Review: How an Economy Grows and Why It Crashes

How an Economy Grows and Why It Crashes, by Peter D. Schiff and Andrew J. Schiff. Hoboken, NJ: Wiley, 2010. 256 pp. $19.95 (hardcover).

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Very few economists predicted an economic catastrophe in 2007. Even following the crash, many continued to claim that our present economic course was fine. As for today? “Three years into the mess, economists now offer remedies that strike most people as frankly ridiculous. We are told that we must go deeper into debt to fix our debt crisis, and that we must spend in order [to] prosper” (pp. xi–xii).

The source of such seeming obliviousness, according to Peter and Andrew Schiff, is the early-20th-century economist John Maynard Keynes. According to the Schiffs, Keynes taught that governments could smooth market volatility, increase employment, boost growth, and raise living standards simply by going into more debt and printing more money. Although they grant that Keynes was smart, the Schiffs say he developed some very stupid economic ideas—ideas that are false, dangerous, and causing the collapse of America’s economy. The Schiffs set out to counter these harmful ideas in How an Economy Grows and Why It Crashes.

The book is an extended allegory of U.S. economic history, with supplementary discussions and illustrations. It begins with three men living on a tropical island, each subsisting on one fish per day, which he catches with his bare hands. One of the men, Able, devises a better way to catch fish: a net. Thus equipped, he hopes to catch more fish, and faster, leaving himself spare time to make new clothes.

After a long day spent constructing his net, having had no time to fish, Able goes to bed hungry. But the next day, using his net, Able snags two fish within an hour. This changes Able’s life in a big way—and allows the Schiffs to conclude their first chapter with a fundamental truth: “By doubling his productivity Able is now able to produce more than he needs to consume. From gains in productivity all other economic benefits flow” (p. 9). They further develop this point, showing that it remains true whatever the size of the economy and that, “although it was never his intention to benefit anyone other than himself, Able’s capital [his extra fish] helps everyone nevertheless” (p. 14).

In this case, Able lends each of his fellow islanders one fish now in exchange for two later—allowing them to build their own nets (without going hungry like he did) and thus increasing “the island’s fishing capacity from three fish per day to six” (p. 21). From there the island economy continues to expand—as the productivity of the workers, their savings, and their investments work together without interference. The three build huts, an elaborate fish catching system, canoes, carts, and surfboards.

Not long after, the island’s first immigrants arrive. The larger, more diverse economy allows more people to specialize in what they do best, which readers see leads to increased production, higher living standards, and ever-lower prices. All of these, the Schiffs say, are unmitigated positives—positives that remain even when the division of labor is on a larger scale. “Trade on a national level,” they say, “is no different than labor specialization on a personal level” (p. 86).

But as the population on the island grows, misunderstandings multiply, and spears are often used to solve disputes. Gangs of “fish filchers” also occasionally go on rampages and, worse, “every now and then the island [is] invaded by the Bongobians, who in addition to being great drummers [are] also fierce plunderers.” Given these threats, the islanders decide to form a government that settles disputes and provides for the common defense—and is strictly “limited in its ability to take away the freedoms that had brought the island its prosperity in the first place” (pp. 92, 94). They each agree to fund it with a yearly fish tax. For many generations, the island government works as planned: The citizens are protected from domestic and overseas threats and, in time, widespread prosperity ensues. “[Almost] every family owned a canoe. Some families even had two or three” (p. 102).

But then a problem develops. Politicians such as Franky Deep, Lindy B., and George W. Bass see that people love getting stuff for free and hate paying taxes. The Schiffs show these politicians borrowing money and issuing Fish Reserve Notes to pay for special projects that they say will make everyone’s life better. They fund needless bridges across Trickle Creek and employ many islanders via the Clean Rocks Job Program. But the increased standard of living that was promised never materializes.

As the economy begins to falter, bureaucrats such as Ally Greenfin and Ben Barnacle offer what they believe to be the solution: to print even more Fish Reserve Notes. But this expansion of the money supply (inflation) has many negative consequences. It encourages the islanders to spend their earnings quickly, it demolishes the savings of retirees, and it leads many to speculate on risky investments so as to keep up with rising prices. After generations of such behavior, the island’s economy is in shambles, and unemployment reaches a critical level. The islanders, who now resemble present-day Americans, demand action.

One politician pledges lots of action. He campaigns on “a theme of transformation” and promises greater government intervention “to turn the island’s economy around” (p. 194). After being elected, Barry Ocuda gets to work—transforming the previously failed policies by tripling them in size. This transformation does not turn out so well. In fact, it leads to even more dire consequences that the Schiffs refer to when making an important point about our current economic troubles:

In the months since the financial world imploded, a consensus emerged that a lack of adequate regulations brought on the crisis. The roles of government and the Federal Reserve in particular have been largely ignored. As a result, we are getting more of what we don’t need (spending and restrictive regulations) and less [of] what we do (savings and free enterprise). (p. 224)

This, they say, must change, or else “we will all be back to fishing without a net” (p. 227). By the end of How an Economy Grows and Why It Crashes, readers are likely to agree with the Schiffs’ assessment.

But is a clear view of how an economy grows and why it crashes enough to reverse the ominous trend? After all, as the Schiffs themselves point out, most people, or certainly a significant number, already see the proposals from Washington as “ridiculous” (p. xi). Yet these proposals pass anyway, largely because, however impractical, the electorate is disarmed by moral arguments in their favor, such as arguments that these proposals are in the “public interest,” are for the “common good,” or help the “less fortunate.”

Unfortunately, although the Schiffs make a good argument for the economic viability of capitalism, they entirely miss the boat in regard to the justification for capitalism. In their view, “The best thing about private capitalism is that it forces those who may only be motivated by personal gain to raise the living standard of others” (p. 25). Setting aside their unfortunate choice of words (“private capitalism” and “forces”), their attempt to justify capitalism on altruistic grounds is hopeless. Capitalism is justified not because it results in producers raising the living standards of others, but because it leaves everyone free to think, to produce, and to profit for his own sake.

Aside from that substantial flaw, however, How an Economy Grows and Why It Crashes is a valuable contribution to the pro-capitalism corpus. The Schiffs’ clever allegory demonstrates both the practicality of capitalism and the impracticality of the welfare state.