Imagine you are Adam Smith. It's mid-18th century Britain; following the Commercial Revolution, the Industrial Revolution is in its early stages.
|Madeley wood furnaces: "Coalbrookdale by Night"
(1801), by Philip James de Loutherbourg [A]
Banking and finances, centered on London, changed remarkably in the previous decades. Physical production, which lagged behind them, began, during Smith's own time, to display unusual dynamism: new production lines, technologies and occupations appear; resulting in greater abundance and variety of goods. And with these changes come new fortunes with their own interests, not necessarily coincident with the traditional ones.
Consider the economy as a machine, as Smith, influenced by Newton, must have: stuff comes out at the right end; some of it is consumed, some flows back to the left entry point; something happens inside; even more stuff pours out.
That is economic growth. And Smith, living in a transitional time, must have been acutely aware of it.
Where does it come from? Can it be sustained? How you measure output? How is it distributed?
Smith and others attempted to understand this process.
I will focus here on a single aspect of Smith's work: how to appraise output.
We do this by using market prices (hence, nominal GDP, for instance). To us, this seems natural; to do otherwise would seem odd.
Smith, however, initially proposed the use of labour times, instead of market prices:
"In that early and rude state of society which precedes both the accumulation of stock and the appropriation of land, the proportion between the quantities of labour necessary for acquiring different objects, seems to be the only circumstance which can afford any rule for exchanging them for one another. If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer." (The Wealth of Nations, Book I, Chapter VII)Why would Smith make such a choice?
There might be several reasons. For one, assuming that science must be based on objectively observed facts, Smith's reasoning seems logically unassailable, at least within that hypothetical "early and rude state of society": there is no other objectively observable measure justifying any proportionality in exchange, as Smith himself remarked.
Further, if it were at all possible in that social state, it's not obvious that a modern system of market prices would do a better job.
For one, like market prices, virtually everything offered in the marketplace is there because someone, somewhere, spent time producing it. Unlike market prices, however, labour time is also spent to produce non-market goods and services (many of which are excluded from current statistics).
Indeed, in our own times the government's contribution to GDP is appraised in a way only a step removed from Smith's original proposal: it's valued at cost (i.e. other inputs, plus labour time).
More importantly, market prices are volatile (much more so than labour times) and in essence, in Smith's view, unpredictable. For Smith an invariant standard for measuring long-term economic change was important: it's not just growth that matters, but how much effort it costs to achieve it, a matter often overlooked nowadays.
In other words, Smith's choice was neither uninformed nor arbitrary and it may even be supported on some reasoning.
But Smith himself makes a better case for his labour times approach:
"Equal quantities of labour, at all times and places, may be said to be of equal value to the labourer. In his ordinary state of health, strength, and spirits; in the ordinary degree of his skill and dexterity, he must always lay down the same portion of his ease, his liberty, and his happiness. The price which he pays must always be the same, whatever may be the quantity of goods which he receives in return for it. Of these, indeed, it may sometimes purchase a greater and sometimes a smaller quantity; but it is their value which varies, not that of the labour which purchases them. At all times and places, that is dear which it is difficult to come at, or which it costs much labour to acquire; and that cheap which is to be had easily, or with very little labour. Labour alone, therefore, never varying in its own value, is alone the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared. It is their real price; money is their nominal price only." (The Wealth of Nations, Book I, Chapter V. My emphasis)
As many other economic ideas, one can consider that the modern labour theory of value started with Adam Smith, if in an embryonic form.
Curiously, out of the many subjects Smith studied, this particular one has become highly contentious among mainstream economists. Apparently, Smith, who in general did a good job defending capitalism, in this particular case did not do a good enough job and, worse, may have furnished ammunition to critics of capitalism.
William J. Barber offers a different view of Smith's labour theory of value:
"Smith labour approach to the analysis of value has been severely criticized by later schools of economists. To one group of writers its fatal shortcoming was that it did not offer a full account of the determination of prices, and, most particularly, that it neglected the demand side of market behaviour. This criticism would carry more force had Smith sought to produce a systematic analysis of market price formation. But in fact this objective was peripheral to his main programme. He was more concerned with forging concepts that might provide leverage on the problem of measuring economic change over prolonged periods. The materials for developing a clearer analysis of the formation of short-term market prices were at his disposal. Concepts of utility and demand (which were to be used for their purpose by a later school of thought) had been part of the teaching he absorbed from Hutcheson. He chose to reject this orientation toward value theory, presumably because he regarded it as lacking relevance to his central purpose". (A History of Economic Thought. Chapter 1. Emphasis mine).Eventually, Smith himself modified his views, to take into account later and less "rude states of society".
Ironically, it is perhaps in this change that Smith's real fault was.
[A] "Coalbrookdale by Night" depicting Madeley wood furnaces (1801), by Philip James de Loutherbourg (1740–1812). Source: The Yorck Project: 10.000 Meisterwerke der Malerei. DVD-ROM, 2002. ISBN 3936122202. Distributed by DIRECTMEDIA Publishing GmbH. Wikipedia.