Before the publication of Adam Smith's An Inquiry into the Nature and Causes of the Wealth of Nations there had been no major works written on economics, and economic policy was usually influenced by the powerful merchant class. A system called Mercantilism, or the Commercial System, was in place. It was characterised by the use of lots of restrictions and incentives to push trade in the “right” directions to enrich the country. Smith demonstrated that most of these measures were counter-productive, and his views contributed to the introduction of the Classical System, which dominated European trade for well over a century.
Mercantilism
Adam Smith had plenty of experience of Mercantilism. His father, guardian and cousin all worked in customs. In The Wealth of Nations Smith listed all the ways in which trade was encouraged or hindered, such as: restraints upon the import of goods which could be produced in the home country, restrictions on imports from certain foreign countries, bounties (a sum paid to encourage the export of certain goods), and monopolies (when one country or company had sole right to trade with a particular colony).
Adam Smith argued that this system did not enrich the country. He showed that the policy of encouraging exports and discouraging imports so that there was more physical money in the country did not mean that the country was richer. It just meant that the value of money was reduced, and that food and clothing, which have real worth, became more expensive. He explained that encouraging exports meant that the poor were taxed twice on the things they bought. The first, direct tax, was paid to the government so that it could pay merchants the bounty. The second, indirect tax was the higher price of goods due to less being available because too much was exported.
The Classical System
What Smith proposed was a system of “perfect liberty”. Trade should be free to do what was most profitable, not pushed into unnatural channels where it had to be subsidised by the government. As an Enlightenment thinker he believed in the good of the greatest number, not just the good of the rich. He believed that free trade would benefit the poor by not keeping prices artificially high.
Wealth of Nations also argues for the division of labour. Smith showed how in a factory, different people performing different tasks meant that the product could be produced much quicker and more cheaply than if each person performed every task.
Growing the World Economy
Smith's controversial idea was that this principle could be applied internationally. Goods which could be produced in other countries more cheaply should be imported, because that was better for both countries. His famous example was that wine could be produced in Scotland by using greenhouses, but it would cost thirty times more to make it than in France. It made much more sense to import it, and this principle applied to everything.
By examples like this Adam Smith showed that it was possible for trade to benefit both countries, causing mutual growth. Previously it had been believed that there was a fixed amount of wealth in the world, so trade always benefited one country at the expense of the other – hence the heavy restrictions on the “wrong” kind of trade. Smith showed that this wasn't true – the economy as a whole could grow. As people in all countries became richer their appetite for imported luxury goods would get bigger, creating even more wealth. In laying down the principle that it is possible for the whole world economy to grow, Adam Smith produced the basis of modern economics.
Sources: M Skousen (2007) The Big Three in Economics, S G Medema and W J Samuels (2003) The History of Economic Thought: A Reader
