The function of the economic theory

Adam Smith is the founder of the modern economic theory. The title of his book is The Wealth of Nations. From the title, it seems economic theory is to advise nations to become wealthy. Adam Smith advised America to remain an agricultural society. Let’s have a look at his advice to America in detail.

It has been the principal cause of the rapid progress of our American colonies towards wealth and greatness that almost their whole capitals have hitherto been employed in agriculture. They have no manufactures, those household and courser manufactures excepted which necessarily accompany the progress of agriculture, and which are the work of the women and children in every private family. The greater part both of the exportation and coasting trade of America is carried on by the capitals of merchants who reside in Great Britain. Even the stores and warehouses from which goods are retailed in some provinces, particularly in Virginia and Maryland, belong many of them to merchants who reside in the mother country, and afford one of the few instances of the retail trade of a society being carried on by the capitals of those who are not resident members of it. Were the Americans, either by combination or by any other sort of violence, to stop the importation of European manufactures, and, by thus giving a monopoly to such of their own countrymen as could manufacture the like goods, divert any considerable part of their capital into this employment, they would retard instead of accelerating the further increase in the value of their annual produce, and would obstruct instead of promoting the progress of their country towards real wealth and greatness. This would be still more the case were they to attempt, in the same manner, to monopolize to themselves their whole exportation trade. (Smith, 1776, p 193)

Several decades later, David Ricardo, an English economist, gave the same advice:

Under a system of perfectly free commerce, each country naturally devotes its capital and labor to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the universal good of the whole. By stimulating industry, by rewarding ingenuity, and by using most efficaciously the peculiar powers bestowed by nature, it distributes labor most effectively and most economically: while, by increasing the general mass of production, it diffuses general benefit, and binds together, by one common tie of interest and intercourse, the universal society of nations throughout the civilized world. It is in this principle which determines that wine shall be made in France and Portugal, that corn shall be grown in America and Poland, and that hardware and other goods shall be manufactured in England. (Ricardo, 1817)

If America adopted this comparative advantage theory, today it would still be mainly a corn growing country. While Smith and Ricardo saw it as optimal that corn should be grown in America and manufacturing should be in England, Alexander Hamilton, an American lived at roughly the same time as Ricardo, apparently had different opinions. His argument is as relevant today as was two centuries ago. We will quote him in length.

Experience teaches, that men are often so much governed by what they are accustomed to see and practice, that the simplest and most obvious improvements, in the most ordinary occupations, are adopted with hesitation, reluctance, and by slow graduations. The spontaneous transition to new pursuits, in a community long habituated to different ones, may be expected to be attended with proportionally greater difficulty. When former occupations ceased to yield a profit adequate to the subsistence of their followers, or when there was an absolute deficiency of employment in them, owing to the superabundance of hands, changes would ensure; but these changes would be likely to be more tardy than might consist with the interest either of individuals or of the Society. In many cases they would not happen, while a bare support could be insured by an adherence to ancient courses; though a resort to a more profitable employment might be practicable. To produce the desirable changes as early as may be expedient, may therefore require the incitement and patronage of government.

The apprehension of failing in new attempts is perhaps a more serious impediment. There are dispositions apt to be attracted by the mere novelty of an undertaking – but these are not always the best calculated to give it success. To this, it is of importance that the confidence of cautious sagacious capitalists, both citizens and foreigners, should be excited. And to inspire this description of persons with confidence, it is essential, that they should be made to see in any project, which is new, and for that reason alone, if, for no other, precarious, the prospect of such a degree of countenance and support from government, as may be capable of overcoming the obstacles, inseparable from first experiments.

The superiority antecedently enjoyed by nations, who have preoccupied and perfected a branch of industry, continues a more formidable obstacle, than either of those, which have been mentioned, to the introduction of the same branch into a country in which it did not before exist. To maintain between the recent establishment of one country and the long matured establishments of another country, a competition upon equal terms, both as to quality and price, is in most cases impracticable. The disparity, in the one or in the other, or in both, must necessarily be so considerable as to forbid a successful rivalship, without the extraordinary aid and protection of government.

Because of the protectionist policy of the US government, US manufacturing industries were able to become established. After US industries became highly competitive, government policy gradually shifted to free trade to access larger market for domestic products.

Why does the establishment of a new industry often need the support from the government? Often substantial fixed cost investment for a new industry is required before it becomes viable.  High fixed cost investment is highly sensitive to market uncertainty and require large market size to breakeven. Government support, by lowering uncertainty and guaranteeing market share, increases the chance of success for a new industry.

All superpowers throughout time advocate free trade, while poor countries prefer protectionist policies. So it is easy to link free trade with prosperity, and protection with poverty. But historically, all latecomers that turned into industrial powers, including England, the USA, Japan, and Germany, adopted protectionist policies in the period of takeoff (Bairoch, 1993).

From the above discussion, if we follow the advice of dominant economic theory, wealthy countries will remain wealthy and poor countries will remain poor. For latecomers, we have to look into the history of successful latecomers from earlier ages or follow common sense. For example, the standard argument against infant industry policy is that once government provides support to a new industry, it is difficult to decide when this industry should become independent. It is also difficult for parents to decide when their children should become independent. But should we expose infants to “market competition” immediately after they are born because of this difficulty? The fact that we can not time the “optimal” moment to let children become independent does not mean infants should not be supported at all. For the same reason, the difficulties involved in supporting new industries should not discredit infant industry policies completely.