Adam Smith: Capital Grows a Nation's Wealth in These 2 Ways

This article is an excerpt from the Shortform book guide to "The Wealth of Nations" by Adam Smith. Shortform has the world's best summaries and analyses of books you should be reading.

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What role does self-interest play in capital lending? How is it good for the economy as a whole?

According to Adam Smith, capital grows a nation’s wealth. He identifies two main reasons. First, the self-interest of the capital lender encourages them to invest in productive labor. Second, the self-interest of the lender guides them to invest in less-developed portions of the economy and help them develop.

Keep reading to learn how lending capital for profit plays an essential role in growing the wealth of nations.

1. Capital Naturally Seeks Productive Labor

According to Adam Smith, capital naturally seeks productive labor: labor that can generate surplus goods. Surplus goods add to a nation’s overall wealth because they enter a nation’s overall supply of circulating capital. For example, a brickmaker creates bricks all day for a construction project. They make more bricks than the project needs, and the excess bricks are sold to another construction project. The brickmaker increases the national supply of circulating capital, thereby growing the economy.

Smith suggests that, when capital lenders are free to pursue their self-interest, they’ll naturally direct their wealth towards productive labor—which strengthens the nation’s economy and produces national wealth. This is because work that generates surplus goods can create greater profit than work that does not.

Productive Labor and Outsourcing

Smith notes that capital markets seek out profitability—businesses with higher margins between costs and revenue. One of the most controversial ways this plays out is in a market preference for outsourcing—the practice of hiring outside contractors at a cheaper rate than it would cost to hire employees.

While most businesses outsource some of their functions to outside contractors, outsourcing becomes controversial when manufacturing jobs in industrialized countries are outsourced to developing countries where labor is cheaper. Some argue that this is simply an example of market efficiency—that it’s better for total prosperity if businesses are more profitable and goods are cheaper. Others have maintained that governments have a vested interest in protecting manufacturing jobs to distribute income and protect domestic supply chains.

2. Capital Markets Seek Out Undeveloped Industries

Smith also asserts that capital markets grow new sectors of the economy, boosting the national economy as a whole.

Recall that the lenders of capital are competing against each other for a chance to lend their capital at profit. Therefore, the more capital that has already been invested in a given industry, the lower the profits for the investors. This is because the supply of capital outweighs the demand.

Therefore, the self-interest of the capital lender directs them to seek out industries with less capital investment. This process balances out the distribution of capital, driving investment toward new industries, new regions, and new markets—growing the economy.

(Shortform note: Smith is largely talking about developing a domestic economy by moving capital from one industry to another. However, in the age of globalization, this same dynamic has led capital investors to seek out “emerging markets”—capital markets in poorer, developing, or post-Soviet countries where there is supposedly room for rapid economic growth. However, this practice has been controversial. Some tout this development as an opportunity to build prosperity in less developed countries. But critics contend that—in practice—this has benefited wealthy investors at the expense of poorer countries, arguing that unregulated predatory lending has left poorer countries with unpayable debts.)

Adam Smith: Capital Grows a Nation’s Wealth in These 2 Ways