Political Economy: Theory
Putting aside the analysis of WN’s first three chapters for the moment, the theory of prices is built around the distinction between “natural price” and market prices, where the former refers to what may be called, in latter-day language, the equilibrium competitive supply-price of a commodity, and the latter refer to actual particular prices at which market transactions occur.
For each commodity, the unique natural price is determined by the production method in use (tacitly, the dominant method in use) and natural rates of remuneration for the collaborating inputs of labour, capital and land required for its production. (Hence Smith appears to make land-rent price-determining, a doctrine which would be overturned in the subsequent forty years.) Market prices result from the interaction of supplies and demands, with imbalances between aggregate supply of a commodity and “effectual demand” causing deviations between market prices and the natural commodity price. When supply is fully adapted to effectual demand - the aggregate demand for a commodity, forthcoming when the natural price has to be paid - market prices align with natural price. Competition, understood especially as the free mobility of capital, is the dynamic which brings about this adaptation, in response to the abnormal profitability which results from deviations between natural and market prices.What then determines the natural rates of remuneration of labour, capital and land? The theory of wages is partitioned into an account of the general level of wages, or the wages of “common” labour (or the lowest-skill form of labour), and an account of wage differentials for heterogeneous labour. The determination of the general level of wages is conceived of in terms of the balance of bargaining power around the labour contract, with that balance in general favouring the employers.
In the limit, wages will be pushed to a subsistence level, where that subsistence consumption is understood as a customary, historically determined minimum. (In extreme circumstances, the consumption of at least the unemployed can fall below subsistence: WN: I.viii.26.) The balance between the growth of labour demand (driven by the rate of capital accumulation) and population and workforce growth serves as a proxy for the balance of power, so that high real wages can result from a liberal, competitive economic society which has high rates of capital accumulation and growth. Wage differentials (putting aside the influence of policy) are due to the relative “disagreeableness” of occupations, the costs of acquiring skills or human capital, the irregularity or otherwise of employments, “the small or great trust” involved in employments, and differential risk (WN: I.x.a-b).On profits, Smith offers only a vague and indeterminate notion of competition between capitals tending to reduce profit rates in general, though maximum and minimum normal (“ordinary”) profit rates are defined (WN: I.ix.18-21). (In any case, this attempt at a theory of profit rates separate from the theory of real wage rates was later rendered redundant by the determinate inverse functional relation between real wages and rates of profit, for given production methods, first enunciated by David Ricardo.) Competitive profit differentials are explained by differential risks and “the agreeableness or disagreeableness” of alternative employments of capital, with the former the more important factor (WN: I.x.b.33-4). The highly unsatisfactory attempt at a theory of rents, notably, in the final chapter of book I of WN (the longest chapter of WN, near one-eighth of the entire text), is even more problematic than the theory of profit rates, seeming to make land-rent, at one and the same time, price-determined as well as price-determining. (For an attempt at a more positive and charitable interpretation, see Brewer 1995.)
Economic growth is understood by Smith to have two proximate causes: division of labour and capital accumulation, with human capital explicitly included (but not the term).
These two factors in turn are seen as derivative from underlying propensities of human nature, which are treated as parameters for the purposes of the political economy: “the propensity to truck, barter, and exchange” is the source of division of labour; “the desire of bettering our condition”, the driving force of saving and accumulation (WN: I.ii.1, II.iii.28). In the opening three chapters of WN he enunciates the doctrine that labour specialization, the source of labour productivity growth, is limited or enabled by the size of the market. This is perhaps second only to the “invisible hand” as the doctrine for which Smith is most well known, though it is not original to him. The division of labour doctrine is a doctrine of ongoing technical change, expressing Smith’s basic technological optimism, though he is careful to allow also, that at least some natural scarcities will likely become more binding as commercial societies grow, so that real wages measured in such commodities might fall (WN: I.xi). Smith has been criticized for over-emphasizing the importance of labour specialization at the expense of the role of mechanization in economic development, but introduction of new machinery is a very common accompaniment in his commentaries on division of labour.In any case, since in the social economy Smith theorizes, wages are part of the capital advanced by employers, capital accumulation is the necessary prerequisite to division of labour and the realization of technical progress. The role of capital accumulation is also articulated in terms of the distinction between “productive” and “unproductive” labour, inherited, somewhat transformed, from the Physiocrats. (He also takes over from them a distinction between circulating and fixed capital.) There are inconsistencies in the manner in which Smith draws the productive/unproductive distinction; but his primary intention is to distinguish between labour devoted to capital accumulation and growth, versus labour devoted to the production of luxury consumption.
In short, the coherent and important conception of productive labour in Smith’s text is labour devoted to the production of capital goods, keeping in mind that capital for Smith includes the wages or consumption of the productive workers themselves. The rate of capital accumulation appears as driving the growth process, Smith being able to avoid the issue of any possible aggregate demand constraints upon the growth of the capital stock, and hence of output capacity, by recourse to a saving-is-spending doctrine (WN: II.iii.18). In effect, this doctrine facilitates an avoidance of the question of the coordination of saving and investment (in general undertaken by different classes of economic agents, even in 1776), by treating saving and investment as one and the same thing (Aspromourgos 2009: 164-78, 192-6; also Eltis 1984: 68-105). To that extent, Smith’s theory is really a theory of how production capacity can grow, or one may say, a theory of potential growth.With regard to monetary theory, Smith firmly endorses a commodity-standard for currency (WA: I.v.41-2, I.xi.g.5, I.xi.m.20). The conventional unit of account should be fixed in terms of a quantity of a precious metal. He is well aware of the history of actual currency debasements. Smith believes also that, as a matter of fact, it is the quantity of the commodity currency (not quantity in terms of the conventional unit of account) which agents have regard to in monetary exchange. Under these conditions, equilibrium money prices are just a particular case of equilibrium relative prices, or of the theory of natural prices: those money prices will be determined by the relative natural costs of production (including natural profits and rents) of the money commodity versus other commodities, and with the quantity of commodity money in circulation demand-determined. Interest rates are understood to be regulated by the profitability of capital in production, the differences between the two sets of rates of return being primarily determined by the distribution of risk-bearing between lenders and borrowers (WA: I.ix.16-22). Smith also has much to say about banking, the most notable theoretical element of which is his “real bills” doctrine, that secure and adequate collateralization of at least short-term loans with real assets ensures no excess issue of paper currency or credit, a doctrine further developed by the Banking School in the nineteenth century (WA: II.ii.26-106; Green 1992: 114-27; and further to Smith’s monetary thought in general, Rockoff 2013).