Adam Smith’s greatest insight?

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Many people would cite Smith’s “invisible hand” metaphor as his greatest contribution to economics. This is from The Wealth of Nations:

By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.

On the other hand, this sort of idea had already been discussed by thinkers like Bernard Mandeville. While I’m certainly no expert on Adam Smith, I wonder if another insight is not more interesting. Here is AI Overview:

Adam Smith wrote "there is a great deal of ruin in a nation" in 1777 to reassure a panicked young British politician, Sir John Sinclair, who feared Great Britain was completely destroyed following General Burgoyne’s defeat at the Battle of Saratoga during the American Revolutionary War.

And AI adds this context:

• The Context: Sinclair wrote to Smith saying, “If we go on at this rate, the nation must be ruined.”
• Smith’s Reply: Smith calmly responded, “Be assured, my young friend, that there is a great deal of ruin in a nation.”

In my view, there is far more to this phrase than just “calm down, don’t panic.” Economies really can fall into “ruin”. America’s Great Depression and the collapse of Venezuela’s economy over the past 15 years are just two examples of very serious economic problems. In some cases, a bit more “panic” would have been appropriate. So how exactly should we view Smith’s reassurance?

I read Smith as at least implicitly saying something like the following (my words, not his):

When it comes to the wealth of nations, most people vastly overrate the importance of factors that they can easily visualize and underrate the importance of the deeper determinants of economic growth. As a result, people tend to overreact to highly visible shocks, at least in terms of the macroeconomy.

Consider the following two natural disasters:

1. The Great Mississippi River Flood of 1927
2. The Dust Bowl of the 1930s

Why is the Dust Bowl much more famous, more widely known by the public? Perhaps because in many peoples’ minds, it is linked to the Great Depression. In contrast, the economy boomed during the 1920s, so people today have no reason to assume the flood was important.

I asked AI Overview to name the most famous American stock market crash:

The most famous and devastating U.S. stock market crash is the Wall Street crash of 1929, also known as the Great Crash.

The 1987 stock market crash was almost identical in severity and duration, even occurring at the identical time of year. And it is far more recent. So why is the 1929 crash more famous? Perhaps because people link the 1929 crash and the Depression?

Suppose you are an average person and don’t have much understanding of economics, especially macroeconomics. The endless cycles of good times and bad times will seem like something of a mystery. It would be natural to employ some sort of folk wisdom and try to explain economic events with something that you did understand.

Something like the Dust Bowl would be expected to impose a great deal of hardship on many farmers. A big stock market crash would inflict a great deal of hardship on investors. It would be natural to latch onto those sort of highly visible events as factors playing a significant causal role in the Depression, an event that created hardship for much of the country. On the other hand, if you are a politically minded person then you might fixate on whoever was president when the economy took a turn for the worse.

Japan’s tsunami of March 2011 killed nearly 20,000 people, far more than any natural disaster in US history (apart from pandemics.) But it had remarkably little effect on Japan’s macroeconomy, as the unemployment rate fell in the months after the tsunami:

Output took a hit, but for a far briefer period than during even a mild Japanese recession:

When I was young, people often spoke of the “German miracle”, referring to West Germany’s rapid growth after WWII. In fact, Germany’s economic recovery was a bit disappointing, held back during the immediate postwar period by economic policies such as price controls. Growth only took off after 1948, when German policymakers removed the price controls over the objections of American occupation officials. Draconian price controls are among the most ruinous of all economic policies. Here’s how AI Overview describes the impact of deregulation:

The Outcome

• Immediate Success: Rather than causing inflation, lifting the controls coaxed hoarded goods out into the open, ended chronic shortages, and dissolved the black market almost overnight. [1, 2, 3]
• The Economic Miracle: Industrial production jumped by 50 percent in just six months, launching the West German Wirtschaftswunder (economic miracle)

It would be natural for average people to assume that the poor condition of the West German economy in 1948 was due to the war, as the major cities were full of bombed out buildings. But that wasn’t the biggest problem—it was bad economic policies that delayed the German recovery for three years. When the boom did finally begin, it was natural for people to attribute it to things like the Marshall Plan. But is that true? Again, here’s AI Overview:

The United Kingdom received about $3.3 billion (26% of the total fund), and the Western-occupied zones of Germany received about $1.45 billion (11% of the total fund) from the Marshall Plan.

The Marshall Plan probably helped. But even adjusting for inflation, that’s not very much money for a country the size of West Germany. And why was Germany’s recovery so much more impressive than the UK’s recovery, given that it got far less money?

Again, the public’s “folk wisdom” supplies an answer. When I was young, people said that the German and Japanese economies had actually benefited from being destroyed in WWII, as this allowed them to rebuild with newer plant and equipment. I hope I don’t have to explain to readers just how nonsensical that theory is.

A much more plausible theory very much in the spirit of Adam Smith was put forward by Mancur Olson. Again, AI Overview:

Mancur Olson argued that Germany and Japan recovered rapidly after World War II because the total devastation of the war destroyed their entrenched special-interest groups and cartels, allowing for streamlined economic rebuilding.

I don’t know if Olson’s theory is true, but at least it is consistent with Smith’s view that a free-market system underpinned by the impartial use of the rule of law is much more important than foreign aid (or mercantilist profits from exploiting colonial subjects.)

Smith would probably be able to explain to our foreign policy establishment why Russia’s economy continued to do well after “draconian” sanctions were imposed in early 2022, and why economic sanctions almost never achieve their policy goals.

So when you hear people quote Smith as saying “there is a great deal of ruin in a nation”, please think about what that actually means. The implication goes far beyond “don’t panic”. It suggests that we should be very skeptical of claims that any single policy error—say Trump’s tariffs—would derail the economy. We should be skeptical of claims that a financial crisis or a Middle East war would cause a recession. That’s not to say that real shocks never matter—Covid certainly had an impact on the economy—rather that people tend to overestimate the impact of any given shock.

Smith (1755) had some quite reasonable policy views:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which force things into another channel, or which endeavour to arrest the progress of society at a particular point, are unnatural, and to support themselves are obliged to be oppressive and tyrannical.

That explains why places like Singapore and Switzerland do quite well. But the corollary of this claim is that a country with good fundamentals can absorb some quite significant blows—whether natural or policy related—and still maintain a reasonable degree of “opulence”.

Another implication of Smith’s insight is that it is unlikely that a positive shock would dramatically improve the trajectory of an economy. This may or may not apply to the impact of AI on economic growth—time will tell—but I believe it largely explains why economists are skeptical of predictions that growth will radically accelerate in the near future.

PS. Think for a moment about living standards for the median income person in what Smith called the countries with “the highest degree of opulence” back in 1755 and stop your whining!

PPS. One of my favorite examples of folk wisdom is the effect of immigration. I see the same people make the following two arguments:

1. Immigration will make us poorer by depressing wages.
2. America is richer than Canada because we have a much bigger market with more economies of scale.

So, which is it? Actually, per capita income and population are almost completely uncorrelated.

PPPS. I once met some Koreans who tried to explain to me that North Korea’s poor situation was due to a lack of natural resources. Folk wisdom.

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