Adam Smith and Government Intervention in the Economy Sima Siami-Namini Graduate Research Assistant and Ph.D. Student Texas Tech University

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1 Review of the Wealth of Nations Adam Smith and Government Intervention in the Economy Sima Siami-Namini Graduate Research Assistant and Ph.D. Student Texas Tech University May 14, 2015 Abstract The main purpose of this paper is to address the government intervention in the economy. It is considered the founder of modern economics. Adam Smith stated that the free market is guided by an invisible hand and less government intervention in some special area that could be efficient. He identified three major duties for government, national defense, administration of justice, and the provision of public goods. But a lot of issues happened to people during the Great Depression, and proposed new theories about government interference in the society. Introduction The father of capitalism in his famous book, The Wealth of Nation, stated three ideal functions that should be performed by government. In his classic work, the first function of government is to create the internal Social Security regulations and also provide national defense for protecting the society and all citizens from all the violence and invasions or attacks forces from other societies. Secondly, the function of establishing an exact administration of justice in the context of order and law. Thirdly, the function of providing public goods and maintaining the related public Institutes which it can be never for the interest of any specific individual or definite groups. A good example for the latter is transportation, health, education, etc. However, it seems that government interventions has grown beyond of these functions, and in fact, Adam Smith identified a special role for government to involve in the economy. Today, the modern society has considered the other functions for government to protect the society, and for instance, redistribution of wealth and revenue and employment and economic growth and sustainable development and stability in the economy are some of them. The concepts like free market failure has been caused more interventions for government in these 1 P a g e

2 societies in all cultural, social and economic respects. In fact, the question is that how the countries should solve the current issues and remove all concerns in achieving the economic growth and redistribution of total revenue, to control of population growth, to decrease of poverty and increase the standard of living, to control of inflation and liquidity, tax collection, management of natural resources like oil, and gas and allocation of scarce resources between economic sectors and the similar issues, if they want to follow the Adam Smith's insights about free market in managing the society, and believe to this point that there is invisible hand or market forces to perform in a good way to reach the equilibrium, and trust to free market and accept the ideal functions of governments. But in fact, what were the reasons for opposing to government intervention in the Societies? The next section will be address to this subject. Adam Smith Adam Smith argued against monopoly, mercantilism, and feudalism. He believed that the economy should be allowed to run on its own using free market forces and without any government intervention. In his opinion, the economy could create wealth and improve efficiency through the invisible hand. He argued that any government intervention will weaken the economy. Adam Smith believed that invisible hand is a natural phenomenon that guides the market through competition for scarce resources. He believed that human wants are unlimited but human needs are limited, and people can compete with each other, then existence of competitive is the necessary condition for free market. With government intervention, people would stop competing, and in turn it causes that prices increases and quality decreases. As mentioned above, Adam Smith recognized significant areas where only government could act effectively, and then identified three specific duties for the government, and believed all unnecessary interventions must be avoided. For example, each country must be protect all citizens and society from foreign invasions, and then the necessary budget is estimated. But it does not mean that government can involve into the other societies and causes to create a lot of things. This is also the same for the provision of systems of justice. He confirmed an independent court system and administration of justice and verdict to control crime and protect the private right and his property. The aim of the establishment of systems of justice is to reduce the injustice and protect all citizens from oppression of others. He suggested that government interventions in providing public goods, such as roads and public bridges or infrastructure, education of the youth and education to people of 2 P a g e

3 all ages, health and medical care can be useful for earning a living and also can be productive. But, it does not mean for government to behave like a firm in order to maximize its profit. In fact, the father of laissez faire in the economics wanted all classes of society, even the poorest, to benefit from the free-market system. He believed that only the social conditions cause to create a little difference in intelligence between the poor and the rich people, and then supported this kind of people by public taxed (according to one's ability to pay) and small parents fee. In fact, he made aggressive arguments for competition and private funding in education. He believed that government and State can play an important role for managing the public schools, as many young students have no money for going to the private universities, and it is very important to know the student's abilities and talents and invest in them as a human and as a labor force of the society. As a result, most trouble in the economy arises from the latter function of government. It is because profit - seeking individuals may not be able to efficiently build and operate and they become state monopolies. Today, it can see that government could not work properly, and leaving the management and not ownerships of these works to the private sector in framework of some contracts like BOT, joint venture and the same contracts with foreign investments. Adam Smith referred to laissez - faire and the natural liberty concept which the latter relates the individual liberty to the positive economic outcomes. He argued that government interference in the economy will damage the nation's wealth, and then insisted to the elimination of these interventions as restrictions. It is pointed out that progressive tax is the only source of revenue for governments and all public expenditure was to be paid from tax collection on the high - income households or rich people and their maintenance financed by user - charges of public facilities for the financing of repairs to roads and bridges and paying for medical care to the people who suffers from diseases and could not pay the cost of their therapy. Government must develop the postal service for public use, and provide the other services, and also it should be run an official mint to guarantee the purity of the coinage. It is clear that central bank (The Bank of England at that time), should manage government and introduce necessary regulations in order to stop extra spending by monetary tools (issues bonds or using liquidity). Now the question is, what did he consider inappropriate for government intervention, despite of mentioned features for government services? In fact, the father of economy suggest the appropriate involvement in the economy for government. 3 P a g e

4 Legislators and policymakers who influence them are sensitive to all mistake thoughts about how societies work (Galileo is a good example in this respect). There were some notions as the balance of trade required to be positive in favor of exports, so that a nation could accumulate stocks of gold. Therefore, trading policies of protection against imports were developed, and supported by tariffs and prohibitions, and then the price of goods allowed to be higher than importing them, and of course following these kind of polices destroyed the relations between nations and created many conflicts and wars between them. Adam Smith rejected with this kind of government interventions in the economy, because he wanted to use the mutually advantages trade between nations. In his sense, each country had its absolute advantage and relative advantage in producing a goods than the other country, and then they have their specific technology and innovations which can obtain them with peaceful trading countries. The nations will lost the opportunities with imposing tariffs or restrictions in their trading with other nations, and Smith disagreed with the similar interventions by government in this area. He argued that this kind of interventions in economy and imposing tariff policy on trade is a high price that tends not to compensate. Of course, there are many political factor that contribute to an individual or a country becoming rich or poor, and decreasing its share in the trade, and it needs more scrutiny. The father of economy explained that government and its high interference in the economy is a violation of natural liberty, but it introduced for pursuing policies related to progress of the economy like development of trade, but because of creating many consequences, it became a big obstacle to the development of free trade, and creating two poles of rich and poor countries makes it extremely difficult. Adam Smith observed all bad effects from government interference in the economy and then opposed all of them, and limited the role of government in the economy. In summary, Adam Smith expected that government should leave the economy alone and not involve with the natural liberty of free market and free trade. He was concerned about the government performance in granting the special privileges to some manufacturers and merchants in production and trade respectively, and believed that it made some huge monopolies that will be enemy with free market and at least destroy the market forces, and create market failure. It is clear that price and wage in monopoly is greater than its natural rate in free market, and because of existence this gap, the economy do not work in proper way and the later issues like bribery and corruption and usury are coming to destroy the economy. The two next sections briefly present 4 P a g e

5 Mercantilism and the Physiocrats thought about government interventions in the economy. Mercantilism Under this theory, government's role is important in the economy and especially in foreign trade. Mercantilism suggests that the longest ruling government should advance trade by playing a protectionist role in the economy, by encouraging exports and discouraging imports, especially through using of tariffs. Mercantilism believed that the only measure of a country's wealth is gold, and then the best way for maximizing the country's gold stock, was to make few imports for necessary goods and many exports, and then made their trade policies in order to increase gold and then maximize the income. Mercantilism pursued their goals with more government intervention in the economy. Mercantilism restricted imports of manufactured goods via tariffs or quotas, encouraged imports of raw materials, encouraged exports of manufactured goods via subsidies, encouraged production and discourage consumption by imposing taxes on imports of final products. In general, because of scarce resources, mercantilists advocated specific government programs that would benefit them, and also advocated government intervention, tariffs, and charters for trading companies, etc. Some countries like Britain followed the same proper policies to protect their traders, and also in some cases restricted their imports. But the father of economics disagreed with regulation heavy mercantilist doctrine, and concerned with the effects of these policies. He explained about improper results of overweening government intervention in the economy that monopolies is one of them. It is clear that the wages in monopolies will be greatly above the natural rate in free market. In his discussion, he referred to the East India Company which was a quasigovernment organization at that time. Smith pointed out the situations in which government intervention in the economy was necessary, and outlined the cases where government intervention in trade is useful. He agreed with some of them, but not the cases where governments could abuse from their power for getting wealth. Therefore, he made it clear that governments can help a part in making markets to behave in proper way. But, the question is how much it would play? Today, it can be seen the role of mercantilism thought in the trade policies for some developed countries. For example in 2012, President Barack Obama made a goal for doubling of American exports over the next five years. But, the problem is that it does not increase the demand. 5 P a g e

6 In summary, Adam Smith disagreed with wars and criticized it because creating a large public dept. He saw that mercantilists encourages wars and give money at high interest rate or usury to the government, and it causes a huge public debt that in turn create many issues in the economy, and Smith viewed wars a source for wasting the money and producing a huge public debt cause to divert money away from investment and then reduce the economic growth. Because of this, Smith attacked on mercantilism's policy that their goal was to increase exports to its colonies and other societies, and limit imports from them, and stated that continuing this policy will end the free trade between countries. He disagreed with the mercantilist nations about the definitions of wealth. The mercantilist believed that gold and silver is the only source for increasing wealth, and tried to increase their export and restricted their imports to obtain a surplus trade and more gold and more power for their government and this is conflict with the economics thought. Smith did not believed that gold is the nation wealth, because he saw that many workers live in a bad situation with low wage, and they could not buy the necessary things. They had bad nutrition's with bad healthy and full stress. Then he stated that consumable goods is the nation's wealth. When the people could buy anything, it shows that the people of this country live in welfare and this society will be rich, and then disagreed with mercantilist trade practices and increasing government involvement in the economy and trade. Smith believed that above trade practices will slow production and international trade. In his sense, mercantilist was self-defeating caused from the monopolizing nature of some merchants and manufacturers, and all this caused by more interventions for government which must be stop. The father of economy advised that let the free market operate without extra intervention of government. The Physiocrats The Physiocrats argued, that government leave the economy alone and allow individuals within the economy to do as they please in attempting to realize their own selfish interests. They called laissez faire, or let people do, to their doctrine. The Physiocrats stated that the only source of a nation's wealth was derived from agriculture, and their thought were in opposite direction of the mercantilist. They believed to self - interest and competition for improving the economy. In their sense, government plays like a parasite in the free market, because it might pass a law that makes it difficult for market forces. They argued for removing of all restrictions on internal trade and labor migration, and also discussed for the removal of state- 6 P a g e

7 sponsored monopolies and trading privileges, etc. They believed that if there is any tax, it should impose on landed property. As they believed that the only agriculture sector can add the net product, then any taxes levied throughout the economy will fall upon the net product, and then it is more efficient to go to the root and tax land rents directly. Adam Smith agreed with the Physiocrats about the limited role of government in the economy in some special area. Keynesian Economics The Great Depression proved the importance of government interventions in the economy, and the Keynesian theory explained why the government is needed to control the economy when crisis occurred. In the crisis period, when inefficient performance of the private sector raised, public sector needs to take proper decisions in the context of monetary and fiscal policies for transition and establishment of stability in the economic growth. The Keynesian theory proved to be effective through fiscal policies. Government spending and tax are the tools for fiscal policy and affect the economic variables through multiplier effect. The difference between Adam Smith approach and Keynesian approach, is the fact instead of waiting for the economy to transit of a crisis period, the government interventions to alleviate the economy and help to economy back to recovery and do not permit that the crisis became worst. But, the question is again how much the state would play in the economy? Because it is not correct to give the control of economy to the government and make it an omnipotence. In summary, Keynes supported government intervention during the crisis period. He explained that economics are unstable because of many internal and external factors that happened and it is impossible to establish full employment without having government intervention in the economy, and in fact, it is an ideal function for government to bridge the gap between economy's potential and its difference with actual output during times of economic turmoil. Market Failure A market failure occurs when the Adam Smith's invisible hand could not lead the economy and individual decisions do not lead to desirable results. Now, this question is coming, is there any acceptable reason for government intervention to improve the outcomes caused by market failure. Of course it does mean that increase the ideal functions of government, or modify the method of interference in the economy for government. It seems that the political of implementing the solution cause to create 7 P a g e

8 further issues and then it does not advised to have more government intervention. It seems that governments fails too in when it has more intervention in the economy in order to improve the market failure. As the logic of the market is profit and government do not have more information, and also do not have an incentive to solve the problem. More intervention in the markets complicate the situation that need to more interventions, and then became government failure in the economy. Smith believed that market forces solve the problem at least and then economy will reach to its equilibrium state. Conclusions The aim of this paper is to pay in a short to the government interventions in the economy base on Adam Smith thought and the others. The father of economics has considered three major and efficient role for government, national defense, administration of justice, and the provision of public goods. He disagreed with all disturbing factors that destroyed the equilibrium in free market. In economics, the equilibrium is a state where supply and demand are equaled in there, and it happened when a market price is established by competition and without existence of monopolies. When government intervenes too much in free market, then people expect to see many monopolies in the economy which perform in a shadow economy. Adam smith disagreed with excessive government interventions in the economy, but at the same time consider three special function for government, which could be effective in its place. But, these functions will cause a big involvement in the economy for government to solve the global crisis. Reference Adam Smith The Wealth of Nations. 8 P a g e

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