How an Economy Grows and Why It Crashes

1. Economic growth stems from savings, not spending

For all species, except our own, economics really boils down to day-to-day survival.

Savings drive growth. Unlike animals focused solely on survival, humans can save and invest to increase productivity. When individuals like Able underconsume and take risks to create capital (like fishing nets), it allows for greater future production. This increased efficiency frees up time and resources for new innovations and industries, raising living standards for all. Savings provide the seed capital for entrepreneurs to start businesses, develop new technologies, and expand productive capacity.

Consumption doesn't create wealth. While politicians and many economists focus on boosting consumer spending to grow the economy, this puts the cart before the horse. An economy can't grow simply because people spend more; rather, people can spend more when the economy grows through increased productivity. Policies aimed at artificially boosting consumption often lead to debt bubbles and misallocation of resources, rather than sustainable growth.

2. Government intervention distorts markets and misallocates resources

Loans made to individuals or enterprises that do not succeed in creating a needed innovation or expanding productive capacity tend to weaken the overall economy by wasting the supply of savings.

Markets allocate resources efficiently. In a free market, capital naturally flows to its most productive uses through the profit motive and price signals. When governments intervene with subsidies, guarantees, or artificially low interest rates, it distorts this process. For example:

• Housing subsidies and guarantees fueled an unsustainable real estate bubble
• Student loan subsidies have driven up tuition costs
• Bailouts of failing companies prevent the reallocation of resources to more productive firms

Unintended consequences abound. While government interventions are often well-intentioned, they frequently lead to unintended negative consequences that outweigh any benefits. Policymakers lack the knowledge and incentives to effectively direct an economy. By trying to pick winners and losers, they often misallocate society's limited resources to suboptimal uses.

3. Inflation erodes purchasing power and discourages saving

Keeping this in mind, it is easy to see what makes economies grow: finding better ways of producing more stuff that humans want. This doesn't change…no matter how big an economy eventually gets.

Inflation is monetary expansion. Many people mistakenly believe inflation simply means rising prices. In reality, inflation is an expansion of the money supply, with rising prices as a symptom. When governments print money, it devalues the existing currency, eroding purchasing power over time. This "hidden tax" silently transfers wealth from savers to debtors.

Saving becomes less attractive. In an inflationary environment, holding cash loses value over time. This discourages saving and encourages immediate consumption or speculation in assets. Without adequate savings, there is less capital available for productive long-term investments. Inflation also distorts price signals, making economic calculation more difficult for businesses and consumers alike.

Effects of inflation:

• Erodes purchasing power of savings
• Discourages long-term investment
• Encourages immediate consumption and speculation
• Distorts price signals and economic calculation
• Transfers wealth from savers to debtors

4. Easy credit fuels asset bubbles and economic instability

When interest rates for hut loans dropped due to the Finnie and Fishy guarantees, islanders were able to take out bigger loans. As a result, just like surfing school tuition, hut prices started moving noticeably higher.

Artificially low rates distort markets. When central banks keep interest rates artificially low, it sends false signals about the true cost of capital. This encourages excessive borrowing and malinvestment, often fueling asset bubbles in areas like real estate. These bubbles inevitably burst, leading to economic crises.

The boom-bust cycle intensifies. Easy money policies create an illusion of prosperity during the boom phase. But this growth is built on an unsustainable foundation of debt. When reality sets in, the bust that follows is often more severe than if the economy had been allowed to grow organically. This cycle of booms and busts creates economic instability and misdirects resources from productive long-term investments.

Key drivers of asset bubbles:

• Artificially low interest rates
• Government guarantees and subsidies
• Speculation and "greater fool" mentality
• Loosening of lending standards
• Belief that "this time is different"

5. Trade imbalances and fiat currency lead to economic vulnerability

Without the built-in demand for dollars made possible by the global economic system, no country could long sustain such imbalances. Companies and governments would simply refuse to trade goods for a currency with which it couldn't buy anything.

Reserve currency status enables imbalances. The U.S. dollar's role as the world's reserve currency has allowed America to run persistent trade deficits. Other countries accept dollars for their goods because the currency is needed for international trade. This has enabled Americans to consume more than they produce for decades.

Fiat money lacks intrinsic value. Since abandoning the gold standard, the dollar (like other modern currencies) is backed only by faith in the government. This gives policymakers the ability to create money at will, potentially leading to currency debasement. The current system of floating fiat currencies and large trade imbalances is unprecedented in history and inherently unstable in the long run.

Risks of the current system:

• Accumulation of unsustainable debt levels
• Potential for rapid currency devaluation
• Misallocation of resources towards consumption rather than production
• Vulnerability to loss of confidence in fiat currency
• Economic distortions from artificial suppression of interest rates

6. Service economies are built on shaky foundations

Most economists assumed that the higher prices simply reflected the increasing social value of a surfing degree.

Production drives prosperity. A robust economy requires a strong foundation of productive industries that create tangible value. While service sectors can add value, they ultimately rely on goods produced domestically or imported. An over-reliance on services, particularly in finance and consumer services, can lead to economic fragility.

Education bubble parallels housing bubble. Just as government policies fueled an unsustainable housing boom, similar dynamics have inflated the higher education sector. Easy student loans have allowed tuitions to skyrocket while the value of many degrees becomes questionable. This saddles graduates with debt while potentially adding little to their productive capacity.

Risks of an over-financialized service economy:

• Dependence on imports and trade deficits
• Vulnerability to shifts in global trade patterns
• Inflation of asset bubbles (e.g., education, real estate)
• Misallocation of human capital to unproductive sectors
• Lack of resilience during economic downturns

7. Economic downturns are necessary for rebalancing

Recessions should be deflationary. Falling prices will cushion the blow of low employment. Somehow, modern economists see falling prices as a never-ending abyss toward demand destruction. They forget that when prices fall far enough, people start spending again.

Creative destruction is healthy. Recessions, while painful, serve an important function in a market economy. They expose unsustainable businesses and investments, allowing resources to be reallocated to more productive uses. This process, though difficult in the short term, leads to a stronger, more efficient economy in the long run.

Deflation can be beneficial. Contrary to conventional wisdom, moderate deflation can be a positive force. Falling prices increase purchasing power, benefiting consumers and savers. It encourages delayed consumption and long-term investment rather than immediate spending and speculation. While rapid deflation can be problematic, gradual price decreases due to productivity gains are a sign of a healthy economy.

Benefits of allowing recessions to run their course:

• Liquidation of malinvestments
• Reallocation of resources to productive sectors
• Correction of asset bubbles
• Increased purchasing power through deflation
• Encouragement of saving and long-term investment

8. Stimulus and bailouts delay necessary economic adjustments

The policy goals of both the Bush and Obama administrations have been to encourage consumers to spend as they had before the housing crash. But where will the money come from?

Short-term pain, long-term gain. Government interventions during economic downturns often focus on boosting spending and propping up failing industries. While this may provide temporary relief, it prevents the necessary rebalancing of the economy. Bailouts keep unproductive firms alive, while stimulus spending often goes to politically favored sectors rather than where market forces would direct resources.

Debt-fueled stimulus is unsustainable. When governments attempt to boost spending during recessions, they typically do so by taking on more debt. This creates the illusion of recovery while merely pushing the problem into the future. Eventually, the debt must be repaid through higher taxes, inflation, or default – all of which have negative economic consequences.

Problems with government stimulus and bailouts:

• Prevents reallocation of resources to more productive uses
• Creates moral hazard by rewarding risky behavior
• Increases government debt burden
• Distorts market signals and incentives
• Delays necessary structural reforms in the economy

9. Debt-fueled growth is unsustainable in the long run

At some point in the foreseeable future, perhaps in the next few years, we will have a very ugly encounter with our debt.

Living beyond our means. The accumulation of debt at both the government and household levels has allowed for artificial economic growth and elevated living standards. However, this process is unsustainable. Debt must eventually be repaid or defaulted upon, leading to painful economic adjustments.

Day of reckoning approaches. As debt levels continue to rise relative to economic output, the burden of interest payments grows. This leaves less room for productive investment and increases vulnerability to economic shocks. While timing is uncertain, a debt crisis becomes increasingly likely as the problem compounds.

Consequences of excessive debt:

• Higher taxes or reduced government services to service debt
• Potential currency crisis if faith in fiat money erodes
• Reduced economic growth due to debt overhang
• Intergenerational wealth transfer as future taxpayers bear the burden
• Increased economic fragility and vulnerability to shocks

Last updated: January 23, 2025