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What Would the Great Economists Do?

How Twelve Brilliant Minds Would Solve Today's Biggest Problems

Linda Yueh




Adam Smith: Should the Government Rebalance the Economy?

Widely viewed as the seminal figure in economics, Adam Smith witnessed the beginning of the Industrial Revolution, which fundamentally changed the Western world. During this time and in the decades that followed, Britain became the world’s first industrialized economy. This extraordinary period formed the backdrop to one of the most influential books in economics.

Adam Smith’s magnum opus, An Inquiry into the Nature and Causes of the Wealth of Nations, took a decade to write. It sets out the concept of the ‘invisible hand’, which refers to the unseen market forces that set prices by equating supply and demand. It has become the mantra for laissez-faire economics. Even though Smith himself never used that term in that specific way, his writings did envision a limited role for the state:

The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.1

Smith was even more dubious when it came to taxation: ‘There is no art which one government sooner learns of another than that of draining money from the pockets of the people.’2

Adam Smith would view a policymaker who intervened in the operation of market forces with scepticism. Yet, that’s what post-industrial nations like Britain and the United States are attempting to do – roll back the deindustrialization process by encouraging manufacturing and reducing the share of national output accounted for by services. This urge to rebalance the economy arose after the 2008 financial crisis which revealed the fragility of a large banking sector that brought the economy to its knees. It led the then-UK Chancellor George Osborne to start wearing hard hats and to promote the ‘March of the Makers’. In the US, President Barack Obama invested in advanced or high-tech manufacturing. His successor, Donald Trump, explicitly extolled companies to bring factories back to America.

What would Adam Smith make of these efforts? Should government rebalance the economy towards making things once again? Is it possible to rebalance the economy in countries where the services sector makes up more than three-quarters of national output, as it does in Britain and the US? The answer holds lessons for other economies that may follow those two nations as they embark on the typical economic path of industrialization followed by deindustrialization.

Industrialization, deindustrialization and reindustrialization

Great Britain became the first industrialized nation in the late eighteenth and nineteenth centuries, followed by Germany and the United States. The period, which became known as the Industrial Revolution, saw the economy transformed from an agrarian society into one characterized by factories owned and run by merchants who traded their wares both at home and overseas.

In our own times, Britain and several other advanced economies, including the United States, have experienced yet another fundamental structural change: deindustrialization. Since the 1980s Thatcher-era reforms that liberalized the financial sector – notably the ‘Big Bang’ of 1986, when markets were opened up to greater competition – Britain has seen industry give way to services. (Relatively speaking, that is. The UK is still the ninth biggest manufacturer in the world, and was in the top five until around 2004.) Similarly, although the US remains the second biggest manufacturer in the world (having been overtaken recently by China), its services economy accounts for the larger part of American national output. In the European Union the services sector makes up 70 per cent of the GDP or national output for the bloc, but the EU also counts among its ranks some of the biggest manufacturing nations in the world, for example Germany, France and Italy. Even the world’s biggest manufacturer, China, which is only a middle-income country, has seen its services sector overtake industrial output in the economy.

When countries grow, they tend to industrialize, so they move out of agriculture and into manufacturing, which has higher productivity or output per worker and thus generates higher wages. Industrialization is how countries become middle class and prosper. Deindustrialization then follows. In advanced economies, manufacturing starts to become relatively less important as a share of output once they become richer and services in the business, retail and finance sectors start to dominate the economy while employment shifts from factories to offices or stores.

The 2008 crisis revealed the downside to having an economy with a large financial services sector. Banks had become complex and interconnected, and their business became harder to understand and to regulate. Their responsibility for causing the worst recession in a century prompted calls from the public to regulate the banks more tightly in the US and UK. The crash also led the American and British governments to want more manufacturing, thus they have sought to ‘rebalance’ the economy towards making things once again.

That’s a big task. Manufacturing accounts for around only 11 per cent of Britain’s value-added output, while, as noted, the dominant services sector accounts for over three-quarters of the economy. British manufacturing has declined from contributing a quarter of national output in 1980 to 20 per cent in the 1990s to just 12 per cent in the 2000s. It’s a similar picture in the US. By contrast, manufacturing still makes up about 20 per cent of the German economy on the same value-added basis. At its peak, financial services alone made up some 8 per cent of UK national output, which is not that much smaller than all of Britain’s manufacturing combined. This is the essence of deindustrialization, where industry has given way to a dominant services sector in the same way that agriculture was overtaken by manufacturing during Adam Smith’s time.

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The question is, can the US, and perhaps the UK, reverse deindustrialization? It’s a refrain heard frequently since the crisis. ‘Made in America’ and ‘Made in Britain’ are among the phrases uttered by governments and businesses after the worst recession in a century. But, reversing the process of deindustrialization is challenging in a globalized world economy.

Emerging economies like China can produce more cheaply while information and communications technology (ICT) has lowered the costs of logistics, so globalization makes it harder for rich nations to compete with lower-cost producers. In fact, Harvard economist Dani Rodrik even points to ‘premature deindustrialization’ in some developing countries which are moving from agriculture directly to services due to the forces of globalization, which holds potentially worrying consequences for countries that have yet to gain a firm foothold in the middle-income stratum.

We are in unknown territory. The impetus for deindustrialization is greater in Britain and America than in other nations. After suffering their worst financial crisis in a century, they are anxious for change.

That’s not the sole consideration. Adam Smith may be the economist who named the ‘invisible hand’ that allowed the market to dictate what was produced and how it was priced, but he did not think highly of the services sector. A product of his time, he did not believe that services could produce output that was as valuable as that from a factory or a bakery. In fact, Smith didn’t condone much of what makes up the modern economy, for example he wasn’t in favour of joint-stock companies, which are the basis of modern-day corporations.

His legacy continues to affect attitudes today. Even the way that national statistics are collected breaks down manufacturing data in great detail while aggregating much of services output. That’s probably also because it’s hard for statisticians to put a figure on what a consultant contributes while he sits at his computer or what a meeting adds to national output. We’ve all been in too many of those to know that they are not all productive!

So, should the government be trying to rebalance the economy? Can market forces driven by the ‘invisible hand’ be reshaped by the state? What would Adam Smith have to say about it all?

Copyright © 2018 by Linda Yuehb