Wednesday, March 05, 2008

Smith Was Right, Ricardo Was Wrong

Niranjan Rajadhyaksha asks: “Will high food prices strangle growth? The differing views of Adam Smith and David Ricardo can shed light” in the Wall Street Journal (, 4 March (here):

The 18th century [sic] English economist, David Ricardo, believed that societies would be forced to cultivate increasingly less fertile land as demand for food expanded. Food prices would rise, pushing up wages and rents. This would leave a smaller part of the national income for profits. Low profits would make new investments unattractive to the capitalist class. Ricardo believed that the capitalist economy would eventually settle into a stationary state of zero growth.

Ricardo was proved wrong. The discovery of the Americas led to a sudden increase in the supply of high-quality land. Technical improvements increased farm productivity. Relative prices of food have fallen dramatically over the past century. But the Ricardian belief that an agricultural pinch would act as a constraint on economic growth got a fresh lease of life in the development debates of the 1950s

Reading Ricardo on these terms seems strange, but is explained, perhaps, by the zero sum version of an economy prevalent among economists until recently. When you capture an economy within an equilibrium framework, any movement in one variable (food prices) is bound to have knock-on effects in other variables (wages, rents), which was not helped by the Ricardian anchor of diminishing returns. Agriculture remained the largest sector of the economy in employment and output, and was itself trapped in the mercantile policy of price regulated tariffs (the ‘Corn Laws’) until they were repealed in 1846.

Low profits, wrote Smith, are associated with expanding economies and new industries generate higher profits, which shifts capital towards them. ‘The acquisition of new territory [North America], or new branches of trade, may sometimes raise the profits of stock’ (WNI.ix12: p 110)

High profits are associated with stagnating economies, mercantile monopoly policies and prodigality. The doom-laden versions of Ricardian economics dominated popular thinking, even as the evidence of the real world contradicted them. The beautiful irony of Malthusian gloom lies in his articulation of the so-called ‘trap’ of misery of permanent poverty for the majority was being undermined by rising per capita real incomes all around him and on through the 19th-20th-and 21st centuries for commercial markets. Something was wrong with the diminishing returns model, though to be fair, the Malthusian trap had operated with impunity for thousands of years. The difference from the late 18th century was the re-appearance and expansion of commerce.

Smith came before Ricardo. His was the more optimistic view. This 17th [sic] century Scottish economist believed that the division of labour and specialization would spur innovation and growth. No stationary state for him.

In a recent blog post on economic history, Mark Koyama of Oxford University compared the two views of economic growth. “There are, broadly speaking, two different perspectives in economic history: a Ricardian/Malthusian perspective…emphasizes the significance of the constraints that bound pre-industrial economies… This view was certainly the dominant view amongst economic historians in the post-war period and it seems also to have dominated discussions in development—particularly the emphasis on importance natural resources, savings and population control and the comparative neglect of institutional considerations that typified the approach taken in the 1950s and the 1960s follows from a Ricardian paradigm,” writes Koyama. He earlier described “Smithian growth based upon falling transactions costs and increases in specialization and the division of labour

“No stationary state for him [Adam Smith]”. Not quite true. Within Adam Smith’s model of growth there was a ‘stationary state’ conclusion:

In a country which had acquired that full complement of riches which the nature of its soil and climate, and its situation with respect to other countries allowed it to acquire; which could, therefore, advance no further, and which was not going backwards, both the wages of labour and the profits of stock would probably be very low. In a country fully peopled in proportion to what either its territory could maintain or its stock employ, the competition for employment would necessarily be so great as to reduce the wages of labour to what was barely sufficient to keep up the number of labourers, and, the country being already fully peopled, that number could never be augmented. In a country fully stocked in proportion to all the business it had to transact, as great a quantity of stock would be employed in every particular branch as the nature and extent of the trade would admit. The competition, therefore, would everywhere be as great, and consequently the ordinary profit as low as possible." [WN I.ix.14: p 111]

He also pointed to China’s stagnation and its causes:

"But perhaps no country has ever yet arrived at this degree of opulence. China seems to have been long stationary, and had probably long ago acquired that full complement of riches which is consistent with the nature of its laws and institutions. But this complement may be much inferior to what, with other laws and institutions, the nature of its soil, climate, and situation might admit of. A country which neglects or despises foreign commerce, and which admits the vessels of foreign nations into one or two of its ports only, cannot transact the same quantity of business which it might do with different laws and institutions. In a country too, where, though the rich or the owners of large capitals enjoy a good deal of security, the poor or the owners of small capitals enjoy scarce any, but are liable, under the pretence of justice, to be pillaged and plundered at any time by the inferior mandarines, the quantity of stock employed in all the different branches of business transacted within it, can never be equal to what the nature and extent of that business might admit. In every different branch, the oppression of the poor must establish the monopoly of the rich, who, by engrossing the whole trade to themselves, will be able to make very large profits. Twelve per cent. accordingly is said to be the common interest of money in China, and the ordinary profits of stock must be sufficient to afford this large interest.

A defect in the law may sometimes raise the rate of interest considerably above what the condition of the country, as to wealth or poverty, would require. When the law does not enforce the performance of contracts, it puts all borrowers nearly upon the same footing with bankrupts or people of doubtful credit in better regulated countries. The uncertainty of recovering his money makes the lender exact the same usurious interest which is usually required from bankrupts. Among the barbarous nations who over-run the western provinces of the Roman empire, the performance of contracts was left for many ages to the faith of the contracting parties.*73 The courts of justice of their kings seldom intermeddled in it. The high rate of interest which took place in those ancient times may perhaps be partly accounted for from this cause."(WN I.ix.15-16: pp 111-2)

However, Adam Smith’s growth theory was different from Ricardo’s and most modern economists. His was not based on the equilibrium constraint, and this fact was steadily ignored until the mid-20th century. Smith’s was an increasing returns, not a diminishing returns theory, and this was rooted in the propensity to exchange, the division of labour and the inter-linked supply chains that necessarily developed in consequence. The famous ‘pin factory’ was only part of Smith’s division of labour. Perhaps the more important other part is in the same chapter as the pin factory: the account of the supply chains that linked together to produce the common labourer’s woolen coat:

Observe the accommodation of the most common artificer or day-labourer in a civilized and thriving country, and you will perceive that the number of people of whose industry a part, though but a small part, has been employed in procuring him this accommodation, exceeds all computation. The woollen coat, for example, which covers the day-labourer, as coarse and rough as it may appear, is the produce of the joint labour of a great multitude of workmen. The shepherd, the sorter of the wool, the wool-comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production. How many merchants and carriers, besides, must have been employed in transporting the materials from some of those workmen to others who often live in a very distant part of the country! how much commerce and navigation in particular, how many ship-builders, sailors, sail-makers, rope-makers, must have been employed in order to bring together the different drugs made use of by the dyer, which often come from the remotest corners of the world! What a variety of labour too is necessary in order to produce the tools of the meanest of those workmen! To say nothing of such complicated machines as the ship of the sailor, the mill of the fuller, or even the loom of the weaver, let us consider only what a variety of labour is requisite in order to form that very simple machine, the shears with which the shepherd clips the wool. The miner, the builder of the furnace for smelting the ore, the feller of the timber, the burner of the charcoal to be made use of in the smelting-house, the brick-maker, the brick-layer, the workmen who attend the furnace, the mill-wright, the forger, the smith, must all of them join their different arts in order to produce them. Were we to examine, in the same manner, all the different parts of his dress and household furniture, the coarse linen shirt which he wears next his skin, the shoes which cover his feet, the bed which he lies on, and all the different parts which compose it, the kitchen-grate at which he prepares his victuals, the coals which he makes use of for that purpose, dug from the bowels of the earth, and brought to him perhaps by a long sea and a long land carriage, all the other utensils of his kitchen, all the furniture of his table, the knives and forks, the earthen or pewter plates upon which he serves up and divides his victuals, the different hands employed in preparing his bread and his beer, the glass window which lets in the heat and the light, and keeps out the wind and the rain, with all the knowledge and art requisite for preparing that beautiful and happy invention, without which these northern parts of the world could scarce have afforded a very comfortable habitation, together with the tools of all the different workmen employed in producing those different conveniencies; if we examine, I say, all these things, and consider what a variety of labour is employed about each of them, we shall be sensible that without the assistance and co-operation of many thousands, the very meanest person in a civilized country could not be provided, even according to what we very falsely imagine, the easy and simple manner in which he is commonly accommodated. Compared, indeed, with the more extravagant luxury of the great, his accommodation must no doubt appear extremely simple and easy; and yet it may be true, perhaps, that the accommodation of an European prince does not always so much exceed that of an industrious and frugal peasant, as the accommodation of the latter exceeds that of many an African king, the absolute master of the lives and liberties of ten thousand naked savages.” (WN I.i.11: p 22-24)

Employment in agriculture and other products of the land is now a minority activity in a country’s GDP. Productive employment, defined as the production of ‘vendible’ products in markets for revenue, dominates economic activity. As improvements in quality, cost and distribution (now global) are generated all along the supply chains of billions of products in trillions of transactions, the rise in per capita incomes is relentless. Allyn Young put well (Economic Journal, 1928):
specialisation and the division of labour cause ‘cumulative’ improvements all along the economy’s supply chains which, necessarily, use each other’s outputs as inputs into their outputs. It’s a far more powerful force than a hasty reading of Wealth Of Nations (more often a quotation only from it) that stops after the account of the pin factory would suggest.

What Adam Smith called the ‘spread of opulence’ brought about commercial economies, despite the many imperfections imposed by continuing mercantile policies, ‘consistent with the nature of [each country’s] laws and institutions’, despite lapses in the administration of justice, natural calamities, human wars, social disorder, and the malfeasance of state and private officials, bears witness to his optimism for the revived ‘age of commerce’.

Ricardo was wrong – and obscure too; read his works for examples. Niranjan Rajadhyaksha, despite the slips in his(?) analysis is asking the right question. I am not so sure that he did enough to provide the appropriate answer.


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