The Wealth of Nations and Free Trade

Adam Smith’s famous book The Wealth of Nations (1776) developed economic and moral arguments against “the mercantile system” or protectionism. The relevant chapters are among the best of the book and there is much to be learned from them.

Smith’s argument for free trade starts from his idea that the extent of the market favors the division of labor. With foreign trade, “the narrowness of the home market does not hinder the division of labour in any particular branch of art or manufacture from being carried to the highest perfection.” This leads to higher “real revenue and wealth.” Smith understood that this benefit comes from people buying at lowest prices, not from producers making higher profits:

In every country it always is and must be the interest of the great body of people to buy whatever they want of those who sell it cheapest. The proposition is so very manifest, that it seems ridiculous to take any pains to prove it; nor could it ever have been called in question, had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind.

Free trade is always profitable to the countries involved, except when trade is subsidized (assisted by “bounties,” that is, government subsidies), in which case it is the exporting country, not the importing one, that loses out:

The trades, it is to be observed, which are carried on by means of bounties, are the only ones which can be carried on between two nations for any considerable time together, in such a manner as that one of them shall always and regularly lose, or sell its goods for less than it really costs to send them to market.

Smith uses his monetary theory to criticize the argument that imports — the protectionists’ villain — will make specie (gold and silver money) leak to other countries. The mercantilists proposed that “countries” (in fact individual consumers and producers) export as much as possible and import as little as feasible. These prejudices, Smith observes, “have taught us to believe, that national wealth arises more immediately from exportation than from production.” On the contrary, production of real goods and services is what matters for wealth creation. A country can ultimately buy other countries’ production only with its own production. Money is merely a medium of exchange.

Consequently, “nothing … can be more absurd than this whole doctrine of the balance of trade.” This mercantilist doctrine, which has survived to our day, holds that the balance of trade, that is, the difference between exports and imports, must be positive and as high as possible. What is important, on the contrary, is that people be free to exchange whatever they find beneficial to trade. The amount of money in circulation will adapt to real production capacities. Concern with the balance of trade is thus a “most insignificant object of modern policy.”

Eighteen-century protectionism was more coherent than today’s version. The state not only helped domestic merchants by restricting imports; it also restricted some exports in order to depress the prices of raw materials used by domestic manufacturers. For example, the exportation of British wool was forbidden, and violations long constituted felonies punishable by death. One must read Smith’s description of the detailed regulations on domestic transportation of wool that were necessary to maintain this prohibition. Protectionism requires heavy regulation.

Export prohibition caused direct harm to domestic wool growers. Perhaps Smith did not fully understand how severe was his indictment of the modern state, whose main business is redistribution:

To hurt in any degree the interest of any one order of citizens, for no other purpose but to promote that of some other, is evidently contrary to that justice and equality of treatment which the sovereign owes to all the different orders of his subjects. But the prohibition [of wool exports] certainly hurts, in some degree, the interest of the growers of wool, for no other purpose but to promote that of the manufacturers.

In Smith’s time, the British state also prohibited the exportation of machines that could make foreign producers more efficient. It even protected the domestic supply of “artificers” (skilled workers especially those working with machines) by preventing them from emigrating. Smith comments:

It is unnecessary, I imagine, to observe, how contrary such regulations are to the boasted liberty of the subject, of which we affect to be so very jealous; but which, in this case, is so plainly sacrificed to the futile interests of our merchants and manufacturers.

Smith observed that other states were often worse than the British state. But the latter was very far from free trade.

The long chapter on colonies contains not only much information about the history of colonial trade but also good economic analysis. Smith argued that, although British colonialism was more enlightened than that of most other countries, its restrictions on free trade with the colonies were detrimental to everybody except the merchants and manufacturers of the mother country.

Exports of some commodities from the colonies could be made only to England. The restrictions on the colonies’ imports were more severe as any maritime imports could only come from British ports, giving a “monopoly” to British merchants. Colonists thus had to pay more for their imported goods, and obtained lower prices for some of their exports.

Furthermore, all goods traded between the mother country and the colonies — including the American colonies among themselves — had to be carried on British ships, increasing costs. Those who would dismiss this restriction as the remnant of an unenlightened past should recall that the Jones Act has imposed a similar restriction on trade between American ports since 1920.

Exports of manufactured goods from the colonies were often forbidden on the false theory that exporting finished commodities was more profitable and should be reserved for the mother country. In the same spirit, steel furnaces and steel mills were prohibited in America, as was any commerce of wool and woolen goods among the colonies. Smith correctly concludes:

To prohibit a great people, however, from making all that they can of every part of their own produce, or from employing their stock and industry in the way that they judge most advantageous to themselves, is a manifest violation of the most sacred rights of mankind.

Ultimately, the system was not even profitable for the British. The Wealth of Nations frequently defends the consumers against the “men of business.” In his discussion of colonialism, Smith expressed this idea in clear and beautiful terms:

To promote the little interest of one little order of men in one country, it hurts the interest of all other orders of men in that country, and of all men in all other countries.

Everything considered, including the military expenses necessary to defend the colonies, “Great Britain derives nothing but loss from the dominion which she assumes over her colonies.”

When he was writing The Wealth of Nations in 1773, Smith had original opinions on the future of America. The American colonies that would refrain from revolution, he suggested, could be totally integrated into the British state with full representation in the British Parliament. He even envisioned a future move of the enlarged country’s capital to America.

Today’s student of economics will find errors in Adam Smith. He did not have a clear vision of the comparative advantage of nations, as opposed to absolute advantage — a theory that would have to wait for David Ricardo and Robert Torrens in the following century. Smith’s mistaken labor theory of value popped up here and there. He claimed that the exclusive colonial trade increased the profits of British merchants without explaining why these abnormal profits would not be eliminated by new British competitors. He was too tolerant of protectionism in industries “necessary … for the defence of the society.”

A political economist more than a modern economist, Smith often mixes up positive and normative statements, what is and what ought to be. But once we realize that normative judgments are indispensable when economics is used for evaluating public policy, Smith’s moral preference for the “liberty of the subject” and “the sacred rights of mankind” is very commendable.

In other ways, Smith is a very modern economist. He understands the crucial idea that “consumption is the sole end and purpose of all production” and that “the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer.” He adds:

The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it. But in the mercantile system, the interest of the consumer is almost constantly sacrificed to that of the producer; and it seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce.

Smith even anticipated the theory of Public Choice and collective action. The exportation of raw hides and tanned leather was prohibited, he explained, in order to push down their prices for the benefit of leather goods manufacturers. How could the latter win such a privilege? Domestic graziers, Smith cleverly observed, are “separated from each one another, and dispersed through all the different corners of the country,” and thus “cannot, without great difficulty, combine together” to defend their interests, while “manufacturers of all kinds, collected together in numerous bodies in all great cities, easily can.”

It is difficult not to love Adam Smith on free trade. His defense is still current, even if further developments of economics have improved on it. His general argument for the spontaneous order — the “invisible hand” — is well known if underrated:

The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle, that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations; though the effect of these obstructions is always more or less either to encroach upon its freedom, or to diminish its security.

In the area of international trade, he writes, “the natural interests and inclinations of men coincide as exactly with the publick interest as in all other cases.”

It would remain for other economists, two centuries later, to emphasize the ambiguity of the concept of “public interest,” but Smith correctly saw that protectionism hurts most people for the benefit of a small class of businessmen.

Economists like to think that we have made progress regarding the public understanding of the benefits of free trade. But it is a fragile progress. “National prejudice and animosity,” to use Smith’s terms, are still threatening, as we see today in America and much of the developed world.