Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Adam Smith

What it is:

Adam Smith is one of the world’s most famous economists. Modern capitalism owes its roots to Adam Smith and his Wealth of Nations, which many consider the single most important economic work in history. Though other economists such as Marx and Keynes have fathered monumental economic theories, Smith and his theories rest at the apex of transcendent economic thought.

How it works (Example):

Adam Smith was born in Kirkcaldy, Scotland, in 1723. He attended the University of Glasgow, and 12 years after his 1740 graduation, he became the Chair of Logic there. The next year, he became the Chair of Moral Philosophy. In 1759, Smith published his first book, The Theory of Moral Sentiments, which contained many of his lectures.

In 1764, Smith quit his job and became a "travelling tutor" to the Duke of Buccleuch (who incidentally is the fifth great-grandfather of Sarah, Duchess of York) for two years. On the job, Smith met many leading philosophers and economists who influenced his work. 

In 1766, Smith went back home to his mother in Kirkaldy and began work on what is still his most well-known treatise, The Wealth of Nations, which took about 10 years to write and was published on March 9, 1776. But quite the mover, Smith uprooted again and went to London to work and write. While he was there, the colonies were enduring some of their most contentions pre-Revolutionary times, including the Boston Massacre in 1770, the Boston Tea Party in 1773, and the Battles of Lexington and Bunker Hill in 1775. Smith was very interested in the colonies' political activities, at one point wondering whether the seat of the British Empire would eventually move from London to America.

The Wealth of Nations was so popular that five editions were published while Smith was still alive. He died on July 17, 1790, allegedly stating on his death bed that he'd wished he'd achieved more. Adam Smith was more interested in being known for his work than for his personality, and he succeeded mightily in that goal. Dubbed the father of capitalism, Adam Smith was largely a Scottish academic, an only son who never married, and a person who didn't much care for writing. Today, more than 200 years after his death, he's one of the world's most famous economists.

Why it Matters:

Perhaps no other man in the history of economics enjoys the rock-star status Adam Smith holds. If Adam Smith were alive today, however, and he could say only one thing to the government, it would probably be "Leave us alone; we'll figure it out ourselves."

After all, one of Smith's biggest theories was that people work naturally toward maximizing their self-interests. The exchange of goods and services facilitates this goal, he argued, and market participants engage in those activities most beneficially when regulations and government intervention do not inhibit them from doing so. That is, the invisible hand of self-interest guides participants into exchange that is the most mutually beneficial.

Smith said, for example, that by selling products people want to buy, butchers, brewers and bakers make money. However, they only get that money if they can meet the needs of their customers effectively -- that is, if they offer things people want to buy. By doing so, they are financially rewarded and they create wealth for the nation as a whole by being productive citizens. In other words, they inadvertently create the best outcome for everyone by looking out for their own self-interests. As Smith put it, "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest."

This idea -- that self-interest actually serves a greater good -- sits at the heart of why even today people invest their retirement money, college funds and other savings in companies or enterprises that are most likely to give them a high return for a given level of risk. And because people look out for their own self-interests, Smith argues, others benefit: Money is more likely to flow from investors into viable companies, which creates companies, jobs and a bigger economy.

It is important to emphasize another central tenet of Smith's philosophy: Generally speaking, government should not interfere in this natural course of commerce activities. In particular, Smith rejected the mercantile system, which was an economic system prevalent in 18th century Europe, whereby the objective of commerce was to increase a nation's wealth via government regulation of all the nation's commercial interests. Smith dismissed as "absurd" the mercantile system's regulatory restraints on imports and encouragement of exports in order to build a trade surplus. Rather, he felt that a nation's wealth lay in its trade rather than its capital. Smith wrote:

"No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain. It can only divert a part of it into a direction into which it might not otherwise have gone; and it is by no means certain that this artificial direction is likely to be more advantageous to the society than that into which it would have gone of its own accord."

Smith argued that government regulation not only created commercial headaches, it harmed society at large by infringing on the rights of the masses to tend to their own well-being. Instead, the best contribution government can make to society is to leave people to their own tendencies to do business. (However, Smith did believe government should enforce contracts, patents, copyrights, and other items that encouraged entrepreneurial activity.)