An Alternative to Schiff's Doomsday Scenario

In December of 2007, as Apple was approaching $200 a share, you couldn't say a word about it for fear of backlash from the Apple investment community that insisted it was going to $600 a share. Today, Nouriel Roubini and Peter Schiff are considered gods for predicting the economic turmoil, and anyone discrediting their teachings should be burned at the stake. Well, get the gas and matches, because I have to say that Peter is full of Schiff in his latest article.

A broken clock is still right twice a day. The problem is this: If you look at that clock at that exact "right" moment in time, you should not automatically assume that the clock is always right. Warren Buffett came out recently and said how "dumb" he was in 2008. Should we then assume that Buffett is doomed to be eternally wrong in the future?

The "Credit" Economy

In this March 2nd article on SeekingAlpha, Schiff posits that the government's plan to restore the flow of credit is somehow a plan to entice people to leverage themselves further to the hilt.

Government efforts to simply make credit available, without rebuilding productive capacity or increasing savings, are doomed to destroy what's left of our economy.

True. But then he goes on to explain how a "real economy" works in simple terms:

Suppose there is a very small barter-based economy consisting of only three individuals: a butcher, a baker, and a candlestick maker. If the candlestick maker wants bread or steak, he makes candlesticks and trades. The candlestick maker always wants food, but his demand can only be satisfied if he makes candlesticks, without which he goes hungry. The mere fact that he desires bread and steak is meaningless.

He continues, explaining what would happen if the candlestick maker began borrowing steaks and bread, issuing IOUs, yada yada, until there was a natural disaster that destroyed all the equipment and nobody could produce anything any more. The takeaway lesson: If everyone maxes out their credit cards and a meteor hits Earth and destroys every business and piece of equipment, our economy might have some problems.

(I've got news for you Mr. Schiff: Not everyone is leveraged to the gills.)

Growth in the "Real" World

Let me propose a different scenario to Schiff's doom and gloom economic outlook. We have the same three players above, but we also have a city down the street with ten unemployed, starving citizens. The butcher employs one of these citizens so that he can work a little less. That citizen, now enjoying a paycheck, buys a candle. With increased demand, the candlestick maker hires a citizen, who in turn starts buying bread.

And so on and so forth until all ten citizens are employed.

Credit in the "Real" World

Everything is hunky dory and the three empires — bread, meat, and wax — are expanding into neighboring cities. Demand is through the roof, and the businesses rapidly expand. To fuel this expansion, the three companies put themselves on "credit" — borrowing from each other in the short-term to finance growth. (Example: The candlestick maker needs the fat from the cows to make candles. He'll pay for that fat when he sells the candles.)

Short of a Peter Schiff natural disaster that wipes out the machines needed to make the materials, this system works just fine.

Debt in the "Real" World

The citizens, enjoying their newfound wealth, start spending like crazy — some beyond their means. A few citizens start banks; some start clothing shops. A small portion of them — say, 10% or 20% — borrow too much from the banks to buy from the clothing shops.

It's fine while the system is working; but, along comes a draught. Grains dry up, which puts the baker in a bind. With grass in short supply, cows aren't as fat; so, meat is scarce. Less meat means less material for candle wax.

Not able to produce as much, the "Big Three" employers lay off workers. Some (though not all) of those workers are overextended on their debt; so, they blow off the bank. The bank begins to lose money; so, they stop lending to everyone else.

Unable to borrow money to purchase threads to make 1,000 shirts, the clothing maker now has to make just 400 shirts.

The economy now hits a critical point, at which a decision must be made. Do we let it "work itself out," knowing that we will have real pain and shrinkage at all levels until we find balance, at which point we will have flushed the bad debt out of the system? Or, do we help free up credit so that the rest of the system isn't poisoned by the draught hurting the Big Three?

Finding a Balance

Where Schiff and Roubini have it wrong is in the end result. According to them, everything in the economy is going to zero. We have to reboot the system, which means that we'll all move out of our homes and into the woods to start picking berries and making stone tools until a new butcher, baker, and candlestick maker come along.

During the Great Depression, we couldn't possibly lubricate the system because our currency was tied to the gold that the country had in its coffers. It took a World War and the export of 20%+ of our male "consumers" to bring the butcher, baker, and candlestick maker back.

Today, we can manipulate monetary policy to grease the wheels. Admittedly, we won't see Dow 14,000 for quite some time. Still, without plowing money into the system, the "Greater Depression" would have already been upon us.

People might buy fewer shirts; but, unless you think we're all going to run around naked, the strongest tailors will survive. If they don't, another citizen will step up to seize the opportunity and become tomorrow's employer.

Until we have 100% employment around the world, this is how "real" economies work. We don't live in a limited citizen, fully-employed, this-for-that economy that is being destroyed by an abundance of credit and a series of natural disasters. The problem lies in the non-productive "assets" — an overabundance of "investments" that were believed by many to be assets, but ended up being liabilities.

Pain Today or Pain Tomorrow?

To correct the situation, we have to grease the wheels. I hate it as much as anyone else, but that doesn't change the fact that it needs to be done. Few people believe that we can "sit in the tub" while President Obama takes care of things, as Mr. Schiff suggests.

People will need to make sacrifices — greater than they are now. We need to save more — that goes without saying. For example, the few thousand people that read this article will likely do so on a computer, over somewhat expensive high speed internet, with all the lights on in the room. I'd be willing to bet the TV is on in the background while the cell phone sits quietly, racking up those rollover minutes they pay for but never use.

Before you load up on ammunition and bottled water, realize that today's actions will certainly lead to tomorrow's stagflation or inflation, but the game isn't over. Once panic and fear pushes the pendulum beyond the point of equilibrium, things will start to improve.

Now, the race is on. Who will win? Schiff and Roubini, whom have so convinced people that the end is near that nobody will make changes? (Why should I cancel cable or pay off my debt if everything is going to hell?) Or, the desire for a better tomorrow, at the expense of today's instant gratification? (A vision that a lot of people lost a long time ago.)

Is there more pain ahead? Yes, and probably for a number of years when factoring in the stagflation or inflation that is on the way. Nobody is denying that. Still, to promote a full reboot and going back to a "cash only" society is ridiculous. The problems we face are not due solely to the use of credit; they are due to a massive mispricing of risk at many levels, leveraged by the irresponsible use of credit.

If you want to burn me at the stake, go right ahead. But before you do, consider this: At what point will Roubini and Schiff become bullish on America...on businesses? At what point will they declare that stocks are cheap? If they have their way, you might want to save that match — you'll need it when the power companies shut down and you're foraging the Earth for sustenance.

(For the naysayers that want to immediately jump down my throat without reading this article, keep in mind that Roubini and Schiff were not the only ones to see the writing on the walls — they just have great press agents. While they were booking media appearances and kissing babies, some of us were moving clients largely to cash and/or bonds in 2007 and 2008.)

Comments

[socrateazz:]

You are very right about schiff's view being rediculous. Economies are balanced based on many factors. Many things can throw economies out of balance. In fact the post WWII economy was a misbalance favoring the US economy. The lending spree of the last ten to fifteen years was a misbalance causing some of the seriousness of the current problems. Unfortunantly I think Obama's current decisions are more likely to cause more serious misbalances than doing nothing. There will be a Stock ralley into May which probably will create new yearly highs. Then a pull back. The late Summer fall ralley will tell us how effective Obama's actions really are! If things are good enough to make a stronger rally than the coming spring one then I believe OBama's decisions are acceptable. I expect a weak ralley which stalls. Then a drop below current levels is very likely. The problem is: the bank problem is the most immediate problem but there are really many multiple problems which are exasperated by the current government actions. we will see. I hope I am wrong

Mar 05 09:16 AM

[Jakester:]

A drought didn't come along, the malinvestment of capital after years (decades) of Fed stimulation did. That's where your analogy breaks down. Who are all the other economic forecasters that got this right and are anything of them Keynesians? Please provide a link to one of these forecasts instead of telling us others predicted this mess. The only ones I know of that got it right were of the Austrian school and they don't buy your argument one bit.

Mar 05 09:20 AM

[Jakester:]

There was no drought. There were decades of malinvestment created by too easy money. Not a single Keynesian that I know of predicted this correctly. Austrians did and they don't agree with your analysis.

Mar 05 09:23 AM

[jimbolan1:]

Do we let it "work itself out," knowing that we will have real pain and shrinkage at all levels until we find balance, at which point we will have flushed the bad debt out of the system?

Yes, that is precisely what we should do. Housing prices here in northern California are starting to find a bottom without any help from the 'stimulus' plan. Sure, prices are down 40-50% (in some cases more) but this has merely created an opportunity for a new group of buyers. As far as Peter Schiff goes, he has been 'right-on' for some time. Perhaps the author is jealous he does not have the same press agent? I haven't seen Peter say we are all doomed, but he has said this is going to be ugly and will most likely last for some time. In my humble opinion, he is spot on.

Mar 05 09:25 AM

[Pterostyrax:]

Valid points, with one exception. Put a Federal Reserve system in the business of counterfeiting the medium of exchange and that holds interest rates artificially low, which in turn provides incentives for bad investments of capital into your butcher, baker, and candlestick maker economy. Then factor in what the impact will be in the future when the Federal Reserve system increases the counterfeiting rate and reduces even further the artificially low interest rates. A reset is inevitable as this now entirely artificially based economy CANNOT continue in perpetuity.

Jakester pretty much got the counter argument correct.

Mar 05 09:50 AM

[DavidGreen:]

The Great Depression occurred because of the largest credit bubble up to that point in mans History in the 1920's. This was spurred on by the Federal Reserve System or Fiat money. It had nothing to do with the Gold Standard. The Gold Standard makes you work and earn money before you buy something. Credit in large amounts is simply not wise in the long run. Short term interest is wise IF there is sufficient income to allow it.
By not allowing Banks(BOFA, Citi) to fail because they did NOT listen to that wise counsel is Government interventionism into the Free Markets which as noted dont want any Government help. It simply breeds distrust.
The US Government is to do ONLY 2 things in relation to the economy.
COIN MONEY and Regulate the markets to guarantee fraud laws are not violated. Thats it.

Mar 05 09:57 AM

[Bill Jencks:]

Nice argument - but incomplete. Trouble is the US government, as well as the very currency used - the dollar, are in such a mess. In Monetarist or Keynesian terms a little bit of debt is good, a little bit of inflation is good, a little bit of fiscal deficit is good. I don't have to go on about excesses do I? Plainly - alot of govt. debt is very bad, so the US government is not even following Monetarist or Keynesian tenets properly.

After all, how can you cure a huge financial credit mess with more ridiculous credit and therefore debt?

And so what is better then and what makes more sense - the Austrian School tenets of "Savings is the reward of Productivity" or is it to be "Consumersim and Debt must be always be supported by never ending credit from other foreign countries" ? Which one of these tenets makes you feel all warm and cuddly inside and which one makes you feel insecure ?

Mar 05 09:59 AM

[jerrion:]

Hedge fund manager John Paulson got it right and made billions. Now I don't know what economic philosophy he follows but he is just one expample besides Schiff who got it right.

Also, could someone please explain to me how the the fed funds rate influences the rates on mortgages. I thought the forces of supply and demand in the Mortgage Backed Securities market led to the low rates that helped fuel the housing bubble, (along with lax lending standards) which started this whole mess. Did someone force banks and foreign lenders to buy up these securities and accept a low yield for them.

I'm no economist or finance expert so if my thinking is wrong an explanation would be appreciated.

Mar 05 11:03 AM

[Freedom Fan:]

"Warren Buffett came out recently and said how "dumb" he was in 2008. Should we then assume that Buffett is doomed to be eternally wrong in the future?"

Warren Buffet thought Obama and high taxes would be fantastic for the economy and jumped into equities big time at the end of 2008. So yes, Buffett made a slight error, but of course he's still a "genius".

Mar 05 01:27 PM

[CJJ:]

Maybe Schiff's problem is as this author correctly states, he is selling that everything is going to 0.
I don't care how right he has been or continues to be right, his outlook historically is not proven.
Maybe next he'll write an article about the Fall of Rome and compare the US to Rome. Problem is the Fall of Rome could be attributed to any timeframe over 1000 years. Also, last I checked Rome is still around and a great city at that. Sorry its not the center of the world any longer, doesn't seem worse for ware.
Another problem is Peter and just about all Doom and Gloomers have 100% certain predictions and cannot possibly believe they might be wrong. If they are right why are they giving investing advice, if they are right bullets and chickens are the only investment that makes sense.

Doing nothing is impossible. Once Peter and the Doom and Gloomers explain the logistics of this model, maybe they'll gain some support. But as the author points out, you can't just hit a reset button and expect 6 billion people to pick up and start being productive.

Let's work on keeping the 80% of the good on the right track and defeating the 20% of the bad instead of letting a situation fester where the bad start to gain hold.

Mar 05 08:26 PM

[CJJ:]

Another topical analogy to Schiff's ideals can be drawn to the Mexican druge wars.
In Peter's world you would do nothing and let the market decide who wins the Drug lords or the Mexican police. Well since the Drug Lords have more money and play by no rules they have an upperhand to the Mexican Police who can't indescriminately go out and kill the Drug Lords and their families.
In this DO NOTHING atmosphere you run a real risk of having the citizens falling under the Drug Lords rule of fear and having no rules. Does this sound like a good plan???

Obviously you try to quell the Drug Lords by doing WHATEVER it takes even if it doesn't make economic sense. You make up money, you take on debt to save the society. Obviously(although it would be best case) the Mexican Police will always have to play by some sort of rules the Drug Lords do not have to as they are wards of the state. The battle may cause extreme debt, there may be many bad days, but you don't just sit there and hope it works out okay.

So keep blindly following Peter and thinking the police are going to win out. Since so many of you talk about your guns and gold, I don't expect cooler heads to win out.

Mar 05 08:32 PM

[PainfullyAware:]

Your analogy of "Battling The Drug Lords" is not well founded.

Prohibition created the very thing you need to combat.

Short sighted thinking of attempting to "Legislate" Morality is always a fools endeavor. By creating the criminals you justify the "War". This is a Prime Example of "The Cure Is Worse Than The Disease".

No, you do not have to condone use and shame is merited for abuse. However those of benign status now fuel the machine of outlaws. It perpetuates itself and drains money and resources that would best be put to better use.

Peace at all costs and by any means is not peace.



On Mar 05 08:32 PM CJJ wrote:

> Another topical analogy to Schiff's ideals can be drawn to the Mexican
> druge wars.
> In Peter's world you would do nothing and let the market decide who
> wins the Drug lords or the Mexican police. Well since the Drug Lords
> have more money and play by no rules they have an upperhand to the
> Mexican Police who can't indescriminately go out and kill the Drug
> Lords and their families.
> In this DO NOTHING atmosphere you run a real risk of having the citizens
> falling under the Drug Lords rule of fear and having no rules. Does
> this sound like a good plan???
>
> Obviously you try to quell the Drug Lords by doing WHATEVER it takes
> even if it doesn't make economic sense. You make up money, you take
> on debt to save the society. Obviously(although it would be best
> case) the Mexican Police will always have to play by some sort of
> rules the Drug Lords do not have to as they are wards of the state.
> The battle may cause extreme debt, there may be many bad days, but
> you don't just sit there and hope it works out okay.
>
> So keep blindly following Peter and thinking the police are going
> to win out. Since so many of you talk about your guns and gold, I
> don't expect cooler heads to win out.

Mar 06 03:52 PM

[PainfullyAware:]

The fact that the Author of the article does not include "a group of people" , affiliated with the normal commerce described, using a shell game between them to "puff their books" to create the illusion of greater prosperity means that he is not correctly modeling the current system.

Do not assume that because you are moral all others are as well.

Those that were charged with "Leveling The Playing Field" actually joined the other team. Government has and still is tipping the scales. Until this issue is resolved no capital is safe from confiscation by treachery or mandate.

Mar 06 03:59 PM

[Bill Jencks:]

In shooting down Schiff's vision, you also must therefore disagree with the vision of people like Warren Buffet, Marc Faber and Jim Rogers. These are the gurus who really have little to prove and their arguments are all similar to Schiff's.

In fact, Jim Rogers is so disgusted with the US Govt., The Fed, Wall Street and the Dollar that he moved his home, lock,stock and barrel to Singapore and he has moved out of the dollar completely - so he has, if you like, thoroughly acted on his own opinions of the US economy and is living it now.

When these gurus speak - people should listen. But if you are still in the belief that this currrent financial crisis is just another bust with a nice opportunistic boom coming over the horizon, then you dream.

The reasons for this crisis has very little to do with investing, and everything to do with very bad US economic policies.

Mar 08 05:11 AM