Sunday, December 15, 2013


Thursday, April 28, 2011

Adam Smith was a critic of the 18th century corporations that circumvented the operation of the market by obtaining monopoly power from the State. The way he analyzed the role of government in business affairs and the framework that explained the free market still holds true.

From 15th to 18th century, the European economies were endured by the theory of mercantilism. In those days, the primary source of wealth was gold and silver, and the State could acquire wealth by encouraging trade, or rather export, by private companies. Their success would contribute to the State revenue and in return, the State would guarantee their mercantile success. In the process, the world’s first commercial corporation – the British East India Company (EIC) came into existence, which, established to trade with the East Indies, became a monopoly of British overseas trade everywhere, and governed India from the 1770s to 1858. During this period, it expanded into a vast enterprise, conquering the regional powers in India and exercising a total monopoly on trade. The magnitude of the company was that, it ruled over a fifth of the world’s population with a quarter million of private army.

India’s Encouraging Conditions
India’s foreign trade during the 1770s included textiles and spices in exchange for gold and silver. Indian goods enjoyed a tremendous reputation in the European markets and in the Middle East. India came to be known as the ‘land of precious metals’. On the other hand, most of the European goods like woollen garments, lead, tin, coral, Iron etc., brought to India were either exchanged with certain commodities or remained unsold for quite sometime. Import of foreign goods did not prevent India from absorbing a large portion of the gold and silver of the world, gained through a variety of channels.

The EIC made huge profits by trading with India. The export of bullion by the company to the East were estimated to be anywhere around £800,000 per annum. The company exported no fewer than a million pounds of goods annually during the year 1698-1700. The growth of trade during this period was the most important factor in the development of the company, which flooded Europe with the Indian goods, especially cloth.

Adam Smith (1723-90)
The 18th century Scottish political economist and philosopher, and the founding father of free trade who became famous for his influential book “An Inquiry Into the Nature and Causes of the Wealth of Nations” (1776), laid the intellectual framework that explained the free market which still holds true. He is often remembered for the expression “the invisible hand,” which he used to explain how self-interest guides the most efficient use of resources in a nation’s economy, with public welfare coming as a by-product. 

Adam Smith argued that investment at home generates more “revenue and employment” than investment in foreign trade. Self-interest motivates the entrepreneur to invest at home than in foreign trade. He saw the interests of big capitalists conflicting with those of the public: capitalists seek high profits, which corrupt and impoverish society. He criticized the way British mercantilism divided the world into parcels, granted the merchants’ business monopolies, and the corruption of the EIC. Adam Smith emphasized the importance of free market and free trade. To him, there was a convergence of individual and social interests through a free market economy. His premises of free trade are as follows:

• National wealth comes from agricultural produce.
• The farmer and the state shared the same pool of money.
• High tariffs on imported goods meant higher prices for the farmers, and less money for the state.
• Higher tariffs would lead to less investment on the farm hence farmer could not raise crop yield the following year, and this would decrease the tax base for the state.
• Higher tariffs will also lead to: 1) trade monopoly in England that would raise prices, and 2) depletion of farmers’ resources.

Adam Smith expounded the scientific rules for the study of economics and government intervention in economic activities. He championed the cause of the small and medium sized merchants and traders, and in that sense was “progressive” by today’s standards. Smith’s portrayal of the free market economy remains the centerpiece of economic theory. Smith developed much of the theory about markets that are regarded as standard theory even today. 

In 1772, Adam Smith’s friend William Pulteney recommended him to the directors of the EIC, as a member of a commission of inquiry in their administration to be sent to India. Adam Smith, in a letter, dated September 5, 1772, accepted the appointment. Adam Smith highlighted the government-granted monopoly of the EIC and its abuses and inefficiencies. He argued that the Bengal drought was turned into a famine due to the EIC’s incompetence. 

Adam Smith suggested that the workers must be made stakeholders to achieve the greatest possible productivity from them. He quantified the benefits of mechanization but also graphically illustrated the alienation caused by monotonous factory work. He described the divergence of interest that resulted from the separation of management from ownership in large corporations; he recognized that top management would not be motivated to create personal wealth unless they too are corporate stakeholders.

Greedy Mercantilist System

Most European nations, between 16th and 18th century adopted mercantilist policies, which resulted in the colonial expansion. The goal of these policies was, supposedly, to achieve a favorable balance of trade that would bring gold and silver into the European region. The mercantilist theorists like David Hume (Smith’s mentor) and Adam Smith believed that a country should have an excess of exports over imports i.e., favorable balance of trade, to bring in money (wealth) into the country. They recommended legislation to restrict the use of foreign goods, encourage exports, and forbid the export of bullion.

However, the British merchants tried to accomplish this by promoting the imports of cheap raw materials and exports of finished, manufactured goods. The colonies were forced to purchase these goods from the British and had no alternatives i.e., the British had established trade monopolies. Nonetheless, Adam Smith and David Hume were two important opponents of these policies and considered them unfair and inefficient. Adam Smith promoted a laissez-faire approach for governments to operate. He stated that a government should not create monopolies because they could be “dangerous to prosperity.”

Also, government should not keep wages low for its workers and force people into jobs. Adam Smith also did not like the idea of subgroups controlling the economy. He also felt that trade should not be a zero-sum game, but rather a positive-sum game. The comparative advantages of nations should be utilized, but in mercantilist policies, these advantages remain unexploited. Adam Smith saw that monopoly ruined the market system, and the fact that the government created monopolies was one reason that led him to advocate a minimal economic role for government.

The EIC criticized from time to time by the British Parliament for its pursuance of ‘mercantilist policy’ as it was considered not in the interest of the country. In defense of the company, Sir Dudley Digges published his famous pamphlet in 1615 entitled, “A Defense of Commerce”, which stated that re-export of Indian exported from England to India. He proved that the English Nation had from the time of establishment of the EIC saved 70,000 pounds a year, in price of pepper and spices and had further benefited from commerce with India by the increase in customs revenue and the building of great ships and the employment of a large number of Englishmen in the Company’s business. 

                                                                        Henry Martyn

However, Henry Martyn, Merchant in the East India trade, was right from today’s perspective. He recognized that wealth might point in one direction while welfare in another. Henry Martyn’s book “Considerations upon the East India Trade”, written to oppose the EIC’s monopoly, had already anticipated most of what is right and wrong about the theory of free trade: “Things may be imported from India by fewer hands than as good would be made in England, so that to permit the consumption of Indian manufactures is to permit the loss of few men’s labor...A law to restrain us to use only English manufactures, is to oblige us to make them first, is to oblige us to provide for our consumption by the labor of many, what might as well be done by the labor of few, is to oblige us to consume the labor of many when that of few might be sufficient.”

Whatsoever, many economists opine that Adam Smith had prophetic insights on the dominant form of corporate business in his days: the so-called “joint stock company.” During Adam Smith’s lifetime, this risk-sharing system had evolved into a dynamic driver of an expanding global economy. It brought into being the famed East India Companies backed by the Dutch, French, and British governments. They further say, just as Adam Smith was a harsh critic of the 18th century corporations that circumvented the operation of the market by obtaining monopoly power from the State, he would likely to have been equally critical of the powerful oligarchic companies of the 19th through 21st centuries.

Selected Quotes from “The Wealth of Nations on Multinationals”

“The government of an exclusive company of merchants is, perhaps, the worst of all governments for any country whatever.”

“...The rate of profit does not, like rent and wages, rise with the prosperity and fall with the declension of the society. On the contrary, it is always low in rich and high in poor countries, and it is always highest in the countries, which are going fastest to ruin.”

“The interest of the dealers . . . in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public... (They) have generally an interest to deceive and even to oppress the public, and accordingly have upon many occasions, both deceived and oppressed it.”

“Our merchants frequently complain of the high wages of British labor as the cause of their manufactures being undersold in foreign markets; but they are silent about the high profits of stock. They complain about the extravagant gain of other people; but they say nothing of their own.”

“Perpetual monopolies were harmful to the long-term trading interests of any nation. They raised prices artificially, encouraged waste, fraud and abuse and, in India, had interfered with the sovereign interests of the British government.”

“While the East India Company had been a trading endeavor, it had provided great service to the state and its people, justifying the monopoly privileges and helping its stockholders' dividends to growth. After territorial expansion occurred, this role and its privileges required revision, for Company interests were at cross purposes with those of the state.”

N Janardhan Rao, Lead Economist


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