Earlier this year, Peter Schiff published his book “The Real Crash”, which explains how an economy grows and how it crashes, in simple language. Yesterday’s Black Friday appeared to be an ideal event to explain again the basic principles he presents in his book. The author commented on the picture of Black Friday that the media has created: people stepping out of warehouses with their shopping carts full of goods. He points to the key problem that the all those goods are produced in other countries (in this case, seen from the perspective of the US).

Peter Schiff explained in his book and he repeats again that “it’s not the buying” but “it’s the making” that is growing the economy. Buying goods is the result of production, but you cannot consume what you haven’t produced. A strong economy is one that produces a lot. The author repeats over and over again that what we really need is more production and less consumption. If we wouldn’t have had all these bailouts of several financial institutions, the system would have been able to restore on itself.

Gold has been much stronger than the stock market recently, especially with the down day of the Dow Jones on Friday and the intraday rally of gold (with the Dow Jones to Gold Price ratio reaching almost a decade low). The dollar index was also down. Peter Schiff believes that those market actions are related to the economic expectations and the fiscal cliff, as it becomes more obvious that the President and the Congress will work out a solution to avoid to go over the fiscal cliff. Now here it gets interesting. Peter thinks that going over the fiscal cliff will be the first step in reducing deficits, based on tax increases. He believes it would be much better to cut down government spending, as it would result in freeing up resources from the public to private sector where they can be used more efficiently and productively. That’s how Peter believes an economy grows, led by a decrease in debts.

Five key insights about the US federal budget and fiscal cliff (source: video from the Wall Street Journal): In 2011 – 63% of all spending was on autopilot to pay for promises made in the past. Those expenses included social security, Medicaid, medicare, subsidies and debt interests. It means that all debates and discussions in Congress affect only the remaining 37% of the expenses. One out of 4 dollars goes to healthcare. In 1960 it totaled less than 10% of spending, today it makes up for 25%. The next decade it is expected to rise to 33% unless a fundamental change takes place. The governments employs 4 mio people. Most of us think that it would be helpful to decrease that number, but the truth is different. Suppose all 4 mio people were fired, it would save 435 billion dollar, which is even not one third of all expenses. The defense expenses amounted 700 billion in 2011. The defense budget of the US alone is bigger than the next 17 countries combined (China, UK, Russia, France, Japan, Saudi Arabia, Germany, India, Italy, Australia, Turkey, UAE, Israel, Spain, Brazil, Australia, Canada). The share of income that families pay has been falling for more than 30 years. In 1981 a middle class paid 19.2% to federal and related taxes. In 2007 the amount has decreased to 14.3%. It means that the rich pay more and that the governments borrows much more (i.e. 36 cents per dollar for every dollar spent, coming mostly from abroad).

Back to Peter Schiff. He makes a very interesting point. The “Keynesian way of thinking” says that a decrease in government spending hurts the economy, so their attempt is to avoid spending cuts and opt for tax hikes. Peter argues that the key objective should be to avoid deficits, because that’s the real issue. If a choice need to be made between continuing deficits or taxes hikes, then higher tax hikes are the best solution. However Peter points out that Congress has a history of not using tax hikes to reduce deficits, they mostly spend the extra revenue as well, which is the worst of all options.

In closing, Peter believes that the markets are slowly but surely coming to the same insights. Going forward, his expectations are that first the currency will be impacted, followed by an appreciation of gold. Eventually the stock and bond markets will start suffering.