democracy Problem

6) Democratic Socialism:

PUBLISHER’S INTRODUCTION:

Understanding of the economic successes and failures of the past quarter millennium as well as of today begins here. The five books reviewed and analyzed herein provide the basic theoretical material for understanding the development of both the capitalist market mechanisms that have raised billions of people out of subsistence-level poverty, and the socialist administered alternatives to market mechanisms that flourished and collapsed so spectacularly during the 20th century after blighting the lives of billions of people for several generations.¹

Capitalist market mechanisms are of course much more than the Middle East bazaars or the village squares on market day that do little more than facilitate subsistence living. Capitalist markets are the artificial creation of government and private institutions. By facilitating commerce, they generate wealth and rising living standards. Economic evaluation thus must always begin and end with evaluation of the policies, institutional arrangements and regulatory framework within which the markets are embedded.² They can either facilitate or fetter the markets. This is the realm of Political Economy.³ Macroeconomic analyses confined to economic factors or their mathematical representation is inherently incompetent.

Socialist alternatives to market mechanisms depend on the ability of ministerial arrangements to effectively allocate scarce resources without market mechanisms or with just minimal assistance from residual markets. Widespread failure of socialist systems has transformed socialist beliefs into support for various versions of entitlement welfare state, commanding heights government enterprise, redistributionist and industrial policy beliefs. Policies based on these beliefs are all distressingly confined by market realities that repeatedly impose themselves through severely diminished economic prospects, rendered especially noticeable during the business cycle.

If you need or want to know what is actually in these basic books but lack the time to read some or all of them, these reviews are designed for you. They also facilitate easy restoration of precise memory for those who have read the books at some time in the past, or who want to ascertain the precise location of desired material. They are not about the authors or their times – for which there are already copious sources elsewhere.

The format is based on a half century of experience providing technical material for busy professionals – lawyers, accountants, economists, engineers and assorted managerial personnel – willing to pay substantial sums for accurate, readily accessible concise accounts and analyses of texts, documents and events. Such professionals have little patience with factual and analytical weakness or ideological advocacy. The quality of the analytical comments is supported by a half century of accurate published economic forecasts.

The format facilitates speed-reading and scanning, with liberal inclusion of quoted material covering the most important and widely referenced material. The books covered are:

1. Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations (five editions published between 1776 and 1789 during Smith’s lifetime).

2. David Ricardo, The Principles of Political Economy and Taxation (1817).

3. Karl Marx, Capital (Das Kapital). (Book I, 1867) (Book II, published by Frederick Engels, 1885) (Book III, published by Frederick Engels 1894) (Foreign Languages Publishing House translation).

4. John Maynard Keynes, The General Theory of Employment, Interest and Money (1936).

5. Joseph A. Schumpeter, Capitalism, Socialism, and Democracy (1942).

The Wealth of Nations

by

Adam Smith⁴

Introduction:⁵ Market Mechanisms and Administered Alternatives

1) Discretionary Resources

• The wealth of nations is measured by Adam Smith in terms of money—but does not include money.

• It is generated by fixed assets—but does not include those fixed assets.

• Fixed assets must at least generate subsistence consumables for the maintenance of human capital, and resources for the maintenance of physical fixed assets—but the measure of wealth used by Smith includes neither subsistence consumables nor resources expended for such maintenance.

It is net revenues that are available for discretionary uses—either for investing or consuming—or for taxation that does not reach the level of capital levies—that is the measure of national wealth used by Smith. This is what a society can draw upon—without deferring maintenance or otherwise draining existing productive capital. It is available for all discretionary purposes—profound or frivolous—consumption or investment—private or government. It is a measure of economic power—either in terms of money or in its labor and commodity equivalents—that is available without diminishing the productive capacity and prospects of the nation.⁶ Smith is also very aware of the vast economic power that accrues to nations and private entities as they build up their credit.⁷

In An Inquiry Into the Nature and Causes of the Wealth of Nations, Smith explains how societies and individuals work through market mechanisms to build, accumulate and maintain capacity to generate their discretionary economic resources—and thus generate economic power. To an amazing extent—even after more than two centuries—this book still speaks to current economic processes, conditions and problems.

2) Government Economic Policy

The superiority of market mechanisms over the administered alternatives that may be directed by government, private associations, experts or intellectuals is set forth by Smith with classic clarity. Each individual seeks to maximize his profits or wages by employing himself and his capital in the most valuable way. Regardless of human imperfections and limitations, the expertise that individuals gain concerning their own business and economic needs must inevitably be superior to that of any outsider.

Government restraints and other interference with domestic and foreign commerce are both foolish and dangerous.

What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, 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.⁸

For over 200 years, advocates of mercantilism, communism, socialism, price controls, protectionism, industrial policy, social engineering and other administered alternatives have all rejected this wisdom. They have expended vast and varied efforts to improve on market results—and have all failed miserably—often with disastrous results that have blighted the lives of billions of people. Their folly was often vastly dangerous indeed.

All too frequently, administered policies are in reality efforts to promote political or personal interests above national interests. Competitive markets—even with competitive conditions that are far from perfect—provide a cornucopia of benefits and easily achieve results superior to the most elaborate administered alternatives. [DB]

Part I: Markets (Book I)

1) Division of Labor

The value of labor is determined by the skill, dexterity, and judgment with which it is supplied. Thus, Smith stresses from the beginning of his book that raw labor is of little value. How labor is applied—how it is managed and directed, the tools provided and the skills with which it is endowed—determine the vast majority of its value. Residents of savage nations may work extraordinarily hard just to survive, with little left over to take care of the sick or aged, while residents of civilized nations thrive though many do not work at all.⁹

Smith begins with two other broad conclusions:

• Employment depends on the amount of capital stock, and in the particular way in which it is employed. Here, again, Smith stresses management.

• The European nations of 1773 have acted to encourage industry—but primarily that of the cities and towns rather than that of agriculture.¹⁰

The advantages of division of labor are set forth in Book I by Adam Smith in his classic, clear, readily accessible prose—but with full attention to detail. In a justly famous passage, he explains how 10 men each doing one or two or three procedures—can turn out upwards of 48,000 pins in a day, even though each one, if working on his own, could not each of them have made 20, perhaps not one pin in a day.¹¹

Specialization improves dexterity and reduces time lost shifting from one operation to another. It also stimulates invention, since individual workers contrive laborsaving techniques and machines for the particular operations with which they are intimately familiar.

A great part of the machines … were originally the inventions of common workmen, who, being each of them employed in some very simple operation, naturally turned their thoughts towards finding easier and readier methods of performing it.¹²

Even professional inventors tend to specialize—both as inventors and as to the general areas of their interest. And, of course, each manufacturer of machinery constantly seeks improvements for its products.

A day laborer’s course woolen coat is offered as an example. A vast number of people each contribute to an infinitesimal extent to provide each inexpensive coat. In a well governed society, all these procedures are so managed—with appropriate machinery obtained and maintained and labor applied—with needed supplies coming in and output brought to market and sold—so that an industrious and frugal peasant can enjoy a standard of living farther above that of many an African king to a greater degree than the difference between the peasant and a prince of the realm.¹³

The key is management—not labor or even capital—which generally are fungible items. It takes skilled management to bring all the specialized pieces of a production process together—meet constantly evolving competitive requirements—and successfully market the output. Except for rare or exceptional skills, labor is practically a given in the economic calculation—and capital can only be as valuable as the capability of its management. [DB]

2) Markets

It is the market that drives this specialization. Only humans, Smith asserts, intentionally act in concert—the essence of a contract.¹⁴ Civilized man is dependent on a vast web of cooperation and assistance based on the division of labor. His needs cannot be obtained from just friendship or benevolence. He can only obtain his needs by bargaining for what he wants by offering what of value he has. Give me that which I want, and you shall have this which you want, is the meaning of every such offer.¹⁵ That is how we obtain the vast majority of goods and services that we need, Smith explains.

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard for their own self interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.¹⁶

Each individual finds that the market allows him to obtain far more than he could produce himself. He can obtain goods and services in the market in exchange for filling some market demand with a product or service that he provides as a specialty. The market induces each man to apply himself to a particular occupation, and to cultivate and bring to perfection whatever talent or genius he may possess for that particular species of business.¹⁷ Market incentives for specialization quickly open wide gaps in the different skills developed by different people. And it is the market—and only the market—that makes the best use of these diverging skills to maximize a common stock of goods and services available for purchase by all.¹⁸

Thus, the extent of division of labor is limited by the extent of the market served. A broadening market enables increased division of labor and specialization. In the sparsely populated Scottish Highlands, for example, every farmer must be butcher, baker and brewer for his own family. Country smiths and carpenters do not specialize within their craft. A country carpenter is also a joiner, a cabinet-maker, and even a carver in wood, as well as a wheel-wright, a plough-wright, a cart and wagon maker. A specialized maker of nails can turn out a thousand nails in a day—and so could find only one day’s employment in the year in the Highlands.¹⁹

Transportation and communications improvements are essential to broaden markets and thus facilitate economic development. Ports and navigable waterways are essential for the expansion of trade—both national and international—that is essential for economic development.

[It] is natural that the first improvements of art and industry should be made where [efficient transportation] opens the whole world for a market.²⁰

Civilization has generally advanced furthest where water transport was available to broaden markets. However, the Egyptians, Indians and Chinese appear always to have neglected foreign commerce—limiting themselves to commerce along inland and coastal waterways, which due to their great extent afforded very great markets.²¹

3) Money

The use of money as a medium of exchange and store of value is essential if the exchange of goods and services is to be conducted with sufficient efficiency so that producers may specialize in some product or service that they personally need not at all. Their entire product is surplus to their needs. They satisfy their needs entirely by purchases in the market for money they acquire from sales of their output in the market.

The development, uses and misuses of money, are discussed by Smith.²²

For in every country in the World, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coins.²³

With respect to governments and inflation—nothing has changed. By means of inflation, according to Smith, not just government, but all debtors have benefited at the expense of creditors. But, here, Smith is clearly in error. As history has repeatedly demonstrated, most recently during the Keynesian inflationary morass of the 1970s, the threat of inflation forces debtors everywhere to pay much more for credit—where they can get it at all. Even the sovereign will eventually lose to the extent that inflation raises costs and financial risks—hinders capital accumulation or even results in decapitalization—and reduces the value of commerce and tax receipts. [DB]

4) Value

Smith analyzes two aspects of value that he calls value in use and value in exchange.²⁴ Water has great value in use but—in the 18th century—practically none in exchange, while diamonds are—in the 18th century—just the opposite. Markets allocate only scarce resources. Exchange value is what economics is all about. Exchange value depends on a balance of both scarcity and desirability—of which utility is just one factor. With this brief statement, Smith thus finds no further need to discuss use values.

That exchange values are not the real values for the ultimate consumer in no way undermines the necessity of the exchange value pricing mechanism of economic markets. Economics is a practical art—emphasis on the word practical. It does not deal with the commons or with goods and services available outside the markets. For that, other mechanisms are in play – other mechanisms that generally prove far less efficient or effective than markets. Use values are indeterminable—and thus useless for practical economic purposes. Exchange values are always determinable even if always variable. They drive the market incentives that drive the economy—and are thus indispensable.

What is clear is that—barring fraud or mistake—everyone gains subjectively from every exchange in the market. Every exchange is a bargain to both buyer and seller. Sellers who think they’ve gotten more than real value and buyers who think they’ve given less set exchange values at the margin. The essence of the bargain is that the subjective value in use of every product given up is less than that of every product obtained—either directly through barter or indirectly through money. This is the magic of the marketplace. [DB]

Exchange value depends on the amount of labor—the amount of toil and trouble—that others are willing to perform to get what is offered. The exchange value of a commodity is equal to the amount of labor that it can purchase or command. This is the labor theory of value according to Smith.

Labour, therefore, is the real measure of the exchangeable value of all commodities.²⁵

Similarly, the cost is the toil and trouble of acquisition.

What is bought with money or with goods is purchased by labour as much as what we acquire by the toil of our own body.²⁶

However, that labor need not be the labor of the purchaser. The money contains the value of labor.

It was not by gold or by silver, but by labour, that all the wealth of the world was originally purchased.²⁷

However, the value and power of money is dependent on the market in which it can command goods and services, Smith points out.

This has since been repeatedly demonstrated. Efficient markets maximize the value and power of both money and labor—inefficient markets waste the value and power of both money and labor. The destruction of markets destroys the value of both money and labor. It is in the most profound interest of the workman, the capitalist, and the sovereign alike, to be able to access a system of efficient markets. Antitrust problems arise when select groups benefit at the expense of the whole by controlling the markets for their output or their supplies. By destroying markets, socialism inevitably destroys the value of labor as well as capital.

Note that Smith does not believe that value is based on the amount or even the skill of the labor expended in production. Value is based on the labor of others that can be acquired or commanded in the market. This is a determinable objective standard. The value of labor expended in production is an indeterminable subjective standard—and thus useless for practical economic purposes—as Marxists and other socialists would discover. [DB]

All labor is not equal, Smith points out. Some labor is more valuable than other labor, and the proportionate value of different types of labor is often difficult to ascertain. Neither time spent nor hardship endured nor ingenuity applied will necessarily be reflected, although they frequently are.²⁸

Here, Smith easily puts his finger on the primary rock on which Marxism and Socialism would founder. No matter how hard they tried—no matter how dense their reasoning—neither Marx nor any other Socialists could explain how to value labor in the absence of free and at least roughly competitive markets. Every effort—whether socialist or not—to administratively determine values—to administratively determine prices—would end in disastrous failure. There is no mechanism other than competitive markets to fairly and efficiently determine values and allocate scarce resources. [DB]

Although prices of all things rise and fall, the value of basic labor is constant, Smith asserts. It is the goods in the market that vary—rising and falling in relation to basic labor—which is governed by the minimum sums needed to sustain the laboring class. David Ricardo and Joseph A. Schumpeter reject this reasoning since basic labor, too, is not constant. There are thus no fixed measures of value—although Ricardo notes that the value of gold had been remarkably steady.²⁹

The difference between nominal and real values is discussed by Smith using the price of corn—adjusted for inflation—as a surrogate for the value of labor at different times.³⁰ Smith recognizes that the meaning of subsistence varies with customary basic lifestyles in different countries and is thus considerably higher in wealthy nations than in poor nations. Smith points out that land rents reserved to fund colleges in quantities of corn have preserved their value for about two centuries, while those reserved in quantities of coin have declined in value by about 75 percent even though the official weight of metal has remained the same for the last century. The inflation was caused by the vast flows of precious metals from America—and wear and tear of the coins. In Scotland and France, where weight of metal in coins have been declining constantly, such money rents have been reduced almost to nothing.³¹

Prices of agricultural commodities on English commodities markets ranging back into the 16th century vacillated sometimes sharply due to wars, crop failures and so forth, but remained in a remarkably steady range until the Great Depression and the devaluation of the pound in 1931. Somehow, England managed to stay at the forefront of the industrial revolution for over 300 years without inflation with a metallic-based monetary system, and began to fall behind when the pound was devalued and chronic inflation arose, and government began efforts to manage the economy in the Keynesian style.

During the century in which the fiat dollar has been the responsibility of the Federal Reserve System, the dollar has lost over 95 percent of its purchasing power and the nation has suffered through a Great Depression, the Keynesian inflationary morass of the 1970s, and the two bubble busts of the first decade of the 21st century. The United States had prospered and become a dominant world economic power in the preceding century during which the dollar had been pegged to gold and—except during the decades of the gold rush and the Civil War—persistently appreciated slowly in purchasing power. [DB]

Even though corn values vary greatly from year to year, average corn values remained remarkably steady. With almost no productivity gains in agriculture or its transport, values calculated in quantities of corn remained remarkably steady over centuries of time. On the other hand, the value of gold or silver varies little from year to year, but varies greatly over extended periods. But these slow variations in money values influence only long-term contracts, not instant purchases or short-term contracts. For purchases and sales at the same time and place only, both nominal and real values are equal and are the money values in the market. While labor values are always difficult to ascertain, the market sets money values—exchange values—with precision. Money prices thus drive all commerce.³²

5) Legal Tender

When a particular form of metallic money is made legal tender, Smith explains how that can cause some divergence from market relationships between the money of the legal tender metal and other forms of metallic money.³³ Sterling silver shillings were the legal tender of England. Gold guineas and copper pence were fixed in value in relation to shillings—regardless of the difference in wear of the coins and ignoring periodic divergences in market prices. The mint price of a monetary metal may vary from its market price. However, for metallic money, these divergences must be kept minimal, or one coin or another will be melted into bullion for sale in the market.³⁴ Bullion and coinage values are never the same, since metal in coins is so much more convenient than metal in bullion. Coins used abroad where they are not legal tender quickly return home of their own accord because they are there worth more.³⁵ In analyzing prices over time, Smith adjusts for inflation by taking into account the diminution of metal in coins minted in various periods.

6) Profits

The value of labor varies according to many factors. Not just time, but also hardship, skill, ingenuity and dexterity add to labor value. In civilized nations, machinery, supplies, enterprise, financial risk and management skills also add to the value of labor.

To provide an incentive to bring all these factors together and bear the risks of enterprise, the resulting increase in production must pay for wages, supplies, machinery, managers—and profits. For Smith, these are all—including profits—ordinary and necessary costs of enterprise.³⁶

Smith distinguishes between stock, consisting of such things as supplies and facilities—management, in the form of inspection and direction,—and labor. Profits depend on the value of the stock, not the amount of labor and management efforts expended. Of course, the value of the stock employed includes the sums needed to pay for wages and salaries—it thus includes the value of labor and management. It thus includes financial capital as well as physical capital dedicated to the enterprise.

The separation of ownership and management has implications that are evident to Smith even in the 18th century. The business owner may completely separate himself from management duties by hiring trustworthy management, thus contenting himself solely with the profits from his ownership interest. There is no direct relationship between profits and labor. However, the personal interests of management and ownership are far from precisely aligned, he points out, a fact that would continuously plague the corporate form of business enterprise.³⁷

The ownership of raw land permits the owner to charge a rent for its use or the use of its resources. Here, too, there is no direct relationship between labor and rent. Both profits and rent become components with labor in the price of commodities. For commodities that pass through several stages from manufacture to consumer, these markups apply at each stage. For corn, there is the farmer, miller, baker, transporters, and sellers. Profits at each step increase because they are based on the additional capital needed to cover everything that went before. Thus, taxes applied at each step increase the profits of subsequent steps.³⁸

The capital which employs the weavers, for example, must be greater than that which employs the spinner, because it not only replaces that capital with its profits, but pays, besides, the wages of the weavers; and the profits must always bear some proportion to the capital.³⁹

Profits are an ordinary and necessary cost of production just like wages and rent, Smith explains.⁴⁰ Wages, profit, and rent, are the three original sources of all revenue as well as of all exchange value. Interest is just the profit from stock that is lent. Unless borrowed sums are used to earn profits with which to service the debt, they must be replaced from some other source of revenue. All three can be mixed together—can be confounded as profit—when a small farmer or businessman works without employees with his own stock on his own land or in his own premises. But this represents only a small portion of the total goods produced.

That interest expense today is allowed as a cost of doing business while profits are not is a major victory against the public interest for left wing propaganda. The Tax Code thus and in many other ways provides powerful incentives for excessive leverage that undermines the stability of the economy. [DB]

Smith also points out that the proportion of the population employed in its commerce is another factor that determines the total produce of a nation—and its rate of growth.⁴¹

7) Market Price

How prices are set by the marginal supply and demand—the impacts of various market imperfections—and the vagaries of supply inherent in uncertain agricultural activities, are discussed by Smith. The term effectual demand is used by Smith to distinguish market demand from the desires of those without resources to access the market.⁴²

Markets always tend towards equilibrium levels—even if—like waves in the ocean—external influences and demand from episodic needs are always pushing them one way or another. Where supply inherently varies—as for agricultural products—prices are volatile and wages and profits vary with them. However, rents are set to reflect average values and are considerably less flexible.

Barriers to efficient markets include government policies, government monopoly grants, private or government restraints on labor or business competition, and lack of information. Profits or wages in excess of natural amounts can be attained for extended periods of time as a result of such barriers. Such enhancements of market price may last as long as the regulation of police which give occasion to them.⁴³

Smith does not cover the natural barriers to entry that support higher profits and wages. These include startup costs and risks and the competitive advantages of skills and organization developed by existing providers. Those that prosper in niche markets are a prominent example. However, absent artificial restraints, there is always a profit entry inducement point that, if exceeded, will bring in additional competition that, once established, will be difficult to push aside. [DB]

Profits consistently above prevailing profit rates for similar enterprises will draw in new entrants in a free market—while those consistently below will cause providers to depart.

Smith thus provides the basis for Schumpeter’s concept of creative destruction.44 The creative destruction process assures adequate profits for the most efficient providers—and is one of the factors that render impossible the Marxist expectation of a chronic crisis of capitalist overproduction. Technological advance, new products and services, and the constant expansion of prosperity and markets are other factors that confound the expectations of Marxists and other socialists. [DB]

8) Wages

An increase in the productivity of any one type of labor cannot—by itself—long increase the wages of those laborers. Such an increase—say, ten fold—would increase supplies of their product and drive down product costs until it takes ten times the amount of their product to acquire their market needs.⁴⁵

Of course, average productivity gains increase the purchasing power of everyone. Studies indicate that—today—wages along with payroll taxes and benefits, litigation insurance and other labor market costs, capture more than 60 percent of the benefits of productivity increases. The great reduction in population growth that accompanies modern prosperity is just one of the factors that were not foreseen. [DB]

Workers must share the returns of their labor in order to exploit land and the capital of others. Land takes a share as rents, and capital as profit.⁴⁶ Smith points out that governments everywhere restrained workers’ combinations but not those of capital. This gives capital a tremendous advantage in addition to its natural advantage of not being always in need of continuous income. Here, again, Smith expresses his concerns about the noxious impacts of restraints on competition. This is the predominant concern in The Wealth of Nations.⁴⁷

Labor unions have since then been created to change this relationship. The existence of high fixed costs—including taxation, heavy reliance on debt capital, and ongoing administrative costs—has also sharply altered this relationship in modern times. [DB].

Subsistence wages are generally the minimum that can be paid. Wages must be sufficient for the lowliest laborer to subsist and—with the labor of his wife—support a family. To increase above levels beginning at mere subsistence, the economy must grow.

The demand for those who live by wages, therefore, naturally increases with the increase of national wealth, and cannot possibly increase without it.⁴⁸

It was the speed of growth rather than just the extent of wealth that was determinative in those days. England was far richer than North America in 1773, but the latter was growing more rapidly and afforded higher wage rates. Smith attributes this growth to a much greater rate of population growth. Smith cites China as an example of a nation that has been very wealthy for a long time but has also had a stagnant economy for a long time, with very low wages as a result. However, China is at least stable. India is actually a nation in decline—and hundreds of thousands die of starvation in a year.⁴⁹

The difference between the genius of the British constitution which protects and governs North America, and that of the mercantilist company which oppresses and domineers in the East Indies, cannot perhaps be better illustrated than by the different state of those countries.⁵⁰

As industrial productivity has been reducing the cost of manufactured goods, living standards must actually be improving, Smith points out. Wages in large towns are 20 percent to 25 percent higher than in small towns even though living costs are generally lower in the larger towns, Smith notes. Since wages had remained stable in Britain for about 50 years while provisions rose and fell cyclically, wages in Britain must be above subsistence levels.

Indeed, agriculture, too, had benefited from increased productivity. Not only corn, almost all produce had been declining in price during the last century. If the labouring poor could subsist a hundred years ago and are receiving about the same wages in 1773, they must now be living considerably better. This should lead to a population increase that will supply more labor for England’s growing economy, Smith correctly concludes. While the very poor have more children, their mortality kills most before 10. An increase in the prosperity of the work force will reduce child mortality and permit population increase despite a lower birth rate. Where prices have risen, taxes are usually to blame.⁵¹

Adam Smith speculates about the impact of the business cycle on the labor market—the incentives of high wages—the effect of piecework—the comparative productivity of independent and wage labor—sweat equity and gray market labor—the profit incentives that drive invention and increase productivity—and similar labor-related subjects. He particularly notes tendencies towards occupational health problems in the many trades under the lash of piecework. In these trades, most workers are incapacitated in as little as eight years.⁵²

9) Profit Rates and Interest Rates

Competition tends to lower profits and increase wages as more entrepreneurs enter an open market. Ownership (equity) capital is dynamic, Smith points out. Equity capital absorbs or benefits from myriad changes in business conditions. Profits vary widely as ownership capital performs its functions as risk capital.

It varies, therefore, not only from year to year, but from day to day, and almost from hour to hour.⁵³

Marxists and Keynesians, on the other hand, view equity capital as something static. Once it’s created, it need only be professionally managed and physically maintained to sustain its value and utility. Government could thus take over ownership capital and successfully run it.⁵⁴ This gross stupidity became increasingly evident during the 20th century as governments took on ever-larger economic roles. [DB]

Charting average profits is thus impossible. However, Smith examines interest rates as a proxy for average profits. Profits drive the demand for loan funds, creating a correlation between the two.⁵⁵ Smith recognizes the impact of credit risks in nations where creditors’ rights are not legally enforceable. Also, restrictive usury laws raise interest rates because of the added risks to lenders who avoid the law. Muslim nations thus suffer from very high interest rates, Smith notes.⁵⁶

Since the time of Henry VIII—in the first half of the 16th century—England has not only been prospering, but its rate of economic gain has been accelerating.

"The wages of labour have been continually increasing during the same period, and in the greater part of the different branches of trade and manufactures the profits of stock have been diminishing."⁵⁷

Profit rates are generally lower in large towns than in small, due to the greater number of financially sound competitors. Of course, they can make it up in volume because of the much greater amounts of stock that can be employed. However, wages are higher. In the remote parts of the country, there is frequently not stock sufficient to employ all the people, so wages are low and profits from scarce stock is high. Interest rates are higher, there, too.⁵⁸

Prosperous England and economically hobbled France are compared by Smith. In France, wages are low and profits high and poverty far more evident than in England or even than in Scotland.⁵⁹ Holland, on the other hand, is richer than England, with higher wages and the lowest rates of profit in Europe. In North America, both profits and wages are higher than in England—a consequence of an abundance of land and resources. But profit rates are declining as the land is settled. An expanding market—either geographically or technologically—can thus have this positive impact on both profits and wages, while profit rates must decline as capital stock increases into a stagnant market. This is the great attraction of investments in third world nations—in 1773, like India—where capital stock is scarce, labor is cheap, and profits can be enormous.⁶⁰

Market relationships between interest rates and profits, and between profits and wages and prices, are also analyzed by Smith. He examines natural supply and demand reasons why wages and profit rates vary—including variations in skills, education, job hardships, levels of agreeableness or disagreeableness, the intermittent nature of some work, requirements for trustworthiness, and risks of failure.⁶¹

The profits of capital stock cannot be affected by these factors, since capital is so mobile and fungible. However, risky or disreputable businesses—such as a tavern—do earn higher rates of return. Smith notes inherent tendencies towards optimism that reduce both the wage and profit rewards of risk. The spiritual rewards of superior goods like honor, fame, adventure or other personally satisfying factors also tend to reduce wages and profits. This appears to reduce average compensation in the military and in the learned professions. Smith also discusses a variety of other factors affecting wages and profits.⁶²

10) The Mature Economy Fallacy

Smith speculates about mature economies—fully populated and provided with all the capital stock they can use.⁶³

Credulous left wing economists like Keynes, Schumpeter and John Kenneth Galbraith would accept this fallacy well into the 20th century. It would provide one of the foundations of the Marxist scientific forecast that capitalist overproduction must ultimately squeeze profits and wages sufficiently to doom capitalism.64 Smith provides no examples for this speculation—a significant departure from his usual analytical style. No examples would ever appear—although leftists would eagerly announce its arrival during every downturn in the business cycle—and especially during the Great Depression—when this fallacy would afflict FDR and his New Deal administration, and provide one of the bases for disastrous efforts at administered solutions.⁶⁵ [DB]

11) Restraints on Competition

Government trade restraints distort markets throughout Europe, Smith points out—yet again returning to this theme.⁶⁶ He notes several types of restraints.

Restrictive apprenticeship requirements artificially hold down the supply of certain craftsmen. These deprive the poor workman