Economic Theory

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ECONOMIC THEORY

Economic theory made great strides in the latter part of the eighteenth century and the first decades of the nineteenth century. Adam Smith, Alexander Hamilton, and David Ricardo, the three greatest economic thinkers of the era, shattered the existing mercantilist paradigm, replacing it with the doctrines of financial development and free trade.

Mercantilists believed that wealth could be acquired but not created. One of the major roles of the state, they maintained, was to regulate international trade to national advantage. Policies that impeded imports and encouraged exports were in the public interest, mercantilists argued, because they promoted the accumulation of large stockpiles of gold and silver in the government's coffers. An overflowing national treasury, they believed, meant that all was well. The financial, agricultural, and transportation revolutions that transformed the economies of Holland and Great Britain in the seventeenth and eighteenth centuries suggested otherwise, however.

adam smith

In An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Adam Smith decimated the mercantilist position. Wealth, he argued, resided not in barren metals like gold and silver but rather in the capacity to create and sell goods and services desired by others. Smith conceded that the precious metals served important monetary purposes, but he also noted that the use of banknotes convertible into specie was more economically efficient than the circulation of full-bodied gold or silver coins. Hence, Smith sarcastically noted, Britain should no more attempt to accumulate more specie than it needed to conduct trade than it should try to accumulate more pots and pans than its cooks required to prepare dinner.

Human productivity and trade were the ultimate roots of prosperity, Smith showed. Productivity was largely a function of labor specialization. In a famous passage, Smith explained how the output of a pin factory could be increased many times over simply by reorganizing the work so that each man repeated the same simple task the entire day instead of manufacturing each part of the pin himself.

In a less famous but far more important passage, Smith explained that labor specialization permeated advanced economies. A wool coat, for example, was the product of the entire economy, not a single person or firm. Shepherds, wool sorters and carders, dyers, spinners, weavers, fullers, dressers, and many others prepared the wool for a host of other specialists, namely wholesalers, retailers, and tailors. Thousands of others—shipbuilders, sailors, millwrights, and smiths—indirectly participated in the production of the coat by providing the tools and maintaining the infrastructure needed to create, transform, and transport the wool. The amazing thing, Smith realized, was that the coat, and tens of thousands of other goods, were produced without central direction. Without even realizing it, self-interested individuals, most of whom would never meet, cooperated to produce, efficiently and cheaply, a coat far superior to that worn by a king in a region with a less developed division of labor.

The size of the market, Smith argued, determined the degree of labor specialization. The larger the population and area that could trade, the more specialized and efficient an individual could become, and hence the more that individual could help to produce. By restricting the size of the market, trade barriers dampened economic activity. Mercantilist policies like tariffs and quotas thus created poverty and economic backwardness, not prosperity. With precious few exceptions for public goods like national defense, markets led to more efficient outcomes than government decree. The production of everything from roads to education, Smith argued, should be guided by the invisible hand of the market, not the whims and dictates of princes and potentates.

Smith was a Scotsman. Though he never personally traveled to America, he frequently discussed its economic and political conditions in The Wealth of Nations. Americans were well aware of Smith's work and, perhaps with a few quibbles, accepted it. One of those quibblers was Alexander Hamilton.

alexander hamilton

Early America boasted of no great economic theorists, though Benjamin Franklin of Philadelphia and Thomas Hutchinson of Massachusetts deserve more accolades than they are usually accorded, especially in the field of monetary economics. Revolutionary war hero and statesman Alexander Hamilton was by far the early nation's greatest economic and financial mind. By focusing on his December 1791 Report on Manufactures and its subsequent interpretation by advocates of protective tariffs, many contemporaries and later scholars came to see Hamilton as a neomercantilist or economic nationalist. Those who read the entire corpus of his work in the context of his times, however, tended to interpret him as a practical, nuanced thinker working within Smith's free-market paradigm.

The Report on Manufactures sounded mercantilist because of its frequent mention of tariffs and other possible forms of government "encouragement" of domestic manufacturing. As a public policymaker, Hamilton had to confront the reality that the early U.S. economy existed in what modern economists call a "second-best world," a global trading system still riddled with mercantilist antitrade policies. He also had to confront a citizenry steeped in the Physiocratic notion that agriculture produces the greatest wealth. His Report, in other words, can be interpreted as a practical critique of mercantilism, rather than as a return to it.

Hamilton first attacked the notion that agriculture was naturally more productive than manufacturing. After all, manufacturing extends the division of labor, which Smith considered the fount of wealth. Manufacturing also encourages the use of labor-saving machinery, draws additional people into the workforce, promotes immigration, maximizes the use of human capital, encourages entrepreneurship, and creates a relatively stable domestic demand for agricultural products. Given the numerous and important benefits of manufacturing, the rest of the world's immersion in mercantilist practices, and the nation's still precarious independence, it might be prudent, Hamilton suggested, for the government to encourage American manufacturing.

In a stunningly modern analysis, Hamilton proceeded to weigh the relative costs and benefits of protective tariffs (duties or imposts), quotas (quantity limitations or prohibitions on imports), bounties (payments for production), premiums (prizes), patents (protection of intellectual property rights), and quality-control regulations (inspection of imports to ensure their safety and soundness). Unlike many early-nineteenth-century protectionists, Hamilton rejected protective tariffs and quotas in favor of bounties, patents, and inspection regulations. The federal government depended heavily on customs duties for revenue, so imposing quotas or high tariffs was out of the question. Protective (high) tariffs actually reduce revenue by greatly decreasing imports. In this way they protect domestic manufacturers from foreign competition. Moreover, Hamilton deduced that production bounties produced a smaller drag on the economy than tariffs and quotas did—an insight so profound and original that it did not regularly appear in international-economics textbooks until the 1930s.

david ricardo

Still, a major conceptual hole remained to be filled. As Adam Smith pointed out, trade came naturally to people. Most early Americans had no trouble believing that exchange was mutually beneficial to both buyers and sellers. Even some of those steeped in Physiocracy saw that trade could create wealth by putting resources to their most highly valued uses. Economic life is not a zero-sum game that merely shuffles property from one owner to another, as the mercantilists believed. But troubling questions remained. Was it not possible under free trade that a highly advanced, efficient economy like that of Great Britain could oppress or dominate a less developed economy like that of the United States? Would not British producers simply undersell Americans both at home and abroad?

David Ricardo, a prominent London stockbroker turned public policymaker and political economist, showed that such fears were unfounded. His concept of comparative advantage has been called the only idea in the social sciences that is both true and non-trivial. Ricardo showed that a nation was better off trading even when it could not produce anything more efficiently than its trading partner could. It should make and trade away whatever it was comparatively good at producing, even if the other country was absolutely better at making it. If the other country did likewise, total output would be maximized.

Despite that theoretical breakthrough, many Americans, particularly in the urban North, continued to call for protective tariffs. With the spurt of industrialization that accompanied Jefferson's trade embargoes and the War of 1812, manufacturers obtained enough political clout to raise tariffs to protective levels. By the 1820s and 1830s tariffs had become a major political battleground. As followers of Smith, Hamilton, and Ricardo, most modern economists argue that nineteenth-century America became rich in spite of its high tariffs, not because of them.

What made America wealthy, some scholars argue, was its surprisingly modern financial sector. In this sector Smith, Hamilton, and Ricardo made important theoretical contributions and, in Hamilton's case, practical contributions as well. Together, they showed that financial markets helped to ensure that physical capital (land, ships, buildings, and machinery) and labor were put to their most efficient uses. Banks, insurers, and securities (stock and bond) markets were political lightning rods at times, but they proliferated widely, especially in the North. In many ways Smith, Hamilton, and Ricardo were ahead of their time. America's economic might owes much to them.

See alsoGovernment and the Economy; Hamilton, Alexander; Hamilton's Economic Plan; Tariff Politics; Taxation, Public Finance, and Public Debt .

bibliography

Conkin, Paul. Prophets of Prosperity: America's First Political Economists. Bloomington: Indiana University Press, 1980.

Matson, Cathy, and Peter Onuf. A Union of Interests: Political and Economic Thought in Revolutionary America. Lawrence: University of Kansas Press, 1990.

McNamara, Peter. Political Economy and Statesmanship: Smith, Hamilton, and the Foundation of the Commercial Republic. DeKalb: Northern Illinois University Press, 1998.

Ricardo, David. On the Principles of Political Economy and Taxation. New York: Barnes and Noble, 2005.

Peskin, Lawrence. Manufacturing Revolution: The Intellectual Origins of Early American Industry. Baltimore: Johns Hopkins University Press, 2003.

Smith, Adam. The Wealth of Nations. New York: Barnes and Noble, 2004.

Wright, Robert E. The Wealth of Nations Rediscovered: Integration and Expansion in American Financial Markets, 1780–1850. New York: Cambridge University Press, 2002.

Robert E. Wright

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