Dr Adam Smith, I presume

The other day I sat down to have a conversation with the spirit of Dr Adam Smith (1723-1790), professor of moral philosophy at the University of Glasgow and Fellow of the Royal Society of London and Edinburgh. A stellar observer of the human condition, his book, “An Inquiry into the Nature and Causes of the Wealth of Nations,” was published in the same year, 1776, as the Declaration of Independence of the United States. Opinion is divided on which of the two events is of greater importance for the subsequent evolution of the world we live in.

What follows is a rough transcript of our talk.

Me: Prof Smith, the world has seen immense increase in the wealth of some nations since your time. What fundamentally explains the differences between the wealth of today’s nations?

AS: The world indeed has changed in the last couple of centuries. One word encapsulates the differing experiences of development among nations: Freedom. The human spirit’s ability to thrive in an atmosphere of freedom is enduring. Those nations that have granted themselves that freedom have developed. Lack of freedom explains the differences in development.

Me: So that raises the question why all people don’t grant themselves freedom. We must go into that a bit later. But I am puzzled by the Indian experience. India gained freedom from British colonial rule over 60 years ago in 1947. Yet, India has had only limited and qualified success in development and indeed in economic growth. What accounts for that?

AS: Political freedom, though important, is only one aspect of the much wider concept of freedom. The comprehensive freedom which allows individuals to flourish—and therefore groups to flourish—must include economic freedom. India’s lack of economic freedom undermines the potential gains that arise from political freedom. Colonialism is a package deal that denies both economic and political freedoms. Post-colonial India did not have economic freedom.

Me: Please speak a bit more on the nature of colonialism.

AS: Colonialism is motivated by the quest for wealth. Wealth is created by a process that combines natural resources with human agency. So you need not just a lot of land and its resources but also people to eventually create wealth. Compare and contrast the two distinct cases of colonialism in the 18th century: Bengal in India and Massachusetts in North America.

Massachusetts had land and other natural resources but had very few people. To translate the resources into wealth that you could later extract, you had to first get people to settle there. To attract people and for them to create wealth, the policies had to be development oriented. In other words, the policies gave settlers economic freedom, the freedom to create wealth.

Bengal, in contrast, already had people who were creating wealth. The policies for colonial Bengal were therefore designed to extract and exploit that already existing wealth. Therefore controlling economic activity through the denial of economic freedom was required. Command and control of the economy was a more direct route to exploitation. Doubtless, the consequence was similar to that of killing the goose that lays golden eggs. It is a short-term policy since by denying economic freedom, eventually wealth creation comes to a halt. When all the existing wealth is extracted, it is time to move out. Colonialism ended in India when the cost of extracting wealth became greater than the value extracted.

Me: Then why did not the post-colonial government of India immediately after political independence grant economic freedom to the population?

AS: The rulers of politically independent India inherited the entire institutional, administrative, and organizational structure of colonial India. The objectives of these did not change merely because the controls moved into the hands of people with a different skin color. The ability to command and control people is power that is hard to let go of. Private gains, however short-term, trumps long-term public gains. Human nature is hard to argue with. Self-interest is the key motivating factor in every human breast.

Me: But Dr Smith, it was you who pointed out that the self-interest of people gives rise to the public good that no one actively seeks. You wrote:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. … [Every individual] intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.

The new rulers of politically independent India were self-interested as well. Why is that not a good thing?

AS: The distinction is between the self-interest of a few powerful people as opposed to the self-interested actions of the entire population expressed in an atmosphere of economic freedom. The former have the power to coerce others to do their will; the latter lack the power to command economic servitude from their fellow humans. The average person has to seek the economic cooperation of others in society by providing them with goods and services that they value. That is, they have to offer in trade something that others value. This impels the individual to produce something of value and which on the aggregate amounts to the wealth that society produces.

Me: Economic cooperation appears to be inconsistent with competition that is supposed to be the hallmark of a market economy. So is it cooperation or is it competition that we should be more in favor of?

AS: Both competition and cooperation are essential. People are heterogeneous in their inclinations, natural talents, and developed skills. By cooperating, a group of people becomes capable of producing more than otherwise would have been possible through solitary enterprise. Economic freedom allows a person to not only engage in an economic activity that it most suited to his or her talents but also allows the person to seek the cooperation of others with complementary skills. Any successful economy can be thought of as a large number of people voluntarily cooperating in the process of producing wealth.

The production of goods and services, which involves cooperation, is one side of the coin. The other side of the coin is trade. What an individual or a group produces is traded at the marketplace. That is where competition plays its critical role.

Me: So cooperation is critical to production. But how does competition in the marketplace help us all. Should they not be cooperating in the marketplace also?

AS: Markets are where people come to buy and sell, or in other words, exchange goods and services. They compete as sellers – selling to the highest bidder – and they compete as buyers – buying from the lowest priced seller. Through this process, the market determines how much of what is produced by the economy and by whom. This process of competition determines how society’s limited productive resources are allocated to meet the variety of wants that it has. The market is that invisible hand which guides self-interested economic actors to promote the social good without the need for a centralized command structure. The important thing to remember is that while the marketplace is impersonal, to successfully compete in the marketplace, one has to have sympathy.

Me: Sympathy? Surely, you mean selfish ruthlessness and not sympathy.

AS: No, sympathy is important for without it, a producer will not be able to put himself in the position of the buyer and thus be unable to divine what is it that the buyer will value.

Me: So for an economy to thrive, it appears that rather than command and control, what is needed is economic freedom for people to best use their skills in productive activities and a functioning market where voluntary trades can take place. From those generalities, I would like to move on to the specific case of India. What are the impediments to India’s economic development?

AS: As we have been discussing, economic freedom is central because the raw ingredients for economic development exist in India. It has a large population and considerable natural resources. Given economic freedom, people would naturally produce wealth. Liberalization—the notion that people should be economically free—is the key concept. Free people grow and realize their potential naturally.

Me: In the hunter-gatherer stage of human history, there was no central command and control structure. They were free to do as they pleased. Yet, we don’t consider them to be prosperous. What explains that?

AS: The stock of human knowledge explains the difference. Technology allows humans to amplify their abilities. For instance, technology allows humans to use energy from a wide variety of sources. Technology is embodied knowledge. The practical aspect of knowledge is how to do something; it is know-how. The hunter-gatherer society had a very small stock of knowledge.

Me: I agree that today individuals have access to a phenomenal stock of knowledge accumulated over centuries in all parts of the world. Indeed, the revolution in information and communications technologies such as the world wide web and the Internet, have reduced the cost of accessing information and consequently gaining knowledge. It is puzzling therefore that economic growth is still an elusive goal. What’s the major barrier to India’s growth?

AS: Having access to the stock of knowledge is a necessary but not a sufficient condition. One has to be educated to a certain degree to make meaningful use of knowledge. So the short explanation for India’s predicament is the lack of educated people and the lack of economic freedom.

Me: Perhaps you have been out of touch with Indian reality lately. The Indian education system is often held up as a shining example since India has become what is called an “IT superpower.” India does not lack educated people.

AS: Actually, I am familiar with the state of the education system in India. I grant you that there are some very globally successful people who got part of their education in India. But their numbers are not in proportion to India’s vast population of over a billion people, a sixth of all humanity.

The Indian education system is a throwback from a bygone era. It is extremely costly in terms of the resources it uses relative to what it produces. Only about 10 percent of India’s children pass high school and of its college graduates, only about one in four are employable. The real cost of the education system is the immense waste of potential human resources that never become sufficiently trained to become highly productive.

The lifeblood of the wealth of the nation is being bled away due to its dysfunctional educational system. Leave alone an educated population, nearly half of India’s population is illiterate. That is unforgivable after 60 years of self-rule. Fixing the education system is the first unavoidable challenge.

Me: Why is the educational system so important in the wealth of a nation?

AS: Because people are at the core of an economy. People matter because they are what transform the other resources into wealth. Educated people are more productive and therefore create more wealth. But educating people requires resources and the most efficient allocation of resources, as I have stated earlier, is through the market, and not through command and control. You can easily enough figure out that government control of education is responsible for its failures. I leave that as an exercise for you.

Me: I see your point, especially from the experiences of the United States and other advanced industrialized economies. What intrigues me is that their development is also accompanied with their populations becoming urbanized. Why is it that a population concentrated in cities is more productive than the same population living in villages?

AS: Urbanization is a cause and consequence of economic growth and development. If you recall, I had pointed out that specialization and the division of labor increases productivity and therefore greater production. Cities allow what we call economies of scale, scope and agglomeration to occur. In other words, resources are more efficiently used when a population is geographically concentrated. Most significantly, infrastructure is cheaper to provide per capita if the population were concentrated compared to if they were dispersed. People need infrastructural services – such as power, water, telecommunications, transportation, sanitation, security, medical, entertainment, etc. – to live productive and enjoyable lives. Cities are the natural outcome of the need to provide infrastructure as efficiently as possible.

Me: The economies around the world today have widely divergent standards of living. Which is another way of saying that some economies are more productive than others. What are the real constraints on an economy becoming wealthy, say, like the US?

AS: What you have to recognize is that wealth is produced by people. Where people are free to engage in activities that they themselves choose, they are good at it. More wealth is produced by free people than by slaves. So the first requirement is freedom. The Constitution of the US and the Bill of Rights guarantee its citizens freedoms that others outside the US rarely enjoy.

The second fortunate fact is that the US is big. Its land area is large compared to its population. Its endowment of natural resources is enviable. The third factor is that it developed a very large stock of human capital. The US learnt quickly as a young nation that education matters. It not only learnt from the Europeans about great universities but it improved upon them.

So the US had sufficient number of educated people, vast amounts of natural resources, and the freedom for the natural entrepreneurship of people to create wealth. Yet, there is one more factor that I did not mention till now. That factor is energy.

Using energy amplifies human capacity. All manufacturing depends fundamentally on energy. The US developed the technologies that made energy available for manufacturing. Most of the energy that the US had during its early development into an advanced industrialized economy was fossil fuel based. If the US had not developed the technology, it would not have access to the energy, and without inexpensive energy, it could not have become the pre-eminent nation it is today.

Me: Given the critical need for energy, the currently developing economies do need a source of energy other than fossil fuels because they are running. Besides they are polluting. So what is the way out?

AS: The US became rich because it developed technologies. It invested in research and development. That is the road to riches. If India needs an affordable energy source, it will have to develop the technology. The source of practically all energy on earth is the sun. India has to develop technology that will give it access to the solar energy.

Me: Dr Smith, developing technology is extremely costly. Hundreds of billions of dollars will be needed. India cannot afford that.

AS: It is a choice that India has to make. It could invest a few hundred billion dollars in developing the technology to use solar energy. Or it could continue to import increasingly costly fossil fuels, and when the fossil fuels run out, it could pay high prices for licensing the use of solar energy technologies developed by other nations. India has to decide whether it wants to be a leader or a follower in this regard. That is a political decision which its democratic system has to address.

Me: What do you recommend for India then?

AS: What India needs the most is for its citizens to achieve economic freedom. The people are entrepreneurial and inventive enough that they will figure out most of the problems by themselves. Education has to be freed from the control of the government.

The role of the government has to change from being a meddlesome overlord to one of facilitating development. The government has to become an institution that the people use for the provision of public goods. It has to stop attempting to control the economy because control is inimical to the creation of wealth.

India needs energy for development. The primary public good that the government has to facilitate is that of funding research and development of technologies for energy.

Me: Thanks much. Let’s see if we can figure out the details by ourselves.