All Commentary
Sunday, March 1, 1992

Adam Smith and Modern Economics: From Market Behavior to Public Choice

Despite being widely described as the “father of modern economics,” Adam Smith is given cursory mention by most modern economists and is only regarded as important for his 18th-century insights.

Readers will put down West’s book with a comprehension of Smith as a timeless economist whose analysis yields fresh insights into modern economics.

This work, published 200 years after Smith’s death, is both a reinterpretation of Smith and a review of how later writers have extended his ideas. But the most exciting aspect is the reinforcement lent to Smith’s status as a champion of free markets. Some latter-day economists have depicted Smith as a moderate interventionist, falsely claimed by libertarians. West looks at each area in which Smith supposedly favored government action and confirms him as a believer in the minimal state.

West contends that where Smith refers to projects that “could never repay the expense to any individual or small number of individuals,” he did not have in mind the modern concept of a “public good” (a good the provision of which is indivisible or from which recipients cannot be excluded). Rather, he was suggesting that a large number of individuals could receive an adequate return, if enabled to do so through liberalized capital markets.

The historical context is important, as “public” companies—limited liability firms that could raise capital through equity issue—were often permitted to exist by royal charter. Smith wasn’t calling for government provision when he referred to public enterprises, West says, but for charters to allow companies to undertake certain projects.

Smith advocated charters for insurance, banking, canals, and water supply. For most infrastructure he favored local financing, either through local taxes or through tolls, rather than central government funding. He accepted some government financing of education, but believed it should be mixed with local funds, and he argued for teachers to be paid by the tutored.

In a fascinating chapter on the history of economic thought, West places Smith in the laissez-fake school of economics along with Malthus and Ricardo, and contrasts them with John Stuart Mill and Nassau Senior. Whereas Smith presumed that the individual knows his own mind best, Mill and Senior conceded large areas of society to government and saw little reason to set limits.

West maintains that those more dirigiste economists didn’t appreciate the importance of Smith’s analysis of interest groups and how they distort good government—the analysis recently developed into public choice theory.

The modern school of public choice, exemplified by economists James Buchanan and Gordon Tullock, applies economic methods to political behavior. West devotes a chapter to Smith’s public choice analysis, but this is a theme that runs throughout the book.

Economists examine the costs of monopolies in terms of their upward leverage on prices. Smith recognized these costs but saw others, identifiable through his public choice analysis. He pointed out the costs of lobbying, both to the monopoly seeking to retain its privilege and to victims seeking its removal. He also considered the costs engendered by the growth of bureaucracy in monopolistic firms, and the general harm to the body politic caused by allowing people to seek special favors from government. These additional costs are not appreciated in modern economics because of its narrow diagrammatic focus.

Smith’s failure to spell out a theory of comparative advantage in trade has drawn criticism from a number of economists, but West defends his more dynamic approach. As Smith saw the division of labor limited by the extent of the market, so trade provided a widening of the market and was a spur to development.

George Stigler has criticized what he believes is Smith’s suspension of his own public choice analysis in his policy recommendations. Stigler cites Smith’s canons of taxation which suggest convenience, certainty, minimal exaction, and ability to pay as the basis for a tax system. Smith is naive, says Stigler, to expect politicians to be interested in anything other than maintaining votes and raising revenue.

Once again, West provides a novel explanation of Smith’s position. First, he says, Smith was thinking at the pre-constitutional level rather than referring to the hurly-burly of politics. Second, Smith was indeed appealing to self-interest—that of the sovereign to whom his remarks were addressed. It was in the sovereign’s interest to prevent abuse of the constitution, says West. Smith’s “clients were the custodians, the draftsmen, and the innovators of constitution, not a passing government that is intimidated by the mob,” West contends.

One of West’s aims is to defend Smith against critics who have argued that his work contains little that can be tested empirically. Some Austrian economists would quarrel with the assumption that theories must stand or fall on quantitative evidence. Had Smith written today, his work might have been cluttered with statistical analysis, but surely his qualitative prose is more accessible.

West includes a chapter on religion to show how Smith presented his ideas in testable form, but also perhaps to remind us that Smith’s work ranged wider than economics. Smith looked on religions as moral codes, evolved to bind people to their sense of duty and respect for rules. By the same token, said Smith, joining a church is a way of establishing a reputation for newcomers. Religions provide “valuable, reliable information concerning the level of risk attached to dealings with particular individuals,” he suggested.

What could have been a narrow and arcane book opens up Smith and contains some sharp reflections on the questions addressed by Smith and on his place in the history of economic thought. West decides that the reason a subsequent generation of economists strayed from Smith’s individualism “may be that their understanding of it was too superficial.” He could have said much the same of many modern economists, but the departure is something that West’s book will help to remedy.

Nicholas Elliott is a financial journalist in London.