Adam Smith, a brilliant eighteenth-century Scottish political economist, had the
advantage of judging the significance ol colonies by a rigorous examination
based on the colonial experience of 300 years. His overview has a built-in bias:
he strongly disapproved of excessive regulation of colonial trade by parent
countries. But his analysis is rich with insight and remarkably dispassionate in
its argument. Adam Smith recognized that the discovery of the New World not only
brought wealth and prosperity to the Old World, but that it also marked a divide
in the history of mankind. The passage that follows is the work of this economic
theorist who discusses problems in a language readily understandable by everyone.
Adam Smith had retired from a professorship at Glasgow University and Was living
in France in 1764-5 when he began his great work, The Wealth of Nations. The
book was being written all during the years of strife between Britain and her
colonies, but it was not published until 1776. In the passages which follow,
Smith points to the impossibility of monopolizing the benefits of colonies, and
pessimistically calculates the cost of empire, but the book appeared too late to
have any effect upon British policy. Because the Declaration of Independence and
The Wealth of Nations, the political and economic reliations of empire and
mercantilism, appeared in the same year, historians have often designated 1776
as one of the turning points in modern history. The text On the cost of Empire,
the eloquent exhortation to the rulers of Britain to awaken from their grandiose
dreams of empire, is the closing passage of Smith’s book.
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Adam Smith was a Scottish political economist and philosopher. He has become
famous by his influential book The Wealth of Nations (1776). Smith was the son
of the comptroller of the customs at Kirkcaldy, Fife, Scotland. The exact date
of his birth is unknown. However, he was baptized at Kirkcaldy on June 5, 1723,
his father having died some six months previously.
At the age of about fifteen, Smith proceeded to Glasgow university, studying
moral philosophy under “the never-to-be-forgotten” Francis Hutcheson (as Smith
called him). In 1740 he entered Balliol college, Oxford, but as William Robert
Scott has said, “the Oxford of his time gave little if any help towards what was
to be his lifework,” and he relinquished his exhibition in 1746. In 1748 he
began delivering public lectures in Edinburgh under the patronage of Lord Kames.
Some of these dealt with rhetoric and belles-lettres, but later he took up the
subject of “the progress of opulence,” and it was then, in his middle or late
20s, that he first expounded the economic philosophy of “the obvious and simple
system of natural liberty” which he was later to proclaim to the world in his
Inquiry into the Nature and Causes of the Wealth of Nations. About 1750 he met
David Hume, who became one of the closest of his many friends.
In 1751 Smith was appointed professor of logic at Glasgow university,
transferring in 1752 to the chair of moral philosophy. His lectures covered the
field of ethics, rhetoric, jurisprudence and political economy, or “police and
revenue.” In 1759 he published his Theory of Moral Sentiments, embodying some of
his Glasgow lectures. This work, which established Smith’s reputation in his own
day, is concerned with the explanation of moral approval and disapproval. His
capacity for fluent, persuasive, if rather rhetorical argument is much in
evidence. He bases his explanation, not as the third Lord Shaftesbury and
Hutcheson had done, on a special “moral sense,”nor, like Hume, to any decisive
extent on utility,but on sympathy. There has been considerable controversy as
how far there is contradiction or contrast between Smith’s emphasis in the Moral
Sentiments on sympathy as a fundamental human motive, and, on the other hand,
the key role of self-interest in the The Wealth of Nations. In the former he
seems to put more emphasis on the general harmony of human motives and
activities under a beneficent Providence, while in the latter, in spite of the
general theme of “the invisible hand” promoting the harmony of interests, Smith
finds many more occasions for pointing out cases of conflict and of the narrow
selfishness of human motives.
Smith now began to give more attention to jurisprudence and political economy in
his lecture and less to his theories of morals. An impression can be obtained as
to the development of his ideas on political economy from the notes of his
lectures taken down by a student in about 1763 which were later edited by E.
Cannan (Lectures on Justice, Police, Revenue and Arms,1896), and from what Scott,
its discoverer and publisher, describes as “An Early Draft of Part of The Wealth
of Nations, which he dates about 1763.
At the end of 1763 Smith obtained a lucrative post as tutor to the young duke of
Buccleuch and resigned his professorship. From 1764-66 he traveled with his
pupil, mostly in France, where he came to know such intellectual leaders as
Turgot, D’Alembert, AndrMorellet, Helvtius and, in particular, Francois
Quesnay, the head of the Physiocratic school whose work he much respected. On
returning home to Kirkcaldy he devoted much of the next ten years to his magnum
opus, which appeared in 1776. In 1778 he was appointed to a comfortable post as
commissioner of customs in Scotland and went to live with his mother in
Edinburgh. He died there on July 17, 1790, after a painfull illness. He had
apparently devoted a considerable part of his income to numerous secret acts of
Shortly before his death Smith had nearly all his manuscripts destroyed. In his
last years he seems to have been planning two major treatises, one on the theory
and history of law and one on the sciences and arts. The posthumously published
Essays on Philosophical Subjects (1795) probably contain parts of what would
have been the latter treatise.
The Wealth of Nations has become so influential since it did so much to create
the subject of political economy and develop it into an autonomous systematic
discipline. In the western world, it is the most influential book on the subject
ever published. When the book, which has become a classic manifesto against
mercantalism, appeared in 1776, there was a strong sentiment for free trade in
both Britain and America. This new feeling had been born out of the economic
hardships and poverty caused by the war. However, at the time of publication,
not everybody was convinced of the advantages of free trade right away: the
British public and Parliament still clung to mercantilism for many years to come
(Tindall and Shi). However, controversial views have been expressed as to the
extent of Smith’s originality in The Wealth of Nations. Smith has been blamed
for relying too much on the ideas of great thinkers such as David Hume and
Montesquieu. Nevertheless, The Wealth of Nations was the first and remains the
most important book on the subject of political ecomomy until this present day.
It has never, I think, been the good fortune of any founder of a scientific
system to think out to the very end even the more important ideas that
constitute his system. The strength and lifetime of no single man are sufficient
for that. It is enough if some few of the ideas which have to play the chief
part in the system are put on a perfectly safe foundation, and analysed in all
their ramifications and complexities. It is a great deal if, over and above that,
an equal carefulness falls to the lot of a few other favoured members of the
system. But in all cases the most ambitious spirit must be content to build up a
great deal that is insecure, and to fit into his system, on cursory examination,
ideas which it was not permitted him to work out.
We must keep these considerations before us if we would rightly appreciate
Adam Smith’s attitude towards our problem.
Adam Smith has not overlooked the problem of interest; neither has he worked
it out. He deals with it as a great thinker may deal with an important subject
which he often comes across, but has not time or opportunity to go very deeply
into. He has adopted a certain proximate but still vague explanation. The more
indefinite this explanation is, the less does it bind him to strict conclusions;
and a many-sided mind like Adam Smith’s, seeing all the many different ways in
which the problem can be put, but lacking the control which the possession of a
distinct theory gives, could scarcely fail to fall into all sorts of wavering
and contradictory expressions. Thus we have the peculiar phenomenon that, while
Adam Smith has not laid down any distinct theory of interest, the germs of
almost all the later and conflicting theories are to be found, with more or less
distinctness, in his scattered observations. We find the same phenomenon in Adam
Smith as regards many other questions.
The line of thought which seems to commend itself principally to him as
explaining natural interest occurs in very similar language in the sixth and
eighth chapters of book i of the Wealth of Nations. It amounts to this, that
there must be a profit from capital, because otherwise the capitalist would have
no interest in spending his capital in the productive employment of
General expressions like these have of course no claim to stand for a
complete theory.(2*) There is no reasoned attempt in them to show what we are to
represent as the actual connecting links between the psychological motive of the
capitalist’s self-interest and the final fixing of market prices which leave a
difference between costs and proceeds that we call interest. But yet, if we take
those expressions in connection with a later passage,(3*) where Smith sharply
opposes the “future profit” that rewards the resolution of the capitalist to the
“present enjoyment” of immediate consumption, we may recognise the first germs
of that theory which Senior worked out later on under the name of the Abstinence
In the same way as Adam Smith asserts the necessity of interest, and leaves
it without going any deeper in the way of proof, so does he avoid making any
systematic investigation of the important question of the source of undertaker’s
profit. He contents himself with making a few passing observations on the
subject. Indeed in different places he gives two contradictory accounts of this
profit. According to one account, the profit of capital arises from the
circumstance, that, to meet the capitalist’s claim to profit, buyers have to
submit to pay something more for their goods than the value which these goods
would get from the labour expended on them. according to this explanation, the
source of interest is an increased value given to the product over that value
which labour creates; but no explanation of this increase in value is given.
According to the second account, interest is a deduction which the capitalist
makes in his own favour from the return to labour, so that the workers do not
receive the full value created by them, but are obliged to share it with the
capitalist. According to this account, profit is a part of the value created by
labour and kept back by capital.
Both accounts are to be found in a great number of passages; and these
passages, oddly enough, sometimes stand quite close to each other, as, e.g. in
the sixth chapter of the first book.
Adam Smith has been speaking in that chapter of a past time, — of course a
mythical time, — when the land was not yet appropriated, and when an
accumulation of capital had not yet begun, and has made the remark that, at that
time, the quantity of labour required for the production of goods would be the
sole determinant of their price. He continues: “As soon as stock has accumulated
in the hands of particular persons, some of them will naturally employ it in
setting to work industrious people, whom they will supply with materials and
subsistence, in order to make a profit by the sale of their work, or by what
their labour adds to the value of the materials. In exchanging the complete
manufacture either for money, for labour, or for other goods, over and above
what may be sufficient to pay the price of the materials and the wages of the
workmen, something must be given for the profits of the undertaker of the work,
who hazards his stock in this adventure.”
This sentence, when taken with the opposite remark of the previous paragraph
(that, in primitive conditions, labour is the sole determinant of price), very
clearly expresses the opinion that the capitalist’s claim of interest causes a
rise in the price of the product, and is met from this raised price. But Adam
Smith immediately goes on to say: “The value which the workman adds to the
material, therefore, resolves itself in this case into two parts, of which the
one pays the wages, the other the profits of the employer upon the whole stock
of materials and wages which he advanced.” Here again the price of the product
is looked upon as exclusively determined by the quantity of labour expended, and
the claim of interest is said to be met by a part of the return which the worker
We meet the same contradiction, put even more strikingly, a page farther on.
“In this state of things,” says Adam Smith, “the whole produce of labour
does not always belong to the labourer. He must in most cases share it with the
owner of the stock which employs him.” This is an evident paraphrase of the
second account. But immediately after that come the words: “Neither is the
quantity of labour commonly employed in acquiring or producing any commodity,
the only circumstance which can regulate the quantity which it ought commonly to
purchase, command, or exchange for. An additional quantity, it is evident, must
be due for the profits of the stock which advanced the wages and furnished the
materials of that labour.” He could scarcely have said more plainly that the
effect of a claim of interest is to raise prices without curtailing the wages of
Later on he says alternately: “As in a civilised community there are but few
commodities of which the exchangeable value arises from labour only, rent and
profit contributing largely to that of the far greater part of them, so the
annual produce of its labour will always be sufficient to purchase or command a
much greater quantity of labour than was employed in raising, preparing, and
bringing that produce to market” (first account, chap. vi.) “The produce of
almost all other labour is liable to the like deduction of profit. In all arts
and manufactures the greater part of the workmen stand in need of a master to
advance them the materials of their work, and their wages and maintenance till
it be completed. He shares in the produce of their labour, or in the value which
it adds to the materials upon which it is bestowed; and in this consists his
profit” (second account, chap. viii.)
“High or low wages and profit are the causes of high or low price; high or
low rent is the effect of it” (first account, chap. xi.)
Contradictions like these on the part of such an eminent thinker admit, I
think, of only one explanation; — that Adam Smith had not thoroughly thought
out the interest problem; and — as is usual with those who have only
imperfectly mastered a subject — was not very particular in his choice of
expressions, but allowed himself to be swayed very much by the changing
impressions which the subject may have made on him from time to time.
Adam Smith, then, has no perfected theory of interest.(4*) But the
suggestions he threw out were all destined to fall on fruitful soil. His casual
remark on the necessity of interest was developed later into the Abstinence
theory. In the same way the two accounts he gave of the source of interest were
taken up by his followers, logically carried out, and raised into principles of
independent theories. With the first account — that interest is paid out of an
additional value which the employment of capital calls into existence — are
connected the later Productivity theories. With the second account — that
interest is paid out of the return to labour — are connected the Socialist
theories of interest. Thus the most important of later theories trace their
pedigree back to Adam Smith.
The position taken by Adam Smith towards the question may be called that of
a complete neutrality. He is neutral in his theoretical exposition, for he takes
the germs of distinct theories and puts them beside each other, without giving
any one of them a distinct prominence over the others. And he is neutral in his
practical judgment, for he maintains the same reserve, or rather the same
contradictory hesitancy, both in praise and blame of interest. Sometimes he
commends the capitalists as benefactors of the human race, and as authors of
enduring blessing;(5*) sometimes he represents them as a class who live on
deductions from the produce of other people’s labour, and compares them
significantly with people “who love to reap where they never sowed.”(6*)
In Adam Smith’s time the relations of theory and practice still permitted
such a neutrality, but it was not long allowed to his followers. Changed
circumstances compelled them to show their colours on the interest question, and
the compulsion was certainly not to the disadvantage of the science.
The special requirements of economic theory could not any longer put up with
uncertain makeshifts. Adam Smith had spent his life in laying down the
foundations of his system. His followers, finding the foundations laid, had now
time to take up those questions that had been passed over. The development now
reached by the related problems of land-rent and wages gave a strong inducement
to pursue the interest problem. There was a very complete theory of land-rent;
there was a theory of wages scarcely less complete. Nothing was more natural
than that systematic thinkers should now begin to ask in earnest about the third
great branch of income the whence and wherefore of the income that comes from
the possession of capital.
But in the end practical life also began to put this question. Capital had
gradually become a power. Machinery had appeared on the scene and won its great
triumphs; and machinery everywhere helped to extend business on a great scale,
and to give production more and more of a capitalist character. But this very
introduction of machinery had begun to reveal an opposition which was forced on
economic life with the development of capital, and daily grew in importance,the
opposition between capital and labour.
In the old handicrafts undertaker and wage-earner, master and apprentice,
belonged not so much to different social classes as simply to different
generations. What the one was the other might be, and would be. If their
interests for a time did diverge, yet in the long run the feeling prevailed that
they belonged to one station of life. It is quite different in great capitalist
industry. The undertaker who contributes the capital has seldom or never been a
workman; the workman who contributes his thews and sinews will seldom or never
become an undertaker. They work at one trade like master and apprentice; but not
only are they of two different ranks, they are even of different species. They
belong to classes whose interests diverge as widely as their persons. Now
machinery had shown how sharp could be the collision of interest between capital
and labour. Those machines which bore golden fruit to the capitalist undertaker
had, on their introduction, deprived thousands of workers of their bread. Even
now that the first hardships are over there remains antagonism enough and to
spare. It is true that capitalist and labourer share in the productiveness of
capitalist undertaking, but they share in this way, that the worker usually
receives little — indeed very little — while the undertaker receives much. The
worker’s discontent with his small share is not lessened, as it used to be in
the case of the handicraft assistant, by the expectation of himself in time
enjoying the lion’s share; for, under large production, the worker has no such
expectation. On the contrary, his discontent is aggravated by the knowledge that
to him, for his scanty wage, falls the harder work; while to the undertaker, for
his ample share in the product, falls the lighter exertion-often enough no
personal exertion whatever. Looking at all these contrasts of destiny and of
interest, if there ever came the thought that, at bottom, it is the workers who
bring into existence the products from which the undertaker draws his profit —
and Adam Smith had come wonderfully near to such a thought in many passages of
his widely read book — it was inevitable that some pleader for the fourth
estate should begin to put the same question with regard to natural interest as
had been put many centuries earlier, by the friends of the debtor, with regard
to Loan interest, Is interest on capital just? Is it just that the capitalist-
undertaker, even if he never moves a finger, should receive, under the name of
profit, a considerable share of what the workers have produced by their
exertions? Should not the entire product rather fall to the workers?
The question has been before the world since the first quarter of our
century, at first put modestly, then with increasing assertiveness; and it is
this fact that the interest theory has to thank for its unusual and lasting
vitality. So long as the problem interested theorists alone, and was of
importance only for purposes of theory, it might have slumbered on undisturbed.
But it was now elevated to the rank of a great social problem which the science
neither could nor would overlook. Thus the inquiries into the nature of Natural
interest were as numerous and solicitous after Adam Smith’s day as they had been
scanty and inadequate before it.
It must be admitted that they were as averse as they were numerous. Up till
Adam Smith the scientific opinion of the time had been represented by one single
theory. After him opinion was divided into a number of theories conflicting with
each other, and remaining so with rare persistence up till our own day. It is
usually the case that new theories put themselves in the place of the old, and
the old gradually yield the position. But in the present case each new theory of
interest only succeeded in placing itself by the side of the old, while the old
managed to hold their place with the utmost stubbornness. In these circumstances
the course of development since Adam Smith’s time presents not so much the
picture of a progressive reform as that of a schismatic accumulation of theories.
The work we have now before us is clearly marked out by the nature of the
subject. It will consist in following the development of all the diverging
systems from their origin down to the present time, and in trying to form a
critical opinion on the value, or want of value, of each individual system. As
the development from Adam Smith onwards simultaneously pursues different lines,
I think it best to abandon the chronological order of statement which I have
hitherto observed, and to group together our material according to theories.
To this end I shall try first of all to make a methodical survey of the
whole mass of literature which will occupy our attention. This will be most
easily done by putting the characteristic and central question of the problem in
the foreground. We shall then see at a glance how the theory differentiates
itself on that central question like light on the prism.
What we have to explain is the fact that, when capital is productively
employed, there regularly remains over in the hinds of the undertaker a surplus
proportional to the amount of this capital. This surplus owes its existence to
the circumstance that the value of the goods produced by the assistance of
capital is regularly greater than the value of the goods consumed in their
production. The question accordingly is, Why is there this constant surplus
To this question Turgot had answered, There must be a surplus, because
otherwise the capitalists would employ their capital in the purchase of land.
Adam Smith had answered, There must be a surplus, because otherwise the
capitalist would have no interest in spending his capital productively.
Both answers we have already pronounced insufficient. What then are the
answers given by later writers?
At the outset they appear to me to follow five different lines.
One party is content with the answers given by Turgot and Smith, and stands
by them. This line of explanation was still a favourite one at the beginning of
our century, but has been gradually abandoned since then. I shall group these
answers together under the name of the Colourless theories.
A second party says, Capital produces the surplus. This school, amply
represented in economic literature, may be conveniently called that of the
Productivity theories. I may here note that in their later development we shall
find the productivity theories splitting up into many varieties; into
Productivity theories in the narrower sense, that assume a direct production of
surplus on the part of capital; and into Use theories, which explain the origin
of interest in the roundabout way of making the productive use of capital a
peculiar element in cost, which, like every other element of cost, demands
A third party answers, Surplus value is the equivalent of a cost which
enters as a constituent into the price, viz. abstinence. For in devoting his
capital to production the capitalist must give up the present enjoyment of it.
This postponement of enjoyment, this “abstinence,” is a sacrifice, and as such
is a constituent element in the costs of production which demands compensation.
I shall call this the Abstinence theory.
A fourth party sees in surplus value the wage for work contributed by the
capitalist. For this doctrine, which also is amply represented, I shall use the
name Labour theory.
Finally, a fifth party — for the most part belonging to the socialist side
— answers, Surplus value does not correspond to any natural surplus whatever,
but has its origin simply in the curtailment of the just wage of the workers. I
shall call this the Exploitation theory.
These are the principal lines of explanation. They are certainly numerous
enough, yet they are far from exhibiting all the many forms which the interest
theory has taken. We shall see rather that many of the principal lines branch
off again into a multitude of essentially different types; that in many cases
elements of sever theories are bound up in a new and peculiar combination; and
that, finally, within one and the same theoretical type, the different ways in
which common fundamental thoughts are formulated, are often so strongly
contrasted and so characteristic that there would be some justification in
recognising individual shades of difference as separate theories. That our
prominent economic writers have exerted themselves in so many different ways for
the discovery of the truth is an eloquent witness of its discovery being no less
important than it is hard.
We begin with a survey of the Colourless theories.
1. “In exchanging the complete manufacture either for money, for labour, or for
other goods, over and above what may be sufficient to pay the price of the
materials and the wages of the workmen, something must be given for the profits
of the undertaker of the work, who hazards his stock in the adventure…. He
could have no interest to employ them unless he expected from the sale of their
work something more than what was sufficient to replace his stock to him; and he
could have no interest to employ a great stock rather than a small one unless
his profits were to bear some proportion to the extent of his stock”
(M’Culloch’s edition of 1863, p. 22). The second passage runs: “And who would
have no interest to employ him unless he was to share in the produce of his
labour, or unless his stock was to be replaced to him with a profit” (p. 30).
2. See also Pierstorff, Lehre vom Unternehmerggwinn, Berlin, 1875, p. 6; and
Platter, “Der Kapitalgewinn bei Adam Smith” (Hildebrand’s Jahrbcher, vol. xxv.
p. 317, etc.)
3. Book ii. chap. i. p. 123, in M’Culloch’s edition.
4. When Plater in the essay above mentioned (p. 71) comes to the conclusion that,
“if Smith’s system be taken strictly, profit on capital appears unjustifiable,”
it could only be by laying all the weight on the one half of Smith’s expressions,
and leaving the other out of account as contradictory to his other principles.
5. Book ii. chap. iii.
6. Book i. chap. vi. The sentence was written primarily about landowners, but in
the whole chapter interest on capital and rent of land are treated as parallel
as against wages of labour.
“The Invisible Hand”
Adam Smith first described this principle. Since that time it has become the
basis of the concept of the free market.
Self Regulating prices Consider glove manufacturers. If a glove manufacturer
were to raise his prices on his gloves way above his costs, a competitor with
lower prices on gloves would receive all of the orders for gloves. If all of the
glove manufacturers were to raise their prices way above their costs, someone
else would begin to manufacture gloves and sell them at a price closer to the
manufacturing costs. This competiti