The Financial Apocalyptics Are Back
Many writers of investment books approach the topic of saving and investing without any clear economic theory. Value investors often share the sentiments of fund manager Peter Lynch, who said, "If you spend 13 minutes a year on economics, you have wasted 10 minutes."
At the other end of the methodological spectrum, MBAs trained in efficient portfolio theory disdainfully characterize the suggestion that investors should at times not hold any stocks in their portfolios as "market timing" — the investment world's equivalent of casino gambling.
It is not possible to approach macroeconomic questions without an economic theory. A sound economic theory may or may not yield any useful insights for investors, but a false one is almost certain to mislead.
Much investment literature and the financial media in general base their economics on weak foundations. It is almost unquestioned that consumption — not savings — drives the production of wealth. Louis-Vincent Gave, Charles Gave, and Anatole Kaletsky have written an entire book favoring the proposition that capital accumulation is a money-losing proposition for firms.
In his book Crash Proof: How to Profit from the Coming Economic Collapse, investor Peter Schiff presents a macro-driven approach. Schiff believes that the most important issue facing investors over the next few years is a series of macroeconomic crises that will impoverish most Americans. The reader is fortunate that Schiff's approach is based on Austrian economics. The "Further Reading" section contains titles by Rothbard, Mises, Hayek, Hazlitt, and J.B. Say. And unlike some writers who quote these thinkers without understanding them, Schiff displays a grasp of their thought and its application to investing.
Schiff's is really two books in one. The first is his analysis of the US economy, incorporating both theory and historical data. The second consists of his strategies for surviving and even prospering. This review will focus on Schiff's economics more than his investment advice. While his advice could be implemented through the investment firm of your choice, Schiff discloses that he is the founder of a brokerage firm offering investment accounts based on the recommendations he makes in the book. The reader should be aware that the book contains an element of marketing for his firm. However, after reading the book, I believe that his advice is honest in the sense that his investment recommendations are based on his economic view (be they right or wrong) and not the other way around. And by publishing his ideas, the reader could implement the recommended strategies with or without Schiff's help.
One of the greatest areas of economic fallacies in the investment media is the favoring of consumption over savings and investment. It is widely reported, for example, that Americans provide the "engine of growth" in the world economy by consuming what others produce. Americans are described as doing the entire world a favor by consuming the goods that others produce, without which they would all presumably be unemployed. Commentary often describes consumption as if it were hard work, "heavy lifting," or otherwise a highly meritorious and benevolent activity.
Consumption is the fun part, while savings and production is work. While consumption creates demand for the products of others, the point that is missed by most of the media is that demand must be funded by supply. Unfunded demand created by printing more paper is simply a drain on the productive efforts of some by the recipients of the paper. Schiff writes:
The world no more depends on US consumption than medieval serfs depended on the consumption of their lords, who typically took 25 percent of what they produced. What a disaster it would have been for the serfs had their lords not exacted this tribute. Think of all the unemployment the serfs would have suffered had they not had to toil so hard for the benefit of their lords.
The way modern economists look at things, had the lords increased their take from 25 percent to 35 percent, it would have been an economic boon for the serfs because they would have had 10 percent more work. Too bad the serfs didn't have economic advisers or central bankers to urge such progressive policies. (p. 14)
In contrast to the anti-savings bias of the financial media, Schiff understands that savings are necessary to fund economic growth:
It is important to remember that in market economies living standards rise as a result of capital accumulation, which allows labor to be more productive, which in turn results in greater output per worker, allowing for increased consumption and leisure. However, capital investment can be increased only if adequate savings are available to finance it. Savings, of course can come into existence only as a result of [consuming less than one earns] and self-sacrifice. (pp. 6–7)
Another common economic fallacy is that we don't need to save because our assets are going up in value. Rising asset values benefit the owners of existing capital assets, but they do nothing to add to the total capital stock. That would require additional savings. Moreover, as Schiff points out, rising asset values reflect largely the effects of inflation on financial assets.
Savings? Who needs savings when you own stocks that can only go up in price and a home that gains equity every year? Let the dismal scientists worry that stock values or home equity might simply be the result of inflationary bubbles created by an irresponsible Federal Reserve, or that when the bubbles burst, all that will remain are the debts that they collateralized.
One area where Schiff may be on less firm ground is in his analysis of the US trade deficit, which he sees as prima facie evidence that Americans are selling claims on their accumulated capital structure to support current levels of consumption. Schiff believes that the trade deficit is evidence that consumption has been outstripping production, and that Americans are making up the difference by taking on debt. For example,
The shift from manufacturing to services caused growing trade deficits. (p. 9)
We are financing that consumption [the trade deficit] not with money we have saved but with money we have borrowed, mostly from the same countries we're importing from. (pp. 28–29)
A trade deficit as such does not necessarily indicate an unsustainable imbalance between production and consumption. All that a trade deficit means is that the deficit country is importing capital. If the imported capital is used to fund the development of the productive structure within the country, then the resulting financial claims are supported by production. A country can run trade deficits forever as long as this is the case. Economic historian Sudha Shenoy writes that Australia has run trade deficits and imported capital for over 100 years.
Schiff's view of the trade deficit could be correct but it does not follow from the mere existence of a trade deficit. To prove this, he would need to show that the imported capital is largely or entirely spent on consumption, not on productive capacity. On the contrary, Shenoy provides evidence that capital goods, not consumption goods, make up the majority of US imports. Shenoy has broken down international trade data to show that US trade in the private sector is balanced for the years in her study (up to 2002). Her analysis puts the blame for the trade on government over-consumption. (This is not to imply that the US government's financial profligacy is not a problem, only that Schiff's analysis of the trade deficit is questionable.)
Schiff shares the skepticism of most Austrians toward central banking and inflation. One of my favorite sections is called "Fiat Money: Why it is the Root of our Economic Plight." Schiff correctly identifies inflation as an expansion in the quantity of money. As he points out, central banks create debt not backed by any production: "demand created by inflation is artificial because it does not result from increased productivity" (p. 70).
This underlying economic principle is known as Say's Law or Say's Law of Markets …the supply of each producer creates his demand for the supplies of other producers. This way, equilibrium between supply and demand always exists on an aggregate basis. (pp. 70–71)
His discussion of "How the Government Obfuscates the Reality of Inflation" is excellent. Schiff soundly refutes a series of scapegoats for inflation used by government economists: cost-push inflation, the wage-price spiral, and inflation expectations. A sidebar (p. 93) explains that inflation is not caused by economic growth, either.
He follows with a discussion of the politically based manipulation of inflation measurements. "Core inflation," for example, is often cited as evidence of low inflation; however, it is computed from the same data as the CPI excluding food and energy, as if price increases in food and energy don't matter. Another section is devoted to the questionable practice of substitutions in the basket of goods used to compute the CPI. Substitutions allegedly better reflect actual consumer spending, but in practice, as Schiff points out, replacing higher-priced goods that people consume less of with lower-priced substitutes imparts a downward bias to the basket.
The underlying reason for manipulating the CPI is for the central bankers and their political allies to avoid taking the blame for the inflation that they have created:
If you really want to see the effects of inflation, just look around you. The prices are rising wherever you look, yet the CPI, the PPI, and the PCE say otherwise. That is because the indexes do not measure how much prices actually rise, but how much the government wants us to think they rise. (p. 78)
The deflation bogey is frequently raised by Wall Street economists as a justification for further central bank inflation. According to this way of thinking, deflation is supposed to be even worse than inflation, and we should be thankful that we have the Fed artfully charting a course between the two terrors. Schiff dismisses this nonsense:
Deflation, which we technically define as the opposite of inflation, meaning that in deflation the supply of money contracts, is erroneously defined by government and Wall Street as falling consumer prices. Using that false definition, what is wrong with falling consumer prices? Aren't lower prices, in general, beneficial and conducive to better living standards? Why would it be a problem if food became less expensive, or if education or medical care became more affordable? What is so bad about being able to buy things at cheaper prices? Why does the government have to save us from the supposed scourge of lower prices?
Furthermore, contrary to popular belief, falling prices are actually a more natural phenomenon in a healthy economy than are rising prices. Manufacturers recover their costs and gain economies of scale that result in lower consumer prices, which lead to greater sales, higher profits, and rising living standards. In fact, it is the natural tendency of market economies to lower prices that makes them so successful. (p. 79–80)
It is widely stated by deflation-phobic Wall Street economists and central bankers that people will stop spending if prices are falling, and that business firms will not be able to make profits. Schiff skewers these fallacies as well, pointing out that the goods that have had the greatest growth in sales volume are those whose prices have fallen the most, such as computers. Moreover, firms increase profits by selling greater volumes at lower prices because capital investment has enabled them to reduce their costs even more than their prices. Without the supply of money increasing, the prices of these goods would have fallen further. Schiff writes,
The usual fears about falling prices …simply don't make sense. Unless an economy is in a total free fall, people don't stop buying in anticipation of lower prices.…
Nor does the argument that corporate profits suffer from falling prices hold water. Profits represent margins, which exist independent of prices, and what is lost in dollar sales is gained in volume.
Yet under the guise of "price stability," generally defined as annual price rises of 2–3 percent, the government robs its citizens of all the benefits of falling prices and uses the loot to buy votes, thereby trading the rising living standards of their constituents for their own reelection. (p. 80)
His discussion of the business cycle is clearly Austrian. As the Austrian business cycle theory has become the flavor of the month, analysts are frequently quoted in the media who misinterpret the theory as an over-investment theory, while it is in reality a mal-investment theory. In a section titled "The Classical and Correct View of Business Cycles," the author explains:
According to the classical economists, like Ludwig von Mises and Friedrich A. von Hayek of the Austrian school, recessions should not be resisted but embraced. Not that recessions are any fun, but they are necessary to correct conditions caused by the real problem, which is the artificial booms that precede them.
Such booms, created by inflation, send false signals to the capital markets that there are additional savings in the economy to support higher levels of investment. These higher levels of investment, however, are not authentically funded because there has been no actual increase in savings. Ultimately, when the mistakes are revealed, the malinvestments, as Mises called them, are liquidated, creating the bust. Legitimate economic expansions, financed by actual savings, do not need busts. It is only the inflation-induced varieties that sow the seeds of their own destruction.
This flies in the face of modern economic thinking that regards the business cycle as the inevitable result of some flaw in the capitalist system and sees the government's role as mitigating or preventing recessions. Nothing could be further from the truth. Boom/bust cycles are not inevitable and would not occur were it not for the inflationary monetary policies that always precede recessions.
Economists today view the apparent overinvestment occurring during booms as mistakes made by businesses, but they don't examine why those mistakes were made. As Mises saw it, businesses were not recklessly over investing, but were simply responding to the false economic signals being sent as a result of inflation. (p. 87–88)
While I object to Mises and Hayek being identified as classical and Austrian, as if they were the same thing, Schiff's coverage of the Austrian business cycle is sound.
I will say a few words about Schiff's forecasts. He sees on the horizon a stock market crash, the bursting of the real estate bubble, and the collapse of the dollar. For the first two of these, his reasons are the overvaluations of these asset classes, runaway credit expansion, and the moral hazard created by bailouts. His argument for the collapse of the dollar is tied very closely to his view of the trade deficit, which I have called into question above.
Schiff's book falls in a long line of gloom-and-doom forecasts offering advice on how to profit from them. Many of these books even have titles containing the words "how to profit from the coming 'X.'" A search on Amazon.com for those words shows a number of titles including the coming Y2K computer crash, the coming hyperinflation (1985) and the coming currency recall (1988).
I recall reading a column by a prominent financial reporter in which she heaped scorn and ridicule upon gloom-and-doomers because they had been wrong for an entire year, so they rolled out the same forecasts for the next year. Her point was, when are they going to just admit that the economy is in great shape, is growing, and that their whole bearish world view is out of step with reality?
My purpose in bringing up blown forecasts is not to suggest that anyone forecasting a crisis is always wrong. Crises do happen. In recent years, a number of countries have had their currency collapse or have defaulted on foreign debt. Recall the Asian contagion, the Mexican peso crisis, the Russian ruble crisis in 1998, and the Argentine banking crisis. America is not inherently immune from such a crisis. Perhaps we have one unfolding now in the sub-prime sector, though there is still debate about whether it will remain contained there or will spread. Either way, the laws of economics apply to America as well anyplace else. And I believe that Schiff does as good a job as anyone making the case that the trends that he examines are unsustainable, excepting possibly the trade deficit.
While it is possible to see unsustainable trends playing out, some of them take many years to reach the breaking point, and in the meanwhile, there can be very long counter-trend movements. While bubbles burst, getting the timing right is difficult. It is possible to be right about the bursting of a bubble but wrong for a long period about the timing. Many of the bears in the late '90s who correctly identified the stock market bubble were wrong for several years. At the time of this writing, it very much appears that the collapse of the housing bubble is underway.
The book recommends that investors hold foreign stocks having higher earnings yields and paying greater dividends than US stocks; gold and gold mining; and cash or liquid short-term bonds to preserve purchasing power until after bubbles have burst, when the money will be put to work at much more favorable valuations. While these recommendations make sense given his forecasts, it is possible that the same recommendations might make sense even given a different set of forecasts than Schiff's.
Due to space, I have left out many things I liked about Crash Proof. I recommend the book to anyone who wants an analysis of current economic trends from an Austrian viewpoint along with some appropriate investment ideas; it is one of the best examples of sound economic writing among investment books. While I believe that Schiff makes a good case for most of his forecasts, time will tell whether the crises are imminent.
 Shenoy's articles are "The Case Against Neo-Protectionism" (mp3), "The New Global Marketplace" (mp3), "The Division of Labor is World-Wide," and "'Is America Living Beyond its Means?' — Is That the Right Question?" and "Foreigners and those Vast Dollar Holdings." For another contrary view that directly addresses some of Schiff's points, see "Trade Deficits and Fiat Currencies," "Trade Deficits and Collectivism," and "Isn't the Capital Surplus a Good Thing?" by economist Robert Murphy.
 See Mark Thornton's "Apoplithorismosphobia," in the Quarterly Journal of Austrian Economics, Vol. 6, No. 4 (Winter 2003): 5–18, available in PDF. You can also listen to a talk he gave on this paper at the Mises Institute Supporters Summit, 2004, available in MP3.