Adam Smith's Wealth of Nations: Episode 4--Capital and Book II: Introduction

Book Two of Adam Smith's "The Wealth of Nations" provides the conceptual foundation for understanding how commercial society sustains growth through capital accumulation and the employment of stock. Smith challenges common misconceptions about wealth creation and offers profound insights on the role of capital in economic development.

• Capital is not capitalism – Smith wrote before "capitalism" was invented, using the term "stock" to describe accumulated resources
• Division of stock works alongside division of labor – capital must be accumulated before it can be employed productively
• Justice (protection of person, property, and promise) is prerequisite for investment – without security, people hide rather than invest their stock
• Fixed capital (tools, buildings, skills) versus circulating capital (money, wages, materials) form different branches of stock
• Money serves as "the great wheel of circulation" – facilitating exchange but not itself productive
• Banking allows society to operate with less precious metal – freeing resources for productive investment
• Productive labor creates vendible commodities while unproductive labor (government, services) perishes in performance
• Parsimony (saving) drives growth while prodigality reduces funds available for productive employment
• Interest is legitimate compensation for foregone use of capital – similar to rent on land
• Agriculture, manufacturing, wholesale trade, and retail are the four main employments of capital
• Modern financial markets solve Marx's "primitive accumulation" problem – entrepreneurs can sell shares of future profits

Let me know your thoughts on these ideas from Adam Smith in the comments below. 

If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !

You can follow Mike Munger on Twitter at @mungowitz

Chapters

• 0:00 Introduction to Book Two
• 9:57 The Division of Stock and Capital
• 22:33 Marx vs Smith on Capitalism
• 37:14 Fixed vs Circulating Capital
• 54:51 Money as a Wheel of Circulation
• 1:12:10 Banking, Credit and Economic Growth
• 1:26:02 Productive vs Unproductive Labor
• 1:40:30 Interest, Usury and Legitimate Returns
• 1:53:07 Four Employments of Capital
• 2:07:39 Solving the Primitive Accumulation Problem

Transcript

This is Mike Munger, the knower of important, things from Duke University. This is episode four of the series on Adam Smith and the Wealth of Nations. This series is produced in cooperation with AdamSmithWorks at Liberty Fund, and I do want to acknowledge the essential help of Amy Willis. This episode gives some background on the important of Book Two of the Wealth of Nations, which is really quite an amazing achievement. Next week, on Tuesday September 30, we’ll have the second episode on Book II, where we discuss the book itself. So, as always, straight out of Creedmoor, this is TAITC.

Book two of the Wealth of Nations is about what we now call capital. Now we need to be clear. Adam Smith did not understand capitalism because it wasn't a thing, the word hadn't even been invented. Worse, the idea of capitalism fundamentally misrepresents commerce, as we'll see. Capitalism is a Marxist conception, which is fair enough. But saying that Adam Smith was writing about capitalism is just a mistake. That's what [Karl] Marx wrote about. Well, where does book two fit into the structure of the Wealth of Nations? Let's reorient ourselves. 

01:28

Wealth of Nations is a handbook for legislators and policymakers. Book one, as we talked about in the previous episode, explained how wealth is created through labor exchange and specialization. The key concept there was increasing returns and division of labor. Book two, the subject of today's podcast, explains how wealth is started, sustained and expanded. It works through savings, capital accumulation, and the employment of stock. Foregone consumption or saving is the way that Smith defined stock and he thought that the accumulation and employment of stock was the key to increasing the productivity of labor. So the key concept is how capital increases labor productivity through division of stock. Now, you may not have heard about division of stock, but it's the title of the first chapter of book two. Smith may not always be clear, but he's usually intentional. Book one had a chapter entitled that the division of labor is limited by the extent of the market. Book two has a chapter entitled the division of stock, and so we should recognize that division of labor and division of stock are closely related, parallel concepts. 

02:51

Well, book three, which we'll talk about next month, traces the historical or stadial sequence of economic development under gathererism, pastoralism, agriculture, manufacturers, and commerce. Book four critiques mercantilism and physiocracy. It's about what Smith called good police. We would now call that policy. Book five examines the state's duties- defense, justice, public works, education. It's the first work of self-conscious public finance, both about taxation and expenditure. Thus today's subject, book two, is the conceptual hinge. It provides the theory of capital that explains how commercial society grows and why it differs from simpler or earlier forms of society. Not just commerce and division of labor. We need capital for the system to work. Not just commerce and division of labor. We need capital for the system to work. 

03:49

Barry Weingast, my graduate advisor and a leader in institutional analysis is working on a project, in part with Glory Liu, called, rather unimaginatively frankly, the Adam Smith Project, and I'll put up a link to that. Weingast's core theory is about Smith's model of capital investment and how equilibrium should be understood. Smith's economic engine is the division of labor. The fuel for division of labor is capital accumulation, that is, the collection and accumulation of stock. But the theory is institutional. It's almost as if there were a switch. 

04:25

People accumulate or invest only if they can depend on what Smith calls justice, and remember, justice is the protection of person, property, and promise. Under oppression or fear of violence, people hide their stock and they avoid investment. They have to keep resources liquid so they can flee. In such settings, people content themselves with their necessary subsistence, in Weingast's words, because gaining more would tempt the injustice of their oppressors. They're oppressors, for the most part of the state itself, which is violating its obligation to protect person, property and promise. But there's no such thing as the state. The state is people. So the question is can institutions guarantee that the people who make up the state are obliged, and in fact want, to protect person, property, and promise? 

05:19

Now there's direct evidence that Weingast has this right. When I talk about quotes from Wealth of Nations. I will give the page numbers from the Liberty Fund edition, the two-volume edition of the Wealth of Nations. This is on page 284 and 285. Smith says, quoting, “In all countries where there is tolerable security, every man of common understanding will endeavor to employ whatever stock he can command in procuring either present enjoyment or future profit. A man must be perfectly crazy who, where there is tolerable security, does not employ all the stock which he commands. But in those unfortunate countries where men are continually afraid of the violence of their superiors…” End of quote. Now notice this is very similar to the Hobbesian claim about justice. If there is no justice we will get no investment. But Smith's being very specific. It's not that there'll be no investment. There'll be very little accumulation of stock that we can actually use to increase the productivity of labor. People are going to save, but they're going to hide their savings. What little gold they can accumulate, perhaps in a clay jar out in the back garden, they're not going to make it available to loan to other people because they can't be sure that it won't be stolen and for the most part they're worried that it will be, certainly. True also that, simply, the failure of the state to protect person, property, and promise would also be sufficient to prevent that kind of accumulation of stock equilibrium. 

07:21

And he's in other places with other authors, called this the violence trap in which rational authors don't undertake risky long horizon investments. And feudal society is just such a low growth, low investment equilibrium. The thing about it being an equilibrium means that there's no inherent tendency for it to change. This can last for a very long time. The question is how to break out of it, how to break out of the violence trap. And the reason that calling it a violence trap makes sense is that a nation, an otherwise potentially prosperous nation, can be trapped in it indefinitely. Smith's narrative from this perspective then shows how towns and kings restructured the incentives, charters, self-government, fixed taxes that wouldn't be arbitrary, letting cities escape to a new, higher equilibrium of trade and growth. The power of Weingast's model of Smith's analysis is that he uses a simple conception of equilibrium to explain the stability of social, economic, and political arrangements in feudal society, but then uses comparative statics to explain how exogenous changes shift society from one equilibrium to another. Now we'll talk more about this equilibrium problem and the contributions of [Douglass] North and Weingast in later episodes. 

08:40

I thought it would just be interesting to say that this is actually a topic of current research interest. It's not just historical consideration. For now, though, let's go back to one other loose end, and that is, as I said at the beginning, the pejorative use of capitalism which, for some reason, even many market defenders have adopted. Defenders have adopted, that is, market defenders have been tricked into accepting the name capitalism, when there are more accurate ways to describe this phenomenon. I think the two most accurate are either market process or market order. Those descriptions, of course, we owe to Austrian economics. 

09:22

Let's give definitions of market process and market order. Ludwig von Mises said the market is a process of entrepreneurial rivalry where actors pursue profits and avoid losses. It's not a static equilibrium, but a continuous adjustment of supply, demand and prices. It is a process. Then the idea of equilibrium is just misleading. Friedrich Hayek said that markets constitute a spontaneous order, a spontaneous emergent market order, a self-organizing system where dispersed knowledge held by individuals is communicated through prices. The order is not designed, but emerges from decentralized interactions. Order is not equilibrium, it's more like a network. Now the network may be fixed, but the way that different nodes are activated at different times, new nodes added, old ones destroyed constantly. What's persistent is the order or network, but again the idea of equilibrium is misleading. What's persistent is the order or network, but again the idea of equilibrium is misleading. Finally, Israel Kirzner. The market process for Kirzner is driven by entrepreneurial alertness, the discovery of previously unnoticed profit opportunities. 

10:41

Markets are a discovery procedure, continually correcting errors and bringing expectations into alignment. Now, that doesn't mean that there aren't errors in the existing system, in the sense that some resources are allocated to other than their most highly valued uses. The process of entrepreneurship tends towards correcting those errors. But the idea of an equilibrium system without any errors is just nonsense. Errors are everywhere. 

11:03

So a market order is the emergent coordination pattern that's created by individual decisions in a context where property rights are defined and enforced. In the institutions of exchange, currency, banks, accounting are not illegal. They actually function well and at low transaction costs. This is surprisingly similar to Smith's notion of justice as a precondition for commerce. So remember, justice is the security of ownership in person, property, and promise. More importantly, market orders are produced by market process, the dynamic trial and error sequence of exchange, competition, and entrepreneurial discovery. Those are the dynamic parts of the process. In a context where there's no external interference or distortion of prices or other market signals. So again, market orders, which is the network, is produced by market process, the dynamic trial and error sequence of exchange, competition and discovery. Capitalism, in the way that it should be properly defined, does play a role in market orders and market process, but it's not the role understood by the dirigistes of both the left and the right. Now let's take a look for a moment at what the left means by capitalism. 

12:21

First use of the word capitalism wasn't by Marx. It was reasonably common in early 19th century Europe, both in German and in French. In French, capitalism was used pejoratively til the 1860s, often in either socialist or Catholic critiques of the growing industrial system. The Oxford English Dictionary cites the first use of capitalism in English in 1854, in William Thackeray's novel The Newcombs, where it was used ironically meaning the power of capital. So the term was in circulation among intellectuals and critics of industrial society by the mid-19th century. Marx didn't invent the word, though he eventually made it central to his analysis. In fact, of course it's the title of his book not commerce, not wealth, but Capital. Now, Marx didn't actually use the word capitalism. What he said was the capitalist system of production. 

13:30

Marx is taking the romantic position of [Jean-Jacques] Rousseau. And then he brilliantly adds a villain. What Rousseau had done was demonize civilization, and maybe that's true, but most of us are not willing to give up on civilization. Marx was clever enough to say no. The real problem is capital. There are villains that live among us. All we have to do is get rid of the power of capital and we will be living in paradise. 

13:56

Marx's writings in the 1840s and 1850s analyze the capitalist mode of production, which he contrasts with earlier forms like feudalism. And to be fair, he thinks the capitalist mode of production is much more efficient. It produces a lot more than feudalism. He agrees with Adam Smith about the problems of feudalism. Marx intentionally and tendentiously, I would say muddles market process and capitalism. Most of what he was seeing was market process, which of course leads to a market order. Marx was saying that it leads to the capitalist system of production. The industrial revolution, wage labor and factory production created a distinct economic order that Marx saw as qualitatively different from earlier commercial societies. In his book Capital, in Volume 1, chapter 6, Marx defines the specifically capitalist process of production as the combination of capital and wage labor. “Capitalism is that economic order of society in which the means of production are monopolized by one part of society. The working class possesses nothing but its labor power, which it must sell to the capitalist.” End of quote. 

15:11

However, we have to credit Marx with a deep insight about what Smith called previous accumulation and what Marx called primitive accumulation. Marx actually does call attention to something important about what Smith called previous accumulation, and that's the reason for this long introduction, before we start Smith's book on capital, book two. What Marx says in chapter 26 of volume one of Capital and the title of the chapter, is the Secret of Primitive Accumulation. “We have seen how money is changed into capital, how, through capital, surplus value is made, and from surplus value more capital. But the accumulation of capital presupposes surplus value. Surplus value presupposes capitalistic production. Capitalistic production presupposes the…” Well, that's brilliant capitalist accumulation, an accumulation not the result of the capitalistic mode of production, but its starting point. End of quote. Well, that's brilliant. Marx is absolutely right about that. 

16:31

There's a chicken and egg problem. How can it be that we have enough capital or stock, which we'll talk more about once we get to Smith, and that'll happen soon, don't worry. But Marx really did identify an important chicken and egg problem. After all, you could only earn profits if you have enough capital to invest in the tools and factory. You need to employ labor. But you can't do that unless you already have saved. But how can you have saved if you haven't even started the production process yet? Most labor, after all, is not able to save much because their wages are relatively small. So you could produce value if it were possible to borrow against future earnings. But earnings are, to say the least, uncertain and in any case such profits are in the future, certainly by years and maybe a decade. How do we solve the problem of accumulating enough capital to make labor more productive now? We solve the problem of accumulating enough capital to make labor more productive now. To start the process of accumulation 

17:30

Now, for Marx, the essence of capitalism is the commodification of labor and the extraction of surplus value in a system of generalized commodity production. Whoever possessed capital had an enormous advantage in terms of power, in terms of politics and in terms of the amount of money that they could earn for a given amount of effort. So, as Marx said in chapter 31 of Capital, the different momenta of primitive accumulation distribute themselves now more or less in chronological order, particularly over Spain, Portugal, Holland, France, and England. In England at the end of the 17th century, they arrived at a systematical combination, embracing the colonies, the national debt, the modern mode of taxation and the protectionist system. These methods depend in part on brute force, that is, the colonial system, but they all employ the power of the state, the concentrated and organized force of society, to hasten, hothouse fashion, the process of transformation of the feudal mode of production into the capitalist mode and to shorten the transition. Here's the key phrase Force is the midwife of every old society pregnant with a new one. I'm going to say that again. Force is the midwife of every old society pregnant with a new one. It is itself an economic power. And again, that's from chapter thirty one of Capital. 

18:59

Marx has a conception of the movement from feudalism to what he calls capitalism that mostly involves the power of the state protecting and helping to accumulate capital. And there has to be some kind of private or primitive accumulation where some people have capital but most of us don't. How does that happen and why is it so important? For Marx, the struggle against the implication of commodification has to be political because the economic logic is inescapable. It's inexorable. So the only answer is political. The problem is partly political because the power of the state is driving it, but the economic logic itself is just inescapable. Feudalism is going to collapse in the face of the expansion of capitalism. 

19:47

Now, Marx was on to something. The attractiveness of Rousseau's Second Discourse shows how powerfully engaging this argument is at an emotional level. Why do people who shower before work make so much more money than people who shower after work? All the people who shower after work don't make very much. People who work in my yard, people who work in a lumber yard, people who work at the Amazon plant and sweat like crazy, they all shower after work. I shower before work, I take my shower, put on my suit and I don't sweat all day long and I make many times as much as those physical laborers. Why is it that those who shower before work make so much more money than people who shower after work? And Marx's argument is that it is a disproportionate distribution of capital. Now, that's a good argument rhetorically, maybe not economically, because it recalls the ant and the grasshopper. 

20:49

You may recall Aesop's fable of the ant and the grasshopper. Goes like this: 

One bright day in late autumn, a family of ants were bustling about in the warm sunshine drying out the grain they had stored up during the summer, when a starving grasshopper, his fiddle under his arm, came up and humbly begged for a bite to eat. What, cried the ants in surprise? Haven't you stored anything away for the winter? What in the world were you doing all summer? I didn't have time to store up any food, whined the grasshopper. I was so busy making music that before I knew it, the summer was gone. The ants shrugged their shoulders in disgust. Making music were you? They cried very well, now dance. They turned their backs on the grasshopper and went on with their work. 

21:39

Moral is, there's a time for work and a time for play. Well, the reason that that is important, for and I'm attributing that to Marx; he did not himself mention Aesop's fable, but he is scornful of this idea that some people had morally good ancestors and they saved money, and so they have capital. And there were other people who had morally bad, dissolute ancestors, and so all they have is their labor. Because the story is, there are some people- that is, the ones who showered before work whose ancestors saved up. They're the ants in this metaphor. They saved up, and so now they are wealthy because they're earning income from capital and they don't need to work as hard. The grasshoppers all spent all their time drinking, dancing, making music, and then, when hard times come, they don't have anything except their own labor to sell. And so the moral is that poor people deserve to be poor and wealthy people deserve to be wealthy, and that's why primitive accumulation is okay. 

22:52

Now, Marx is rather scornful of that, of course, but regardless of what you think about the moral content of this, it is an interesting question why it is that a current generation one person owns capital, another one does not makes such a big difference in the amount of wealth that they have and how much resources they're able to gain access to. On the other hand, Marx famously predicted a consistent and constant fall in wages in capitalist society, and that turned out not only to be false, but absurdly false. It's an embarrassment for Marxist theory. We'll talk more about that later, but I wanted to give some foreshadowing of the importance of this section on capital and stock and the way that it's been used by Marxists for Smith and then later for political economy. Well, finally, all of that brings us to Adam Smith's Wealth of Nations, book two, of the Nature, accumulation and Employment of Stock. Let's start out with a quote from the Wealth of Nations, so that it's clear why I spent all that time talking about Marx and what Marx called primitive accumulation. It's on page 279 of the Liberty Fund edition. It's, of course, in book two. It's in part one, chapter one. 

24:16

When the stock which a man possesses is no more than sufficient to maintain him for a few days or a few weeks, he seldom thinks of deriving any revenue from it. He consumes it as sparingly as he can and endeavors by his labor to acquire something which may supply its place before it be consumed altogether. His revenue is in this case derived from his labor. 

This is the state of the greater part of the laboring poor in all countries. Well, why? The answer has to be the ant and the grasshopper. We'll come back to that, back to the quote. This is on page 279. 

But when he possesses stock sufficient to maintain him for months or years, he naturally endeavors to derive a revenue from the greater part of it, reserving only so much for his immediate as may maintain him till this revenue begins to come in. His whole stock, therefore, is distinguished into two parts. That part, which he expects is to afford him this revenue, is called his capital. The other is that which supplies his immediate consumption and which consists either, first, in that portion of his whole stock which was originally reserved for this purpose, or, secondly, in his revenue, from whatever source derived, or, thirdly, in such things as had been purchased by either of these in former years and which are not yet entirely consumed, such as a stock of clothes, household furniture and the like. One or other or all three of these articles consists. The stock which is a stock of clothes, household furniture and the like. One or other or all three of these articles consists the stock which commonly reserve for their own immediate consumption.

 Now let me pause quoting there for a minute. 

25:55

Some people have only their own labor. They have no stock, they have no way of investing it because they eat or use almost everything that they produce. We would now call this living paycheck to paycheck, and it is true of many people. I don't make enough to save very much. I may try to save some, but I don't save very much. Those who have already saved quite a bit, or perhaps whose ancestors saved quite a bit, have two sources. One I have an amount that I reserve to supply my own consumption, and the other is I have something that I can lay aside that I can use to produce income. So then my income is both what I use my labor to produce and the income from the saved up capital or stock. Now, the advantage of calling it stock is that I have a bunch of stuff, maybe some of its food, maybe some of its clothes, some of its household furniture. Those are the ones that Smith gives in this paragraph. If I don't need to use all of them in a given period, I'm likely to want to rent them out or to sell them. I'm going to try to derive income from them. That is an interesting way of thinking about the origins of capital and it is very fundamental and it's interesting that Marx picked up on that. We'll come back to that page in a few minutes, but that was the first part, the very first part of that section of that chapter on page 279. 

27:27

Smith's conception of commercial society and the way that he pitches book two is that commercial society is the most advanced stage of social organization. In the stadial system, commercial society is characterized by a dependence on markets rather than the custom or command or feudalism for the satisfaction of needs, that is, for the most part, I buy in the open market the things that I need, rather than depending on the obligations of others to give it to me, and that means that my relationship with the rest of society is much more fluid, that my relationship with the rest of society is much more fluid. Second, a complex division of labor, where individual specialization requires exchange because of increasing returns to labor. If I'm producing pins, I have way too many for my own use, so it actually requires that I be able to exchange with others so that I can use all of what I have produced. And third, capital accumulation, since the continuation and expansion of production requires advances of stock, tools, raw materials. Capital or stock must come before production uses a division of labor. But where exactly does it come from? This is something that Smith worries about and obviously something that Marx worries about also. 

28:47

Book two elaborates on this third element. What is capital? Where does it come from? How does it work without capital? Division of labor cannot advance. Without savings, capital cannot grow. Thus book two is Smith's theoretical explanation of how commercial society reproduces and augments itself through time. In brief, nations that grow must accumulate and invest stock.

29:12

Marx claimed that the source from which this accumulation arose was surplus value. The puzzle is a chicken and egg problem. Capital is necessary for manufacturing to start and, okay, that's the source of profits and investment. But if capital has to come before capitalism, where does it come from? How does it get started? Smith's answer is in the intro part of book two. In the intro to book two, on page 277, that's two seven seven. 

29:43

Smith says this, quoting: 

As the accumulation of stock must, in the nature of things, be previous to the division of labor, so labor can be more and more subdivided in proportion only as stock is previously more and more accumulated. So labor can be more and more subdivided in proportion only as stock is previously more and more accumulated. The quantity of materials which the same number of people can work up increases in a great proportion. As labor comes to be more and more subdivided and as the operations of each workman are gradually reduced to a greater degree of simplicity, a variety of new machines comes to be invented for facilitating and abridging those operations. As the division of labor advances. Therefore, in order to give constant employment to an equal number of workmen, an equal stock of provisions and a greater stock of materials and tools than what would have been necessary in a ruder state of things must be accumulated. But the number of workmen in every branch of business generally increases with the division of labor in that branch, or rather, it is the increase of their number which enables them to class and subdivide themselves in this manner, as the accumulation of stock is previously necessary for carrying on this great improvement in the productive powers of labor, so that accumulation naturally leads to this improvement. 

The person who employs his stock in maintaining labor necessarily wishes to employ it in such a manner as to produce as great a quantity of work as possible and to furnish them with the best machines which he can either invent or afford to purchase. His abilities in both these respects are generally in proportion to the extent of his stock or to the number of people it can employ. The quantity of industry, therefore, not only increases in every country with the increase of the stock which employs it, but in consequence of that increase, the same quantity of industry produces a greater quantity of work. 

End of quote. And again, that was on page 277. That's why this is about division of stock. Where does the stock go? Well, it is divided among different activities. How is it decided? How it will be divided among different activities? The owner of stock is looking for ways to increase his return, and so he will invest it in those activities that are most profitable. 

32:12

Division of stock, then, is what enables and drives division of labor. It is prior, and so we have this problem. Where does that initial stock come? And Smith is not that concerned about it, because his concern is that it happens. Marx's concern is about the distributional consequences. 

32:34

Well, let's go on now and talk more about the substance of book two. To be clear, I'm not criticizing Smith. There's no way he could have known the correct answer, particularly in 1776. The reason to discuss this is that Marx should have known the answer by 1860 when he was writing Capital. Completely wrong, and we'll come back to this later. 

32:56

For now let's turn to Smith. Smith uses stock in a broad 18th century sense, closer to wealth held for future use than our narrower modern view of capital. For Smith, stock is the set of valuable assets I possess that need not be used immediately but that can be preserved for future use. You should think of it like seed corn, some of the product that was in excess from previous production but which was not consumed. So if you have to eat your seed corn, you've used up your capital, your source of income for the future. So a farmer every year has his harvest of corn and he saves and dries a quantity of corn sufficient to be able to plant next year's crop. However, that could also be sold. It also could be, if he's starving, consumed. If you are able to retain some of your stock and then use it in the future, that's going to be much more profitable. But it means that you need to have some sort of surplus, because you have more than you actually need. Many people don't have enough stock to live very long, and so they require a constant source of new supplies, which they can only acquire by selling their labor. Someone who can store and not use some current supplies can plan and invest, and then they wait for a delayed return on that investment. Now they'll expect a return on that investment not from their labor but from letting someone else use their stock while they don't have it. 

34:37

And in chapter six of book one we heard that Smith thought that interest, the return on capital. Those are very important, very legitimate returns. He is not saying that profit is not legitimate. To the contrary, profit is the legitimate return to capital or to stock People's expectation. They have to have a reason why they would forego consumption and it benefits the society that they do that. So both to them individually and to the society, there's a good, moral- and utilitarian also- reason why we would have substantial returns to capital. 

35:18

Now the idea of stock itself. The intellectual origins of it come from several sources. There's everyday commercial language. Merchants, farmers, craftsmen, all spoke of their stock, tools, provisions, inventory, goods on hand. Smith elevates this into an analytic category. And in Scottish moral philosophy, Francis Hutcheson, Gershom Carmichael had already linked property and the use of resources to human progress. Wealth is thus access to resources, not to money. If you had lots of resources but no cash, you'd be wealthy. If you had lots of cash but no access to resources, you'd be poor. And in David Hume's essays, especially Of Commerce and Of Money, which argue that treasure or species is not wealth in itself, but that real resources and industry, things that are produced, available for consumption, are what actually matter. In James Stewart's Principles of Political Economy in 1767, Stewart had used the word stock to analyze trade and production, even though he retained some mercantilist elements. 

36:26

Smith's book too can be seen partly as a corrective and rival to Stuart, but he uses Stewart's language of describing what we would call capital as stock. And in Smith's own lectures on jurisprudence, some of which date from the early 1760s, 15 years before the Wealth of Nations was published, Smith distinguished between stock reserved for immediate consumption and stock employed so as to yield a profit, which is an embryonic version of the later distinction we're finding in Book Two between fixed and circulating capital. Now it can be quite confusing, because capital is both liquid and solid and, as Marx showed, capital can also have a gaseous state. Smith systematized a concept that was in circulation, but he gave it a theoretical precision and a developmental significance that it had not had until Smith started writing about it. Now it's true that Smith's terminology is not identical to modern economics, but the distinctions that he made do anticipate later ideas of capital. 

37:31

So the general idea of stock is all resources beyond what is immediately consumed: money, tools, provisions, raw materials, machines, improvements, even acquired skills. Capital is a subset of stock. It's that portion of stock which is employed productively, that is, which is used to generate a profit or maintain productive laborers. Stock is used for immediate consumption, for fixed capital or circulating capital that is. Smith said that stock has three categories- what we use for immediate consumption, so all people, even the poorest workers, have stock. They just consume it all and for them; it's that first category and nothing else. Second category is fixed capital, and that is things that I have bought, tools where I have invested the saving from before. And fixed capital, then, is something that produces its own income without being sold, so a factory land, rental property, maybe furniture if I rent it out. And the third is circulating capital. Circulating capital includes money, wages, provisions, raw materials used up in the process of production, has to be continuously replenished. The first aspect of it is stock that's used for immediate consumption. Let's take that out, because that's more like food and clothing that I actually use up in a given period. 

39:02

The kind of stock or capital that Smith is worried about in book two is fixed and circulating. Fixed capital is durable investments, machines, building skills, each of which produce revenue on their own. Circulating capital includes money, wages, provisions, raw materials that are used up in the process of production that have to be continuously replenished. So capital is the dynamic profit seeking employment of stock. Stock becomes capital when it's advanced to labor or invested in production rather than merely consumed, and by advanced labor I mean paid out in wages. So I, as an employer, am paying out some of my stock in wages to workers in anticipation of getting a product produced that I'll be able to sell for more than I paid the workers. And again, this shows that Smith thought that profits and wage labor were entirely just, and, in fact, unless I expect some return from investing my circulating capital in workers, I'm not going to do it, which means that they won't be employed in the first place. That division allows him, Smith, to analyze the conditions under which growth is possible. 

40:17

The accumulation of capital requires the redirection of stock away from luxury consumption towards productive uses. How, though, is stock accumulated? Smith's explanation for that was parsimony, or saving. So parsimony is the great source of growth for Smith, while prodigality diminishes the funds that are available for employment. There's an old joke about the origin of copper wire. It was two Scotsmen and one penny, that is, they both grabbed so hard to the penny that they pulled it into copper wire. The point was that parsimony was particularly Scottish, and this is a joke. I should tell that Scots tell on themselves it's a particularly Scottish virtue, because the alternative is prodigality, constantly throwing pennies away. 

41:07

Now John Maynard Keynes inverted this idea that parsimony is what causes growth and prodigality is what limits growth. Keynes inverted this saving is the source of growth because for Keynes it was spending and consuming. Those are the sources of growth. That's the Keynesian model- the consumption, spending is what causes GDP. Keynes understood capital as liquidity and stock exchange, and so Keynes, as we'll talk about later, did understand something that Adam Smith had no way of understanding. The mechanism by which savings causes growth is that savings is the accumulation of capital. It makes labor more productive. Profits then add to that original stock, creating a self-reinforcing cycle. 

42:00

The implication is that capital accumulation explains why nations grow richer over time, not the possession of land or money. You can have a lot of land or money, but it's accumulating capital that causes growth. And this is actually the essence of the famous Solow growth model developed by Robert Solow in the 1950s. His claim was that capital accumulation machines, factories, infrastructure, labor, growth, size of the population, but most importantly, technological progress. So capital accumulation will get you only so far. What you need is technological progress. Smith didn't factor that in separately, but I would say that he thought technological progress was something that came along with capital accumulation, because the development of tools and the improvement in production processes was something that he thought was natural, just as a consequence of the propensity to truck barter and exchange. So Smith wouldn't have denied that third factor. So again, the three factors in the Solow growth model are capital accumulation, labor growth, and technological progress. Smith would certainly have agreed that technological progress was important, but he thought it was inherent in the commercial system. It is useful to think when we think about why capital is important. 

43:21

Consider something I've written about a number of times the parable of the spoon jobs. There was a famous story about the Chicago economist Milton Friedman. Stephen Moore told this story about Milton Friedman in the Wall Street Journal, quoting at the end of one of our dinners. Milton recalled traveling to an Asian country in the 1960s, visiting a work site where a new canal was being built. He was shocked to see that instead of modern tractors and earth movers, the workers had shovels. He asked why there were so few machines. The government bureaucrat explained oh well, oh, you don't understand. This is a jobs program. To which Milton said he replied oh, I thought you were trying to build a canal, if it's a story that was told by Stephen Moore that he claimed Milton Friedman had told. I'm not sure that's right. I expect that Friedman told it as a story that he had heard. In fact, a little digging reveals that essentially the same story is also told about a number of other people, and the supposed location of the incident ranges from China, India, Canada, or a rural part of the UK. Turns out and that's the little digging part that none of those is the actual origin of the story. As far as I can tell, it was first put in print in Philadelphia in the newspaper the Philadelphia Public Ledger in 1901. That version of the story goes like this An incident which struck me at the time as quite amusing occurred not long ago on North Broad Street. 

45:01

A steam shovel at work had attracted a large number of spectators, including two Irishmen who, judging by their appearance, were toilers temporarily out of employment, as the big shovel, at one lick scooped up a whole cartload of dirt and dumped it upon a gondola car. One of the Irishmen remarked oh, what a shame to think of them digging up dirt in that way. What do you mean, asked his companion. Well, said the other. That machine has taken the bread out of the mouths of a hundred laborers who could do the work with their picks and shovels. Ah right, you are, Barney, said the other fellow. Just then, a man who'd been looking on and had overheard the conversation remarked See here you fellows, if that digging would give work to a hundred men with shovels and picks, why not give a thousand men employment and just give them teaspoons with which to dig up the dirt? The Irishman, to their credit, saw the force of the remark and the humor of the situation and joined heartily in the laugh that followed. And one of them added I guess you're right, captain. The scoop's the thing after all, and again, as I said, that was in the Philadelphia Public Ledger in 1901. So there's a problem to note, and Smith recognized this, but I think he isn't often given enough credit for this. 

46:16

Prosperity and growth happen precisely because of the growth of the amount of capital over time that is combined with each worker's effort. One worker with a bulldozer can do as much as 250 workers with shovels, according to my research on Reddit, on any given day, but the worker who drives the bulldozer makes as much as 20 or 30 of those shovel workers. Is that exploitation? Having worked construction myself, I know that the skilled workers were what we all would have preferred to be. Working yourself with a shovel is not that great and it doesn't pay that well. The real payoff is cheaper products and buildings. So let me say those numbers again. You've got one guy with a bulldozer. He can do as much as 250 workers. He gets paid as much as 30 workers. Notice that. That's a big improvement in productivity. That's what brings prices down and that's what causes growth. That was Smith's recognition. 

47:12

Capital, the accumulation of capital and the combining of fixed capital with labor allows you to have an enormous increase in productivity. However, it will decrease the number of jobs, and the reason is you now need fewer workers to make a much larger amount of the stuff. Problem is accumulating enough capital that all the spoon jobs are converted into productive jobs. How does that happen? That's the question that Smith has to address in book two on capital. Where does the capital come from? Now I have an answer myself. That came from a recent conversation with Russ Roberts on EconTalk. 

47:49

For now, though, let's see what Smith had to say. He claimed that there were four ways to employ stock: agriculture, manufacturers, wholesale trade, or retail trade, and Smith established a kind of priority ranking. Capital and agriculture increase national wealth the most directly. Manufacturing and commerce also add real value. This is kind of a nod to the physiocrats whom Smith admired but critiqued. They thought that only labor employed in agriculture was the way to create wealth. Smith also thought that manufacturing and exchange were ways to create wealth. But he did think that the most important way for a nation to improve its output was to invest in agriculture and make the land more productive. 

48:35

There's also, as a category of capital, money. Now money is a kind of dead stock. According to Smith, hoarded money is sterile. If I have money and it's in a mayonnaise jar or I put it under my mattress, it isn't producing anything. Money is only productive when it's circulated to support productive labor. Smith has an interesting theory about banks and paper credit. Properly managed banks multiply the effect of capital by mobilizing idle money. Now, badly managed, they destabilize commerce. So banks are kind of a two-edged sword. They can make things much worse by expanding the effect of misuse of money. This anticipates modern discussions of credit and financial intermediation. We'll come back to this because Smith's insight is fundamental here. But Smith recognizes the importance of what might now be called fractional reserves and anticipates Walter Badgett's system of having some sort of lender of last resort. Anyway, the point is that movements by labor actually caused increased wealth if the society allows labor mobility, that is, workers will move around to where they can get the highest wages. Movement of productive labor creates vendable commodities, that is, commodities that can be sold, that add to the capital of society. 

50:00

Unproductive labor, as we talked about in book one, provides services, menial servants, court retainers, soldiers, in peacetime that do not reproduce capital. One of Smith's most debated claims, reflected in his interest in explaining why some employments of stock generate sustained growth and others do not, is that that stock is being invested or combined with productive or unproductive labor. The system itself, Smith says, will cause the movement from unproductive to productive labor if legal restrictions that prevent such movement are lifted. Why is that? And the answer is the wages will get higher in the jobs that are more productive. Interestingly, that means that as servants become more expensive, then the reason is that manufacturers' work have become more productive. It'll be harder and harder to hire servants that will naturally he doesn't say, and harder to hire servants that will naturally he doesn't say, as you know, by an invisible hand. But there's a kind of invisible hand mechanism operating here, that is, as manufacturing workers become more productive because their work is being combined with capital. Having servants will be more expensive, and that means that the unproductive part of the labor force of a society will grow less and less and the society will become more prosperous. That doesn't mean that the wages of servants are going to rise to the wages of manufacturing workers, but there's a sharp tendency upward. So the commodification of labor makes labor worth more, even if it does turn workers into brutes. 

51:34

Now Marx emphasized that the commodification of labor was harmful to workers because they're just doing repetitive tasks. But Marx also thought that wages of workers would always fall. That turns out to be not true, and that fact was the positive effect of the accumulation of capital. What Smith noted. This is on page 117 of back in book one of the Wealth of Nations that we talked about last week. But let's go back there for a minute. 

52:04

The wages of labor vary with the ease or hardship, cleanliness or dirtiness, the honorableness or dishonorableness of the employment. Thus, in most places take the year round a journeyman tailor earns less than a journeyman weaver. His work is much easier. Journeyman weaver earns less than a journeyman smith. His work is not always easier, but it's much cleaner. A journeyman blacksmith though an artificer seldom earns so much in 12 hours. As a collier, that is, someone who digs coal, who is only a laborer, does in eight. His that is, the blacksmith's work is not quite so dirty, is less dangerous and is carried on in daylight above ground, whereas the coal-digger obviously is underground. It's dangerous but he gets paid a lot more. 

Honor makes a great part of the reward of all honorable professions in In point of pecuniary gain. All things considered, they are generally undercompensated. Disgrace has the contrary effect. Trade of a butcher is a brutal and odious business, but it is in most places more profitable than the great part of common trades. The most detestable of all employments, that of public executioner, is, in proportion to the quantity of work done, better paid than any common trade whatever. So the point is that people will move among different professions and they'll do it in a way that may actually affect wages of those professions, because if the wages of two different jobs are the same but one is cleaner or easier, you'll end up having to pay more for the one that is less clean or more difficult in order to keep workers. 

53:36

Well, that's enough of an introduction. Point is that book two is not just a technical aside. It's the heart of Smith's explanation of how commercial society sustains growth. So Smith wrote book two is the analytic foundation for understanding the division of capital, the way that capital is allocated in a commercial society. So, within this larger project, book two explains why commercial society grows and why it is different from earlier, poorer forms of society. Because, remember, in the stadial theory commercial society is just seen as being more prosperous, more opulent. Book two is his explanation for why. 

Next week, on Tuesday, September 30, we’ll release the fifth episode, taking on the actual contents of Book II.  I’m looking forward to it!