Warren Nutter, an economist at the University of Virginia, conducted a detailed study of the Soviet economy, arguing that the CIA’s estimates of Soviet output were much too high (Nutter 1962). Too much information was required, and it was too difficult to structure the incentives. As Smith put it, government could not be expected successfully to superintend the industry of private people. To them, it was simply not possible for centrally planned economies to achieve higher standards of living than market economies. To many, it looked as though centrally planned economies could achieve higher growth rates than market economies.Įconomists who saw themselves as followers of Smith took issue. Such authorities as the Central Intelligence Agency estimated that, before long, Soviet gross national product per capita would exceed that in the United States. In the 1960s, reported gross national product grew at much higher rates in the Soviet Union than in the United States or western Europe. Smith’s idea received its biggest challenge when the Soviet Union achieved world power status following World War II. Thus, Smith’s conclusion was that private markets worked better if they were free from government supervision, and for him it was just about that simple. He called on the king to discharge himself from a duty “in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient the duty of superintending the industry of private people, and of directing it toward the employments most suitable to the interests of the society.” (Smith 1776 Book IV, Chapter 9) Smith thought that these monopoly grants were a bad idea, and that instead private companies should be free to compete. The king would grant that company a monopoly, usually in exchange for payment. If the king wanted to initiate some large economic project, such as expanding trade with the colonies, he would encourage formation of a company to conduct that project, such as the East India Company. In 17th and 18th century England prior to Smith it was taken for granted that economic and political leadership came from the king, not from private citizens. Also important are views on the effectiveness of government involvement. Differing views on the degree of applicability of those assumptions underlie a good deal of the debate over the appropriate balance between relying on markets versus government intervention. The discussion in this Letter points to the key assumptions in the arguments. This Economic Letter discusses two versions of the argument in favor of private markets: that of Adam Smith in the 18th century and that formulated in the 19th century by the Italian sociologist and economist Vilfredo Pareto. Did Adam Smith get it wrong about private markets? To many, financial markets in the last several years appeared dysfunctional to an extent that was never imagined possible earlier. The financial and economic debacle of the past few years, however, has led many to revisit this question, particularly in Europe, but also in the United States and elsewhere. In much of the latter part of the 20th century, support for Smith’s pro-private-market verdict gained favor, as reflected in the partial deregulation of financial and nonfinancial markets in the 1980s and subsequent decades. The answer to that question is something of a moving target, with views of the public and policymakers tending to ebb and flow. The question is when and to what extent-not whether-private markets fail and therefore must be supplanted or regulated by government. Almost everyone acknowledges that some functions, such as contract enforcement, cannot readily be delegated to market participants. Except for some extreme supporters of free markets, today the preference for private markets is not an absolute. This proposition was first clearly formulated by Adam Smith in his classic Wealth of Nations. The single most important proposition in economic theory is that, by and large, competitive markets that are relatively, but generally not completely, free of government guidance do a better job allocating resources than occurs when governments play a dominant role. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources.
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