Peter Schiff is an open and enthusiastic advocate of Austrian economics and is the president of Euro Pacific Capital Inc., a brokerage firm that specializes in trading foreign securities. He is well known in the Austro-Libertarian community, and is becoming better known in the mainstream media, because he not only successfully predicted the crash of the housing bubble well before it happened, he has also earned a large fortune based on his accurate financial foresight.
In my March 6th post I wrote that rather than shy away from the U.S. stock market in response to the Dow tumbling by 50%, we should instead view the resultingly cheap stocks as a great bargain akin to the 50%-off or buy-one-get-one-free sales we've been seeing lately in the consumer goods sectors. When one wants to buy something, I argued, isn't it better for that person if the thing -- even if it's stock -- is cheap rather than expensive? Although I still think that fundamental rule is sound, and Schiff agrees with it, Crash Proof solidly argues that in a world where reality and public opinion are often painfully at odds with each other, time-tested investment strategies (of the sort found in most investment classics published by Wall Street) sometimes need to be modified in response to widespread insanity.
The particular insanity Schiff writes about in Crash Proof is the combination of the U.S. trade deficit, budget deficit, and national debt (especially when unfunded liabilities such as Social Security are included). The U.S. has rapidly gone from the world's largest creditor nation to its largest debtor nation, and in the process our manufacturing base has almost completely disappeared. Plus, U.S. citizens used to have one of the highest savings rates in the world but are now the world's biggest spenders with a near-zero savings rate.
Schiff explains that economic growth requires capital accumulation by businesses, which requires savings by consumers. The Austrian perspective is that saving is a tradeoff between present and future consumption. When people save, they consume less today in order to consume more in the future, and this sends a signal to the market that production capacity should be increased to meet the higher demand that will be created in the future as the people spend their savings. The market signal is sent in the form of lower interest rates created by the wider availability of loans to businesses as a result of increased savings. Businesses use these loans to accumulate capital, which they then use to expand and improve their operations. That ultimately results in more and cheaper consumer goods, i.e., a higher standard of living. We thus see that in a free market, the individual virtues of thrift and saving create greater prosperity for all. If a country's national savings rate is negative or close to zero, its economy is therefore not growing -- it is shrinking. Such is the case for the U.S. and its debt-ridden citizens.
As for the U.S.'s huge trade deficit, Schiff points out the Austrian observation that a country ultimately "pays" for its imports not with money, but with its exports. The reason for this is that ultimately the money Country A pays for goods from Country B comes back to it when Country B (or some other country that has purchased that money) uses it to purchase goods from Country A. If a country has zero balance of trade, it means that it exports roughly as much stuff as it imports (in terms of units of money). By contrast, a country that exports more stuff than it imports (i.e., it largely "imports" money) has a positive balance of trade, and a country that exports less stuff than it imports (i.e., it largely "exports" money) has a negative balance of trade. The U.S. has a negative balance of trade -- a big-time trade deficit -- because our manufacturing base that used to produce exportable goods has gradually disappeared. By contrast, our biggest trading partner, China, has a positive balance of trade -- a trade surplus -- due largely to their impressive manufacturing base. In effect, the U.S. is getting a "free ride" since China has not yet traded in all those dollars for actual goods. When it eventually decides to do that, all those dollars coming back to the U.S. in search of goods will bid prices up into the stratosphere. And this is in addition to all the new money reserves that U.S. banks have gotten from the Fed but haven't used as a base of an inflationary credit pyramid yet.
So why does creditor China continue to give debtor U.S. a veritable free ride? There may be a variety of reasons, but the biggest one appears to be that the U.S. dollar enjoys special status as the world's reserve currency since the U.S.'s repudiation of the Bretton Woods Agreement in 1971. As long as the dollar remains the reserve currency, China has reasons to accept them in exchange for its exports and hold onto them. However, there is no reason to think that the U.S. dollar will be the world's reserve currency forever. Given how recklessly the U.S. government has been running the printing presses since late 2008 to bail out American corporations in the wake of the financial panic, combined with our nation's sky-high trade and budget deficits and near-zero savings rate, the U.S. dollar appears to be on its way out. And given that a number of "common-sense" investment strategies (e.g., as outlined in investing-for-the-average-Joe type books) depend totally on the U.S. dollar remaining the world's reserve currency, it just might benefit us to reconsider our basic approach to investing.
Schiff suggests a three-pronged strategy to minimize one's exposure to the effect of the tanking U.S. dollar:
- Invest in foreign stocks: If the U.S. dollar crashes, all business that deal in U.S. dollars (including all U.S. businesses) will crash with it. Select only foreign stocks of companies that do most of their business in foreign currencies rather than U.S. dollars. Choose conservatively by selecting stocks that have sound fundamentals (sound management, reasonable P/E ratio, etc.) and high yields paid in foreign currencies. Especially conservative sectors are energy/oil/gas utilities, commercial real estate, commodities, and natural resources. If investing in a mutual fund, make sure it is unhedged for "currency risk" since that "risk" is the very reason we want to invest in the fund in the first place. The biggest currency risk right now is not that the foreign currency will tank, but rather that the U.S. dollar will. Forget the mainstream warnings about "political risk" whenever investing in established foreign stocks is mentioned. The biggest political risk our investments face right now is from our own government. Schiff suggests that 70-90% of one's investment portfolio should consist of conservative foreign stocks (the rest would be in gold -- see next bullet).
- Invest in gold: Aside from the fact that gold is the soundest money there is, and that its price is bound to increase dramatically as the government and banks print U.S. dollars like mad, Schiff also points out some more interesting reasons for investing in the yellow metal. One of them is that he thinks people are going to start moving to gold standards after the U.S. dollar collapses, and this might create political pressure for governments to follow suit. If that happens, gold will command a premium above its bullion price by virtue of its being used widely as legal money. Another reason is that the Internet and debit cards make transacting with precious metals easier than it has ever been in the past. Interestingly, despite his enthusiasm for gold investing, he warns that a bubble in mining stocks similar to the dot-com bubble may occur. Schiff suggests that 10-30% of one's investment portfolio should be in gold-related investments such as physical gold and shares of gold mining stock.
- Stay liquid: If the U.S. dollar tanks, it will be important to have savings not only to handle emergency expenses, but also to take advantage of great bargains that are likely to pop up during the turmoil. Save three to six months' living expenses in U.S. dollars in case of emergencies, but any additional savings that will not be needed immediately should go into foreign currencies to avoid the effects of the declining U.S. dollar. Schiff recommends a diversified mix of relatively sound foreign currencies ("relative" being the operative word), such as can be found in foreign money market funds like the Merck Hard Currency Fund. He also suggests possibly saving money at institutions actually located in foreign countries so that if unbearable conditions force one to leave the U.S., one will have money waiting at the new location. In conditions that bad, it is unlikely that the U.S. government would let citizens leave the country with anything more than the shirt on their back. Everything else would probably be confiscated.
Schiff's advice in Crash Proof is a bit extreme, but I cannot deny that we are living through a rather extreme situation. On the one hand, investment advisors usually point out that the saying, "This time it's different" is one of the most dangerous sentiments in finance, as well as one that is not supported by most historical evidence. I fully agree, but let's not forget that history repeats itself in more than just one way. Mainstream advisors say things like, "The U.S. dollar will not collapse, because previous financial panics have not caused it to do so. History repeats itself, so we'll be fine." To that I respond: "In previous financial panics, government was more limited and our national and personal debt was much lower. This time we have a perfect storm forming around the U.S. dollar, and yet you expect it to survive? Many other paper currencies from the past have been hyperinflated away by governments printing money in a panic, just like our government is doing right now. History repeats itself, so we will not be fine."
If the thrift, discipline, and love of freedom of the American people is simply laying dormant within us and can be reawakened, the U.S. economy will recover and return to greatness someday. But as Schiff convincingly argues, that recovery is not likely to occur as quickly as the Fed-engineered false "recovery" we saw at the end of the dot-com debacle. The reality is that the true engine of economic growth in the U.S. -- a strong manufacturing base, thrifty citizens, and limited government -- has been destroyed over several decades and will take many years to rebuild, if it is rebuilt at all.
Before the American house of cards crashes down completely, might it be worth considering Schiff's advice? It may not be a bad idea to position oneself to survive the demise of the U.S. dollar by investing in conservative foreign stocks and gold and saving cash in foreign currencies.
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