When The Wealth of Nations was published on March 9, 1776, there was no such thing as an economics profession. Two hundred fifty years on, there is no shortage of economists, and Adam Smith is widely regarded as the godfather of their profession.
If asked, Smith would have probably described himself as a Scot who made a living as a moral philosopher. And as for his famous book, it came to be seen as a true expression of the Enlightenment. This period of cultural and intellectual flourishing helped create an alternative vision for humanity based on reason, science, individual liberty, and human dignity.
Despite detours and missteps, it is a moral frame of reference that resonates to this day. It is why we continue to listen to what Smith had to say.
He illuminated the structural foundations of modern economies. Although he is best known for his idea of the “invisible hand,” Smith gave us an insight that is even more important: Moving from a static, subsistence economy to increasing income and prosperity requires what he called the “division of labor.”
Without this specialization, one cannot achieve dramatic increases in productivity coming from scale economies, learning curves, and improved conditions for innovation. Like all scientific discoveries, it seems obvious after the fact.
Division of labor
For specialization to work, we need two structural elements, which are mutually reinforcing.
One is trade, which is implied by specialized production. Indeed, while the supply side of the economy is specialized, the demand side is not. Hence the need for an “invisible hand” in the form of trade, a market system using prices and currencies. Trade is efficient, unless there are glaring externalities and informational gaps and asymmetries. It is economical by not requiring the collection of vast amounts of centralized information. And as a decentralized resource-allocation system, it allows for diverse preferences and creates incentives for innovation.
Of course, Smith was no stranger to trade. His father served as the customs agent in his hometown and birthplace, Kirkcaldy, and Smith himself served as the commissioner of customs for Scotland from 1778 to 1790. While he is sometimes unfairly accused of codifying a system that glorifies selfishness, he envisioned the opposite: an economy with moral underpinnings and supporting structures, such as regulations, government revenues, and a stable currency.
The second structural element needed for specialization is a sufficiently large market. In other words, an economy needs to generate enough demand to support the specialized producer. Otherwise, the producing entity will have to reduce its level of specialization. Think of the general store in the American West giving way to specialized shops as the population grew and became richer and urban centers expanded.
This is especially relevant for high-tech industries, where the total addressable market is central to assessing investment returns. The economics are clear: Developing new technology involves up-front investment. And the return on that investment is proportional to the size and scope of the market for the innovation. As an aside, the return on investment is also proportional to the duration of the market opportunity—until it is superseded by the next innovation. This is where the Schumpeterian dynamics enter the model.
All these factors—from specialization and trade to finding ways to access large potential markets—lie at the heart of any successful development model. They are complementary and structural. It is their coevolution that produces the desired result: rising productivity and incomes, economic growth, increasing purchasing power, and the resulting expansion of domestic markets for products and services that, by virtue of growth, become more affordable and desired.
Technology and development
Let’s remember that Smith lived at the very beginning of the British Industrial Revolution. To my mind, it is simply stunning that he understood, and to some extent foresaw, the structural features and dynamics that have driven much of the evolution of the global economy in which we now live.
Time and again, technology has played an essential role in directly driving productivity growth, but also in specialization via a connectivity channel, hence expanding the size of the addressable market. Smith may have seen James Watt’s steam engine (1769), which was more efficient than earlier models; if so, he would have certainly understood its potential in factories and transportation. He did not live to see the first steam locomotive, developed by Richard Trevithick in 1804. Nor did he get to see our modern digital economy, including the latest AI tools.
But again, he would have understood the implications of these revolutionary developments: the immense benefits of expanding market size at reasonable cost, the opportunity to foster inclusive growth patterns, and the prospect of another jump discontinuity in specialization and productivity.
The relevance to economic development is hard to overstate. Think of how specialization and trade accelerated in scale and scope after World War II. Over time, specialization moved from being a defining feature of developed economies to being one of the key engines of the entire global economy. It helped generate unprecedented growth rates, productivity expansions, and—over the past three decades—the biggest reduction in extreme poverty in human history.
In countries in the early stages of development, income levels are low and domestic demand is limited, which in turn limits specialization. But if the global economy is accessible, the domestic demand constraint is removed, at least for tradable goods and services. Leveraging this opportunity requires technology, connectivity, and infrastructure. It also requires the removal of barriers to trade that are created by policies. Hence the importance of the General Agreement on Tariffs and Trade and its successor, the World Trade Organization, and the general acceptance that trade can be broadly beneficial to all.
While technology, connectivity, and infrastructure cannot be acquired overnight, they can be built, and then the tradable part of the economy specializes and starts to grow. Employment shifts toward the tradable side, and average incomes grow. This income growth initially produces demand that spills over to nontradable goods and services markets. Relaxing the demand constraint on specialization beyond its tradable part benefits the economy as a whole.
Risk and complexity
The process of development gathers momentum because its underlying dynamics are mutually reinforcing. And yet myriad things can go wrong. These risks are well documented in the literature: macroeconomic mismanagement, instability and crises, insufficient investment in infrastructure and hence poor connectivity, and failure to leverage the opportunity created by global demand, to name just a few risks.
Let me briefly expand on one of them. A specialized economy entails risk for the simple reason that anything that causes a disruption or failure of the trading system is dangerous, the more so the longer it lasts. Perceived risks to market openness, functioning, and access could severely constrain specialization. We could even restate Smith’s fundamental insight as follows: Specialization is limited by the extent of the market and the probability that it will remain accessible.
One way to understand recent developments in the global economy is that, as the risks from multiple sources rise, there is a predictable partial pullback in specialization.
Moreover, a highly specialized economy is by definition complex. The degree of specialization and complexity can be seen as different sides of the same coin. The market and network connections that underpin a modern economy exceed the capacity of its participants to fully comprehend them. Perhaps advances in AI will give us tools to enhance this comprehension and our ability to adapt. A promising and growing application of AI is precisely in assisting in the management of complex systems, such as global supply chains and smart grids.
Complexity also entails hidden risks, which are often systemic. They are embedded in the complex network of interconnections that are hard to see comprehensively. Unless we get better at managing them, complexity will become an additional major constraint on specialization. More broadly, complexity at this level makes it hard for people to understand the economic system. That creates a vacuum, with all kinds of unsubstantiated theories about how, and in whose interests, it works. Some of these theories risk undermining political and social cohesion.
All this would make for a fascinating conversation with Smith, who saw plenty of economic disruption and dislocation. He lived at a time when the economy went from extremely local—where people probably knew most of those with whom they interacted and transacted—to the beginning of a rapid increase in specialization and the scope of markets.
This journey continues in our lifetimes. We increasingly depend on people and places we have never seen and that are largely unknown to us. We depend on science, technology, media, and expertise that go beyond our capacity to verify directly. How we address these challenges will shape our individual well-being and the wealth of nations in the years ahead.
