Adam Smith's Wealth of Nations: Episode 5--The Text of Book II

This episode explores Book 2 of Adam Smith's Wealth of Nations, focusing on his revolutionary concept of the "division of stock" and how capital accumulation drives economic growth.

• Smith distinguishes between fixed capital (machines, buildings, land improvements) and circulating capital (money, goods in transit)
• Money is described as "the great wheel of circulation" – necessary but not productive in itself
• Banking allows society to economize on expensive metallic currency by substituting paper money
• Smith's concept of productive versus unproductive labor helps explain which activities increase national wealth
• The acquisition of skills represents "human capital" – a concept Smith pioneered centuries before Gary Becker
• Interest on loans is justified as compensation for the productive use of capital, though Smith supports moderate usury laws
• Smith identifies four employments of capital: agriculture (most beneficial), manufacturing, wholesale trade, and retail
• Smith criticizes mercantilism for privileging foreign trade over domestic production
• Division of stock and modern financial markets solve the "time travel problem" by allowing entrepreneurs to access capital without primitive accumulation

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 2: Division of Stock
• 12:08 Fixed vs. Circulating Capital Explained
• 23:57 Money as the Wheel of Circulation
• 33:44 Productive vs. Unproductive Labor
• 47:13 The Moral Case for Interest
• 1:01:19 The Four Employments of Capital
• 1:12:29 Solving the Time Travel Problem

Transcript

This is Mike Munger, the knower of important things from Duke University. This is Episode 5 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 takes up the actual text of Book 2 of the Wealth of Nations, which focuses on the division of stock, following Book 1's coverage of division of labor. It's some great stuff Straight out of Creedmoor. This is TAITC.. 

00:51

 Smith begins Book 2 with Chapter 1. And again the title of it is On the Division of Stock. That serves the conceptual foundation for everything he's going to say about capital accumulation and growth. And the core argument is that if restrictions on the movement and investment of capital are reduced, then capital will move organically to its highest valued social purpose. But you have to remove the restrictions that medieval society, that guilds, had placed on capital. Those investments would be different from what some central planner would have done, because each owner of capital is constantly looking for a more productive read profitable use of his capital. That produces levels of local information that could not be replicated by any centralized system. Over and over again Smith talks about this knowledge problem. 

The core argument of Chapter 1 is that stock, combining what we might today call capital and all the inventory, like a stockroom at a grocery store of a nation, can be divided into two broad categories. First, that portion that is reserved for immediate consumption and that portion that is employed so as to yield a profit or revenue, what we would now call capital proper. So Smith insists that the prosperity of nations depends critically on how much of the total stock is devoted to that second category- capital that is productively invested or saved rather than merely consumed. If we produce a lot of capital but consume it all, there will be no growth. The only way we can get growth is if we divert some capital from consumption into investment. Now there's an accounting identity that saving equals investment. But that's not the way that Smith thinks about it. Saving actually causes investment. Now, of course it's true that all investment had to be saved, but for Smith it's the act of saving itself, combined with the fact that people then look for the highest rate of return, that causes saving to become investment. It's not automatic. Quoting from page 279. 

There are two different ways in which a capital may be employed so as to yield a revenue or profit to its employer. First, it may be employed in a raising, manufacturing or purchasing goods and selling them again with a profit. The capital employed in this manner yields no revenue or profit to its employer while it either remains in his possession or in the same shape. The goods of the merchant yield him no revenue or profit till he sells them for money and the money yields him as little till it is again exchanged for good. His capital is continually going from him in one shape and returning to him in another, and it is only by means of such circulation or successive exchanges that it can yield him any profits. Such capitals, therefore, may very properly be called circulate. Secondly, the capital may be employed in the improvement of land, in the purchase of useful machines and instruments of trade or in such like things that yield a revenue or profit, without changing masters or circulating any further. Such capitals, therefore, may very properly be called fixed. 

End of quote. Smith then uses this distinction between stock and capital in a way that may seem awkward to us. For Smith, stock is the more general term. Capital is used more narrowly as what is being employed to produce further revenue. Then there's a further distinction between dead stock, hoarded wealth or consumption goods that do not generate more income, and active stock. The two kinds of stock that can be used to produce revenue were circulating capital and fixed capital. You'll find that just in that quote from page 279. 

Circulating capital is stock which is continually exchanged or moved in the process of production and distribution. It could include money used to facilitate exchange. It could be provisions in the hand of producers, merchants, things that we buy and sell. Smith has an interesting theory of exchange here and it's worth going into that in a little more depth. On page 284, Smith says, 

The farmer annually replaces to the manufacturer the provisions which he had consumed and the materials which he had wrought up the year before. The manufacturer replaces to the farmer the finished work which he had wasted and worn out at the same time. This is the real exchange that is annually made between those two orders of people, though it seldom happens that the rude produce of the one and the manufactured produce of the other are directly bartered, because it seldom happens that the farmer sells his corn and his cattle, his flax and his wool to the very same person of whom he chooses to purchase the clothes, furniture and instruments of trade which he wants. He sells, therefore, his rude produce for money with which he can purchase wherever it is to be had. The manufactured produce that he has occasion for, land even replaces, in part at least, the capitals with which fisheries and mines are cultivated. It is the produce of land which draws the fish from the water. It is the produce of the surface of the earth which extracts the minerals from its bowels. 

So that's really interesting. 

What Smith is noting is that things amount almost to barter, except that they're facilitated by having money as a means of making the exchange less costly. I don't have to get my goods directly from you. If I am selling something too, I can get my goods from somewhere else, but the money moves back and forth without creating any value. What creates the value is the goods themselves, however. Without money, it would be much more difficult and it might not happen at all, and so that's what Smith is thinking about when he talks about circulating capital. The confusing thing is that one example of circulating capital is money, but it can also be the goods and services that are being moved back and forth because they themselves do not produce value but are produced for exchange in value. 

The other kind of capital, the not circulating capital, is fixed capital. Fixed capital is stock that yields income without changing owners. Machines, instruments of trade that used to make things, buildings that assist production, improvements of land, drainage, irrigation and so on. You keep the land and it's just more productive and, interestingly, the acquired talents of individuals, what Smith strikingly calls the acquired and useful abilities of people. Now, this is actually an early recognition of human capital, and in fact, in chapter two of book two, on page 282, so this is page 282, Smith says of the acquired and useful abilities of all the inhabitants or members of the society, talking about fixed capital, 

The acquisition of such talents by the maintenance of the acquirer during his education, study or apprenticeship always costs a real expense, which is a capital fixed and realized, as it were, in his person. Those talents, as they make a part of his fortune, so do they likewise of that of the society to which he belongs. The improved dexterity of a workman may be considered in the same light as a machine or instrument of trade which facilitates and abridges labor and which, though it costs a certain expense, repays that expense with a profit. 

Well, that's really something. And in fact there was a conversation between Russ Roberts and Vernon Smith on EconTalk, where well, I'll just play it, but Russ Roberts said this this is maybe 15 or so years ago. 

[Russ Roberts] There was a symposium in honor of Gary Becker. At the end of it, Gary stood up and people asked him some questions. One of the questions they asked him was who are your biggest influences? And he said Adam Smith and Alfred Marshall. And I was kind of shocked by that. I was a student of Gary's and I would never have predicted those answers. 

09:08

So Adam Smith actually invented the idea of human capital in this chapter on the different uses of capital, and that's one of the things that led Gary Becker to formulate his theory of human capital. And, to Becker's credit, he actually gives Smith credit for that. So if you're surprised, it's because you haven't read that part of chapter two. I have to admit I hadn't, and so I was surprised that Smith was so explicit about it. 

Well, why does this first chapter, chapter one, come first? It establishes Smith's analytic framework for the rest of book two, before he can talk about accumulation of capital, which is chapter three- the difference between productive and unproductive employment of stock- also chapter three or the role of banks, credit, and money, which is chapters two and four. In chapter one, he has to make clear what stock is, how it's divided and how it functions. He establishes the meaning of stock and capital. The distinction between fixed and circulating capital in particular, but I want to emphasize this becomes central to his later discussion of economic growth and the role of investment. Only the portion of stock that's employed as capital leads to an extension of productive capacity. By placing this first, Smith also signals the shift of focus from book one, which was the division of labor and exchange in a commercial society, which is book two, the material foundations, the capital and stock on which the system depends. The division of stock determines how productive is the division of labor. So all the subsequent chapters money, banking, credit accumulation and productive versus unproductive labor rest on this classification. So this is part of Smith's ongoing inquiry into the sources of national wealth. Division of labor explains how productivity rises. Accumulation of capital explains how this process is sustained and enlarged over time, which of course is what growth means. So book two, chapter one, is the conceptual hinge between the theory of production, which was book one, and the theory of accumulation and growth, which is book two. 

Let's turn now to chapter two of book two. The title of it is Of Money Considered as a Particular Branch of the General Stock of the Society or of Expense of Maintaining National Capital. Smith is refining his analysis of money as a subpart of capital in book two generally examines the nature, accumulation and employment of stock. Chapter one distinguished between fixed and circulating capital. Chapter two, Smith identifies money as being a subpart of circulating capital. He wants to prevent a common confusion, treating money as if it were productive capital. He argues that money is only, but this is quite a bit, but it is only a means of circulation. It is not a productive source of wealth in itself. Its value lies in facilitating the exchange of goods and services. Obviously, on this podcast, what it does is reduce the transaction cost of exchange. So he uses this chapter two to show that a nation's wealth does not consist in its quantity of gold and silver but its productive resources and labor. 

However, the amount of money, the ability to exchange things for money, is an important part of what causes the ability for resources and labor to be productive. So the main argument of the chapter is money is not the same as capital. Capital is the tools, buildings, machinery, provision of raw materials. Money does not feed or house people. It is a medium of exchange, what Smith calls the great wheel of circulation. But the wheel itself is not productive. It's like a lazy Susan in a restaurant; it moves things around, but it's not not productive. So, on the nature of money, money's not productive. It's a tool to facilitate exchange, it belongs to circulating capital, but it doesn't maintain productive labor directly. It is not because wealth consists more essentially in money than in goods. 

Smith said that money is more eagerly demanded than goods, but because it is more useful for the purchase of goods. Later, on page 438, and this is in book four Smith talks about this problem of wealth being money and gold, wealth being money and gold. So page 438, 

It would be too ridiculous to go about seriously to prove that wealth does not consist in money or in gold and silver, but in what money purchases and is valuable only for purchasing. Money no doubt makes always a part of the national capital, but it has already been shown that it generally makes but a small part, and always the most unprofitable part of it. It is not because wealth consists more essentially than in money than in goods that the merchant finds it generally more easy to buy goods with money than to buy money with goods, but because money is the known and established instrument of commerce for which everything is readily given to exchange, but which is not always with equal readiness to be got in exchange for everything. 

So pause the quote for a moment. He recognizes that there's a demand for cash, that is, I have a desire for certain cash balances, and if I don't have enough, I can sell goods because I want to use them to buy money. We don't usually think of it that way, so it's a very sophisticated way. But monetary theorists talk about it this way all the time. But that's a very sophisticated way of talking about it for that period. So back to the quote. 

The greater part of goods, besides, are more perishable than money, and he may frequently sustain a much greater loss by keeping the goods instead of the money. When his goods are upon hand too, he's more liable to such demands for money, as he may not be able to answer, than when he has got their price in his coffers. Over and above all this, his profit arises more directly from selling than from buying, and he is, upon all these accounts, generally much more anxious to exchange his goods for money than his money for goods. But though a particular merchant with abundance of goods in his warehouse may sometimes be ruined by not being able to sell them in time, a nation or country is not liable to the same accident. The whole capital of a merchant frequently consists in perishable goods destined for purchasing money. But it is but a very small part of the annual land and labor of a country which can never be destined for purchasing gold and silver from their neighbors. 

So there's no point for a country to have to sell off all of their stuff in order to get gold and silver, whereas a merchant may have to. 

The point is that Smith thinks of having and maintaining a monetary system as a kind of public good or a background condition that facilitates exchange, maybe something like a road system. A road system is not immediately itself productive, but it allows an increase in productivity. Smith talks about the expense of maintaining money. A society must devote labor and resources to the extraction of precious metals, minting and maintaining coin. This is an expense of maintaining its capital stock. But unlike productive investments, this expense itself yields no direct return. This expense itself yields no direct return. Smith compares it to the upkeep of highways, necessary but not itself a productive outlay he talks about, he praises the substitution of paper money or banknotes, and by banknotes he means private banknotes. 

Paper money and banking is a solution to this problem of making the national expense of maintaining a system of gold and silver, so he believes. Smith believes that paper serves the same function as coin, but at a far lower cost to society. More of the nation's real resources can remain in productive use instead of being locked up in gold and silverplate where they actually accomplish nothing. So allowing the banking system to produce banknotes is beneficial if it substitutes paper for metallic currency prudently. Now it seems like fraud, but it's really a kind of brokerage. It economizes on the need for currency which is expensive to maintain. Now, of course, gold and silver you're going to use to buy things from other countries, and so this is exactly the inverse of the mercantilist suggestion intuition. Smith thinks that all of your domestic transactions should be done using paper money, close enough to the bank that issued the note that you can trust it, and all of your gold and silver ought to be employed with buying things from abroad. So you're going to send all your gold and silver abroad, and the reason is that you get stuff for it. So we'll come back to this in a minute. 

Smith implicitly then rebuts mercantilist ideas that equated wealth with having your own stores of precious metals. He stresses that the abundance or scarcity of money is not the measure of a nation's wealth. So a nation, the Netherlands especially, or Holland, could be very rich with very little metallic money if circulation is well managed, or they could be very poor, like Spain, which had an abundance of gold and silver and almost no ability to acquire the things that gold and silver could buy because they wouldn't spend it. Why are the things that gold and silver could buy? Because they wouldn't spend it. Smith offers a classical account of what money does, and that's a medium of exchange, a measure of value and an instrument of circulation. But he thinks of that function like a road or having a system of wagons. It helps goods move but doesn't add to the value itself, and so it's tricky to wonder how we should think about money Smith spends. He realizes it's tricky and he spends a lot of time trying to describe this. 

Most important though, unlike productive capital, money produces nothing. It is not a source of wealth. Wealth arises from labor, land and productive capital. Those are Smith's, as we saw in book one. Those are the three productive factors for Smith- land, labor, and productive capital, not from holding coin. Money is, for Smith, a wheel of circulation. So Smith talks about this on page 289. And again, this really does seem to me a lazy Susan at a restaurant where you've got a number of dishes and we move them around. On the lazy Susan. It doesn't increase the amount of food, but it makes it easier for each of the diners to get access to the food. So Smith calls money necessary to the great wheel of circulation. Here's what he says on page 289. 

As the machines and instrument of trade which compose the fixed capital either of an individual or of a society, make no part either of the gross or the neat we would say net revenue of either. So money, by which the whole revenue of the society is regularly distributed among all its different members, makes itself no part of that revenue. The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods and not in the wheel which circulates them. In computing either the gross or the neat revenue of any society, we must always, from their whole annual circulation of money and goods, deduct the whole value of money, of which not a single farthing can ever make this proposition appear either doubtful or paradoxical. When properly explained and understood, it is almost self-evident. 

Well, Smith may think that it's obvious once it's explained, but he explained it pretty clearly and most people still understand it. There's a famous economist joke that I've always thought was just stupid. But a lot of economist jokes are pretty stupid, but the joke, in brief, brief version, goes like this: Two economists were shipwrecked on a desert island. Over the next 20 years they made $124 million selling their hats to each other. So they were just bartering their hats with each other, but each time, let's say, they charged each other $10,000. So $10,000 goes back and forth all those times. That's $124 million. Smith would have found that absurd. The money going back and forth counts for nothing. But to be fair, that is now how we define GDP. Under Keynesian rules it's spending. GDP is denominated in dollars because it's hard to know how else it could be denominated other than in value. But if all we're doing is moving money back and forth, we're not having any net increase in value or, for that matter, production. 

22:13

Well, in this chapter Smith is trying to clarify the role of money, to highlight the cost of maintaining a monetary system and to lay the groundwork for his discussion of, specifically of banking and credit. So the later sections in chapter two, which anticipate some of the modern debates on money supply and financial intermediation, are really quite interesting. As Smith puts it, the substitution of paper in the room of gold and silver money replaces a very expensive instrument of commerce with one much less costly and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one. But in what manner this operation is performed, and in what manner it tends to increase either the gross or the neat revenue of the society, is not altogether so obvious and may therefore require some explication. Smith goes on on page 292. 

Still, a particular banker lends among his customers his own promissory notes to the extent, we shall suppose, of a hundred thousand pounds. As these notes serve all the purposes of money, his debtors pay him the same interest as if he had lent them so much money. This interest is the source of his gain. Though some of these notes are continually coming back upon him for payment, part of them continues to circulate for months and years together, though he is generally in circulation. Therefore, notes to the extent of a hundred thousand pounds, twenty thousand pounds in gold and silver, may frequently be a sufficient provision for answering occasional demands. By this operation, therefore, twenty thousand pounds in gold and silver perform all the functions which a hundred thousand could otherwise have performed. The same exchanges may be made, the same quantities of consumable goods may be circulated and distributed to their proper customers by means of his promissory notes to the value of a hundred thousand pounds as by an equal value of gold and silver money. Eighty thousand pounds of gold and silver, therefore, can in this manner be spared from the circulation of the country, and if different operations of the same kind should at the same time be carried on by many different banks and bankers, the whole circulation which may thus be conducted with a fifth part only of the gold and silver which would otherwise have been requisite. 

Let us suppose, for example, that the whole circulating money of some particular country amounted at a particular time to one million sterling, that sum being then sufficient for circulating the whole annual produce of their land and labor. Let us suppose, too, that, sometime thereafter, different banks and bankers issued promissory notes payable to the bearer to the extent of one million, reserving in their different coffers two hundred thousand pounds, answering occasional demands. There would remain, therefore, in circulation eight hundred thousand pounds of gold and silver and a million of banknotes, or eighteen hundred thousand pounds of paper and money together, but the annual produce of the land and labor of the country had before required only one million to circulate and distribute to its proper consumers. That annual produce cannot be immediately augmented by those operations of banking. One million, therefore, will be sufficient to circulate it. After them, the goods to be bought and sold being precisely the same as before, the same quantity of money will be sufficient for buying and selling them. 

The channel of circulation, if I may be allowed such an expression, will remain precisely the same as before. One million, we have supposed sufficient to fill that channel. One million eight hundred thousand pounds are poured into it. Eight hundred thousand pounds, therefore, must overflow, that sum being over and above what can be employed in the circulation of the country. But though this sum cannot be employed at home, it is too valuable to be allowed to lie idle. It will therefore be sent abroad in order to seek that profitable employment which it cannot find at home. But the paper cannot go abroad because, at a distance from the banks which issue it and from the country in which payments of it can be exacted by law, it will not be received in common payments. Gold and silver, therefore, to the amount of 800,000 pounds, will be sent abroad, and the channel of home circulation will remain filled with a million of paper instead of those million of metals that can now be sent abroad. Well, I apologize for the long quote, but that's really something Smith is saying that what we should do is use paper money at home and send all our gold and silver abroad. It's exactly the opposite of the mercantilist claim. 

The analogy that Smith makes, then, is that maintaining a circulation of species is like maintaining a standard army or a standing army or a road system, an expense you actually want to minimize if you can. Smith treats it as a drain on the national capital, since money could otherwise be replaced by productive stock. On page 320, he says, 

It is not by augmenting the capital of the country, but by rendering it a greater part of that capital active and productive that would otherwise be so that the most judicious operations of banking can increase the industry of the country. That part of his capital, which a dealer is obliged to keep by him unemployed and in ready money for occasional demands, is so much dead stock which, so long as it remains in this situation, produces nothing either to him or to his country. The judicious operations of banking enable him to convert this dead stock into active and productive stock, into materials to work upon, into tools to work with and into provisions and subsistence to work for, into stock which produces something both to himself and to his country. The gold and silver money which circulates in any country, by means of which the produce of its land and labor is annually circulated and distributed to the proper consumers, is, in the same manner as the ready money of the dealer, all dead stock. 

Smith has discovered why banking is important. One of the reasons that a few countries but England and the Netherlands in particular, managed to operate with much lower interest rates and much lower, in effect, total money supplies was that, instead of a business person having to store a large amount of money in case there was some demand for him to pay a debt or to be able to buy something he had promised to purchase, they could have a line of credit, and that line of credit didn't actually operate, didn't actually charge interest until and unless they had occasion. So I have occasional need for money. Rather than having always to keep a stock of money, I can have a line of credit that I only use and that I only pay for in those instances when I actually need it, and that's what banks can do. Smith actually recognized that banks are a kind of brokerage service and most of the time, most people don't need to draw on that line of credit. Now, if everyone has to draw on the line of credit all at the same time, there will be a run on the bank. So there is a potential problem. But during normal business this is a much cheaper way of operating and it means that you can operate on a much lower margin and you can make much higher profits. Consequently, private banking and credit systems allow nations to reduce this dead stock of a money supply burden, freeing up capital for productive uses. 

29:47

And this brings me, as I said, I promised I'll get back to Smith, but first I want to talk about Walter Bagehot, badgett's principle. Bagehot was a financier, a philosopher. He was really quite an important, interesting person during the 19th century. He died at the age of 51, sort of tragic. But his advice was that what was needed was some sort of lender of last resort, and for him this was we would call it a central bank. Now it was more like a national bank for Bagehot, and Bagehot is B-A-G-E-H-O-T. I've heard a lot of pronunciations, but as far as I can tell, the correct pronunciation is “Badgett” and it's Walter Bagehot, and he wanted there to be a national bank that was a lender of last resort, and what that meant was that the bank needed to be able to lend freely and literally without limit to solvent financial institutions during a panic, using good collateral, but at a penalty rate of interest. So let me say those parts again: Lend freely and without limit, first. Second, to solvent financial institutions. Third, using good collateral, fourth, at a penalty rate of interest. So what that means is they stood ready to. 

If there was a run on a bank and everybody wanted to draw their line of credit or withdraw their deposits at the same time, the bank wouldn't have enough cash to do that. But if you think of all these deposits as assets, if you think of all the paper that the bank has issued as loans that will, over time, be paid back, the bank is solvent, they have assets to cover all of these. They just don't have the cash to cover them immediately, and so the central bank says we will give you the cash you need to get through this run. The interest rate is really high, but the point is that this means that, as long as the bank is solvent, it doesn't matter if there's a run on the bank, because that will be made up from this central source of funds and in equilibrium, knowing that means there won't be any bank runs. So it's an interesting kind of game theory. 

Walter Bagehot saw if there was some credible commitment to bail out solvent banks, then there would never be bank runs. Problem is that it's very difficult not to have a commitment to bail out insolvent banks. Suppose that the bank has made a bunch of loans they're not going to be paid back. These other companies are bankrupt, these other counterparties are bankrupt. You have to not bail out insolvent banks, and that's a problem that we saw in 2008 and 2009, where the US bailed out insolvent financial institutions. But Bagehot recognized, and is an extension of the logic that Smith had first described in his discussion of the importance of the banking system in Book Two, chapter Two. 

The short English version of this is that money is a kind of standing army and the central bank is a strategic reserve, a force multiplier. You don't have to have all of your forces defending everywhere at once along the line, so long as you're defending interior angles. If you have a strategic reserve, if there's an attack anywhere along the line, you can send your strategic reserve there and it's as if, since you are countering the attack with a strategic reserve, you have numeric superiority and they'll back off. It's likely to mean you won't be attacked at all. You don't need to keep all the currency that is deposited as long as there's a sufficient reserve maintained. If people know they can withdraw their money, they won't want to. If they know they can withdraw their money, they won't want to, and the system is stable. 

33:37

Let's turn now to Book 2, chapter 3, of the accumulation of capital or of productive and unproductive labor. Now here Smith develops one of the most influential distinctions in his political economy- the difference between productive and unproductive labor. His aim is to explain how societies grow wealth by accumulating capital. We already talked about the distinction between productive and unproductive labor in book one. What's important here is that only productive capital can produce anything from which saving is possible, and saving, or what Smith calls parsimony, is the source of capital. So chapter three addresses both where capital comes from, which is savings and frugality, and what uses of labor contribute to this growth Productive labor versus those that consume without producing wealth, which is unproductive labor. 

So for Smith, productive labor is labor that's fixed and realized in a particular subject, or vendable commodity, in modern terms, work that produces tangible, marketable goods that can endure and be exchanged. So a manufacturer, a farmer, a miner, their output adds to the stock of capital. Unproductive labor, as you'll recall from book one, is labor that perishes in the act of performance, leaving nothing to sell or accumulate as future stock. Servants, the sovereign, all the officers, both of justice and war, churchmen, lawyers, musicians, actors, they may be useful, honorable, even necessary, but their output does not add to reproducible wealth. So the distinction is not moral but economic. He's not saying that unproductive labor is wasteful, it's just that unproductive labor does not increase the stock of the society. So again, this is different from [John Maynard] Keynes who saw spending creating wealth. 

In fairness, Smith may well have had one eye on the feudal system of the Scottish Highlands, the Gowkini [?], the local rulers and their retainers and taxmen. You could. If you went to one of the Scottish Highland lairds, you'll see that the clan chief's power and prestige was judged by the number of big, strong dudes lying around the main house doing nothing. That, by the number of big, strong dudes lying around the main house doing nothing, that was the sign of power. But power is not the same as wealth. In that system wealth by definition was static and the source of income was land, and it was worked by what we'd call serfs, who were at best like sharecroppers and had no real reason to try to improve the land. In other words, then, labor produces goods, but only saving, and investment of saving, can transform those goods into an enduring capital stock. 

Now, the reason this matters for economic growth, for Smith, is that the accumulation of capital is what allows a nation to sustain an expanding number of productive workers. Having an expanded number of unproductive workers is not growth. A society's wealth grows not simply by working harder, but by ensuring that more labor is employed productively and maintained by capital derived from saving. When savings are high, more productive workers are supported, capital expands and wealth grows. When luxury consumption and prodigality dominate, even if everyone's working very hard, more unproductive labor is maintained, capital contracts and growth stagnates. So, for Smith, the composition of labor in a society and the proportion of revenue devoted to saving versus spending determines long-term growth. 

Remember, though, he's already said something important, and that is as capital starts to accumulate, the wages of workers in productive labor start to go up, which means that workers will start to move from unproductive to productive activities, not because the society says they should, but because their own self-interest will lead them to do that. That's a really important point. This happens automatically unless and this is important the government has rules that says they can't. And of course that's exactly what was going on in the Scottish Highlands. People were tied to the land. In any feudal system serfs are tied to the land. They can't move to more productive labor and in a guild system you can't go to a new city and start to work. So restrictions on the movement of labor are a way to prevent the accumulation of capital is Smith's insight. So the role of this chapter in book two is to link Smith's general concern with stock and its employment. So overall, book two asks how is stock accumulated and how is it best used. 

Chapter three provides the moral of Smith's story: Wealth depends not just on production but the redirection of resources from consumption into accumulation, that's, saving, and the redirection of labor from unproductive into productive employments. He mentions explicitly the role of sovereigns and unproductive hands/productive employments. He mentions explicitly the role of sovereigns and unproductive hands and says that sovereign officers, officers of justice, soldiers, churchmen, servants are also unproductive. Their labor may be necessary, but well, what he says is the sovereign, for example, with all the officers both of justice and war who serve under him, the whole army and navy are unproductive laborers. They are the servants of the public. Now, that's not a bad thing, but you would like to have fewer of those people if you want more growth and what that means. In modern terms and I'm looking at you, Franklin Delano Roosevelt people that are employed to work for the government for the most part do not add to the productive capital stock of the society. So making up shortfalls in private employment by increasing public employment, Smith would have said it's going to depend what they're doing. Employment itself is not enough if that employment is unproductive. It's interesting to read this on page 330. Smith is pretty fierce about this, page 330. 

The labor of some of the most respectable orders in the society is like that of menial servants, unproductive of any value and does not fix itself in any permanent subject or vendible commodity which endures after that labor is passed and for which an equal quantity of labor could afterwards be procured. The sovereign, for example, with all the officers both of justice and war who serve under him, the whole army and navy, are unproductive laborers. They are the servants of the public and are maintained by a part of the annual produce of the industry of other people. Their service, how honorable, how useful or how necessary soever, produces nothing for which an equal quantity of service can afterwards be procured. The protection, security and defense of the commonwealth, the effect of their labor this year will not purchase its protection, security and defense for the year to come. In the same class must be ranked some both of the most grave and most important and some of the most frivolous professions. Churchmen, lawyers, physicians, men of letters of all kinds, players, buffoons, musicians, opera singers, opera dancers, and so on. 

Pause the quote for a moment. I think it's hilarious that he groups all those together, not clear what the distinction is. Some may be in multiple categories, that they may be both grave and frivolous. Back to the quote. 

The labor of the meanest of these has a certain value, regulated by the very same principles which regulate that of every other sort of labor, that is, supply and demand and wages. And that of the noblest and most useful produces nothing which could afterwards purchase or procure an equal quantity of labor. Like the declamation of the actor, the harangue of the orator or the tune of the musician, the work of all of them perishes in the very instant of its production. 

End of quote. 

41:40

This was in a slightly different fashion, something that concerned Douglass North and the national income and product accounts people a lot. Simon Kuznets had tried to define productive economic activity and Douglass North was very interested in measuring the size of what he called the transaction cost sector. So is this actual production or does it enable production? Now, enabling production is important but it's not production. Should we account expense on law enforcement? Smith might have said no, it's essential, but not productive. We've gone in the Keynesian direction of measuring spending, not production. That may be good or bad, there's arguments for it. I just want to say that it is interesting that Smith and Douglass North agreed that we might separate the productive and non-productive sectors. So, while luxury consumption may benefit some trades, only saving leads to durable wealth accumulation. 

The frugal individual, without intending it, promotes the national interest. The prodigal person, on the other hand, harms not only himself but the entire society by reducing the available stock. So, as often true with Smith, there's a kind of virtue ethics underlying this. The way people are moved to act also harms or benefits the society. If the institutions are good, people act to benefit the society and we react with approval. If we see prodigality, we disapprove, and that means that our sentiments will reinforce those activities that benefit or harm society. 

Smith's discussion of this is great. It's on pages 339 and 340. On page 339, Smith says that the prodigal perverts his wealth. 

By not confining his expense within his income, he encroaches upon his capital. Like him who perverts the revenues of some pious foundation to profane purposes, he, the prodigal, pays the wages of idleness with those funds which the frugality of his forefathers had, as it were, consecrated to the maintenance of industry. By diminishing the funds destined for the employment of productive labor, the prodigal necessarily diminishes, so far as it depends upon him, the quantity of that labor which adds of value to the subject upon which it is bestowed and consequently the value of the annual produce of the land and labor of the whole country, the real wealth and revenue of its inhabitants. If this prodigality of some was not compensated by the frugality of others, the conduct of every prodigal, by feeding the idol with the bread of the industrious, tends not only to beggar himself but to impoverish his country. 

Pause quote when he says to feed the idol, he doesn't mean the poor, he means the rich. He means the rich are the ones. The rich prodigals are the ones that are feeding the idle. They're using up their capital. And then, on page 340, Smith goes on. 

Whatever, therefore, we may imagine the real wealth and revenue of a country to consist in whether in the value of the annual produce of its land and labor, as plainly seems to dictate, or in the quantity of the precious metals which circulate within it, as vulgar prejudices suppose. In either view of the matter, every prodigal appears to be a public enemy and every frugal man a public benefactor. 

The effects of misconduct are often the same as those of prodigality. Every injudicious and unsuccessful project in agriculture, mines, fisheries, trades or manufacturers tends, in the same manner, to diminish the funds destined for the maintenance of productive labor. In every such project, though, the capital is consumed by productive hands only, yet, as by the injudicious manner in which they are employed, they do not reproduce the full value of their consumption, there must always be some diminution of what would otherwise have been the productive funds of the society. 

Close quote. That's pretty amazing. So he starts out by talking about how the productive use of capital increases the stock of the society. That's good, we approve. And people who exhibit parsimony and frugality, we admire them. Now there are some people who are profligate, and these prodigals will end up wasting the funds of the society and we disapprove. Now there are some otherwise productive people that are trying to make good investments but they fail. They do it injudiciously, they lose as a result and we disapprove of them too. So if you go bankrupt, even if you're trying to invest in something that is productive, we still disapprove. That is something that is morally wrong because you have wasted not just your own resources but the resources that actually are the way that society finds the increase in capital for the next generation. 

46:42

Well now chapter four of book two, Of Stock Lent at Interest, Smith turns to the question of capital lent at interest, which was a controversial topic because of the long theological and moral tradition condemning usury. In medieval and early modern Europe, charging interest was seen as sinful because money itself was thought to be sterile following Aristotle and Aquinas and of course taken up by [Karl] Marx. Yet by the 18th century, lending at interest was central to commercial society. So Smith's task here is not just to explain economics but to defend interest as a natural and justifiable payment morally, while distinguishing it from exploitative usury. He did think that was possible. 

So the main arguments in chapter four are that interest is a payment for the use of the stock of capital. He's pointing out that stock is employed in a way that generates profit. So if I use it myself, I earn the ordinary profits of stock. If, instead, I lend out my stock to another person, I forego not just the use of that stock but the profit that it would have earned. Interest is thus the compensation for the lender's forbearance. I've lost the use of my stock and I've lost the return that I could have earned from using that stock because I would have used it as productive capital. Lending out stock at interest, Smith would argue, does not diminish total productive capital in the society. It merely transfers the use of that capital from one person to another, and presumably it transfers it from a person who has a less valued use to someone else who has a higher valued use. Let's see what he says about this. I'm going to quote from page 350, which is the very beginning of chapter 4. 

As a capital or as a stock reserved for immediate consumption? If he uses it as a capital, he employs it in the maintenance of productive laborers who reproduce the value with a profit. He can in this case both restore the capital and pay the interest without alienating or encroaching upon any other source of revenue. If he uses it as a stock reserved for immediate consumption, he acts the part of a prodigal and dissipates in the maintenance of the idol what was destined for the support of the industrious. He can, in this case, neither restore the capital nor pay the interest without either alienating or encroaching upon some other source of revenue, such as the property or the rent of land. 

The stock which is lent at interest is no doubt occasionally employed in both these ways, but in the former much more frequently than in the latter. The man who borrows in order to spend will soon be ruined, and he who lends to him will generally have occasion to repent of his folly. To borrow or to lend for such a purpose, therefore, is, in all cases where gross usury is out of the question, contrary to the interest of both parties, and though it no doubt happens sometimes that people do both the one and the other. Yet, from the regard that all men have for their own interest, we may be assured that it cannot happen so frequently as we are sometimes apt to imagine. Ask any rich man of common prejudice to which of the two sorts of people he has lent the greater part of his stock to those who he thinks will employ it profitably or to those who will spend it idly, and he will laugh at you for proposing the question. 

Even among borrowers, therefore not the people in the world most famous for frugality, the number of the frugal and industrious surpasses considerably that of the prodigal and idle. The only people to whom stock is commonly lent without there being expected to make any very profitable use of it are country gentlemen who borrow upon mortgage. Even they scarce ever borrow merely to spend. What they borrow, one might say, is commonly spent. Before they borrow it. They have generally consumed so great a quantity of goods advanced to them upon credit by shopkeepers and tradesmen they find it necessary to borrow an interest in order to pay the debt. The capital borrowed replaces the capital of those shopkeepers and tradesmen which the country gentlemen could not have replaced from the rent of their estates. It is not properly borrowed in order to be spent, but in order to replace a capital which had been spent before. 

End of quote. 

51:18

So you can see here what Smith's argument about usury is. As long as interest rates are relatively low, I will only loan capital to someone who is going to invest it in a productive fashion. If I'm allowed to loan capital at very, very high rates of interest, then I may be loaning it to prodigals, and prodigals are less likely to repay. That's the reason that the interest is so high is that it encompasses the risk of not being repaid. But we don't want those loans made in the first place being repaid. But we don't want those loans made in the first place, and so allowing borrowing at interest is good for the society. But Smith thinks there should be a limit on the interest rate that can be charged, because if you can charge very high rates of interest, you'll start to extend your loans to people who actually have no business borrowing. It are going to waste the resources of the society. But overall, the justification for interest lies in the idea that capital, just like land or houses and Smith's very explicit about this is productive. 

A borrower uses the money as capital to set up trade, improve land, purchase materials and thus earns a profit. That profit will allow the borrower to pay back the capital that was loaned as well as the interest that is charged, and to have something left over, because the presumption is that the money went from a lower to higher valued use. The lender, having supplied the capital, is then justly entitled to a share of that return. Denying interest would be like denying property rights in capital. And this takes us back to book one, chapter six, where Smith talks about the legitimacy of profit. So on page 69, 

Whoever derives his revenue from a fund which is his own must draw it either from his labor, from his stock or from his land. The revenue derived from labor is called wages. That derived from stock, by the person who manages or employs it, is called profit. That derived from it by the person who does not employ it himself but lends it to another, is called the interest or use of money. It is the compensation which the borrower pays to the lender for the profit which he has an opportunity of making by the use of that money. Part of the profit naturally belongs to the borrower, who runs the risk and takes the trouble of employing it, but also part to the lender who affords him the opportunity of making this profit. The interest of money is always a derivative revenue which it is not paid from. The profit which is made by the use of the money must be paid from some other source of revenue, unless perhaps the borrower is a spendthrift who contracts a second debt in order to pay the interest of the first. 

So Smith insists there's no real moral difference between rent for land or rent for stock. 

Now he does acknowledge the longstanding hostility toward usury, but reframes the debate. The key is not whether interest is paid, but what rate of interest is reasonable. Too high a rate encourages reckless speculation and drives out the prudent borrowers. Too low a rate suppresses some useful lending out the prudent borrowers. Too low a rate suppresses some useful lending. Thus Smith supports moderate legal limits on interest rates, pegged slightly above the lowest ordinary market rate of interest. That means that lending remains available to the sober people who are likely to make a safe and profitable use of it. 

54:48

Who does this protect? Interestingly, he's not trying to protect the borrower or the prodigal. He doesn't care about exploitation or what we would now call predatory lending. He doesn't care at all about that. He doesn't like those people. What he cares about is the society and the stock of stock. Bad borrowers have to be blocked from borrowing to protect the society, to make sure that money is used only for productive purposes, and a ceiling on interest rates. For Smith will do that, because no one will lend to prodigals at low rate, you get a sorting where only the justifiable projects are going to be funded. 

It may be useful to think a little bit about the historical context. Smith's discussion also reflects on what he understands as the history. He notes that ancient religious prohibitions on usury were misguided, but like many traditions, they may be prudent in the sense that some regulation is justified. Unlike land or houses, stock is mobile and can easily be squandered. Thus society has a collective interest in discouraging reckless borrowing and lending because it dissipates the stock of the entire society. Now, whether that's actually true in a modern society is hard to say, but Smith lived at a time when the accumulation of stock was just beginning, and so being concerned about dissipating it made a lot more sense. 

He justifies interest despite usury's bad moral reputation, because his claim is that interest is not making money from money, because, remember, money is not productive. Interest is compensation for the productive use of stock and that just means that I've saved. I could invest it in capital. It happens to be in liquid form when I loan it to you, but what I'm giving up is the physical it in capital. It happens to be in liquid form when I loan it to you. But what I'm giving up is the physical form of capital. And he makes an analogy to rent. Just as land or housing naturally yields rent to the owner, capital naturally yields interest to its lender and property rights. The lender has a right to the return he could have earned by employing the stock himself. So if we say that if you're going to loan something out, you lose that property, right, that seems like an odd policy. 

So while usury laws condemning all interests are unjust and in fact economically unwise, Smith thought that the modest regulation of rates serves a public or collective interest by protecting prudent borrowers and deterring excessive risk-taking. And we have seen some of the societal consequences of excessive risk-taking, because the public has to bail out people who were not profligate have to bail out the profligates, and so there might be some reason to restrict the ability of profligates to destroy the capital stock. Notice, this really is quite different from the modern justification. The modern justification is almost always the worry about predatory lending, an asymmetry of power. That's not Smith's concern at all. He thinks the profligates get whatever bad things have coming to them. What he's worried about is the spillover or externality effects on the larger society. Optimizing interest, he integrates credit markets into his theory of capital accumulation. Lending at interest, then, is a mechanism for channeling stock from those who can't or won't employ it productively to those who can, thus promoting the nation's wealth. So Smith thinks that interest is a fair and natural rent on capital, analogous to rent on land. Far from being immoral, usury is a necessary institution of commercial society, though it should be regulated to protect the society itself. 

58:39

Well now Chapter 5. Title of Chapter 5 is Of the Different Employment of Capitals. Remember that this entire book is about division of capital, just as Book 1 was about division of labor. Smith believes that capital will find its own highest valued and that's, from a social perspective, the socially highest valued use if we can limit friction, false information and the distortions that are introduced by government policy that try to keep capital in inefficient uses. So chapter five is the culmination of book two, where Smith has defined stock, its division into fixed and circulating forms, and how it supports production. 

In chapter five he asks how is capital employed in a commercial society, what are the different ways capital can be used and what are the consequences for a nation's wealth? His core aim is to show that not all employments of capital are equally beneficial to the society. Each individual seeks the best return. The aggregate effect on the annual produce of the land and labor differs depending on whether capital is directed toward agriculture, manufacture, domestic trade or foreign trade. We talked before about the four great employments of capital. Agriculture is the best. So Smith is giving a nod here to the physiocrats who thought that agriculture was the only long-run productive use of capital. Smith doesn't believe that, but he thinks improving the land is the best for making the country strong. 

01:00:16

Second is manufacturers supporting productive labor that turns raw materials into finished goods that are then purchased and used by other people. Third is the wholesale trade, both domestic and foreign, which is buying goods to sell again at a profit. Now, you're not changing those goods. You buy the goods to sell again at a profit. Now, you're not changing those goods. You buy the goods to sell them at a higher price. There's the home trade, the foreign trade and the carrying trade of moving goods between different countries. And then the least great employment of capital is just the retail trade buying in small quantities and selling at a higher price in smaller quantities to consumers. Now, those are necessary, but that last thing is not what most of your capital should be involved in, because all that's really doing is the last mile problem. You're delivering all those goods to the people who are going to consume them, but it's not in and of itself productive. You want to make that as efficient as possible so you can spend all of your capital everywhere else. 

This raises the question that's a tension in this chapter and throughout the entire book too how can capital be both fluid and mobile, and yet fixed and embodied? So remember, Smith talks about capital as being fixed machines, tools, land improvement, buildings. It's locked into a place or form enabling ongoing production. And then capital is also circulating money, raw materials, wages, inventory that are constantly moving, changing hands and being consumed in production. Consumed in production. So even when capital is embodied in a plow, a factory or land improvement, it's fluid in its employment because the investors can decide where to direct that stock. 

The decision about where to employ capital in agriculture, manufacture or trade is flexible, even if the form it takes afterward is fixed. So Smith recognizes two senses of mobility. One is allocation, so before investment, capital can flow into any sector seeking profit, and it's important to maintain that. The second is physical fixity Once invested, it takes a determinate form. It's a plow or a machine. It can't be easily repurposed, but there's some ability to direct it to a different activity. So capital is mobile in the aggregate, it flows to higher returns, but it's immobile in the particular. So an improved field cannot then be exported. Once you have invested in improving the field by manuring it, by leveling it, by improving the drainage, improving the quality of the soil, those things cannot easily then be taken out. 

So Smith warns policymakers against favoring one use of capital over any other, and in particular he wants to argue against favoring the artificial privileging of foreign trade. The last thing you want to do is invest your capital in reducing the cost of things that are being sent abroad. What Smith means is that capital will naturally find the use that is most valuable to the society, provided that the government does not interfere. If the government distorts those price and profit signals, then necessarily the allocation of capital will be less valuable for the society, and even if it is of the same value to the investor, because there's an artificial subsidy, so it's the society that pays for it. He believes that agriculture naturally has a preeminence because it inherently yields the greatest multiplication of labor and produce. All employments of capital are beneficial, none should be prohibited. But if left free, capital tends to order itself in a hierarchy that maximizes the wealth of nations. 

So this chapter integrates Smith's distinction between fixed and circulating capital with his broader theory of productive and unproductive labor broader theory of productive and unproductive labor. And it sets up his later attacks on mercantilism in book four. And he has a proto-classical theory of capital mobility, anticipating labor debates in [David] Ricardo, Marx, and what we would call modern growth theory, that capital flows to its best return but past investment can lock in resources. Let's hear what he has to say about agriculture. This is on page 363. 

No equal capital puts into motion a greater quantity of productive labor than that of the farmer. Not only his laboring servants but his laboring cattle are productive laborers. In agriculture too, nature labors along with man, and though her labor costs no expense, its produce has its value. The most important operations of agriculture seem not so much to increase, though they do that too as to direct the fertility of nature towards the production of the most profitable. A field overgrown with briars and brambles may produce as great a quantity of vegetables as the best cultivated. The laborers and laboring cattle therefore employed in agriculture not only occasion, like the workmen and manufacturers, the reproduction of a value equal to their own consumption or to the capital which employs them, together with its owner's profits, but of a much greater value. 

So if you want to produce things as a manufacturer, you have to build a factory. If you want to produce things as a farmer, all you have to do is use the land, and it's much easier and cheaper to improve the land than it is to build a factory, and the land lasts. So, as a result, Smith agreed with the physiocrats that agriculture was at least the first among equals. 

And then Smith talks and this is unique, at least at the time, to Smith about manufacturing as the second most productive activity. 

Part of the capital of the master manufacturer is employed as a fixed capital in the instruments of his trade and replaces, together with its profits, that of some other artificer whom he purchases them from. Part of this circulating capital is employed in purchasing materials and replaces, with their profits, the capitals of the farmers and the miners whom he purchases them from. But a great part of it is always, either annually or in a much shorter period, distributed among the different workmen whom he employs. It augments the value of those materials, by their wages and by their masters, profits upon a whole stock of wages, materials and elements of trade. It puts immediately into motion, therefore, a much greater quantity of productive labor and adds a greater value to the annual produce of the land and labor of the society than an equal capital in the hands of any wholesale merchant. 

So not as much as agriculture, but more than someone who is just buying and then reselling products that he does not improve. 

01:07:01

Well, he goes on then to talk about the wholesale trade and the retail trade, and he notes that these things will happen more or less on their own. We don't require subsidies, we shouldn't worry about trade deficits. That's going to take care of itself. Retailers are necessary middlemen. They break bulk and distributed goods into convenient quantities, make them available in quantities that can actually be purchased. But this is going to happen, naturally, without any kind of government policy or follow-up. The main thing that policy should worry about is to make sure that agriculture and manufacturing are able to be carried out without distortion and that the money supply, the roads, other infrastructure are available to promote that. 

What Smith says, and this is on page 380, 

According to the natural course of things, therefore, the greater part of the capital of every growing society is first directed to agriculture, afterward to manufacturers and last of all to foreign commerce. This order of things is so very natural that in every society that had any territory, it has always, I believe, been in some degree observed. Some of their lands must have been cultivated before any considerable towns could be established, and some sort of coarse industry of the manufacturing kind must have been carried on before they could well think of employing themselves in foreign commerce. Think of employing themselves in foreign commerce. But though this natural order of things must have taken place in some degree in every society, it has in all the modern states of Europe been in many respects entirely inverted. The foreign commerce of some of their cities has introduced all their finer manufacturers or such as were fit for distant sale, and manufacturers and foreign commerce together have given birth to the principal improvements of agriculture. The manners and customs which the nature of their original government introduced, and which remained after the government was greatly altered, necessarily forced them into this unnatural and retrograde order. 

That's an indictment of mercantilism. Naturally, what happens naturally is you invest in agriculture and then you invest in manufacture for home use, and then you start to ship some things abroad for international trade. What Smith is saying is that what the countries, the cities, especially, but the countries of Northern Europe, have done is emphasize mercantilism, where they're trying to get as much gold and silver as they can from other countries, and so they waste all of their capital by investing in things that can only be shipped abroad, and what they get back is not capital but gold and silver, and so their growth, their opulence, their prosperity, all are held back by mercantilism. And notice, he's going to talk about this much more in book four. But you can't understand book four without understanding the role that division of stock plays in book two. And division of stock, if it's allowed to work on its own, will go first into agriculture and then into manufacturers domestically. That has to be allowed to happen. 

Well, now we're finally in a position to solve the time travel problem that Smith posed and that Marx thought was the central, inherent contradiction of capitalism, the immense monopoly power that's conferred by primitive accumulation. So again, the problem is the ant and the grasshopper, but it's brought to life in commercial manufacturing. If your ancestors saved their money, you have a lot of stock and as a result you have an easy life and don't have to work very hard. If your ancestors were like grasshoppers and were dissolute and just played music and you know how those people are you don't have any capital and the only thing that you can do is to sell your labor. If your ancestors happen to save money and invest it, you're rich. In fact, you get paid far more than the people whose ancestors did not save and who now have to work constantly. But, as I argued in my podcast with Russ Roberts on the essence of capitalism, there's a difference between market exchange and commerce and capitalism. Capitalism is actually a set of institutions and organized markets that generate liquidity or movable, adaptable capital. 

If I want to start a business, I don't have to save money for years from meager wages. I can raise money by selling shares in the future profits. Notice that these are called shares of stock. They're called shares of stock. Smith wants to talk about division of stock. You might expect these to be called shares of stock, given the way that Smith talks about capital. So when a company runs an IPO, they're literally raising stock from a widely divided and dispersed set of investors. I don't have to save up the money. I can attract it from other people by having a good idea. These can include people who never could start a business on their own, but they get stock by supplying capital so that the company can invest those investments, solve the time travel problem. We can go ahead into the future, collect the profits from the sales of those products that do not yet exist, and then time travel back to the present and sell those shares of stocks to investors who can collect the future profits in the form of appreciation of their equity holdings. The value of my stock is going to go up. The fact that these are literally called shares of stock shows just how influential Smith's formulation was. Division of stock allows us to raise capital rather than to rely on primitive accumulation. 

Marx is just wrong. Stock, for Smith, is the excess of revenues over cost. Now Marx had some complex formula for surplus, because he defined value using an Aristotelian conception of objective value based on labor. The only source of surplus, then, for Marx, is the theft of labor value. But that's just incorrect. It's factually, empirically incorrect. If we accept Smith's idea of stock as the accumulation of revenues over expenses, we can see why Smith had this right. Stock is the value of the stream of future profits from an activity. If we can sell shares of that stock now as a way of building the factory of the tools needed to make the product that will make the profits. Then we can raise that stock. The entrepreneur can invest money from owners of the stock Remember, stock is future profits to create the means of earning the profits, primitive accumulation is just not important in a capitalist system. Marx thought it was a way of chaining down class. 

It's not. Now,  Marx was wrong about many things. This may be the thing he was most wrong about. Not only is it not true that wages constantly fall and in fact wages constantly rise, and even middle-class people are usually capitalists in the sense that they own shares of stock which are claims on the profits that are produced by their labor. So it's true that some people are very wealthy, and if you defined injustice in terms of envy, that's a problem. But if you define justice as a system that protects person, property and promise and that's Smith's definition of justice then you get the greatest increase in the widely shared prosperity of all people that the world has ever known In less than 50 years people that the world has ever known. 

In less than 50 years, the worldwide poverty rate has fallen from more than 80% to less than 10%. That is, more than 80% of the world's people were below the $2 per day, and that's controlling for cost, it's controlling for inflation. So we're comparing apples to apples. 80% of the world's people were below that poverty line. Now less than 10% are. So 90% of the world's people are above that absolute measure of poverty. 

That's because of division of labor enabled by division of stock. Well, the implications for policy we've already talked about and we'll talk about it more in book four. Smith implicitly criticizes mercantilist policies that privilege foreign trade over domestic agriculture and manufacturing. If you just unshackle division of stock, that will produce wealth on its own through the division of labor. True national wealth depends on the order of capital accumulation that most increases domestic productive labor. And the nice thing about it is that all the government has to do is make sure that the money supply, the roads and the infrastructure are available and are available as cheaply and as easily as possible, and that justice, which is the protection of person property and promise, are available at low cost and equally to all people. Well, the next episode, part six, will be released on Tuesday, October 21st, where we will take up book three, where Smith develops most completely what we would now call a comparative statics view of economic development. I'm looking forward to it.