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How an Economy Grows

Mises Daily: Tuesday, November 02, 2010 by

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Since World War II, most economists have been apologists for government growth.[1] Now the "experts" who never see a crisis coming tell us that we must once again abandon free-market principles to save the free-market system.

But there's always the possibility that people not seated at the government's table will finally wise up. Who or what could help them understand what's going on? People need someone to draw a clear picture of what makes an economy thrive — briefly, without jargon, and, most importantly for today's readers, in an entertaining fashion.

Going Hungry for a Day to Eat Better Later

A strong candidate for this task is Peter Schiff and his illustrated book, How an Economy Grows and Why It Crashes, which he coauthored with his brother, Andrew Schiff. Other elementary texts will continue to be effective in conveying economic basics, but the Schiffs have a story to tell, an extension of a tale first developed by their father, Irwin Schiff. There's nothing quite like a story to get people turning the pages. And in this case, the story is made more enjoyable by the creative work of illustrator Brendan Leach.

The authors waste no time getting to the root of economic growth. In the opening chapter, we find three men on an island — Able, Baker, and Charlie — fishing by hand, catching one fish per day each, enough to sustain them until the following day when they head into the surf again. Able gets an idea for an invention that might enable him to catch more than one fish, but when will he have time to build it? He spends all his waking hours working. Nor has he any assurance his invention will work.

One day Able decides to take a chance. He tells the others he will forego fishing for a day to fashion a device he calls a net. They tell him he's crazy, but he goes hungry and succeeds. Using his net, he's able to catch two fish a day, saving one and eating the other. This allows him to spend half as much time fishing and more time working on other ways to improve his life. (In this story, fish don't spoil.)

Schiff augments this narrative with the first of many sidebars he calls a Reality Check. In this one, he points out that Able, in progressing beyond hand-to-mouth existence, was underconsuming and taking a risk.

At the end of this and every other chapter he has a section called Takeaway. What lesson should the reader take from the opening chapter? "By using our natural faculties we can create tools to improve our lives … and to create an economy." No tools, no economy.

Not surprisingly, the other two men want nets but are unwilling to go hungry while they build them. They ask to borrow Able's net on days when he isn't using it. He turns them down. They ask him to loan them fish while they build their nets. He tells them he has no assurance they will succeed. Finally, they propose to borrow fish and pay him back at interest — for every fish he lends them they will pay him back two. If they succeed, everyone will profit. Able accepts their proposal.

The men build their nets, and their economy grows from three fish a day to six, a 100 percent increase.

In another Reality Check, Schiff points out that "the economy didn't grow because they consumed more. They consumed more because the economy grew."

From Barter to Money

As their savings grow, they have more time to undertake other projects. They pool their savings and build a trap that catches 30 fish a week. They never have to fish again. Able starts a clothing company. Baker builds a canoe and a cart, while Charlie constructs a surfboard.

Savings, ingenuity, hard work, risk taking, and prudent lending move the economy upward. The island's prosperity attracts and is able to support immigrants seeking a better life. Some of them borrow fish to clear land for farming. People start offering services, such as cooking and fish-trap maintenance. The economy becomes more diversified.

And as it does, they discover they need a better way to trade their goods or services. A spear maker may want the services of a chef, but the chef may not want any spears. What they need is something that can be traded for anything and that is acceptable to everyone. They need money.

They settle on fish. Not only do fish serve to facilitate trade, they can also be saved for old age and emergencies. Money also allows people to specialize in what they do best. Duffy, for example, can build a canoe with eight fish in savings rather than the ten fish that others require. By charging nine fish per canoe, he makes a profit and his customers save money. Over time, Duffy buys specialty tools with his savings that allow him to build a canoe with only four fish. Duffy doubles his production, and by charging six fish, doubles his profit margin and sells canoes at a more affordable price (six fish instead of nine). A luxury becomes an everyday commodity.

As productivity increased, prices fell, benefiting the producer as well as his customers. Falling prices induce people to save, which swells the amount of capital available for loans. The Keynesian fear of falling prices was yet unknown.

A Middleman between Saver and Borrower

Not everyone on the island is willing to work for a better life. Some of them turn to stealing fish. Seeing an opportunity, an entrepreneur named Max Goodbank decides to open a bank and charge a storage fee for safeguarding people's savings.

With profits scarce from such a service, Max decides to loan out the savings. To entice people to deposit their fish he pays them interest. He charges borrowers a higher rate of interest so he can pay his expenses and earn a profit. Max calls his enterprise the Goodbank Savings and Loan.

"We can either return to gold or we can pursue the fiat path and return to barter."

Max knows that a prosperous economy would increase fish deposits. Interest on loans would then drop, but so would interest paid to depositors. As savings diminished, Max would charge borrowers a higher interest rate. He would also pay depositors a higher rate to encourage more savings, and eventually the loan rate would come down.

The safety and convenience of the bank attracts depositors, and Max is able to finance a huge waterworks project to bring water inland. New pipelines mean previously infertile land can be made into productive farmland. The steady flow of water can be used to harness machines, giving birth to new industries.

The Birth of Government

To settle disagreements and protect themselves from violence, the islanders decide to form a limited government. They elect 12 senators and a senator-in-chief with executive authority. The senate would create a court system to settle disputes and a police squad to enforce the decrees of judges. It would also create and regulate a navy of spear-packing war canoes.

The islanders agree to pay a yearly fish tax to finance the government. To keep the government confined to its assigned responsibilities, they draft a constitution to spell out what it can and cannot do. The constitution protects people from the government and protects minorities from the tyrannies of majorities.

It is widely understood that government could only function because it taxed producers. Government spending therefore was really taxpayer spending, and only taxpayers could vote. The new country is called Usonia.

As generations pass, the island's economy continues to flourish. Then one day some creative senators decide the original constitution was undemocratic in allowing only taxpayer suffrage. The restriction is removed, and on election day the polls are crowded with people who don't care much for government austerity.

The Birth of the Free Lunch

It isn't long before an ambitious senator named Franky Deep comes along with a radical idea. Franky loves power, and the way to get it in politics is to promise voters free stuff. But how could he carry it off? Government can only give by first taking.

After breezing into office as senator-in-chief, he comes up with an idea for giving away more than government has. To pay for his spending plans, Franky decides to issue government paper money — Fish Reserve Notes — that can be redeemed for actual fish stored at the Goodbank. Citizens could now use either the fish or the notes in trade.

The island's chief judge points out that the Constitution didn't authorize Franky to issue paper notes for fish. Franky solves the problem by firing the judge. In his place he puts one of his political buddies, who views the Constitution as "a living document" subject to reinterpretation at the discretion of the chief judge.

Though uncomfortable with paper money at first, the citizens begin to like it because it is more convenient to carry. Those who redeem their notes for fish suspect they are not as big as the original fish deposited, but comparing them is outlawed, so no one knows for sure.

With a more progressive judge in office, Franky's people find more spending projects for the government to undertake. All they need is enough support from potential voters. The new notes were the miracle solution.

"Once the savers on the island realize that there is really no safety in bank deposits, they'll stop saving! … Our whole economy could collapse!"
Max Goodbank VII

Taxpayers are pleased because the spending doesn't require tax hikes, progressives love it because government is showing it "cares," and politicians feel relieved because they don't have to balance their budgets. The only potential problem is economists, who might see the subtle theft taking place, but that is solved by cutting them in on the deal with research grants and jobs.

Eventually, bank president Max Goodbank VII starts making noise about government legerdemain. Franky replaces him with Ally Greenfin, and Goodbank Savings and Loan becomes the Fish Reserve Bank. The modern world is born.

The Fate of Usonia

The Schiffs are only getting started, and to see how the former laissez-faire economy of Usonia ends up you will find no better source than the book itself. Though the story illustrates critical economic fundamentals, the authors carry it off with elegant infusions of humor. Some examples: Franky Deep, Jim W. Bass, and Barry Ocuda as chief executives, the "Carp for Carts" program, Finnie Mae and Fishy Mac, Hank Plankton as the head fish accountant, and my favorite, Brent Barnacle, who becomes Ally Greenfin's replacement and promises to drop notes from palm trees if needed. Peter Schiff even pokes fun at himself, making reference to Piker Skiff, TV's comic relief man, who warns of the pending hut collapse.

The Schiffs add a touch of satire when Barnacle tells a conference that Usonia's policy of sending Fish Reserve Notes to the island of Sinopia in exchange for fish and goods is merely the latest development in economic specialization. With their voracious appetites, Usonians "had a comparative advantage in consuming," while Sinopians were tops in the areas of savings and manufacturing things.

Many otherwise-good stories founder with forgettable endings. But I suspect the final two lines of this story will stay with you forever.

Given the critical role of money in an economy, including the economy of Usonia, I would've preferred to see a more detailed development of how the island economy moved from barter to money. The authors tell us on page 52 that because "everyone on this island ate fish, it was decided that fish would serve as money." Though I'm aware of the authors' free-market convictions, the wording left me wondering if the decision was done by a committee rather than the market.

People who find anything related to economics tedious will find the Schiff book an exciting discovery. It should have special appeal to Austrians at all levels of expertise, while the Keynesian wizards who laughed at Peter Schiff when he predicted the housing collapse will likely disdain it.

It might be the only economics book ever written that could be read aloud to one's family without putting them to sleep. The narrative never once lags or becomes academic. The authors manage to convey the critical concepts without straying from their "Connecticut straight-talk" approach.

The Schiffs' tale of Usonia would make an excellent text for a "pre-economics" course, as a way of burning in the basics and of showing how they apply to the US history of the past 100 years. Precalculus is a requirement for premed, as one of my daughters has discovered. A "pre-econ" class featuring How an Economy Works and Why It Crashes would make it clear how government interventions operate in diametric opposition to the medical principle of primum non nocere ("first, do no harm"), with predictable results.

The Schiffs have hit one out of the park. I'm already introducing parts of their book to my five-year-old grandson — who enjoys fishing.

Notes

[1] See also, "Economists Opposing Fed Audit Have Undisclosed Fed Ties" by Ryan Grim, and "The Gold Standard in Contemporary Economic Principles Textbooks: A Survey" by James Kimball.Download PDF See the list of prominent economistsDownload PDF who signed the petition opposing the Fed audit.