How an Economy Grows and Why It Crashes: Why is this important?
The book demonstrates why governments should not interfere with market forces.
Let's see what happens in the story:
On an island live three people named Able, Baker and Charlie - who go fishing,
every day, for one fish - which they eat that same day.
No fish are saved, and no investment is made to improve their ability to catch more fish,
which would give them more free time.
Able makes a net, giving up one day of fishing.
Because he took the risk of not eating for one day, Able can now catch 2 fish, every day.
Since, in our story, the fish don’t spoil - Able is the first on the island to create savings.
Reality check:
The possibility of using tools,
alongside reduced consumption and risk taking, creates financial wealth.
Baker and Charlie see that Able now catches two fishes a day.
They also want to have more fish - and more free time.
The only way they can achieve this, is by producing their own fishing net.
In order to spend the day building nets and not fishing,
they each take a loan of one fish from Able.
Now, they each have one net, and Able has gained two fish - without working at all.
The reason that Able helped Baker and Charlie was that he made a profit
- not that he cared about his friends.
This example demonstrates how, as a result of the risk Able took,
the standard of living of all of the people on the island was increased.
Able was motivated by a purely capitalist interest, which helped all of the island’s residents.
Reality check:
This is how the first investment and loan system was created on the island,
a system which increased production and boosted the economy - allowing greater consumerism.
Over time, Able, Baker and Charlie built a trap that allowed them to catch 20 fish per day,
with almost no effort at all.
Building the fish trap allowed the people on the island to save for hard times ahead,
and for investments.
Over the centuries different specialties developed which allowed the island dwellers to increase their standard of living.
Each person became skilled at something which allowed him to maximize his profits:
building huts, building boats, transferring fish from the sea to people's huts, cooking fish, and more.
Of course, increased profit isn't only expressed in terms of money.
When money was invested to increase the production capabilities of a particular business,
production increased, and the cost decreased.
For example, instead of carrying the fish from the sea to the huts in his hands,
one of the island dwellers decided to build a wheelbarrow.
Increasing his efficiency enabled the deliveryman to transport more fish at a time.
This allowed him to reduce the price of transporting the fish to the huts,
which benefitted the fishermen,
while still earning more than he would have earned if he had continued to carry the fish in his hands.
As a result of specialization and investments, the price of most products went down,
allowing even the less wealthy people to buy more.
This reduction in prices is called deflation. Deflation is a natural market process.
As the amount of fish in savings increased, the fishermen started to run out of room.
Max Goodbank decided to open a fish bank.
The bank set a low interest rate for secure loans and higher rates for riskier loans, if they were granted.
Reality check:
When a bank gives a loan, it gives the loan according to parameters related to profit,
and not according to political interests.
Since there were ongoing disputes and fights between the island dwellers
which couldn’t be resolved peacefully,
they decided to dedicate a small percentage of their income to a police force,
a judicial system and elected officials.
Reality check:
Since the government services were paid for by the manufacturers, they were very limited at first.
Today, government monopolies control entire industries.
After several hundred years the island was flooded, which caused financial hardships for some of its residents.
As a result, the island dwellers elected a government official who promised to improve the economy by investing public money.
In addition, he decided to replace the fish with a banknote whose value was equivalent to that of one fish.
However, in the interest of jumpstarting the economy, too many public projects were started,
and the official began to run out of fish.
To hide the problem, he decided to issue more banknotes
- even though he was creating more banknotes than the number of fish being kept by the bank.
Worse, a significant number of investments were made out of political considerations, and not financial ones;
production was not increased, harming future production and consumption.
Reality check:
Gold, used for trade throughout human history,
was replaced with banknotes printed by the government.
Bad financial investments and the over-printing of money led to inflation,
a decrease in the value of the money.
One day, the island dwellers discovered that on the neighboring island people were still catching fish by hand.
The ruler of the neighboring island decided to send fish to trade for banknotes, to allow trade between islands.
This may sound strange, but trade between islands in general was based on competitive advantage - meaning,
each island produced the item that was cheapest for it to make, and traded for products it did not produce.
For example, one island specialized in making nets, and the other, in making drums - this way,
each island had more merchandise at low cost.
Reality check:
China produces merchandise at low cost and exports to the United States in exchange for the universal banknote - the dollar.
The problem is that production in the U.S. is declining steadily, and you can't consume more without producing more.
Most of the jobs related to production moved to the neighboring island, since the people there could be paid with banknotes.
People spent more, because the value of their money decreased instead of increasing.
They preferred to spend the money as soon as they earned it, and didn’t invest in savings.
This created a new industry: a service industry, which replaced the production industry.
People on the island spent their free time surfing.
Therefore, a need was created for more people to sell surfboards in stores and teach surfing in schools:
the surfboards themselves were being made on the neighboring island and paid for in banknotes,
so there was no need for production.
Reality check:
Since the export industry in the U.S. keeps decreasing, the main industry became a service industry,
based on going to college, mall shopping, and increased consumerism - all of which increase debt.
Because the people on our island live in huts and the service industry didn’t require very high investments,
there was nothing to invest the fish in. As a result, the bank decided to grant loans to people who wanted to buy a hut.
For the bank, this was a low risk loan: if the loan wasn’t being paid back, the bank could seize the hut.
Over time, instead of paying for a hut with the fish they had saved,
people took out bigger and bigger loans to buy bigger and bigger huts.
People who had a hard time buying a hut received a grant from the government.
Social pressure and government encouragement to get a degree in surfing caused many young people to study surfing -
but this didn’t result in an increase in production, or a decrease in the price of the surfboards.
Reality check:
Again, these investments didn’t boost the economy or increase production capabilities,
but rather, increased the amount of public debt.
Eventually, sales of huts dropped off. There were no new buyers in the market,
but there were plenty of sellers!
Now, instead of profiting from their investment, the owners of the huts were struggling to repay the loans they took.
Reality check:
The housing market crash in our story is the subprime mortgage crisis.
Instead of allowing the economy to recover, the government tried to give incentives to buy a hut.
In addition, it created projects which were unnecessary from a business point of view
- such as building a lighthouse far from sea - so that unemployment on the island would stay low.
These investments only made the financial situation worse.
In contrast, the ruler of the neighboring island decided to change his policy.
Instead of exchanging fish for banknotes and leaving his citizens hungry,
he decided to focus on internal trade and stop exporting products.
Reality check:
The U.S. dollar is the global trade currency, but its value is decreasing.
Once demand for the dollar drops, its value will crumble.
To summarize:
The story illustrates how instead of investing in production,
the government today is investing in political interests with money that it doesn’t really have - as a result,
not only is the economy not thriving, consumer debt is rising.
What do you think of Peter Schiff's outlook on the global economy?
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