Rule No. 2

The law of supply and demand is one of the great natural forces of the universe, as ineluctable as gravity. Unhappily for the world, the law—like Rodney Dangerfield and unlike gravity—gets no respect. Nobody would jump out a tenth-story window without intending to die. But a great many people, from historians to elected officials, ignore the law of supply and demand or simply declare it null and void to suit their purposes. Regardless, the law works its way inexorably.

In the case of the necklace and the mansion, the supply of mid-Manhattan land is fixed. There is just so much of it, and that is that. The Dutch made the greatest real estate deal in history when they bought the whole island for trinkets and blankets valued at sixty Dutch gulden. (An excellent example, by the way, of the difficulty of translating the value of money over time: What are sixty Dutch gulden of 1626 worth in today’s dollars? Tradition has said twenty-four for many generations.) Because the demand for Manhattan real estate has been rising ever since that time, the price has been rising steadily as well.

The supply of quality pearls, on the other hand, has increased manyfold since cultured pearls were developed at the close of the nineteenth century and widely promoted after the First World War. At the same time, the demand for them has decreased since the end of the Gilded Age, when grandes dames favored wearing pearls by the yard. Because of increasing supply and diminishing demand, the price of pearls peaked in 1929 and has been in decline ever since.

The law of supply and demand is so fundamental to understanding why things cost what they do that it even explains the most significant economic event since the invention of agriculture: the Industrial Revolution. Before the coming of the steam engine, it was difficult for the economy to put energy to work. There was plenty of energy, with wood and coal in abundance, but it couldn’t be used for anything much beyond producing heat. Real work—even in the strict physical sense of transferred motion—could be done only by wind, falling water, animals, and human beings. But wind and falling water are erratic and often are not found where they are needed. Animals and people require expensive fuel and maintenance.

Then James Watt’s rotary steam engine converted the heat energy of coal and wood into a higher form that could do work. Suddenly there was a way to add massive amounts of energy to the economic system very cheaply. The price of work-doing energy collapsed with the vastly increased supply, and demand soared as the price fell. Entrepreneurs unleashed a flood of inventions to make use of the newly available resource.

Because energy is one of the fundamental inputs of any economic system, the price of nearly all commodities, especially manufactured ones, declined significantly with the decline in the cost of energy. The economic universe was turned upside down in only two generations.

The consequences of the Industrial Revolution continue to work themselves out in the marketplace to this day. Among these consequences are some that the historian must deal with in trying to translate the value of money over time.

The first of these is rapidly rising real wealth. Before the rotary steam engine, economies necessarily grew slowly, only about 1 percent a year. Without powered mechanical equipment, physical capital—such as new fields and pastures for agriculture, new factories and mills for industry, and new roads and canals for transportation—could be created only very slowly. Virtually all products for consumption were handmade as well. Once the Industrial Revolution had begun, however, economies affected by it grew much more rapidly, averaging about 4 percent a year.

This accelerated growth has had profound consequences for simple arithmetical reasons. Growing at 1 percent a year, an economy will double its production in seventy-two years. At a 4 percent growth rate, however, an economy will be sixteen times as productive in seventy-two years. Such is the magic of compounding. (See “The Rule of 72” on page 62.)

Inflation, therefore, is by no means the only reason you need so much money to be rich nowadays. Equally important, real wealth and income —not just the illusion of them produced by inflation—have been rising very steeply for all levels of society since the Industrial Revolution. Many things that were once thought the distinguishing privileges of the rich, such as ample living space, fine clothes, private transportation, education, and professional entertainment, are now regarded as the ordinary perquisites of middle-class life.