Peter Schiff on avoiding the brick wall

Peter Schiff, who was famously ridiculed for calling the crisis of 2008, steps up as a prognosticator again in his new book, The Real Crash: America’s Coming Bankruptcy - How to Save Yourself and Your Country. We had way too much government and cheap credit leading up to 2008, he says, and even more government and cheap credit since then, which is why the next crisis will be the real haymaker.

His book is divided into two main sections. Part I addresses the problems, while part II, which is by far the lion’s share of his discussion, presents solutions. In a nutshell, the problem is government, and the solution is to take an ax to it - again and again. Since this view is currently unacceptable to policymakers and the public at large, we can only hope reality will win out before calamity hits.

The Real Crash is encyclopedic in its coverage and highly readable in its presentation. Is there a government agency that truly serves the interests of all Americans? He finds few. What about services people actually want, such as K-12 education: Could they be done better at the state or local levels? Or better still by the free market? In most cases the answer is a profound “Yes!” to both.

Living on Bubbles

Our problems stem from a love of bubbles and the flawed economic theory that blesses them.

During Alan Greenspan’s reign at the federal reserve we had a savings and loan bubble, followed by a tech bubble, followed by a housing bubble. Now with Ben Bernanke at the Fed, we have a government bubble, meaning the Fed is creating money that the banks are then lending to the Treasury to expand government. “If you keep replacing one bubble with another, you eventually run out of suds. The government bubble is the final bubble.”

When the dot-com and housing bubbles burst we at least had something to show for them - “a few good Internet companies and some pretty nice McMansions, [but] no such benefits will remain when the government bubble pops.”

The Fed, Schiff says, should let interest rates rise so people can start saving again. The Fed’s low rates discourage savings, which are

the key to economic growth, as it finances capital investment, which leads to job creation and increased output of goods and services. A society that does not save cannot grow. It can fake it for a while, living off foreign savings and a printing press, but such “growth” is unsustainable— as we are only now in the process of finding out.

But for politicians and central bankers, rising interest rates are an abomination. The cost to service the national debt would go through the roof, while the economic contraction that would likely result would raise the deficit. The federal government would have to spend less, and many of the country’s biggest companies depend on government spending, through contracting, subsidies, or consumption.

But rising rates and the terrible pain it would cause is the good news; the bad news, if the Fed continues to hold rates low, is the economy will eventually go into hyperinflation. “Rising interest rates will be productive pain— like medicine,” he writes, “while hyperinflation will be destructive pain.” If we stay the course and pretend everything will somehow work out, we could be facing a crisis worse than the Great Depression.

Bernanke on the Great Depression

Chairman Bernanke, of course, is well-known as an “expert” on the Great Depression, and many people are betting the farm that he and his Keynesian staff have the skills to steer us back to sunny beaches and bikinis. Bernanke’s approach is to keep asset values from falling by any and all means. One of the reasons the depression of the 1930s became great, he believes, is because the Fed allowed the money supply to fall following the Crash. With less money in the economy, prices nosedived. People didn’t consume as much, consequently businesses didn’t profit as much, therefore employees got fired, and the economy headed south in a self-perpetuating spiral.

“Sustained deflation can be highly destructive to a modern economy and should be strongly resisted,” Bernanke said in a 2002 speech that inspired his nickname. And by deflation, he means “falling prices.”

Schiff explains what’s wrong with this analysis.

First, for 100 years prior to the 1929 Crash, bank deposits actually gained value each year. In other words, we had a century of deflation, that much-feared condition that Bernanke has vowed to avoid at all costs.

Second, from mid-1921 to mid-1929, the Fed increased the money supply by 55 percent, giving rise to a real estate and stock bubble. Most but not all economists missed the bubble and its inevitable consequences because rising productivity kept consumer prices fairly stable. Even as stock prices were falling only days before the Crash, Irving Fisher said stocks had reached a “permanently high plateau,” and he expected to see “the stock market a good deal higher than it is today within a few months.” In 1928, Ludwig von Mises had published a full critique of Fisher’s monetary theory, claiming that Fisher’s reliance on price indexes would bring about the Great Depression. Nonetheless, Fisher’s stable price theory carried the day, and when the sky fell the Fed, along with Hoover, “did something,” as Schiff explains:

Hoover’s Fed actually boosted the money supply by 10 percent in the two weeks following the 1929 crash. Repeatedly throughout Hoover’s term, the Fed created more money. But the money supply fell because people began hoarding cash, and banks stopped lending out their money.

Also,

Deposits went down by 30 percent, but most of that was due to people pulling their money out.

In other words, the money supply shrank despite the Fed’s interventions, not because of its inactions.

Did a falling money supply promote massive unemployment?

Not by itself. Hoover insisted on keeping wages high, and during his re-election bid in 1932 boasted that the wages of U.S. workers were “now the highest real wages in the world.” They probably were, and by not allowing wages to fall along with other prices, unemployment soared.

Had Hoover simply allowed the free market to function, the recovery would have been so strong that he likely would have been elected to a second term, and Teddy would have been the last Roosevelt to occupy the White House. Instead he handed the Keynesian baton to Franklin Delano Roosevelt . . .

None of this, as we know, is even close to the standard view of the Depression. Instead, we’re told

that government needs to play a bigger role in battling downturns, and the Fed needs to pump in cash to jump-start the economy. This bad lesson stays with us today, and beginning in the early 1990s, this way of thinking started the cycle of bubbles that put us where we are now.

End Keep the Fed

The one puzzling part of Peter Schiff’s masterpiece is his view that the federal reserve, as originally conceived, was a good idea. He describes the Fed as “reckless,” the “biggest culprit in discouraging savings,” and insists “we never should have trusted the Fed to respect its boundaries.” But he also says:

The original intention of the Fed was something I might have supported had I been around back then. In theory, it was an agent of stability that could also promote economic growth. . . .

The Fed would increase the money supply as the economy expanded, and then reduce the money supply as the economy contracted. . . .

In theory the Fed was a good idea. It’s just that in practice it did not work, because politicians quickly abused it.

He argues that before 1913, banks were issuing their own currencies backed “by assets, such as gold, and by the banks’ loan portfolios.” If “you traveled to California, your bank note from Connecticut might not be honored by other merchants or the California banks.”

Thus, he concludes, it was natural “for bankers to hatch an idea of a “banks’ bank. Banks could deposit some of their assets— commercial paper or gold— with the Fed, and the Fed in return would issue its own bank notes to the individual bank.”

While this may sound plausible, questions arise as to (1) why the “banks’ bank” needed “guns and badges” (i.e., government cartelization) to make it work; (2) why loan portfolios or commercial paper can be assumed to be an acceptable substitute for gold coin; (3) why a central bank is needed to expand and contract the money supply - in other words, why assume the supply/demand relation of the free market fails when the good in question is commodity money; (4) why the historical record of central banks acting as an agent of stability and sustainable economic growth is short on examples; and (5) why did the Fed, at its creation, possess a massive inflationary structure if it was sold as a means to promote stability?

I believe central banking, by its nature, is a means of institutionalizing, centralizing, and cartelizing moral hazard. It is my view that the Fed was never a good idea, but one of the absolute worst ever brought to fruition.

These concerns notwithstanding, his critique of the Fed as it currently exists is emphatically on the money. Though he doesn’t support its abolition he does say, “In an ideal world, there would be no Fed, and I think the nation would be better off if the Fed had never been created.”

How we can save ourselves

Readers of his book don’t have to be swept up in the impending disaster. Unlike the crash of 2008 when investors flocked to the dollar as a safe haven, he believes the dollar and U.S. bonds will collapse before the U.S. economy goes under. He devotes a chapter to crisis investing based on the observation that since Americans have been living beyond their means, many others have been living beneath their means.

Elsewhere in the world there are more creditors than debtors, and there is pent-up demand and excess production. In the future, these economies will see a surge in demand, while ours will see demand fall. . . .

Bottom line: purchasing power is shifting. You should try to invest in companies that will benefit from this shift. These will primarily be foreign companies. Of course, many foreign companies sell to the United States. These aren’t the businesses I’m talking about.

He describes his investment strategy as

a stool with three solid legs: (1) quality dividend-paying foreign stocks in the right sectors; (2) liquidity, and less volatile investments, such as cash and foreign bonds; and (3) gold and gold mining stocks.

Of particular interest to this reader was his section on the poor man’s investment strategy. If consumer prices head for the moon the government will likely impose price controls, thereby creating shortages. Solution: buy in bulk now and stock up. One advantage is that

any returns are tax free. For example, if you buy a box of cornflakes today and eat it two years from now when the price of a new box is 40 percent higher, that’s a 40 percent tax-free return.

His writing is full of fresh and sometimes bold insights on long-standing issues. Readers will find his discussions on drug prohibition, marriage, abortion, guns, health care, and prostitution especially engaging, I believe. His detailed historical and legal discussion of the income tax is the best I’ve ever read, nor does he pull punches in describing it:

It’s hard to imagine a tax more destructive of productivity, more destructive of entrepreneurship, more destructive of our lives, more difficult and costly to comply with, more subject to gaming, or more absurd in its logical consequences. Congress should immediately, fully, and permanently abolish the income tax, and the Internal Revenue Service (IRS) along with it.

He would replace the tax with a revenue-raising tariff on imports.

Yes, tariffs suck. But they suck less than income tax. In fact, they might be preferable to a national sales tax.

Conclusion

Peter Schiff has written a riveting guide on what to do about our snowballing social, financial, and economic problems. Inasmuch as he recommends freeing people from government, his solutions are far from pain-free and consequently will not be popular with the political class or their dependents. Well, it’s time they got over it. As Schiff writes in his introduction, it’s as if we’re headed down an icy hill with politicians in the driver’s seat accelerating toward the bottom.

We need a grown-up to grab the wheel and steer us into the ditch on the side of the road. That won’t be pretty, but it’s better to go into the ditch at 80 miles an hour than crash into a brick wall at the bottom of the hill at 120.