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Will It Work?

This is the question many think about as they look at shrinking 401-K statements and read the daily headlines with both President Bush and President-elect Obama declaring their plans to stabilize the economy.

Well, Peter Schiff, who heads up Euro Pacific Capital, was remarkably prescient at predicting our current economic travails, even when he was being ridiculed. Just take a look at him on this video compilation:

Now, at this point, he says there is nothing President Bush or President-elect Obama could do to solve the problem. Anything that is done will just make the problem worse in the long run:

“…the economy is in terrible shape and everything the government is doing now and everything the government is likely to do when Obama takes over is going to make the situation worse…we got into this mess because we borrowed and spent too much money. The solution isn’t going into deeper debt to encourage Americans to spend even more money.”

Mr. Schiff makes the point that asset prices could suffer from deflation while consumer prices suffer from inflation:

“…unfortunately government policy can’t help, it only makes it worse… we don’t have money to bail out anybody, we are broke, we are borrowing the money from China, we are borrowing it from Saudi Arabia, we are running it off a printing press… the dollar is going to fall through the floor. Asset prices are still going to fall but consumer-good prices, prices that Americans pay when they go to the supermarket; they are going to go through the roof.”

See his explanation here:

Mr. Schiff also says that the “flight to safety” that is leading people to Treasury bonds is missing the big risk of inflation:

“I think when this bubble bursts, we are going to take out the lows in the bond market from the 1970s. It is going to be a blood bath in bonds… Not only are bonds going to plunge but the dollars in which they are denominated… are going to plunge too. So people are going to get wiped out in Treasuries. They are going to lose almost all their money or their purchasing power…

“… right now the Treasury is benefitting because everybody is focusing on default risk and nobody believes that the Treasury would default… but the real risk isn’t default, the real risk is that they pay you back but they do it with the printing press. They give you money that has no value.”

He points out that looking at these things in nominal dollars is very deceptive and predicts this recession could have five to ten years to go. He looks at stock prices in relation to gold prices and says history shows that enormous declines in the stock market are possible from current levels:

“The Dow was worth 43 ounces of gold in 2000. It just went below ten ounces of gold today. I think it is going to hit one ounce of gold before it is over just like the last major bear market. Remember in 1966 the Dow was at 1,000; it was worth 20 ounces of gold. By 1980 the Dow was at 800 and it was worth just one ounce of gold. The Dow did not get back above 1,000 again until 1982 from 1966. Major, major bear market. This one is going to be worse.”

Peter Schiff also thinks that retail is going to suffer… and that we need to shrink the retail sector:

“It is going to get much worse for the retailers but… that is a good thing. As we were taking our credit cards to the malls and buying imported products and running up these trade deficits and leveraging up our houses. That was the problem. The solution… is that we stop buying stuff.

We need to remember it is the thought that counts. Americans need to stay home for Christmas and not buy as many presents. We have to start saving and digging our way out of this hole. Of course that means a lot of pain for the retailers but that has to happen. We need to shrink our retail economy; we need to get rid of a lot of excess capacity; we have more shopping centers per capita than any place in the world. We don’t need it. We need more factories. We need more people making stuff. We don’t need people buying stuff.”

You can hear his assessment right here:

Peter Schiff has been as accurate as anybody in predicting what would happen to the stock market and to the broader economy. His diagnosis — that we need to have a deep recession, allow companies and people to go bankrupt so we can liquidate their debts — is surely harsh, but that doesn’t mean he is wrong.

In the first place, we seem to be unclear about what we really want to see happen. We alternatively chastise financial institutions for allowing their leverage to get too high and then, when they hold onto government investments so as to improve their financial ratios, we attack the financial institutions for not lending more aggressively!

Second, there are real limits to what stimulation of demand can accomplish. If the government spends money, it has to get it either through taxes, borrowing or the printing press. If it gets the money from taxes or borrowing, you have to argue that government expenditure of this money is somehow going to be more stimulative than the uses taxpayers and investors would have made of these funds if the government didn’t tax or borrow them. If the government simply turns on the printing presses, it will debase the currency and cause enormous inflation. In the short run this may be stimulative, but people will soon catch on and adjust their behavior — the stimulative effect will end.

There is, however, a question mark hanging over Peter Schiff’s specific prescription. To say we don’t need more consumption, we need more factories and “people making stuff” begs the question of who would buy the products made by all these factories and workers.

President Nixon famously announced that “We are all Keynesians now.” Yet, the oft-repeated narrative that President Hoover resisted interference in the economy and thus worsened the Great Depression and then President Roosevelt came in and saved the day with a stimulative policy is history as seen through rose-colored glasses. President Roosevelt’s Secretary of the Treasury and close ally put it this way at the time:

We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong … somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises…. I say after eight years of this Administration we have just as much unemployment as when we started…. And an enormous debt to boot!

— Henry Morgenthau, Jr., Secretary of the Treasury, testimony to the House Ways and Means Committee, May 9, 1939 (17.2% unemployment)

In fact the Great Depression was not ended by the Works Progress Administration or any other such “stimulation” — unemployment didn’t drop until World War II put everyone in the army or to work making armaments. Living standards didn’t rebound until after the War was over and the Dow Jones Industrial Average did not reach 1929 levels until 1954 — and that didn’t account for inflation.

Some Keynesians would not disagree; they would say that Roosevelt’s efforts were insufficiently stimulative and that World War II was a fine test of Keynesian policy and it worked. Or course, they wouldn’t urge a war; they would typically be fine with massive stimulative policy — employing tens of millions of people in jobs programs, etc. Here is how John Kenneth Galbraith explained the matter:

INTERVIEWER: You’ve written that World War II affirmed Keynes.

JOHN KENNETH GALBRAITH: Oh, there was no doubt about it. We entered the war with massive unemployment, general hardship, and a very weak, ineffective economy. That was the nature of the American economy in 1940, ‘39, ‘40. And then came the war, public borrowing on a vast scale, public employment simulating private employment, a return to full employment, a return to the problem with which I was overwhelmingly concerned, that of inflation.

One could not have had a better demonstration of the Keynesian ideas, and I think it’s fair to say that as a young Keynesian in Washington, in touch with the other Keynesians there, we all saw that very clearly at the time. We saw the war, which we regretted, and I still regret it. I don’t easily tell other people they should get killed, but we saw the war as a justification of the Keynesian theory, the Keynesian doctrine, and the Keynesian recommendation.

Of course, by 1945 the US had 12,350,000 people in uniform out of about 132 million people. This would be equivalent today to employing almost 30 million Americans in jobs programs — not counting the many millions producing weapons, food, etc., to supply the army.

Since there is basically no possibility that such a scale of stimulus will be proposed or enacted, if this is what is required, it is an academic theory with little practical application.

And, in fact, it is not clear it would work. Keynes used to speak of the importance of “animal spirits” in capitalism, which is just another way of saying that money alone may not be enough. The certainty of a policy that is designed to obtain victory at all costs and the importance of such a victory may rouse the animal spirits of entrepreneurs far more than the pledge to paint murals on the side of every public building or to clean up trash.

In fact in his critique of stimulus, Peter Schiff is alluding to Say’s Law, which is a principle articulated by Jean-Batiste Say that the supply of goods, in and of itself, creates demand. As Say put it:

“…a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.”

Ludwig von Mises, the leader of the Austrian School of economic thought, wrote an essay, entitled Keynes and Say’s Law, which explained Say in this way:

Commodities, says Say, are ultimately paid for not by money, but by other commodities. Money is merely the commonly used medium of exchange; it plays only an intermediary role. What the seller wants ultimately to receive in exchange for the commodities sold is other commodities.

Every commodity produced is therefore a price, as it were, for other commodities produced. The situation of the producer of any commodity is improved by any increase in the production of other commodities. What may hurt the interests of the producer of a definite commodity is his failure to anticipate correctly the state of the market. He has overrated the public’s demand for his commodity and underrated its demand for other commodities.

Consumers have no use for such a bungling entrepreneur; they buy his products only at prices which make him incur losses, and they force him, if he does not in time correct his mistakes, to go out of business. On the other hand, those entrepreneurs who have better succeeded in anticipating the public demand earn profits and are in a position to expand their business activities. This, says Say, is the truth behind the confused assertions of businessmen that the main difficulty is not in producing but in selling. It would be more appropriate to declare that the first and main problem of business is to produce in the best and cheapest way those commodities which will satisfy the most urgent of the not yet satisfied needs of the public.

So Peter Schiff is really saying that all our efforts to stimulate demand are on the wrong side of the equation. We should instead focus on the production side. Aye but here is the rub: Stimulation of production is just as flawed as stimulation of consumption if the production is not valued.

So if we bail out automakers that can’t produce cars people value enough to buy at a price that covers the cost of production, all we are doing is slowing recovery as we delay the Schumpeterian forces of Creative Destruction that reallocate resources to more productive uses.

Peter Schiff doesn’t say it, but this is the real reason why efforts to revive the economy will probably not be productive. The nature of capitalism is that those who are damaged by a change in the status quo are almost always known — so if Bear Stearns was allowed to fail there were specific people who would have been badly hurt and this creates a constituency for bailouts. It is why we will probably wind up doing something for the auto makers. The list of names of who will be hurt by a failure is likely too prominent to let it happen.

Yet the list of those who would gain from the redeployment of capital and labor is a mystery. After all, there is no lobbying group representing these people — they, themselves, do not know who they are or how they would benefit. So the institutional reflex in democratic capitalism is always to defend the status quo — whatever industry we happen to have.

This is a great loss because we can’t know what the people and resources allocated to one industry or company might have achieved if the situation was such that they had to find new opportunities. It may well be that among the researchers who will keep on designing cars is the guy who might have made solar power competitive but now he will never uproot his family, move to Arizona and reeducate himself to make a living in a new industry.

Politicians of both parties feel the need to be seen as “doing something” when there is a problem. Whether they are doing anything that is actually useful is, in fact, often an open question.

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