Murphy vs. Schiff

Back in September 2007 Robert Murphy posted an article concerning one of the analogies that Peter Schiff makes in his book Crash Proof. Schiff’s argument is essentially that persistent trade deficits are unsustainable and Murphy’s article attempts to refute this.

Since I appear to have fallen into the same trap as Schiff in one of my recent posts, Murphy’s article got me thinking and the following is an attempt to clarify the objections to Schiff’s argument and my previous post, both for myself and the reader. With a bit of luck I can also add a bit to the discussion that was not covered in either Schiff’s book or Murphy’s post.

I’m going to do this by telling a story similar to the one in my somewhat naive Feasts to cure famine post, but where the previous story described farmers who both raised sheep and grew tomatoes, in this story I’m going to dispense with the tomatoes.

American Farm Inc.

Initially our farmers start out with enough sheep to eat a couple of lamb chops a day, as well as keep aside enough breeding sheep to maintain the same level of consumption year after year. In the second year of production the farmers decide to go it rough for a bit and save. Instead of eating two lamb chops per day they only eat one. Their savings (and their short term hardship) mean that at the end of the year they then have enough sheep left for breading that in the following year they have way more lambs and can now eat 3 lamb chops per day (and have enough sheep left over to maintain the same population of sheep the next year).

Basically the point here is to illustrate that savings (and thus delaying immediate consumption) are required in order to provide the capital to invest in improved productive output and thus provide long term gains. Essentially the same process happens in the real economy when savings are invested in factories and other round about production methods but it’s much easier to see in the case of lambs and sheep. In either case, the investment of capital and the decision to delay immediate consumption is made for what is hoped to be even greater profits (and eventual consumption) at some stage in the future.

Now in the fourth year, rather than keeping enough spring lambs and tomatoes aside to sustain their current consumption (long term) they do the opposite of what they did in year two and they consume 4 lamb chops per day. However in order to do this they had to eat into their capital reserves (lambs that were to become breeding sheep for the following year). As such in year 5 they only have enough lambs to provide a dismal 2 lamb chops per day. The farmers thus find themselves in the same situation in which they started. This point is just as important as the point in the previous paragraph. For if delayed consumption and positive savings can provide the necessary capital to increase the productive output of an economy then it is also true that negative savings can have the opposite effect.

Now let’s imagine that in year 6 the farmers decide that they’d like to be back where they were before (eating 3 or even 4 lamb chops per day). However they don’t really feel like saving and going through the whole 1 lamb chop a day thing for another year in order to be able to save the capital required to get their production back up to previous levels. So this time round they decide to borrow some sheep from the Chinese down the road.

The story can now go one of two different directions. If Peter Schiff were telling it then the farmers would, in year 6, eat ALL the sheep that they borrow from the Chinese. If Murphy was telling it then they would invest at least some of the sheep that they borrow in future production (i.e. keep them aside for breeding)… and this is where the analysis of Murphy differs from Schiff [1]. For Schiff assumes that the US trade deficit is currently used entirely to sustain over consumption.

So let’s run with a Bob Murphy version of the tale. Let’s imagine the farmers do not consume all the goods that they import but instead choose to invest a certain portion of them with a mind to boost their future production. What are our possible outcomes? Effectively the farmers are borrowing savings and can choose what portion of those savings they want to use for immediate consumption and what portion they want to invest in future production.

  1. If too much is invested in short term consumption then they will not be able to improve their productive output enough to pay back even all the interest on the loan (much less the principal). In this case the farmers are in a worse position than they were before having taken the loan out… this kind of borrowing is clearly unsustainable and consumption must be curbed in order to bring the economy back within sustainable limits (if this is still possible).
  2. If just enough is invested, their productive output will be increased enough that they can continue to pay the interest on their loan (and thus they don’t go any further into debt). There is no real point in this outcome from the farmers’ point of view although it works out OK for the Chinese lenders.
  3. If they get it right then they can improve their productive output enough to both pay back the interest and have some left over (which could be used either to enjoy higher levels of consumption or to pay down the principle on their loan).
  4. If they invest too much in long term production then they might even run into shortages and insufficient lamb chops to sustain immediate consumption. In the case of our lambs and sheep this isn’t such a problem, since you can go out and cannibalise your capital (i.e. your breeding sheep) and turn them into consumer goods (mutton, if not lamb chops) reasonably easy. In the real world economy it isn’t always so easy to convert factories into cherry pies though and so this is a very real possibility.

Let’s imagine that what played out was scenario number 3. This turned out to be profitable for both the Chinese and the US farmers. Now if borrowing from the Chinese in scenario number 3 turned out to be so profitable in year 6, why wouldn’t the farmers do it again in year 7 for an even larger quantity of sheep? Suppose this is what occurs and suppose the Chinese economy is also growing. In year 6 the famers borrow 10,000 spring lambs and in year 7 they pay back 6,000 of these (so they still have 4,000 outstanding) but they strike a new deal with the Chinese for a further loan of 20,000 lambs. Essentially they now have a net import of 14,000 lambs where in the previous year they had imported only 10,000. Clearly their trade deficit has increased, but so have the revenues that the Chinese are earning from their loans to the US farmers and (the important bit) the productivity of the US farmers has increased by enough to pay for all of this.

What is important then is not the trade deficit, but that the economy which is borrowing is able to improve its productive output, as a result of the loans, by enough to both pay back the interest and to reap some gains (which could be used either for consumption or to pay back the principal). If this is not the case then the lending does not make sense and will only detract from the profitability of the economy doing the borrowing… eventually perhaps to the point where they start to make a loss.

If the productive output of the US farmers were to shrink for any significant amount of time then no doubt both lender and borrower would do well to re-evaluate the wisdom of further borrowing. For the purpose of borrowing should not be to sustain unprofitable economic activity but to enable profitable activity. Just as companies that consistently make losses eventually find it difficult to obtain loans, so too do countries.

Therefore as long as the US (real world US) is able to continue to pay sufficient yeild on their bonds to entice people to buy them and as long as the US economy continues to grow, a persistent trade deficit in and of itself is not necessarily cause for concern.

There is one further complication in the real world, which is not reflected in the simple story above, which is that in the real world international investors in US Inc. are implicitly making a currency play. Anyone purchasing US denominated assets and investing in the United States is taking a risk on the exchange rate. If I live in Japan and buy US bonds that pay a yeild of 2% over 12 months but the USD drops against the Yen over the same period by 10% then it’s clear that I’ve made a real loss, in terms of my buying power. Similarly the USD could shift in the opposite direction and increase my profits. As such, the spectre of inflation is ever looming over the Federal Reserve that runs the printing press over at US Inc. For if they should ever let this cat out of the bag then they will have to pay a hefty yield on their bonds in order to entice ever more wary investors to buy their bonds… and an increased yeild on bonds would perhaps turn an otherwise profitable economy into one that was instead making a loss. On this, at least it seems that both Murphy and Schiff agree that the early signs aren’t good.

[1] Note that Murphy also discusses, at some length, the distinction between service and manufacturing but I figured this was probably because Schiff placed so much emphasis on the recent trend towards service industries in the US. To my mind this wasn’t really relevant. There is no difference between the profits that banks make and the profits that manufacturers make. In both cases what goes into the entity is a set of goods/capital that is considered (by the markets) to be inferior in value to what comes out of them. So a profitable company is a profitable company, regardless of the origin of its profits (service or manufacturing)… similarly a country can export services or manufacturing goods to the world. What is important is not the nature of the goods but their relative values in the free market.

It may be that the conventional statistics measuring imports/exports fail to take account of certain profits but that wasn’t really what interested me. I was interested in discovering, assuming that perfect statistics could be maintained, whether a consistent trade deficit was sustainable and whether continued investment by outside parties count be considered reasonable. I think the analogy we’re using above takes care of this since the only good involved is sheep – thus all profits are measurable and nothing can slip through the cracks.

8 thoughts on “Murphy vs. Schiff

  1. Well I’m sure one of the main reasons Schiff complains about more service sector jobs isn’t because he believes the service sector is inferior. Its just his objection to the illusion of economic growth and job creation during the “boom”.

    I think one of the examples he gave was to imagine a circus came into town- so now a local restaurant owner is getting more customers and decides to start hiring more workers. This was the boom. But a week later the circus leaves town- and now the restaurant owner has to go through a “recession” and let go of some of his workers. Those service sector jobs of new workers for the restaurant was the illusion of economic growth and what Peter objects to when people point out new jobs.

    Another example would be if an entire town got credit cards(but they had no savings), and their local retail clothing spot had a spike in sales and so needed to hire more workers to service all these customers. But when the town defaults and are unable to pay any of the money they borrowed back- the “phony” service jobs all go under.

  2. Perhaps I’ve been misunderstood here – Schiff’s book is a good read and contains a lot of insightful stuff. My interest was in whether a persistent trade deficit was theoretically possible and, in that regard, I think the answer is yes – providing it is used to increase the productive output of the economy.

    Whether the trade deficit of the United States has been used to increase productivity or not is a more difficult question (it may be that the ostensible statistical growth of the US since 2001 has happend in spite of the trade deficit, rather than because of it). My suspicion is that since 2001 a great deal of the US trade deficit has merely served to fund overconsumption. Evidence such as the sheer size of Mortgage Equity Withdrawls tends to point in this direction… but it’s very difficult to say this with any certainty and my point was merely that a persistent trade deficit in and of itself was insufficient evidence.

  3. I’m still a little shaky here with your analysis. I may be simply misunderstanding it.
    Where am I going wrong?

    There exists a trade deficit between the US and China, i.e, we import from China more the US exports to China. China get a whole lot of green paper, US dollars, from us for their exports to the US. Instead of spending those US dollars back in our economy, which would increase our exports and eventually balance the trade, they decide to buy US Government securities. I assume those are the loans we are talking about. Now here is what I don’t understand:

    1. Even if we are making our payments on the interest, and instead of paying back the principle, we just keep borrowing every year, I don’t see how the chinese can ever benefit from this. At the end of the day, if they don’t eventually spend those US dollars they accumulate, then they are exporting for free. Since they are forced to spend those worthless dollars in China in the US economy, and since they obviously don’t, then they are getting worthless paper for real goods that we consume. Even if we do use those loans for growth and not just consumption, how is China ever getting anything in return? All they get is more paper. So I am a little not sure I understand you or whether your analysis fits the real situation of the trade deficit with china.
    2. I have always been confused with Schiff’s analysis about the trade deficit and the “phony” economy that he describes. I see the deficit aa a serious issue now that we have had this recent bubble burst. But is the bubble a result of the trade deficit? I would think that if there is a relationship between the two, then it is the bubble, which is a result of monetary policy, that enables the sustainment of the trade defict. Of course you mentioned in your previous post the Chinese pegging their currency, which is of course another issue.
    3. Also shciff seems to imply that inflation is coming because of deficit spending. But he seems to not discriminate between loans from the public or foreighners, and debt that is monetized by the FED. Isn’t it true that inflation can only occur as a result of the FED monetizing debt, and not as a result of just any kind of deficit spending? perhaps I am misunderstanding Shiff, or that he just doesn’t bother to be specific because he knows that hardly anyone understands what he is sayin anyway.

    What do you think?

  4. Answer to DD:

    1. The Chines received induxtrial production plants, know-how and our trade secrets. On this basis they could build up their industrial capacity quantitatively and qualitatively. A Marxist propertyless society could never have achieved this. It doesn’t matter to them that the surplus dollars needed to be invested in T-bills in order peg the yuan to the dollar so they could export consumer products cheaply to the US. All which matters is that China can build up its industirla prowess and political might. The productive capacity we lost, they won. We will meet their flotillas on the high seas in the coming resource wars.
    2. The steady expansion of credit in the US caused all the bubbles in recent history. This expansion is also the cause for the trade deficit. In a closed economy the prices would rise, in an open borders economy the additional money not covered by domestic production floods into cheap foreign products.
    3. Indeed, price inflation can only be created by money and credit inflation. But price inflation can be muted if the phantasy money flows first to China and buys cheap products there. It works for a while until the capacity limits of China and the mining companies of the world are reached. The end of the story of fiat money creation we see now. It’s destructive and we have to stop the crime.

  5. DD:

    I think you ignored the 6000 payment that was made in year 7 back to the Chinese. What the Chinese do with that profit is another matter. Perhaps they choose to reinvest it (by loaning it back to the US farmers) in which case they further delay consumption of their profits… but they could just as easliy consume these profits entirely AND still maintain a trade surplus with the US farmers, providing their economy had enough surplus to do this at the same time as lending the US farmers ever larger and larger amounts year after year.

    And, of course, they could mix and match the above options – consuming and investing domestically and perhaps loaning a bit back to the US farmers. If they have sufficient surplus output then all three of these things would be possible.

    So the system can be sustainable, but only if BOTH economies are growing. Whether this is what is playing out in the real world or not is another question, which I haven’t attempted to answer.

  6. I think you did a really good job with the story; it was a joy to read.

    One thing that I think could make it really good though. You say that the US farmers could use the borrowed sheep for over-consumption which would in time result in the Chinese no longer lending to the US since they wouldn’t get a return. This is Schiff’s point. I think that Murphy agrees with this hypothesis but he understands more clearly why there is overconsumption–which I think is the crucial point.

    In the current situation it’s not that the US borrowed and knowlingly consumed their capital. They actually believed that they were making gains in output. This belief came as a result of perpetually rising real estate values which in turn were a result of monetary inflation by the federal reserve. We actually thought that we were producing enough so that we could consume that much more and still pay the Chinese. Of course, this was an illusion.

    If you could incorporate this into your example I think it would be fantastic. One way that you could do this, for example, would be for you to introduce a farm hand who reports to the head farmer how many sheep he has produced. You would then suppose that the farm hand over-reported how many sheep had been produced. This would induce the farmer to consume a part of his capital and in time he would discover that he had not really produced enough to both pay the Chinese and consume at higher levels. He would thus be either foreced to default on his loan or dramatically reduce his consumption levels.

    The farm hand is analagous to the Fed pumping money, etc.

  7. I feel like Murphey’s article isn’t comparing his apples to Schiff’s apples. When Schiff talks about a “phony service sector economy” he’s talking about it in the domestic sense. Obviously if we import iPod and laptop computers built in China (which they then also consume themselves) and then WE provide their tech support, we’d have aa sustainable service-for-product trade happening…but that’s not the case. The Asian countries send us goods and then we give them nothing back. In my example you might note that the Indian countries actually supply our tech support, but that’s another rant altogether.

    Hazlett said it in Economics in one lesson, you import in order to export and vice versa. In Murphey’s “rotherbard isle” scenario he’s talking about a German investment in a consulting firm. It’s an investment and the investor providing the investment expects returns on his money. When we buy a sweater made in Thailand, the textile company isn’t expecting a return on their sweater…they expect us to pay for it and be done with it.

    So in Schiff’s example some at the Gap will then sell that sweater, the sales clerk (with their wages) can then go see a movie, the concession stand employee can then go get guitar lessons…at what point does any of this bring our trade back in line with Thailand? We would have to provide something they are interested in purchasing and we don’t. In fact through our inflation monetary policy we won’t. Because US wages are so high, no business owner in their right mind will employ a US worker for $10 an hour to make sweaters when they can just import the sweater for 20 cents.

    Now, on a gold standard this will eventually have to come to an end. Our country would be paying out lots of gold to Thailand. They would accumulate wealth and prices will rise until eventually it would no longer make sense to buy sweaters from them anymore. But we’re not on a gold standard, we can just print money and send it over to them.

Leave a Reply

Your email address will not be published. Required fields are marked *