The contribution to economics of
Adam Smith and John Maynard Keynes

Adam Smith and John Maynard Keynes both have had a major effect on economic thought and many of their ideas are still influential today. This essay will look at the contribution that both men made to economic thought.

According to Adam Smith Institute (2012), Adam Smith was born in 1723 in Scotland and is popularly known as the father of economics. His best known work is called “An Inquiry into the Nature and Causes of the Wealth of Nations” which is more commonly known as the Wealth of Nations. It was published in 1776 and in it; Adam Smith outlines his main economic ideas. Many ideas in the book were not ground breaking or original but Smith was the first to put them all together.

In the Wealth of Nations (1776) Smith begins with an example of a factory that produces pins which he uses to explain the benefits of specialisation and division of labour. Smith explains how:

“One man draws out the wire; another straights it; a third cuts it; a fourth points it; a fifth grinds it at the top for receiving the head”

And so on until the pin is finished. Splitting the production of the pins into different operations, would result in more pins being created. Smith believed that 10 workers could produce 48,000 pins a day using specialisation and division of labour. If the workers were to produce pins individually then Smith believed that they would only produce 20 or less pins a day. It was Smiths argument that a worker should concentrate on one task rather than multiple tasks and that this would result in a higher level of productivity. In the present day, specialisation and division of labour is used widely in lots of different industries to improve productivity.

Before Smith, classical economists believed the wealth of a country should be based upon the amount of gold or silver it had. Smith argued that a countries wealth should be based on the total of its production and commerce. In the present day, we would call this a country’s Gross National Product.

Perhaps Smiths most important contribution to economics was his idea of the “Invisible Hand” which guides the rich to act in a way that is beneficial to society. A famous quote from the Wealth of Nations (1776) is:

“They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.”

Smith believed that the government should operate a laissez-faire approach to controlling markets. Although he did not use the word “laissez-faire” in The Wealth of Nations. He believed that markets would correct themselves in times of recession and depression without the need for government intervention. Smith believed that if a recession/depression were to occur, then the actions of private individuals, motivated by self-interest, would work together to end the recession/depression and restore growth. However, Smith was not entirely against all forms of Government intervention, He believed that governments should be involved with establishing rules and laws that ensured the smooth running of the free market.

Smith also believed in perfect competition. According to Economics Online (2013), Perfect competition is:

“A perfectly competitive market is a hypothetical market where competition is at its greatest possible level.”

Perfect competition will exist in a market with characteristics such as no barriers to entry and a large number of firms in the market. Smith thought that markets with lots of competing firms would benefit society more than markets with little to no competition.

Smith advocated free trade between countries. In the Wealth of Nations, Smith discusses his views on trade:

“If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.”

Smith also came up with the “Canons of Taxation” which are used to judge taxes. According to Bized (2013), Smiths 4 canons were 1. The cost of collecting the tax must be low in comparison with the amount being collected. 2. The tax payer must be aware of when the tax has to be paid and its total amount. 3. The means and timing of payment of the tax must be convenient to the tax payer. 4. Taxes should be levied according to ability of the tax payer to pay. These canons of taxation can still be used today to judge whether a tax is progressive or regressive. Taxes that follow the 4 canons would be considered progressive taxes.

If Adam smith was considered the Father of Economics then John Maynard Keynes can be considered the father of Macroeconomics. According to Britannica (2013), Keynes was born in 1883 in England. Many of his theories played a major role in government decision making during the 20th century. In a BBC (2012) documentary about Keynes, Joseph Stiglitz said that “Keynes saved capitalism from the capitalists”.

Keynes first gained worldwide notoriety with his views on how the defeated Germany should be treated after the First World War. The majority of people at that time thought that Germany should be made to pay the full cost of the war. However, Keynes thought that the Versailles Treaty was an immoral and stupid plan. In his book The Economic Consequences of the Peace (1919) he correctly predicted that it would foster a desire for revenge amongst Germans in the years to come. Keynes resigned his position in the GB Treasury because of this.

After the First World War, he had the role of bursar at King's College. Keynes was successful at greatly improving the financial position of the College. Keynes was also able to amass a substantial personal fortune by investing in bonds and shares. He used his knowledge of probability theory to predict when the best time to enter the market was. However, in October 1929 the Wall Street Crash occurred and Keynes along with many other investors lost substantial amounts of money. Keynes was disappointed that that he was not able to foresee the crash.

Keynes came to realise that you can’t accurately predict the future of markets. Someone who did correctly predict a crash was likely to do so because of luck rather than judgement. Keynes realised that markets were made up of people and people are unpredictable. In his book the General Theory of Employment, Interest and Money (1936), Keynes came up with the idea of “Animal Spirits” which he used to describe emotions which influence human behaviour. Keynes believed that there would be high animal spirits at the peak of the market and low animal spirits when the market was in a crash. Keynes recognised that people had a herd mentality e.g. when everyone else in the market is buying, then they also buy because they think the price is going to keep going up and when everyone else in the market is selling, then they think they should sell because the price might go even lower.

Classical Economic theory before Keynes said that in periods of recession and high unemployment, the market would act in self-correcting manner and would return to growth if given enough time. Classical Economists believed that the market would solve these problems by reducing staff wages, which would lead to a rise in demand for labour, resulting in increased employment and a market recovery. In the General Theory of Employment, Interest and Money (1936), Keynes contradicted this view by saying that markets were not self-correcting and that the national income of a country could reach equilibrium without reaching full employment. He also said that if wages fell during a recession, that this would cause a fall in consumption, which would in turn cause more unemployment. In this way an economy could be caught in a downward spiral. Keynes also disagreed with Say's Law which was believed by many economists at that time. Say's Law states that supply creates demand. Keynes believed the opposite to be true, that in fact supply is determined by demand.

Classical Economists believed that the Government should have a laissez-faire attitude to the market. Keynes thought the opposite to be true. In times of recession Keynes believed the best way to create demand in the economy was for the Government to intervene by increasing government spending and reducing interest rates. This would cause demand to increase in the economy. Keynesian Economics lead to the discovery of the multiplier effect of an increase in spending in an economy .i.e. that an increase in spending by the government or anyone else in an economy will result in a proportionally greater increase in national income e.g. If the government of Country X increases government spending by 10 billion and this causes an increase in Country X’s national income of 40 billion, then we can say that Country X has a multiplier effect of 4. Keynes also came up with the Marginal propensity to consume (MPC) which according to Investopedia (2013) is:

“A component of Keynesian theory, MPC represents the proportion of an aggregate raise in pay that is spent on the consumption of goods and services, as opposed to being saved.”

Many of Keynes ideas were not favoured by politicians is his home country of Great Britain. They thought it was too risky to start spending more money in times of recession. However, Keynes ideas fared better in the USA. Keynes met the American President Franklin Delano Roosevelt in 1934. Roosevelt agreed with Keynes that something had to be done if the USA was to recover from the crash in 1929. Both men knew that the policies of Roosevelt’s predecessor Herbert Hoover were wrong. Hoover had instigated substantial spending cuts but this had not succeeded in improving the situation in the USA. Roosevelt decided to launch what he called his “New Deal” for Americans. It involved the US Government spending large amounts of money on projects such as the Hoover Dam to help reduce unemployment and increase demand in the economy. Roosevelt’s New Deal was widely accepted as being a success and proof that Keynes ideas worked.

In 1939, World War 2 broke out in Europe. Keynes returned to work with the treasury to help Britain fund their war effort. Once the war in Europe was over, Keynes led the Britain delegation at the Bretton Woods conference in the USA. Keynes played a significant role in the planning for the creation of the World Bank and the International Monetary Fund (IMF). Keynes championed the idea that richer countries should help poorer countries. Keynes realised more than anyone there, that we are all in it together.

In conclusion, both Smith and Keynes had very different ideas about how an economy should be run. Smith thought that there should be minimal intervention from government in the market. Whereas Keynes thought that government intervention was the key to preventing long term recessions. These differing views are still being played out today; with some countries like the USA deciding to spend their way out of recession while other countries like Ireland decide to cut government spending.