Adam Smith earned his title as the father of economics and free market capitalism with his 1776 work, commonly refered to in abbreviated form as The Wealth of Nations. Smith suggested that self interest in the form of an "invisible hand" would suffice to keep capitalism on solid footing. From this simple idea, economics would eventually branch into numerous warring schools of thought: 1) Classical School, 2) Neoclassical, 3) Keynesian, 4) Post Keynesian, 4) New Keynesian, 5) Monetarists, 6) New Classical, 7) Neo-Ricardian, 8) Marxists, 8) Austrian, and so on. Each school of economics or associated political ideology would in turn have a hero which it worships. The conservatives have their Adam Smith, the libertarians their Ludwig von Mises, the liberals their John Maynard Keynes, the communists their Marx, and so on. The problem with hero worship is that it blinds the worshipers to the giant elephant standing in their ivory tower or on their political party platform.
For the modern student of economics armed with a modern textbook, the various elephants are not quite so visible. At least that was my experience, having sweated through clones of mainstream textbooks during the first two years of my effort to deconstruct economic theory. Not until it occurred to me to dig into the history of economic thought did these very large elephants become visible. They were everywhere: The invisible auctioneer of modern general equilibrium theory, the subsistence wages of Smith's classical school, the Austrian idea of manna from heaven (Menger's diamond example), Keynes' multiplier heading to infinity if you don't save, and the Quantity Theory of Money (QTM) which implies economics is a form of stone-age barter. Economics had so many elephants, that it appeared to me as a circus parade, clowns and all. Having been fed intellectual cotton candy as they marched by, I eventually realized I was being fattened for the intellectual slaughter of free trade and had no choice but to conclude there has never been a sound theory of economics (see my previous essay The Unraveling of Economics).
Smith's elephant is a one of the meanest, biggest bulls in the parade. This bull is so strong he can bring entire nations to its knees. His name is Subsistence Wages. The harsh reality of England's wage problem could not be hidden behind an invisible hand in spite of the rosy title of Smith's work. In fact, subsistence wages would be the foundation for all classical school followers. Maltus built a theoretical model around the idea of population growth outstripping the food supply. Ricardo ran with starvationomics, and dreamt up a more sophisticated model of free trade than Smith could conjure up (Ricardo's elephant was really Hume's QTM). Marx, as mixed up as the rest of the classical school, would leverage slave-like wages as the basis for his exploitation argument. The terror of communism and tens of millions of corpses would be the final fruit borne by the exploitation argument.
In order to understand how Smith's elephant could do so much damage in the long run, we need to understand that the critical mistake of the classical school. It took the sound model of a labor-based cost of production for industrial goods, and misapplied it to labor. Labor thus became just another commodity. In other words, in a strange twist of illogic, labor itself had a cost of production. In short, overpopulation/starvation mechanics would force the price of labor down to a level sufficient to barely keep the laborer fed and housed in shanty towns. Thus subsistence wages became the cost to "produce" a laborer (just enough to allow a sufficient number to reproduce; the rest would starve). Dismal science indeed.
Smith's defective solution for subsistence wages was low cost imports (free trade). Unfortunately, in my analysis it is free trade that generates subsistence wages in the first place. At some level even angry-man Marx understood this when he called for the eventual destruction of capitalism via free trade. But rage never seeks a real solution; it only just searches for enemy to destroy (not repair). So it fell to a forgotten Marxist by the name of Maltman Barrie, who eventually was expelled from the party (surprise?), to recognize that closing the economy would solve the problem of subsistence wages. Though Barrie did not focus on money's theoretical role in such a solution, he did grasp the end result: The laborer can consume the wealth what he produces. This is the result Smith's invisible hand could not achieve, but only very visible sky high tariffs.
To help grasp this proposition, one only needs to consider how the cotton plantation owner did not need to rely on the purchasing power of his slaves to remain in business. He simply had to export a portion of the nation's wealth to prosper, while his slaves lived in squalor. In short, an open economy, even with an export surplus is a broken economy. If this is not obvious, take the argument to its extreme. Say you export 90% of everything you produce with no imports. Of what value is this to the laborer? The factory owner will be happy, but the laborer is 90% poorer so to speak. But by closing the economy, money is no longer an afterthought in the form of the "veil" of modern economics (another elephant), but provides THE foundation for protectionist economics and the road to full employment and prosperity. The producer of wealth is now able to consume the wealth that he produces.
Smith's incomplete logic in my view (as an engineer) does not end with wages, but spills over into his ideas on money, agriculture over industry, and division of labor. In other words, Smith had several elephants in his room. Though it might be argued that hindsight is 20/20 and that these errors should be forgiven since Smith was breaking new ground, the reader must keep in mind Smith's invisible hand is alive and well today in modern free market economics. In practical terms, Smith's invisible hand means his worshipers literally "see nothing" that would lead them into believing that there is a need to distinguish between free domestic markets and free international markets.
What free market worshipers and all schools economics fail to grasp is that money is a domestic phenomenon, not an international one. Money is a domestic phenomenon because a minimum wage is defined by decree. A minimum wage base line is absolutely necessary in a fiat system, because paper money has no intrinsic value associated with a labor unit. This makes money an arbitrary scale as James Steuart (writing before Smith) understood. The logic of an arbitrary scale ultimately can be applied to gold too, since the labor content of an oz of gold can vary from country to country depending on its natural abundance. This oversight has confused gold bugs for two centuries, in contrast to Steuart who could foresee the power of credit money in the coming age of industry.
Even here we find another elephant in the form of modern economics which rejects money's role as an "arbitrary domestic scale" by assuming the scale is instantly and infinitely flexible (i.e. code word for supply and demand driven pricing). It is for this reason they reject a minimum wage, because it would break the mechanics of barter (no true cost of production pricing here). From barter we are able to leap and construct models of free trade. But anyone who has used a ruler knows that for a scale of measure to function properly it must be fixed. It must be fixed (rigid baseline) so that productivity gains can be properly tracked (reduction in labor content in an industrial good). This way the consumer's new savings can be spent elsewhere in the closed economy, reemploying the newly unemployed following productivity gains. This is how a sound economy grows. It relies on domestic money to track labor in a closed economy.
Though growth and automation go hand in hand, they play out very differently in open and closed economies. There is much confusion being written lately in the press about automation and job loss. It is worth clarifying this point. Automation in a closed economy only means short term unemployment because the consumer savings will be spent in a new sector providing new employment opportunities for the newly displaced. On the other hand, an exporter who can robotize his factory no longer needs to rely on the purchasing power of his workers and therefore generates long term unemployment. In other words, the Luddites might have been on to something after all. This is Smith’s elephant, still alive and on a rampage 200 years later.
Subsistence wages were of great interest to American protectionists of the 1700 and 1800s. They were well aware of the superior wages paid to American workers. As a result, they were not Smith worshipers. Some would even travel to Europe to study the plight of the European worker. Consider the observations of Robert Percival Porter, author of Protection and free trade to-day: at home and abroad, in field and workshop, who packs his bags and begins an investigative trip across Europe in the late 1800s in an effort to get his head wrapped around the impact of free trade and protectionism. Consider the following series of snippets from his book:
After a disastrous attempt to establish free trade, the German Empire in 1880 was obliged to return to protection. I spent a portion of 1883 in Germany, and opportunity was afforded to observe the results of four years of protection. The places which I visited covered the industrial regions of the entire Empire.
...Wages have increased; hundreds of thousands of the unemployed have been given profitable work [in Germany]; old blast furnaces which had become moss-grown under free trade have been relighted ; new ones have been built; others are to-day in course of construction; silent spindles are humming again; looms covered with dust and cobwebs are once more clattering; old mills have been reopened and new ones have been built, and English firms have found it profitable to move to Germany [emphasis added] and give employment to hundreds of the weavers and spinners who under free trade had nearly starved on black bread and horseflesh. (Porter. 1884. 19)
Not only did Porter “get it”, so did American statesmen, such as Hamilton, Lincoln (and GOP till 1960s), the Constitution creators, Carey, Kelly, Clay, Raymond, McKinley, and other statesmen such as the German expatriate List. They rejected Smith and turned America and Germany into super powers as a result. They did this by recognizing the critical difference between wealth producing free domestic markets and destructive international markets.
In the end, China has adopted Lincoln’s logic, and we Marx. The elephants don't come much bigger than that.
Additional reads by this author: http://www.economicpopulist.org/content/myth-middle-class-economics-5665