THE CHINESE CURRENCY: A BIG SHOE THAT COULD DROP!

For over a year the U.S. economy has been just chugging along without any apparent stresses. I mean, nothing has happened within our economy to cause panic or increase the level of fear people are feeling. Certainly, the economy is far from healthy. It is not growing to speak of. Unemployment is very high and few jobs are being created. Some communities appear to be in depression, while others are only marginally affected.

In the political area, the focus related to the economy is all of the promises made and no results. The current administration isn’t being blamed for making things worse, just not making them better. The government has declared that the “big drop” is over, the recession has ended, but the signs that growth is occurring or may happen in the future are muted at best.

My own mood is that of waiting for the other shoe to drop. Well, there are many shoes that could drop. And any of them could be more disastrous than the big dip of 2007. Which one will it be? Or perhaps the question to ask is which one will be first? Only time will tell. Let’s think about one potential shoe, the push to have the Chinese revalue their currency.

One issue that the politicians are focusing upon is the international value of the Chinese currency. It is contended that if the Chinese currency is valued more in line with real relative national purchasing power, the U.S. dollar would be stronger and the U.S. would benefit from a greater demand for its products. There are several things that are difficult about this. It is true that China’s approach is the old, thoroughly discredited view (among those who are aware of the history of economic ideas) that a nation’s wealth is achieved by hoarding valuables. At the beginning of the exploration of the New World, for example, countries would scour for gold and silver in the Americas, bring it home, and put it in a vault and declare that they were wealthy. So, several Asian countries, including Japan and China, insist on controlling the exchange rates (although Japan is trying counter balance that now) and hoarding the dollar and the Euro (China has a large surplus with the Euro Zone as well).

Of course, hoarding anything is not wealth. A dollar, or any currency is only as valuable as what it will buy. A currency, especially a fiat currency, in international trade is a claim on that country’s production.

On the other hand, a country does need reserves (speaking within today’s structure), i.e., a stash of cash available when and if needed to settle international debt or payments. What cash is available? Well, they aren’t going to begin using gold, if for no other reason than that the process of beginning to use gold would cause the value of the dollar to die. The same problem holds for any other currency that could be chosen other than the dollar. If the process of changing to another currency was done slowly, perhaps the dollar wouldn’t collapse. Unfortunately, such a process should have started a couple decades ago.

As it is, the international system is stuck with dollars into the foreseeable future. Okay, but there is no need for countries like China and Japan to continue accumulating dollars. They have more than they need, and they are worried about the constant flow of dollars and what that means for the future. What they could do is to turn around and begin buying stuff from us with the dollars that they would have hoarded, the current cash flow. Sounds good, right?

We will even ignore the probable, immediate consequence that the dollar would lose significant value just because it wasn’t being hoarded as before. Forget that. Forget that immediately, foreign goods would be significantly more expensive. Let’s just concentrate on our own goods.

The mainstream economists think that to create growth, what is needed is consumption, more spending. That is why they set things up to expand the money supply. More money, more spending, more wealth, they think. Great, huh! So, these same economists would be happy for foreigner to be spending more in the U.S. It means more demand. They felt the same way years ago when the economy seemed to be humming right along, with very high employment, and very low unemployment. We had what some called “full employment”. I always wondered what they thought was going to happen. The unions, progressives, Keynesian economists all thought that more money running after our goods was going to be good, when there was no one to produce them.

Today things are a little different. We have a large number of people unemployed and lots of capacity that is sitting idle. It is not the most efficient capacity, but it is there. What we don’t have is a significant amount of raw material sitting around. Nevertheless, as foreigners began to send those dollars that they don’t hoard back to the U.S., we will now see more dollars running around. At first, the new demand will cause some shortages, and prices will begin to rise, since the actual stock of good will be unaffected, at least for a while. Then, over time, more capacity will be used, more people rehired, more produced. But, then the real bottleneck appears. Or rather two bottlenecks. One will be the need for raw materials for the higher level of production. Costs will have to rise to compensate for the higher costs of materials as users bid for the material available. The other bottleneck is that some new investment will be needed, but the government has soaked up all available savings for its deficit. To get loans or attract investors, businesses wanting to expand will have to bid against the government for savings. That will also tend to raise costs, and the cost of government borrowing will also increase.

What this really means is that the return of all of the money we send out in a year for foreign trade will result in higher prices, both for domestic goods and much more so for foreign goods. It is unlikely that we would see the “gentle” 1-3% inflation we have seen with few exceptions over the last couple of decades. It will be higher.

Now why would we see higher inflation just because foreigners spend the money that we sent for goods? It certainly wasn’t the case throughout our history, right? Wouldn’t it make sense for there to be a balance? Well, yes. But our situation over the last decades is very different. It is hard to understand, apparently. Some supposedly free market bloggers don’t accept my thinking here.

For decades we have had not only a trade deficit, but a cash-flow deficit, called a current account deficit. While the trade category covers trade, obviously, it doesn’t include investment flows between nations and government transfers. Normally, if a country has a trade imbalance, the difference is made up by the return of the deficit in investment, or the purchase of government bonds, for example. Even then, if the current account is not in balance one year, it swings back the other way the next, or at least over time a country’s current account will balance out. This has not been the case for the U.S. for a long time. The current account deficit will be less than the trade deficit.

One way to understand what is happening would be to imagine that you are a country and buying from other people – countries – often. Your purchases are all made by check. You send out many checks and everybody honors them and sends you the merchandise you want. But, you find out, by analyzing your checkbook that some of your trading partners are not cashing your checks. They are just keeping them (for some strange reasons – your crazy cousin has all kinds of weird theories as to why, saying that they want your checks as reserves, that your partners use them as cash with other people, etc.). So, you have both the things you bought and the money you with which you thought you bought them. Sounds like a good deal. It is sort of. But, if your honest, and know that there is a future, you might be somewhat worried about what happens when all of those checks come wondering back, especially if they all come back at once!

Let’s take 2009. The U.S. bought more stuff than it sold by $374 B. The current account difference was $378 B (usually, the current account deficit is smaller than the trade deficit). You can look at the history of the U.S. current account here. So, there have been billions upon billions of dollars that have left the country and not come back, not even as loans to our government. My discussion in this post is limited just about this year’s money not returning. (Think how bad things would be if the money from past years returned as well!)

Under a gold system, if money left every year and didn’t return, the money supply would continue to shrink and there would be a corresponding drop in prices. There would be ramification of a continued outflow of dollars. There are ramifications under the present circumstance, just not the ones that would occur in a rational economy. In the present circumstance, the U.S. price level actually continues to creep up. That is because the money supply continues to creep up. The money supply creeps up in spite of billions of dollars being lost every year to foreigners. Where is the money that is being lost coming from? I am sure that you know the answer. It is the Fed., the official U.S. money maker upper!

One key fact to remember about international trade is that it functions completely on credit. When an importer buys, he sends a letter of credit, which does not pay the exporter until the goods are received and accepted by the importer. The letter of credit is a bank document, and is what it says it is, a credit, a loan. Purchases by U.S. importers are financed by bank credit pushed by the Fed. We see that even though banks in the U.S. are not making loans to businesses for new production, they are making loans for importing, i.e., we still have a big trade deficit. The money we have been exporting for years is all made up, Fed. produced money. So the Fed increased the money supply, we sent it overseas to buy stuff, and those people kept the money, just like the example with your checks. (Why? See my discussion of Schiff’s book, Crashproof. The “Why?” is even more a big question after they have kept so many dollars after so many years.)

The situation is not good for the Chinese and other countries that have built up big surpluses of foreign money (which is mostly in digital form). Recently, there was a push to move away from dollars toward a “basket” of currencies, including Euros. The wisdom of that idea was demonstrated this summer as many of the Euro Zone countries have been shown to be in financial difficulties. Maybe people will begin to realize that fiat currencies of any stripe will not stand up to normal, mixed economy political processes. The dollar became strong, i.e., higher priced against the Euro, for a while because the dollar again looked like the strongest, safest currency. That view will fade. So the Chinese, to use them as the example because they have the biggest hoard, are sitting on vast sums of dollars, some of which are “invested” in U.S. government debt, a little of which is invested in other countries, both real assets and government debt, and some of which is sitting as reserves, as gold would sit. If and when the dollar falls, the value of these massive holdings will fall, which would not be good for the Chinese economy. Thus, the Chinese are walking a tight rope, trying to keep the dollar from a death dive, which also means their currency at a lower price, and make small moves to reduce their dependency on the dollar. Everyone is watching them. They have to be careful.

Which also means that they are confused by the U.S. political leaders constant demands that they increase the value of their currency. The Chinese realize to some extent the consequences of that action. They can only be astounded by the U.S. politicians. Those fine people, the Congressional leaders don’t seem to have much understanding of international economics (not surprisingly, since they don’t have much understanding of domestic economics, either). They do understand that the jobs issue plays very well in this country. They see that demanding that the Chinese buy more U.S. stuff there might be more U.S. jobs, and play it for all they can. Real consequences are far out weighted by political appearance. They can always blame someone else for the unexpected consequence.

But if the Chinese, and the other Asian countries begin spending those dollars on U.S. goods, we begin to see those made up dollars running after the few goods we have purchased and prices begin to rise, interest rates begin to rise, and the quiet calm that we have had, a quiet calm in which we have been able to have good fight for our lives, will end and who knows what could happen then.

"Too Big To Fail": Financial Reform

As you would expect, the mainstream “experts” have it all wrong. Their idea of reform of the financial market is to attack the companies. They, the “experts”, decided when the financial crisis hit that some financial companies were “too big to fail”, and that the government must step in and “save” them by pouring mountains of money down drain holes. These companies were insolvent and needed to be liquidated, but the “experts” argued that the government must not let that happen, the consequences, they said, were too dire. But, people in general didn’t really buy off on that. There was enough of a ruckus about the massive amount of money spent in the bailouts that the “experts” then argued that something had to be done to avoid this problem in the future. Now, of course, that “something” did not include any suggestion that bailouts shouldn’t be made, or that the cause of the problem in the first place might be to government policy.



Now the Congress is considering what to do. We are now hearing from those same “experts”. As pointed out elsewhere (e.g., Meltdown by Thomas Woods) these “experts” are the same people who said that the rise of residential real estate prices was not a problem, that the types of mortgages being offered wasn’t a problem, that the increasing foreclosures wasn’t a problem, and that the initial problems with financial institutions wasn’t a problem. Why is anyone listening to these people now? Apparently, no one in the government and the media has the capability to learn from past mistakes. They certainly do not posses the ability to question any belief that they hold, let alone the ideas of the “experts”.


So the Congress is considering the issue of “reforming” the financial industry. The answer is of course, more regulation, which will mean more unproductive cost and layers of government employees with arbitrary power. But there is one proposal to which we should pay particular attention.


The answer to the “too big to fail” problem, it is shouted, is to reduce the size of the American financial companies. This is said, ironically, in the face of the fact that the solution to the potential failure of many financial companies was to push them off on other not-so-bad-off large financial companies, making the resulting companies much bigger. All of those companies that assisted in the “solution” to the last bust are now to be reduced in size.


One of the architects of the original mess, the crisis, the bailouts, and the lack of recovery, the Chairman of the Federal Reserve Board, Ben Bernanke, was recently speaking to a banking conference. He said, “If, in the end, funds must be injected to resolve a systemically critical institution safely, the ultimate cost must not fall on taxpayers or small financial institutions, but on those institutions that are the source of the too-big-to-fail problem,” Bernanke continued in his speech to the Independent Community Bankers of America. “It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms,” Bernanke said. “If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.”


Any history of the world financial markets will record that the push to increase the size of the major financial firms came from two sources, one is the market and the second is the actions of governments. The market would make the scope and range of activities in our world market pushing toward the ability of a financial firm to meet the demands of large, international companies, both in the lower costs of scale of a large company and the ability to work in the large size of the transactions required. The governmental actions were, to name a couple examples, the additional costs that regulations impose, which are easier to absorb for larger firms, the fact that the size of the funds is made larger than necessary by the constant inflation that central banks create, and the success of larger firms in receiving government handouts and favors (and giving the support that legislators require; this list of government influences is not meant to be exhaustive).


To the extent that American financial firms are forced to downsize, in contrast to their competitors in other countries, American firms will encounter a competitive disadvantage. The financial center of the world could and most likely will swing away from New York toward the East. We will see a self-imposed degradation of the United States and its ability to maintain a competitive position. American non-financial firms will tend to move toward foreign companies to meet their international financial requirements. American financial firms, being smaller, may be picked off and purchased by the larger Eastern institutions.


It may be the case that the U.S. government “experts” will attempt to encourage their foreign counterparts to follow their lead and downsize foreign financial firms. To the extent that all financial firms are downsized, we will see a curtailment of international activity as financing becomes less available. But, some countries will see the benefit of being financial giants, in a world of pigmies.


We will be seeing another step in the continuing destruction of the United States of America as a economic powerhouse and standard of freedom and individual liberty.

Notes and Commentary On "Crash Proof 2.0" Part 2

Chapter 5, p. 148: 2009 UPDATE

This chapter is about the stock market and the Dow Jones Industrial Average, which was at its recent low under 7000 when Schiff was writing. It is now in the 9600 range. Probably, Schiff would call this a bear rally.

p. 150: He expects to Dow to go to 4000 to 5000 and last for 5 to 10 years. ???? Unexplained.

p. 151: He refers to GE, which hit $5.72 in March, 2009 is now at $16.08 at a P/E of 12. He considers the Price/Earnings Ratio to be important. 12 is way below the traditional average.

p. 152: “Therefore, much of the big profits earned by such companies through their financial activities from the 1990’s on…were phony.” Here we are again. Jump. Phony because the financing was supported and the interest rates kept low by the Fed’s massive money creation. But how that makes the finance arm’s profits more phony than any other part of the company I do not know. It is true that those activities cannot be sustained because the Fed’s inflationary policies cannot be sustained. But dollars from one sector spend just as well (or poorly) as dollars from another sector.

Chapter 6, p. 186: 2009 UPDATE

For this chapter I have nothing to add or criticize. Not bad

Chapter 7, p. 227: 2009 UPDATE

p. 228: “As I noted in the chapter [of the first edition], the Social Security Trust Fund is a pure case in point [of a Ponzi scam].” Okay, this is not a big point, as far as the book is concerned. It is as far as he goes, however. He did not explain the Social Security Trust Fund in the chapter. He mentioned it. He did explain Social Security. He did not explain that Social Security is a very big problem looming just around the corner.

Nor did he explain that Medicare, which is already bursting out of its direct tax revenue and eating into the General Account, i.e., income taxes, etc., is an even bigger problem than Social Security, and it is starting now. The correct description is that Medicare is selling its special Treasury Bonds in its Trust Fund back to the Treasury. It is a fraud.

Perhaps, and this is just a perhaps, Schiff is so much of a finance guy that no other issues are big to him.

p. 231: “Out of this pseudo economy emerged the now-dominant service sector….” Here we are back to the service sector. Now, at least, it is only “dominant” in stead of providing services as the only thing we do rather than manufacturing.

I do not want to attribute this to Schiff without some evidence, but maybe the reason why he places the service sector here is because he cannot find another culprit for the deficit. I don’t know. But harping on the service sector only undermines what is often decent material. What he sees as the service sector is also very narrow. But, ultimately, he just doesn’t look at our economy as part of the world economy. It is. So is our service sector. Services, as long as your not restricting the definition narrowly to menial tasks done locally, are actually easier to transport and provide than physical goods. Looking at the U.S. as part of the world, offering services makes us very flexible in a rapidly changing technological world.

p. 234: “China funds about 50 percent of our borrowing,….” The numbers do not add up. Let’s say that our trade deficit is $800 B and that our federal deficit is $1 T. So, Schiff is saying that China receives three fourths of our trade deficit, and the put all of it into our Treasuries. Our total imports, which went down this year, were only $2.4 T, which means that China would have to be on the selling end of more than half of our imports. No, they weren’t. If he is going to throw numbers out, I wish he would give us some idea where they came from. I do not want to accuse him of making them up, really.

What numbers that I can find shows that out of the total U.S. federal debt of over $10 T, 25% is foreign owned. It could be that foreigners are buying 50% of new debt, expanded debt. I would still like to see his source.

p. 235: “In effect we imported foreign goods and exported inflation.” My very words. Where do services stand in this statement?

“…foreigners get to keep their goods….” This is part of his “decoupling” thesis, often mentioned but not explained in this book in either edition. I think I know what he is trying to say. The problem derives as to why the Chinese exports are so attractive, to focus on the country that Schiff refers to most often. They do not want many of the things that they build for us. The goods they do want they buy in as large a quantities that they can afford. I don’t see that the production capacity that they use for export is of much value within their country. Their general population is, after all, low income.

I will say that I generally agree with his analysis of the federal bond market. The current low rates cannot continue, the market will not buy a continuous stream that shows no end, ultimately, the buying of bonds by the Fed, with or without the trick of expanding bank credit, will reach consumer prices, with the help of dollars held overseas coming home. Price inflation will rise, and tend to rise at an increasing rate.

A general note, which applies since the last chapters are about investment advise. Schiff has not discussed the Fed’s major tactic of expanding the credit supply via the use of member bank’s deposits. It may not be relevant, or desirable in this book, but I often wonder if he knows.

Chapter 8, p. 273: 2009 UPDATE

p. 275: Schiff apparently has many other writings on the internet in which he explains much of his thinking. He left a lot out of the earlier edition of this book. Now, in the revision/add on, he sort of writes as if the reader had read the other stuff as well. Here, finally, he recounts some of his broader views that make some sense of the first edition.

p. 280: Another problem I have here is that he states several events as facts. They vary well might be, but I would like to see myself. Schiff does not give me a way to find out. There are no references. Okay, finding out is not as difficult as it once was. Go internet.

“The world is rapidly waking up to reality.” This time some evidence would really be worthwhile. I do not see this happening. I think that the central bankers around the world are still the same central bankers. They have not all of a sudden had a brain transplant. Private actors, currency traders, businessmen, investors, etc., may be, but again, having some reference to substantiate this would be helpful. Schiff acts as if anything he says is to be totally accepted. Please.

“I’m talking prosperity and growth unlike anything we could imagine when those nations had their wings freighted with the United States’ excessive debt and trade imbalances.” Does Schiff realize that all of these countries are less free than the U.S. was prior to the 60’s? Further, I do not understand how their internal economies, or even several countries, or the entire rest of the world, is going to absorb the production that the U.S. has received, or even a significant portion of it, without experiencing drastic reductions in the prices of everything. It isn’t as if there is all kinds of ready money, real or otherwise, sitting around to buy what the U.S. can no longer buy. How does Schiff expect that to work. The central banks in the other countries look at their economies not that differently from the Fed. If they see prices begin to drop they may just as well act as the Fed would and pump money into their economies, and bang, have the same problems we have. Schiff needs to explain how this works. I don’t see it.

“We are already seeing signs of decoupling….” Meaning that foreigners are tending to buy fewer U.S. Treasury Bonds, sell dollars, and not expect to sell goods to the U.S.. So, where does he see this?

p. 281: As the world’s producers begin making more for themselves and less for us, they will demand even more basic commodities, while recent capacity reductions will further limit supply.” But also, we will be demanding less, and therefore some supply will be opened up. But, as I said before, it is less obvious how the other countries are going to be able to take advantage of “making less for us” without prices dropping, which means that they will have less ability to pay higher commodity prices.


Chapter 9, p. 309: 2009 UPDATE

p. 311: “I do not believe there will be an official decree to replace the dollar as the world’s reserve. It will simply lose that status due to independent market forces. My guess is that central banks will began [sic] to hold more of their reserves in other currencies, such as the euro, yen, or Chinese renminbi, and significantly higher percentages in gold.”

Let’s consider what the situation would be if the U.S. had not been exporting inflation, i.e., made up dollars. Let’s say that the $10 T that is currently being held by foreign central banks and the $1 T held by foreign private interests were part of a stable currency. Of course, that could not have happened, because about 30 years ago our total liquid money supply was about $1 T. What would have happened is that as we sent dollars overseas to buy goods, they would have held on to them, pretty much as they held on to the made up money. Dollars would have disappeared from circulation in the U.S., and prices would have had to go down, simply because there were fewer dollars around to spend on things. Wages would have gone down, too, but not as much. This scenario would be just like the last few decades of the 19C. Internationally, the dollar would be bid up consistently, year by year, making foreign goods even cheaper and more attractive. Our standard of living would improve, especially as we became more productive and allowed our creative people to create. What a world.

The point of going through that scenario is to point out what would happen in countries whose currencies would be chosen to be reserves. Every yen taken out of circulation in Japan is one less yen being used for prices in that country. There isn’t much of a yen bond market. The situation would be similar for the euro.

As I mentioned in an earlier note in this commentary, the central banks in those countries do not view falling prices as a good, and would tend to make more money to replace money that was effectively exported, and the cycle would begin, as it did here.

I do not think that gold would be the general response because it is too restrictive. Central banks could not do what they consider their responsible activities of controlling the business activity within their countries.

Schiff has this unrealistic view of what other countries are like. They have an even lower attitude toward the free market than our “leaders” do, and less experience. (I am willing to consider exceptions, but those would not be major economies, I expect.) I would not expect milk and honey in China, Japan, Korea, and certainly not in Europe.

On the other hand, I think that Schiff’s expectation that gold will continue to rise in the long run, or even intermediate, is accurate. What’s to stop it?

“…the fact is that the world does not need a reserve currency. Rather than replacing the dollar with some other flawed fiat alternative, the world could simply return to the traditional gold standard that existed prior to Brentton Woods.”
Well, yes, that is what it should do. But, to do so, it would have to recognize why. The Chinese do not. And I see no reason to think that anyone in the governments of the other major players understand either. The fact is that governments that exist today prefer fiat currencies, and really have no problem with a fiat currency as a reserve. If they have a problem with the dollar it is because the U.S. has gone overboard, in their opinion.

p. 313: “…but I’m also surprised at the extent to which the European Central Bank (ECB) and other foreign central banks have adapted inflationary policies.”
Mr. Schiff, U.S. central bank policies were patterned upon foreign central banks. We did not invent the central bank, the Europeans did.

The balance of this section is, in my opinion, sound.


Chapter 10, p. 335: 2009 UPDATE

In this section Schiff sort of ping-pongs around, accurately demonstrating the problem with suggesting the thing to do in our current situation. What to do?

If his expected economic disasters come to pass, it is very unclear when they will. This leaves the asset holder in a difficult quandary. If his second collapse is as drastic as he expects, then holding the right things will wipe them out just as much as holding the wrong things. The most important assets to hold may be gold, food, and weapons. That is the worst-case scenerio. Frankly, if you expect the worst case, you should be moving to a small town in an agricultural area, get to know your neighbors, help on farms, buy some gold coins and bullion, and hunker down. Holding foreign stocks might not be helpful.

If, on the other hand, you expect things to be hard fought, that the efforts by yourself and other Objectivists and people who want freedom are going to have enough of an effect to keep things running well and then turn around, owning foreign stocks, gold indirectly, and a selection of solid U.S. companies would make sense. I do not think that someone who felt that reason has a good chance of prevailing today would give up entirely on U.S. companies.
Not a good set of choices, sorry.

Notes and Commentary on "Crash Proof 2.0" Part 1

p. vii: “More importantly, while most believe that the economic collapse is over, the reality is that it has only just begun. What we have witnessed thus far are merely the events that have set the collapse in motion. It will take some time for all the dominoes to fall. But fall they will, perhaps even more spectacularly now than how I initially envisioned back in 2005.”

p. viii: “…you to see that our problems today are the consequences of pernicious fundamental trends that I have recognized and warned about for years.”

Maybe. They were not really in the book. He did warn about the residential real estate mess. Credit to Schiff. Lots of credit to Schiff. I think that he has shown some ability there.

Yet, the thesis of the book, the collapse of the dollar, has not occurred. We’ll see what he has to say.

Chapter 1, p. 24: 2009 UPDATE

p. 27: “…and provide the capital investment that entrepreneurs need to create jobs and finance the production of exportable goods.” ???? Where did this emphasis on exportable goods come from? Why does he get so excited about exportable goods? Why does “exportable” matter? Why not just goods, goods for everyone?

I need to say that the sections that I am not commenting about are at least decent, and often good.

p. 29: “But buying stuff we couldn’t afford with money we didn’t have was what got us into this fix.” While this is true, it is superficial. I fear that as long as he focuses on consumer oriented thinking, he will be letting our opponents off. What he needs to focus on, which he has elsewhere, is the inflation that underlies the consumer spending. Much of this behavior is driven by the cheap money policy and the mistaken notion that the key factor in an economy is consumer demand. With an emphasis on production and the manipulation of the money supply stopped, people would not benefit from over spending and the practice would be less prevalent.

“Rather than encouraging American borrowers to once again tap the savings of foreigners….” We weren’t getting the savings of foreigners, we were getting our own previously made inflation dollars back. This is one of his worst statements in that, one, he is claiming something that sounds so vile and, two, he says it with no support, in this case, with not even a supporting explanation. I expect that he is referring to the U.S. federal debt that is purchased by foreign central banks with dollars they hold in their reserves. These dollars come into the local economy as exports are sold to the U.S. The exporter then trades his dollars to the central bank in exchange for local currency. As long as the local currency is not being inflated for this exchange, then the process to then is neutral. The problem comes when the central bank just holds the currency instead of allowing it to continue ciruclarating in international commerce. This is a drain on the local economy. But these are still dollars created by inflation. When the central bank then buys U.S. federal debt, it is putting our inflated dollars back into our economy, which is then spent as “real dollars” here, and will tend toward pushing up prices. It is still difficult to see how we are tapping into the savings of foreigners.

At the end of the page he actually said, “worst-case scenario” regarding the “crash” he has been predicting with each book. That means that the outcome that he has been using to frighten his readers is now regarded as a worst case.

p. 31: “I have always said, however, that it wouldn’t happen overnight.” Ahhh. Please show me where in the first book that was said. In this book he seems to be encompassing all of what he has said anywhere as opposed to just Crash Proof. What is a crash but an overnight event.

p. 32: “It’s absolutely unarguable that they [foreign economies], not we, are the engine of economic growth.” This very arguable statement is an assumption that undermines his entire argument. If he recognized that there is a strong foundation still in the U.S., he would be a better analyst and predictor. He is good in some respects. He could be better. Schiff is an intelligent man. I do not understand why he would make this statement and provides no support. As I say, I have not looked at everything he has written or said, but in what I have seen, including his most public presentation, Crash Proof, he offers little evidence to support his conclusions.


Chapter 2, p. 53: 2009 UPDATE

“Clearly recent events have proven my point: Wall Street, the U.S. government, and the mass media have been using manipulated data to foster a falsely optimistic view of a ….” I don’t see where he gets this. It isn’t the data that confuses those people. It didn’t confuse Schiff. What confuses most people are their ideas, their philosophy. Schiff’s confusion on this point is a reason why I am not impressed with the claims by his supporters that Schiff is a defender of reason or a follower of Ayn Rand. He just doesn’t demonstrate a recognition of the importance of ideas. His point here is that if these people looked at good data they would act differently. No, they wouldn’t.

He does end the paragraph with the accurate point: “Even more distressing, to my mind, is that the experts did not actually understand the problems threatening our economy.” That is correct. I wish he would show that he, Schiff, knows why those experts did not understand.

p. 58: “Note, too, that a 1 percent fed funds rate provided the stimulus that sparked the housing bubble and made teaser rates so enticingly low.” While this is technically true, it is not really helpful. I mean, how does the Fed keep the rate at 1 percent and how does that “provide the stimulus”? Without that information I think many people, including many who reasonably agree with him, are left with a floating abstraction. It needs to be explained.

p. 61: “…our economy is fundamentally broken.”

“But we spent an excessive amount of money on consumer goods with the result that we don’t have the manufacturing bases….” Still don’t see how spending on consumer goods, excessive or otherwise, or importing a lot of it destroys our manufacturing base.

His basic point in this section is correct. We have not learned from our previous mistakes.

“When the problems predictably worsen, let’s hope Washington finally learns the proper lesson.” He is right about the lesson to be learned. But he doesn’t understand that Washington as it is now constituted (and the last administration as well) is incapable of learning.

Chapter 3, p. 83: 2009 UPDATE

p. 84: “…where I had predicted earlier that the Dollar Index would likely bottom out at around 40, I now see a bottom closer to 20 or maybe even lower.” It was around 70 in March, 2008. He does say when or how fast. The timeline would be the difference between a crash and a decline. I do not disagree with a decline, a continuing decline. I wouldn’t begin to suggest a number. A crash won’t happen. Strategies for retaining value in your assets would differ between a crash and a decline. A slower decline would offer some chances to do something about it, if we had the opportunity. A swift decline or a crash would bring us to a desperate situation.

p. 85: “As our trading partners see it, they were watching their best customer go down the tubes, and their first reaction was to come to its rescue.” Yes. And the fact that they have $10 T in dollars and bonds. They are not going to want to see that go down the tubes either. Which has been my point.

This section is an excellent description of the interrelatedness of our world economy. The U.S. is a very significant part of it. Schiff’s decoupling would shrink the world economy drastically, and the consequences he relates in this section would happen again. His tag line that they should stop manufacturing for us and do it for themselves is so screwy.

p. 88: “The problem is that too many people lack the sophistication to understand why [foreigners supporting the U.S. dollar and selling goods to the U.S. is harmful].” Again, he shows that he does not understand the importance of ideas. The currency and bond traders of the world, the manufacturers and exporters of the world, and businessmen, wealthy people, and so on, are not unsophisticated. To the extent that they are making bad decisions as envisioned by Schiff, they are miss-trained. They have bad philosophies. But, to some extent, they are making some reasonable decisions, since Schiff is incorrect in claiming that the U.S. is an economy without foundation.

p. 89: The last sections are reasonably good. The bond market is going to see higher interest rates, even if the Fed tries to support low interest rates. There will just be too many bonds. The Fed will have to flood the market with credit. Schiff does not mention this but things will be rockier as Obama’s plans play out. After that we will get the huge increases in Social Security and Medicare spending, and we will have taxes that will take up every bit of capital and discretionary spending.

“When this rally ends, the bottom is going to fall out of the dollar.” So we are back to the collapse. Well, I think that the post-panic government actions, plus Obama’s programs could do it. Interestingly, Schiff has not mentioned Obama’s programs directly. He is focused only on the bailout. He hasn’t mentioned Social Security and Medicare.


Chapter 4, p. 118: 2009 UPDATE

p. 122: “If we were still on a gold standard, as was the case during the 1930’s….” While technically we were on the gold standard in the 30’s, it was not a real one. FDR famously sat down with one of his “economics” advisors every morning and decided what the gold price should be. There was also lots more gold than there were gold certificates, meaning the Fed could make as much money as it wanted, and did.

Schiff constantly refers to inflation in terms of “printing presses”. I think that this is so misleading to people. It is so simplistic. I understand that using accurate terms is more cumbersome, but accuracy and precision of language is important.

p. 123: “…and now that we are in a downturn, we have even more inflation because the money supply is growing even faster.” Is it? I know it will. But it isn’t now. Credit is still dead; no lending is going on. This is why his using the term “printing press” is a problem. He is not using in his descriptions what he does know, that inflation in the U.S. is caused by bank credit expansion, and the lowering of the dollar because of the size of the foreigner dollar holdings the exist because of credit expansion in the past. So he knows that, although the Fed is certainly trying to get banks to lend, they aren’t. Thus, there is no inflation now. That will reverse, and with the amount of new government debt, the idea of stimulus, and the goal of low interest rates, bank lending will pick up, grow and grow and grow. Inflation. It will burst out somewhere.

“Many argue that all this money printing is not inflationary as it merely replaces the money lost due to debt defaults. However, this naïve view fails to account for the loss of output represented by defaulted loans.” ????? The loans were mortgage-backed securities based on loans to people who couldn’t make their payments. Where is the loss of output? My problem is that I do not see the connection between these two sentences. He does not deny that the bail-out money is replacing reserves and capital, and is not particularly inflationary (it is not good for us). And a recession has a loss of output. Is he saying that since there was a loss of output that there should be less money in the system? Is this loss of output permanent? I am not seeing these connections.

p. 125-6: “Why Inflationary Pressures Will Prevail” This is a very curious section. He talks quickly about a vast array of economic actors, including commodities, consumer goods, credit, farms and mines, retailers, etc. But nowhere does he talk about the Fed and its money machine? When someone tries to declare what is going to happen at this level of detail, they are always wrong, because the number of actors and factors is too large. He needs to stay on the broader level on which he usually works.

p. 126: “The Real Game Changer” This analysis of the value of the dollar in international trade is correct, but I wonder at the size of the impact. I think the bigger impact within the country will be the Federal budget, the higher interest rates, and most important, the Fed’s actions. The fall of the dollar will have its impact, but will not be as big as Schiff thinks. He seems to go back and forth as to what is most important. But he always returns to the value of the dollar in international trade. I wonder why? The reason that I say that it will not be as big a deal as he thinks is that international trade is not a large segment of our economy. We have already seen a nearly 50% drop in the value of the dollar against the Euro and the Yen, even the Canadian Dollar is much stronger against our currency, but we have seen little effect within the country. Perhaps he is expecting the U.S. government debt to have fewer buyers. This idea ignores the trillions of dollars that will still be out there and the very few places that it can be placed.
The one way in which his analysis could be correct is if some major holder dumps their dollars. The major players include England, the Euro Block, Japan, China, probably Canada, and maybe one or two of the oil producing countries. One of them would have to decide to start selling their large holdings of dollars. One of the first events would be the other countries buying to protect their vast holdings of dollars.

Crash Proof, 2.0; Review

Peter Schiff’s newly published book has an unusual organization. It is the original Crash Proof, exactly as originally published, with updates written in 2009 at the end of every chapter. He has changed none of his positions. At least some of his positions and predictions came to pass. He crows about this repeatedly. I don’t hold this against him, mind you. In fact, in his business, where often even if the market goes the way you predicted, you are wrong about why, so everyone is wrong. Being right significantly is worth crowing about.

Since the whole original book is intact, all of my original problems remain. I will not repeat them (see the original review on this blog).

The “Updates” generally extend the ideas in the original text, including the ones with which I disagreed. In some cases, he makes clearer what those ideas are, and why his original ideas are not quite right.

I thought that the following quotation demonstrates what may be his biggest confusion: “…but I’m also surprised at the extent to which the European Central Bank (ECB) and other foreign central banks have adapted inflationary policies.” (p. 313) He has consistently treated the U.S. as a country that acts differently than every other country. Yet the concept of the central bank and how it should function is a European invention. The fiscal policy that our country follows was created by our old friend Keynes, an Englishman. All of the central bankers in the world went to the same schools, read the same texts and authors, and talk and communicate all the time. Why does he think that they wouldn’t all act the same?

Even worse is the following: “I’m talking prosperity and growth unlike anything we could imagine when those nations had their wings freighted with the United States' excessive debt and trade imbalances.” Does Schiff realize that all of these countries are less free than the U.S. was prior to the 60’s? Why is just not selling to the U.S. going to bring on the days of milk and honey?

Also wrong about that quotation is that the trade imbalance is the result of foreigners holding on to our dollars. If they had not held on to the dollars, the foreign central banks would not be faced with the problem with where to put the money, and they would not be funding our debt. If other nations, especiall China in recent years, had spent the money, the dollar would be much lower, we would have had to finance our own debt and interest rates would have had to be higher and there would have been more restraint. I'm not saying that our problems are the fault of other nations. They are responsible for the number of dollars they hold on to.

A criticism concerning understanding the book comes from the fact that Schiff has written and talked (audio and video posts) a great deal on the web. His stronger supporters are familiar with this material. I have read one or two things, seen two or three short videos, and heard one audio piece that went on for about an hour. In the online material somewhere, Schiff has developed some ideas that did not appear in the first book, but he mentions briefly in the 2.0. Most importantly among them is the idea of “decoupling”. This is very important in Schiff’s thinking, but it is not explained in his book. I do not think that I can adequately present the idea with its supporting argument. Generally what decouples is the Asian economies from U.S. purchases and government debt. As a result they have “prosperity and growth unlike anything we could imagine”.

I disagree. To have that growth in mature economies, they would have to have freedom. The reason they got there was the support of the country that was, and hopefully will be again, the freest in the world, the U.S. If the U.S. hadn’t existed, they would not have cleared the 19C.

The last three chapters contain advise as to how an investor can protect himself and perhaps even profit while the U.S. economy suffers. There is some interesting advise there. Schiff does recognize the major issues, e.g., timing and changes in the laws. As with my above comments, I don’t think that he realizes that what happens in the U.S. is going to have significant adverse effects elsewhere. (In my notes that I will publish after this review I discuss what would have to happen in the “decoupling”). Without considering what could happen in other countries, I think that Schiff’s discussion lacks completeness. It is still worth reading, if you keep both the shortcomings in mind.

I also think that his comments on Treasury Bonds and the actions by the Fed are decent.

Actually, if it weren’t for his shortcomings regarding the rest of the world, he would be good. Certainly much better than most of what you can find these days.

Status of inflation and prices today, September 2009

I have four things to say about inflation, prices, and the state of today’ economy, late September, 2009.


NO CREDIT EXPANSION CURRENTLY
One, since inflation is introduced into our economy by means of credit expansion, which means bank lending. Currently, because of the nature of our current mess, i.e., a financial panic, bank lending has shrunk and credit availability has all but disappeared due to the liquidation of bank capital and reserves. You might ask about the money that the federal government has put into banks. It was a lot of money. That money went into three areas. Some did go into the credit area, as the government purchased bad debt, those sub-prime, mortgage-backed bonds. But the government bought them at an extreme discount, so it did not replace much of the credit. The other two areas in banking that received money were those of reserves and capital accounts. These accounts within a normal functioning bank, consist of a significant percentage of fund, maybe as much as 50% of the bank’s checking deposits. However, these funds are not spent, not really invested. They must remain available for the bank’s needs. Consequently, they have never been part of the money supply, M1 or MZM, and cannot really be considered inflationary. The real problem with all of these measures by the government is that the recession hasn’t been allowed to do its work. The misallocations and created money have not been worked out of the system.

FALL OF THE DOLLAR
The upperward pressures on consumer prices today come primarily from two sources: one, the fall of the international value of the dollar. Foreign goods and services are now considerably more expensive that they were just a few years ago. The dollar has dropped in value almost 50% in just a couple years.

There is a second consequence for prices. U.S. goods and services are much cheaper for foreign buyers. That might sound good, but what it really means is that there are more dollars chasing our domestic production, which will mean higher prices for us. It is a double whammy of price inflation.

The current fall of the dollar is happening because foreigners hold so many dollars. They are finally spending them instead of holding on to them. They have been accumulating dollars for almost three decades, from our trade deficit. There is almost $11T in dollars overseas. All of these dollars that we have exported were created dollars. Notice that during the time that foreigners accumulated $11T, we still had constant 2% to 3% price inflation as our domestic money supply grew to over $10T. New money was being created at a tremendous rate. Now the overseas money is beginning to return. It is from our past inflation.

OIL PRICE SPIKE COMING!
Third, there is probably another event that is going to happen soon that will affect us financially. The conditions that produced the oil shock a couple years ago are returning. The world has no new capacity, and none coming on line in the foreseeable future. The existing industrialized countries have not reduced their requirements for oil, and will not do so, unless they retreat from industrialization. Finally, the two largest countries in the world, which are slowly moving into the modern age, and slowly increasing their need for energy, are slowly reemerging from the recession. We are all slowly reemerging from the recession. As we reemerge, more demand for energy will drive the spot prices for oil beyond what it was two years ago. This is not inflation. It is forced shortages. Prices will go up. All goods and services are dependent upon energy, and as energy prices go up, so will all the others.

MEDICARE AND SOCIAL SECURITY SHORTFALL: A REAL MESS!
Finally, in the relatively near future, we come to the fruition of the Medicare and Social Security mess. Medicare already costs more than the annual Medicare taxes bring in, and is consequently taking money out of general taxes. Social Security will follow suit within just a few years. Both programs will begin growing faster than realistic taxes can support. What will happen then? Depends a lot on who is in power and whose voices are being heard. As these two programs grow they will force out everything else, including Obama’s programs, and national defense! If instituted, Obama’s programs will just bring on the mess earlier because the poorer the economy performs, the sooner the shortfall between Medicare and Social Security costs and their direct revenues will occur. Also, the faster consumer price levels rise, the sooner the problem because both programs are tied to the price levels, either directly or indirectly.

What is Inflation?

In a discussion of today’s U.S. economy, a serious writer must include inflation. Yes, I am going to talking about inflation. Probably, I am going to talk about it a lot. I guess that makes me a nut, right? I mean only scaremongers and right wing fanatics talk about inflation. Besides, since the early 90’s we have had almost no inflation, I mean only about 2 to 3% a year, which the Fed (the Federal Reserve Board) thinks is close to the right range.

But here is the killer, if you loaned the government $10,000 for a 10-year bond, at a 2.5% inflation rate, you would get back $7,810 of purchasing power. A loss of 22%, guaranteed! If I told you that I was going to give you an investment in which the principle would loose 22% guaranteed, would you like that? (At best, after taxes, the interest paid on the bond would bring the total to maybe $9000. You would still have a loss.)

In addition, any plan to retire ten years later would have to take into account the rate of inflation. None of that sounds as if a “low” inflation rate is a minor deal. And we are talking here about the potential of a higher rate of price inflation in the future, maybe the near future.

Well, what is inflation? That is the question. There are two competing definitions. Actually, if you look practically anywhere on the web, in “official” government materials, or at the writings of mainstream economists, you will find that inflation is defined as “a general raising of prices”. That is, the prices of just about everything in the economy are going up.

Is this definition really helpful? Does it mean something?

Well, maybe you want to know what causes inflation. (Some would argue that a definition should include causes.) This is an area of controversy. We have a difference of opinion. You will quickly find that the sides are drawn this way.

On the side of an answer that is wide ranging and offers little in the way of a means to reduce the threat of inflation. The best statement of this side that I have found so far is:
http://www.wisegeek.com/what-causes-inflation.htm. You will note that all sorts of actors in the economy can be at fault including producers, raw material suppliers, and others, many others. It just depends. I always wanted to know how one, or even a combination of these different actors could cause price inflation that went on for years. Any one of these explanations has some plausibility if you hold your frame of reference to a year or two. But how do you get commodity price increases that cause consumer prices go on from 1990 to 2007? I do not think it will work. I think that the people who use these answers do not actually look at the nuts and bolts. I think they are willing to settle for plausible. I do not like that because we are talking about people’s lives and goals here. Inflation eats away at what a person and their family are depending upon over the course of their lives, even 2%.

Really, think about this. We have all heard that the price of something is the result of supply and demand. When you think about all of the items in the economy, what you really have is that each buyer is allocating his money among the things that they have decided to buy at that time. If something costs more than it did, a person will have to make do with hoping something else will be less expensive, the amount they purchase of that item reduced, or taken off the list completely. If prices continue to go up, more stuff must be scrubbed from the list, unless more money is found. What we generally understand about supply and demand, reasonably, I think, is that the supply consists of the products we want to buy and the demand consists of what we want, our choices. More people want something and its price will tend to go up until there is more of it, and so on. In general, especially in a mostly capitalist economy, that is a good way of thinking about prices. But, in considering price inflation, we have to think more concretely.

At root, supply and demand consists of the products (goods or services) vs. the actual currency, dollars offered for the item. It is a purely mathematical/mechanical thing. At a specific time a certain amount of a product is available and a certain number of dollars is offered and the price is the dollars divided by the number of products. If in the next time period the number of dollars offered is higher per item of product, the price goes up. If the price continues to go up, the number dollars per product is continuing to go up. If this is true generally throughout the economy, then there has to be an increase of in the number of dollars overall. It can’t work any other way. If you look at the U.S. money supply over the years, you will find a constantly increasing supply of money. You will be surprised at the size of the steady increase. (This would be the dollars in the U.S. There is still more money being pumped overseas. Nor do the money supply figures include money that has been created and then invested, say in residential real estate, or in a business.)

That is the other definition of inflation: an increase in the money supply, which can and usually does, lead to an increase in consumer prices (which, for want of a better term, I call “price inflation”). Thus, we have had significant inflation for most of the last 60 years.
So the question is, where do all of those dollars come from? That will have to be the subject of another post. Sorry. The answer is long, complicated, and tedious.

Having just devoted “serious” time and space to talking about inflation, some may say, “But isn’t today’s problem the threat of deflation?” or “But they say that prices dropped this year, and probably will next year, too!”

Prices may have dropped in 2009. Government reports should not be accepted just because they are from the government. The government is not omniscient. What is always important is for you to keep an eye on the things that you and your family need and want. Did those prices go up, down, stay the same? Your personal situation is what counts for you.

More to the point here is that we can do little to change what is happening today, or even in the next several months. My concern is for 2010 and the next few years. Given that inflation is the increase in the money supply, Obama’s plans do make me concerned about what is going to happen. His spending and deficits will tend to put a lot of money into our economy. New money is inflation.

To anticipate my technical discussion of the government’s manipulation of the money supply, the U.S. money supply is increased by means of increasing bank credit, bank loans. Since the recent crisis began, banks have cut down their lending to near zero. That means that the primary money pump has not been working, and consequently, less new money (there is another way new money is introduced, but that is not as large as bank credit manipulation). I will talk about the banks and credit as time goes on.

We are also seeing import prices going up across the board. The value of the dollar has been falling. There are many dollars overseas, and the amount is continuing to increase. It takes only a slight increase in the portion of those dollars to begin coming back to lower the value of the dollar. That is happening. So the prices of imports have been rising. The dollars coming back are also competing for our domestic production, and will be a source for higher prices of our own goods. There are upward pressures on prices today. I think we will see more and more upward pressure as time goes on. Forewarned is forearmed.