Crash Prone

[What follows is an essay-type-thing by a reader that may be of some interest. I was especially interested because I follow Pete Schiff and generally agree with his view on things. Schiff was Ron Paul's economic adviser during the 2008 presidential race. I will be adding my own comments as "SG- xxxxx" in bold later on]

[But first a short video that will give you an idea of where Pete Schiff is coming from. As a small business owner I see this sort of thing directly. I might like to give a raise to my workers, but sometimes can't because of the costs of regulatory burden. This isn't an imaginary thing for me; I see how BTP workers including myself are hurt by government meddling.]

Assessment of Crash Proof 2.0 by Peter Schiff

Schiff’s Core Thesis
Schiff’s primary assertion is that the dollar will dramatically plunge in value, causing an economic meltdown analogous to 1920s Germany. He’s vague on when he thinks this will happen, but his general tone and stridency imply that he thinks this going to happen soon.
He believes that the dollar’s dramatic plunge in value is inevitable due to the synergistic effect of the following events:
1. Other nations (mainly China and Japan) will conclude that the US cannot honor its obligations and will therefore stop buying US treasury securities and will even liquidate their holdings of US treasury securities.

2. When this happens, the government’s deficit spending can no longer be financed by selling treasury bonds to outsiders. The US government will then be forced to print huge amounts of money, causing hyperinflation.

3. Hyperinflation will dramatically erode the dollar’s purchasing power (as much as 90%), with these consequences:

a. Other nations will stop buying and holding dollars since their value will be wiped out by hyperinflation.

b. Foreign manufactured goods will become unaffordable in the US because they will increase in dollar cost at the same rate as inflation.

4. The US people, lacking a productive (i.e., a manufacturing) economy, and being unable to afford foreign goods will quickly become destitute since there is no significant manufacturing base in the US.

5. This will be exacerbated by the fact that the American people have few savings and have therefore incurred a great deal of debt to finance their activities.

6. China will simply start selling their goods to their own people and ultimately supplant the US.
Schiff suggest the following solutions:
1. Individuals should immediately convert all wealth to inflation-proof investments like gold, land, etc. Especially gold, since it has a value outside the US. This will protect them from hyperinflation.

2. As a whole, the American people should dramatically increase their savings and shift back to a productive economy (i.e., a non-service oriented economy), which will take a very long time and result in dramatic economic upheaval.

3. In particular, the US should return to a manufacturing economy in which a majority of workers have higher paying manufacturing jobs, rather than lower paying service jobs.

4. Individuals should invest in foreign companies in the more productive Asian economies.

My Assessment
1. Things I Agree With

a. Many of Schiff’s arguments are logical and persuasive to me. I especially agree with his indictment of US deficit spending and his observation that the Federal Reserve has utterly failed at its primary mandate – to control inflation—and that the Fed has actually created the problems it was supposed to solve.

b. I also agree that the Keynesian school of economics is fundamentally wrong in its assumption that spending is the most effective solution for recessions.

c. In general, I agree that continued deficit spending will be highly inflationary, once foreign nations stop buying our bonds. And it does appear to me that China and other nations have more or less maxed out on their purchases of US treasury bonds.

d. And if the dollar loses its status as the reserve currency, I’d agree that some devaluation of the dollar would occur.

e. He thinks that the stock market is “overvalued”. I agree, but only if you exclude any consideration in the stock prices for future growth. I’m not sure that’s a reasonable approach, though I personally think most public stocks are overpriced.

2. Things I Disagree With

a. Schiff misunderstands certain fundamental economic facts and also misrepresents some important facts that are crucial to the validity of his thesis. I won’t list every quibble and will focus on the flaws that are directly relevant to his thesis.

b. Savings

i. He misunderstands the real role of savings in the economy. He equates savings with “deferred production” -- assets that are invested in activities that will produce far more value in the future. However, savings and deferred production are not the same thing. Savings can certainly lead to deferred production. But not necessarily.

ii. Savings leads to deferred production (and therefore true investment in future productive activities) only when there’s enough demand for loans to put the savings to productive use. I'm not certain that Schiff fully understands that banks are really just “loan brokers”. They take your savings and loan it to other folks. The interest difference is the bank's fee for brokering that loan (and insuring it through the FDIC and compliance with fractional reserve rules). In economic terms, savers are loaning money to others.

iii. Therefore, the economy only benefits from high savings if there is sufficient demand for bank loans for “productive” activities.

iv. The problem is that an excessive savings rate will actually limit the opportunities to defer production. If more money is saved than can be loaned to productive enterprises, then production actually declines and the economy suffers. So a huge savings rate could easily limit the number of viable productive activities that need bank loans. This is because savers won't able to afford the goods/services produced by these ventures, which will then limit the number of ventures that are feasible.

v. Schiff also excludes stock market investments as a form of deferred productivity. I disagree; buying equity in a productive company is economically similar to loaning it money and both are forms of deferred production. Stock certificates represent an actual investment in the company at some point. By buying these shares, you enable the owner to directly or indirectly reinvest in other productive activities. In many cases, the owner is the company itself.

vi. All this means that his focus on savings is misplaced. I do not think that a low rate of personal savings will cause permanent material damage to the dollar’s prospects. Nor do I think that dramatically increasing the savings rate will help the US economy. As Japan found out in the 1990s, a high savings rate weaken economic growth. The high Japanese savings rate deprived the Japanese economy of growth capital. Essentially, the total value of Japanese savings greatly exceeded demands for loans to create/grow “productive” ventures. And this high savings rate meant that the Japanese people had less money to spend, which reduced the opportunity for productive businesses to be created. No sales (due to an unhealthily high savings rate) = no business.

c. Foreign Holders of US Treasury Bonds

i. A bond is nothing more than an unsecured promissory note. So when Asian nations buy US bonds, they are effectively loaning us money.

ii. Like any lender, the Asians could decide to stop loaning us money.

iii. Like any lender, they could decide to liquidate their stockpile of US bonds (i.e., sell the promissory notes to someone else).

iv. However, I am very skeptical that either of these events will seriously damage the US economy:

1. If the Asians stop loaning us money (by not buying US treasuries), we can probably find other lenders (though the interest rate will be higher). If we can’t, then the Asians will have done us a tremendous favor. Our political class will be forced to live within its means or court political disaster by creating serious inflation. Either outcome should be a long term benefit. As Jimmy Carter found out, high inflation will end your political career quickly. The reason Obama can be sanguine about deficit spending is that so far, foreigners have financed his deficit spending. When that stops, further deficit spending will cause a serious inflation spike, which will get Obama (and Congressional spendthrifts) fired.

2. If the Asians liquidate their holdings of US treasury bonds, then it’s hard to see how that will seriously harm us. It will hinder our borrowing somewhat because a glut of US bonds will drive the price down. But it will do serious harm to their currency and securities because suddenly, their national asset value will drop significantly. This means that their bondholders and currency holders will be less certain that they will get paid, which will force them to (in effect) pay higher interest rates for their borrowing. In addition, any commodity denominated in dollars (i.e., all of them) will be reduced in value as the dollar takes a modest hit. This will damage countries that are large exporters of commodities (like China). Assuming, of course, that the US treasury bonds are truly worthless.

3. In addition, such a liquidation would be political suicide for the political classes of many Asian nations (since they made the decision to buy all these US bonds).

d. Foreign Holders of US Dollars

i. As Schiff notes, there are a significant number of dollars held by foreign governments. This is due to two factors—(a) the dollar is used to directly or indirectly fund international trade transactions; and (b) the dollar is seen to have more value than other currencies.

ii. I don’t see either of these situations changing in the near future. What will replace the dollar? No Western currency is plentiful enough nor strong enough to replace the dollar. The Euro has – as I predicted a decade ago – turned into a fiasco and is on life support. Non-western nations lack even the most basic accounting safeguards for anyone to trust their currency. And none of them are numerous enough to do the job.

iii. Hyperinflation could cause the dollar to lose its status as a reserve currency. But that level of hyperinflation would require both item C. and D. to pass, and for the US political class to commit political suicide. I just don’t consider this a very likely occurrence.

e. US Manufacturing

i. Schiff, like many economic commentators, breezily claims that the US lacks any significant manufacturing base. This has been repeated so often that everyone accepts it as an axiom. But is it really true?

ii. Short answer – no, it is not true, and here’s why. If almost everyone was in a service economy and the US had virtually no manufacturing capability, we would all starve or die of exposure. There would be no roads, buildings, cars, machine tools, food production, etc. Since these things exist in abundance in the US, the narrative that the US is not a manufacturing country must, as a matter of logic, be false.

iii. Consider this hypothetical. Ten men constitute an economy. All of them produce tangible goods that they all need to survive. If six of them stop producing and start providing services to everyone, then the economy will immediately collapse, if nothing else changes. But if the four non-service people can triple their productivity, then the economy actually sees a net increase in tangible goods. This should apply at the national level as well.

iv. To test this idea, I pulled the US annual Gross Domestic Product numbers for 1929-2009. I excluded all “non-productive” items – services, government spending, consumer spending (even on durable goods), all imports, etc. For that period, “productive” economic activity has constituted from 30% to 40% of total GDP. The major exceptions are the Great Depression and World War 2, where it was much lower (remember that weapons are not really “productive” – they create no additional wealth). As recently as 2001, the productive economic activity was nearly 40% of total GDP. The fluctuations largely correlate with booms and recessions, which is what you’d expect. And since this is a relatively fixed percentage, and since the GDP has grown dramatically in real dollars over that period, our “productive” economic output (valued in real dollars) has increased dramatically. See the chart below:

v. In addition, as recently as 2009, the US produced about 25% of the total value of manufactured goods in the world.

vi. So given these facts, it is absurd to assert that the US is not a manufacturing nation.

vii. Now, what is true is that there are far fewer manufacturing workers today. But so what? In a technologically advancing nation, one would expect that machines would dramatically improve productivity and reduce the number of people required. And since our overall unemployment rate has been very low (until 2008) and since the average income per worker (in real dollars) has increased steadily since 1929, it’s hard to make the case that these industrial jobs were replaced by lower paying service jobs (as Schiff claims).

viii. In fact, this claim another fundamental economic absurdity in Schiff’s thesis. If manufacturing jobs were actually worth more than service jobs, then there would have to be a strong economic need for those workers. But there isn’t any such need and Schiff’s call to turn the clock back to 1950 would dramatically reduce our net economic output.

f. China, Etc. Replacing the US

i. Schiff argues that China (and other nations) will simply stop selling their manufactured good to the US and instead sell them to their own people.

ii. In my opinion, this is a ridiculous claim that highlights some serious flaws in his reasoning, for the simple reason that China cannot afford to sell all their goods to their own people:

1. China’s per capita GDP is still a tiny fraction of per capita GDP found in most Western economies. This means that the average Chinese citizen annually produces about 7% of the wealth that the average American citizen does. ($3700/yr vs $47,000/yr).

2. China is selling their export goods at very low margins. This mean that the actual economic cost of Chinese export goods is pretty close to what they sell those goods for.

3. So…how will individual Chinese citizens with only 7% of the purchasing power of individual Americans be able to buy these same goods?

4. Or, in raw economic terms, how will the Chinese people, with 7% of the per capita GDP of Americans, produce enough wealth to pay the cost of goods that their factories now export to the US?

5. China’s economy is simply too poor to pay for its own manufactured goods.

iii. This suggests that China’s industrial economy can only survive if the US (or another very wealthy nation) continues to buy their goods. If that stops, most of their factories will quickly go bankrupt. Bottom line – it takes wealth to create wealth, and China is still a poor country on a per person basis.

iv. Now, when China’s per capita GDP is close to that of the US, then Schiff’s scenario starts to become more plausible. Of course, that won’t happen in this century, if it happens at all. Indeed, I expect that robotics will largely make China’s industrial output uncompetitive.

v. As an aside, China has a serious systemic flaw in their economic approach – they are not building an educated, technically skilled middle class. If you look at construction projects in Shanghai, you’ll see very little mechanization. Rather than a couple of large backhoes, you’ll see hundreds of laborers with shovels. This “brute force and ignorance” approach will seriously limit the growth of a middle class in China. And no modern industrialized nation has ever made it to first world status without a large middle class.

vi. Finally, a comment on the recent news that China’s economy is now larger than Japan’s. Uh, so what?

1. When dealing with large nations, I think that per capita GDP is a far more useful indication of a country’s economic power. By that standard, China is hardly a powerhouse. With 12x Japan’s population, their economy is approximately equal in size. This means that the Japanese create 12 times the wealth per person that the Chinese create per person.

2. And while developing economies can experience tremendous growth early on, that growth almost always slows dramatically as the economy matures. You can’t assume that because China (say) doubles its $1500 per capita GDP in 10 years, it can do the same when its per capita GDP is $15000.

3. Also some very astute observers believe that China is “padding their books” and that their true economic performance is far lower than reported. One of these guys is the guy who figured out that Enron was cooking its books. I recall a salient point he made about China – that while they reported a tremendous increase in car sales in 2009 (increasing their total car stock by 25% in that year alone), their gasoline consumption remained flat. There are similar dissonances in other sectors of the Chinese economy. Of course, investment counselors who have touted China in the past have elaborate lists of speculation as to why this isn’t evidence that China is cooking the books. But given the fact that China lacks even the most rudimentary level of financial transparency, Occam’s Razor suggests to me that they are probably cooking the books.

g. A Return to the Gold Standard

i. Schiff argues that fiat currency (i.e., paper currency not backed by assets with inherent value) is a Bad Thing and that a return to the gold standard would dramatically benefit the US economy.

ii. While it is true that gold-backed money would put an end to deficit spending, there are some serious negative consequences to returning to the gold standard:

1. Politicians could replace deficit spending with higher taxes (economically similar), so the gold standard is no guarantee of reduced government spending.

2. Gold itself has no “intrinsic” value, other than as an industrial metal. So it is really a fiat currency as well. It’s just one that governments can’t magically create.

3. And since gold is a commodity, its value fluctuates considerably, often on a daily basis, and often far more than paper currency does. This could easily cause economic upheaval as currencies would fluctuate just as much. In addition, gold would be far easier for unscrupulous individuals to manipulate, and it would be nearly impossible for governments to counter such manipulation. There were economic booms and busts just as frequently when the US was on the gold standard. Note that the Great Depression occurred when we were on the gold standard. (Of course, the length of the Great Depression was caused by government interference in the economy, not by being on the gold standard).

iii. So I have never been convinced that a return to the gold standard would be of serious benefit to the US economy. It is certainly not a serious solution to our problems.

h. Printing Money

i. Given his detailed critique of the Federal Reserve, I am surprised that Schiff would claim that the US government would resort to printing money. This is because the US Government cannot print money. It can only tax the citizens and borrow money via bond sales.

ii. And if Schiff’s other predictions come true, no one will loan us money.

iii. And while it’s certainly possible that the US government could raise taxes to very high levels, that won’t cause inflation.

iv. Of course, the Federal Reserve prints money. And if it buys US treasury bonds, then the result is analogous to the government printing money. However, this has been a relatively small scale occurrence. To flood the economy with cash and create massive hyperinflation, the Federal Reserve would have to increase such activities by several orders of magnitude. I don’t see that happening, simply because the Fed chairman is not controlled by the Congress or the President. Also, the Congress would have to approve the sale of huge amounts of bonds, and that would be political suicide for the politicians who support this.

v. I should add that I think that the Fed will create higher inflation by purchasing treasury bonds. But 10-15% inflation is not hyperinflation.

i. Deficit Spending

i. Schiff is highly critical of deficit spending (and the Keynesian obsession with spending as a panacea for recessions). I generally agree with him that deficit spending is a Bad Thing and that the Keynesians are wrong.

ii. However, I disagree strongly that deficit spending is inevitable and uncontrollable. In the 1990s the deficit was eliminated. And had Bush not chose to fund the War on Terror with deficit spending, he would have had a balanced budget. So there is strong, recent precedent for the political class to eliminate deficit spending. They will just have to be convinced that doing so is critical to their survival.

iii. Even if deficit spending continues, it will be nearly impossible to create hyperinflation from just that. The reason is that you would have to flood the economy with ~$10 trillion of extra money to cause ~50% inflation. (Assuming about $10 trillion in the current liquid money supply, which was the case last year). And that would have to be done every couple of years to maintain such inflation. Not even B. Hussein Obama is considering that. So even trillion dollar annual deficits won’t create hyperinflation. They will, however, create normal inflation, which is bad enough.

3. Bottom Line

a. Schiff has artfully painted a very bleak scenario that seems inarguable. But – this is true only if his underlying factual assertions and logical assumptions are accurate.

b. Fortunately for the rest of us, many those assertions and assumptions are inaccurate or logically dubious.

c. Of course, Schiff did predict the real estate meltdown of 2008. However, past performance does not always translate to future performance. And it should be noted that he was hardly the only person predicting a coming real estate bubble. Many commentators were very concerned that the permissive lending environment (combined with Fannie Mae and Freddy Mac’s de facto guarantee to purchase loans, no matter how dubious) was causing housing prices to increase to absurd levels. And that there was an inevitable day of reckoning coming. But no one – including Schiff –knew when it would occur. So I wouldn’t make too much of the fact that he predicted an event that many sensible folks expected to happen at some point.

d. And note that Schiff is in the business of selling gold and investments in other countries. Awfully convenient that these are the very solutions he recommends…

e. So while I do think that there will be serious economic issues in the near future, I am not persuaded that Schiff’s scenario is very plausible. I would not make serious economic decisions based on his scenario. The likely economic problems in the future are bad enough.

Note: This paper is my opinion. I am not a professional economist, nor do I play one on television.



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