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 believe 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.[1] (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.[2] 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.
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"A sound economic theory may or may not yield
any useful insights for investors, but a false one is almost certain to
mislead."
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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.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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