Hello, welcome to the Investor’s Bookshelf. In this session, I will walk you through an economics book titled How an Economy Grows and Why It Crashes. I will take about twenty minutes of reading time to distill the essence of this book for you: through a fable, it illustrates several key ideas of the Austrian School of Economics and analyzes what truly drives economic growth.
We know that economics has many schools of thought, and they are always in debate. Broadly speaking, there are radical, orthodox, and conservative schools; there is the division between macroeconomics and microeconomics; and there is the split between interventionism and economic liberalism, among others. Among these, the Austrian School advocates economic liberalism. They champion laissez-faire markets, arguing that the government should not intervene. Its representative figure, Friedrich Hayek, once won the Nobel Prize in Economics. In contrast, Keynesianism supports government intervention. Keynesians believe that the market economy has inherent instability and that at critical moments the government needs to step in. The debate between the Austrian School and Keynesianism has a long history.
From academic writings, we know that Hayek and John Maynard Keynes were actually fighting to win the same war, but their approaches differed: Hayek believed that not an inch of ground could be surrendered, while Keynes believed that to preserve the core stronghold, peripheral positions could be abandoned. Thus, Hayek was a typical “hedgehog” scholar, always holding firmly to a single viewpoint. Keynes, by contrast, was a typical “fox” scholar, pragmatic and adaptable, shifting and adjusting his views as circumstances changed.
The authors of How an Economy Grows and Why It Crashes, Peter Schiff and Andrew Schiff, are staunch supporters of the Austrian School. These two authors are brothers and both are economists. From the Great Depression of the 1920s to the financial crisis of 2008, the United States largely practiced Keynesianism. Therefore, this book takes the perspective of the Austrian School to critique America’s prevailing economic policies. The authors state explicitly that they aim to prove Keynesian economics wrong, even dangerous. With this context in mind, you will better understand why some of the arguments and recommendations in the book appear somewhat idealized, or even biased and debatable.
For example, the authors argue that inflation is entirely the creation of the Federal Reserve, since before the Fed existed, the United States had experienced more than a century of deflation while still enjoying rapid economic growth. They also argue that quantitative easing is merely another variant of inflation, another poison that will drive the U.S. economy into the abyss. As for who is right—Austrian economics or Keynesianism—we cannot make a simplistic conclusion. Instead, we must analyze objectively: every school of economics has conditions where it applies, each has advantages and drawbacks, and it is up to us to judge according to different circumstances.
How an Economy Grows and Why It Crashes uses a fable set on a small island to condense and simplify the history of the U.S. economy back to its most primitive state. By telling stories of islanders fishing, weaving nets, saving, lending, and investing, it reveals how the entire American economic system operates. The book begins with the simplest economic activity—fishing—and connects it to the reality of the U.S. economy. Through storytelling, it clarifies abstract economic principles.
For instance, the small island in the story later comes to be called the “Republic of Makebelieve Islands,” symbolizing the early United States. Fish represent money in reality, equivalent to gold. “Fish Reserve Notes” correspond to real money—the U.S. dollar. Fishing nets represent production equipment—capital. Huts represent real estate, and so on. Moreover, most of the people and events in the story have real-life prototypes, though they are not limited to them. For example, “Ben Barnacle” in the book is modeled after former Federal Reserve Chairman Ben Bernanke, but the character represents not just Bernanke himself but also the group of experts like him who support high inflation.
In this session, I will narrate the fable of the small island and connect it with U.S. economic realities to introduce three key ideas of the Austrian School:
- The fundamental driver of economic growth is production, not consumption.
- To improve a deteriorating economy, what is needed is saving, not spending.
- During an economic downturn, the remedy is deflation, not inflation.
Part One
Now let us look at the first key idea: the fundamental driver of economic growth is production, not consumption.
Put simply, economics is about making limited resources generate the greatest possible benefit in order to satisfy human needs as much as possible. In real life, scarcity is the norm, and human needs can never be fully satisfied. The cause of economic growth lies in finding better ways to produce the goods people need. Through production, limited resources generate maximum efficiency to meet human needs as fully as possible.
Let’s turn to the story in the book. On the island, the tale unfolds like this: Once upon a time, on a tropical island, people lived very hard lives. Their menu had only one dish: fish—and only one kind. The place was isolated, with no advanced fishing techniques or tools. All people could do was jump into the water and try to catch fish with their bare hands. As a result, productivity was extremely low: each person could only catch one fish a day, just enough to feed themselves for that day. The next day, they had to fish again. So, the entire economic life of the island was basically just fishing. Every day was: wake up, fish, eat, sleep. There were no savings, no lending, no investing; every fish caught was consumed immediately.
But everyone wanted a better life. The story’s protagonist, Able, after much thought, made a “fishing net” that allowed him to catch more fish in less time. This increased productivity, and Able now had surplus wealth. With that one simple act, the island’s economy began to change dramatically. Able’s actions demonstrate a fundamental economic principle emphasized in the book: underconsumption and risk-taking.
What does underconsumption mean here? In the island story, it refers to Able deciding not to fish on the day he wove the net, which meant he had to go hungry. He didn’t do this because he didn’t need fish. Rather, he deliberately postponed consumption—he skipped eating fish for a day so he could weave a net, with the purpose of catching more fish in the future and improving his life. That was his risk. Before making the net, Able didn’t know whether he would succeed; he had never seen a net and didn’t know if it would even work. But eventually, he succeeded, built the net, and caught more fish. In this story, the net represents capital.
Most people are not unfamiliar with the concept of capital, but many reduce it to just money, which is too simplistic. In economics, capital broadly refers to the total of production materials and money. In Western economic theory, capital more specifically refers to equipment that can be used to produce other goods. For example, Able wanted fish, not a net. But with the net, he could obtain more fish. Therefore, the net is capital—it has value. With the net, Able’s productivity increased significantly. He could catch far more fish than he needed to eat. Thus, surplus emerged. For the story to continue, the book assumes that the fish did not spoil. The extra fish that Able caught with the net could be stored, sold, exchanged, or invested. Surplus is the foundation of economic activity and the lifeblood of a healthy economy.
It is clear, then, that production promotes economic growth. This is a very important fundamental principle. Yet in real life, most Keynesians argue that it is consumption that drives growth, so they advocate giving ordinary people more money to spend in order to boost demand. But the result is the opposite: it does not change real demand; it only makes people spend more money on goods already produced.
The book gives an example: take air. It’s always been there; no one produces it. Then one day, someone starts selling air, and you even spend one million dollars to buy it. At that moment, GDP increases by one million. But what does it actually mean? You haven’t created value, and the economy hasn’t truly grown. Only production can give consumption real value. Consumption is just a stimulus, a way of measuring production. Without production, there is nothing to consume.
To be objective, understanding that production is the first priority for growth means we have found the root of economic expansion. But if we only emphasize this, it becomes one-sided. We cannot exclude the importance of consumption. After all, consuming what is produced helps expand reproduction and achieve added economic value. Production and consumption cannot be completely separated.
From this discussion, we see that production is the fundamental driver of economic growth. Through production, limited resources generate the greatest possible benefit, greatly satisfying human needs. No matter how powerful a country becomes or how complex its economic system grows, this basic principle does not change. It is foundational. And this is the first key idea of the Austrian School of Economics introduced today.
Part Two
Now that we understand production is the fundamental driver of economic growth, we can see that once surplus products are created, savings naturally emerge. Next, let us examine the Austrian School’s second key idea: when economic conditions deteriorate, the solution should be saving, not spending.
In the book, the story of saving goes like this: Under Able’s influence, his two friends, Baker and Charlie, also learned the technique of net-making. Together, the three even built massive fishing devices. Soon, the island had an abundance of fish, and savings began to accumulate. At this point, storing the fish became a problem. In the past, people were used to keeping fish at home, but this was inefficient and unsafe—thieves were difficult to guard against. Then a man appeared, with a rather fitting name: Max Goodbank (a play on “a good bank”). He opened a “fish depository,” where islanders could store their fish as savings, guarded by hired watchmen. Max Goodbank charged a storage fee to cover his operations. But he was not satisfied with that small income. He also lent out the savings. The returns he earned were used partly to pay depositors interest and pay salaries to the watchmen, while the remainder was his profit. Thus, a professional banking institution was born.
What does this story correspond to in reality? At the beginning of the 20th century, during America’s urbanization process, the nation accumulated large amounts of savings. These savings provided abundant financial support for industrial production and commercial activity, and also served as a safeguard against unexpected risks. But in recent decades, economists have greatly underestimated the importance of saving. Many of them regard saving as a burden. In particular, Keynesians believe that consumption is the key driver of growth. In their view, putting money in the bank suppresses spending, disrupts circulation, and harms development. Influenced by this view, governments created policies to encourage people to spend more and save less. As a result, Americans developed the habit of overconsumption, and often ended up living beyond their means.
On the island, without savings, Max Goodbank would lose his job and his investment would be wasted. His personal interest was closely tied to the health of his bank. Therefore, he was the one best suited to determine deposit and loan rates. For instance, in lending, he could charge low interest to those with strong repayment ability and high interest to riskier borrowers as compensation for risk. Loan rates ultimately determined deposit rates. Deposit rates also depended on the length of time savings were kept—the longer the term, the higher the rate; the shorter the term, the lower the rate. Overall, saving helps people build wealth and delay consumption, while also providing funds for investment and production. Increased capacity then raises living standards. Over time, this creates a virtuous economic cycle. Moreover, if the economy is hit by an unexpected shock, savings serve as a crucial buffer to prevent collapse or to quickly rebuild damaged assets. In this sense, reducing consumption to save is a prudent, forward-looking strategy.
But then the Federal Reserve appeared. For nearly a hundred years, U.S. benchmark interest rates have been set by the Fed. When they raise or lower the benchmark, banks adjust their lending rates accordingly, which in turn influences whether the entire market trends upward or downward. The country’s entire interest-rate structure is built on this benchmark. However, the book points out two major flaws in this mechanism: First, the Fed is “above it all.” It is not a real participant in the economy and has no direct stake in lending or saving. It doesn’t suffer if loans go bad. Second, its decisions are often based more on politics than economics. This has led to a bias that assumes low interest rates are always desirable.
We all know that low rates do stimulate borrowing—but they also discourage saving. Thus, America shifted from being a nation of savers to a nation of borrowers. When the 2008 financial crisis erupted, governments and economists used every possible method to push consumers to spend more and save less. But spending for the sake of spending is meaningless. Furthermore, excessively low rates send the wrong signal to the market: they make people think the economy is doing well and that it’s a good time to invest, so borrowing increases. In reality, consumption has not truly been delayed, and reserves are not sufficient. This creates only a false prosperity, which is often followed by major crises.
That said, we must remain objective: placing all blame for inflation on the Fed would also be one-sided. The Fed has undeniably played an important role in the development of the U.S. economy and society.
This brings us to the Austrian School’s second key idea: saving creates capital, and capital expands production. Therefore, when the economy is struggling, the solution should be saving, not spending. In a free-market environment, banks will lend money to sound businesses and projects, expanding production and generating value. From the perspective of society as a whole, the profits from successful loans offset the losses from failed ones. Thus, saving one dollar has a more beneficial impact on the economy than spending it. And whether commercial loans, consumer loans, or emergency loans, all must operate within the limits of savings—in other words, total lending must not exceed the amount saved.
Part Three
So, apart from saving, what else can be done when the economy is in a downturn? This brings us to the Austrian School’s third key idea: when the economy is weak, what is needed is deflation, not inflation.
The authors argue that American Keynesians have always demonized deflation while being relatively tolerant of inflation. In reality, deflation is not a monstrous evil, and inflation is no cure-all. One of the original purposes of creating the Federal Reserve was to adjust the money supply in response to economic conditions—expanding it in times of growth and contracting it in times of decline—in order to ensure stability during both booms and busts.
Let’s go back to the island story. At first, the island had no government; there was no concept of a nation, and residents could solve disputes peacefully on their own. But as society grew more complex, government institutions inevitably emerged—courts to resolve disputes, police to catch fish thieves, and so on. Thus, government appeared.
As productivity increased and savings accumulated, some residents could shift into other industries such as services and tourism, creating a division of labor. To facilitate trade, the island designated real fish as money. Islanders paid taxes in fish to support the government’s work. But as government spending grew larger and tax revenues became insufficient, officials sought other solutions. They introduced paper currency called “Fish Reserve Notes,” declaring that these could be exchanged for real fish at a fixed ratio. Islanders could use these notes to shop or to redeem fish at the bank.
At first, every Fish Reserve Note issued corresponded to real fish stored in bank accounts. But soon, the amount of Fish Reserve Notes far exceeded the stored fish. Thus, “fishflation” began. The government claimed this was due to prosperity and rising employment, which increased demand for fish and drove up prices. Without the stimulus of “fishflation,” demand for fish would decline or disappear, shrinking the island’s economy. Therefore, they argued, inflation was a vital stage of economic development.
What does this look like in reality? We know that inflation happens when the money supply issued far exceeds the actual demand for money in circulation, leading to currency devaluation and rising prices. Thus, price increases are the result of inflation, not inflation itself. What expands is the supply of money. Yet economists have consistently blurred this cause-and-effect, leading nearly everyone to equate inflation with rising prices. If prices don’t rise, they say, there is no inflation. This mistake hides the true essence of inflation: the expansion of the money supply.
Assuming people are rational and respond to supply and demand, when the economy is weak, they reduce consumption. Demand falls, prices decline, and balance is restored. This is deflation. Once prices drop to a certain level, people can accept them again and resume spending. This process is necessary—it eliminates obsolete industries and fosters healthier growth. But governments, by artificially driving inflation, suppress this natural adjustment.
To economists and politicians, deflation means a broad decline in prices for a period of time—something they liken to a plague on the economy. As soon as deflation appears, governments rush to push prices back up. But is falling prices truly so terrible? From the late 18th century to 1913—a span of 150 years—U.S. prices steadily declined. Yet this did not prevent economic development. On the contrary, this was one of the fastest periods of growth in American history. The reason was increased productivity, which drove prices lower.
This is not unfamiliar to us. The Industrial Revolution greatly boosted productivity, raising living standards for wage earners. Workers could suddenly afford what only the wealthy once could—fine furniture, plumbing repairs, train rides. Falling prices do not necessarily harm industries, either. In the early 20th century, Henry Ford continuously improved productivity and cut prices, turning automobiles from luxuries into goods ordinary people could buy. Ford became enormously wealthy, and his workers earned some of the highest wages in the industry. More recently, when the first plasma TVs came to market, their $10,000 price tag deterred buyers. But once prices dropped, demand exploded. Rising sales volumes more than offset lower prices, boosting profits substantially.
So why do many still see falling prices as dangerous, and deflation as harmful? The authors give two reasons. First, modern economics mistakenly believes consumption drives growth, so deflation is seen as shrinking consumption. But as we explained earlier, it is production—not consumption—that drives growth. Second, for governments, the easiest way to escape fiscal shortfalls is to print money. By causing inflation, debt is devalued—it is like repaying debt in another form. Compared to raising taxes or cutting spending, generating inflation is often the easiest and most tempting option for governments, though ultimately the cost can be devastating: the devaluation of the national currency.
At present, the U.S. dollar’s reserve currency status remains relatively secure. Despite periodic fluctuations, most countries still accept the dollar. But if one day the dollar were to lose this status, it could collapse like other currencies, with catastrophic consequences. Thus, the authors warn that America must take these potential risks seriously, staying alert to prevent disaster. Of course, this is not only an American issue—other nations should also recognize and confront it.
This is the Austrian School’s third key idea: in an economic downturn, consumers will naturally cut back on spending, which pushes prices down to more reasonable levels and stimulates renewed demand. Therefore, what we need is deflation, not inflation.
Conclusion
Let’s briefly review today’s discussion. By applying the three key ideas of the Austrian School of Economics, we can see the problems currently facing the U.S. economy as well as the potential risks of certain stimulus policies. Specifically:
First, production is the fundamental driver of economic growth. Merely stimulating consumption does not address the root issue.
Second, when economic conditions deteriorate, the solution is to save, not spend. Adequate savings not only enhance personal consumption capacity, provide funds for lending, and expand production, but also help cushion against unexpected risks. By contrast, spending for its own sake creates only false prosperity, often hiding enormous crises beneath the surface.
Third, in times of economic downturn, people naturally reduce demand and prices fall. This process helps eliminate unnecessary capacity. Once prices fall to an acceptable level, people resume spending. Thus, deflation is not to be feared, and inflation is by no means a universal remedy.
In short, the authors write from the perspective of the Austrian School, critiquing Keynesianism and advocating for greater reliance on market self-adjustment and less government intervention.
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