My favorite quote by Adam Smith

As you can probably tell, I’m a big fan of not talking about people, but about what they actually wrote or did. And the discrepancy between the two is especially large with Adam Smith. (As you can also tell, blogging-as-usual has now resumed.)

In my latest comment on the Economist, I could not help but drop one of my favorite quotes of him saying that the “rate of profit is[…] naturally low in rich, and high in poor countries, and it is always highest in the countries which are going fastest to ruin.”

Of course, this quote has to be read within the context of the 18th century Europe, which I alluded to in the comment. Smith was looking at what he called the past – the early and middle of the century, at a continent consisting of countries that had, roughly speaking, similar economies. Of course there were large disparities, but they were more of a quantitative than a qualitative kind, insofar as the work itself and the applied technology was concerned. (This was, of course, about to change – but those changes only came about in a significant way during the decades after Smith wrote the Wealth of Nations.)

Within todays developed stagnating countries, we can assume that a very similar scenario is playing out. The general idea why the inverse relationship of the  wealth of a society and the rate of profit comes to be, is quite simple. You assume that a society has a certain potential economic output. If the actual economic output is below the potential, it will tend to be increased by businessmen investing in new businesses – those will, of course, tend to be the most profitable ones available – the proverbial low hanging fruits.

The closer you get to potential output, the more of the high-profit opportunities will have been taken and one average, the low-profit businesses will tend to dominate the economy as a whole. As a consequence, you would expect that people in rich economies would tend to invest into the high-profit opportunities in those countries where they are still available. Which means, of course, that if Homo Economicus ruled the world, there would be no poor countries. The evidence points to the contrary.

There must be hindrances preventing people from benefiting from opportunities in other countries. In our modern world, those tend to be infrastructure, language barriers, corporate structures, subsidies, embargoes, preferential trade agreements, information deficits, psychological  and far too often barbed wire fences and immigration policies.

Nothing puts as much of a dent in your prospects to generate a higher rate of profit by employing desperate illegal African immigrants, hellbent on sending money to their relatives at home, in your European business, than the fact that said desperate illegal African immigrants stand a very good chance of drowning in the Mediterranean or being thrown into a concentration camp and, cruelly, only be sent back after months to deter them from returning right away, if they survived the trip in the first place – as, due to the illegal nature of any poor persons attempt to trespass on a rich countries’ territory (as stated in so many weasel words in those rich countries legislation), seaworthy vessels are not usually available.

(If you don’t feel sufficiently offended by the preceding paragraph, please break it down into the individual statements I made and try not to let your outrage about any one of the statements diminish your appreciation of the outrageousness of all the other statements therein contained. There is a whole new world of outrage to be attained if you manage to keep the outrageousness of all those statements in your mind at once. Oh and yes,”A camp where civilians, enemy aliens, political prisoners, and sometimes prisoners of war are detained and confined, typically under harsh conditions.” fits the bill far too closely for what is being done to those people.) [/rant]

The barriers of realizing access to high profit opportunities are one of the main reasons for the disparities between countries. Unlike those that tend to touch my nerves, a lot of them are perfectly unavoidable. There is a distance between countries that needs to be bridged – which involves costs. Although that depends a lot on which products and services an economy is dominated by and their properties. Sometimes, new developments can reduce those costs significantly.

Call centers in India are a classic example of such “transport” suddenly becoming very cheap. The relatively small language barrier created opportunities to build call centers in India, train their staff, get a high rate of profit and still offer prices so low that corporations in other countries could reduce their costs that way. This would not have been possible, had there not been the required infrastructure – which was fortunately in place once an abundance of glass fibre lines have been laid during the dot.com bubble years. (The best way to connect Europe to East Asia goes through India.)

But there is more than that. Because unlike during the times of Adam Smith, levels of technology are now such, that some infrastructure needs to be build in order to use more advanced technology in the first place – whereas 18th century technology could basically be build from scratch. Although some of it was very labor intensive and heavily dependent upon local terrain and resources, such as the digging of canals – which was the least energy intensive and often only feasible way of transporting large amounts of goods over land. The Low Tech Magazine has described one example in its latest article.

Infrastructure, here, also means a lot more than just roads, canals, phone lines or water. It is also both education as it happens and education as it happened in the past, health services and other things such as the structure of the society, which must be tweaked in such a way to let people with the right ideas get in touch with the means to put them into practice. (Whatever that “right idea” is. Even if it is just economic performance you are looking at, social, environmental and other factors have a large enough influence on the economy that it is impossible to ignore them.)

To sum this up: There are a lot of things that determine how large the potential of an economy is and how much of it is put into practice. What gets left out, is usually the least profitable businesses.

It is this last part also explains the last part of Adam Smiths statement. Because if a society suddenly generates much higher rates of profit, a lot of the less profitable economic activities are no longer being pursued. This may be a good thing, if there is a genuine innovation in business that is increasing the wealth of the nation – but not such much if those high rates of profit come from idle speculation in finance, tulips or some other kind of pyramid scheme.

Because in this case, business in replaced with nothing that has any practical value for the nation. And it should not surprise that this is the road to ruin.

Btw.: There is such a thing as productive speculation. But I will leave this to my next blog entry.

2 thoughts on “My favorite quote by Adam Smith

  1. Great words, TP. Unless there is some sort of production ( doesn’t have to be tangible, thoughts and ideas can be considered valuable production too ) the system that encourages speculation and discourages production cannot last long without first improverishing and finally destructing itself.

  2. Nice post. I particularly enjoyed the link to the Low Tech Magazine. Thanks

    When we talk about equal opportunities to education and health care, we may also include the equal opportunity to the access of information, like access to broadband, mobile device. And without information fairness, we will only have crooks in the Wall Street to destroy the world.

    Financial innovation is like explosives, it is great if we use it in engineering, but bad in war. Some risk-sharing innovations are great, like venture capital for Youtube, equity and shares for Google, bonds to build railroad or infrastructure, or micro-finance for the poor in the world, combined with “Western-union” style of financial services and mobile phone. Sometimes equity and bonds just create financial crisis, long in human history. The same can be said for leveraging.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s