A beginner’s guide to Adam Smith, part II

Following on from last week's missive, in which we looked at the life of the great Scottish philosopher, Adam Smith, today I'm going to outline some of his main ideas.

By the end you'll know everything you need to know about Adam Smith.

Almost.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Smith's most famous work An Inquiry into the Nature and Causes of the Wealth of Nations is some 950 pages long, while his Theory of Moral Sentiments is another 370-odd pages, so I am inevitably going to gloss over some things.

But, all the same, here we go...

Adam Smith's revolutionary ideas on trade

He argued that instead you should measure a nation's wealth by the value of everything it produces what we would today call GDP (gross domestic product).

It seems obvious today, but it was innovative stuff at the time.

Both sides benefit from trade, he argued, not just the seller. The seller gets your money, but you get his product. Thus restrictions on trade inevitably make both sides poorer.

He argued that both individuals and nations should do what they are good at and trade that. Specialisation boosts productivity. There is no point each of us making our own needles, when we can buy needles from somebody else who makes much better needles than we do and much more cheaply.

Nor is there any point in the people of Scotland making wine, when the French do it so well and so much more cheaply than the Scots ever could. It is better to buy theirs and focus on something else. Nor does it make any sense for governments to try and protect Scottish wine makers "Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland?" he asked.

He was a great champion of free markets. Markets are inherently efficient, he thought. If there is a shortage of something, its price will rise and producers will make more of that thing as a result. If there is too much of something, its price will fall, so will profits and producers will thus direct their efforts elsewhere.

It all happens automatically, and legislators think too much of themselves when they think their interventions direct production better than the market.

"He [the legislator] seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might choose to impress upon it."

In other words, he was no fan of what we would today call central planning. When legislators do intervene, be it by tariff, subsidy or any other form of protection, it is the poor who end up suffering the most, because they end up paying higher prices.

The ideas of Smith have been used to champion the cause of anarchists and anarcho-capitalists (who oppose any form of government at all), but Smith did believe that government was necessary.

Its functions should be to maintain defence, to keep order, build infrastructure and promote education. It should keep the markets open and free, and not act in ways that distort them.

The power of the invisible hand

Despite self-interest, individuals also self-regulate. Prudence moderates excess. Empathy tempers the harm we might do others. An innate sense of morality and justice means we instinctively approve and reward acts that benefit society, but disapprove and punish acts that harm it.

Freedom and self-interest do not, therefore, produce chaos, but order and concord. It is as if we are guided by an "invisible hand". Harmony and prosperity grow, organically, as a result of human nature. By following our instincts, we end up, unintentionally, promoting the betterment of mankind.

"Every individual," he said, "neither intends to promote the public interest, nor knows how much he is promoting it... 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."

Laws and regulations may aim at the same results, but they will never be as consistent or effective as human nature. You cannot force people do good. We do not punish people to force them to do good only for acts of harm.

But they will do good anyway.

"The natural effort of every individual to better his own condition is so powerful, 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 encumbers its operations."

He was a great believer in human nature.

There are probably a hundred Adam Smith ideas that have not made it into this piece for a reasons of space not least his ideas about taxation, which I will cover another time. But you now know enough about Smith to hold court at dinner parties!

And if you want to learn more, and you're up in Edinburgh for the Festival, come to Panmure House, where he lived for the last 12 years of his life, and where he completed Wealth of Nations.

I'm giving a lecture about the history of the Fringe, and how it proved the realisation everything Smith argued for that's Adam Smith: Father of the Fringe.

Or you can discuss the big issues of the day with Merryn, me and guests from the world of politics, economics and finance. That's The Butcher, The Brewer, The Baker and the Commentator. I host from 7-16 August, Merryn hosts 17-25 August.