If NASA engineers had evidenced the same level of forecasting skill as our top economists, the Galileo mission would have had a very different outcome. Not only would the satellite have missed its orbit of Saturn, but in all likelihood the rocket would have turned downward on lift-off, bored though the Earth’s crust, and exploded somewhere deep in the magma.
In 2007 when the world was staring into the teeth of the biggest economic catastrophe in three generations, very few economists had any idea that there was any trouble lurking on the horizon. 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 prosper. The reason their vision was so poor then, and their solutions so counterintuitive now, is that few have any idea how their science actually works.
The disconnect results from the nearly universal acceptance of the theories of John Maynard Keynes, a very smart early-twentieth century English academic who developed some very stupid ideas about what makes economies grow. Essentially Keynes managed to pull off one the neatest tricks imaginable: he made something simple seem to be hopelessly complex.
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).
Keynes’s work came at the tail end of the most expansive economic period in the history of the world. Economically speaking, the nineteenth an early-twentieth-century produced unprecedented growth of productive capacity and living standards in the Western world. The epicenter of this boom was the freewheeling capitalism of the United States, a country unique in its preference for individual rights and limited government.
But the decentralizing elements inherent in free market capitalism threatened the rigid power structures still in place throughout much of the world. In addition, capitalistic expansion did come with some visible extremes of wealth and poverty, causing some social scientists and progressives to seek what they believed was a more equitable alternative to free market capitalism. In his quest to bring the guidance of modern science to the seemingly unfair marketplace, Keynes unwittingly gave cover to central authorities and social utopians who believed that economic activity needed to be planned from above.
At the core of his view was the idea that governments could smooth out the volatility of free markets by expanding the supply of money and running large budget deficits when times were tough. When they first burst onto the scene in the 1920s and 1930s, the disciples of Keynes (called Keynesians), came into conflict with the “Austrian School” which followed the views of economists such as Ludwig von Mises. 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 governments “stimulate” economies with low interest rates.
So whereas the Keynesians look to mitigate the busts, Austrians look to prevent artificial booms. In the economic showdown that followed, the Keynesians had a key advantage. Because it offers the hope of pain-free solutions, Keynesianism was an instant hit with politicians. By promising to increase employment and boost growth without raising taxes or cutting government services, the policies advocated by Keynes were the economic equivalent of miracle weight-loss programs that required no dieting or exercise. While irrational, such hopes are nevertheless soothing, and are a definite attraction on the campaign trail.
Keynesianism permits governments to pretend that they have the power to raise living standards with the whir of a printing press. 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.
Similarly, large financial institutions, the other major employers of economists, have an equal affinity for Keynesian dogma. Large banks and investment firms are more profitable in the Keynesian environment of easy money and loose credit. The belief that government policy should backstop investments also helps financial firms pry open the pocketbooks of skittish investors. As a result, they are more likely to hire those economists who support such a world-view.
With such glaring advantages over their stuffy rivals, a self-fulfilling mutual admiration society soon produced a corps of top economists inbred with a loyalty to Keynesian principles. These analysts take it as gospel that Keynesian policies were responsible for ending the Great Depression. Many have argued that without the stimuli provided by government (including expenditures necessary to wage the Second World War), we would never have recovered from the economic abyss. Absent from this analysis is the fact that the Depression was the longest and most severe downturn in modern history and the first that was ever dealt with using the full range of Keynesian policy tools. Whether these interventions were the cause or the cure of the Depression is apparently a debate that no serious “economist” ever thought was worth having.
With Keynesians in firm control of economics departments, financial ministries, and investment banks, it’s as if we have entrusted astrologers instead of astronomers to calculate orbital velocities of celestial bodies. (Yes, the satellite crashed into an asteroid, but it is an unexpected encounter that could lead to enticing possibilities!) The tragi-comic aspect of the situation is that no matter how often these economists completely flub their missions, no matter how many rockets explode on the launchpad, no one of consequence ever questions their models.
Most ordinary people have come to justifiably feel that economists don’t know what they are talking about. But most assume that they are clueless because the field itself is so vast, vast, murky, and illogical that true predictive power is beyond even the best and most educated minds.
But what if I told you that the economic duality proposed by the Keynesians doesn’t exist? What if economics is much simpler than that? What if what is good for the goose is good for the gander? What if it were equally impossible for a family, or a nation, to spend its way to prosperity? Many people who are familiar with my accurate forecasting of the economic crash of 2008 like to credit my intelligence as the source of my vision. I can assure you that I am no smarter than most of the economists who couldn’t see an asset bubble if it spent a month in their living room. What I do have is a solid and fundamental understanding of the basic principles of economics.
I have that advantage because as a child my father provided me with the basic tool kit I needed to cut through the economic clutter. The tools came to me in the form of stories, allegories, and thought experiments. One of those stories serves as the basis for this book.
Irwin Schiff has become a figure of some renown and is most associated with the national movement to resist the federal income tax. For more than 35 years he has challenged, often obsessively, the methods of the Internal Revenue Service while maintaining that the income tax is enforced in violation of the Constitution’s three taxing clauses, the 16th Amendment, and the revenue laws themselves. He has written many books on the subject and has openly challenged the federal government in court. For these activities, he continues to pay a heavy personal price. At 82 he remains incarcerated in federal prison.
But before he turned his attention to taxes, Irwin Schiff made a name for himself as an economist. He was born in 1928 in New Haven, Connecticut, the eighth child of a lower-middle-class immigrant family. His father was a union man, and his entire extended family enthusiastically supported Roosevelt’s New Deal. When he entered the University of Connecticut in 1946 to study economics, nothing in his background or temperament would have led anyone to believe that he would reject the dominant orthodoxy, and to instead embrace the economic views espoused by the out-of-fashion Austrians…but he did.
Irwin always had the power of original thinking, which, combined with a rather outsized belief in himself, perhaps led him to sense that the lessons he was learning did not fully mesh with reality. Digging deeper into the full spectrum of economic theory, Irwin came across books by libertarian thinkers like Henry Hazlitt and Henry Grady Weaver.
Although his conversion was gradual (taking the full decade of the 1950’s to complete), he eventually emerged as a fullblooded believer in sound money, limited government, low taxes, and personal responsibility. By 1964, Irwin enthusiastically supported Barry Goldwater for president.
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.
Irwin sent a letter to Texas Senator John Tower, who was then a member of the committee reviewing the gold issue, explaining that the United States faced two choices: force down the general price structure to bring it in line with the 1932 price of gold, or raise gold to bring it in line with 1968 prices. In other words, to adjust for 40 years of Keynesian inflation, America now had to either deflate prices or devalue the dollar.
Although Irwin argued that deflation would be the most responsible course, since it would restore the lost purchasing power of the dollar, he understood that economists erroneously view falling prices as a catastrophe and that governments have a natural preference for inflation. Given these biases, he argued that authorities could at least acknowledge prior debasement and officially devalue the dollar against gold. In such a scenario, he felt that gold would have to be priced at $105 per ounce.
He also feared a much more likely, and dangerous, third option: that the government would do nothing (which was precisely what they chose to do). Then as now, the choice was between facing the music or deferring the problem to future generations. They deferred, and we are the future generation.
Tower was so impressed with the basic logic of his arguments, that he invited Irwin in to address the entire committee. At the hearings, all the highly placed monetary experts from the Federal Reserve, the Treasury Department, and Congress testified that removing gold backing would strengthen the dollar, cause the price of gold to fall, and usher in an age of prosperity.
In his testimony, Irwin asserted that the removal of gold backing from U.S. currency would cause gold prices to soar. But more importantly, he warned that a currency devoid of any intrinsic value would lead to massive inflation and unsustainable government debt. This minority opinion was completely ignored, and gold backing was removed. Contrary to everything the economists had predicted, the availability of additional reserves failed to stop the outflows of gold. Finally, in 1971 President Richard Nixon closed the window, which severed the dollar’s last link to gold. At that point, the global economic system became completely based on worthless money. Over the next decade, the United States experienced the nastiest outbreak of inflation in our history and gold headed towards $800 per ounce.
In 1972 Irwin set out to write his first major attack on how Keynesian economics was putting the United States on an unsustainable economic course. His book The Biggest Con: How the Government Is Fleecing You, enjoyed wide-spread critical acclaim and decent sales. Among the many anecdotes the book contained was a story about three men on an island who fished with their hands.
The story had its genesis as a simple time killer on family car trips. When caught in traffic, Irwin attempted to entertain his two young sons with basic lessons of economics (any boy’s idea of a perfect afternoon). To do this he almost always resorted to funny stories. This one became known as “The Fish Story.” The allegory served as the centerpiece of a chapter in The Biggest Con. About eight years later, after so many readers had commented to him about how much they loved the story, he decided to develop an entire illustrated book around it. How an Economy Grows and Why It Doesn’t was first published in 1979, and went on to achieve quasi-cult status among devotees of Austrian economics.
Thirty years later, as I watched the United States’ economy head off a cliff, and as I watched our government repeating and redoubling the mistakes of the past, my brother and I thought it would be an ideal time to revise and update “The Fish Story” for a new generation. Certainly, there has never been a greater need for a dose of economic clarity, and the story is the best tool we know of to give people a better understanding of what makes our economy tick.