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Four Hundred Years of Dynamic Efficiency

Mises Daily: Friday, January 08, 2010 by

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[This speech was given at the Mises Institute's Supporters Summit 2009: "The Birthplace of Economic Theory: A Trip to Salamanca, Spain." ]

Jesus Huerta de Soto
Jesus Huerta de Soto

Thank you very much for your kind introduction. It is for me a great honor and privilege to be here today; first of all, I would like to thank the Mises Institute and Professor Gabriel Calzada for inviting me to come to Salamanca to speak about "The Theory of Dynamic Efficiency" in this marvelous city.

I will divide my presentation into three parts. First, I will speak about the Spanish roots of Austrian economics; second, I will introduce, following the Austrian tradition, a dynamic concept of economic efficiency; and third, I will try to demonstrate the intimate relationship that exists between ethics and efficiency in the capitalist system.

Now let me begin by making a few points on the true origin of the Austrian School of economics, which should be traced back to the works of the Spanish Scholastics of what is known as the "Siglo De Oro Espanol" (the "Spanish Golden Age"), which ran from the mid-16th century through the 17th century. In 1974, the great Austrian scholar Murray N. Rothbard first developed the thesis that the Austrian School is of Spanish origin. The Nobel prize winner Friedrich von Hayek shared this view, particularly after meeting Bruno Leoni, the Italian scholar and author of the book, Freedom and the Law. The two met in the 1950s, and Leoni convinced Hayek that the intellectual origins of classical economic liberalism lay in Mediterranean Europe and not in Scotland.

I have here a letter from Hayek dated January 7, 1979, in which Hayek writes that Rothbard "demonstrates that the basic principles of the theory of the competitive market were worked out by the Spanish Scholastics of the 16th century and that economic liberalism was not designed by the Calvinists but by the Spanish Jesuits." Hayek concludes his letter by telling us, "I can assure you from my personal knowledge of the sources that Rothbard's case is extremely strong."

Now, who were these Spanish intellectual ancestors of the modern free-market movement? Most of them were scholastics teaching morals and theology here at the University of the City of Salamanca. These scholastics were mainly either Dominicans or Jesuits, and they were able to articulate the subjectivist, dynamic, and libertarian tradition that, 250 years later, was to be stressed by Carl Menger and his followers in the Austrian School of economics. Let us recall some of these early scholastics' main contributions.

Perhaps the first author to be mentioned should be Diego de Covarrubias Y Leyva. Covarrubias, the son of a famous architect, was born in 1512; and he became bishop of the city of Segovia and Minister of King Philip II. If you have the opportunity to visit the city of Toledo, I recommend you tour the museum of the great Spanish painter El Greco. There you will see a stunning portrait of Covarrubias, who, in 1554, set forth better than anyone before him the subjectivist theory of value, which is the foundation of all free-market principles.

Specifically, Covarrubias concludes that "the value of an article does not depend on its essential nature but on the subjective estimation of men, even if that estimation is foolish." He adds that "in the Indies wheat is dearer than in Spain because men esteem it more highly, though the nature of the wheat is the same in both places."

Another important author is Luis Saravia de la Calle, who was the first Spanish Scholastic to demonstrate that prices determine costs, not vice versa. Saravia de la Calle also has the special merit of having written his main work in Spanish, not in Latin. Its title is Instruccion De Mercaderes (Instruction to Merchants), and there we read that "those who measure the just price by labor, costs, and risk incurred by the person who deals in the merchandise are greatly in error. The just price is found not by counting the cost, but by common estimation."

Saravia de la Calle is also a great critic of fractional-reserve banking. He maintains that receiving interest from a bank is incompatible with the nature of a demand deposit and that, in any case, a fee should be paid to the banker for the custody and safekeeping of the money entrusted to him.

A similar conclusion is reached by another famous Spanish scholastic, Martin Azpilcueta. Azpilcueta was also known as Dr. Navarro, because he was born in Navarra, the northeastern autonomous region of Spain famous for the Encierros, a festival held in the region's capital city of Pamplona, where every July people run in front of the bulls at great risk to their lives. Azpilcueta was born the year following the discovery of America (1493), lived to be 49 years old, and is especially famous for explaining the quantity theory of money for the first time, in 1556. Azpilcueta observed the effects on Spanish prices of the massive inflow of precious metals from America and declared,

Experience shows that in France, where there is less money than in Spain, bread, wine, cloth, and labour cost much less; and even when there was less money in Spain, saleable items and the labour of men were given for much less than after the Indies were discovered and covered Spain with gold and silver. The reason is that money is worth more when and where it is scarce than when and where it is abundant.

The Spanish scholastics also gained a clear insight into the true nature of market prices and the impossibility of attaining an economic equilibrium. The Jesuit Cardinal Juan de Lugo, wondering what the equilibrium price was, as early as 1643 reached the conclusion that the equilibrium depends on such a large number of specific circumstances that only God can know it. In Latin, he stated, "Pretium Iustum Mathematicum Licet soli Deu notum." Another Jesuit, Juan de Salas, with regard to the possibility that an authority could come to know the specific information of the market, asserted that the market is so complex that, in Latin, "Quas Exact Comprehendere et ponderare Dei est non hominum." ("That only God, not men, can understand it exactly.")

Furthermore, the Spanish scholastics were the first to introduce the dynamic concept of competition (in Latin, concurrentium), which is best understood as a process of rivalry among entrepreneurs. For instance, Jeronimo Castillo de Bovadilla (1547–?) wrote that "prices will go down by an abundance of sellers, and by rivalry and competition among them."

Like Ludwig von Mises, Friedrich von Hayek, and most members of the Austrian School, who are naturally prone to be classical liberals, the subjectivist Spanish scholastics tended to defend strong libertarian positions in political matters. For instance, the founder of international law, the Dominican Francisco de Vitoria, whose burial site we visited yesterday, began the Spanish scholastic tradition of denouncing the conquest and particularly the enslavement of the Indians by the Spanish in the New World, thus reviving the idea that natural law is morally superior to the mere might of the State.

This natural law was further developed by the great libertarian Jesuit Juan de Mariana, who gives the name to our institute. In his book, On the Alteration of Money, (In Latin, De Monetae Mutatione), published in 1609, condemns as robbery any government debasement of coins. Mariana also maintained in his well-known theory on tyrannies that any individual citizen can justly assassinate a governor who imposes taxes without the people's consent, seizes the property of individuals and squanders it, or prevents a meeting of a democratic parliament.

Now, let me remind you that in the 16th century, the Emperor Charles V, who was the King of Spain, sent his brother Ferdinand I to be the King, or better, the Archduke, of Austria. Etymologically, "Austria" means "Eastern part of the Empire." The Spanish Empire in those days comprised almost all of continental Europe, with the sole exception of France, which remained an island surrounded by Spanish forces. Now you will understand the origin of the intellectual influence the Spanish scholastics exerted on the Austrian School.

This was not pure coincidence or a mere whim of history, but originated from the intimate historical, political, and cultural relations that arose in the 1500s between Spain and Austria and which would continue for several centuries. Italy also played an important role in this connection, acting as a cultural, economic, and financial bridge over which the relations between the two furthest points of the Empire (Spain and Austria) flowed. So, as you see, there are very strong arguments to support the thesis that, at least at its roots, the Austrian School is a truly Spanish school.

Indeed, I think the greatest merit of the founder of the Austrian School, Carl Menger, was to rediscover and take up this continental Catholic tradition of Spanish scholastic thought, which was almost forgotten due to the negative influence of Adam Smith and his followers of the British Classical School. To quote Professor Leland Yeager in his "Review" of Rothbard's last book on the history of economic thought,

Adam Smith dropped earlier contributions about subjective value, entrepreneurship and emphasis on real-world markets and pricing and replaced it all with a labour theory of value and a dominant focus on the long run "natural price" equilibrium, a world where entrepreneurship was assumed out of existence. Adam Smith mixed up Calvinism with Economics, as in supporting usury prohibition and distinguishing between productive and unproductive occupations. Adam Smith lapsed from the laissez-faire of several eighteenth-century French, Italian and Spanish economists, introducing many waffles and qualifications. And Smith's work was unsystematic and plagued by contradictions.

Fortunately, despite the overwhelming intellectual imperialism of the British Classical School, the continental, subjectivist, free-market tradition was never totally forgotten. Several economists, like Cantillon, Turgot, and Say, kept the torch of subjectivism and entrepreneurial analysis burning. Even in Spain, during the years of decline in the 18th and 19th centuries, the old scholastic tradition survived, in spite of the typical inferiority complex toward the British intellectual world at that time.

"Mainstream neoclassical economics developed as a pure copy of 19th-century mechanical physics…"

We find proof of this in that another Spanish Catholic writer solved the "paradox of value" and clearly set forth the theory of marginal utility 27 years earlier than Carl Menger did. His name was Jaime Balmes.

Balmes was born in Catalonia in 1810 and passed away in 1848. During his short life, he became the most important Spanish Thomistic philosopher of his time. A few years before his death, on September 7, 1844, he published an article entitled "True Idea of Value or Thoughts on the Origin, Nature and Variety of Prices," in which he solves the paradox of value and clearly sets forth the idea of marginal utility. Balmes asks himself, "Why is a precious stone worth more than a piece of bread?" And he answers,

It is not difficult to explain, since the value of a thing is determined by its utility.… If the number of means of satisfying a need increases, the need for any one of them in particular decreases; as it is possible to choose among many, none of them is indispensable. For this reason, a necessary relationship exists between an increase or decrease in value, and the shortage or abundance of a thing.

In this way, Balmes was able to close the circle of the continental Catholic tradition of subjectivism, which could then be completed a few years later by Carl Menger and enhanced by his followers in the Austrian School of economics.

We can conclude that to a large extent, we owe to these great thinkers of the "Spanish Golden Age" the current revival of free-market liberalism, and of the Austrian School of economics all over the world.

The Austrian Concept of Dynamic Efficiency

Now let us proceed with the second part of my presentation. I am going to criticize the mainstream, static concept of economic efficiency, which I propose to replace with a typically Austrian concept of dynamic efficiency.

The term "efficiency" derives etymologically from the Latin verb ex facio, which means "to obtain something from." The application to economics of this concept of efficiency as the ability to "obtain something from" predates the Roman World and can even be traced back to ancient Greece, where the term Oeconomia was first used to refer to the efficient management of the family home.

Now, let us remember that Xenophon, in his work on Economics, written 380 years BC, explains that there are two different ways to increase the family estate; each of his ways is equivalent to a different concept of efficiency. The first corresponds with the static concept of efficiency and consists of the sound management of the available (or "given") resources, to prevent them from being wasted. According to Xenophon, the best way to achieve this static efficiency is by keeping the home in good order.

However, along with the concept of static efficiency, Xenophon introduces a different concept, that of "dynamic" efficiency, which consists of the attempt to increase one's estate through entrepreneurial creativity — that is, by trade and speculation more than by the effort to avoid wasting the resources already available. This tradition of clearly distinguishing between the two different concepts of efficiency, the static and the dynamic, survived even until the Middle Ages. For example, Saint Bernardine of Siena wrote that the profits of merchants were justified not only by the sound management of their (already given) resources but also, and mainly, by the assumption of the risks and dangers (in Latin, pericula) that arise from any entrepreneurial speculation.

Unfortunately, the development of mechanical physics, which began with the Modern Age, had a very negative influence on the evolution of economic thought, especially after the 19th century, when the idea of dynamic efficiency was almost entirely forgotten in economics.

Both the Austrian Hans Mayer, before the Second World War, and Philip Mirowski, nowadays, have stressed that mainstream neoclassical economics developed as a pure copy of 19th-century mechanical physics: using the same formal method but replacing the concept of energy with that of utility and applying the same principles of conservation, maximization of the result, and minimization of waste. The author most representative of this very negative trend was Leon Walras, who, in his 1909 paper, "Economics and Mechanics," claimed that the mathematical formulas of his book Elements of Pure Economics were identical to those in mathematical physics.

In short, the influence of mechanical physics eradicated the creative, speculative, and dynamic dimension that was implicit in the idea of economic efficiency from its very beginning, and all that remained was the reductionist, static aspect, which consists solely of minimizing the waste of (already known or given) economic resources. This change occurred despite the fact that neither resources nor technology are "given" in real life, but vary continually as a result of entrepreneurial creativity.

The reductionist concept of static efficiency had an immense theoretical and practical influence in the 20th century. The Fabian socialists Sydney and Beatrice Webb provide a good example. This married couple were shocked by the "waste" they believed was produced in the capitalist system, and they founded the London School of Economics in an effort to champion the socialist reform of capitalism. The object of such socialist reform would be to eliminate waste and make the economic system "efficient." The Webbs later made no secret of their warm admiration for the "efficiency" they believed they observed in Soviet Russia, to the point that Beatrice even declared, "I fell in love with Soviet Communism."

Another noted author entirely influenced by the static concept of economic efficiency was John Maynard Keynes himself, who, in his introduction to the 1936, German edition of his General Theory expressly states that his typically Keynesian economic-policy proposals "are more easily adapted to the conditions of a totalitarian state." Keynes also highly praised the book Soviet Communism, which Sidney and Beatrice Webb had published three years earlier.

"Neither resources nor technology are "given" in real life, but vary continually as a result of entrepreneurial creativity."

Furthermore, in the 1920s and 1930s, the static concept of economic efficiency became the focal point for a whole new discipline, which came to be known as "welfare economics," and which grew from alternative approaches, of which the Pareto approach is the most well known.

From a Paretian perspective, an economic system is in a state of efficiency if no one can be made better off without making someone else worse off.

Our main criticism of welfare economics is that it reduces the problem of economic efficiency to a simple mathematical problem of maximization, in which all the economic data are assumed to be given and constant. However, both assumptions are entirely wrong: the data are continually changing as a result of entrepreneurial creativity.

And precisely for that reason, we need to introduce a new concept, that of dynamic efficiency, understood as the capacity to foster entrepreneurial creativity as well as coordination. In other words, dynamic efficiency consists of the entrepreneurial capacity to discover profit opportunities as well as the capacity to coordinate and overcome any social maladjustments or discoordinations.

In terms of neoclassical economics, the goal of dynamic efficiency should not be to move the system toward the production-possibility frontier, but rather to enhance entrepreneurial creativity, and thus to continually "shift" the production-possibility curve to the right.

The word "entrepreneurship" derives etymologically from the Latin term in prehendo, which means "to discover," "to see," "to realize" something. In this sense, we may define entrepreneurship as the typically human ability to recognize opportunities for subjective profit that appear in the environment and to act accordingly to take advantage of them.

Entrepreneurship therefore involves a special alertness, the ability to be watchful: vigilant. Also fully applicable to the idea of entrepreneurship is the verb "to speculate," which comes from the Latin word specula, which refers to the towers from which lookouts could see into the distance to detect anything that approached.

Every entrepreneurial action not only creates and transmits new information, but also coordinates the previously discoordinated behavior of economic agents. Whenever someone discovers or creates a profit opportunity and buys a certain resource cheap and sells it dear, he harmonizes the previously discoordinated behavior of the owners of the resource (who very probably were squandering and wasting it) with the behavior of those in need of that resource. Therefore, creativity and coordination are two sides of the same (I would say, "entrepreneurial") coin.

Now, from a dynamic standpoint, an individual, a company, an institution, or even an entire economic system will be more efficient the more it promotes entrepreneurial creativity and coordination.

And from this dynamic perspective, the truly important goal is not so much to prevent the waste of certain means considered known and "given" as it is to continually discover and create new ends and means.

For a more extensive treatment of this entire matter, I recommend to you the principal works of Mises, Hayek, Kirzner, and Rothbard on the idea of the market as a dynamic process driven by entrepreneurship and on the notion of competition as a process of discovery and creativity.

In my opinion, these "Austrian" authors provide us with the most exact concept of dynamic efficiency, which contrasts with the more imperfect concept of dynamic efficiency developed by both Joseph A. Schumpeter and Douglas North.

North and Schumpeter offer totally opposite perspectives. While Schumpeter exclusively considers the aspect of entrepreneurial creativity and its destructive power (which he calls the process of "creative destruction"), Douglas North concentrates on the other aspect, which he calls "adaptive efficiency," or the coordinating capacity of entrepreneurship. Now we see that the true Austrian concept of dynamic efficiency, that developed by Mises, Hayek, and Kirzner, combines both the creative and coordinating dimension, which Schumpeter and North studied only in a separate, partial, and reductionist manner.

Dynamic Efficiency and Ethics

And now, third and finally, let us concentrate on the intimate relationship that exists between ethics and the concept of dynamic efficiency, which I have just presented. Mainstream neoclassical economic theory rests on the idea that information is objective and given (either in certain or probabilistic terms), and that the issues of utility maximization have absolutely no connection with moral considerations.

Furthermore, the dominant, static viewpoint led to the conclusion that resources are in a sense given and known, and therefore that the economic problem of their distribution was separate and different from the issue of their production. Granted, if resources are given, it is vitally important to inquire into the best way to allocate among different people both the available means of production and the consumer goods that result from them.

This whole approach collapses like a stack of cards if we adhere to the dynamic concept of market processes, the theory of entrepreneurship, and the notion of dynamic efficiency I have just explained. From this perspective, every human being has a unique creative capacity that continually enables him to perceive and discover new profit opportunities. Entrepreneurship consists of the typically human ability to create and discover new ends and means, and is the most important characteristic of human nature.

If ends, means, and resources are not given but continually created from nothing as a result of the entrepreneurial action of human beings, clearly the fundamental ethical problem is no longer how to justly distribute what already exists, but instead, how to promote entrepreneurial creativity and coordination.

Consequently, in the field of social ethics, we arrive at the fundamental conclusion that the idea of human beings as creative and coordinating actors implies the axiomatic acceptance of the principle that every human being has a natural right to appropriate all results of his entrepreneurial creativity. That is, the private appropriation of the fruits of entrepreneurial creation and discovery is a tenet of natural law.

And it is a tenet of natural law because if an acting person were not able to claim what he creates or discovers, his capacity to detect profit opportunities would become entirely blocked, and his incentive to act would disappear. Moreover, the principle is universal in the sense that it can be applied to all people at all possible times and in all conceivable places.

"From this dynamic perspective, the truly important goal is not so much to prevent the waste of certain means considered known and "given" as it is to continually discover and create new ends and means."

To coerce free human action to any degree by impairing people's right to own what they entrepreneurially create is not only dynamically inefficient, since it obstructs their creativity and coordinating capacity; it is also fundamentally immoral, since such coercion prevents human beings from developing that which is by nature most essential in them, i.e., their innate ability to create and conceive new ends and means to attempt to achieve their own goals and objectives. Precisely for these reasons, not only socialism and interventionism but also any form of statism are not only dynamically inefficient but also ethically unjust and immoral.

It must be taken into account that the force of entrepreneurial creativity also manifests itself in the desire to help poor people and in the systematic search for situations in which others are in need, in order to help them. In fact, coercive state intervention, through the typical mechanisms of the so-called "welfare state" neutralizes and to a great extent blocks the entrepreneurial effort to help one's neighbors (both close and distant) who are experiencing difficulties. And this is an idea that, for instance, Pope John Paul II stressed in Section 49 of his 1991 Encyclical, Centesimus Annus.

Furthermore, according to our analysis, nothing is more (dynamically) efficient than justice (understood in its proper sense). If we think of the market as a dynamic process, then dynamic efficiency, understood as coordination and creativity, results from the behavior of human beings who follow certain moral laws (mainly regarding the respect for life, private property, and the fulfillment of contracts.)

Only the exercise of human action subject to these ethical principles gives rise to dynamically efficient social processes. And it is now easy to see why, from a dynamic standpoint, efficiency is not compatible with different models of equity or justice (contra the second fundamental theorem of welfare economics), but instead efficiency arises only from one idea of justice (that based on the respect for private property, entrepreneurship, and as we will see in a moment, also the principles of personal morality). Therefore the contradiction between efficiency and justice is plainly false.

What is just cannot be inefficient, and what is efficient cannot be unjust. A dynamic analysis reveals that justice and efficiency are but two sides of the same coin, which also confirms the consistent, integrated order that exists in the spontaneous social universe of human interactions.

Now, let us conclude with some ideas on the relationship between dynamic efficiency and the principles of personal morality, especially in the field of family and sexual relations.

Up to this point, we have looked at social ethics and discussed the key principles that provide the framework that makes dynamic efficiency possible. Outside of that realm lie the most intimate principles of personal morality. The influence of principles of personal morality on dynamic efficiency has rarely been studied, and in any case, they are considered to be separate and different from social ethics. However, I believe this separation to be completely unjustified.

In fact, there are moral principles of great importance to the dynamic efficiency of any society, which are subject to the following apparent paradox: the failure to uphold them on a personal level entails a huge cost in terms of dynamic efficiency, but the attempt to impose these moral principles using the force of the state generates even more severe inefficiencies. Hence, certain social institutions are needed to transmit and encourage the observance of these personal moral principles, which by their very nature cannot be imposed by violence and coercion but are nevertheless of great importance to the dynamic efficiency of every society.

It is mainly through religion and the family that human beings, generation after generation, are able to internalize these principles and thus learn to keep them and transmit them to their children. The principles that relate to sexual morality, the creation and preservation of the family institution, the faithfulness between spouses and the care of children, the control of our atavistic instincts, and the overcoming and restraint of envy, are all of crucial importance to every successful social process of creativity and coordination.

As Hayek taught us, both the progress of civilization and economic and social development require a constantly expanding population capable of sustaining, among a continually increasing number of people, the steady growth in the volume of social knowledge that entrepreneurial creativity generates. Dynamic efficiency depends on people's creativity and capacity for coordination, and, other things being equal, it will tend to increase as the number of human beings increases, which can only happen within a certain framework of moral principles to govern family relationships.

However, as I have already stated, this is a kind of paradox. The entire framework of personal moral principles cannot be imposed by violent coercion. The imposition of moral principles by force or coercion would only give rise to a closed, inquisitorial society depriving human beings of individual freedoms, which comprise the foundation of entrepreneurship and dynamic efficiency.

This fact precisely reveals the importance of alternative, noncoercive methods of social guidance that expose people to the most intimate and personal moral principles and encourage their internalization and observance.... We can conclude that, other things being equal, the firmer and more enduring a society's personal moral principles are, the greater its dynamic efficiency will tend to be.

Thank you very much for your patience and attention.