Adam Smith's Wealth of Nations: Spending, Taxing, and Debt
In this, our ninth episode, Mike Munger walks us through Book Five of The Wealth of Nations to map a state that defends, adjudicates, and builds wisely, then pays for it without killing growth. From militias to standing armies, fee-based courts to salaried judges, turnpikes to basic schooling, and taxes to debt, we test what holds up now.
This the ninth in our series of podcasts with Mike Munger in anticipation of the 250th anniversary of The Wealth of Nations. The recording is also available via Munger's podcast, "The Answer is Transaction Costs" [TAITC].
Want to explore more?
Want to explore more?
- Revisit the very first episode of this series!
- John Burrow, Adam Smith and Stadial Theory, at AdamSmithWorks.
- Maryann Keating, Adam Smith and the Public Debt, at AdamSmithWorks.
- Thelmo Vargas-Madrigal, Adam Smith on Taxation, at AdamSmithWorks.
- Mike Munger on the Division of Labor, an EconTalk podcast.
Read the transcript.
This is Mike Munger, the knower of important things from Duke University. This is episode nine of the series on Adam Smith and the Wealth of Nations. This series is produced in cooperation with AdamSmithWorks at Liberty Fund, and I'm pleased to acknowledge the partnership of Amy Willis.
This episode takes up the final book, Book Five of The Wealth of Nations, which is entitled “Of the Revenue of the Sovereign or Commonwealth.” This is Adam Smith writing the first public finance textbook, and it's still one of the best textbooks out there. Straight out of Creedmoor, this is TAITC.
Book five is “Of the revenue of the sovereign or commonwealth.” It's 259 pages long, so it's long enough to be a book by itself. Book five is Adam Smith's most explicit treatment of the state. After explaining how wealth is generated through markets and the division of labor, Smith turns to the question he regards as unavoidable: What must government do and how should it be paid for without undermining the wealth it exists to protect? Smith's answer is neither libertarian minimalism nor bureaucratic expansion.
Book Five develops a theory of necessary but limited government, grounded in institutional incentives, fiscal discipline, and concern for the moral and civic effects of commercial society. Chapter one of Book Five is “Of the expenses of the sovereign or commonwealth.” It by itself is 130 pages long, so half of the total- very long book. Chapter two is “Of the sources of general or public revenue of the society.” Chapter three is “Of public debt.” So Smith begins the book and chapter one by identifying the three great duties of the sovereign defense, justice, and public works and institutions, before adding a fourth, very short, residual category, the support of sovereign dignity. I wonder what he would think of building a ballroom in the east wing of the White House?
In the first part, he talks about the expense of defense. He argues that economic development transforms the nature of war. In early societies, citizens are naturally martial. In commercial societies, the division of labor renders them prosperous, but very likely unwarlike, while simultaneously increasing the value of what must be defended because the country becomes wealthy. Smith therefore argues that modern states face a stark choice. On page 698, he says, In these circumstances (meaning once a country has developed division of labor and become wealthy) In these circumstances there seem to be but two methods by which the state can make any tolerable provision for the public defense. It may either first, by means of a very rigorous police and in spite of the whole bent of the interest, genius, and inclinations of the people, enforce the practice of military exercises and oblige either all the citizens of the military age, or a certain number of them, to join in some measure of the trade of a soldier, in addition to whatever other trade or profession they may happen to carry on.
Pause the quote for a minute. So basically we would now call that a draft. And there are some countries, Switzerland and Israel, where almost universal draft of young people is enforced. Oh, back to the quote.
Or secondly, by maintaining and employing a certain number of citizens in the constant practice of military exercises, it may render the trade of a soldier a particular trade, separate and distinct from all others. If the state has recourse to the first of these two expedients, its military force is said to consist in a militia. If to the second, it is said to consist in a standing army. The practice of military exercises is the sole or principal occupation of the soldiers of a standing army, and the maintenance or pay which the state affords them is the principal and ordinary fund of their subsistence. The practice of military exercises is only the occasional occupation of the soldiers of a militia, and they derive the principal and ordinary fund of their subsistence from some other occupation. In a militia, the character of the laborer, artificer, or tradesman predominates over that of a soldier. In a standing army, it is that of the soldier predominates over every other character. And in this distinction seems to consist the essential difference between those two different species of military force.
End quote. And again, that's on page 698. So Smith is careful to distinguish between a militia and a standing army. Smith concludes then, reluctantly but decisively, that standing armies are actually inevitable in advanced commercial societies. Defense is the first duty of the sovereign, and its cost rises with prosperity. But the vulnerability of the society also rises with prosperity because it becomes a more tempting target for outsiders. So Smith argues that national defense is the first duty, but the cost of defense depends entirely on the stage of social and economic development. In the most primitive societies, hunters, there's effectively no public expense of defense because every adult is already a warrior who supports himself. War imposes no fiscal burden because it requires no additional specialization. Among pastoral societies, defense remains inexpensive in monetary terms, but war now involves the entire community moving with its property, which makes such societies more formidable than hunters. Still, there's no standing military institution and no taxation devoted to defense other than the obligation of all the men who can to participate in defense.
With the emergence of agriculture, however, a critical change occurs. And remember, this is Smith going through the stadial theory of development. So we start with hunters and then we have shepherds and then fixed agriculture and farmers. Farmers, the third stage, cannot abandon their land without loss. War therefore requires that some portion of society specialize in fighting, while others continue producing subsistence. This introduces for the first time a real fiscal cost of defense, because soldiers must now be maintained by the surplus produced by others. As societies advance further through commerce and manufacturing, military specialization intensifies. Smith emphasizes that skill, discipline, and habitual training become decisive in war, making temporary militias inferior to professional forces. Modern warfare is no longer decided by bravery, but by long practice and technical expertise.
This leads Smith to his most controversial conclusion. A well-regulated standing army is ultimately more compatible with liberty than a militia. Militias may appear republican and virtuous, but in advanced societies they are militarily ineffective and politically dangerous when they fall. A disciplined standing army, properly subordinated to civil authority, is both more effective and less destabilizing. Of course, there's a lot packed into that “properly subordinated to civil authority”, and that is one of the great problems that democracies have always faced, is to ensure the military deference to civilian authority. The question is, how do you do that? After all, the military has the guns.
Smith closes this section by rejecting the fear, which is common in republican theory, that standing armies necessarily destroy freedom. On the contrary, he argues that liberty has often been better preserved in commercial societies with professional armies than in states that rely on ill-trained citizen militias. And a big part of the reason is that Smith is concerned about defense as actual defense. It has to carry out the function of not losing the war. And militias are going to lose the war to a standing army. So you have to put up with a standing army with all of its problems, because it's even worse to have a militia, which is admirable from a republican perspective, but you lose the war.
Let's go into that a little more deeply. On page 701, Smith says,
A militia of any kind, it must be observed, which has served for several successive campaigns in the field, becomes in every respect a standing army. The soldiers are every day exercised in the use of their arms and being constantly under the command of their officers are habituated to the same prompt obedience which takes place in a standing army. What they were before they took the field is of little importance. They necessarily become in every respect a standing army, after they have passed a few campaigns in it. Should the war in America drag out through another campaign, the American militia may become in every respect a match for that standing army, of which the valor appeared in the last war, at least not inferior to that of the hardiest veterans of France and Spain. This distinction being well understood, the history of all ages, it will be found, bears testimony to the irresistible superiority which a well-regulated standing army has over a militia.
End of quote. Well, of course, that prediction about what would happen to the American militia proved prescient. The American army was never very big, and [George] Washington always had trouble keeping people from deserting. But boy, by the end of the war, the American militias had become something like a standing army for just the reason that Smith says. Now there was a problem. They didn't get paid very well, and so you can't depend on that always working. But it is true that a militia, if you can keep it together over several campaigns, may become at least able to resist a professional standing army.
On page 705, Smith notes that discipline may stand in as a good substitute for what looks like bravery and unit morale in a militia. Again on page 705,
The soldiers of a standing army, though they may never have seen an enemy, yet have frequently appeared to possess all the courage of veteran troops, and the very moment that they took the field to have been fit to face the hardiest and most experienced veterans. In 1756, when the Russian army marched into Poland, the valor of the Russian soldiers did not appear inferior to that of the Prussians, at that time supposed to be the hardiest and most experienced veterans in Europe. The Russian Empire, however, had enjoyed a profound peace for near 20 years before and could at that time have very few soldiers who had ever seen an enemy.
Well, that gives you a flavor of Smith's view of the costs of defense. Turning now to part two of chapter one of Book Five, “Of the expense of justice.” Justice becomes necessary, Smith argues, once property becomes unequal. In poor or egalitarian societies, disputes are limited. In wealthy societies, the accumulation of property creates the need for formal, impartial enforcement. Now it's important to recognize that what Smith means by justice is abstaining from what is another’s. That is, justice and property are very closely linked. Justice and the protection of property are nearly synonymous. And here, as in the expense of the military or defense, we see the stadial theory. On page 709,
Among nations of hunters, therefore, as there is scarce any property, or at least none that exceed as the value of two or three days' labor, so there is seldom any established magistrate or any regular administration of justice. Men who have no property can injure one another only in their persons or reputations. But when one man kills, wounds, beats, or defames another, though he to whom the injury is done suffers, he who does it receives no benefit. It is otherwise with injuries to property. The benefit of the person who does the injury is often equal to the loss of him who suffers it. Envy, malice, or resentment are the only passions which can prompt one man to injure another in his person or reputation. But the greater part of men are not very infrequently under the influence of those passions. And the very worst men are so only occasionally. As their gratification, too, how agreeable soever it may be to certain characters, is not attended with any real or permanent advantage, it is in the greater part of men commonly restrained by prudential considerations. Men may live together in society with some tolerable degree of security, though there is no civil magistrate to protect them from the injuries of those passions. But avarice and ambition in the rich, in the poor, the hatred of labor, and the love of present ease and enjoyment are the passions which prompt to invade property, passions much more steady in their operation and much more universal in their influence.
End of quote. Well, what that means is that the temptations to behave unjustly are less in what Smith thinks of as less developed societies because there's not yet any property. With the advent of property, Smith actually kind of anticipates [Jean-Jacques] Rousseau on this, but he disagrees about the solution. The advent of property is what creates a need for, as Smith sees it, justice. On page 710, Smith says that,
The causes or circumstances which naturally introduce subordination, or which naturally, an antecedent to any civil institutions, give some men some superiority over the greater part of their brethren, seem to be four in number. First of these causes or circumstances is the superiority of personal qualifications. The second is the superiority of age. The third of these causes or circumstances is the superiority of fortune. The fourth of these causes or circumstances is the superiority of birth. Superiority of birth supposes an ancient superiority of fortune in the family of the person who claims it.
That is, being from a family that has status must at some point have relied on one of the first three. And Smith explains then that the cause of those differences in privilege and authority are not likely to be very big in societies of hunters. Someone who is the best hunter might be the head person, but their authority may not even pass down to their son because we don't rely as much on family. There's nothing for the person to hand down unless it is their physical characteristics, in which case the son would rule by virtue of his own characteristics, not because of family name. Smith quite bluntly then says that it is the advent of property that starts to change these four points, and actually to make the fourth of them, the family that you come from, more important, because property is easier to hand down. On page 715, Smith is quite blunt.
It is in the Age of Shepherds, in the second period of society, that the inequality of fortune first begins to take place and introduces among men a degree of authority and subordination which could not possibly exist before. It thereby introduces some degree of that civil government which is indispensably necessary for its own preservation. And it seems to do this naturally and even independent of the consideration of that necessity. The consideration of that necessity comes no doubt afterwards to contribute very much to maintain and secure that authority and that subordination. The rich, in particular, are necessarily interested to support that order of things, which can alone secure them in the possession of their own advantages. Men of inferior wealth combine to defend those of superior wealth in the possession of their property, in order that men of superior wealth may combine to defend them in the possession of theirs. All the inferior shepherds and herdsmen feel that the security of their own herds and flocks depends upon the security of those of the great shepherd or herdsman, that the maintenance of their lesser authority depends upon that of his greater authority, and that their subordination to him depends his power of keeping their inferiors in subordination to him. They constitute a sort of little nobility, who feel themselves interested to defend the property and to support the authority of their own little sovereign, in order that he may be able to defend their property and to support their authority. Civil government, so far as it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor, or of those who have some property against those who have none at all.
That's a very famous passage, let me say it again. Civil government, so far as it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor, or of those who have some property against those who have none at all. End of quote, and that's on page 715. Well, the reason that is important is that shepherds, in Smith's view, have some small amount of herd, and they depend on collective action to be able to defend the little herd that they have, and they're willing to contribute to the defense of the group, which mostly benefits those who have even more property because it protects the small amount of property that they have themselves. That is, even those who have relatively less property have a stake in mutual defense. We should be careful. Smith says that property is a way of defending the rich against the poor. This is not moral condemnation, but institutional realism. He doesn't have the words, but it's what we would now call incentive compatibility. Justice stabilizes expectations and prevents predation. Smith then warns strongly against some forms of financing the courts. Again, on page 715,
The judicial authority of a sovereign in a shepherd society, far from being a cause of expense, was for a long time a source of revenue to him. The persons who applied to him for justice were always willing to pay for it, and a present never failed to accompany a petition. After the authority of the sovereign too was thoroughly established, the person found guilty over and above the satisfaction which he was obliged to make to the other party was likewise forced to pay an immersement to the sovereign. He had given trouble, he had disturbed, he had broken the peace of his lord the king, and for those offenses an immersement was thought due.
Let me pause there for a second and say that immersement is a non-statutory monetary penalty or forfeiture, usually applied at the discretion of a court. And basically it comes from the old French, asking for mercy. So immersement is a request for mercy for having violated the peace of the realm and disturbed the order of the king. Perhaps unsurprisingly, Smith is not really a fan. He says on page 716,
This scheme of making the administration of justice subservient to the purposes of revenue could scarce fail to be productive of several very gross abuses. The person who applied for justice with a large present in his hand was likely to get something more than justice, while he who applied for it with a small one was likely to get something less. Justice too might frequently be delayed in order that this present might be repeated.
Well, what Smith means there is that I can, you know, I haven't decided yet. Maybe another little present would help me decide. This is a hard case. Back to the quote on page 716.
The immersement, besides, of the person complained of might frequently suggest a very strong reason for finding him in the wrong, even when he had not really been so. That such abuses were far from being uncommon, the ancient history of every country in Europe bears witness.
End of quote. For Smith, judicial salaries and independence are essential to the functioning of a commercial society. Smith opens part two by insisting that the administration of justice is the second great duty of the sovereign. Its necessity arises directly from the emergence of property inequality. Remember that justice for Smith exists primarily to protect the rich from the poor, not because the poor are morally worse, but because inequality generates incentives for resentment, envy, and appropriation. Smith's not that upset about inequality so long as it results from the honest pursuit of profit. So he thinks inequality is inevitable in a commercial society because of the differences in people's ability, how hard they work. But the administration of justice requires that those differences in property have to be protected by the state. And so he quite honestly says what that means is that justice and property are the protection of the wealthy against the poor. Justice is not a moral luxury. It's not primarily a moral question, even. It's an institutional prerequisite for social order and survival in commercial societies, because property is required in order to raise the funds to have a standing army, which he has already tried to establish is necessary for the survival, the literal survival of the society.
As societies become more complex, justice must be administered by specialized judges, trained in law and supported by public revenue. Smith argues that judicial independence improves as judges are paid fixed salaries rather than fees tied to case outcomes. Fee-based systems distort incentives and undermine impartiality, whereas salary judges can better uphold consistent rules. Smith then turns to the historical development of courts, especially in feudal Europe. He shows how early judicial authority was fragmented among local lords, whose courts were arbitrary and often corrupt. Over time, as monarchs consolidated power, they centralized judicial authority, replacing feudal discretion with more regularized legal systems. This process, Smith argues, unintentionally promoted liberty by weakening local tyrannies, even when monarchs themselves were not in any way motivated by liberal ideas. A key theme is that justice should be funded publicly, but only insofar as the general security of property and person is advanced by justice. Smith rejects the idea that justice should be a profit-making enterprise or discretionary favor. Law must be predictable, general, and accessible. Finally, Smith stresses that secure property rights are a condition for economic growth, but they're not self-enforcing. Justice has to be strong enough to restrain violence and fraud, yet limited enough not to become an instrument of oppression. This balance, strong law, limited arbitrariness, is where Smith most closely intersects with Montesquieu and Hume, while also departing from them in important ways.
So Smith is agreeing with Montesquieu on three points. The law has to be general and predictable, judicial independence matters, and arbitrary justice is the enemy of liberty. But Smith departs sharply from Montesquieu's emphasis on constitutional form. Smith is less interested in formal separation and more focused on incentives and funding mechanisms. Where Montesquieu asks, who holds power? Smith asks, how are they paid? How is their compensation contingent on their actions? Smith also agrees, perhaps even more, with David Hume. So, for example, David Hume's essays of justice, Of the Origin of Government, Smith would argue that justice emerges from scarcity and self-interest, property precedes justice institutionally, and government is an unintended but strong and useful equilibrium. Smith's account of monarchs restraining feudal lords mirrors Hume's evolutionary, non-teleological account of political order. It has worked out pretty well, but no one intended it. What's interesting is that Smith is more candid than either Montesquieu or Hume about the class dimension of justice. His claim that justice exists to protect the rich from the poor is not cynical, it's just analytic. He treats justice as a coordination device that stabilizes inequality enough to permit growth, specialization, and long-run prosperity. And that's partly based on the realistic hope that some of the people who are not now rich can become rich. And that means that they have a stake in supporting a system that protects the rich.
And so we come to part three of chapter one of the expense of public works and public institutions. Smith introduces this third duty of the sovereign as covering institutions that are socially advantageous but privately unprofitable and therefore not likely to be produced by commerce. As Smith puts it on page 723,
The third and last duty of the sovereign or commonwealth is that of erecting and maintaining those public institutions and those public works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the prophet could never repay the expense to any individual or small number of individuals, and which, it therefore, cannot be expected that any individual or small number of individuals would erect or maintain.
The performance of this duty requires two very different degrees of expense in the different periods of society, so again referring to the stadial theory. After the public institutions and public works necessary for the defense of the society and for the administration of justice, both of which have already been mentioned, the other works and institutions of this kind are chiefly those for facilitating the commerce of the society and those for promoting the instruction of the people.
The institutions for instruction are of two kinds, those for the education of the youth and those for the instruction of people of all ages. The consideration of the manner in which the expense of those different sorts of public works and institutions may be most properly defrayed will divide this third part of the present chapter into three different articles. And he already said what the articles are- public works facilitating commerce, education of youth, and then the instruction of people of all ages. In Article 1, Smith discusses roads, bridges, canals, and harbors, arguing that these works should often be funded by user charges rather than general taxation. Smith begins this part by identifying a class of state activities that are neither defense nor justice, but are nonetheless essential to a flourishing commercial society, public works, and institutions that facilitate commerce and improve human capital. The defining feature of these works is not that they're unprofitable, but they're insufficiently profitable for private individuals, even though they might be highly beneficial. So the canonical examples are roads, bridges, canals, harbors, navigable rivers. It's the clearest statement of what we would now call the public goods problem. So he doesn't argue that all such works must be financed from general taxation. Instead, he says, whenever possible, public works should be funded by user fees such as tolls, because that aligns the maintenance incentives with usage and limits political abuse. That is, the taxes will not be redistributive, they'll be related to the actual activity that is producing value. So he has compared different systems of infrastructure provision, praising turnpike trusts and criticizing systems where maintenance is left to local magistrates without earmarked revenue. So the problem is not public ownership per se. He's sanguine, he's optimistic about public ownership and operation. But he is concerned about misaligned incentives and diffuse responsibility. So these are very nuts and bolts sort of considerations.
Smith then argues that infrastructure does more than move goods. It civilizes society by reducing isolation, encouraging exchange, and weakening parochial power structures, because it actually makes you feel like you're part of something larger than yourself. Roads, canals, transportation generally; communication networks knit people together, dissolving feudal dependencies and local monopolies. So Smith insists on a governing principle. Public provision is justified only where private provision systematically fails. And even then, institutional design matters more than intention. Badly designed public works can become engines of corruption, rent-seeking, and stagnation. This section, therefore, completes a trilogy. Defense secures society from external violence. Justice secures society from internal violence. Public works secure the material and institutional conditions for peaceful cooperation. That's what Smith thinks are the objectives and the duties of the state.
This part three is conceptually central to Smith's enterprise because he doesn't seem to be a night watchman minimalist. He might be a fan of what we would now call the productive state. So the state should do those things that it is productive for the state to do. And Smith is optimistic for the ability of smart people acting well to create a system of institutions and incentives that produce more productive outcomes. So, in a way, this presages the more optimistic side of James Buchanan’s “politics as exchange.” Now, the big question is whether the productive state is actually possible because of the other problems that public choice mentions. Smith is optimistic. But as my friend Dan Klein often points out, there's a very strong underlying rebuttable presumption here in favor of liberty. Smith wants any government action to have to be justified. That is, the burden of proof is on whoever wants the government to do something. You have to demonstrate that markets cannot do it, that commerce cannot take care of this function. And so there's a tension here. While Smith is optimistic that people can figure out institutional and incentive problems, he also thinks there's a strong, though rebuttable, presumption in favor of private action. On page 724, Smith says,
It does not seem necessary that the expense of those public works should be defrayed from that public revenue, as it is commonly called, of which the collection and application is in most countries assigned to the executive power, in other words, taxes. The greater part of such public works may easily be so managed as to afford a particular revenue sufficient for defraying their own expense, without bringing any burden upon the general revenue of the society.
So pause quote for a second. He's talking about user fees. There's a lot of things that can be funded with user fees, and even if it can't entirely be funded, a substantial part of it can be funded. Back to the quote on page 724.
A highway, a bridge, a navigable canal, for example, may in most cases be both made and maintained by a small toll upon the carriages which make use of them. A harbor by a moderate port duty upon the tonnage of the shipping which load or unload in it. When the carriages which pass over a highway or a bridge and the lighters which sail upon a navigable canal pay toll in proportion to their weight or their tonnage, they pay for the maintenance of those public works exactly in proportion to the wear and tear which they occasion upon them. It seems scarce possible to invent a more equitable way of maintaining such works. This tax or toll, too, though it is advanced by the carrier, is finally paid by the consumer, to whom it must always be charged in the price of the goods. As the expense of carriage, however, is very much reduced by means of such public works, the goods, notwithstanding the toll, come cheaper to the consumer than they would otherwise have done, their price not being so much raised by the toll as it was lowered by the cheapness of the carriage, meaning the bridge or the canal. The person who finally pays this tax, therefore, gains by the application more than he loses by the payment of it. His payment is exactly in proportion to his gain. It is in reality no more than a part of that gain, which is he obliged to give up in order to get the rest. It seems impossible to imagine a more equitable method of raising a tax. When the toll upon carriages of luxury, upon coaches, post chases, and so on, is made somewhat higher in proportion to their weight than upon carriages of necessary use, such as carts, wagons, and the indolence and vanity of the rich is made to contribute in a very easy manner to the relief of the poor by rendering cheaper the transportation of heavy goods to all the different parts of the country.
End quote. And that ended on page 725. Well, so Smith is talking about some amazing things here that anticipate hundreds of years later theoretical things that were discussed in public finance. The idea of using user taxes, the difference between tax payment and tax incidence. So even though the tax is literally paid by the wagon carrying the goods, it ultimately falls upon the consumer because it raises the price of the goods. But the fact that these are public goods, these means of conveyance are a public good means that the cost of the consumer goods is reduced by the availability of transportation more than it is increased by the ultimate incidence of the tax. And Smith also makes the point that the tax is in proportion to the intensity of use and to the ability to pay, because wealthier people have heavier carriages. Not all of his examples are quite so apropos, but this one, it is easy to understand why he was excited, is a perfect example of many of the factors that he wants to emphasize.
Well, there's a number of other important insights in that discussion of public goods, what we would now call public goods. Paul Samuelson did the math, but Adam Smith clearly recognized the underlying structure of the problem, that it would not pay an individual or a small number of individuals in terms of profit, so it wouldn't be provided, but it does benefit the society. And so having the state provide it and then tax it and have those taxes pay for the provision of the good works out very well. Well, that brings us to Article II, Education of Youth, something in which Smith had a lot of thoughts of, and in this section, he is somewhat scabrous, even insulting to the people who teach for a living. But first, Smith recognizes the importance of education because he confronts the moral and civic dangers of extreme specialization. Having celebrated division of labor, he honestly recognizes that there are some problems with division of labor. It narrows workers' faculties and runs the risk of making them brutish. He begins section two by repeating the same theme from before that it's better to finance at least part of a publicly beneficial activity by having a user fee. So on page 758, he says,
The institutions for the education of the youth may, in the same manner, that is, as the roads and canals, may in the same manner furnish a revenue sufficient for defraying their own expense. The fee or honorary which the scholar pays to the master naturally constitutes a revenue of this kind.
Skipping down a bit on page 759,
In every profession, the exertion of the greater part of those who exercise it is always in proportion to the necessity they are under of making that exertion. This necessity is greatest with those to whom the emoluments of their profession are the only source from which they expect their fortune, or even their ordinary revenue and subsistence. He then contrasts this with having some endowment or overall payment.
On page 760,
The endowments of schools and colleges have necessarily diminished more or less the necessity of application in the teachers. Their subsistence, so far as it arises from their salaries, is evidently derived from a fund altogether independent of their success and reputation in these particular professions. In some universities, the salary makes but a part, and frequently but a small part of the emoluments of the teacher, of which the greater part arises from the honoraries or fees of his pupils. The necessity of application, though always more or less diminished, is not in this case entirely taken away. Reputation in his profession is still of some importance to him, and he still has some dependency upon the affection, gratitude, and favorable report of those who have attended upon his instructions, and these favorable sentiments he is likely to gain in no way so well as by deserving them. That is, by the abilities and diligence with which he discharges every part of his duty. [Then, in effect, but continuing on page 760] In other universities the teacher is prohibited from receiving any honorary or fee from his pupils, and his salary constitutes the whole of the revenue which he derives from his office. His interest is in this case set as directly in opposition to his duty as it is possible to set it. It is the interest of every man to live as much at his ease as he can, and if his emoluments are to be precisely the same, whether he does or does not perform some very laborious duty, it is certainly his interest, or at least as interest is vulgarly understood, either to neglect it altogether, or if he is subject to some authority which will not suffer him to do this, to perform it in as careless and slovenly a manner as that authority will permit. If he is naturally active and a lover of labor, it is his interest to employ that activity in any way, from which he can derive some advantage rather than in the performance of his duty, from which he can derive none.
End of quote. Oh man, as a college professor, I feel seen. So not only is my pay not dependent on the number of students that I teach or the evaluations that they give me, I have tenure. I can't be fired for almost any reason. So what Smith recognizes here is that perhaps some professional respect or concern for my reputation might keep me from doing nothing, but what I'm likely to do is to shirk in the classroom and get my reputation from publishing stuff in professional journals. And that's eerily prescient in predicting the course that universities, it's basically illegal for students to bribe you. Maybe a student might bring me an apple. Sometimes I get gifts from students. It would be very strange if someone were to give me a gift card or worse, cash. But that means, just as Smith says, that my duties, my understanding of my duties, the incentive to perform my duties is completely divorced from my payment. We're relying entirely on people's concern for their reputation. And if I can, I'm going to invest in a reputation for being a scholar who publishes rather than a person who studies and teaches. This is so great. I can't help. I have to go on to get so close to home. Page 763.
If in each college the tutor or teacher who is to instruct each student in all arts and sciences should not be voluntarily chosen by the student, but appointed by the head of the college, and if in the case of neglect, inability, or bad usage, the student should not be allowed to change him for another without leave first asked and obtained, such a regulation would not only tend very much to extinguish all emulation among the different tutors of the same college, but to diminish very much in all of them that necessity of diligence and attention to which their respective pupils depend. Such teachers, though very well paid by their students, might be as much disposed to neglect them as those who are not paid by them at all, or who have no other recompense but their salary. If the teacher happens to be a man of sense, it must be an unpleasant thing to him to be conscious, while he is lecturing his students, that he is either speaking or reading nonsense, or what is very little better than nonsense. It must too be unpleasant to him to observe that the greater part of his students desert his lectures, or perhaps attend upon them with plain enough marks of neglect, contempt, and derision.
Well, pause quote for a second. It is disturbing to me how often my fellow professors, particularly those not at Duke, I don't find this much at Duke. Duke values teaching. Our teaching load is not very heavy, and our students are really terrific. So to be fair, we're spoiled. But at many universities, I hear professors complaining about students, and understand that, but it's a strange industry where the producers blame the consumers for being too stupid to understand or want their product. Well, back to the text on page 763. Smith has just said that the students are going to treat professors with neglect, contempt, and derision.
If he is obliged, therefore, to give a certain number of lectures, these motives alone, without any other interest, might dispose him to take some pains to give tolerably good ones. Several different expedients, however, may be fallen upon, which will effectually blunt the edge of all these incitements to diligence. The teacher, instead of explaining to his pupils himself the science in which he proposes to instruct them, may read some book upon it. And if this book is written in a foreign or dead language, by interpreting it to them, into their own. And what would give him still less trouble by making them interpret it to him, and by now and then making an occasional remark upon it. He may flatter himself that he is giving a lecture. The slightest degree of knowledge and application will enable him to do this without exposing himself to contempt or derision, or saying anything that is really foolish, absurd, or ridiculous.
End quote. Those are graduate seminars, people. I'm going to make the students talk. I will occasionally make a wry or derisive remark. Perhaps I interpret it occasionally. That doesn't have to be the way graduate seminars are, but it sure is the way a whole lot of graduate seminars are. And now Smith brings out the heavy artillery, page 764.
The discipline of colleges and universities is in general contrived, not for the benefit of the students, but for the interest, or more properly speaking, for the ease of the masters. Its object is in all cases to maintain the authority of the master, and whether he neglects or performs his duty to oblige the students in all cases to behave to him as if he performed it with the greatest diligence and ability. It seems to presume the perfect wisdom and virtue in the one order and the greatest weakness and folly in the other. Where the masters, however, really perform their duty, there are no examples, I believe, that the greater part of the students ever neglect theirs. No discipline is ever requisite to force attendance upon lectures which are really worth the attending, as is well known wherever any such lectures are given. Force and restraint may no doubt be in some degree requisite in order to oblige children, or very young boys, to attend to those parts of education which it is thought necessary for them to acquire during that early period of life. But after twelve or thirteen years of age, provided the master does his duty, force or restraint can scarce ever be necessary to carry on any part of education.
Close quote. I often hear from my faculty friends that they have a problem with large classes because almost no one attends their lectures. Well, folks, you could suck less. You could actually devote some effort to giving real lectures. I find that my lectures are pretty well attended. And if someone wants to not attend my lecture, that's on them. I have a very libertarian attitude towards that. But I do have an obligation to try to make them want to show up for the lectures, and by and large, they do. I think Smith is right. If the lecture is worth listening to, the good people, at least, will listen, and the bad people wouldn't accomplish much if they came anyway. Skipping ahead a bit to page 773,
In England, it becomes every day more and more the custom to send young people to travel in foreign countries immediately upon their leaving school, and without sending them to any university. Our young people, it is said, generally return home much improved by their travels. A young man who goes abroad at 17 or 18 and returns home at 1 in 20 returns three or four years older than he was when he went abroad, and at that age it is very difficult not to improve a good deal in three or four years. In the course of his travels, he generally acquires some knowledge of one or two foreign languages, a knowledge, however, which is seldom sufficient to enable him either to speak or write them with propriety. In other respect, he commonly returns home more conceited, more unprincipled, more dissipated, and more incapable of any serious application, either to study or to business, than he could well have become in so short a time had he lived at home. By traveling so very young, by spending in the most frivolous dissipation, the most precious years of his life, at a distance from the inspection and control of his parents and relations, every useful habit which the earlier parts of his education might have had some tendency to form in him, instead of being riveted and confirmed, is almost necessarily either weakened or effaced. Nothing but the discredit into which the universities are allowing themselves to fall could ever have brought into repute so very absurd a practice as that of traveling at this early period of life. By sending his son abroad, a father delivers himself, at least for some time, from so disagreeable an object as that of a son unemployed, neglected, and going to ruin before his eyes. Such have been the effects of some of the more modern institutions for education.
Close quote. That's savage. It's a terrible idea just to send people abroad to travel around and drink and go to brothels for three years. They come back, they're three years older, they learn some things, they probably know some language. That seems like an awful idea, but the reason it happens is that the universities are even worse. Again, I will say no more about the correctness of this observation for today's universities. Skipping ahead to page 780 at 780, and I will skip around a little bit now…
Were there no public institutions for education, no system, no science would be taught for which there was not some demand, or which the circumstances of the times did not render it either necessary or convenient or at least fashionable to learn. A private teacher could never find his account in teaching. Either an exploded and antiquated system of science acknowledged to be useful, or a science universally believed to be a mere useless and pedantic heap of sophistry and nonsense. Such systems, such sciences, can subsist nowhere but in those incorporated societies for education whose prosperity and revenue are in a great measure independent of their reputation, and altogether independent of their industry. Were there no public institutions for education, a gentleman, after going through with application and abilities the most complete course of education which the circumstances of the time were supposed to afford, could not come into the world completely ignorant of everything which is the common subject of conversation among gentlemen and men of the world.
Pause the quote. What Smith is saying is that the only reason that certain majors, certain courses of study, and certain, I'm making air quotes, “sciences” are taught in universities is that students have no other option and universities have no incentive to try to teach real subjects. So, what is his point? He's been pretty savage in his assessment of universities. On page 781, he asks,
Ought the public therefore to give no attention to the education of the people? Or if it ought to give any, what are the different parts of education which it ought to attend to in the different orders of people? In some cases, the state of the society necessarily places the greater part of individuals in such situations as naturally form in them, without any attention of the government, almost all of the abilities and virtues which the state requires, or perhaps can admit of. In other cases, the state of the society does not place the greater part of individuals in such situation, and some attention of government is necessary in order to prevent the almost entire corruption and degeneracy of the great body of the people.
Pause quote for a moment. It is here that Smith makes the most powerful argument that he makes for the importance of education and why Smith thinks that the state has some role in providing education. I'll start quoting at the bottom of page 781.
In the progress of the division of labor, the employment of the far greater part of those who live by labor, that is, of the great body of the people, comes to be defined to a few very simple operations, frequently to one or two. But the understandings of the greater part of men are necessarily formed by their ordinary employments. The man whose whole life is spent in performing a few simple operations, of which the effects, too, are perhaps always the same or very nearly the same, has no occasion to exert his understanding or to exercise his invention in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit of such exertion and generally becomes as stupid and ignorant as it is possible for a human creature to become.
So pause quote for a moment. He's obviously connecting the need for education with division of labor. Division of labor is great, it makes us wealthy, but that means that people who were hunters were likely to know all sorts of things. They constantly had to face problems. I know my own father, born in 1919, grew up during the depression. He could tear down an automobile engine and put it back together. He wasn't good at it, but he could do it. He could do plumbing, he could solder pipes, he could do electric. I know how to do a few things. I can repair, replace a toilet. I'm not sure that my sons know how to boil water. So as we have become more specialized, it's not just that we become stupid, but we become, we have an inability to do anything outside of the narrow area of knowledge from which we make our living. That's probably mostly a good thing, but it does mean that we become more and more dependent.
Smith's point is that for those people who work in factories, who do the simple sort of work that really really challenges their mind, education is a necessary means of allowing them to have good lives. Division of labor gives us wealth and prosperity, but it takes away the ability to live any kind of fulfilled life. And I think this is a very deeply insightful view. His concern is we need division of labor, can't do without it, but there's these costs, and the state needs to put its thumb on the scale as a kind of makeweight to ensure that people are able to live fulfilled lives. Going back to the text on page 782, talking about a worker who works in a factory:
The uniformity of his stationary life naturally corrupts the courage of his mind and makes him regard with abhorrence the irregular, uncertain, and adventurous life of a soldier. It corrupts even the activity of his body and renders him incapable of exerting his strength with vigor and perseverance in any other employment than that to which he has been bred. His dexterity at his own particular trade seems in this manner to be acquired at the expense of his intellectual, social, and martial virtues. But in every improved and civilized society, this is the state into which the laboring poor, that is the great body of the people, must necessarily fall, unless government takes some pains to prevent it.
Smith is therefore endorsing publicly supported but modest education, basic literacy and numeracy, delivered locally and with the incentives intact, taking into account all the problems with education he's already talked about. Well, let's press on to Article III of Chapter 1, the instruction of people of all ages. Smith is then turning to higher education and religion, focusing on institutional incentives. And he recognizes that both underpayment and over-endowment generate dysfunction. And in some ways, his discussion here echoes the earlier discussion about education. He notes that every established church, if it is allowed to operate under state support, it eliminates almost all incentive for that church to participate in the lives of the people. On page 813, he says,
The proper performance of every service seems to require that its pay or recompense should be as exactly as possible proportioned to the nature of the service. If any service is very much underpaid, it is very apt to suffer by the meanness and incapacity of the greater part of those who are employed in it. If it is very much overpaid, it is apt to suffer perhaps still more by their negligence and idleness. A man of a large revenue, whatever may be his profession, thinks he ought to live like other men of large revenue and to spend a great part of his time in festivity, in vanity, and dissipation. But in a clergyman, this train of life not only consumes the time which ought to be employed in the duties of his function, but in the eyes of the common people destroys almost entirely that sanctity of character which can alone enable him to perform those duties with proper weight and authority.
That's on page 814 and close quote. If a church is state-supported, then it may be that the clerics are well compensated, they feel secure, and they would like to live a life of ease. That's going to reduce the sense of legitimacy from the parishioners, from the people who attend the church. And over time, you are likely to see the church shrink. And so there's an interesting comparison between European churches, most of which have at least some state support, and US churches where the church attendance is much higher. It is partly, probably, as a result of this fact that churches in the United States are not state supported, they're not state-owned, whereas in Europe they are, and churches, when you travel around Europe, there's many beautiful cathedrals, they're museums. These are not places that are vibrant and where many, many people go to worship, because they are provided by the state.
The final section in Book 5, Chapter 1, is of the expense of supporting the dignity of the sovereign. And I'm going to read it in its entirety because it's quite short. On page 814,
Over and above the expense necessary for enabling the sovereign to perform his several duties, a certain expense is requisite for the support of his dignity. This expense varies both with the different periods of improvement, [That is, parts of the stadial theory] and with the different forms of government. In an opulent and improved society where all the different orders of people are growing every day more expensive in their houses, in their furniture, in their tables, in their dress, and in their equipage, it cannot well be expected that the sovereign should alone hold out against the fashion. He naturally, therefore, or rather necessarily, becomes more expensive in all those different articles also. His dignity even seems to require that he should become so. As in point of dignity, a monarch is more raised above his subject than the chief magistrate of any republic is ever supposed to be above his fellow citizens. So a greater expense is necessary for supporting that higher dignity. We naturally expect more splendor in the court of a king than in the mansion house of a doge or burgomeister.
End quote. It is interesting that the claims against Donald Trump in the U.S., right or wrong, focus on, well, no kings. And part of what “no kings” is intended to mean is the concentration of power. But part of it is the concentration of pomp and excessive, in quotes, dignity. The building of the vast new ballroom after tearing down the East Wing. It may not even matter that it is supported by private funding. There may be a sense of corruption in the contributions of private funding, but just the fact itself of excessive pomp is a sign that we are violating the kind of Republican equality. The president happens to be our leader, but is not better or above the people. And that's not the perception that Trump is trying to give out.
Well, that's the end of chapter one, which is very long, half of the very long book five, which brings us to chapter two of the sources of general or public revenue of society. So he turns from spending to taxation, beginning with crown revenues and moving to his enduring theory of public finance. He begins with what he calls the four maxims of taxation on page 825.
The private revenue of individuals, it has been shown in the first book of this inquiry, arises ultimately from three different sources rent, profits, and wages. Every tax must finally be paid from some one or other of these three different sorts of revenue, or from all of them indifferently. I shall endeavor to give the best account I can, first of those taxes which is it intended should befall upon rent, secondly, of those which is intended should fall upon profit, thirdly, those which it is intended should fall upon wages, and fourthly of those which it is intended should fall indifferently upon all three. Before I enter upon the examination of particular taxes, it is necessary to premise the four following maxims with regard to taxes in general. First, the subjects of every state ought to contribute towards the support of the government as nearly As possible in proportion to their respective abilities. Second, the tax which each individual is bound to pay ought to be certain and not arbitrary. Third, every tax ought to be levied at the time or in the manner in which it is most likely to be convenient for the contributor to pay it. And fourth, every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.
So that ends on page 826. Close quote. The first one, where subjects of every state ought to contribute towards the support of the government as nearly as possible into proportion to their respective ability, what that sounds Marxist, from each according to their ability. He means something simpler. He means ability to pay. The wealthy ought to pay proportionately more than the poor. Not disproportionately more, but proportionately more. So this is the origin of what in taxation is called the ability to pay standard. And then three and four both have to do with transaction cost. So the point is that the tax, in order to raise revenue, ought to minimize the difference between the cost to the taxpayer and the revenue that is collected by the state. If the revenue collects only a small part of the costs that are imposed on the taxpayer because the taxes are highly distortionary or it's inconvenient to pay them, it takes a lot of paperwork. Those are costs that are not received by anyone. And so you need to adjust the tax system to reduce the difference between the cost to the people paying the taxes and the revenue by the people who receive and then will spend the taxes. In other words, Smith is evaluating taxes on rent, profit, and wages, and consumption largely through what we would now call incidence, distortion, and administrative costs. And these are exactly the categories that we still consider in public finance.
As Smith sees it, there's two essential sources or bases of public revenue. Public revenue can come either from property belonging to the sovereign or taxes that are levied upon private individuals. And that distinction structures the entire chapter. So Smith notes that many governments have tried to support themselves largely through domain revenues, land, mines, forests, monopolies, or trading enterprises owned by the state. In theory, such revenues may seem attractive because they avoid taxation altogether. In practice, Smith argues they almost always fail. The reason is incentive-based. State-owned enterprises are going to be badly managed, and if you're going to take the surplus out of them, there won't be any surplus. Without private ownership, managers lack both accountability and motivation. Public lands are neglected, public monopolies are inefficient. State trading companies crowd out private industry while producing inferior returns. So Smith's conclusion is pretty blunt. Modern governments cannot fund themselves adequately from property alone, and attempts to do so usually weaken rather than strengthen public finance.
You may recall that earlier we saw that Smith said that the desire of great feudal lords to have diamond buckles meant that they sold off all of their land, and that meant that what had in effect been public land now became private and became much more productive. The advantage of that is that we saw an increase in privatization, not because people thought privatization was a good idea, but because commerce and wealth had produced this desire for ostentation, which worked out as if it had been well intended. Smith examined several forms of sovereign property in detail, so crown lands, that leasing such land almost always improves both productivity and public revenue. Even if you want to own it, you should lease it out. And so this does make me think of the Bureau of Land Management policies in the American West. Second, mines and natural resources. Though precious metal mines appear lucrative, Smith observes that they're rarely reliable sources of income. Even if they're productive, they distort incentives and encourage corruption and rent seeking. Smith is also deeply hostile to state monopolies over salt, tobacco, or trade. These monopolies raise revenue only by raising prices above competitive levels. So the argument against monopoly in the private sector is at least as powerful as monopoly in the public sector. At least private monopolies have some incentive to be efficient because they get profits. State monopolies only charge really high prices and they don't raise any revenue.
Smith recognizes that monopolies are a tax disguised as commerce, and it's a particularly bad tax because it's distorting. Smith discusses borrowing and claims that borrowing is not a true source of revenue at all. Loans, as we'll see in chapter three, are merely a way of shifting the burden of taxation into the future while also magnifying it. Smith does take it as a given that the government needs taxes, it needs revenue. So taxes are unavoidable in a commercial society for the reasons that he talked about, for the three functions of the state. But the key question then is not whether to tax, but how. What is the most efficient way? And for that you have the four maxims that tell you whether they're the taxes efficient or not.
He's particularly a fan of land rent taxes because he sees that as not distorting productive incentives, relatively stable and visible, and it reflects surplus rather than necessary cost. So a well-designed land tax can raise revenue with minimal economic harm, but he does warn against arbitrary assessments. Constantly changing the taxes is very harmful. Predictability matters then more than precision. It's better to have a general tax, not change it very much over time, than constantly try to calibrate new taxes. He also distinguishes between taxes on actual rent and supposed rent, which is the assessed value. The former are fairer but harder to administer. The latter are easier but risk injustice if they're poorly calibrated, because you have to make an estimate of what the underlying value is rather than look at the actual rents that are being collected. Smith's view of taxes on profits or revenue that's arising from capital is more cautious. He accepts that profits can be taxed, but he warns that such taxes are easily shifted onto consumers or workers. They encourage concealment and evasion, and they discourage accumulation and investment. Unlike land, profits, meaning stock, capital, is mobile and sensitive to taxation. Heavy taxes on profits tend to drive capital elsewhere or reduce productive activity. He's especially skeptical of taxes on interest, which are often evaded and distort credit markets. Smith emphasizes that capital is far more responsive to taxation on land, making it a dangerous base for heavy revenue extraction.
Finally, Smith is mostly opposed to taxes on wages. He argues that wages are already determined by the cost of subsistence and the demand for labor. Taxes on wages therefore tend to reduce workers' ability to support families or force employers to raise wages, increasing cost and reducing employment. Either way, the burden ultimately falls on society at large. Wage taxes, he thinks, are both unjust and inefficient. So his analysis here anticipates later arguments about tax incidents and labor market adjustments, but you also have to say Smith is handicapped here by his labor theory of value, which is a bit misleading in its connection between wages and the cost of subsistence. There's just no necessary connection of those. And I would say that [Karl] Marx took that misleading connection and ran with it in some very harmful directions. Smith's conclusions at the end of chapter two is that there's a hierarchy of revenue sources, judged not by how much they raise, but by how much damage they do compared to the amount that they raise. Sovereign property is unreliable and corrupting. Borrowing, that is, issuing debt or bonds to finance public spending, is illusory. Taxes are unavoidable, but some are vastly better than others. And property or land taxes, Smith sees as being physical property taxes, Smith sees as being the least distorting.
Chapter three is the final chapter of Book Five, and it is called “Of Public Debts.” It's a deeply pessimistic account of public borrowing. Smith recognizes that commercial states borrow easily, and that's fine, but there's also a tendency to be irresponsible. As he says, and we'll come back to this, the state foresees the facility of borrowing and therefore dispenses itself from the duty of saving. When Smith looks at European history, once societies have converted to commercial society, he says on page 911, “The progress of the enormous debts which at present oppress and will in the long run probably ruin all of the great nations of Europe has been pretty uniform.” Let's go back to page 908 and see how he starts to reach this conclusion. In the period before commerce, that is, after the hunter, but during the agricultural period, there was a tendency to hoard, to try to save up. So on page 908, Smith says,
The same disposition to save and to hoard that we see in individuals, that is, prevailed in the sovereign. Among nations to whom commerce and manufacturers are little known, the sovereign, it has already been observed in the fourth book, is in a situation which naturally disposed him to the parsimony requisite for accumulation. In that situation, the expense even of a sovereign cannot be directed by that vanity which delights in the gaudy finery of a court. But in a commercial society, abounding with every sort of expensive luxury, the sovereign, in the same manner as almost all the great proprietors in his dominions, naturally spends a great part of his revenue in purchasing those luxuries. His own and the neighboring countries supply him abundantly with all the costly trinkets which compose the splendid but insignificant pageantry of a court. For the sake of an inferior pageantry of the same kind, his nobles dismiss their retainers, make their tenants independent, and become gradually themselves as insignificant as the greater part of the wealthy burghers in his dominions. The same frivolous passions which influence their conduct influence his. How can it be supposed that he should be the only rich man in his dominions who is insensible to pleasures of this kind?
Well notice that Smith is referring back to the positive development that the desire for baubles and diamond buckles leads the barons of the country to sell off their land in order to have finery. But then, since they don't have land, they don't have retainers, they don't have private armies, they're no better, and in fact they may be poorer than the business people that they want to be better than with their diamond buckles. Going back to the text on page 909,
The want of parsimony in time of peace imposes the necessity of contracting debt in time of war. When war comes, there is no money in the treasury but what is necessary for carrying on the ordinary expense of the peace establishment. In war, an establishment of three or four times that expense becomes necessary for the defense of the state, and consequently a revenue three or four times greater than the peace revenue. Supposing that the sovereign should have what scarce he ever has, the immediate means of augmenting his revenue in proportion to the augmentation of his expense, yet still the produce of the taxes from which this increase of revenue must be drawn will not begin to come into his treasury till perhaps ten or twelve months after they are imposed. But the moment in which war begins, or rather the moment in which it appears likely to begin, the army must be augmented, the fleet must be fitted out, the garrisoned towns must be put into a posture of defense. That army, that fleet, those garrisoned towns must be furnished with arms, ammunition, and provisions. An immediate and great expense must be occurred in that moment of immediate danger, which will not wait for the gradual and slow returns of the new taxes. In this exigency, government can have no other resource but in borrowing.
So Smith is saying that borrowing is going to happen even at the best of times, because even a king who is not profligate will not have much more in the treasury than is necessary for peacetime operations, because to do otherwise would mean your taxes are too high. So even if you're not spending a lot on the court, if you want to have sensible taxes, you're probably not going to save very much. Then, as soon as there's a war, you have to borrow. And kings are profligate. Kings are not sensible like that, which means that if anything, they already have debt. When a war comes, they have to resort to mountains of new debt. But this public debt shifts the burden of war and mismanagement onto future taxpayers, undermining fiscal discipline and long-run prosperity.
So he confronts in chapter three what he regards as one of the most dangerous physical, fiscal innovations of modern European states, the systematic use of public borrowing to finance ordinary government expenditure. So using it for war, okay, but as he showed, that's probably inevitable. Using it for ordinary expenditure is catastrophic. So his concern is not merely accounting or technical. He treats public debt as a constitutional and moral problem, a lack of self-command. So just as the commercial system will not work unless individuals possess self-command, the commercial society as a whole cannot work unless the monarch and the government possess self-command. And it's important to recognize that Smith writes against the backdrop of Britain's rapid accumulation of debt after 1688, and especially after the wars of the 18th century, his core thesis is stark.
No large modern commercial nation has ever permanently freed itself from a heavy public debt, and the mechanism used to manage such debt tend to undermine good government rather than to secure it. So the chapter begins by explaining why public debts emerged at all. War was funded partly through temporary taxes or extraordinary levies, but this had a really bad political effect. The cost of war was immediate and visible, which meant that citizens and rulers alike had to confront its real burden. But if you want to have wars, if you feel like you need to have wars, that makes war too unpopular. And kings wanted to have wars. So the innovation of public borrowing changed that. By funding war through loans rather than taxes, governments could shift much of the burden into the future, making wars appear cheaper in the present than they truly were. And since many people benefited from war, a lot of people who were able to sell their products at higher prices because imports were restricted, there are many people who benefited from war, and they just thought this was a great idea. So it wasn't the king acting alone. There's also economic interests that are benefited by receiving money from future generations. Because the king isn't keeping this money, he borrows it, and then he spends it on domestic producers of the things that they need for war. And this sounds a lot like what is now called the military-industrial complex in the U.S.
The public, Smith believes, tends to underestimate future burdens. Borrowing therefore creates a dangerous illusion. Wars seem affordable precisely because their costs are deferred. Smith distinguishes between unfunded debt, which is short-term borrowing intended to be repaid quickly, and funded debt, where the government assigns specific tax revenue to pay perpetual or long-term interest. Funded debt is the real danger. Once governments establish permanent funds to service debt, borrowing becomes institutionalized. It seems like it doesn't cost anything. Each new war adds another layer of obligations. We'll have a sinking fund, we'll have this money that we'll use as an endowment that will pay off these debts. Well, when you add those more and more, you have to keep borrowing in order to repay the money that you've already borrowed because there's not going to be sufficient endowment to take care of the interest, much less the principal.
Smith is referring in part to what we would now call consuls, which is short for consolidated annuities. These were created by the Chancellor of the Exchequer, Henry Pelham, in 1750, and they were designed to consolidate England's crushing high-interest war debt. So the government combined various existing debts into a single lower interest bond at 3% and then later 4%. The purpose of consuls was twofold. To stabilize British public finances by refinancing all the expensive short-term obligations into a long-term manageable liability, and second, to create a liquid, tradable instrument that could underpin a reliable domestic capital market. So consoles were a means of assuring liquidity for the financial system. Ultimately, the outstanding consoles were finally called and redeemed in 2014 and 2015, ending their 250 plus year run. Well, as I said, consoles paid 3% and later 4%. What exactly does that mean? Well, remember, consul is permanent, it's perpetual. So in effect, let's say I promise to pay you 40 pounds per year forever. How much will you pay me for the promise that I will pay you 40 pounds a year forever? Well, you might wonder is you're going to default on this, you're actually going to do it. But this is the government. It's likely that the government will, they have some reason to make sure that these consoles have value because, as I said, they were going to use them as a secondary market, almost a kind of currency to ensure liquidity, because you could buy and sell these.
So the answer, it's interesting, there is an answer. If I promise to pay you 40 pounds a year forever, and if the interest rate is 4%, the answer is 1,000 pounds. There's a formula. P equals X divided by R. Let's let the price P of a console be defined by X, which is the yearly coupon rate, divided by R, the interest rate. So the yearly coupon rate is 40 pounds. The interest prevailing interest rate in the society is 4%. 40 divided by 0.04 is 1,000 pounds. And so if I were to sell a console that pays 4% forever, I would get a thousand pounds for it. Now, what if the interest rate goes to 5%? Well, that console is now worth only $800 because it's If we take the coupon rate, which is 40 pounds, and divide it by the interest rate, which is now 0.05, that's only 800. So these consoles were a bit like Bitcoin. They were used as a kind of pseudocurrency, but they also fluctuated in value with markets. And let me note that that formula, that the price of an asset is the recurring payment divided by the interest rate is really useful. You can just remember that it can help you all a lot of times if there's some recurrent payment, even if it's not infinite, it's a useful thing to keep in mind.
Well, the reason to go through all that was that Smith had noted the increasing tendency to have long-term and eventually infinitely termed debt. And that wouldn't have been a problem at any one time. The advantage of a console is that it has low interest and you will be able to retire it anytime in the future that you want. But if you keep issuing more and more of it, then the fact that you have to make those interest payments, and these are interest-only payments, because otherwise it's infinitely lived. When those things keep adding up, you can get to the point where it's a very substantial amount of the annual obligations of the treasury. So Smith's point is that the use of the implicit tax of extending credit, of using debt, obscures the true cost of government and weakens accountability. Citizens no longer see any connection between public spending and what they pay. Instead, they experience rising rising prices, hidden excises, and all kinds of complicated duties. However, there's always a Baptist and Bootlegger aspect to this.
This system privileges certain groups, especially holders of government securities, whose incomes are secured by law and they're going to be paid by taxes, while productive sectors bear ever-increasing burdens. So Smith takes direct aim at the claim that public debt represents a form of national wealth. He rejects the idea that government securities add to the real resources of a nation. Public debt, he insists, is a transfer, not the creation of wealth. And he goes on to describe this in great detail. The chapter is quite long and detailed. I'm not going to spend any more time on those details, but let me say this was a topic that later became a central subject in public choice. James Buchanan, Dick Wagner, and others have written about this a great deal, Geoffrey Brennan. But it was Smith who first recognized and challenged this increasing and frankly dangerous orthodoxy that debt was wealth. It's sort of shocking when you put it that way, but that's the claim that even today most Keynesian macroeconomists would make.
The chapter then closes on a somber note. Smith doesn't claim that bankruptcy is inevitable tomorrow, but he says that the long-run trajectory of perpetual public debt is deeply ominous. It tempts government into war, disguises costs, entrenches vested interests, and undermines both economic efficiency and political accountability. If there's a lesson, it's not just borrow less, but rather restore the discipline of paying for public expenditures openly and contemporaneously. When you do that, citizens feel the true cost of government, and only then, Smith believes, can liberty and prosperity be preserved. This chapter is often read narrowly as an early treatise on debt finance, but in fact, it's one of Smith's most profound institutional critiques. It anticipates the later public choice concerns about fiscal illusion, rent-seeking, and intergenerational redistribution, while grounding all of that in a moral and constitutional framework. For Smith, then, public debt is not just bad economics, it's bad political economy, a system that allows government to evade responsibility and citizens to evade judgment until the bill finally comes due on future generations.
It's worth noting that Smith is building here on David Hume's “Of Public Credit” essay. They're distinct, but they're pretty closely aligned. Public debt allows governments to do things they otherwise could not politically sustain, especially wars. That's probably necessary. So Hume describes public credit as a device that makes war deceptively easy, allowing governments to fight without immediately taxing citizens. That's probably bad. Smith adopts that Humean claim almost wholesale. So for both of those authors, borrowing substitutes for consent, deferred costs weaken political restraint, and war becomes artificially cheap, not just in the cost of lives, because you're able to pay people, maybe have mercenaries, but also you don't recognize the full cost that goes out into the future. And all of those things were going on. The Hessian mercenaries that the English were employing in the American Revolution made it seem like it didn't cost them anything. But they had gigantic debts as a result. So the key difference between Hume and Smith is Hume writes as a moral and political essayist, issuing a warning saying that debt is bad. Smith is writing as a political economist, as a proto-public choice economist, explaining why that warning, though correct, keeps on getting ignored. More tersely, Hume says debt is dangerous. Smith explains why debt keeps happening anyway, in spite of the fact that it's dangerous. So if Hume is the prophet of public debt, Smith is its anatomist.
Overall, Book Five shows that Smith's political economy is institutional to the core. Markets require defense, justice, education, infrastructure, and fiscal restraint by the government. Smith's achievement is to analyze these necessities without utopianism, without cynicism, always asking how incentives and human frailty shape the state itself. Book five had a big influence on later scholars. In public finance, Musgrave and Peacock, in their 1958 book, Classics in the Theory of Public Finance, treat Smith's tax maxims as still being the canonical foundation of normative public finance. James Buchanan repeatedly highlights Smith's extended treatment of debt in his collected works, noting Smith's critique of mercantile war finance in the study of public debt. Emma Rothschild, in her economic history review paper in 1992, “Adam Smith and Conservative Economics,” argues that Smith has been misappropriated by later ideologies, stressing his concern with institutions, education, and public responsibility. Now, she may or may not be right about that, but it is Book V that is her central focus. And then, last, as an example of later scholars that have taken book five as a central part of Smith's contribution, Douglass North's institutional analysis is often in dialogue with Smith's treatment of the law of enforcement and fiscal structure. And book five is the place where Smith gives that his fullest treatment. And that is the end of episode nine. We have now gone through all five books of the Wealth of Nations. It's a little bit sad. I do have one, of course, thank Amy Willis. We do have one more episode, which is a summing up and taking stock of why the Wealth of Nations still matters today. It will post Tuesday, February 24th, 2026, coming very close to exactly 250 years after the first emergence of the completed Wealth of Nations, which first started to come out in March of 1776. So I look forward with a little sadness and a lot of excitement to that final taking stock. Talk to you next time.