How an Economy Grows and Why It Crashes

by Peter D. Schiff

In Keynes’s time, physicists were first grappling with the concept of quantum mechanics, which, among other things, imagined a cosmos governed by two entirely different sets of physical laws: one for very small particles, like protons and electrons, and another for everything else. Perhaps sensing that the boring study of economics needed a fresh shot in the arm, Keynes proposed a similar world view in which one set of economic laws came in to play at the micro level (concerning the realm of individuals and families) and another set at the macro level (concerning nations and governments).

The Austrians argued that recessions are necessary to compensate for unwise decisions made during the booms that always precede the bursts. Austrians believe that the booms are created in the first place by the false signals sent to businesses when government’s “stimulate” economies with low interest rates. So whereas the Keynesians look to mitigate the busts, Austrians look to prevent artificial booms.

As a consequence of their pro-government bias, Keynesians were much more likely than Austrians to receive the highest government economic appointments. Universities that produced finance ministers and Treasury secretaries obviously acquired more prestige than universities that could not. Inevitably economics departments began to favor professors who supported those ideas. Austrians were increasingly relegated to the margins.

At the 1944 Bretton Woods Monetary Conference, the United States persuaded the nations of the world to back their currencies with dollars instead of gold. Since the United States pledged to exchange an ounce of gold for every 35 dollars, and it owned 80 percent of the world’s gold, the arrangement was widely accepted. However, 40 years of monetary inflation brought about by Keynesian money managers at the Federal Reserve caused the pegged price of gold to be severely undervalued. This mismatch led to what became known as the “gold drain,” a mass run by foreign governments, led by France in 1965, to redeem U.S. Federal Reserve Notes for gold. Given the opportunity to buy gold at the old 1932 price, foreign governments were quickly depleting U.S. reserves. In 1968, President Lyndon Johnson’s economic advisors argued that the gold drain resulted not from the attraction of bargain basement prices, but because foreign governments feared that U.S. gold reserves were insufficient to provide backing for domestically held notes and to redeem foreign notes. To dispel this anxiety, the president’s monetary experts advised him to remove the required 25 percent gold backing from domestic dollars so that these reserves would be available for foreign dollar holders. Presumably this added protection would assuage the concerns of foreign governments and would stop the gold hemorrhage. Irwin, then a young business owner in New Haven, Connecticut, thought their reasoning was absurd. Ir...

In economic terms, capital is a piece of equipment that is built and used not for its own sake, but for building or making something else that is wanted.

The simplest definition of economy is the effort to maximize the availability of limited resources (and just about every resource is limited) to meet as many human demands as possible. Tools, capital, and innovation are the keys to this equation.

But the economy didn’t grow because they consumed more. They consumed more because the economy grew. This is a simple concept, but it’s amazing what modern economists can do with a simple concept. Most economists think that demand can be increased by giving people more money to spend. But that doesn’t change real demand, just how much people can spend on items that have been produced. Only by increasing supply can people actually get more of what they demand.

The best thing about private capitalism is that it forces those who may only be motivated by personal gain to raise the living standards of others.

Savings are not just a means to increase one’s ability to spend. They are an essential buffer that shields economies from the unexpected.

This system has two massive flaws. First, it assumes that a small group of people at the Fed can make better decisions than millions of people making independent decisions (also known as “the marketplace”) about the proper level of interest rates. But, the Fed has “no skin in the game,” as the saying goes. It does not generate the savings and will not suffer if loans go bad. The people saved the money and the bank’s profits depend on its wise stewardship. Without this connection, lending is inherently inefficient. Second, the Fed’s decisions are always determined by political, rather than economic, considerations. As low rates tend to make the economy appear better on the surface, push down the cost of servicing mortgages and other loans, and help financial firms make money, there are a great many people who want lower rates. Presidents seeking reelection will always bang the drum for lower rates, and they will pressure the Fed to help out. On their part, Fed policy makers naturally want to be seen as the good guys who help the economy, not the tightfisted Scrooges who push it into recession. The members of society who would favor high rates, most notably the savers, have no well-organized interest group. Their voices are never heard. As a result, there is a consistent bias toward holding rates too low, rather than too high. Remember, low rates encourage borrowing and discourage saving. Not surprisingly, the United States has been transformed from a nation of savers ...

Now that the island community is so much bigger than it was when there were just three guys fishing by hand, to some it may appear that the economics have changed…but have they? Just as the principles of mathematics don’t change with the size of the problem, basic economic principles do not change with the size of the economy. They’re just harder to see because of the many layers that exist between savers and borrowers. But the direct relationship among self-sacrifice, savings, credit, investment, economic incentive, and social and economic progress are always the same.

In our desire to make the pain of economic contraction go away, we have forgotten that freedom involves risk. If government is obligated to cure all hardships, then no one is really free in the first place. Take away the freedom to fail and you have obliterated the freedom to succeed.

Over the past 100 years, the dollar has lost more than 95 percent of its value. So much for price stability! The truth is that the Fed now exists for the sole purpose of providing the inflation necessary to allow the government to spend more than it collects in taxes.

Any dictionary printed before 1990 defines inflation purely as an expansion of the money supply. Newer editions have hedged their bets. But if you understand the true definition, you know that it is possible that prices can stay flat, or even fall, while the money supply itself is being inflated.

Normally, trade deficits tend to be self-correcting. A country with a trade surplus, in that it sells more abroad than it buys, will create an international demand for its currency. If you want its stuff, you need its currency. As a result, strong trading positions tend to strengthen a country’s currency. The opposite is true with countries with weak trading positions. If no one wants your stuff, no one really needs your currency. But when a country’s currency rises, its products become more expensive. This gives a competitive opportunity to countries with weak currencies to start selling some of their products into that market. When they sell more, demand for their currencies rises. This currency counterweight should keep runaway trade imbalances in check. But the dollar’s reserve status, and the decision of the Chinese government to maintain the currency peg, has gummed up the machinery and has allowed the situation to grow dangerously out of kilter.

From the beginning of recorded history, humanity has used all sorts of things as money. Salt, shells, beads, livestock—all had their day. But over time metals, particularly gold and silver, have emerged as the most widely used forms of money. This is not an accident. Precious metals have all the qualities that make money valuable and useful: scarcity, desirability, uniformity, durability, and malleability.

In his book Irrational Exuberance economist Robert Shiller determined that in the 100 years between 1900 and 2000, home prices in the United States increased by an average of 3.4 percent per year (which is just slightly higher than the average rate of inflation). There were good reasons for this. Prices were firmly tied to people’s ability to pay, which is a function of income and credit availability. But from 1997 to 2006 national home prices gained an astounding 19.4 percent per year on average. Over that time incomes barely budged. So why could people pay so much? The difference was credit, which government policy made much cheaper and easier to get. But credit could not expand forever, and eventually conditions tightened. When they did, there was nothing to hold prices up. So when the market crested, the easy money that for years had poured into the economy stopped flowing. Even if there had been no other economic reversals that followed the housing bust (which there were), the economy would have had to shrink without all the free cash. A recession was not only inevitable but absolutely necessary to rebalance the economy. But when the economy started to contract, lawmakers and economists treated the development not as the inevitable consequence of years of easy money and overspending, but as the problem itself. In other words, they mistook the cure for the disease.

But our “good fortune” can’t last forever. Ultimately the U.S. government will have only two options: default (tell our creditors that we can’t pay, and negotiate a settlement) or inflate (print money to pay off maturing debt). Either option will lead to painful consequences. Default, which does offer the possibility of a real reckoning and a fresh beginning, is actually the better alternative. Unfortunately, while inflation is worse, it is also the more politically expedient.

Inflation is simply a means to transfer wealth from anyone who has savings in a particular currency to anyone who has debt in the same currency.