The Wisdom of Adam Smith

What would Adam Smith, the father of modern economics and famed author of The Wealth of Nations (1776), had to say about the current global financial crisis:

Peter O'Rourke, author of On The Wealth of Nations, Books that Changed the World (2007), wrote in a recent article it is ironical that people always want to know what Adam Smith would say whenever the free market principle seems to be expired or dead; something that probably happened 10 times already in the past century!

Well, Smith identified the exact course of our current economic misery when he wrote The Wealth of Nations:

“A dwelling-house, as such, contributes nothing to the revenue of its inhabitant. If it is lett [sic] to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue.” Therefore Smith concluded that, although a house can make money for its owner if it is rented, “the revenue of the whole body of the people can never be in the smallest degree increased by it”.

Smith was familiar with rampant speculation, or “overtrading” as he called it.
In 1772, while Smith was writing The Wealth of Nations, a bank run occurred in Scotland. Only three of Edinburgh’s 30 private banks survived. The reaction to the ensuing credit freeze from the Scottish overtraders sounds familiar, “The banks, they seem to have thought,” Smith said, “were in honour bound to supply the deficiency, and to provide them with all the capital which they wanted to trade with.”

The phenomenon of speculative excess has less to do with free markets than with high profits. “When the profits of trade happen to be greater than ordinary,” Smith said, “overtrading becomes a general error.” And rate of profit, Smith claimed, “is always highest in the countries that are going fastest to ruin”.

One simple idea allows an over-trading folly to turn into a speculative disaster – whether it involves ocean commerce, land in Louisiana, stocks, bonds, tulip bulbs or home mortgages. The idea is that unlimited prosperity can be created by the unlimited expansion of credit.

How then would Adam Smith fix the present mess? Sorry, but it is fixed already. The answer to a decline in the value of speculative assets is to pay less for them. Job done.

We could pump the banks full of our national treasure. But Smith said: “To attempt to increase the wealth of any country, either by introducing or by detaining in it an unnecessary quantity of gold and silver, is as absurd as it would be to attempt to increase the good cheer of private families, by obliging them to keep an unnecessary number of kitchen utensils.”

Quoted from: "Adam Smith gets the last laugh" by P.J. O'Rourke, FT.com, February 10, 2009