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Real Crash 2014
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Posted by Peter Schiff on 06/13/2014 at 6:40 AM
Thus far 2014 has been a fertile year for really stupid economic ideas. But of all the half-baked doozies that have come down the pike (the perils of "lowflation," Thomas Piketty's claims about capitalism creating poverty, and President Obama's "pay as you earn" solution to student debt), an idea hatched last week by CNBC's reliably ridiculous Steve Liesman may in fact take the cake. In diagnosing the causes of the continued malaise in the U.S. economy he explained, "the problem is that consumers are not taking on enough debt." And that "historically the U.S. economy has been built on consumer credit." His conclusion: Consumers must be encouraged to borrow more money and spend it. Given that Liesman is CNBC's senior economic reporter, I would hate to see the ideas the junior people come up with.
 
Before I get into the historical amnesia needed to make such a statement, we first have to confront the question of causation. Just as most economists believe that falling prices cause recession, rather than the other way around, Liesman believes that economic growth is created when people tap into society's savings in order to buy consumer goods that they could not otherwise afford. But consumption does not create growth. Increasing productive output allows for greater consumption. Something needs to be produced before it can be consumed.
 
But even allowing for this misunderstanding, consumer credit does little to increase consumption. All it accomplishes is to pull forward future consumption into the present (while generating a fee for the banker). This is like giving yourself a blood transfusion from your left arm to your right. Nothing is accomplished, except the possibility of spilling blood on the floor. But it's not even that benign.
If, for instance, a consumer borrows to take a vacation, the debt will have to be repaid, with interest, from future earnings. This just means that rather than saving now (under-consuming) to pay in cash (which under normal circumstances would earn interest and defray the cost) for a vacation in the future, the consumer borrows to vacation now and pays for it in the future. But shifting consumption forward can only create the illusion of growth.
 
Unlike business credit that can be self-liquidating (businesses borrow to invest, thereby expanding capacity, increasing revenue, and gaining a better ability to repay the loan out of increased earnings), consumer credit does nothing to help borrowers repay. Why would a consumer expect it to be easier to pay for a vacation in the future that he can't afford in the present? Especially when he is using credit to pay, which will add interest costs to the final bill. As a result,  consumer loans diminish future consumption more than current consumption is increased.
 
In fact, borrowing to consume is the worst use of society's limited store of savings. As explained in my book, How an Economy Grows and Why it Crashes, savings leads to capital formation and investment, which grows productive capacity. When production grows, goods and services become more plentiful and affordable, thereby raising living standards. Consumer credit interferes with this process. Funds borrowed for consumption are not available for more productive uses. Since consumer credit reduces investment, it also reduces future production, which must also reduce future consumption.
 
Liesman is also mistaken that consumer credit has been the historic foundation of growth in the United States. It may surprise him to know that consumer credit was largely unknown until the second half of the 20th Century. Before that, people simply did not, or could not, buy things on credit. They tended to pay in cash (even for cars) or with the now quaint system of lay-a-way (which is essentially the opposite of consumer credit). Credit cards did not become ubiquitous until the 1970s. It was also much more common for Americans to save money for an uncertain future, the "rainy day," that we were always being warned about. But savings rates now are only a fraction of where they had been for most of our history. Consumers now expect to borrow their way out of any crisis. Yet the American economy enjoyed some of its best years before consumer credit ever became an option.    
 
What Liesman is really advocating is that consumers borrow money to buy things they cannot afford. What kind of economic advice is that? Especially now that one third of Americans have less than $1,000 saved for retirement; a statistic so shocking that even CNBC recently cited it as a cause for concern. Does he really think that these savings-short Americans should take on even more consumer debt? Does creating a nation of bankrupt seniors who are too broke to retire ever create a more prosperous society?
 
Contrary to Liesman's asinine contention, it's not consumer credit that built the U.S. economy but its opposite - savings! Under-consumption not excess-consumption is what made America great. By saving instead of spending, consumers provided society with the means to increase investment and production that led to rising living standards for all. Unfortunately, it's consumer credit that is helping to destroy what savings once built.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.

Catch Peter's latest thoughts on the U.S. and International markets in the Euro Pacific Capital Spring 2014 Global Investor Newsletter!

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Posted by Peter Schiff on 06/11/2014 at 12:00 PM

The French economist Thomas Piketty has achieved worldwide fame by promoting a thesis that capitalism is the cause of growing economic inequality. Unfortunately, he is partially right. However, the important distinction missed by Piketty and all of his supporters is that state capitalism, not free market capitalism, has reigned supreme in recent decades in the world's leading democracies. It is this misguided attempt to wed the power of the state to the private ownership of capital that has led to the mushrooming of economic inequality. If the public cannot be made aware of the distinction, we risk abandoning the only system capable of creating real improvements for the vast majority of people.

 

In his book entitled 'Capital in the 21st Century', Piketty, like Karl Marx in 'Das Kapital,' places the hinge of economic tension at the supposed opposition between the competing interest of labor and capital. He believes that "capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based." However, this can only become true if free markets become controlled, or distorted, by the establishment of monopolies, be they private or state owned. 

 

In the early twentieth century, U.S. Governments were alert to the destruction of free markets by monopolistic cartels and enacted strong anti-trust laws to curb their power. The United States thereafter achieved strong economic results in the first three decades of the 20th Century. In contrast, the socialist governments of post WWII Britain used public funds to establish state owned monopolies, similar to those existing in the Soviet Union. This resulted in dramatic economic declines, that continued into the 1980s when the U.K. was rescued by the free market policies of Margaret Thatcher. Her central strategy was to restore individual freedom by breaking state owned monopolies and reducing the coercive control of trade unions. Her actions unleashed a resurgence of prosperity in Britain that was imitated in many other countries. Her policies were adopted with particular enthusiasm by countries, like Poland, which had only recently shaken off the yoke of Soviet Communism. Poland is now one of the strongest economies in Europe.

 

History provides ample evidence that when allowed to function properly free market capitalism generates massive national prosperity with high employment, a strong currency and rising standards of living. It is only when the state manipulates and over regulates free markets that capitalism fails. However, capitalism usually takes the blame for the failures of statism.

Piketty asserts that capitalism is "inherently unstable because it concentrates wealth and income progressively over time, leaving behind an impoverished majority. ..." He proscribes even an international wealth tax and higher income taxes, above 80 percent, to redistribute rather than to invest savings. This would essentially create a state monopoly on wealth. But again, history tends to demonstrate that state monopolies create poverty for all but the politically connected elite. 

 

Even the Soviet Union, a military superpower, was brought to its economic knees by state monopolies. Communist Party Secretaries, Andrapov and Gorbachev, were forced to the recognition that free markets should be introduced within Russia. This led to 'Perestroika' and 'Glasnost' and the freeing of markets in Russia. 

 

By concluding that capitalism, even if it is confined to just a few countries, will lead to increasing poverty among the masses around the world, many cynical observers may conclude that Piketty is laying out a carefully planned case towards global socialism along the lines first attempted by the Bolshevik Commintern. Some conclude that such a move could be spearheaded by international institutions like the UN and IMF. 

 

To achieve inherently unpopular global power, national elites must cooperate to bring about such levels of economic chaos and human suffering that people, despairing of ineffective democracy, will look for strong, global government as a welcome solution. To achieve this end the economic problems and human suffering must be extreme and seemingly beyond solution by any national government. By continuing to debase and destroy fiat currencies while preventing the markets from healing themselves, central banks around the world are doing their part to create these conditions. 

 

However, those who look towards strong global government must realize that likely it will lead to a world of extreme global inequality in which any effective opposition will be impossible. This is the fascistic face behind the cuddly and concerned image that has made Piketty the economic North Star of a new generation. These faulty bearings must be corrected or the world's poor will suffer far more than they need to.

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Posted by Peter Schiff on 06/06/2014 at 11:08 AM

Economists, investment analysts, and politicians have spent much of 2014 bemoaning the terrible economic effects of the winter of 2014. The cold and snow have been continuously blamed for the lackluster job market, disappointing retail sales, tepid business investment and, most notably, much slower than expected GDP growth. Given how optimistic many of these forecasters had been in the waning months of 2013, when the stock market was surging into record territory and the Fed had finally declared that the economy had outgrown the need for continued Quantitative Easing, the weather was an absolutely vital alibi. If not for the excuse of the bad weather, the entire narrative of a sustainable recovery would have been proven false.

 

Remarkably, this optimism was largely undiminished when the preliminary estimate for first quarter GDP came in at a shocking minus one percent annualized. This number, almost four percentage points lower than the forecasts from the end of 2013, hinted at an economy on a path toward recession. Still, the experts brushed off the report as a weather-related anomaly.

 

In contrast, I spent the better part of the last five months arguing that the weather was a straw man. I saw a fundamentally weak and contracting economy being artificially propped up by Fed stimulus, illusory accounting, and massive federal deficit spending.  However, while it is difficult to precisely measure the effects of bad weather on the economy, a fresh look at the historical data does tell me that a bad winter usually has an economic effect, but not nearly enough to support the oversize excuses being made by our leading pundits.

 

According to Rutgers University's Global Snow Lab, the winter of 2014 was one of 18 winters in which North America experienced demonstrably "above the trend line" snow accumulation since 1967 (this is as far back as Rutgers data goes). But there were at least eight winters in that time period that had more snow than in 2014. So it would be a stretch to say that this past winter made a greater impact than the average of the 10 snowiest winters since 1967. Cross-checking those winters with corresponding GDP figures from the U.S. Bureau of Economic Analysis (BEA) reveals some very interesting conclusions.

 

In general, first quarter (which corresponds to the winter months of January, February, and March) shows annualized GDP growth that is in line with other quarters. For instance, since 1967 average annualized 1st quarter growth came in at 2.7%, slightly above the 2.55% for the average 4th quarter, and below the 2.8% in 3rd quarter and 3.4% in 2nd. But when winter gets nasty, the economy does slow noticeably in the first quarter. So, to that extent my initial analysis likely underestimated its impact.  The bad news for the apologists is that the drag is not nearly enough to explain away the current lethargy.

 

The average annualized GDP growth for the 10 snowiest winters (not counting 2014) was just .5%. This is more than two percentage points below the typical first quarter. It's also more than two percentage points below the average annualized growth for the 4th quarters that preceded those 10 snowiest winters. This is important, because the economy tends to develop in waves that occur outside of the weather cycle. So based on this, we can conclude that the snow of this year likely shaved two percentage points from 1st quarter GDP growth.

 

But the negative one percent growth is almost four points off the initial forecasts. So, at best, the winter accounted for half the disappointment. Imagine if we had a mild winter, and 1st quarter GDP came in at a measly 1%. Without a convenient excuse to blame it on, how optimistic would Wall Street be now? Would the Fed really be continuing to taper in the face of such anemic growth? I doubt it.

 

The apologists also ignore the increased ability of current consumers to shop on the Internet at home even when the snow keeps them from the malls. This is an ability that simply did not exist more than 10 years ago...and should help to minimize the winter slowdowns.

 

An analysis of the bad winters also reveals a clear tendency for the economy to bounce back strongly in the following quarter. This confirms the theory that pent up demand gets released in the spring. In the ten 2nd quarters that followed the ten snowiest winters, annualized GDP averaged a strong 4.4%, or almost four percent higher than the prior quarter. (The snap back was even more dramatic in the five snowiest winters, when the differential was more than five percent.) Based on this, we should see annualized 2nd quarter growth this year of at least three or four percent. 
 
However, the raft of statistics that have come in over the past few weeks does not show that this is happening. A horrific trade deficit report came in this week widening to $47 Billion, the highest since July 2012. The data out this week also showed that consumer spending fell .1% in April (for the first time in a year), and that productivity falling in the 1st Quarter by 3.2% in the face of higher labor costs, which grew at 5.7% annualized. And although May's 217,000 increase in non-farm payrolls was in-line with expectation (following the big miss in ADP data earlier in the weak) it nonetheless represents a significant slowdown from April's 288,000 pace. The level of hiring did nothing to push up the labor force participation rate, which remained stuck at a 35 year low of 62.8%. Predictably, almost all of the jobs added were in low paying sectors that will not contribute much to overall purchasing power, like hospitality (mostly bars and restaurants), healthcare, and education. The report included a big drop in the number of construction workers added, which is the latest sign that the real estate sector is decelerating.

 

But even if growth picks up in the 2nd quarter to 4%, my guess is that most analysts will herald the news as confirmation that the economy is back on track, and discussion of the weather will disappear. However, since half of that four percent will have been borrowed from Q1, Q2's higher growth rate will also be weather-related. But while everyone blamed first quarter weakness on the weather, very few will likely cite it as a cause for any potential second quarter strength. But if you add the minus one percent from Q1 to a potential plus four percent from Q2, the average would still only be just 1.5% growth for the first half of 2014. Despite this, the Fed has yet to revise down its full year 2014 growth estimates of 2.8% to 3.2% that it made at the end of last year. To grow at 3% for the year, even with 4% growth in Q2 (which is above the current consensus estimate), the economy would have to grow at 4.5 percent for the entire second half. Good luck with that. 

 

So yes, the winter was bad, and yes it had an effect. But it was not likely the driving force of the first quarter slow-down and its effects should be very confined. But that won't stop the pundits from gnawing on that particular bone as long as they can get away with it. Unfortunately, they can get away with it for a long time.


Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 


Catch Peter's latest thoughts on the U.S. and International markets in the Euro Pacific Capital
Spring 2014 Global Investor Newsletter!


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Posted by Peter Schiff on 06/05/2014 at 9:44 AM
Even investors who typically eschew precious metals have been hard-pressed to ignore the platinum industry this year. The longest strike in South African history paired with surging Asian demand is set to push the metal back into a physical deficit in 2014 - and could have repercussions for years to come. While gold remains the most conservative choice for saving, the "industrial precious metal" platinum is a compelling investment for those, like me, who are bullish on global net economic growth.

China in the Driver's Seat

As with gold and silver, examining platinum demand takes us to the Eastern hemisphere and China's rapidly expanding economy. In particular, the growing Chinese middle class is generating massive demand for new automobiles, which in turn is consuming plenty of platinum.

For the last ten years, autocatalysts have composed 40-50% of total global platinum demand. Autocatalysts use platinum to clean the emissions of motor vehicles, and 95% of the world's new passenger cars come equipped with them. Both auto production and emissions standards are steadily increasing around the world, especially in the huge emerging market of China.

Global auto production grew 4% in 2013 to almost 89 million units. According to IHS, Inc., world auto sales will continue to grow to more than 100 million units by 2018 - that's 12% growth in the next five years. And you can bet that growth won't be coming from the US.

China's share of global vehicle production has exploded from under 4% in 2000 to an astounding 25% last year. I expect this demand to keep expanding as more Chinese citizens grow wealthier and are able to enter the auto market.


Chinese vehicle production grew almost 15% in 2013 and should grow another 10% in 2014. New emissions standards that went into effect last year are already forcing Chinese auto manufacturers to use more platinum. Indeed, platinum use in Chinese autocatalysts increased 33% in 2013.

I believe this trend will continue as the Chinese government tries to tackle the country's critical pollution crisis. Just last week, the PRC announced that it would be removing 6 million vehicles from China's roads by the end of the year because they no longer meet emissions standards.

Platinum as an Investment

Though industrial applications have the largest impact on its price, platinum remains a sought-after precious metal with growing demand from the investment and jewelry sectors. Jewelry accounts for well over 25% of platinum demand, and that figure has been steadily increasing. Once again, we look east for the most compelling numbers.

Chinese platinum jewelry demand represents about 65% of the world's total and is expected to expand 5% this year. But India is the real bright point - high import tariffs imposed on gold by the Indian government in 2013 have created shortages and very high premiums on the yellow metal, driving consumers to replace gold with platinum. India's platinum jewelry market has seen 30-50% growth every year so far this decade. 2014 should continue that trend with a 35% projected growth in platinum jewelry sales.

While Eastern investors buy physical platinum in the form of jewelry, Westerners are piling into relatively young exchange-traded funds (ETFs) backed by the metal. Platinum ETFs did not exist until 2007, and the first South African-based platinum ETF began just last year. 2013 saw a 55% increase in the amount of physical platinum held by ETFs, totaling 2.5 million ounces.

As short-term traders wake up to the same supply/demand issues summarized in this commentary, the trend of increasing retail investment may well absorb a greater share of the limited supply.

Just as with gold and silver, I believe platinum ETFs are inferior to physical bullion for long-term investment. However, many investors prefer the liquidity they offer, and as a fundamental data point, they should not be ignored.

Supply Goes from Shaky to Shocked

With promising new sources of demand, platinum supplies have been under pressure. To put into perspective how little platinum is available, simply compare it to gold and silver. Over the past decade, about 13.5 times more gold and 100 times more silver have been mined than platinum. The vast majority of the meager platinum supply comes from just two countries - South Africa and Russia. Troubles in both of these countries are pushing supply constraints into a market shock.

Beginning in January, more than 70,000 South African miners went on strike against the three largest platinum producers in the world - Anglo American Platinum, Impala Platinum, and Lonmin. This is the longest strike in South African history and is estimated to have already reduced global platinum production by 40%. About 1 million ounces of platinum will not be mined this year due to the strikes.

No matter when these wage disputes are resolved, they're going to have a deep impact on the platinum industry. Wages are already one of the biggest expenses of mining, and the Association of Mineworkers and Construction Union (AMCU) is demanding a doubling of wages by 2017. They've already rejected an offer of a 10% increase.

This much seems clear: wages are going to go up and the industry will have to restructure its operations to handle the extra expense. The average global all-in cost of production (including capital expenditures and indirect overhead costs) is already at about $1,595 per ounce of platinum - 10% above the current market price.

As the cost of business rises, some industry analysts are forecasting that Lonmin and perhaps other companies will be forced to keep some of their mines closed after the strikes end. This could affect the platinum market for many years into the future. Large mining operations cannot be started and stopped at the drop of a hat, and it may take a significant increase in the price per ounce to justify reopening any shuttered mines.

Meanwhile, there's the possibility that Russia's annexation of Crimea could draw stricter economic sanctions from the United States and the European Union. How this would affect Russia's giant mining industry is hard to tell, though it has already put a lot of upward pressure on the price of palladium, another important platinum group metal (PGM). Russia is the world's largest producer of palladium and is widely suspected of having exhausted its official reserves of the metal. This rumor, combined with the news that Russia has been exporting abnormally large amounts of palladium to Switzerland in anticipation of economic sanctions, helped to drive the metal's price to its highest since 2011 in May.

The rising price of palladium and its ever-deepening physical deficit might even spur more producers to pay the extra for platinum, which can be more efficient than palladium in some autocatalysts. Generally, any limitations on Russian mining are bullish for all PGMs, and I am waiting for platinum to follow palladium's spike.

An Opportunity to Diversify

All told, Thomson Reuters GFMS is predicting at least a 700,000-ounce physical platinum deficit this year. It projects that platinum will pass $1,700 per ounce by the end of 2014, a 18% increase from today's price. Johnson Matthey is even more pessimistic (or optimistic, from the point of view of a platinum investor), predicting a deficit of more than 1.2 million ounces - the largest since 1975.

Even precious metals bears cannot deny the robust fundamentals for platinum this year. Investors who have already formed a bedrock for their portfolio with gold should consider adding physical platinum to increase future returns.

Peter Schiff is Chairman of Euro Pacific Precious Metals, which sells high-quality physical platinum, gold, and silver coins and bars. 

Click here for a free subscription to Peter Schiff's Gold Letter, a monthly newsletter featuring the latest gold and silver market analysis from Peter Schiff, Casey Research, and other leading experts. 

And now, investors can stay up-to-the-minute on precious metals news and Peter's latest thoughts by visiting Peter Schiff's Official Gold Blog.



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Posted by Peter Schiff on 05/29/2014 at 8:54 AM
There can be little doubt that Thomas Piketty's new book Capital in the 21st Century has struck a nerve globally. In fact, the Piketty phenomenon (the economic equivalent to Beatlemania) has in some ways become a bigger story than the ideas themselves. However, the book's popularity is not at all surprising when you consider that its central premise: how radical wealth redistribution will create a better society, has always had its enthusiastic champions (many of whom instigated revolts and revolutions). What is surprising, however, is that the absurd ideas contained in the book could captivate so many supposedly intelligent people.  

Prior to the 20th Century, the urge to redistribute was held in check only by the unassailable power of the ruling classes, and to a lesser extent by moral and practical reservations against theft. Karl Marx did an end-run around the moral objections by asserting that the rich became so only through theft, and that the elimination of private property held the key to economic growth. But the dismal results of the 20th Century's communist revolutions took the wind out of the sails of the redistributionists. After such a drubbing, bold new ideas were needed to rescue the cause. Piketty's 700 pages have apparently filled that void.

Any modern political pollster will tell you that the battle of ideas is won or lost in the first 15 seconds. Piketty's primary achievement lies not in the heft of his book, or in his analysis of centuries of income data (which has shown signs of fraying), but in conjuring a seductively simple and emotionally satisfying idea: that the rich got that way because the return on invested capital (r) is generally two to three percentage points higher annually than economic growth (g). Therefore, people with money to invest (the wealthy) will always get richer, at a faster pace, than everyone else. Free markets, therefore, are a one-way road towards ever-greater inequality.

Since Pitketty sees wealth in terms of zero sum gains (someone gets rich by making another poor) he believes that the suffering of the masses will increase until this cycle is broken by either: 1) wealth destruction that occurs during war or depression (which makes the wealthy poorer) or 2) wealth re-distribution achieved through income, wealth, or property taxes. And although Piketty seems to admire the results achieved by war and depression, he does not advocate them as matters of policy. This leaves taxes, which he believes should be raised high enough to prevent both high incomes and the potential for inherited wealth.

Before proceeding to dismantle the core of his thesis, one must marvel at the absurdity of his premise. In the book, he states "For those who work for a living, the level of inequality in the United States is probably higher than in any other society at any time in the past, anywhere in the world." Given that equality is his yardstick for economic success, this means that he believes that America is likely the worst place for a non-rich person to ever have been born. That's a very big statement. And it is true in a very limited and superficial sense. For instance, according to Forbes, Bill Gates is $78 billion richer than the poorest American. Finding another instance of that much monetary disparity may be difficult. But wealth is measured far more effectively in other ways, living standards in particular.

For instance, the wealthiest Roman is widely believed to have been Crassus, a first century BC landowner. At a time when a loaf of bread sold for ½ of a sestertius, Crassus had an estimated net worth of 200 million sestertii, or about 400 million loaves of bread. Today, in the U.S., where a loaf of bread costs about $3, Bill Gates could buy about 25 billion of them. So when measured in terms of bread, Gates is richer. But that's about the only category where that is true.

Crassus lived in a palace that would have been beyond comprehension for most Romans. He had as much exotic food and fine wines as he could stuff into his body, he had hot baths every day, and had his own staff of servants, bearers, cooks, performers, masseurs, entertainers, and musicians. His children had private tutors. If it got too hot, he was carried in a private coach to his beach homes and had his servants fan him 24 hours a day. In contrast, the poorest Romans, if they were not chained to an oar or fighting wild beasts in the arena, were likely toiling in the fields eating nothing but bread, if they were lucky. Unlike Crassus, they had no access to a varied diet, health care, education, entertainment, or indoor plumbing.

In contrast, look at how Bill Gates lives in comparison to the poorest Americans. The commodes used by both are remarkably similar, and both enjoy hot and cold running water. Gates certainly has access to better food and better health care, but Americans do not die of hunger or drop dead in the streets from disease, and they certainly have more to eat than just bread. For entertainment, Bill Gates likely turns on the TV and sees the same shows that even the poorest Americans watch, and when it gets hot he turns on the air conditioning, something that many poor Americans can also do. Certainly flipping burgers in a McDonald's is no walk in the park, but it is far better than being a galley slave. The same disparity can be made throughout history, from Kublai Khan, to Louis XIV. Monarchs and nobility achieved unimagined wealth while surrounded by abject poverty. The same thing happens today in places like North Korea, where Kim Jong-un lives in splendor while his citizens literally starve to death.

Unemployment, infirmity or disabilities are not death sentences in America as they were in many other places throughout history. In fact, it's very possible here to earn more by not working. Yet Piketty would have us believe that the inequality in the U.S. now is worse than in any other place, at any other time. If you can swallow that, I guess you are open to anything else he has to serve.

All economists, regardless of their political orientation, acknowledge that improving productive capital is essential for economic growth. We are only as good as the tools we have. Food, clothing and shelter are so much more plentiful now than they were 200 years ago because modern capital equipment makes the processes of farming, manufacturing, and building so much more efficient and productive (despite government regulations and taxes that undermine those efficiencies). Piketty tries to show that he has moved past Marx by acknowledging the failures of state-planned economies.

But he believes that the state should place upper limits on the amount of wealth the capitalists are allowed to retain from the fruits of their efforts. To do this, he imagines income tax rates that would approach 80% on incomes over $500,000 or so, combined with an annual 10% tax on existing wealth (in all its forms: land, housing, art, intellectual property, etc.). To be effective, he argues that these confiscatory taxes should be imposed globally so that wealthy people could not shift assets around the world to avoid taxes. He admits that these transferences may not actually increase tax revenues, which could be used, supposedly, to help the lives of the poor. Instead he claims the point is simply to prevent rich people from staying that way or getting that way in the first place.

Since it would be naive to assume that the wealthy would continue to work and invest at their usual pace once they crossed over Piketty's income and wealth thresholds, he clearly believes that the economy would not suffer from their disengagement. Given the effort it takes to earn money and the value everyone places on their limited leisure time, it is likely that many entrepreneurs will simply decide that 100% effort for a 20% return is no longer worth it. Does Piketty really believe that the economy would be helped if the Steve Jobses and Bill Gateses of the world simply decided to stop working once they earned a half a million dollars?

Because he sees inherited wealth as the original economic sin, he also advocates tax policies that will put an end to it. What will this accomplish? By barring the possibility of passing on money or property to children, successful people will be much more inclined to spend on luxury services (travel and entertainment) than to save or plan for the future. While most modern economists believe that savings detract from an economy by reducing current spending, it is actually the seed capital that funds future economic growth. In addition, businesses managed for the long haul tend to offer incremental value to society. Bringing children into the family business also creates value, not just for shareholders but for customers. But Piketty would prefer that business owners pull the plug on their own companies long before they reach their potential value and before they can bring their children into the business. How exactly does this benefit society?

If income and wealth are capped, people with capital and incomes above the threshold will have no incentive to invest or make loans. After all, why take the risks when almost all the rewards would go to taxes? This means that there will be less capital available to lend to businesses and individuals. This will cause interest rates to rise, thereby dampening economic growth. Wealth taxes would exert similar upward pressure on interest rates by cutting down on the pool of capital that is available to be lent. Wealthy people will know that any unspent wealth will be taxed at 10% annually, so only investments that are likely to earn more than 10%, by a margin wide enough to compensate for the risk, would be considered. That's a high threshold.

The primary flaw in his arguments are not moral, or even computational, but logical. He notes that the return of capital is greater than economic growth, but he fails to consider how capital itself "returns" benefits for all. For instance, it's easy to see that Steve Jobs made billions by developing and selling Apple products. All you need to do is look at his bank account. But it's much harder, if not impossible, to measure the much greater benefit that everyone else received from his ideas. It only comes out if you ask the right questions. For instance, how much would someone need to pay you to voluntarily give up the Internet for a year? It's likely that most Americans would pick a number north of $10,000. This for a service that most people pay less than $80 per month (sometimes it's free with a cup of coffee). This differential is the "dark matter" that Piketty fails to see, because he doesn't even bother to look.
Somehow in his decades of research, Piketty overlooks the fact that the industrial revolution reduced the consequences of inequality. Peasants, who had been locked into subsistence farming for centuries, found themselves with stunningly improved economic prospects in just a few generations. So, whereas feudal society was divided into a few people who were stunningly rich and the masses who were miserably poor, capitalism created the middle class for the first time in history and allowed for the possibility of real economic mobility. As a by-product, some of the more successful entrepreneurs generated the largest fortunes ever measured. But for Piketty it's only the extremes that matter. That's because he, and his adherents, are more driven by envy than by a desire for success. But in the real world, where envy is inedible, living standards are the only things that matter.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.

Catch Peter's latest thoughts on the U.S. and International markets in the Euro Pacific Capital Spring 2014 Global Investor Newsletter!

Tags:  CPIeconomy
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Posted by Peter Schiff on 05/23/2014 at 11:51 AM

In this week's release of the minutes from its April 29-30 meeting, Federal Reserve policymakers made clear that they see little chance of inflation moving past their 2% target for years to come. In order to make such a bold statement, Fed economists not only had to ignore the current data, but discount the likelihood that their current stimulus will put further upward pressure on prices that are already rising.

Even if you believe the highly manipulated government CPI data, April's year over year inflation rate came in at 1.95%, a statistically insignificant difference from the Fed's 2% target. If annualized, April's monthly change would equate to a rate closer to 4%. On the producer side, the numbers are even worse. Last week the Producer Price Index (PPI) came in at .6% for April, after notching up .5% in March. These two months together annualize at 6.6%. So already there is very little wiggle room, if any, before the Fed reaches the point where even its dovish leaders should admit that inflation is a problem.

But like most modern economists, leaders at the Fed deny Milton Friedman's famous maxim that inflation "is always and everywhere a monetary phenomenon." Instead they like to think of it as a kind of pesky but necessary byproduct of economic growth. (Recently the theory has gone even further, mixing cause and effect to determine that inflation causes economic growth). If this were so, then the Fed would have a lot to worry about if its economic forecasts can be trusted.

Despite the muted economic statistics over the last few months, the Fed has not backed off Janet Yellen's 3.0% forecast for 2014 GDP. The near zero growth we saw in Q1 (likely to be revised negative) has not convinced her, or anyone at the Fed, to ratchet down this estimate. So to hit that target, growth for the remainder of the year will have to come in close to 4% per quarter.

If the economy finally picks up to that level, by throwing off the supposedly chilling effect of the past winter, then based on the Fed's views it should expect significant upward pressure on inflation. Yet nowhere in the minutes released today is that possibility even considered. In fact, they explicitly said that inflation would be well below 2% for the next few years, despite the fact that it's already at 2% right now...during a period of admitted weakness! So they expect the economy to grow and inflation to subside even while real interest rates stay deep in negative territory? In essence, they are writing a new economic textbook on the fly. In truth, they are simply stringing together words and ideas designed to soothe the market and to keep anyone from detecting the dangerous trap that they have led us into. So just as the Fed saw no risk of housing prices falling in 2006, they see no risk of consumer prices rising now. In fact, they are just as confident that inflation is "contained" as they were about the sub-prime mortgage crisis. Based on their track record, people should fear exactly what the Fed is not worried about.

In the meantime, the truth about inflation is bubbling up in some unexpected places, sometimes from the same government that tells us that it's not a problem. In order to calculate the payment levels for the SNAP Food Program (aka "Food Stamps"), The U.S. Department of Agriculture is responsible for providing a baseline estimate for the costs needed to feed the typical family that would qualify for the program.

Looking over a twenty-year time frame provides a revealing pattern that we have seen in other places (see Big Mac Index). From 1994 to 2003 the CPI rose by a total of 25% or about 3.2% per year. This is almost exactly the same change that was seen in both the food component of the CPI and the USDA SNAP estimates for their "thrifty" plan to feed a family of four (the "thrifty" plan is the least expensive) over the same period.

But that all began to change in the early part of the current century as the costs began drifting apart from the official CPI. I have made the case many times that this occurred as a result of changes in the way the CPI is calculated, all of which were designed to conceal the true level of inflation. 


From 2004 to 2014 the CPI was up 26% or about 2.5% per year. However, the food component of the CPI was up 30% and the USDA estimate for a family of four was up 32% (The higher cost "liberal plan" increased even more, at 35% over that time). When comparing two sets of government data, it's tough to credit one over the other. But the USDA data is likely much closer to what most of us who shop for food actually experience. If accurate, the USDA numbers mean that over the past decade the costs to actually feed a family increased 23% more than most economists like to tell us.

Rising food prices are a major problem for many Americans struggling to make ends meet in our listless economy. Exactly how much more pain does the Federal Reserve want to inflict on the middle and lower classes before it relents and stops creating even more inflation? 

There is a growing belief among economists, highlighted in a recent debate I had with Nouriel Roubini, that higher prices are actually a benefit to consumers. They believe that the growth created by inflation is worth more than the cost imposed at check-out lines. Instead, we are simply getting another dose of 1970s-style stagflation as higher prices simply amplify the pain of a stagnant economy and diminished employment opportunities.  

The good news for Roubini and his ilk is that inflation does indeed help some people...the very rich. I have long argued that Fed stimulus and quantitative easing only result in the formation of asset bubbles that unevenly favor the rich, while misdirecting capital away from savings and productive investments that would benefit everyone else. Economists had blamed the recent disappointments from mass-market retailers like Walmart, Target, Best Buy, Staples, Dick's Sporting Goods, and Pet Smart (to name but a few) on the ravages of winter weather rather than weak fundamentals. Butyesterday the upscale vendor Tiffany's issued a boffo report that showed net income up an astounding 50% over first quarter in 2013. The rich seemed to have little trouble braving the elements to buy baubles on Fifth Avenue, yet average Americans were too thin-skinned to make it to Dick's Sporting Goods.  

While the world talks about the dangers of deflation, which offers no harm to economies or consumers, actual inflation is everywhere to be seen and nowhere acknowledged. Instead, we get a universal agreement that the middle class must continue to suffer so that the Fed and financial speculators can continue to revel in the charade.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Catch Peter's latest thoughts on the U.S. and International markets in the Euro Pacific CapitalSpring 2014 Global Investor Newsletter!


Tags:  CPIeconomy
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Posted by Peter Schiff on 03/21/2014 at 12:54 PM
The red flags contained in the national and global headlines that have come out thus far in 2014 should have spooked investors and economic forecasters. Instead the markets have barely noticed. It seems that the majority opinion on Wall Street and Washington is that we have entered an era of good fortune made possible by the benevolent hand of the Federal Reserve. Ben Bernanke and now Janet Yellen have apparently removed all the economic rough edges that would normally draw blood. As a result of this monetary "baby-proofing," a strong economy is no longer considered necessary for rising stock and real estate prices.

But unfortunately, everything has a price, even free money. Our current quest to push up asset prices at all costs will come back to bite all Americans squarely in the pocket book. Death and taxes have long been linked by a popular maxim. However, there also exists a similar link between debt and taxes. The debt we are now incurring in order to buttress current stock and real estate will inevitably lead to higher taxes down the road. However, don't expect the taxes to arrive in their traditional garb. Instead, the stealth tax of inflation will be used to drain Americans of their hard earned purchasing power.

I explore this connection in great length in my latest report Taxed By Debt, available for free download at www.taxedbydebt.com. But diagnosing a problem is just half the battle. I also present investing strategies that I believe can help Americans avoid the traps that are now being laid so carefully.

The last few years have proven that there is no line Washington will not cross in order to keep bubbles from popping. Just 10 years ago many of the analysts now crowing about the perfect conditions would have been appalled by policies that have been implemented to create them. The Fed has held interest rates at zero for five consecutive years, it has purchased trillions of dollars of Treasury and mortgage-backed securities, and the Federal government has stimulated the economy through four consecutive trillion-dollar annual deficits. While these moves may once have been looked on as something shocking...now anything goes.

But the new monetary morality has nothing to do with virtue, and everything to do with necessity. It is no accident that the concept of "inflation" has experienced a dramatic makeover during the past few years. Traditionally, mainstream discussion treated inflation as a pestilence best vanquished by a strong economy and prudent bankers. Now it is widely seen as a pre-condition to economic health. Economists are making this bizarre argument not because it makes any sense, but because they have no other choice.

America is trying to borrow its way out of recession. We are creating debt now in order to push up prices and create the illusion of prosperity. To do this you must convince people that inflation is a good thing...even while they instinctively prefer low prices to high. But rising asset prices do little to help the underlying economy. That is why we have been stuck in what some economists are calling a "jobless recovery." The real reason it's jobless is because it's not a real recovery!  So while the current booms in stocks and condominiums have been gifts to financial speculators and the corporate elite, average Americans can only watch from the sidewalks as the parade passes them by. That's why sales of Mercedes and Maseratis are setting record highs while Fords and Chevrolets sit on showroom floors. Rising prices to do not create jobs, increase savings or expand production. Instead all we get is debt, which at some point in the future must be repaid.

As detailed in my special report, when President Obama took office at the end of 2008, the national debt was about $10 trillion. Just five years later it has surpassed a staggering $17.5 trillion. This raw increase is roughly equivalent to all the Federal debt accumulated from the birth of our republic to 2004! The defenders of this debt explosion tell us that the growth eventually sparked by this stimulus will allow the U.S. to repay comfortably. Talk about waiting for Godot. To actually repay, we will have few options. We can cut government spending, raise taxes, borrow, or print. But as we have seen so often in recent years, neither political party has the will to either increase taxes or decrease spending.

So if cutting and taxing are off the table, we can expect borrowing and printing. That is exactly what has been happening. In recent years, the Fed has bought approximately 60% of the debt issued by the Treasury. This has kept the bond market strong and interest rates extremely low. But a country can't buy its own debt with impunity indefinitely. In fact the Fed, by winding down its QE program by the end of 2014, has threatened to bring the party to an end.

Although bond yields remain close to record low territory, thanks to continued QE buying, we have seen vividly in recent years how the markets react negatively to any hint of higher rates. That's why any indication that the Fed will lift rates from zero can be enough to plunge the markets into the red. The biggest market reaction to Yellen's press conference this week came when the Chairwoman seemed to fix early 2015 as the time in which rates could be lifted from zero. That possibility slapped the markets like a frigid polar wind.

Janet Yellen may talk about tightening someday, but she will continue to move the goalposts to avoid actually having to do so. (Or as she did this week, remove the goalposts altogether). As global investors finally realize that the Fed has no credible exit strategy from its zero interest policy, they will fashion their own exit strategy from U.S. obligations. Should this happen, interest rates will spike, the dollar will plunge, and inflation's impact on consumer prices will be far more pronounced than it istoday. This is when the inflation tax will take a much larger bite out of our savings and paychecks.  The debt that sustains us now will one day be our undoing.

But there are steps investors can take to help mitigate the damage, particularly by moving assets to those areas of the world that are not making the same mistakes that we are. In my new report, I describe many of these markets. Just because the majority of investors seem to be swallowing the snake oil being peddled doesn't mean it's wise to join the party. I urge you to download my report and decide for yourself.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Catch Peter's latest thoughts on the U.S. and International markets in the Euro Pacific CapitalWinter 2014 Global Investor Newsletter!


Tags:  debteconomytaxes
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Posted by Peter Schiff on 03/07/2014 at 5:45 PM

Everyone agrees that the winter just now winding down (hopefully) has been brutal for most Americans. And while it's easy to conclude that the Polar Vortex has been responsible for an excess of school shutdowns and ice related traffic snarls, it's much harder to conclude that the it's responsible for the economic vortex that appears to have swallowed the American economy over the past three months. But this hasn't stopped economists, Fed officials, and media analysts from making this unequivocal assertion. In reality the weather is not what's ailing us. It's just the latest straw being grasped at by those who believe that the phony recovery engineered by the Fed is real and lasting. The April thaw is not far off. Unfortunately the economy is likely to stay frozen for some time to come.    

Over the past few weeks, I have seen just about every weak piece of economic news being blamed on the weather. First it was lackluster retail sales that were chalked up to consumers being unable or unwilling to make it to the mall. (This managed to ignore the fact that online sales were similarly weak - which would be unexpected for a nation of snowed in consumers). Then came the weak auto sales that were ascribed to similarly holed up potential car buyers. However, this ignores that while GM and Chrysler sales were way down, sales for luxury cars like BMW, Mercedes and Maserati, surged to record high levels (more on that later). No one offered a reason why wealthier motorists were able to brave the cold. A number of other data points, such as lower GDP, productivity, ISM and factory orders were also ascribed to the elements.

Analysts also blamed the weather for weak housing sales and mortgage applications, which both hit multi-year lows. The idea being that hibernating buyers could not get to real estate open houses or to the bank to process loans. This idea ignores the fact that the weakest home sales over the last few months have come from the states west of the Rockies, where temperatures have been above average.

Of course the biggest weakness ascribed to the snow and ice has been the very disappointing employment reports over the last few months. Analysts faced a very difficult task in squaring these reports, which showed fewer than 187,000 new jobs created in December and January combined, with the accepted narrative that the recovery was firmly underway and that the economy was no longer dependent on the Fed's monetary support. 

For these desperate economists the weather was a godsend. Mark Zandi had virtually guaranteed that job creation was being deferred by the weather and that hiring would come roaring back once the mercury started rising. The weather has become such a handy and versatile tool for economic apologists that we may expect that financial news stations will start featuring meteorologists more heavily than financial analysts. Move over Jim Cramer, hello Al Roker. 

The weather continued to be horrible in February and as a result, there were wide expectations thattoday's February jobs report would be similarly bleak. But this morning's release of a detailed a slightly better than expected 175,000 new jobs, thereby convincing economists that the economy was so strong that it is overcoming the drag created by the weather. This lays aside the fact that 175,000 jobs should not be causing any optimism. After years of sub-par job growth, I believe a recovering economy would be expected to create more than 300,000 jobs per month in order to make a real dent in underemployment. Those levels, once routine in past decades, seem untouchable today. But weather-related pessimism had caused economist to ratchet down their predictions to just 150,000 jobs in February. Based on that, today's numbers were seen as a win.

But economists are ignoring the likelihood that the weather was never a major factor. Take the cold out of the equation and you would be left with a mediocre February number following two consecutive monthly disasters. This does not change the downward trajectory. In fact, the number may be revised lower in future months, as has been the norm in the years since the economic crisis began.

Drilling deeper into the report will provide little reason for optimism. The labor force participation rate stayed at generational low and the unemployment rate edged up. On the other hand, the long-term unemployed (those out of work for more than 27 weeks) increased by 203,000 to 3.8 million. Furthermore, over half of the jobs created were low-paying or part-time jobs in education, health care, leisure and hospitality, government, and temporary services. Higher paying information jobs declined by another 16,000 following last month's 8,000 loss, and manufacturing added a scant 6,000 jobs. 

The report also contained data that shows how older workers are coming out of, or postponing retirement. This trend is likely caused inadequate savings rates, low interest rates, and increases in the cost of living that are rising faster than official CPI numbers. Not only does this point to falling living standards, but the jobs being taken by these older workers would normally be filled by younger, less skilled workers, who are left unemployed, buried beneath a pile of student debt and living in their parent's basements.

In truth, economic activity persists in good weather and bad. Winter is largely predictable. It comes around once a year, basically on schedule. Consumers are used to the patterns and know how to deal them. But don't tell this to today's economists.

A much more plausible explanation to me is that the economy has been weak recently because it is weak fundamentally. The data deterioration corresponds not just to unseasonably low temperatures but also to the diminishment of monthly QE from the Federal Reserve. If you recall the highly anticipated "taper" finally began in mid- December. From my perspective the Quantitative Easing has become the sunshine that drives our phony economy. Diminish that sunshine and the economic winter spreads.

But the sad fact is that QE can push up prices in stocks and real estate, but can do very little to affect positive change in the real economy. That's why I believe that BMW's are selling like hotcakes even as Chevies sit on the lot. Our current policies help the wealthy at the expense of everybody else. Unfortunately, I don't think the economy will improve as long as the QE keeps us locked into a failing model. What's worse, once the weather warms and the economy does not, look for Janet Yellen to first taper the taper, then to reverse the process completely.

So be very wary of the rationalizations that come from economists. I believe they are being used to hide the truth. I just can't wait to see the excuses they come up with once the flowers start blooming in April. They will be doozies.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Catch Peter's latest thoughts on the U.S. and International markets in the Euro Pacific CapitalWinter 2014 Global Investor Newsletter!


Tags:  economy
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Posted by Peter Schiff on 02/21/2014 at 10:41 AM

Two pieces of business news announced this week provide a convenient frame through which to view our dysfunctional and distorted economy. The first (which has attracted tremendous attention), is Facebook's blockbuster $19 billion acquisition of instant messaging provider WhatsApp. The second (which few have noticed) is the horrific earnings report issued by Texas-based retail chain Conn's. While these two developments don't seem to have much in common, together they shed some very unflattering light on where we stand economically.

Given the size and extravagance of the Facebook deal, it may go down as one of those transactions that define an era (think AOL and Time Warner). Facebook paid $19 billion for a company with just 55 employees, little name recognition, negligible revenues, and little prospects to earn much in the future. For the same money the company could have bought American Airlines and Dunkin' Donuts, and still have had $2 billion left over for R&D. Alternatively they could have used the money to lock in more than $1 billion in annual revenue through an acquisition of any one of the numerous large cap oil producing partnerships. Instead they chose a company that is in the business of giving away a valuable service for free. Come again?

Mark Zuckerberg, the owner of Facebook, is not your typical corporate CEO. Through a combination of technological smarts, timing, luck, and questionable business ethics, he became a billionaire before most of us bought our first cars. And in the years since social media became the buzzword of the business world, Wall Street has been falling over backward to funnel money into the hot sector. As a result, it may be that Zuckerberg looks at real money the way the rest of us look at Monopoly money. It also helps that a large portion of the acquisition is made with Facebook stock, which is also of dubious value.

But even given this highly distorted perspective, it's still hard to figure out why Facebook would pay the highest price ever paid for a company per employee - $345 million (more than four  times the old record of $77 million per employee, set last year when Facebook bought Instagram). The popular talking point is that the WhatsApp has gained users (450 million) faster than any other social media site in history, faster even than Facebook itself. Based on its rate of growth, the $42 per user acquisition cost does not seem so outrageous. But WhatsApp gained its users by giving away a service (text messaging) for which cellular carriers charge up to $10 or $20 per monthIt's very easy to get customers when you don't charge them, it's much harder to keep them when you do.

Boosters of the deal expect that WhatsApp will be able to charge customers after the initial 12-month free trial period ends (it now charges 99 cents per year after the first year). Based on this model, the firm had revenues of $20 million last year. But what happens if another provider comes in and offers it for free? After all, the technology does not seem to be that hard to replicate. Google has developed a similar application. More importantly, no one seems to be projecting what the cellular carriers may do to protect their texting cash cows.

WhatsApp gives away what AT&T and Verizon offer as an a la carte texting service. As these carriers continue to lose this business we can expect they will simply no longer offer texting as an a la carteoption. Instead it will likely be bundled with voice and data at a price that recoups their lost profits. If texting comes free with cell service, a company giving it away will no longer have value. People will still need cellular service to send mobile texts, so unless Facebook acquires its own telecom provider, it can easily be sidelined from any revenue the service may generate.

Some say that texting revenue is unimportant, and that the real value comes from the new user base.  But how many of the 450 million users it just acquired don't already have Facebook accounts? And besides, Facebook itself hasn't really figured out how to fully monetize the users it already has. In other words, it is very difficult to see how this mammoth investment will be profitable.

From my perspective, the transaction reflects the inflated nature of our financial bubble. The Fed has been pumping money into the financial sector through its continuous QE programs. The money has pushed up the value of speculative stocks, even while the real economy has stagnated. With few real investments to fund, the money is plowed right back into the speculative mill. We are simply witnessing a replay of the dot com bubble of the late 1990's. But this time it isn't different.

In another replay of that spectacular crash fourteen years ago, the appliance and furniture retailer Conn's has just showed the limits of a business built on vendor financing. In the late 1990's telecom equipment companies almost went bankrupt after selling gear to dot com start-ups on credit. For a while, these "sales" made growth and profits look great, but when the dot coms went bust, the equipment makers bled. Conn's makes its money by selling TVs and couches on credit to Americans who have difficulty scraping up funds for cash purchases. For a while, this approach can juice sales. Not surprisingly, Conn's stock soared more than 1500% between the beginning of 2011 and the end of 2013. These financing options are part of the reason why Conn's was able to keep up the appearance of health even while rivals like Best Buy faltered in 2013.

But if people stop paying, the losses mount. This is what is happening to Conn's. The low and middle-income American consumers that form the company's customer base just don't have the ability to pay off their debt. The disappointing repayment data in the earnings report sent the stock down 43% in one day.

In essence, Conn's customers are just stand-ins for the country at large. In just about every way imaginable, America has borrowed beyond its ability to repay. Meanwhile our foreign creditors continue to provide vendor financing so that we can buy what we can't really afford.

So thanks for the metaphors Wall Street. Too bad most economists can't read the tea-leaves.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Catch Peter's latest thoughts on the U.S. and International markets in the Euro Pacific CapitalWinter 2014 Global Investor Newsletter!


Tags:  economy
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The GDP Distractor
Posted by Peter Schiff on 08/20/2013 at 10:06 AM
Albert Einstein, a man who knew a thing or two about celestial mechanics, supposedly once called compound interest "the most powerful force in the universe." While the remark was likely meant to be funny (astrophysicists can be hilarious), it sheds light on the often overlooked fact that small changes, over time, can yield enormous results. Over eons, small creeks can carve large canyons through solid rock. The same phenomenon may be at work in our economy. A minor, but persistent under bias in the inflation gauge used in the Gross Domestic Product (GDP) may have created a wildly distorted picture of our economic health.

It would be impossible to measure the economy without "backing out," inflation. That is why economists are very careful to separate GDP reports into two categories: "nominal" (which are not adjusted for inflation), and real (which are). Only the real reports matter. The big question then becomes, how do we measure inflation? Just as I reported last week with respect to the biases baked into the government's GDP revisions, the devil is in the details. 

As it turns out there are a number of official inflation gauges that vie for supremacy. Most people tend to follow the Consumer Price Index (CPI) which is compiled by Bureau of Labor Statistics, a division of the Department of Labor. The CPI is regarded as the broadest measurement tool, but it has been changed many times over the years. Most famously, its formulas were loosened in the late 1990's as a result of the "Boskin Commission" which said that the CPI overstated inflation by failing to account for changes in consumer behavior. I believe those changes seriously undermined the reliability of the index. But the CPI itself has to contend for relevance with its stripped down rival, the "Core CPI," which factors out food and energy, which many believe are too volatile to be accurately counted. The core CPI is almost always lower than the "headline" number.

Another set of inflation data, the "GDP Deflator" is compiled by the Bureau of Economic Analysis (part of the Commerce Department), and is used by them to calculate GDP. The deflator differs from the CPI in that it has much more flexibility in weighting and swapping out items that are in its sample basket of goods and services. While the CPI attracts the lion's share of the media and political attention, it is the deflator that is relevant when looking at economic growth.

On a quarterly basis the two numbers are usually close enough to escape scrutiny. (However, the most recent 2nd quarter GDP estimates relied on annualized inflation of a ridiculously low .7%!). But if you look at a broader time horizon a very clear pattern emerges that makes a great difference in how we perceive the economic landscape.  

Available data sets for both the CPI and the GDP deflator go back to 1947. That 66 year period falls neatly into two phases. From 1947 to 1977 both yardsticks moved together almost identically, both rising 173% over that time. But in the ensuing 36 years (until 2013), the CPI is up almost three fold (292%) while the deflator is only up about two fold (209%). The CPI rising 40% more than the GDP deflator is an extremely significant factor. How did that happen? As it turns out, quarterly inflation assumptions have been, on average, .17% lower for the deflator than for the CPI since 1977. That is a small number. But as with compound interest small numbers add up to big numbers over time.

If you replace the GDP quarterly growth rates using the higher CPI rather the deflator, our current economy would be closer to $13 trillion than 16.6 trillion, about 28% smaller. Even if you were to split the difference between the CPI and the deflator you would still get an economy that is significantly smaller than it appears.

The $64,000 question ($188,000 adjusted by CPI inflation since 1977) is what happened in 1977 to make the CPI and the deflator diverge? Sadly, the details aren't really made public. What we do know is that the BEA took over the task in 1972, and that the separation occurred a few years later when inflation really started to run out of control. We also know that the deflator is more flexible than the CPI and that the interests of the government are better served by reporting low inflation and higher growth. So in other words, the deflator is likely lower for the same reasons that dogs lick themselves in intimate places: because they want to and they can.

If we had been growing as quickly as the official GDP indicates, why would our labor force have contracted so significantly? Why are we continuously replacing middle class jobs with lower paying ones? Why would we be using 3 percent less energy nationally than we did 10 years ago despite an 8.8% growth in population? Why would Americans be spending a higher percentage of their disposable incomes on basic necessities than they were 10 years ago? These trends don't conform to healthy GDP growth. So maybe the growth is largely an illusion?

When you take into consideration the likelihood that even the CPI drastically understates inflation, you get a much clearer picture of the true state of the U.S. economy. If you ever wondered how we went from being the world's largest creditor to its biggest debtor despite all this economic growth, now you know. As the growth was merely a statistical illusion, we have been forced to borrow money to maintain a life style our economy can no longer support.

So the next time you see a GDP report remind yourself that the "deflator" should really be called the "distractor." It's there to distract you from the truth.  

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

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Tags:  CPIeconomyGDPinflation
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