BOOK II: Of the nature, accumulation and employment of stock
Of the division of stock
If the stock that a person possesses will not maintain him for more than a few days or weeks, he will not attempt to use it to earn revenue, but will attempt to consume it as sparingly as he can, and will seek to immediately replace it by his labor. However, if the stock of a particular individual is sufficient to maintain him for several months or years, he will attempt to derive a revenue from the stock that he does not need for immediate consumption, thereby reserving only a minimum of his stock for his basic needs. The part of his stock that he uses to derive a revenue is called capital.
There are two different ways in which capital may be used to yield a revenue. First, it may be employed in raising, manufacturing, or purchasing goods that will be sold again at a profit. Capital employed in this manner first yields a revenue when these goods are sold for money, and when this money is then exchanged for an increased quantity of goods. In order for revenue to be increased over time, this process must continue. Smith refers to capital employed in this manner as circulating capital. Secondly, capital may be invested in the improvement of land, the purchase of useful machines and instruments of trade, or in such things that yield a profit by increasing productivity, without the capital changing hands. Capital employed in this manner is called fixed capital. Different trades require different proportions of capital to be employed either as fixed or circulating capital.
Smith extends his explanation to society in general, making the argument that the general stock of a society is equal to the stock of all of its members, and that this stock naturally divides itself into three portions, with subsections therein:
1) stock that is reserved for immediate consumption, which includes not only food, but also clothes, household furniture, dwelling houses, and every good that is purchased for consumption.
2) fixed capital, consisting mainly of four sorts:
a) all useful machines and instruments of trade that serve to facilitate or abridge labor
b) all profitable buildings that serve as a means of procuring a revenue, either as rent or as the locations of a business or warehouse, work-house or farm-house
c) the improvements of the land, which may be likened to a useful machine that serves to ease labor and increase productivity
d) the acquired useful abilities or talents of the members of a society.
3) circulating capital, and the circulating capital of a particular society consists likewise in four sorts:
a) money, clearly a form of circulating capital
b) the stock of provisions which are sold to make a profit
c) the crude materials that are manufactured or used to make clothes, furniture or buildings
d) the work which is made up and completed in the form of goods, but which has not yet been sold.
The sole end of both fixed and circulating capital is to maintain and increase the capital used for immediate consumption, and wealth is measured by the abundance of stock that is available for immediate consumption.
Of money, considered as a particular branch of the general stock of the society, or of the expense of maintaining the national capital
It was explained in Book I that the price of every product divides itself into three parts, one part of which pays the wages of the labor, the second part of which the profits of the stock, and the third part of which pays the rent of the land. The same is true of all the commodities which compose the annual produce of the land and labor of every country. The whole price or exchangeable value must resolve itself likewise into the same three parts. In thinking about the whole annual revenue that is divided among the different inhabitants of a country, the distinction must be made between the gross and the neat revenue. The expense of maintaining the fixed capital of a country may be compared to the expense of maintaining the fixed capital of an individual, whereas the circulating capital of a society may not be compared to that of an individual. The two differ in that, for an individual, money symbolizes circulating capital, while for a society, money symbolizes fixed capital. In the context of a society, money is more like fixed capital in that it does not augment the stock reserved for immediate consumption, but serves in all cases as a tool of commerce. Smith further explains why the amount of money circulating within a particular society cannot compose any part of the revenue. Since money changes hands several times, a given amount is used to pay at one time rent, at another time wages, and at another time the profits of stock.
Smith goes on to explain the increasing prevalence of paper money, which for him is a useful tool of trade. He details the benefits of the banking system. During the time of his writing, banking had newly developed systems of issuing credit to merchants. He praises this system, as it not only allows bankers to earn a living by granting credit at an interest, but also increases trade by freeing up money that merchants or other business owners would have to keep on hand in order to carry out business. When they are extended credit, more money is freed to be used as revenue-producing capital. Smith warns, however, that the amount of paper money that circulates in a particular country should never exceed the amount of gold and silver that country possesses.
Smith goes on to make further observations and admonitions about banking. He states that the primary expenses of a bank consist in keeping in its coffers a certain sum of money at all times for answering demands (and thereby losing the interest it might have earned by lending out this sum of money) and the expense of replenishing those coffers as they are emptied, sometimes borrowing from other banks. When the amount of paper money circulated by banks exceeds either what the country's economy can absorb, or the amount of gold or silver that the country possesses, the banks incur the expense of filling their coffers after money is sent abroad to a market that can employ it, or purchasing gold in order to back paper money it has issued.
Smith also warns that banks may only lend to business owners an amount which they would otherwise be obliged to keep on hand for answering occasional demands. If a bank lends over and above this amount, they bring themselves into danger of being defaulted upon. More adventurous undertakers who expose themselves to higher risk should not borrow from a bank, but should instead borrow from private persons, who can comfortably live from the interest of their money, and, if defaulted upon, would not incur any severe financial blow.
Though the use of paper money makes a particular economy more flexible and can encourage growth, it can also be somewhat dangerous, as it is more theoretical, and more open to manipulation at the hands of a few individuals or groups of individuals. For this reason, Adam Smith cautions that paper money only be issued in relatively large notes, which would limit the groups of people that could use paper money in their transactions. He notes that the circulation of a particular country can be divided into two categories: that between dealers and dealers (merchants and business owners), or that between dealers and consumers (business owners and their retail customers). In order to be carried out, both require a certain stock of money. Dealings between dealers require a relatively large stock of money since they are carried on wholesale, while dealings between dealers and consumers require a relatively small stock. Small amounts of money change hands more quickly, or are circulated more often and more rapidly. When small sums of money become available in the form of paper (promissory notes), people are less likely to investigate and reject promissory notes (because they are worth so little), meaning that worthless notes from unreliable sources will be issued and change hands, adding to the instability and risk of the system.
Smith states that the only regulation that should justly apply to banks is that they should be restrained from circulating bank notes for less than a certain sum, and these notes must be subjected to the obligation of immediate and unconditional payment as soon as they are presented. Aside from this, banks should be allowed to flourish. A high number of different banks, as long as they self-regulate in the manner described, are in fact a great benefit to society: competition among banks increases as a result of their number, obliging them to be more prudent in their conduct and more generous with their customers.
In Book II of the Wealth of Nations, Smith begins to describe how the surpluses created by the division of labor begin to build off capital, and how that accumulation of capital reinforces the system, expanding the division of labor and supporting technological advances and specialization. In the first two sections, he speaks in a more theoretical manner about money (touching again on his theory of value), and about consumption and investment.
Smith's discussion of fixed and circulating capital in the social (as opposed to the individual) context reinforces what he wrote in Book I about money's lack of intrinsic value. The same money note or coin turns over several times in the course of a year, and represents the income of many individuals. The true value in society is what money leaves in its wake, as it were—in what is purchased, produced, or sustained by its brief tenure in each person's hands.
Smith goes on to make some observations about banking, and the role of banks in the economic system. In Smith's time, wide scale use of paper money was a relatively new, or at least still very limited, phenomenon. Today, the Federal Reserve or other national banks have the power to simply declare the notes they issue to be legal tender. In Smith's time, however, paper money was promissory notes, which were backed by gold reserves. Paper money could be exchanged for the equivalent quantity of gold at any bank. Banks facilitated trade by issuing these notes, allowing capital to flow and change hands at a more rapid pace.
Smith, however, had just witnessed the 1772 banking crisis, in which many Scottish banks collapsed. He was therefore sensitive to a number of risks. He issues warnings against over-issuing bank notes. Smith believed that competition among banks would serve to ensure that banks behave in a prudent manner. In this case, he was not completely opposed to government regulation.
It is worth mentioning here that while banks were still negotiating their role in society, and while they did not yet have the power that they have today, Smith's banks were still likely to be well-established. Something akin to the modern banking system began developing in the wealthy merchant cities of 14th century Italy. The London Royal Exchange had been already been developed around two hundred years prior to Smith's writing, and the Bank of Amsterdam, which would remain a financial powerhouse far into the Industrial Revolution, had existed for over one hundred years. Indeed, Smith had the opportunity, at the time of his writing, to draw on extensive banking history to make his observations and criticisms.
The distinction that Smith makes in Chapter II between gross and net income was a revolutionary one. This distinction has been an important one for analyzing business models and productivity, and it has endured to the modern day. Indeed, much of Smith's work serves to render a more complex and accurate account of how prices are structured, what they consist in, and how they are divided among various individuals, with various stakes in the factors of production. Distinguishing gross and net income, after having made so many groundbreaking observations about the factors of production, was the logical next step for Smith.
Of the accumulation of capital, or of productive and unproductive labor
Labor is of two kinds: productive and unproductive. Productive labor adds value to its subject, and unproductive labor does not. A manufacturer, for example, adds value to the materials he works with, therefore contributing to his own maintenance and his master's profit. Though the manufacturer receives his wages from a master, in reality the manufacturer is maintained by his master at no real cost. A menial servant, on the other hand, who produces nothing and whose work is without value, has his wages advanced to him at a cost to his master, who afterward has no product and no profit to show from this advancement of wages. A master who maintains manufacturers may, in this sense, grow rich, while a master who maintains menial servants will grow poor. Smith says that maintaining productive laborers who add value by producing material goods is like storing up wealth. Smith's idea of unproductive labor extends far beyond the profession of menial servants, to artists, churchmen, physicians, men of letters, soldiers and the sovereign himself. However valuable and necessary these individuals are to society, they are not productive laborers and are therefore maintained by the annual produce of the productive land and labor of the country. The amount of unproductive land and labor varies with the amount of productive land and labor, and is ultimately limited.
The produce of land and labor, upon completion or fruition, is divided into two parts. The first part is destined to replace lost capital, and the second constitutes the revenue of the person who owns the capital as the profit of his stock, or the person who owns the productive land as rent. The part of the annual produce destined to replace capital in fact goes toward the maintenance of productive laborers in the form of wages. The second part, which constitutes revenue, may go toward maintaining unproductive labor. If a common laborer's wages are so high that they exceed the amount necessary for his basic maintenance, he may spend them on non-necessary things, like entertainment or a personal menial servant. Thereby, the excess is likewise employed in maintaining unproductive labor.
The proportion between productive and unproductive labor is very different in rich and poor countries. In the ancient feudal system, a very small portion of the annual produce was sufficient to replace the capital employed in cultivation. During Smith's time, Europe devoted the greatest portion of its produce to replacing capital, or paying the wages of productive labor. In richer European countries during Adam Smith's time, considerable capital was devoted to trade and manufacturing, which was responsible for a considerable portion of the revenue of these countries. However, the profit margin, because of the proliferation of stock, was lower than in feudal times.
Of stock lent at interest
Stock lent at interest constitutes capital for the lender. The borrower, in turn, can also use the capital lent as such, investing in productive labor that brings a profit, or for immediate consumption. If the borrower chooses to use the capital for immediate consumption, he will have to encroach upon his property or his rent in order to repay the capital. Unwise use of lent capital is checked by the fact that a person who borrows in order to spend will soon find himself in financial ruin.
The amount of money lent in a society depends upon the amount of annual produce that is destined to replace a capital, but a capital which the owner does not deem necessary to use himself. Loans are often made with money, which ultimately represents capital. The same amount of money can be lent many times over (to person A who purchases from B, and then from B who in turn, with the value from the sale, lends to C, etc). In this way, the same amount of paper money may participate in a number of loans, all perfectly secured.
As the quantity of stock to be lent at interest increases, the interest diminishes. This has to do not only with the simple law of supply and demand, but with other causes as well. As capital increases, the competition between those who posses that capital increases as well, diminishing profits and raising wages. When profits of capital diminish, they become harder to employ, and therefore interest must diminish as well.
Adam Smith goes on to consider the possible reasons behind the lowering of interest rates, which is not due, as was thought then, to the devaluation of silver. Interest rates are proportional to the value of money, so fluctuations in the value of silver would lead to similar fluctuations in the rate of interest. In general, the interest of money always keeps pace with the profits of stock.
Governmental regulation of interest rates is a tricky subject. Adam Smith argues that it is improper to forbid interest altogether, for money, invested well, makes a profit, and therefore a fee should be charged for its use. If a government fixes a limit on the interest, it should be slightly higher than the lowest market price. If the legal rate is fixed below the market rate, the effect is the same as a prohibition of interest, because the creditor will not feel inclined to lend his money. If the legal rate is fixed precisely at the lowest market price, it ruins the credit of those debtors who cannot ensure anything but the best security.
Land prices are also regulated by interest rates, because a person who has capital from which he desires to derive a revenue contemplates either lending it as capital or purchasing land. Land purchase offers greater security, and is therefore a priori a more attractive choice. When interest rates fall, the price of land rises, and vice versa. The values are indirectly proportional.
Of the different employments of capitals
A capital may be employed in four different ways.
1) in procuring the rude produce that is required for the use and consumption of a society each year
2) in manufacturing and preparing the rude produce for immediate use and consumption
3) in transporting the rude or manufactured produce from the places where they abound to the places where they are lacking
4) in dividing particular portions of either into portions that suit the occasional demands of those who want them.
Each of these four employments are necessary, either to the existence or extension of the other three, or to society in general. People who employ their capitals in one of the four above ways are themselves productive laborers, since their labor serves to augment the annual value and produce of the society to which they belong.
Capital used to support farming is the most productive. This is because, in the case of agriculture, nature's labor works alongside man's labor to produce commodities, and nature's labor costs no expense. After agriculture, the capital employed in manufactures puts into motion the greatest quantity of productive labor, and adds the greatest value to the annual produce. That which is employed in the trade of exportation has the least effect of any of the three.
Capital can be used to improve and cultivate the lands, manufacture and prepare rude produce for use and consumption, and to transport the surplus part of rude or manufactured produce to markets where it can be exchanged for something that is necessary at home. Indeed, these activities constitute farming, manufacture, and merchant trade, which are the categories of commerce in Smith's work. When a country has insufficient capital to carry out these activities, it should not attempt, with insufficient capital, to do all three. Instead, it should focus on the activity that adds the greatest value to the annual produce. This is agriculture. This focus on agriculture is evident in the colonies, which are still developing toward their optimal degree of opulence.
The capital that is used for trade at home will do more to encourage and support productive labor in that country than will an equal value of capital that is used for foreign trade and consumption. Foreign trade should only be carried out when there is a surplus produce that cannot be consumed at home. The same is true of surplus capital, which, when it cannot be used properly at home, must be more productive abroad.
In Chapter 3 of Book II, Smith introduces a core distinction between productive and unproductive labor. Unproductive labor is not unnecessary or useless, but it does not create economic surpluses. It is funded from labor that does indeed create these surpluses. Unproductive labor needs to be limited, and checked by the surpluses that productive labor makes available. It is important to remember Smith's idea that the economy is a system that automatically regulates and propagates itself. If spending on services goes unchecked, however, fortunes that were built up with a view toward maintaining industry far into the future can be squandered over the course of a few years or decades.
However, Smith goes on to argue, the admonition to maintain a careful balance between productive and unproductive labor applies above all to governments. Private individuals, who are looking out for their personal well-being, are aware that they cannot spend all of their income, and that a certain portion of it must be saved in order to be reinvested in their endeavors. However, the government rarely has these long-term concerns in mind. It is engaged in employing a great number of unproductive laborers at all times (in Smith's view, it must be reiterated, government bureaucrats, lawyers, and officials are all unproductive laborers). The larger the government is, Smith argues, the more it will spend on unproductive labor, and the more tax-payers will be forced to part with their capital, making them unable to use it in ways that will encourage growth and industry into the future.
In these chapters, Adam Smith implicitly but powerfully suggests that societies follow a natural progression toward both industrialism and opulence, and the examples he gives of the colonies' intensive focus on agriculture as well as his assessment of productive versus unproductive labor are both examples of this underlying belief. Smith's argument that menial servants, civil servants and professionals, and entertainers represent unproductive labor may be seen as an indirect criticism of feudal society, or the noble class, which supports and champions a system in which such unproductive professions are supported by nobility as a way to demonstrate wealth. He also points out that in a system in which laborers are paid in wages (which seems to be an implied counter-example to the feudal system), they may contribute excess wages to entertainment. Wage laborers would thereby support unproductive labor, an activity of luxury previously limited to the wealthy nobles. In general, by outlining his ideas about productive and unproductive labor, Smith seems to be clearly pointing to an inevitable future, and signaling what kinds of lifestyles he thought were becoming obsolete.
Smith, in reflecting upon the various ways in which capital may be used, observes that the role of retail is to break goods down into portions that may be readily consumed on the market. A butcher, for example, brings his meat to market as a series of small cuts that can be sold individually, rather than selling entire animals whole. Considerations of retail lead Smith to reflect upon how retail offerings are also governed by supply and demand. He uses the example of ale-houses and drunkenness. The disposition toward drunkenness is not, he argues, a result of the plethora of ale houses, but the plethora of ale-houses is a result of the widespread tendency toward drunkenness. This observation, at Smith's time and in modern times, as well, is an implicit and powerful commentary on government regulations to restrict the sale of certain substances.
The most important and enduring message of this section is the idea that a certain portion of capital must be saved so that the productive capital of a society can be expanded. This in turn allows for greater efficiencies in the future: as capital accumulates, more specialist and labor-saving methodologies can be developed, which, in turn, lead to greater surpluses. These surpluses represent expanded capital, and the cycle goes on. These processes lead to a rise in wages, because when capital competes, wages increase. The good decisions and expanding capital of the wealthy classes with the means to invest, therefore, trickle down to the poorest workers, and increase their well-being as well. This entire process occurs only through trade and prudent reinvestment, and is completely unrelated to the amount of gold in the coffers of a particular nation. This idea, then, is another implicit critique of the mercantile idea. Smith implies that countries will be better off if they engage in trade with one another, and dissolve trade barriers erected in a convoluted and misguided effort at self-protection.