Why Should We Care About Economic Theory?

0:00I want to thank, first of all, again, Mr. Jerry Davis for the idea of this and for putting it on. I'm going to talk today about why should we care about economics, why should we care about economic theory. I think the reason is because economics offers two kinds of knowledge that you are not likely to acquire anywhere else. One type of knowledge explains that there are absolutely impenetrable walls all around human ambitions, strict limits in the world that dash the dreams of utopians and curb the appetites of those who have lost touch with reality. The second kind of knowledge might appear to contradict the first. Economics explains the conditions under which the human imagination can be unleashed to create miracles all around us every day.

0:51These two kinds of knowledge present a paradox of sorts. The talk in economics on the one hand tell us about the existence of impenetrable limits in the social order and on the other hand reveal the workings of a limitless frontier for human imagination. These seem to be opposite lessons. I'd like to use this talk to discuss these traits of economic science and explain how they are not in contradiction. Let us first recall the founding of economics as a science and examine the historical context. The place was Spain, and the time was the 14th and 15th centuries. Spain had become the most prosperous place on the planet. This was due to its position in the trade routes of the time, its relative political stability, its rich endowment of natural resources, including in its colonies, of course, and also its history as a meeting ground for several different Cultural Forces. In Spain, Christians mixed and traded peacefully with Muslims and Jews for some 700 years. And this mixture led to a sharing of knowledge from which every group

2:02could benefit. Generally, Muslims brought scholarship and technical knowledge, Jews brought cost accounting, merchant skills and love of learning, and Christians brought a deep moral commitment to private property and an ethic of hard work. This confluence of cultural sharing led to the combination that gave rise to modernity itself, and most especially the institutions that make up modern capitalism, which has made the world what it is today. We see here the beginnings of capital investment, stock markets, money markets, borrowing and lending, large-scale production facilities, complex labor contracts, investments, and the expansion of the division of labor. Spain was also a host to some of the great centers of learning in the entire world. Most especially, they were the great thinkers situated at the University of Salamanca, scholastics who were theologians first, but who looked for the application of their theological commitments in everyday affairs. In the workings of all scientific matters, they saw the hand of God. This was true in both the physical sciences and also what we now call the social sciences of which economic

3:16Let me give an example. Let's say there is a man with a small office and his service is to lend money and collect interest and lend again. As part of this, he is also involved in buying one kind of money and selling another kind of money in cases in which there is a buy-sell spread in the goods price of money in different regions. He builds nothing physical. He sells no goods or other services. He imports nothing. He exports nothing. He is mainly dealing with ledger lines and money that is coming and going. And yet this man becomes extremely rich, richer than anyone else in town, including the laborers who sweat from sun up to sun down, and the industrialists who build large buildings.

4:05His riches lead him to become, to have a great deal of local influence, and he becomes the talk of the town. Now on one level, this is mystifying to people. How can this man become wealthier than everyone else even though he is only sitting at a desk? What is he doing precisely? Is it really a service? Is it really moral? These were the kinds of questions that led the first economists to their investigations. They wanted to know about how lending and borrowing really work, and whether these activities are a benefit to society. They wanted to know how prices for goods and services come to be in terms of money. They wanted to know how and why money had different valuations in different regions, and what role money changers had in trading these valuations against each other.

4:56And they became curious about the value of money itself, the conditions under which it would rise and fall. From these investigations came the first modern writings on the field of study called economics. They observed that prices for goods and services were influenced by their relative scarcity. If something was super-abundant, it had a low price or no price. And if something was in short supply or very hard to get, it obtained a much higher price. From here they discovered how prices came to be formed on the market and what conditions influenced them. They also discovered that the value of money acted in a similar way. Where the quantity of money was very high, they found that one had to spend more of it to obtain goods and services.

5:46And when the quantity of money was very low, one needed less of it to engage in transactions. They also found that an influx of money would cause a shift in prices in an upwards direction whereas a reduction in the quantity of money available would cause a fall in prices. Now these were seen as very interesting phenomena, not entirely new in the history of the world of course, for inflations and deflations have always been with us. But in Spain in the late Middle Ages, the appearance of the subject matter of economics became more pronounced and more obvious and impossible to avoid. Economics became a science because scholars were surrounded by gripping subject matter to examine and think about.

6:31These scholars became convinced of the existence of what we now call economic laws. These laws are not made by legislators or judges, kings or presidents. They exist as part of the social order, invisible to the naked eye, but just as real as gravity or any other force of nature. They began to enumerate these laws, like supply and demand. With the law of supply, we can see that if nothing else changes, more of a good will be offered at a higher price than at a lower price. Account Availability forces the law of demand. That is, people will demand a greater quantity of a good at a lower price than a higher price. Another law they observed concerned money.

7:17The greater the quantity available, the lower the value of money will be in terms of goods and services. They also began to observe the operation of cost accounting in business affairs. A business must take in more in revenue than it spends its goods to make its goods or services or else it cannot continue to do business. Nothing on earth will change this reality. It is a fixed part of the social order and a fixed part of the commercial world. No one legislated this reality or even had to enforce it. It is part of the way business operates and this is good for society because it makes It's the best use of scarce resources, discouraging waste and encouraging thrift.

8:03The more they looked at the operation of the commercial world, the more they found that it works in an orderly way. Prices were not arbitrary. They were set according to the agreement of buyers and sellers, which in turn reflected features of the physical world. These features are constantly changing according to the production of enterprises, and so of And of course, prices must be free to fluctuate. The behavior of business people particularly fascinated these thinkers. They saw how traders had to accumulate large quantities of goods in order to make money selling them to consumers. They had to take a guess about a future that was unknown and unknowable. This capacity indicated a certain virtue of planning ahead and courage to face the unknown.

8:51For their profits were wholly justified. But in profiting, they were also serving others who were buying of their own volition, exchanging money for things that they desired to make their lives better. This was the beginning of the great insight that gave rise to what would later be called liberalism. The insight was that people were fully capable of arranging and producing resources to their mutual betterment, and in so doing, they were helping themselves and Helping Everyone Else Too. This was even true of the money trader who gained great riches even as he sat at a desk. He was lending on terms that were mutually agreed upon by borrower and lender. All parties were better off than they were before. It was on this basis that the scholastic theologians came to approve of merchants and bankers as socially and morally is really essential to society.

9:48Now this represented a dramatic change from the attitudes of the ancient world. The ancient philosophers tended to see the merchants as only slightly better than slaves, mere peddlers who moved things around from here to there but otherwise lived a very lowly existence and rightly so as compared with the philosophers and kings who sat on the top of the social hierarchy. This change in attitude The greatest change in attitude from condemning to celebrating the merchant class was the greatest change in social theory of the late middle ages and the beginning of the drafting of the science of economics. The science of economics established that there were such things as economic laws working in the world on a continual basis.

10:33These laws led the world of commerce to be an orderly and beautiful place that brought the whole of society goods and services. What's more, these theologians observed that society could grow ever richer by letting the world of commerce operate without moral condemnation or government intervention. So long as persons are trading honestly with each other and there is no fraud or coercion as part of the exchange, they deemed it perfectly suitable and socially wonderful. In fact, they saw these laws as an extension of the hand of God operating in the temporal world. Now, if you know something about Spanish history at this time, you know that the Newfound Prosperity also came at a cost. New wealth meant new wealth for government too. And with these new resources at its disposal, the government was tempted to intervene in economic life in a manner consistent with its imperial aims abroad. In fact, Spain was host to the first big government in the modern world. The theologians who discovered economics were not silent in

11:38Speaking about the workings of government. Government everywhere is tempted to attempt to fix prices higher or lower than the market would dictate. They are tempted to grant monopoly privileges to some producers over others. They are tempted to establish limits on borrowing and lending. They wanted to collect taxes and as much as possible. When that didn't work to generate what they thought of as sufficient revenue, they were tempted to change the definitions The first economists in the modern world weighed in to condemn most of the efforts as unworkable interventions in the market. They pointed out that fixing prices would cause shortages or surpluses to appear in the marketplace. If the price of silk, for example, were held artificially low, it would be impossible for silk importers to cover their costs that they incurred in bringing silk to consumers, to cover their costs that they incurred in bringing silk to consumers, and they would cease doing so, thereby causing shortages along with pressure for rising prices.

12:43The ambitions of the prints to make silk cheaper would result in the very opposite. The same was true of the attempts to keep prices from falling. This would lead to products to be in surplus because consumers are not willing to pay such high prices for them. Most limits on the power of the prince also occurred when he tried to tax people because higher taxes end up discouraging production and leading to a smaller revenue base. And tampering with the money was also fraught with danger because doing so would cause all prices to rise, therefore defeating the point of the depreciation. This tendency of economics to instruct government on its limits began in the late Middle Ages and continued until the twentieth century. It was a universal feature of the profession and the field of study. This is how economists gained the reputation of being the dream crushers, the people who annoyed princes, kings and presidents. They were profoundly aware that economic laws work as a strict limit on the ambition of the rulers. This is why also famously

13:57This is all well and good for government officials to dream of a world of perfect equality or universal wealth or universal high quality health care for everybody, but if they interfere with the market, they will end up creating all kinds of dislocations and will not and cannot achieve their aims. This is why government, said these economists, should limit themselves to their areas of competence and never go beyond that. As to what their areas of competence might be, of course that's another, that's a time for another talk. One can see then that the economists were never very popular with rulers, policy wonks, political planners or social meddlers of all stripes.

14:47Economists were the gang standing over in the corner constantly wagging their fingers and reminding everyone else that they had better curb their dreams and wake up and smell the strong coffee of economic theory. Even to this day, this tendency is still in operation. Observe the social patterns on any college campus when you attend, and you will find the inhabitants of the departments of English, Sociology and History don't like to hang out around the economists. And you rarely find economic insights invading the textbooks of other professions unless it is of the Keynesian or Marxist variety. Those with unhinged intellectual visions don't like to be reminded of reality and economists are nothing if not attached to the workings of the real world.

15:34Of course, I've only addressed one aspect of the contribution of economics, that which delineates strict and insurmountable limits to what can happen in the material world. World. That is only half the story. The other half is that economics is the one science that has come to terms with the conditions under which the human imagination can be unleashed to create miracles all around us every day. And here again we can tell the story in light of the experience in Spain, in the Middle Ages. If you look for example at the art of that period, particularly as we approach the Renaissance, we see something completely new. We observe color, life and freshness that indicates a kind of optimism about life. This is because wealth was growing, people were living longer, incomes were increasing for all classes, new foods, new fabrics were appearing by the year, the month, the day.

16:29For the first time we began to see the creation of what we today call the middle class. People did not have to live forever in poverty. Through enterprising hard work, there existed the possibility of enhancing one's standard of living, provided the private capital was available to support this and provided that both producers and consumers enjoyed economic opportunity in a world of freedom. These trends that began in Spain and extended to other parts of the continent and finally England during the Industrial Revolution demonstrated just what can happen in a world that permits the unleashing of human creativity. Working within the structure of economic laws, entrepreneurs can take risks, inventors can come up with new ideas, merchants can bring new products and services to ever larger groups of people. When people are permitted to change jobs, move and negotiate their own contracts, the division of labor can extend to larger and larger numbers. This allows even more talents to come to the table and work towards creating wealth.

17:33To understand how this market-based productivity works in action, you only have to compare an imaginary reality with the reality you see all around you. Imagine that you, your family, and your friends were plopped down in this world exactly as it was made. You come with one set of clothes and nothing else. There are no houses, no grocery stores, no Wii consoles, no cell phones, no books, no No Wikipedia, no cars, no machines for doing anything. All you have is your knowledge and your language. This is what might be called the state of nature. The situation in which you find yourself is precisely what the world would be like in the absence of economic productivity.

18:19Can you imagine how long it would take to build the world we now live in? It would not happen in your generation, or the next, or the next, or the next. It would take many hundreds of years, perhaps, just to arrive at a point that we would find more or less acceptable from the point of view of our own comfort. Knowing this, it is good to keep in mind the debt that we owe to economic freedom and to all the accumulated capital of previous generations, each building on the last. This economic freedom has unleashed the creative spirit of mankind for hundreds of years, bestowing great blessings on you and everyone in society. These blessings are quite often surprises and remarkable ones. Right now I can pick up a device I have in my pocket, click a few buttons, and talk face to face with a friend in Europe.

19:11No wires anywhere. By any standard, this is amazing. All the more amazing is I can do it without paying any fee for the particular service that I would be using, in this case, Skype. So we can see that the products of the market are not only miraculous, they also follow an unexpected path. So many amazing services are offered today at zero price, from Facebook to Google to Wikipedia. And I can tell you that no one ten years ago would have ever imagined that these services would exist, much less exist, without fee-based subscriptions. We must be cautious to never think of the blessings of the market, however, as bestowed on this generation as a natural right. Our natural right is to live in a state of nature.

20:00Everything else has been made by man in his capacity as a freely choosing and rational creature. And remember too that this means these blessings can disappear even more quickly than they came about if we take the wrong steps. Look at countries that nearly shut down the market economy such as Russia after the Bolshevik Revolution, China after the Communist Revolution, Cuba after its revolution, or North Korea today. These countries stagnated economically. Their technological advances came to a grinding halt. History literally stopped for them, really had moved backwards. This is what happens when you permit the government to own and manage social resources. Even today we can see that the freest sectors in society are the ones that are making the Compare the progress in cell phones and computers to the pace of progress in public schools and the post office.

20:57There is no intrinsic reason why some sectors should be stuck in the mud and others moving ahead at a fast pace. It all comes down to how much control government exercises over the sector. When the government keeps its hands off, we enjoy the possibility of progress. When government is running things, we doom the chances for progress. This is the great lesson of economics, and it is a thrilling one to discover. Like Doug French, I highly recommend the Bob Murphy book on lessons for young economists, the great Henry Hazlitt book, Economics and the Lesson, as the way to start learning about economics. Although, of course, many of you in this room are already young economists.

21:43But be careful, as you read these books, you might catch the bug. You might end up spending your life thinking and writing about this topic. If that happens to you, and you continue to reflect on what freedom means to the human population and the inherent limits that economics Reveals concerning government power, you have an exciting journey ahead. You might make the decisive intellectual contribution that will help preserve freedom and prosperity for the next generation. Thank you, and I hope you do it.