I reached for my hard copy version of Wealth of Nations, hoping to hunt down a certain section. I found the bookmark at page 96. There I found three insights that are still relevant today.
1) I recently posted on Berstein’s theory of lower returns to capital. Well, here’s Smith:
In a country which had acquired its full complement of riches, where in every particular branch of business there was the greatest quantity of stock that could be employed in it, as the ordinary rate of clear profit would be very small, so the usual market rate of interest which could be afforded out of it, would be so low as to render it impossible for any but the very wealthiest people to live upon the interest of their money
It’s hard to claim we’re fully stocked to the brim, but Bernstein’s analysis is about the trend towards satiation. As the ranks of rentiers retreat and the means afforded from idle ownership dwindle, one would expect confusion and commotion.
2) Mainstream Wall Street propaganda often cites non-GAAP earnings – earnings that exclude “extraordinary items” and make other, usually favorable, adjustments. Sensible market observers know this is a dangerous game, because though a specific item may be “extraordinary”, there is nothing unusual about unexpected adversities. Smith writes:
The lowest ordinary rate of profit must always be something more than what is sufficient to compensate the occasional losses to which every employment of stock is exposed. It is this surplus only which is neat or clear profit.
Domestic corporate profits as a percentage of GDP are near all time highs at the very high end of their historical averages. Based on “forward operating earnings” equity multiples don’t appear to be fearfully high. Buyer beware.
3) Since the housing crisis there have been ongoing efforts to limit the tools with which lenders may recover collateral (foreclosure on someone’s house) in response to non-payment. Level-headed people have warned against overstepping, since it may cause future lending to be restricted and causing rates to be higher than they otherwise would be.
Earlier today I linked to an economist’s “Christmas wish list“which included the lament of “that silly Homeowner Bill of Rights that passed in January of this year [which] could still cost future homeowners by making credit even harder to get.” Smith writes about a more extreme circumstance, but the lesson is clear:
When the law prohibits interest altogether, it does not prevent it. Many people must borrow, and nobody will lend without such a consideration for the use of their money as is suitable… The high rate of interest… is accounted for… partly from the difficulty of recovering the money.
It’s pretty simple: The more difficult or dangerous it is to collect on debts, the higher the interest rate will be. I’ll note too that severe restrictions on collection constitute a backdoor socialization of risk, since rock solid borrowers with extremely low risk of default will be forced to pay higher rates to compensate for expected losses from riskier borrowers. Lenders cannot practically segregate rates on every single loan and a myriad of other laws makes such attempts fraught with danger.
Smith is no prophet and Wealth of Nations is not a holy book, but it’s still amazing to find so much applicable wisdom on a single page dating from 1776.