TOPICAL STUDY #19
THE TRIUMPH OF ADAM SMITH
Dr. Edward E. Yardeni
David A. Moss July 17, 1990
Communism collapsed suddenly and unexpectedly in Eastern Europe at the end of 1989.
In the Soviet Union, the Communist Party still rules, but the extraordinary social and
economic chaos gripping the country suggests that the party’s days are numbered. In the
West, many commentators acclaim the triumph of capitalism over communism. However,
neither the success nor the survival of capitalism is guaranteed by the failure and demise
of Soviet communism.
Capitalism is a legal system that safeguards private property and permits free trade in
competitive markets. Individuals are free to pursue their self-interest. As long as self-
interest is restrained by competition, society benefits from lower prices and greater
choices. The problem is that the powerful forces of self-interest have a natural tendency
to collusion and corruption. In other words, capitalists tend to seek power and to use it to
rig the market in their favor to the detriment of society.
The intellectual father of capitalism is Adam Smith. He observed over 200 years ago that
the competitive market, as if by an “invisible hand,” transforms self-interest into a force
for public good. Smith explained how competition maximizes productivity and social
welfare by assuring the optimal allocation of capital and labor in the overall economy.
Yet, always a pragmatist, he recognized that capitalists could corrupt the system: “People
of the same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the public, or in some contrivance to raise
Karl Marx predicted that capitalism would eventually collapse as a result of this and other
internal contradictions of the system. Marx believed that the distribution of income and
wealth would become increasingly unequal under capitalism. When the workers could no
longer tolerate being exploited by the capitalists, a communist revolution would result.
Initially, Marx said, there would be “a political transition period in which the state can be
nothing but the revolutionary dictatorship of the proletariat,” which would seize all
private property from the capitalists on behalf of the working class. Eventually, class
distinctions would disappear. Then the state would wither away and be replaced by an
international, and presumably democratic, commune of the proletariat.
Marx devoted virtually all of his economic writings to an unrelenting attack on
capitalism. He provided only the sketchiest of outlines as a guide to how a communist
society would function. In countries that embraced Marxism, most property and the
means of production are owned by the state. Citizens of the communist state are expected
to work for the good of the community. The goods and services that they produce are also
Dr. Yardeni, is the chief economist of PrudentialISa doctoral candidate in history at Yale University. Prudential-Bache
owned by the state and are distributed among the members of the community by the
governing communist party. Most economic activities are centrally planned by government
bureaucrats. Only a few transactions are permitted to take place outside of the administered,
or “command,” economy in tightly regulated markets.
Marx predicted that a society that was organized in a communist fashion would deliver the
greatest welfare for the most people. That was the theory. In practice, the results have been
disastrous. Every day the devastating consequences of Soviet communism are becoming
more apparent. The ecological damage has been immense. Corruption and incompetence
have stifled economic creativity. Central planning has produced massive economic
stagnation and waste. Technology is often primitive and even dangerous, as demonstrated by
the Chernobyl catastrophe. Products are inferior in quality and scarce in supply. The standard
of living is miserable. Health conditions are among the lowest in the world.
On the other hand, Adam Smith’s predictions have been remarkably accurate. It is in this
predictive sense that recent events mark the triumph of Adam Smith’s ideas over those of
Karl Marx. Capitalism has outlived communism. Although capitalism tends toward an
unequal distribution of income and wealth, it has delivered far greater prosperity to far more
people than any other economic system. And in an ironic twist, it certainly confounded
communists—most notably Marx, Engels, and Lenin-who predicted that capitalism would
eventually collapse. Smith did warn that special interests could do a great deal of harm, but
he believed that the power of capitalism would prevail. And it has.
Unlike Marx, who was a revolutionary, Smith was a reformer. Where Marx saw class
struggle, Smith saw special interests that were often at odds with the public interest. If he
were alive today, it is unlikely that he would join the chorus of triumphant anticommunists.
Instead, he would warn that capitalism is prone to excess. He would observe that vigilance is
required to ensure that the political system is not manipulated for the economic benefit of a
few to the detriment of the entire society. He would be advocating political reforms to make
sure that the system is not corrupted by special interests.
Smith recognized that in a capitalist economy some individuals might become much
wealthier than others: “The order of proprietors may, perhaps, gain more by the prosperity of
society, than that of labourers: but there is no order that suffers so cruelly from its decline.”
Smith argued that as long as there was economic growth, the rich would get richer, but the
poor would also be better off. Marx, of course, predicted that the poor would become poorer.
Smith and Marx do have something in common. Both attempted to formulate comprehensive
and integrated models of society, economics, and politics. They stand out as two of the
greatest political economists of all time because their intellectual reach was so ambitious.
Neither one, however, fully finished the job.
The political foundation of Marx’s utopia always had a critical structural flaw. He never
explained how the members of the transitional dictatorship would be chosen, and why they
would voluntarily relinquish their authoritarian power once they had confiscated all private
property. Similarly, Smith failed to resolve the grand political enigma that he himself posed:
How can a capitalist society be protected from being corrupted by the special interests that
are an integral part of its political economy?
Smith did devote a considerable amount of effort to constructing a theory of law and politics.
But he was never satisfied with his work. Very early in his intellectual career, he
hoped to construct a definitive theory of the three types of human interaction—social,
economic, and political. He managed to complete path-breaking works on the first subject,
The Theory of Moral Sentiments (1759), and the second, An Inquiry Into the Nature and
Causes of the Wealth of Nations, which he spent ten years writing from 1767 to 1776. But
the third book on jurisprudence, which he considered the most important, he never
In his first book, Smith attempted to explain what motivates human behavior. In his second
and most famous book, he argued that a free-market economy was the economic order best
suited to human nature. But he never adequately explained what sort of political system was
necessary to protect the competitive market from the manipulations of the special interests—
though he did try. In an “advertisement” to the sixth edition of Moral Sentiments, Smith
admitted late in his life that he no longer expected to complete the overall project:
What remains, the theory of jurisprudence, which I have long projected, I
have hitherto been hindered from executing, by the same occupations which
had till now prevented me from revising the present work. [M]y very
advanced age leaves me, I acknowledge, very little expectation of ever being
able to execute this great work to my own satisfaction . . . .
Just before he died on July 17, 1790, Smith asked his close friends to bum several folio
volumes of his papers. They did, and he reportedly was quite relieved once the deed was
done. In the two thirds of the system he did complete, Smith made enormous intellectual
contributions to political economy.
Two hundred years after his death, his ideas remain as relevant as ever. The savings and loan
debacle in the United States is an extraordinarily good example of the damage that special
interests can do. Yet, the fact that the U.S. economy has continued to expand despite this and
numerous other shocks, including the 1987 stock market crash and the 1989 collapse of the
junk-bond market, strongly supports Smith’s unswerving faith in the resilience of the
capitalist system. His brilliant expose of how mercantilism and protectionism lead to
economic stagnation still stands as the most influential manifesto guiding so many
governments to privatize their industries, to deregulate their markets, and to join their nations
in free trade. His optimism was both refreshing and accurate during the late 1700s, when so
many pessimists predicted ruin. His optimism is just as compelling today.
II. Self, Special, And Public Interests
Over the past two centuries, Adam Smith’s insights have been trivialized by his critics and
disciples alike. His work is commonly associated with two phrases–the “invisible hand” and
“laissez faire. ” Actually, the first phrase appears only twice in his published writings. Still,
the metaphor is useful because it neatly conveys the idea that individuals pursuing their self-
interests inadvertently improve the condition of others. But the invisible hand hardly
encapsulates Smith’s world view. Neither does the second phrase, which does not appear
even once in Smith’s work. Yet “laissez faire” is frequently used to describe the central
theme of The Wealth of Nations.
Today, Adam Smith is often remembered as a champion of the capitalist class. Nothing could
be further from the truth. Contrary to the conventional view, Smith did not advocate
unrestrained capitalism, and he certainly was not an admirer of capitalists. Smith repeatedly
warned that in pursuing their self-interests, capitalists tend to join in powerful special-
interest groups. These coalitions seek political influence to promote public policies that
benefit themselves, often at the expense of the public interest.
During the second half of the eighteenth century, capitalists (i.e., the owners of capital) were
mostly agricultural landlords, merchants, and small manufacturers. The Wealth of Nations is
an all-out assault on numerous public policies that increased the wealth of these special
interests to the detriment of the wealth of the whole nation. Smith believed that the wealth of
the nation would increase much faster if these policies were abandoned.
Throughout the book, Smith railed against the capitalists and accused them of hoodwinking
the nation. He frequently observed that the interests of merchants and manufacturers always
run contrary to those of the general public. Because their interests are at odds with the public
interest, capitalists advocate policies that they claim are good for the entire nation, but in fact
are good only for themselves:
The proposal of any new law or regulation of commerce which comes from this
order, ought always to be listened to with great precaution, and ought never to be
adopted till after having been long and carefully examined, not only with the most
scrupulous, but with the most suspicious attention. It comes from an order of men,
whose interest is never exactly the same with that of the public, who have generally
an interest to deceive and even to oppress the public, and who accordingly have,
upon many occasions, both deceived and oppressed it.
These are hardly the words of a champion of the unbridled pursuit of self-interest. To counter
the political manipulations of the special interests, Smith believed that self-interest could be
disciplined and channeled in socially beneficial directions. He saw three mechanisms that
together would do the job: self discipline, the competitive market, and a system of justice.
Smith believed that individuals have the capacity to be both good and bad. In The Theory of
Moral Sentiments, which was one of the most popular books of the eighteenth century, he
sought to explain the origins of the good instincts, i.e., the moral side of human behavior. In
his view, “we either approve or disapprove of our own conduct, according as we feel that,
when we place ourselves in the situation of another man, and view it, as it were, with his
eyes and from his station, we either can or cannot entirely enter into and sympathize with the
sentiments and motives which influenced it. ”
Many scholars have noted that Smith’s two great books seem to paint radically different
pictures of human nature: One is based on sympathy and social responsibility, and the other
is based on self-interest and greed. In fact, German critics called the apparent contradiction
“Das Adam Smith Problem.” However, Smith did recognize that self-discipline was not
enough. Many people would violate their own moral conscience and act in ways harmful to
society if there were not at least two other checks—the competitive market and a system of
justice. In The Wealth of Nations, Smith exhaustively explored how competition forces
capitalists to better society rather than to exploit it. He discussed justice in a cursory way in
both books, but he never completed a definitive treatment of the subject.
Today, in the United States, the clearest example of the excesses of capitalism and the
destructive influence of special interests is the crisis in the savings and loan industry. The
cost of fixing the problem is likely to exceed $300 billion. It is by far the biggest and most
spectacular failure in the entire financial history of the United States.
The essential features of the modern American credit system were established during the
early 1930s, when Congress enacted a number of banking bills in response to the financial
panics of the Great Depression. The Federal Home Loan Bank Act of 1932 and the Home
Owners’ Loan Act of 1933 permitted savings and loan institutions (S&Ls) to operate much
like commercial banks, but they were limited to making home mortgages. The Federal
Reserve was granted the power to set maximum deposit rates for commercial banks under the
Glass-Steagall Act of 1933. The Interest Rate Control Act of 1966 extended deposit rate
ceilings to the thrifts.
To prevent future bank runs, the Glass-Steagall Act also created the Federal Deposit
Insurance Corporation (FDIC) to insure bank deposits. And in 1934, insurance coverage was
extended to S&Ls and provided by the Federal Savings and Loan Insurance Corporation
(FSLIC). Contrary to a widely held impression, Congress did not pledge the full faith and
credit of the United States government behind the guarantees of the FDIC and the FSLIC.
However, in 1982 and again in 1987, Congress did make such commitments.
During his first press conference in office, President Franklin Delano Roosevelt stated his
opposition to deposit insurance: “As to guaranteeing bank deposits, the minute the
government starts to do that . . . the government runs into a probable loss.” And
prophetically, he added, “We do not wish to make the United States government liable for
the mistakes and errors of individual banks, and put a premium on unsound banking in the
future.” But Roosevelt succumbed to congressional pressure.
This regulatory system, which clearly promoted home ownership, worked reasonably well
for four decades following the end of World War II. As the postwar baby-boom generation
matured during this period, the demand for housing exploded, and the S&Ls helped to
finance the housing boom. By the mid-1970s, there were over 4,000 S&Ls, in just about
every community in the United States. The S&Ls were mostly profitable because mortgage
interest rates generally exceeded deposit rates.
But by the late 1970s, the S&Ls fell into deep trouble. Starting during October 1979, the
Federal Reserve, under the leadership of Paul Volcker, pushed interest rates up to
unprecedented heights in an effort to unwind a runaway inflation spiral. Depositors withdrew
their funds and reinvested the proceeds in Treasury bills and other money-market instruments
offering higher returns than available on fixed-rate deposits. Ultimately, the most fatal
consequence of the Fed’s actions was that the jump in rates immediately clobbered the
market value of the mortgages and other fixed income assets held by the S&Ls.
The thrift industry’s representatives turned to Congress for help, which they promptly
received in the form of the Depository Institutions Deregulation and Monetary Control Act
of 1980. The Act phased out “Regulation Q“ deposit rate ceilings so that S&Ls could pay
much higher interest rates on deposits. Congress also permitted investors to open an
unlimited number of accounts, each insured up to $100,000. Previously, $40,000 was the
limit on insured deposits. These measures stopped the deposit outflows, but they battered
profits because deposit rates soared well above the yields generated by the mortgage
portfolios of the S&Ls.
Once again, the industry turned to their friends in Washington for more help. In 1982, the
Garn-St Germain Act permitted thrifts to invest up to 55% of their assets in commercial real
estate and other loans. Up to 30% of their portfolios could be in consumer loans. State-
chartered S&Ls in Texas and California were permitted by their regulators to plunge as much
as 100% of their assets into practically anything. Now both their assets and liabilities were
The federal regulators were also amazingly helpful. In 1981, the Federal Home Loan Bank
Board permitted S&Ls to be owned by only one shareholder. Prior to this ruling, an S&L was
required to have at least 400 shareholders to limit the influence of developers who might use
the institution as “a cash cow. ”Furthermore, the Bank Board lowered the minimum capital
requirement from 5% to 3%. Some of this capital could be in the form of accounting
“goodwill.” Incredibly, the Bank Board issued “net worth certificates” to institutions that
could not meet even these liberalized capital requirements.
But the greatest gimmick of all was the unique accounting system which the Bank Board
used to determine the regulatory net worth of the thrifts. It was called regulatory accounting
principles, or RAP. In October 1981, thrifts were allowed to amortize the losses on any assets
sold over the remaining contractual life of the asset. The regulators thus encouraged the
S&Ls to sell their “under-water” assets, which were typically packaged as mortgage-backed
securities, and to buy loans with higher yields, which would boost profits.
This short-term fix was a huge gamble that interest rates would come down enough to
reverse the capital losses created by the Fed’s inflation fight. The 1981 rule change created
an enormous divergence between net worth measured under RAP and GAAP (generally
accepted accounting principles). In 1984, 877 S&Ls were bankrupt as defined under RAP,
with a 3% capital requirement; under GAAP with a 5% cut-off, 2,090 institutions were
worthless! Rates did not fall enough to save the day.
Why were Washington’s politicians so helpful to the savings and loan industry? In a word:
money. The S&Ls’ troubles coincided with a dramatic increase in the funds needed to get
elected to Congress. Ronald Reagan’s landslide victory in the 1980 presidential race
convinced the Democrats that they had to raise large sums to counter the Republican
challenge, which was well-financed by special interests. In 1986, the Democratic
Congressional Campaign Committee, headed by Tony Coelho of California, collected huge
contributions from special-interest Political Action Groups (PACs).
In Honest Graft, which was published in 1988, Brooks Jackson, a former investigative
reporter for The Wall Street Journal, writes that the House of Representatives evolved
“into a gigantic bureaucracy, a re-election machine designed principally to return
incumbents to office. ” The S&L operators learned how to press all the right buttons to
make this machine work for them. The current chairman of the House Banking
Committee, Henry B. Gonzalez of Texas, observed that “everything the industry has
wanted, Congress has rolled over and given to them. ”
The savings and loan industry established over 150 PACs to funnel millions of dollars in
campaign contributions to several Congressmen, particularly key members of the House
and Senate banking committees. By far the most favored was former House Banking
Committee Chairman Fernand St Germain, who was instrumental in raising the deposit
insurance limit from $40,000 to $100,000. The contributions were mostly legal. But some
gifts and favors were not legal. Representatives St Germain and Coelho and Speaker of the
House Jim Wright all lost their offices largely because of their unethical ties to the S&L
industry. And other Congressmen in both parties are under investigation.
Why were Washington’s regulators as helpful to the industry as the politicians? George
Stigler, who won a Nobel prize in economics for his pioneering work on the behavior of
regulated firms, observed that such firms have an economic interest in “capturing” the
regulator to achieve their own goals, thereby using “public resources and power to improve
their economic status.” Capture theory, which clearly is an extension of Smith’s work,
predicts that the most highly regulated industries will have the greatest influence over their
That is exactly what happened in the thrift industry. The United States League of Savings
Institutions played a crucial role in establishing both the Federal Home Loan Bank System
and the Federal Savings and Loan Insurance Corporation. The League has had a great deal of
influence over the Bank Board, which provided liquidity to S&Ls and regulated and
supervised their activities. The FSLIC was supposed to close insolvent institutions promptly.
But under industry pressure, Congress refused to provide the FSLIC enough money to do the
job properly in the second half of the 1980s.
The results of Washington’s assistance to the savings and loan industry were disastrous. For
every $3 in capital, the operators of an S&L could accept and raise $100 in government-
insured deposits. Speculators and swindlers moved into the industry. They offered very high
rates to attract deposits. The fastest-growing thrifts paid the highest return and invested in the
most speculative projects. The depositors never worried about the riskiness of the S&Ls’
assets because their deposits were insured by the government.
As things turned out, many of the loans were extraordinarily risky. The credit supplied by the
S&Ls financed a building boom that created a glut of office buildings, condominiums, and
shopping centers. As real estate prices started to sink, so did the net worth of more and more
S&Ls. Last year, Congress responded to the crisis by restructuring and deregulating the
industry and approving extra funds to pay depositors at failed institutions.
The deposit insurance program was a major contributor to the S&L debacle. The federal
deposit guarantees are in fact a government subsidy, rather than an insurance program. The
premiums were paid by the thrifts to the FSLIC. Unlike most insurance programs, high flyers
paid the same premiums as conservatively managed thrifts. And the FSLIC’ Sreserves were
never sufficient to cover the potential liabilities of the insurance fund.
No one really knows how many hundreds of billions of dollars will be required to clean up
the mess. Fortunately, the American economy, with annual GNP currently exceeding $5
trillion, is big enough to absorb this enormous loss. But 200 years after the death of Adam
Smith, the S&L debacle proves that his warning remains as relevant as ever: Capitalism is
prone to excess, and vigilance is required to ensure that the political system is not
manipulated for the economic benefit of a few to the detriment of the entire society.
Ill. Stagnation, Policy Ruts And Free Trade
Returning now to the eighteenth century, mercantilists were the special-interest group that
particularly outraged Smith. Mercantilists argued that the key to national prosperity was a
favorable trade balance. A surplus of exports over imports was necessary to assure an inflow
of gold, which many of them believed was an important source and the best measure of
national wealth. In their view, a nation could prosper only at the expense of other nations.
After all, one country’s trade surplus is another’s trade deficit. In a mercantile world,
international relations are a zero-sum game—for every winner there is a loser.
The mercantilists advocated high tariffs on imports and subsidies for exports. They were also
empire builders. Colonies provided raw materials to the industries of the mother country and
also exclusive markets for their finished products. A large military force was necessary to
build the empire and to defend the colonies from other imperial powers. Financing these
activities required a great deal of money, which is why many mercantilists measured the
wealth of a nation by the amount of gold in the country’s treasury.
Mercantilism made good sense during the fifteenth and sixteenth centuries, when the
feudalism of the Middle Ages was gradually replaced by the nation-state. Mercantilists
successfully centralized and strengthened national authority, which was challenged by the
universalism of the Catholic Church and the provincialism of local barons. They created
national markets out of the hundreds of fiefdoms that arbitrarily imposed tolls and regulated
commerce within their small domains.
By the eighteenth century, mercantilism had clearly triumphed over feudalism. But it had
also lost its raison d’Œtr.eOnce a visionary creed, mercantilism now was just a cover for
special interests. The mercantilists claimed that their objective was to place the country’s
economic resources at the disposal of the state. But, in fact, their policies put the state’s
power at the disposal of merchants, manufacturers, and landlords.
No one saw this more clearly than Adam Smith. He observed that Britain was stagnating
rather than prospering under mercantilist policies. To get out of the rut, Smith argued that
these policies must be abandoned. He advocated the repeal of the Corn Laws, which created
a system of bounties, tariffs, and quotas to regulate the supply of grain–much to the benefit
of the landlords. He also questioned the wisdom of laws which gave English shippers a
virtual monopoly on all trade within the British empire and required most trade between the
colonies and foreign powers to run through England. And he favored independence for the
British colonies, particularly those in America.
Smith believed the wealth of a nation is ultimately determined by the prosperity of its
consumers. Therefore, public policies should aim to maximize the welfare of consumers.
According to Smith, mercantilist policies were unsound because they promoted the special
interests of producers at the expense of the public’s interests: “The mercantile system
absurdly considers production and not consumpti