Guidebook to the Wealth of Nations: CH 8 Book IV.1-6

Chapter 8: BOOK IV, i-vi: Of the systems of political economy

BOOK 4: Of the systems of political economy

Introduction

Book 4 is a bit of a shift in gears since it is where Smith describes different systems of political economy. It is about two different theoretical systems that attempt to offer not just understanding to men of learning, but also influence princes and states. Smith tells us he will consider two systems of political economy: the system of commerce, or mercantile system, and the agricultural system. He will start with the commercial one since it is by far the most popular.

But what is political economy? Smith defines it as the “science of the legislator.” It is meant to help us understand how to enrich both the people and the sovereign, by providing plenty of revenue to the people, or better, how to enable them to provide for themselves, and thereby supplying the state with the revenue for public services.

IV.i: Of the principle of commercial or mercantile system 

Smith opens the first chapter of this Book by addressing his major enemy: the popular notion that money is wealth. Smith believes this mistake is so popular because of the double functions of money as an intermediary in exchange and unit of account. We always want money because we want the things we can buy with it. We measure the value of everything in money. So we think that to grow rich is to get money. Indeed, in common language, wealth and money are used synonymously. Similarly, allegedly, a rich country is a country that has ample money, and getting rich should mean accumulating gold and silver.

The notion that money is wealth is a mistake, though. The Tartars, the Turco-Mongol nomadic population of Central Asia, understand it better than the Spaniard conquistadores or some modern philosophers. To evaluate if a new territory is worth conquering, the Tartars ask: are there sheep here? Instead, the Spainiards in America asked: is there gold here? The Tartars demonstrate a better understanding of wealth than the Spaniards. This could be interpreted as a strong stab to his intellectual enemies: Tartars are considered barbarians, but even barbarians have better economic understanding than mercantilists!

Even the British philosopher John Locke, like the Spaniards, but unlike the Tartars, thought that money is the movable wealth of a nation. The mistake is so luring that some unnamed “other” thinkers (probably alluding to his friend David Hume) who say that in a closed economy money is irrelevant, end up saying that in an open economy we need to accumulate money. Money is needed to finance foreign wars, therefore we need to accumulate money in times of peace. So every country, following the example of Spain and Portugal, tries to keep its gold and silver at home with export prohibitions, under the assumption that it is keeping its wealth at home. Not only are they making a mistake, but their attempts are in vain.

The prohibitions of exporting gold and silver eventually become inconvenient for merchants as commerce expands. Smith suggests that advocates such as the merchant and eventually director of the East India Company Thomas Mun (1571-1641) push for a change in policy. Mun claims, according to Smith, that trying to keep gold and silver at home with prohibitions does not work. Smuggling is quite easy given the small volume and high value of precious metals. This means that prohibitions do not prevent exports of metals but make them more expensive, which means they lead to more metals leaving the country. If one wants to grow rich, one should focus on the balance of trade rather than on prohibitions.

If the value of exports is more than the value of imports, it means that gold and silver will have to come into the country to pay for those excess exports. This is a much better way to grow rich, according to Mun. Smith of course disagrees. For Smith, Mun is correct in saying that the prohibition does not prevent smuggling gold and silver out of the country. But Mun is incorrect when claiming that there is a need of government regulation of trade to get the desired quantity of money.

According to Smith, everybody knows that trade enriches the country, but nobody knows how. Merchants claim to know trade. Parliament members, councils of princes, nobles, and country gentlemen are aware of their own ignorance of trade. It is therefore easy for merchants to convince the parliament that their views are correct and that they would benefit the country. But what merchants know is how to enrich themselves, not how to enrich the country. They say that foreign trade brings money to the country, but the current laws limit it. More money would come in if the laws were changed: rather than focusing on the prohibition to export gold and silver focus instead on the balance of trade: a “much more embarrassing, and just equally fruitless” idea. After all, if a country does not have mines, it gets gold and silver from abroad, just like if a country does not have vineyards, it gets wine from abroad. Freedom of trade provides us with wine, why shouldn’t it provide us with gold and silver too?

Here are some of the “embarrassing” reasons used to justify policies favoring a positive balance of trade.

The government should take measure to preserve gold and silver in a country. But this is unnecessary because if the quantity of gold and silver is more than the effective demand, no government can prevent its exportation. A sign of it, which is not an accident, is that the price of gold and silver is very stable, much more stable than the price of any other commodity. Gold and silver are easy to transport because of their small weight and a high value, so it is easy to keep supply and demand in balance and their prices somewhat stable. Other commodities are bulkier, harder to transport, and indeed their prices are more volatile.

But what if there is not enough gold and silver? Well, if there are not enough provisions, people will starve, as there are few substitutes for basic food. But if there was really not enough money, we can have plenty of substitutes: barter, credit, and paper can do the job of gold and silver. Yet, the most common complaint is that there is not enough money. Why? Because many people want money but have nothing to exchange it for, and can’t easily borrow. For example, if one overtrades, one buys on credit too many goods to send to a distant market in hope that the returns will arrive before the payments are due. But the hope is ungrounded: the payments come in before the returns. Ergo the complaint.

Another “embarrassing and fruitless” reason to want regulation to increase the quantity of gold and silver in a country is that we want gold and silver because they are more durable than any other commodities. This is absurd. We want money because it is easier to exchange it for other things than any other commodity. We do not want money for its own sake, but for what it can buy. Pots are also very durable. But it makes no sense to force people to accumulate more pots than what they need. The quantity of money is similarly limited by its use. It makes no sense to accumulate more than what is needed. It just takes up space, meaning we are just wasting otherwise useful resources.

Another common and wrong reason why people want to accumulate gold and silver is the incorrect belief that wars are financed with gold and silver. But fleets and armies are maintained by consumable goods, not gold and silver. In theory, a country could maintain troops in foreign countries by sending abroad gold and silver, by sending abroad some part of the annual produce of its manufactures, or by sending abroad part of its annual rude produce. Let’s examine each one.

The gold and silver accumulated in a country usually consists of circulating money, the plate of private families, and the treasury of the prince. There is seldom little to spare from the gold and silver used as circulating money. True, with foreign wars there are more people abroad and less people at home, so fewer goods circulate at home, which means less money is needed at home and more goes abroad. But using circulating money to finance wars is not very effective, especially long wars. Melting private plate is insignificant. France did it and it lost more in fashion than what it gained. And finally, the treasury of the prince may have worked in the past, but today the prince does not accumulate much of a treasury and the expense of the wars are enormous. The last war that Britain fought costed three times the amount of gold and silver present in Britain! Even if we think in terms of bullion, the gold and silver that circulates among commercial countries, that is the “money of the great commercial republic”, would not be nearly enough to support a modern war.

Wars are paid with commodities, with refined manufactures to be precise. Merchants sell goods in foreign countries and are paid with foreign bills. The government buys the foreign bills from merchants and uses them to pay for provisions for troops abroad. That is how wars are financed, not with gold or silver. As a matter of fact, during wars manufacturers have a double demand: they produce goods to be sent abroad to pay for the foreign provisions of the troops, and they produce for the domestic market. During the most destructive foreign wars, some manufacturers may flourish and decline when peace returns.

Exporting raw materials, though, cannot finance foreign wars. The transport costs are too high and there is too little to spare from home consumption.

Another way to think about how incorrect it is to want to accumulate gold and silver to pay for wars is to think that in ancient times it was difficult to have long uninterrupted wars. Not so today. The past inability of long wars was not caused by lack of money but by lack of manufactures. Without commerce, one needs to rely on the treasure, since a sovereign cannot tax much more than usual even during emergencies. It works there because non-commercial societies are parsimonious: there is little to buy, so little to spend on. With commerce, we can indulge our vanity in extravagant expenditures. The treasure disappears. But manufactures pay for the (now longer) wars.

Smith concludes this chapter with a reminder that foreign trade has two benefits: it carries out the surplus part of the produce from which there is no demand at home (what later will be called vent for surplus), and it brings back something for which there is a demand at home. So division of labor is not limited by the domestic market, but it can expand and improve the productive powers of labor and increase the wealth of society.

The discovery of American gold did not make Europe richer, but made service of plate (silverware) cheaper. It was a good thing, though, even if not necessarily because of the cheap plate. The new and inexhaustible markets for European commodities helped create a new division of labor and new improvements. Unfortunately, it came at a high price: “The savage injustice of Europe rendered an event which ought to have been beneficial to all, ruinous and destructive to several of those unfortunate countries”. Smith will soon tell us more about the European atrocities in America. Here he just gives us a first taste.

For now, just think that trade brings benefits, and the richer is a trading partner the more benefits one receives. But Europe benefits more from its trade with America than with East Indies, even if in America there were savages (remember that for Smith savage means hunter-gatherer and poor). The only advanced societies (Mexico and Peru) were destroyed as soon as discovered. China, Indostan, and Japan were more advanced and cultivated, even if they did not have mines. But the East India trade is monopolized by the East India Companies. Worst, the exclusive privileges of the East India Companies caused much envy, and envy makes people believe that “trade is pernicious”. Something went wrong.

Indeed, the policy prescriptions of the mercantile system are based on its two wrong ideas: that gold is wealth, and that metals come into the country only with a positive balance of trade. Policies should therefore, incorrectly, focus on increasing exports and decreasing imports. There are two kinds of import restrictions: a restriction of foreign goods for home consumption that can be produced at home; and a restriction of imports of any kind of foreign goods. High duties or absolute prohibitions are the ways to implement these restrictions. There are four kinds of export encouragements: drawbacks, which are tax refunds for goods that are exported; bounties, which are export subsidies; treaties of commerce, which give privileges to some specific countries; and colonies, which create privileges and monopolies for the goods of that countries.

These are the six, wrong, principal means to increase gold and silver in a country by bringing the balance of trade in its favor. The following six chapters will analyze each of them.

IV.II: Of restraints upon the importation from foreign countries of such goods that can be produced at home

The first means to create a favorable balance of trade that Smith analyzes and criticizes are the import restrictions of goods that can also be produced at home.

When there are high duties or absolute prohibitions of goods that can be produced at home, there are monopolies of the home market for the domestic industry “against their countrymen.” Smith spells out loud and clear who benefits and who loses from monopolies: Monopolies benefit the monopolized industry, never society.

Indeed, the general industry of society cannot be more than the capital that society has, and no regulation can increase the industry beyond what its capital can maintain. It can only divert part of the capital in directions different from where it would otherwise go and not necessarily for the best. An individual looks for the most advantageous use of his capital. And even if he has in view only his own advantage, not the one of society, yet, his advantage is what is most advantageous for society.

As the first choice, one would use his capital at home, supporting the domestic industry, all else the same. Given similar profits, one prefers home trade over foreign trade, and foreign trade over carrying trade. Why? Because we like to keep our things close to us. We want to keep an eye on what we own. What we can see matters. With domestic trade, one can keep his capital within his sight and control. Additionally, one knows more about the home market and the domestic laws than about different countries’ ones. With carrying trade, all capital is out of sight all the time. Some are willing to pay extra to have their shipment stop at home just to have it within their sight. This is why the home ports of the country engaged in carrying trade are the emporium for all the goods of all the countries whose trade it carries.

Merchants are trying to convert carrying trade into foreign trade, and foreign trade into domestic trade just to have their capital close to their sight. Today we would say that monitoring costs and local knowledge is what makes a difference.

The home market is therefore the center around which all capital circulates, even if sometimes external forces push it off. This image is not that different from the image Smith uses to explain that the natural prices are the prices around which market prices gravitate, unless some exogenous forces interfere.

When capital stays at home, one directs it toward the industry that has the greatest value. After all, one uses his capital only to get profits. This is why capital will go in the industry which produces the highest value, which implies that the annual revenue of society will be as great as possible. The owner of capital, seeking his profits, does not intend to promote public interest. As a matter of fact, he does not even know he is promoting public interest. He cares only about his own security and his own gains. He “is led by an invisible hand to promote an end which is no part of his intention.”

This is the one and only mention of the invisible hand in The Wealth of Nations. There is an invisible hand in The Theory of Moral Sentiments and one in the History of Astronomy, a “juvenile” essay that Smith spared from the flames at his death and was published posthumously. In The Theory of Moral Sentiments the invisible hand redistributes goods from the rich to the poor: the conspicuous consumption of the rich unintentionally feeds many poor. In the History of Astronomy, the invisible hand of Jupiter is believed to move the planets in an orderly way. This belief helps us explain otherwise mysterious events which would cause us anxiety. The invisible hand of The Wealth of Nations has received an impressively large amount of attention, given its only mention. Its meaning is still an open question, ranging from being the hand of God to being an “as if” statement. What I think is clear so far is that the invisible hand is not an endorsement of unethical or even a-ethical greediness as some occasional caricatures of Smith may portray it. It is also difficult to see it as an unconditional endorsement of laissez-faire. As we already saw on more than one occasion, Smith does support a wide range of government interventions. One may agree or disagree about whether they are a lot or a little, but not on the fact that they exist.

Smith explains why it is better to let capital find its way to the domestic market. He continues with the recurrent theme waved in all chapters since Book 1: not all interests in society are always harmonious. The interest of some groups, those of merchants and manufacturers, clash with the interest of the great body of the people. If they are able to capture political power, they will enrich themselves at the expense of society. As he just explained in the previous chapter, they are very persuasive and often trusted, which is dangerous.

“I have never known much good done by those who affected to trade for the publick good… [E]very individual … can, in his local situation, judge much better than any statemen 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 assumes an authority which could not safely be trusted, not only to a 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 the folly and presumption enough to fancy himself fit to exercise it” (WN IV.ii.10).

In The Theory of Moral Sentiments, Smith describes a man of system who is enamored of his system and tries to implement it, forgetting that he is dealing with real people and not with inanimate pieces on a chessboard. It can therefore be dangerous if he tries to move the “pieces” against their will. Here the argument is similar, but also more complex. The problem is not just that the love of system is blinding. The problem is that someone sees extremely well what his interest is and uses the power of the state to get it, at the expense of society. The same interest, without political power, unintentionally promotes the interest of society. But if able to capture the legislature, it will hurt the interest of society, intentionally or not. And unfortunately, merchants and manufacturers know their interests well, and are willing and able to get political power to implement the policies that favors them, as the whole mercantile system does.

Smith then explains that monopolies of the home market for domestic producers are either useless, if the goods are done more cheaply at home, or hurtful, if it costs more to make them than to buy them. If a foreign country can produce more cheaply than us, buy from them with the produce of our industry; if not, the industry of our country will decrease, because capital is diverted from more productive uses toward less productive uses.

Some may claim that protections are useful because they may help some industries to develop faster than otherwise. Not true. Such protections cannot increase the industry of society. The industry of society can increase only as capital increases; and capital increases only as saving increases. The immediate effect is actually a decrease in revenue.

Scotland is not famous for its wines, given its weather, Smith states. The wine industry does not grow that fast. It does not grow at all, actually. Why not protect it so it could grow faster? Would it be reasonable to make wine in Scotland at 30 times the costs at which it can be imported?

Who benefits the most from monopoly of the home market then? Smith tells us the answer: merchants and manufactures of finer manufactures. Because of lower transport costs, it is easier to export finer manufactures than cattle and corn, so they are the primary beneficiaries and the primary promoters and supporters of these monopolies.

Indeed, if there was free imports of manufactures, home producers would suffer a lot. Some may even go to ruin. Which simply means that their capital will find different employment. But if trade in cattle was free, so few would be imported anyway, because the transport of live cattle is so expensive, especially by sea, that it would make little difference. Even the freest importation of salted meats would make little difference because it is also bulky and expensive to transport, and the quality of the salted meat is much less than fresh meat that it is not a real competitor. So we would not see much changes in the price of butcher’s meat. Also free importation of corn would affect British farmers very little because corn is too bulky to sustain the transport costs needed to be sold at a competitive price.

Furthermore, repeating again what mentioned in the previous Books, country gentlemen and farmers are the least subjected to the spirit of monopoly because they are many and dispersed, thus they cannot easily combine. They demand privileges just because they want to mimic manufacturers.

That said, for Smith there are two cases for which it is ok to tax foreigners to develop domestic industry. One is defense. British defense depends on its number of sailors and ships. The Act of Navigation is thus justifiable even if it is not favorable to trade. Foreign ships cannot come to Britain to take exports but they can come to bring imports. But if someone cannot sell, they can’t buy. Coming with an empty cargo is too expensive. The Act gives de facto a monopoly of the British trade to British ships. But the Act is good because defense is more important than opulence.

The other justified tax on foreign goods is when there are taxes on same goods domestically made. In this way the competition between domestic and foreign made goods remains the same before and after tax.

What is not justifiable is to extend these taxes on the necessaries of life and on all sort of foreign goods. A tax on import of necessities such as soap, salt, leather, or candles, would increase domestic labor costs, and therefore the price of all commodities. Taxing incoming necessities is like having a poor soil or bad climate. And if the tax is too high it becomes equivalent to the “curse” of “barrenness of the earth and inclemency of the heavens.” Only rich countries can afford those absurdities. Here again we have a problem of understanding that correlation is not causation: rich countries are rich not because of these import taxes, but in spite of them.

There are two additional cases in which taxing foreigners could be justifiable. These are not general principles but are situations that need to be evaluated case by case. One situation is to evaluate if we should continue to import freely when another country is taxing our goods. Retaliation may be appropriate if it induces foreigners to repeal their tax.

The other situation to evaluate is whether to restore free import when domestic industry grows enough with protection. This is a difficult decision. It needs to be done very slowly and with a lot of advanced notice. If done too fast, many may lose their jobs and subsistence, causing disorder. Yet, Smith suggests optimistically, disorder may be less common than expected.

After all, at the end of each war, thousands of sailors come home and need to find a job. They do it without problems. Similarly, displaced workmen should be able to find different employment. After all, the capital of the country remains the same, so the demand for labor remains the same too, just in different occupations. It only needs to have freedom of employment and of movement, which means to abolish apprenticeship and the Poor Laws, which, as explained in Book I are the main source of labor impediments.

Smith is more realistic than optimistic about the future of free trade, though. His Public Choice analysis, as we would call it today, is impeccable. He believes that to expect freedom of trade restored in Great Britain is to expect to find Utopia. The prejudices of the public are too strong, and the private interests behind them are “unconquerable”. They are as dangerous as an “overgrown standing army”; they are “formidable”, and can “intimidate the legislature.”

If someone is pro-monopoly, they gain a reputation of understanding trade and they feel important because they become popular among the wealthy. If someone is against monopoly, nothing can protect them from “infamous abuses, insults, even real danger from the insolent outrage of the furious monopolists.” Policy prescription? Do not establish new monopolies or extend existing ones.

IV.iii. Of the extraordinary restraints upon importation of goods of almost all kinds from countries with which the balance of trade is supposed to be disadvantageous. 

Part 1: Of the Unreasonableness of those Restraints even upon the Principles of the Commercial System

The second expedient to increase the quantity of gold and silver has its origins in national prejudice and animosity. This expedient is even more unreasonable than the ones originating from private interests and spirit of monopoly. The expedient is to restrain imports of foreign goods. The high duties used to restrict imports make smugglers the main importers.

Where do these pernicious national prejudices and animosity come from? For Smith they always come from the private interest of some traders. It would be otherwise difficult to justify the popular support for a favorable balance of trade, given the difficulties in measuring it.

Let’s see why measuring a balance of trade is tricky.

First, if we import wines from France, true, the balance is worsened against France. But we would be buying less wine from Portugal. And French wine being cheaper than Portuguese wine, the value of all imports may actually be less. Second, some imported goods are re-exported. Third, customhouse books are famous for their inaccuracy, especially in terms of reported value, and Smith having worked in one knows it well. Fourth, debts and credits do not cancel each other out, as countries deal with many different places. And, fifth, all the previous problems do not count that, a: mint standards are unreliable because the coins are clipped and worn so that the same ounce of pure gold and silver seldom buys the same amount of money, and, b: bank money has often agio, that is the bank money is more valuable than currency.

Digression Concerning Banks of Deposit, Particularly Concerning that of Amsterdam

A large state uses its own coins. A small state uses its own coins and the coins of all other states too. Thus, differently form a large state, if a small state wishes to reform its own coins, it would not reform the currency used in the state, because in circulation there are coins also from several other places. This implies that when one wants to exchange a foreign bill, there is potentially lots of uncertainty regarding what kind of coins one would receive. So the bill is exchanged below what it is worth.

A solution is to have foreign bills of exchange paid with transfer in the books, established on credit with the protection of the state, rather than in currency. By law, the bank will always pay in money of the standard of the state. Small states such as Venice, Genoa, Amsterdam, Hamburg, and Nuremberg use this bank money. And since the money of these banks is better than the local currency, it calls for agio, a premium.

Amsterdam is one of the cities that adopts this form of money. The Bank of Amsterdam is possibly the most famous bank issuing bank money.

The Bank of Amsterdam was established in 1609. It receives deposits and gives credit in its books to the true value of money. Its bank money is always to the standard of the mint. And by law, every merchant has to pay large foreign bills of exchange with this bank money. Since bank money is superior to currency and safer, so it exchanges at an agio. This means that if someone demands payment, the agio is lost. The Bank can therefore claim that all the money deposited is still and always in the bank.

Note that this bank is very different from the merchants banks of Scotland that Smith describes in Book II. The Scottish banks would not accept deposits. They just give loans based on their capital. The Bank of Amsterdam is instead a bank of deposit and with 100% reserves, as we would say today. Meaning that it keeps 100% of its deposits and does not give loans.

So how does it stay in business?

The Bank receives deposits in coins, which become its capital. The value of bank money is supposed to be the same as the value of the coins deposits.

The Bank also receives deposits in bullion (uncoined metals). It issues credit at 5% less than mint price, which is the government set price of the coined metal. The price difference is a sort of warehouse rent for bullion. The depositor gets a receipt and needs to take out the bullion within a specified time, usually 6 months, and paid in bank money. If not, the deposit goes to the bank. It is therefore rare that receipts expire.

The owner of bank money (given for deposited coins) is generally different from the owner of receipts (given for deposited bullions). Thus, receipts are tradable, and they trade between the mint price (price of coins) and the market price (price of bullion). The receipts cannot draw out bullion without giving the bank the equivalent in bank money. If the owner of the receipt has no bank money, he must buy some. Similarly, bank money cannot draw bullion without giving bank receipts for the same amount. If the owner of bank money does not have a receipt, he must buy it.

In times of peace, all is good. But in times of public calamities, there can be some sort of runs on receipts, so that their price may increase significantly.

The city gains from the presence of the Bank thanks to the warehouse rent, the different fees, the sale of foreign coins, the expired receipts of bullions, and the agio of bank money. But the gains are not intentional, in a sense. The Bank was meant to relieve merchants from some of the inconveniences of exchange, and accidentally it turned out to be profitable for the city.

Part 2: Of the Unreasonableness of Those Extraordinary Restraints Upon Other Principles

Let’s go back to the nonsensical mercantile ideas on trade.

If we really want to look at a balance, we should look at the balance of production and consumption, not at the nonsensical balance of trade. If a country consumes more than it produces, it may grow into decay. But if a country produces more than it consumes, then that country will have savings. And since savings are at the base of economic growth, that country will flourish. The balance of trade can be negative, but if the balance of produce is positive, the economy is in good shape.

And yet, we have the popular notion that the balance of trade is the most important indicator of economic growth. It makes no sense. The idea of the balance of trade is based on the idea of zero-sum game, as we say it today; that what a country gains is what another country loses. And there is nothing more absurd than the idea of the balance of trade and that trade is a zero-sum game. Free trade is always advantageous for both countries, even if not equally. It is monopoly trade that is hurtful instead. And it is hurtful for the country that imposes it.

Of course the advantages of trade are not in terms of gold and silver, but in terms of exchangeable value of the annual produce: the annual revenue of a country increases with trade.

And yet again, some people claim that some trades are losing trades. Nonsense: all trades lead to gains. An alleged example of a losing trade is the one of an ale house, what today we call a bar. An ale house is just the result of division of labor and not the source of drunkenness. Cheap wine does not cause drunkenness, indeed, it seems to cause sobriety. Look at France, Smith tells us. In the north of France wine is more expensive than in the south of France. When troupes from the north go south and find its cheap wine, they drink a lot at first. But then, the novelty wears out and they become sober like the locals. The restraints on wine that England has do nothing to promote sobriety. They just favor Portuguese wine over French wines with the excuse that Portuguese are better customers of British goods than the French.

But merchants themselves do their business by buying where it is cheap, independently of who produces the merchandise. Why should all British people not be allowed to do the same? The spirit of monopoly is directly opposite to the interest of the great body of the people. People, like merchants, want to buy from the cheapest seller. But the merchants want monopoly of the home market. So they ask and obtain high duties and prohibitions. Smith does not seem to lose an opportunity to condemn the hypocrisy of merchants.

Merchants are perversely and dangerously clever in fooling who believe in them. They perverse what commerce is and ought to be. Commerce is and ought to be “a bond of union and friendship” among nations. The wealth of one’s neighbor may be dangerous in war but it is beneficial in trade. A rich man, after all, is a better customer than a poor one. Open ports enrich cities and towns, and do not ruin them. Look at Amsterdam. But the “passionate confidence of interested falsehood” of merchants is such that they make every nation look with envy upon prosperity of other countries. The manufactures of rich nations are dangerous rivals, even if this competition is beneficial to the great body of the people. They make the neighbors become necessarily enemies, and their wealth and power inflame violence and “discord and animosity”.

Smith believes there are things that have remedies and things that do not. The universal violence and injustice of rulers has no remedy. The “mean rapacity” and the monopolizing spirit of merchants also has no remedy. But it can be and it ought to be prevented from disturbing the tranquility of society. Merchants are not and ought not to be the rulers of mankind.

IV.4: Of Drawbacks

When merchants affect politicians, they ask and generally obtain monopolies. Merchants want monopoly of the home market, and they want monopoly abroad too. But they can’t get a monopoly abroad. So they ask for encouragement of their exports.

Drawbacks seem to be the most reasonable of these encouragements. They draw back, give back, inland duties or excise taxes if a good is exported or if an imported foreign good is re-exported.

Drawbacks originate from the jealousy of domestic manufacturers. How do we know? There are import duties on imports prohibited in the domestic market. These are goods that cannot be sold at home. They are simply stored in domestic ports waiting to be exported. Yet, manufacturers are afraid that someone will steal them from the warehouses and sell them at home, making them become competition. The jealousy is such to even prohibit carrying goods, such as French ones. They are willing to give up a profit rather than let “our enemies” make a profit by our means.

Yet, drawbacks may have originated as an encouragement of carrying trade. Cargos are paid for in foreign money, so they bring gold and silver into the country. The motivation is foolish, but the institution turns out reasonable enough. It does not force more capital than it otherwise would into those activities. A drawback is not giving any special preferences to the carrying trade, it just removes some obstacles from it.

It is also good for customs because the customs revenue will increase since only part of the duties are given back and part are kept. If all duties were kept, there would be very little gain from customs: those goods would be too expensive, so they would not come to the ports.

But drawbacks are justifiable only for goods exported from countries in which the home country does not have monopoly. They are not meant for European goods going into the American colonies. There, drawbacks would be just a loss of revenue. Also, drawbacks are useful only for goods that are really exported, and not smuggled back.

So far so good.

IV.v: Of Bounties 

But merchants want more. They want monopoly on foreign markets. But we can’t give domestic producers a monopoly in foreign markets. We cannot force foreigners to buy our goods either, as we do in domestic markets. What we can do is pay them to buy our goods. So we give bounties (subsidies) to domestic producers to help them export. If exports increase, the balance of trade would increase too. Win. Not.

A bounty is a subsidy given when trade would not happen without it. But note, Smith tells us, the perversity of the logic: a subsidized trade is an unprofitable trade. It would not take place without subsidies. If it is a profitable trade, it does not need subsidies. The reasons used to justify subsidies are the very reasons for which they should not be given.

Here Smith engages in a sort of dialogue with the supporters of bounties. He lists their objections to their critics, and then answers them to show how nonsensical they are.

The supporters of bounties claim that the value of the exports covers the expenses of the bounty. But they do not count the lost opportunity to use capital in a more profitable way. Without bounties, one would use capital in different ways. Bounties force trade in channels that are less beneficial than it would naturally be. For example, bounties on corn are just a small part of the expense of the bounty. We need to count also the capital that farmers could have used differently. This means, that the national capital decreases as a consequence of bounties.

The supporters of bounties also claim that the price of corn decreased since the establishment of the bounty. This for Smith, is a problem of mistaking correlation with causation. The price decrease happened despite the bounty, not as a consequence of it. Look at France. The price of corn in France dropped too, but there was no bounty. They actually fully banned exports. The reason why the price of corned dropped is because the real value of silver increased. It has nothing to do with the bounties. As a matter of fact, the bounty increased the price of corn at home. In times of plenty, the bounty encourages exports. With less corn at home, the domestic price increases. In times of scarcity, the bounty is suspended. But it is because there was an increase in exports in time of plenty that there is now less corn at home to make up for the bad times, so the price of corn increases also during bad times.

Ah, but high prices at home mean incentives for producers to produce more so the price will eventually go down. No, not quite, Smith answers again. Every bushel of corn exported means less corn at home. It is the foreign market that expands, at the expense of domestic consumption. In addition, domestic consumers have to pay two taxes to subsidize cheap consumption abroad: the actual tax to finance the bounty, and the higher price of corn at home. But because the higher price of corn, all other commodities will increase in price too. And this is the highest tax of the two. Worst, everybody uses corn so everybody pays for it. The poor are hurt the most, since corn is part of their subsistence. The implication is that either population decreases, or monetary wage increases, which means less people will be hired, and industry will have to decrease. The home market shrinks. In the long run the whole market and consumption of corn will decrease. Not good.

Fine, but a higher corn price means higher profits for farmers. Wrong again. The bounty does not affect the real price of corn, just the nominal one. What the bounty does is to decrease the real value of silver, since corn regulates the price of all domestic commodities, the nominal price of labor, the nominal price of all the rude produce of land, and of all materials used in manufacture. But if the value of silver decreases because of the discovery of new mines, the only thing that happens is that service of plate will become cheaper. Everything else will stay the same.

But if the value of silver decreases only in a country, due to some peculiar situation of that country, that country will become poorer, not richer. It will face an increase in money prices, and a decrease in industry. Spain and Portugal are examples of this. They want to prevent gold and silver from leaving the counties. They use taxes and prohibitions. Smugglers export them anyway. When a dam is full, the extra water must overflow. Smith explains that the water may be deeper behind the dam-head than in front of it: Spain and Portugal have lots of plate in their homes. Silver is very cheap there, while everything else is expensive, which discourages agriculture and industry. If they removed the taxes and prohibitions to export gold and silver, the quantity of gold and silver at home would decrease, it would increase abroad, and the value of the metals would level.

The bounty on corn is as absurd as this policy in Spain and Portugal. It makes corn, and everything else, expensive at home and cheaper abroad. The bounty increases the nominal, but not the real, price of corn; it augments only the quantity of silver it exchange it for, and it discourages manufacture without any considerable service to the farmers or landlords. It gives only a little bit more money to farmers and landlords but the value of that money is lower, so it makes little difference.

So who benefits from it, if the domestic population does not and not even the farmers do? The bounty does benefit one set of men: the corn merchants and the exporters and importers of corn. In years of plenty, they export more than otherwise. And in years of scarcity they import more than otherwise. In addition, the price is now higher because of the induced scarcity. It is not by accident that these men are the most zealous to maintain and renew bounties.

But also the country gentlemen support bounties. Why, if they do not benefit from them? They want to imitate the merchants: merchants want high import duties on foreign corn and bounties, a monopoly of the home market, and the market not to be overstocked. So the country gentlemen want to support an increase in the real value of corn, as if it was wool. But they do not understand that it is the nominal value of corn that increases, not the real one. The real value stays the same because corn is corn. The real value of corn is the quantity of labor that it can support. Money price cannot alter it.

If one really wants to increase production, then the bounties should be placed on production, not on exports. Bounties on production create only one tax, the one to pay for the bounty. The price in the home market will then drop (rather than increase, as in the case of bounties on exports), so in this case it is true that the lower price in part repays the tax. But, interestingly enough, we do not see bounties on production. Why? It is not in the interests of the merchants and manufacturers to oversupply their market and have a lower price for the goods they sell. Bounties on exports instead undersupply the home market so that the price of the goods increases.

One could claim that there are some types of bounties on production, but this is not quite so.

There is a production bounty for fishing herrings and whales. But “our vessels are fit out for the sole purpose of catching not the fish but the bounty.” The bounties encourage adventurers to go into businesses they do not understand. Their negligence causes losses greater than the gains from the bounties.

There are also premiums to artists or manufacturers that excel in what they do. But these premiums are different from bounties. They encourage extraordinary dexterity and emulation. And they cost very little money.

Smith concludes that it is seldom reasonable to tax the great body of industry to support some particular manufacture. But it happens in prosperous times. Great folly is, in today’s words, a luxury good.

A bounty may be justified only if the manufacture is needed for national defense. Say, to support the export of British sail-cloth and British gun powder. Here, again, Smith is willing to give defense priority over trade.

Digression Concerning the Corn Trade and Corn Laws

The digression on Corn Laws is a sort of case study that exemplifies the analysis of the chapter and of the Book: some interests align with the interest of society, others do not. Avoiding putting obstacles on the path of the interests that align with society’s promotes growth. Supporting interests that are opposite to society’s does not.

Smith starts by stating that there are four kinds of corn merchants: the inland dealer, the importer for home consumption, the exporter of home produce, and the carrying trade dealer. With the exception of the merchant exporters, whose interest is the opposite of the interest of the majority of people, the interest of the other merchants is in line with the interest of society.

The interest of the domestic trader aligns with the interest of the great body of the people. He raises the price of corn as high as the scarcity of the season warrants it. This discourages consumption, so that it is possible to save for times of scarcity. Without intending to meet the interest of the people, but only his own, he behaves like a prudent master of ship, preventing a famine. Should he be too avaricious, the merchant would actually lose out. He would have corn left over at the start of the new season when the price drops so he would have to undersell it. But if he keeps the price too low, there will not be enough later on. He not only loses profits, but the chance of famine increases.

Why do we have famine, then? Not because of the corn producers. In Smith’s time, it is difficult to create an extensive monopoly for corn. Corn producers are many and dispersed. They cannot easily collude. Not even because of the inland dealers. As we just saw, inland dealers are never the cause of high prices of corn. Real scarcity, deriving from wars or bad weather, is the cause of high corn prices. And if the government orders to sell corn at a “reasonable price”, either too little corn comes to market, causing famine; or too much corn comes to market, selling out soon, also causing famine. Thus, the only source of famine is the violence of government, not inland dealers.

Yet, people believe that it is the avarice of corn merchants that causes famine. So corn merchants become the object of hate and indignation. They can even be in danger of ruin, having their magazine plundered or destroyed by violence. But the years of scarcity are the only times in which they can make a profit. In regular years, they face losses from the perishability of corn and from the frequent fluctuations in its price. Add the popular odium against them, and very few people want to do this job. Remember from Book I, Chapter X that a job with bad reputation requires higher wage to compensate for it? Here we have a problem because there is bad reputation and the higher compensation is threatened away.

The ancient policies of Europe encouraged this hate toward corn merchants, believing it would be cheaper to buy corn from farmers directly rather than through corn dealers, and called for the elimination of the middle men. This was a bad idea because now farmers are forced to be corn merchants. First, as a corn merchant, he cannot sell any cheaper than any other corn merchants. Second, he now needs to use his capital in different ways. Forcing farmers to be corn merchants is a violation of natural liberty and thus unjust. Not surprisingly, it is also inefficient. For Smith, the law ought always to trust people with the care of their interest because with their local knowledge they generally are better judges of it than the legislator. This focus on local knowledge, also present among other places in the invisible hand passage, will find a place a couple of century later in particular in the works of F.A. Hayek.

Smith explains that when scarcity is real, it is better to spread the inconvenience over time. It is in the interest of the merchant to do so, and to do so as smoothly as possible. Nobody has the same interest, the same knowledge, and the same ability than the corn merchant. This is why corn trade ought to be left free.

For Smith, the popular fear that merchants are doing harm to society is the same as the popular fear of witchcraft: the law ending the prosecution of witchcraft put an end to the power of gratifying one’s malice by accusing a neighbor of an imaginary crime. The same would be true for laws freeing the trade of corn.

The second branch of corn trade is the one of the importers of foreign corn for home consumption. These importers contribute to the domestic supply and thus benefit the great body of the people. They lower the average money price of corn, but not the real value of corn which, as we are reminded is the quantity of labor that corn is capable of maintaining.

The third branch of corn trade is the one of the exporters of corn for foreign consumption. They contribute only indirectly to an abundant domestic supply. If a farmer cannot export his surplus, he will make sure not to have a surplus, so he will not produce much. Prohibitions to export therefore limit improvement.

But the problem with the merchant exporters is that their interest is the opposite of the interest of society. If there is scarcity of corn at home and famine abroad, the price of corn abroad will be higher than the one at home. So exporters have incentives to sell abroad, increasing the chance of famine at home. The problem would not necessarily arise if all countries would have free trade of corn. They would be like provinces of a great empire. The freedom of inland trade would be the best palliative against high prices of corn and the most effective prevention against famine. But freedom of corn trade is everywhere restricted, aggravating the misfortunes of high prices and the dreadful calamity of famine.

Interestingly enough, like the Neapolitan thinker Ferdinando Galiani before him, Smith does not offer absolute principles to follow regardless of local circumstances. Smith sees that in small countries, such as Switzerland or in Italy, having a unilateral freedom of trade can be quite dangerous. If there are high prices at home and a famine abroad, corn may leave the home market making things worst at home. There, it may therefore be inevitable to limit corn exports. But this does not hold in a large country, such as France or Britain. Only in case of “the most urgent necessity” it may be justifiable to prevent farmers from sending goods to the best market, and to sacrifice the laws of justice.

But in a sense Corn Laws are like laws on religion. The government “must yield to prejudices to preserve public tranquility”.

The fourth branch of corn trade is the one of carrying trade merchants, who import corn to export it again. They contribute to an abundant domestic supply, even if unintentionally. If a merchant can save the expense of loading and unloading his ships, he takes that opportunity. So if the opportunity comes, he sells at home, rather than exports his goods. The home country of a carrying trade is indeed a storehouse for the supply of other countries, and there are always many merchandises, as explained earlier in this Book. There, the money price of corn, but not its value, will be low.

Carrying trade of corn is de facto prohibited in Britain. Some claim that this prohibition is the cause of Britain’s great growth. But the improvements of Great Britain are not caused by the Corn Laws. Again, correlation is not causation. The reason for the great improvement of Britain lays exclusively in “the security of laws, that each man can enjoy the fruits of his labor.” Smith, who is usually very cautious and qualifies his statements, here drops all hesitations: “that alone [the security of laws] make any country flourish, notwithstanding other absurd regulations of commerce. The natural effort of each individual to better his condition, and the freedom and security to do so, are so powerful a principle that alone, without assistance, carry society to wealth and prosperity, and surmount the hundreds of impediments of the folly of human laws which encroach freedom and diminish security” (paragraph 42).

Correlation is not causation, Smith again warns his readers. Prosperity came at the same time as the Corn Laws, but it came at the same time as national debt too. Nobody though says that national debt is the cause of prosperity of Britain. Nobody should dare say that the Corn Laws are the cause of its prosperity either.

Can we test this? Do we have a counter-example? Yes. Spain and Portugal have bounties too. But only Britain is rich. Spain and Portugal are the most beggarly countries in Europe. Why? Because they do not have good laws to counterbalance the bad effects of bad policies. Their civil and ecclesiastical governments do not offer general liberty and security of the people.

IV.vi: Of treaties of commerce

This short chapter is titled of treaties of commerce but it is more about seingnorage, the tax on coining precious metals, than treaties. Smith admits it is oddly placed. It could have been inserted into the discussion on money. But since as he claims the policy on seignorage is part of the mercantilist scheme, he thinks better to put it in the book about mercantilism.

The connection between treaties and seinograge is part of the rhetoric supporting the treaties. Allegedly, treaties give a country the needed gold and silver. Instead, seignorage would do a better job in keeping gold and silver in the country, Smith claims.

A treaty permits trade of, or exempts from duties, goods of a specific country, causing a more extensive market but only for the goods of that specific country, or a more advantageous market but through a monopoly and higher prices. It grants a monopoly against itself in the hope that the balance of trade would become more favorable, so that more gold would come into a country.

Not surprisingly by now, we hear that merchants are better off, but the country worse off. The more gold comes in from one country, the less it comes in from other countries. As we know, the quantity supplied of precious metals cannot exceed the quantity demanded. If it does, gold goes abroad, purchasing things that are in demand. So for example, the treaty Britain has with Portugal makes Britain worst off because it forces her to produce for Portugal, get money from it, and then buy from other countries the products Britain actually wants. A direct foreign trade is for Smith always more advantageous. So again, merchants are able to capture the government to their favor, via treaties, using the rhetoric that what is good for them is good for the country, even if it is not true.

To the ones who worry that if Britain does not trade with Portugal, which has a lot of gold from its Brazilian colonial trade, Britain would not have enough gold, Smith answers: false. Importing gold is not useful to increase the amount of plate or coins in Britain. Plate and coins come mostly from melting down old plate and old coins. This is why how seignorage is relevant here.

If there is no tax or fee on melting down coins, people will melt their old coins for new coins. But if there is seignorage, coined gold will be more valuable than uncoined gold, since one needs to pay a fee every time it melts gold into coin and vice-versa. Seignorage therefore diminishes profit from melting down coins. So when money is received by tale (at face value), not by weight, seignorage is the most effective way to prevent melting of coins into bullion, that is, seignorage is the most effective way to decrease the exports of gold. One does not need a treaty of commerce.

Why does England not have seignorage then? The Bank of England is in constant need to melt bullion into coins to replenish its coffers. It is for its interest that coinage is done at the expense of the government. The mint cost is irrelevant to the government but significant for the Bank. If there is no seignorage, the government faces the expense of the mint, receives no revenue. What the Bank of England does not understand is that nobody benefits from it.

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