In early times, trade deficits dominated thinking about international trade policy—which is to say that countries tried to avoid them. Until the mid-19th century mercantilist policies predominated. These policies envisioned countries as being like individual households. Households that run surpluses—that earn more than they spend—are seen as thrifty and virtuous. So were countries. Accordingly, countries strove to expand exports and limit imports. Countries that had colonies, as Britain had the American colonies before 1776, could mandate mercantilism by imperial law. Other countries employed tariffs to limit imports and used subsidies to encourage exports.

Mercantilism came under theoretical attack by economists like David Hume, Adam Smith and David Ricardo, who persuaded Britain to abandon it in favor of free trade in the mid-19th century. America vacillated between greater and less protectionism, via tariffs, until the 1940s.

By the time America embraced free trade, at the end of World War II, the idea of trade deficits and surpluses had grown complicated by interconnections among many countries and by new American thinking. The United States ran trade deficits with some countries and surpluses with others. To focus on a single bilateral relationship risked losing the big picture. Moreover, unlike in the days of mercantilism, a country such as the United States was seen as fundamentally different from a household. The behavior of a household has no observable effect on an economy at large. But a country like the United States has a significant effect on the international system. A persistent American trade surplus with the world would risk impoverishing other countries. It could destroy those countries and, in the end, the American surplus that impoverished them.

Beyond this was the benefit a stable international system provided to American security. When the Great Depression, which had been intensified by a tariff war touched off by the American Smoot-Hawley tariff of 1930, led to World War II, American leaders drew a connection between open trade and international peace. They were willing to run trade deficits, if necessary, to promote good will and stability.

America’s trade situation was further complicated by American domestic politics. Starting in the 1970s America’s federal government began running consistent deficits in its annual budget, spending more on government programs than it collected in taxes. The American trade deficit, which also became chronic during this period, wasn’t directly connected to the budget deficit. But each influenced the other, to the degree that they were often called the “twin deficits.”

The connection was this: When the government spent more than it taxed, it covered the deficit by borrowing. The borrowing took the form of auctioning government bonds. When the government auctioned lots of bonds, it had to pay high interest rates to attract the necessary lenders. Some of those lenders were foreigners with dollars from goods they had sold to American purchasers. The more dollars they had from exports to America—that is, the greater the American trade deficit—the better able and more willing they were to buy American bonds. In the absence of the trade deficit, the budget deficit would have cost more to cover, through higher interest rates. Thus the trade deficit funded the budget deficit. And the budget deficit lessened the ill effects of the trade deficit, by repatriating the dollars the foreigners weren’t spending on American trade goods.

No one in a position of responsibility boasted of the trade deficit. Nor did anyone point with pride to the budget deficit. Each was spoken of as something to be reduced or eliminated. Cutting the trade deficit would create American jobs, said one candidate after another. Cutting the budget deficit would restore fiscal sanity and save the American future.

But the twin deficits persisted, each silently supporting the other. Some of those on the inside understood the mechanism. Others accepted the consequence without bothering about its cause.

It sometimes seemed like two drunks staggering down a sidewalk, each holding the other upright. It was kind of sweet that they did. But it meant that one couldn’t fall without the other going down too.

In the beginning, economics was a branch of philosophy. The Economics ascribed to Aristotle might have been written by one of his followers, but it was securely in the realm of philosophy. Thomas Hobbes and John Locke wrote about economics as part of their philosophies. Adam Smith’s first book, The Theory of Moral Sentiments, was a reflection on human nature but included economic matters.

Economics became a social science by the early 19th century. Smith’s Wealth of Nations and the works of David Ricardo and Karl Marx melded it with politics to produce the hybrid discipline political economy.

William Jevons turned economics in a mathematical direction with his 1862 General Mathematical Theory of Political Economy. Jevons’s concept of marginal utility lent itself to the application of calculus and other mathematical tools.

Alfred Marshall pushed the mathematization of economics even further. His supply and demand curves likewise invited mathematical treatment, which produced concepts like producer surplus and consumer surplus, represented as areas bounded by the curves.

After Marshall, economics became chiefly a mathematical science. The rigor of mathematics, which was producing wonders in physics, promised to do the same for economics. In their use of mathematical symbols and notation, economics papers became almost indistinguishable from physics papers.

Yet there was a problem. One proton is like every other proton. And protons and electrons don’t have minds of their own. Humans, by contrast, are individuals and think for themselves. The more mathematical economics became, the further it veered from actual human life. The models were elegant but decreasingly revealing.

The field needed a jolt from outside. It got such a jolt from two Israeli psychologists, Amos Tversky and Daniel Kahneman, who in a 1974 paper titled “Judgment Under Uncertainty: Heuristics and Biases” laid the foundation for what would be called behavioral economics. They followed up in 1979 with “Prospect Theory: An Analysis of Decision under Risk.”

Tversky and Kahneman demonstrated that humans didn’t meet the rational-actor standard required of the mathematical models of economics. The homo economicus of the models was indifferent between a certainty of $100 and the chance of $200 on one flip of a fair coin. The homo sapiens of their experiments much preferred the certain $100.

Homo economicus understood that losing $10 was objectively no different than not winning $10. Homo sapiens felt the former more painfully. By the reckoning of Tversky and Kahneman, the pain to real people of losing was twice as powerful as the pleasure of winning the same amount

Homo economicus avoided the sunk cost fallacy, knowing better than to throw good money after bad. Homo sapiens threw money down holes all the time.

Homo economicus was wise to confirmation bias. Homo sapiens’ judgment was clouded by pre-existing beliefs on a regular basis.

To homo economicus, $100 was $100. To homo sapiens, the difference between $0 and $100 meant much more than the difference between $1,000 and $1,100.

To people not immersed in academic economics, much of the work of Tversky and Kahneman sounded like common sense. Nonetheless, it earned a Nobel prize in economics for Kahneman in 2002. Tversky had died by then and the rules of the prize forbade posthumous conferral.

Perhaps in awarding the prize to psychologist Kahneman, the Nobel committee sought to signal to economists that they had gotten too mathematical, too far removed from daily life. Kahneman didn’t disagree. “Economists think about what people ought to do,” he said. “Psychologists watch what they actually do.”

Life is a struggle against entropy. Life organizes, entropy disorganizes. The second law of thermodynamics dictates that entropy wins in the wild. Life fences off bits of the wild to defy the law.

The first claim to property was the first cell wall erected by the first multicellular organism. Behind this wall the organism marshaled resources and amassed a surplus for its exclusive use.

Plants laid claim to patches of ground. By sinking roots and sprouting stems and branches, they preempted other plants from doing the same.

Animals are mostly mobile. Their territorialism takes other forms. They mark territory and defend it by threatening or employing violence. The evolution of social species allowed the enlistment of numbers in defense of territory. Cooperative defense required coordination and communication. The rise of humans reflected their comparative superiority in this regard.

Hunters were territorial, defending the best hunting grounds. Pastoralists defended the best pastures.

Farmers were the most territorial of all. They planted crops and waited for their crops to yield harvests. Lest their work be wasted and others seize the benefit of their labor, they had to defend the fields they cultivated.

This was tedious business if accomplished solely by physical presence and force. Farming societies developed norms, rules and then laws establishing property rights. So central were property rights that in time they were elevated to a holy trinity of rights, beside life and liberty.

Property rights spurred economic development. Individuals who worked hard and innovated knew they would own the results of their efforts.

But not everything could be owned. Some communities decided that not everything should be owned. In the 17th century, Massachusetts was colonized by English Puritans, the religious stock that produced John Locke, the apostle of property rights. Yet the Puritans of Boston set aside a common, an open space in the middle of the town accessible to all residents and owned by none individually.

Precisely because it was owned by no one, no one had particular incentive to maintain it. The Boston common, like commons elsewhere, suffered from overuse.

In 1968, American ecologist Garrett Hardin published an essay in the journal Science titled, “The Tragedy of the Commons.” Hardin described the mechanism of the commons’ degradation. “Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy. As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, ‘What is the utility to me of adding one more animal to my herd?’ This utility has one negative and one positive component.

“The positive component is a function of the increment of one animal. Since the herdsman receives all the proceeds from the sale of the additional animal, the positive utility is nearly +1.

“The negative component is a function of the additional overgrazing created by one more animal. Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any particular decision-making herdsman is only a fraction of -1.

“Adding together the component partial utilities, the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another. And another.

“But this is the conclusion reached by each and every rational herdsmen sharing a common. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit.”

By the time Hardin wrote, Bostoners were no longer grazing cattle on the common. The commons he was interested in was the global environment. The oceans of the planet and its atmosphere had long served as commons for the industrializing world and its growing population. The oceans were overfished, as each country made the same calculation as Hardin’s herdsman. The atmosphere was polluted on similar reasoning.

Before long the “tragedy of the commons” had entered the lexicon of discourse where economics met politics and environmentalism. In some cases it prompted new regulation. The skies over America grew cleaner during the decades after Hardin’s article appeared. Domestic waterways became less polluted.

But the tragedy persisted in realms beyond the reach of any single nation. The biggest realm—the global environment—experienced the hardest problem: climate change. Each country could reckon much as Hardin’s herdsman reckoned. Each would pay all the cost of a change in its behavior but would receive only a fraction of its benefit. National leaders didn’t have to be climate deniers to conclude that meaningful change didn’t pencil out.

The tragedy persisted.

“Can capitalism survive?” asked Joseph Schumpeter in 1942. “No. I do not think it can.”

Schumpeter was an Austrian economist writing amid a war that was convulsing Europe and threatening this home of capitalism. But it wasn’t the war or the challenge of fascism that made Schumpeter fear for capitalism’s fate. Nor was it socialism, as embodied in the Soviet Union. It was capitalism itself.

Communists, following Karl Marx, had since the 19th century been predicting capitalism’s self-destruction, to be succeeded by socialism. Schumpeter treated Marx with greater respect than did most economists of his day, but he thought Marx missed the point. It wasn’t the contradictions of capitalism that would doom the bourgeoisie and the system they created. It was the success of capitalism.

Schumpeter joined Marx in deeming change the essence of economic life. “The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process,” Schumpeter wrote in Capitalism, Socialism and Democracy. Yet where Marx attributed change to the class struggle, Schumpter credited innovation. “The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.”

Marx liked to talk of revolutions. So did Schumpeter. “The history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening to the mechanized thing of today—linking up with elevators and railroads—is a history of revolutions,” Schumpeter wrote. “So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace to our own type of furnace, or the history of the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mail-coach to the airplane. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”

Schumpeter coined a phrase to capture his point: “This process of Creative Destruction is the essential fact about capitalism.”

Creative destruction was the curse of capitalists, who lived in constant threat of being destroyed, and the blessing of capitalism, which was continually renewed by the process. Successful capitalists understood their predicament and prepared to deal with it. “Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction.”

Economists underestimated creative destruction. They wrote of competition among firms, typically on price, as the characteristic of capitalism. “But in capitalist reality as distinguished from its textbook picture,” Schumpeter said, “it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization (the largest-scale unit of control for instance)—competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives.”

To miss this mortal struggle was to miss the point of capitalism. “It is like Hamlet without the Danish prince,” Schumpeter said.

So why would capitalism itself die?

Because it was likely to meet all the needs of humanity. “A more or less stationary state would ensue,” Schumpeter wrote. “Capitalism, being essentially an evolutionary process, would become atrophic. There would be nothing left for entrepreneurs to do. They would find themselves in much the same situation as generals would in a society perfectly sure of permanent peace. Profits and along with profits the rate of interest would converge toward zero. The bourgeois strata that live on profits and interest would tend to disappear. The management of industry and trade would become a matter of current administration, and the personnel would unavoidably acquire the characteristics of a bureaucracy. Socialism of a very sober type would almost automatically come into being. Human energy would turn away from business. Other than economic pursuits would attract the brains and provide the adventure.”

Schumpeter needn’t have worried. He underestimated the capacity of humans to learn new desires and to convert those desires into needs. Schumpeter died in 1950, at the age of sixty-six. Capitalism had far to go, driven by the entrepreneurism he feared would atrophy.

People forgot Schumpeter’s misguided prophecy. What they remembered was his succinct characterization of the paradox at the heart of capitalism. No economic theorist ever got more mileage out of two words than Schumpeter did with “creative destruction.” This oxymoron captured the essence of his view of capitalism, and it made Schumpeter known to generations of economists and others who knew nothing else about him.

Thomas Carlyle called economics the “dismal science” because he didn’t like the conclusions economists drew. He wasn’t speaking of Thomas Malthus, although the prediction of Malthus that population growth would outstrip economic growth and lead to immiseration was plenty dismal. The label stuck because economists insisted on describing economic life as consisting of trade-offs. You can have more of something only at the cost of something else.

For all this, economists tended to be an upbeat group. The leading thinkers constructed their theories to explain the material progress they observed in the world. Malthus was an outlier who proved to be wrong. Karl Marx was an outlier who was wrong too, in the opposite direction, predicting a socialist paradise beyond capitalism.

By the 20th century, capitalism had displayed a tendency toward recurring panics. Investment became speculation which produced bubbles that inevitably burst. Demand would collapse, workers would be fired, firms would fold. But eventually calm would be restored and the cycle begin anew.

Then came the Great Depression of the 1930s. Deeper and more widespread than any of the panics that preceded it, this one went on and on. Many people wondered if it would ever end.

John Maynard Keynes explained why it might not end. The touchstone of existing economic theories, Marx’s excluded, was the concept of equilibrium. Alfred Marshall’s graphs specified where the equilibrium would be between supply and demand. Economists who wrote about the business cycle had graphs of their own, showing waves that rose and fell above and below an axis of equilibrium. Most theories described a tendency of economies to return to equilibrium when knocked out of it.

Keynes observed economies that refused to return to equilibrium, to climb out of the troughs in which they found themselves. He proposed a theory to explain this behavior.

His key concept was aggregate demand. This was the macroeconomic counterpart to Marshall’s microeconomic demand. The defining characteristic of a depression, Keynes said, was a shortfall in overall demand. An important customer of a manufacturer curtailed its usual order. The manufacturer responded by laying off workers. The workers cut back on household spending. The shops they frequented lost revenue and laid off some of their workers. The spiral continued, and the aggregate effect was a depression.

During previous depressions, the decline in aggregate demand had not been so great as to threaten the entire system. The healthy sectors of the economy carried the system until the wounded sectors recovered.

This time was different. Demand was so deficient that prices kept falling and falling. When prices fall, even people with money have an incentive not to buy, but rather to wait until prices fall more before they buy what they need. Their thriftiness, admirable on an individual scale, aggravates the deficiency in demand and makes things worse.

What to do?

Keynes nominated government to be the purchaser of last resort. When individuals refused to buy, government should step in. From the standpoint of Keynes’s theory, what the government bought didn’t much matter. But the politics surrounding any such action pointed toward fixing roads, building bridges and schoolhouses and tackling other projects that often went begging.

The money spent would have a multiplier effect. An unemployed worker hired by the government and paid $100 would spend nearly all that money supporting his family. The merchants who received his payments would pay their employees and vendors, who in turn would spend the money. The $100 of government money might produce $300 or $400 of new economic activity.

Keynes and others likened this to priming a pump. A pump that stops has to have water poured in for it to restart. This small amount of water allows the device to pump a much greater amount once it gets going.

To many people, Keynes’s counsel seemed dangerously wrongheaded. The depression had slashed tax revenues, throwing governments into deficit. The responsible thing to do was to cut government spending and tighten government belts. Keynes was saying governments should do the opposite. This road would lead to ruin.

Not so, said Keynes. The deliberate deficit would be temporary. Once the pump was primed, the water would start flowing. Prosperity would return. When it did, governments could pay back the debts they had incurred. During good times, governments should spend less than they took in. This countercyclical budgeting would balance in the long run and offset the ups and downs of the business cycle.

Keynes laid out all this and more in his 1936 General Theory of Employment, Interest and Money. He sent a copy to Franklin Roosevelt, who thanked him but kept his distance. Roosevelt was not the one to pioneer Keynes’s counterintuitive strategy. In fact, Roosevelt did just the opposite. In 1937 he took measures to cut spending rather than increase it. The result was a reversal of most of the progress that had been made since the bottom of the depression.

Yet Roosevelt found his way to Keynes’s policy by a back door. As Europe and Asia went to war, the president persuaded Congress to appropriate money for American defense readiness. This increased the deficit and produced the effect Keynes had predicted. The effect intensified after the United States itself went to war in 1941. Shortly the Great Depression was a memory and full employment a reality.

Notwithstanding the war experience, the United States never embraced the full Keynesian model. Nor did other countries. Governments got used to running deficits in downturns, but they never mastered the flip side of running surpluses in good times.They simply spent the extra revenues.

Alfred Marshall assessed the historical debate over value—between labor theorists like Smith and Ricardo and utilitarians like Jevons—and concluded that each side was partly but not entirely correct. The former stressed the supply side of market transactions, emphasizing the costs of production, which they denominated in terms of labor. The latter focused on the demand side, examining how consumers evaluated commodities.

Marshall thought the debate rested on a false dichotomy. Supply and demand interacted. “We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production,” Marshall wrote in his 1890 Principles of Economics. “It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens.”

More than his predecessors, Marshall distinguished between short-term and long-term effects in markets. In the short term, supply might be fixed, more or less. Growing flowers for Valentine’s Day takes months. During the week before, the supply of flowers might be taken as fixed. The price will depend on demand, rising as demand peaks just ahead of the special day and collapsing the day after.

But in the long term, demand will influence supply. A large sale of flowers for Valentine’s Day might cause florists to increase their orders for Mothers’ Day. The larger supply will tend to depress prices. Yet as Mothers’ Day approaches, demand will take over again, showing the last-minute spike, but at a lower level than at Valentine’s Day.

To capture the interplay of supply and demand, Marshall made use of graphs. These had two axes, with the horizontal axis indicating the units of an item for sale and the vertical axis the price per item. The typical supply curve sloped upward to the right, indicating that higher prices caused producers to produce more. The typical demand curve sloped downward to the right, indicating that lower prices caused buyers to buy more. The equilibrium point where the demand curve crossed the supply curve indicated the sale price and quantity sold at any given moment.

Marshall’s curves allowed him to develop the concept of price elasticity of supply and demand. Supply is said to be elastic if a small change in price elicits a large change in supply. If the price goes up, supply increases substantially. Elasticity of demand is similar but in the opposite direction. If the price goes up, demand falls. The degree of elasticity is shown by the slope of the curve. A steep slope indicates a high degree of elasticity. A shallow slope signifies low elasticity.

Marshall’s graph allowed him to display visually what happened when a market was viewed over time. If an underlying condition of the market changed, the supply or demand curve would move. A new technology might reduce the cost of production, thereby pushing the supply curve to the right. That is, the price that previously brought 100 units to market now brought 200 units to market. If the demand curve stayed the same, the new equilibrium would be achieved at a greater quantity and lower unit price than before. This would signify a buyers’ market, one where buyers were better off.

By contrast, if the demand curve moved to the right—on account of more buyers entering the market, perhaps—while the supply curve stayed the same, the new equilibrium would be at a greater quantity and a higher price than before. This would be a sellers’ market.

Marshall’s supply and demand curves became a staple of economic thinking and teaching. They also gave a boost to microeconomics, the branch of economics dealing with individuals and individual firms, in contrast to macroeconomics, which deals with the economy as a whole. Marshall’s curves remain a fixture in textbooks in microeconomics classes and in the reports of business consultants. Supply and demand are as inseparable in economic thought as salt and pepper in restaurants.

Why are diamonds expensive while water is almost free? Diamonds are baubles, pretty but useless. Water is vital to life.

Economists had been wrestling with theories of values for decades when William Stanley Jevons took up the matter. Prevailing theories looked to labor for the key to value. An item was said to have value according to the labor it embodied. A Stradivarius violin cost more than an ordinary fiddle because it embodied the labor of generations of expert luthiers who discovered the secrets of their craft and painstakingly passed them down.

The labor theory worked better in some cases, such as violins, than in others, like diamonds. The labor theorists said diamonds were expensive because they were hard to mine. But they aren’t always hard to mine. Some are found at the surface. The rejoinder was that you have to average out the labor involved in production.

The labor theory was salvageable but at the cost of increasing complexity. Ancient theories of planetary motion had survived by means of more and more epicycles, until Copernicus simplified things by placing the sun at the center. William Jevons wanted to be the Copernicus of economics.

By 1860 he had achieved his insight. “I have worked a good deal at political economy,” he wrote to his brother in June of that year. “In the last few months I have fortunately struck out what I have no doubt is the true theory of economy, so thorough-going and consistent that I cannot now read other books on the subject without indignation.”

Jevons was a better mathematician than most economists of his day, and he sought to place economics on a mathematical footing. His new theory let him do so. “I obtain from the mathematical principles all the chief laws at which political economists have previously arrived, only arranged in a series of definitions, axioms and theories almost as rigorous and connected as if they were so many geometrical problems.”

One of his axioms was drawn from his observation of life. “As the quantity of any commodity, for instance plain food, which a man has to consume increases, so the utility or benefit derived from the last portion used decreases in degree,” Jevons wrote.

With this one sentence Jevons launched a revolution in economics. Often called the “marginal revolution,” it rendered labor theories of value obsolete and opened the way to the mathematization of economics.

It made the diamonds-versus-water problem child’s play. So long as water is plentiful, diamonds are worth more. But a man dying of thirst in the desert will swap a sack of diamonds for a single drink of water.

In 1871 Jevons published The Theory of Political Economy. At the beginning of the first chapter he framed his innovation. “Repeated reflection and inquiry have led me to the somewhat novel opinion that value depends entirely upon utility,” he wrote. “Prevailing opinions make labor rather than utility the origin of value; and there are even those who distinctly assert that labor is the cause of value. I show, on the contrary, that we have only to trace out carefully the natural laws of the variation of utility as depending upon the quantity of commodity in our possession in order to arrive at a satisfactory theory of exchange, of which the ordinary laws of supply and demand are a necessary consequence.”

Just as Copernicus required Kepler and Newton to work out the consequences of heliocentrism, so Jevons required other economists to advance the marginal revolution. Among these were Leon Walras of France, who independently reached some of the same conclusions as Jevons, and Carl Menger of Austria, who founded the influential Austrian school of economics.

So thoroughly did the marginal revolution succeed that a century and a half later marginal utility remains a central concept in economics. Marginal thinking pervades everything from tax codes to the spot market for oil, from ticket prices to hotel rates, from congestion pricing to advertising on the internet.

“Have you ever witnessed the anger of the good shopkeeper, James B., when his careless son happened to break a square of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact that every one of the spectators, were there even thirty of them, by common consent, apparently, offered the unfortunate owner this invariable consolation—‘It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?’

“Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

“Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier’s trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

“But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, ‘Stop there! your theory is confined to that which is seen; it takes no account of that which is not seen.’

‘It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way which this accident has prevented.”

Thus wrote Frederic Bastiat, a French economist, in an 1850 essay called “That which is seen, and that which is not seen.” The importance of the essay lay in what was not seen but which Bastiat made his readers notice. The broken window illustration was one of several examples. All emphasized the fallacy of accounting for what did happen but not for what did not happen. Angry James gave business to the glazier. The neighbors noticed. But he did not give business to the cobbler or the bookseller. No one noticed.

What they failed to notice was what later economists would call opportunity costs. The neighbors acted as though if James hadn’t spent the six francs fixing the window, he wouldn’t have spent them at all. The village economy therefore benefited from the broken window.

Bastiat said no. James would have spent the money on shoes or books. The village economy would have benefited. It was simply that someone besides the glazer would have been the beneficiary.

Bastiat employed the same reasoning against the argument that the French army, which at the time was bloated, couldn’t be diminished without causing the French economy to languish. “You tell me there will be a surplus of a hundred thousand workers, that competition will be stimulated, and it will reduce the rate of wages. This is what you see.”

“But what you do not see is this,” Bastiat continued. “You do not see that to throw a hundred thousand workers on the market is to throw into it, at the same moment, the hundred millions of money needed to pay for their labour; that, consequently, the same act which increases the supply of hands increases also the demand.”

The idea of opportunity cost was simple. It was easy to understand once explained. It was powerful. And yet it was often overlooked—and still is. Ever since World War II, the United States has maintained a large military establishment. Many reformers have tried to trim the defense budget by closing this base or that manufacturing facility. But what Eisenhower called the military-industrial complex is clever. It scatters bases around the country and subcontracts assembly to as many congressional districts as possible. Members of Congress defend the Pentagon budget on grounds that it keeps their constituents in jobs. The ghost of Bastiat—who died at 49 in the year his essay was published—retorts that the constituents would lose their existing jobs, but other jobs would be created by the new private spending from the tax cuts made possible by the budget savings.

Opportunity costs are everywhere. Buying a house is expensive, but not as expensive as you might think, given that much of what you save in mortgage payments you’ll pay in rent. College is expensive, and more expensive than you think, given that beyond tuition and living expenses you’ll lose four years of income from the job you’d have.

I have a friend whose grandfather was a thrifty immigrant who made his kids work in the family store even on holiday weekends. He used the opportunity cost argument without the label. He said they were getting paid twice: once in their pay, and again in the money they saved by not blowing it on holiday silliness.

Benjamin Franklin’s Poor Richard was of the same mindset. “A penny saved is a penny earned,” he said.

“Every man is rich or poor according to the degree in which he can afford to enjoy the necessaries, conveniencies and amusements of human life,” Adam Smith wrote.

But how much could a man afford?

Smith is best remembered for his invisible hand, yet he was prouder of his work on the hardest problem of his era in economics: explaining why things cost what they did. Scarcity had something to do with it. Gold was more valuable than silver. But the growing ranks of manufacturers and merchants had to calculate how to price the commodities they produced and traded, for which scarcity offered only partial guidance.

Smith looked to former times. “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,” Smith wrote. “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. It is natural that what is usually the produce of two days or two hours labour should be worth double of what is usually the produce of one day’s or one hour’s labour.”

This gave Smith his start on the labor theory of value. “The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it,” he wrote. “What every thing is really worth to the man who has acquired it, and who wants to dispose of it or exchange it for something else, is the toil and trouble which it can save to himself, and which it can impose upon other people.”

In trade: “The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command.”

David Ricardo was a fan of Smith’s work. He helped transform Smith’s preference for free trade into British law, adding his own pioneering thoughts on comparative advantage. Ricardo extended Smith’s ideas on the labor theory of value.

Ricardo judged that Smith failed to distinguish among different kinds of labor. A man working with sophisticated tools was more productive than a man working with rudimentary ones. Consequently the labor of the former was more valuable.

Ricardo cited Smith’s example of the beaver and the deer. “Suppose the weapon necessary to kill the beaver was constructed with much more labour than that necessary to kill the deer, on account of the greater difficulty of approaching near to the former animal, and the consequent necessity of its being more true to its mark,” Ricardo wrote. “One beaver would naturally be of more value than two deer, and precisely for this reason, more labour would, on the whole, be necessary to its destruction.”

Ricardo proposed to factor the value embedded in the tools and related items into the value of the final commodity. “Not only the labour applied immediately to commodities affects their value, but the labour also which is bestowed on the implements, tools, and buildings, with which much labour is assisted,” he wrote.

Implements, tools and buildings were called capital, and the economic system based on capital was called capitalism. The returns on capital were often accounted differently than returns on labor. Ricardo contended that there was no fundamental difference. Capital was simply the result of a previous generation’s labor.

Karl Marx took this idea and ran with it. By Marx’s day, an industrial working class—a group of people who would always be laboring for wages—was taking clear shape. These workers seemed to Marx, and many others, to be growing more miserable by the year. Marx adapted the work of Smith and Ricardo to explain why.

Marx pressed the point that labor was the source of all value. Yet under capitalism, labor didn’t receive all the value it produced. What Marx called “surplus value” was siphoned off by the capitalist class, which had no moral claim to that value but had captured the government and written laws to give it a legal claim.

Marx called workers the proletariat and capitalists the bourgeoisie. The exploitation of the former by the latter created a struggle that had roots deep in the past. “The history of all hitherto existing society is the history of class struggles,” Marx wrote in 1848 in The Communist Manifesto, coauthored by Friedrich Engels. The struggle between the proletariat and the bourgeoisie was the sharpest of the historic contests, precisely because the bourgeoisie had grown so rapacious in depriving workers of the surplus value of their labor.

Marx added modestly to the economic theory of value but dramatically to the political practice derived from that theory. Indeed, at about the time economists were moving beyond the labor theory of value, Marx gave leftist intellectuals a politicized version with which to wage war against the bourgeoisie in the name of the proletariat.

Whether that war, which eventually installed Marxist regimes in Russia, China and other countries, was in the interest of the proletariat was a wholly different matter.

If Adam Smith had known which part of his published works would make him famous, he would have worded it more carefully. “Every individual necessarily labours to render the annual revenue of the society as great as he can,” wrote Smith in his 1776 Inquiry into the Nature and Causes of the Wealth of Nations, in a passage describing where investors should place their capital for greatest returns. “He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”

Smith had used the metaphor of the invisible hand before, in his other book, The Theory of Moral Sentiments. Here also the point was unintended consequences. He was describing rapacious landlords who thought merely of themselves but nonetheless promoted the public good. “Though they mean only their own convenience, though the sole end which they propose from the labors of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life which would have been made had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.” In this case, Smith seemed to equate the invisible hand with higher powers. “When Providence divided the earth among a few lordly masters, it neither forgot nor abandoned those who seemed to have been left out in the partition.”

Almost two decades separated Smith’s Wealth of Nations from his Theory of Moral Sentiments. By then he had dropped God from the discussion. In another passage commonly quoted, Smith stressed selfishness as an engine of public good. “It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”

Smith could be sharply critical of the kind of people who would come to revere him. “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Yet in this criticism lay the power of his argument. Most people who professed concern for the welfare of common folk appealed to virtue, making provision of the necessities of life a matter of philanthropy. Smith appealed to self-interest and the pursuit of profit, which he and many others considered more reliable.

Smith’s approach lent itself to caricature. Gordon Gekko in the 1987 movie Wall Street riffed rapturously on “greed is good.” Indeed a great deal of the enthusiasm for Smith over the centuries was self-serving: making capitalists feel good about capitalism.

But Smith’s argument wouldn’t have persisted if the underlying mechanism didn’t work. The most productive economies of the last quarter-millennium have been those that relied on the invisible hand of the marketplace. More people got their dinner from the self-regard of the butcher and the baker than from the altruism of any bureaucrat or commissar.

Capitalism has shortcomings. It can degenerate into cronyism when those conspiring tradesmen have their way—or worse, when they capture the government. By its nature capitalism produces inequality. Its emphasis on the bottom line devalues things that can’t be quantified or bought and sold.

But in terms of delivering the greatest economic good to the greatest number of people, no other system has approached the success of capitalism.

Adam Smith didn’t invent capitalism. That was the work of millions of people over decades and centuries.

But he furnished the metaphor that came to summarize the workings of capitalism. And for that he deserves applause— from hands that are audible, if not necessarily visible.