Robert P. Murphy
In response to a qualified plug that I gave to his book Crash Proof: How to Profit from the Coming Economic Collapse, Peter "Dr. Doom" Schiff sent me a complimentary review copy. (For those worried about trade imbalances, you can relax: I sent Schiff a copy of my own book in return.) I haven't yet finished the book, so I will postpone a proper review until then.
In the meantime, I can definitely say that Schiff is well read in the economics literature, and Austro-libertarian investors will probably enjoy his analysis more than the naοve versions offered by most financial writers. In particular, Schiff is very critical of fiat money systems, and blames the Federal Reserve for his predicted collapse of the dollar and the US economy in general.
Notwithstanding its appeal to cynical anti-government readers, I think Schiff's book reinforces popular "old school wisdom" that is simply false. Namely, Schiff buys into the argument (also made by Paul Craig Roberts) that a country needs a solid manufacturing base and trade surpluses to remain a dominant economic power. Although I do agree with Schiff that the dollar is poised for a (perhaps sharp) fall and I also endorse his advice to investors for protecting their wealth in this environment I think his arguments don't hold up in general. For the remainder of the present article, I'll try to demonstrate the weaknesses in Schiff's case.
SCHIFF'S CLEVER ISLAND ANALOGY
As I always stress whenever I criticize Peter Schiff, his work is a joy to read because it is so clear. So even when I think he's making a serious mistake in his economics, it will be quite easy to pinpoint the problem. Without further ado, let's read his amusing island analogy to (allegedly) demonstrate the unsustainability of a service economy and trade deficits:
Let's suppose six castaways are stranded on a desert island, five Asians and one American. Their problem is hunger. So they sit down and divide labor as follows: One Asian will do the hunting, another will fish, the third will scrounge for vegetation, the fourth will cook dinner, and the fifth will gather firewood and tend the fire. The sixth, the American, is given the job of eating.
So five Asians work all day to feed one American, who spends his day sunning himself on the beach. The American is employed in the equivalent of the service sector, operating a tanning salon that has one customer: himself. At the end of the day, the five Asians present a painstakingly prepared feast to the American, who sits at the head of a special table built by the Asians specifically for this purpose.
Now the American is practical enough to know that if the Asians are going to continue providing banquets they must also be fed, so he allows them just enough scraps from his table to sustain them for the following day's labor.
[To make the analogy more realistic], let's assume the American on the island pays for his food the same way real-world Americans pay, by issuing IOUs. At the end of each meal, the Asians present the American with a bill, which he pays by issuing IOUs claiming to represent future payments of food.
The castaways all know that the IOUs can never be collected, since the American not only produces no food to back them up, but also lacks the means and the intention of ever providing any. But the Asians accept them anyway, each day adding to the accumulation of worthless IOUs. (Schiff pp. 14-16)
THERE'S NOTHING MAGIC ABOUT MANUFACTURING
Of course, Schiff's analogy is very amusing, especially the quip about the tanning salon. And it may very well be a good description of the current Asian/American situation. However, as it stands, Schiff's book argues that this is necessarily the case, if a country turns into a service economy and suffers from prolonged trade deficits. After all, doesn't the island analogy prove that a country can't get by on IOUs forever? Eventually the indebted country is going to have to start producing cars, TVs, sweaters, and so forth to pay for all of the imports its people enjoyed during the deficit years, right?
The answer is "no," and I hope to make this clear with analogies that are every bit as compelling as Schiff's. Let's picture a different island: Manhattan. At any given time especially during a work day there are probably over two million people crammed onto this small piece of land that is under 23 square miles, and it is located in a region that is quite cold for a few months of the year. Indeed, a disciple of Paul Ehrlich who was an "expert" on Africa or Calcutta would conclude from these facts that the residents of Manhattan must be on the verge of starvation.
Yet we know this isn't the case; some of the world's wealthiest people reside there. What happens, of course, is that other workers all over the world grow food, assemble cars, and make TVs to ship them all into Manhattan. In contrast, very few tangible things are made on the island and then shipped to outsiders. Indeed, much of what makes Manhattan famous is not only "produced" on the island but also consumed there including Broadway shows, subway rides, lectures at NYU, and three-pound Reubens at the Carnegie Deli.
Now suppose Manhattan were to secede from the Union. Would anyone want to argue that the new country had an unsustainable situation? I hope not. In particular, if some NYC politicians wanted to subsidize heavy manufacturing so that their economy didn't implode, free market economists would rightly excoriate such a gross misunderstanding of comparative advantage and the gains from specialization.
At this point the skeptical reader especially the fan of Peter Schiff would probably object. For one thing, Manhattan does produce things to pay for its imports, most notably tourism. In other words, when workers in China send a plasma screen TV to be installed in (say) Matthew Broderick's house, this may be ultimately paid for when tourists from China visit New York and watch him perform on stage.
However, right now I'm just trying to debunk the popular awe over manufacturing. For some reason, people seem to think that if a nation doesn't produce cars and flashlights, then it's not strong economically. I hope the Manhattan analysis shows that that thinking can't be right.
If you're still not convinced, try it the other way: Suppose we adopted all of the policies recommended by Peter Schiff, and (presumably) the US returned to its glory days of the 1950s, racking up solid trade surpluses sending Fords all over the world. Then Michigan decides to secede. Would the rest of the US now be in dire straits, after losing such an integral component of its "manufacturing base"? Certainly not, assuming the two countries continued to freely trade with each other.
Now that we're warmed up, let's move on to the really hard sell: I'm going to argue that the ideal economy imagined by Austro-libertarians would almost certainly have perpetual trade deficits!
HERE ON ROTHBARD'S ISLE
Imagine that a few thousand Rothbardians from around the world get sick and tired of their governments and buy some tiny island tucked away in the middle of the Pacific. They all move there and establish a radical libertarian utopia, with no taxes, no regulations (except rules established in voluntary contracts), and a pure gold standard with 100% reserve banking. Most people's first reaction is that such an island would soon be invaded, but for now let's focus on this hypothetical country's economic fate.
I think it is self-evident that at least for the first few years, this Rothbardian island would "suffer" massive trade deficits. Again, if we put aside the problem of military conquest, it is clear that the small economy would eventually become one of the wealthiest on the planet. Presumably the inhabitants won't have to start from scratch like Robinson Crusoe, using vines to make nets, and then gradually building canoes and other tools over the years. Of course not; they will directly import the most advanced capital goods in order to get their fledgling economy up and running as quickly as possible. For the first few years at least, observers from space would see massive inflows of factory components, trucks, cement, drill presses, etc., in addition to consumption goods such as sports cars, TVs, hamburger meat, milk, and corn.
And what would the island ship out in return? I submit that the space observers would see relatively little flowing the other way. For one thing, much of the incoming goods would be accompanied by their owners, who were migrating to the island. But even people who remained abroad wouldn't need to import something produced on the island; instead they would exchange their present goods (whether consumption or capital) for ownership claims to the island's future wealth.
The observers in space would see a cargo ship full of gasoline make a delivery to the island, and leave with nothing (except perhaps garbage that the islanders paid to have hauled away). What they wouldn't see is that a German hedge fund (say) invested 10 million euros in a new consulting firm formed on the island. To do this the Germans bought 10 million euros' worth of gold and then electronically transferred ownership to the consulting firm's owners on the island. The owners then used this investment to pay workers on the island to install fluorescent lights, set up computer workstations, and so forth in the new office. The workers then spent their wages (measured in gold) on local taverns, movie theaters, rent, and so on. The workers and everyone else on whom they spent their wages would also spend gold at the gas station filling up their vehicles. This revenue would then allow the station owner to sell gold to buy US dollars, which he could then use to import refined gasoline from (say) Canada.
Ultimately, after dozens of intermediate transactions, the German investment provided the means with which the island could import the gasoline, without suffering an outflow of gold bullion. So when the space observers ask, "How did the islanders pay for that gasoline they imported?!" the answer is, "With partial ownership of the new consulting firm created on the island." The possibility of short-term trade deficits is quite obvious whenever a company starts; raw materials must flow in before any product is sold to consumers. And that "deficit" is of course offset by a sale of either debt or equity claims on the new company, i.e., expected future income is used to finance present purchases.
COULD THE TRADE DEFICITS LAST?
At this point I hope I've made it clear that manufacturing "solid" things is a silly goal, and that a very healthy economy could have short-term trade deficits. (In fairness to Schiff, I should acknowledge that he admits the US trade deficits of the 19th century were healthy though he doesnt make this small concession until page 160.) Now let me push it one final step, and argue that our hypothetical Rothbardian island would have perpetual trade deficits. In other words, the observers in space would see more finished goods (measured in terms of gold prices) flowing into the country than flowing out, year after year after year. How could this be?! After all, when the island just started, it made sense; foreigners were making loans in anticipation of future production. But if the trade deficits never evened out, wouldn't this constitute a giant Ponzi scheme?
The flaw in this "common sense" reasoning is that it ignores the true services that our tiny libertarian utopia would probably provide to the world. So the fan of Schiff is correct: the island would need to produce something for the rest-of-the-world, in order for the rest-of-the-world to keep sending in TVs, gasoline, SUVs, filet mignon, and so forth. But where the Schiffian analysis goes astray is that the comparative advantage of the islanders would almost certainly consist largely of intangible financial services, and thus by conventional measures (as well as in the eyes of the observers in space, looking at cargo ships crossing the ocean) the islanders would sink deeper and deeper into debt vis-ΰ-vis the rest-of-the-world. Naturally, this condition wouldn't spell doom for the libertarian economy; it would just demonstrate the inadequacy of conventional trade statistics.
The elementary point is that a current account deficit (a slightly broader term that includes the trade deficit) is the flip side of a capital account surplus; see here for a fuller explanation. So if you agree with me that even when it's 30 years old, the Rothbardian utopia would attract net foreign investment, then you have just conceded that the island would still be running a current account deficit after 30 years.
Think of it this way: If foreigners want to invest (say) 1 billion ounces of gold in the island's stocks, bonds, real estate, and other assets, while the islanders only want to invest 950 million ounces of gold in rest-of-the-world assets, then the islanders will accumulate 50 million ounces of gold. So if the trade balance is otherwise even, then the inflow of net investment tips the scales to a trade deficit of 50 million gold ounces. (After all, gold is itself a commodity, and so could reasonably be counted as an import.)
Of course, in practice the islanders probably won't continue to accumulate ever larger stocks of gold, decade after decade. Instead they'll probably use some of this gold to buy productive tools and equipment, yes, but also consumption goods. We know that the trade deficit has to have a market value of 50 million ounces of gold, but it could consist of (say) 15 million gold ounces' worth of consumption goods, 30 million ounces' worth of capital goods, and only 5 million ounces of actual gold bullion flowing into the island that year. (Note that if you don't think it's appropriate to count gold as a commodity for these purposes, the example still shows that net foreign investment = trade deficit + increase in gold holdings, meaning that net foreign investments allows for a "bad" trade deficit, though not requiring it.)
Although Austro-libertarian economists know that the asset values on the Rothbardian island would continually rise, and that the utopia would provide a superior investment destination even decades after its founding, it still seems that Schiff has a point. Why would the rest-of-the-world be content to own ever larger claims on island assets, if there were no hope of ever liquidating them in exchange for tangible exports from the island?
It's here where we need to truly think through the ramifications of our hypothetical economy. Because it would be based on a rock-solid genuine gold standard, investors would never fear that their island-based assets would have their value eroded by inflation. Moreover, the lack of a boom-bust cycle and surprise regulatory rulings would make island-based cash flows much more certain than those from any other asset in the world, other things equal.
Indeed, after several years the most prominent corporations on the island would no doubt be able to raise capital on better terms than even the US Treasury, because although the latter would have the power to tax, the value of the redemption (in US dollars) would be much less certain than the purchasing power of the dividend payments promised by the island's reputable corporations.
In addition to the stable monetary and economic environment, the island would eventually attract the best and brightest financiers from around the world. Without silly regulations and taxes, the most sophisticated hedge funds and investment banks would (eventually) relocate there, bringing their top talent with them.
These two factors would combine to allow islanders to borrow from abroad at much lower interest rates than they could earn by investing abroad. In other words, the island would act as the world's banker. A French investor would be willing to invest one million euros in an island-based bank that he expected to earn (once adjusting back from gold to euros) 1% per year, while the bank could, with the same risk, invest those funds abroad and earn an expected return of, say, 5% per year in euros. Thus the comparative advantage of the island as a financial clearinghouse would allow it to earn a net annual income of 40,000 euros from this single client's investment, which the islanders could use to import champagne.
If someone demanded to know how the islanders "paid" for this purchase, there would be no obvious export to point to, just as your local bank's employees are able to use their salaries to buy houses, cars, and fancy dinners even though the bank doesn't necessarily "sell" all that much to its customers. Yes, the bank might make some revenue off of annual checking account fees and so forth, but the bulk of its income probably comes from its actions as a "middleman," whereby it borrows money from depositors at a lower rate than it itself charges home buyers and other borrowers.
Thus we see that our Rothbardian island could generate true income vis-ΰ-vis other countries, in an entirely sustainable way, even without physically producing anything for export. Of course, in practice some things would be assembled on and exported from the island probably including refined narcotics that were illegal in other countries but this wouldn't be necessary, as Schiff believes. In its role as financial intermediary, the island would enjoy a sizable income stream from "arbitrage" activities, and this exponentially growing stream would constitute the base on which ever more net investment flowed into the island, allowing for a simultaneous net inflow of goods and services (i.e., a trade deficit).
Schiff isn't wrong when he claims that the foreign investors would ultimately need something beyond electronic bank balances that continually increased, signaling their "wealth" in ownership of island assets. But where he goes wrong is in concluding that the foundational real goods and services (upon which the equity and debt claims would be based) would need to be produced by the islanders. On the contrary, by its comparative advantage in financial services, the island would in effect be increasing the productivity of other countries' workers and machines, and then channeling some of that surplus into the hands of the foreigners who invested in island-based firms.
Let's finish the argument by taking it back to Schiff's original analogy. If we viewed the five Asians making meals for the American who sat in the sun all day, it would indeed seem both unfair and unsustainable. But on closer inspection, what if it turned out that the American had a knack for guessing where the best fishing spots were, or how best to kindle fires? He might then strike a bargain where the Asians went out and "did all the work," and gave him a large cut because their work was so much more fruitful with his verbal oversight.
In closing, I want to reiterate that I agree with Peter Schiff on the present dismal prospects for the US dollar. In particular, I do not think that his analogy is that far off; I definitely think that America's current account deficits in the last few years are due to "unproductive" debt, and not to the "wise overseer" role that I discussed in the paragraph above.
However, a large trade deficit even one that persists for decades is not necessarily bad or unsustainable. As I hoped to show in this essay, if the Austro-libertarians ever realized their dream, the resulting society would almost certainly have massive trade deficits and this would be a natural reflection of its economic might.