It’s been a long time but the radio silence was deliberate, both you and me
have more interesting things to look at what with the fun things happening in
the country and world. Have been watching lot of diverse movies (developed a
taste for European movies) and reading books on different topics but there was
not much new or interesting to comment on or propagate. However, the latest
book I read is so incredibly simple and conceptually clarifying that it
warranted a write up. You HAVE to read this book but if you don’t, I am going
to write down most of what is in it because it is so worth knowing. The name of
the book is “How an Economy grows and why it crashes” by Peter Schiff and
Andrew Schiff.
Peter Schiff is the son of a renowned American economist Irwin Schiff who
belongs to the true free market school of thought (also called Austrian school
of economists as against the Keynesian school). Irwin Schiff consistently
fought against the growing government influence on American economy (and its
mismanagement) and in his later years got jailed for 15 years because he did
not pay taxes deliberately. The Schiffs believe firmly in free market economics
as professed when America was founded and this book outlines that thought in a
very simple fable like story. It resonates with what I grew up believing
(thanks dad) and which is such an anathema in India. However, the story that
has been told is so simple and clear that even a non-believer (or a firm
leftist) may pause for a minute and say “maybe this makes sense”. I will not
preach after narrating this story, will only leave you to draw your own conclusions
especially on the economy of India. I will also break this into two parts for
reading convenience though sending them together.
How it begins:
The story is about an island where three people live – Able, Baker and Charlie.
There is no food grown on the island, the only source of food is fish which are
homogeneous around the island and in large quantity. The men can only fish with
bare hands and this enables them to catch one fish a day which also is their
diet for the day. If one of them doesn’t fish that day, he cannot eat. They
don’t have time to do anything else but fish and they cannot save anything. In
essence, the island has no savings, no credit and no investment and life is
hard. Before we discuss further, in this story, a fish cannot be destroyed or
doesn’t despoil so can be stored forever.
Able decides one day that he has had enough and thinks up of a device that may
help him catch more than one fish – a net. He foregoes eating for two days
while building the net. His friends pity him and warn him that he is doing
something foolish and risky – if the net doesn’t work, he will go hungry. Able
succeeds and builds his net, then shows that he can catch two fishes instead of
one in a day. What he has done is under-consumed, taken a risk and created
capital. Essentially – capital (which means only money these days) is a piece
of equipment (in a broad sense) that is built and used not for its own sake but
for building or making something else that is wanted. Able doesn’t want the
net, he wants fish, the net helps him get more fish. The net is therefore a
piece of capital and hence is valuable.
From this simple act, the island’s economy was about to change in a very big
way. Able has just increased his productivity and that is a good thing for
everybody. By increasing productivity, Able is now able to produce more than he
can consume, from gains in productivity all other economic benefits flow.
Essentially, this has created savings which is also spare production
which is the lifeblood of a healthy economy.
Sharing of Wealth:
Able started fishing with his net and started stocking on two fish a day. He
could now afford to fish for a day and then relax the other day eating his
spare fish. He kept working every day thus increasing his stock. Charlie and
Baker started getting restive and asked him to lend them his spare fish so they
could spend couple of days building their own nets without worrying about
eating. Able dithered till they sweetened the pot saying they would give him
two fish back for every one he lent them. He exercised this option, Charlie and
Baker got their fishes, made their nets, earned more, paid Able back and
everyone benefited.
How did this work – Able under-consumed, took a risk and created capital. He
wanted more profit from his savings so he took a risk and lent to the other
two. They used this capital to improve their productivity thus paying back the
loan and in turn getting prosperous without having to under-consume. This could
have gone other ways – on watching Able get rich, the other two could have
bullied him into sharing wealth dubbing him elitist, or Able would have felt
guilty and given away his fish asking for nothing in return. Charlie and Baker
would have had no incentive because of lack of burden of repayment and they
would probably have whiled away their time eating extra fish and playing
basketball. The charity option sounds magnanimous but it doesn’t improve the
island’s productivity the way a business loan would. This is the idea of
credit.
Economic Expansion:
A few weeks had gone and all the three started bringing in two fish a day. Wise
that they were, they only ate one fish a day thus saving on fishes. Baker
thought, “If we have expanded production with hand nets, why not kick it up a
notch and go industrial?” He sketched out plans for an elaborate fish catching
device that would revolutionize the island’s economy – a huge underwater trap
with one way doors that could catch fish continually day or night. If it
worked, they would never have to fish again. However, he realized he couldn’t
do this by himself – his savings, strength and ideas were inadequate – he asked
the other two and a joint venture was born. The three pooled their
savings, invested, took a risk and built the contraption. Result was them
catching 20 fishes a week. Their savings started piling up which enabled them
to create a new fish catcher and more.
The three now devoted their time to other things – Charlie built surfboards
resulting in a new ultracool leisure activity. Able used his savings to
establish a clothing company while Baker used his time to focus on fixing the
island’s transportation problems and designed the island’s first canoe and
cart.
Emigration:
Tales of this unprecedented luxury spread to other islands where fishing was
still done by hand and no one had time to surf. In search of a better life,
immigrants arrived. The greater productivity of the island meant that it could
support a greater population which led to greater economic diversity. Some new
immigrants went into servicing the mega fish catchers, others borrowed extra
fish to clear ;and for farming, the diversified economy soon gave rise to hut
builders, canoe builders, wagon builders and so on. People started working for
others using their skills appropriately and the extra income gave rise to
spending. Key point is they saved first and then consumed.
The Bank:
At about this time, the incidents of fish pilferage, looting started
increasing. An islander named Max Goodbank decided to launch a revolutionary
service. He built a large, climate controlled facility staffed by tough goons.
The new “bank” would safely store the island’s collective fish savings and
consequently solve the theft problem. However, if he only charged a storage
fee, his profit potential was limited. He understood the value of savings and he
knew he could do a better job at lending than a typical islander. He was also
particularly good at evaluating business plans and structuring equitable loans.
With fish earned from loans of neighbour’s fish, he would pay interest to
depositors and wages to his goons. He would keep the leftover profit to
himself.
The Goodbank Savings and Loan was thus born – the Ables of the bank could store
their savings to Goodbank when they underconsumed, those requiring loans in
order to finance capital projects could see Mr. Goodbank. To keep this running,
Max had to keep his loan business profitable which meant he had to carefully
screen borrowers, collect interest and foreclose on collateral when loans
failed. Second, he had to keep his depositors happy through regular interest
payments. Last, he had to attract more borrowers to keep the cycle running.
Failure to do so would mean loss of his deposits and loss of job.
Max handled this all through something called interest rates since he was in
the best position to determine the best interest rates to pay depositors and
charge borrowers. Despite his administering the rates, the entire interest rate
system fluctuated according to market conditions beyond Max’s control.
Sometimes, big gains in productivity swelled the island’s savings. When the
vault was filled, the bank would drop rates charged on loans because the losses
were easier to bear in relative terms and the healthy economy that produced the
savings would provide a fertile ground for new businesses. With little need to
attract new savings, and lower rates charged to borrowers, such an environment
led to lower payments to depositors, which would discourage savings.
When savings dipped, opposite forces would come into play that would tend to
encourage savings thereby replenishing bank coffers. This is the interest rate
cycle followed in a normal economy which is almost always disrupted by
government intervention – making banks invest in unviable populist projects,
loan waivers and what not.
Infrastructure and Trade:
The need to improve infrastructure on the island was getting dire with the
increasing population especially water. This impacted the productivity of the
island, Able Fisher V (Able’s great-great-great grandson) thought up of a water
works system for which he needed a loan of 182, 500 fish which deterred him.
Luckily, Maxine Goodbank (another descendant) weighed in the risks and gave him
the loan which resulted in the Able Waterworks and solved the water problem of
the island.
The second bit was inter-island trade which caught on with islands trading what
they had in abundance with other islands which had something else in abundance.
Republic:
The island had grown into a major economy and there were constant
frictions, crimes and attacks by other islanders especially the fearsome
Bongobians. After experimenting with different chieftains, the islanders
decided to put together a government that would be accountable to the people
and would be limited in its ability to take away the freedoms that had brought
the island its prosperity in the first place. It was decided that the islanders
would elect 12 senators, including a senator-in-chief. To protect the island
from invasions, the senate would create and oversee a navy of spear-packing war
canoes. To promote social stability, the senate would establish a system of
courts to settle disputes and a police squad to enforce the decrees of the
judges.
In order to finance this modest apparatus, the islanders agreed to pay a yearly
fish tax. All fish sent in to the government would go into a special government
account at the bank from which the senators would draw funds to meet
expenditures. In order to ensure that the senators did not overreach, a
constitution was drafted and a supreme judge was put in place to enforce the
constitution and maintain a check on the political ambition of senators. When
the constitution was voted on and passed, the island nation was called the
Republic of Usonia.
Government gets creative:
The economy grew and only a few people were now needed to bring in fish.
Tertiary sectors like hut furnishings, drum making and even theatre troupes
flourished. In between, some senators made an emotional appeal that voting
eligibility should be extended to non-tax payers as well, this brought to the
polls a great many voters who were far less interested in government budgetary
prudence. As the government payroll grew along with the economy, the job of
senator gained in status and appeal and it started attracting ambitious
go-getters. It also incentivized the hopefuls to draft policies that got them
votes rather than enact correct policies.
One particular senator, Franky Deep, wanted to give islanders freebies to get
elected forever but couldn’t since all the government had was what they raised
in taxes. The senate didn’t catch any fish, they could only take to give. After
a very bad monsoon, Franky got elected on the plank of instituting a government
reconstruction program for the neediest citizens – he got elected. His victory
started the spending for which there were not enough fish reserves. To cover
the gap, Franky came up with an idea – they government issued paper money
called Fish Reserve Notes which would be redeemable for actual government fish
stored at the GoodBank. Citizens could get their fish immediately or use the
notes to trade for other goods and services just as they would with real fish.
Franky got his friend nominated as a judge to pass this change to the
constitution and he was off. The Fish Reserve Notes (FRN) were also a hit
amongst citizens since they were easy to carry and smelt better as well.
Meanwhile, Franky’s advisors scoured the island looking for worthy projects to
fund. When they found a project that would guarantee enough support from
potential voters, they would hand out the new notes to make It happen.
Soon, the actual fish available in Goodbank vaults began to run out due to Fish
Reserve Notes being handed over indiscriminately. Max rushed to Franky and his
advisors asking him to stop issuing Fish Reserve Notes and raise taxes so that
the reserves could be replaced. The politicians laughed at the idea – a recipe
for political disaster. They told him their new scheme, a team of technicians
would use body parts of dead fish and construct a completely artificial fish
out of a real fish that would look like a real fish. This could be used to
replenish the fish reserve. Max resisted saying the “official” fish was
skimpier than a genuine fish and that people would know. Franky replied that
the official fish would be only 10% smaller than real fish (10 official fish to
every 9 real) and they would also pass a law preventing the islanders from
comparing them to real fish. They would tell everyone that their scientists had
discovered a new disease among unprocessed fish and they would require everyone
to turn in their genuine fish for officially decontaminated fish as soon as
they are caught.
To keep the people from fishing themselves so they could not see real fish,
they decided to establish a Fishing Department which would have the sole
responsibility for catching fish. To keep people from discovering that the
value of their fish holding was down, the government would have a new agency
called Fish Deposit Insurance Corporation which would insure the fish. Once the
people knew that the Senate was behind their deposits, no one would withdraw
their fish. Max tried to fight this but was conveniently bumped off and the
transition from real to “official” fish took place. The GoodBank Savings and
Loans was now called Fish Reserve Bank and its new chairman was Alan Greenfin.
Shrinking Fish:
The Senate had a free hand on spending now. They announced grandiose projects,
plans and paid for them using Fish Reserve Notes. Some projects benefited the
islanders example bigger canoes for the navy, new system of cart paths for
transportation. There were others like the controversial Clean Rocks Jobs
Program which were harder to quantify. The new Fishing Department was now up
and running and most of the employees in these new found government departments
were happy because of the pay and security. The actual fish catching however
started lagging because Fishing Department had no incentive to take risks and
make profits hence it failed to become a model of efficiency.
Soon so many FRN had been issued that the technicians had to increase the
conversion rate, the ten to nine ratio of official fish to real fish now became
five to four. As official fish became smaller, it soon became apparent to the
islanders that they could no longer survive on one fish per day, they had to
eat two at a minimum to survive. Since fish were used as money on the island,
the prices for everything went up and the problem of “fishflation” was born. No
one understood what caused the prices to rise but Alan Greenfin stood up and
explained it with a theory called “cost-price-fish-push”. He argued that high
employment (thanks in part to government jobs) combined with a strong economy
creates greater demand for fish and forces up prices. As proof of their
prosperity, he pointed out that most islanders were now eating twice as many
fish as their parents.
The spending by government kept increasing and fish kept getting smaller
causing fish-flation. When fish-flation became rapid, islanders finally noticed
that the fish they withdrew from the bank were smaller than the fish they
deposited. So, despite the enticement of interest paid on their savings, they
began to save less while many discontinued saving completely. Instead fish had
to be spent quickly to avoid losses due to rapidly increasing prices. Since
fish-flation discouraged savings, bank deposits dwindled. As a result, there
were less fish available for funding projects and businesses. In response,
business cut back and workers were laid off. When unemployment reached crisis
level, people demanded that government do something.
In response, Senate set strict limits on how much companies could pay workers,
under what circumstances they could be hired and fired and how much the
businesses could charge for their products. With these constraints, it became
more difficult to do business and to grow them. The process continued, FRNs
were produced in ever greater numbers while the fishing fleet returned with
fewer and fewer actual fish. As official fish shrunk to just one-tenth of their
former size, even Greenfin knew that he could not stretch the fish skin any
further. When there were only bones left in the vault, he ran over to the
senate and called an emergency meeting.
Usonia was in trouble…enter Sinopia. Rest of the story in part 2.
