IMPORTANT FINAL THOUGHTS BEFORE GOING TO PRESS

During the late spring of 2009, as I was completing the revisions you are about to read, well-established primary bear market trends in the U.S. dollar and bull market trends in foreign stocks, gold, and other commodities were still in a temporary reversal phase. In mid-2008, investors around the world had reacted to a collapsing American financial system by doing an about-face. Like horses running back into a burning barn, they dumped commodities and foreign stocks and poured funds into U.S. dollars and U.S. Treasury securities. Now, just as suddenly, there is a mad scramble to reverse those trades, and the primary trends have resumed.

What happened in 2008 was the result of several factors: A credit crunch that amounted to a global margin call caused forced, massive selling of gold and other viable assets that had high liquidity; our trading partners were instinctively inclined to prop up their best customer and continued buying American debt, regardless of its diminishing creditworthiness; and the dollar was falsely perceived as a “safe haven” by short-term investors waiting for the storm to blow over so they could resume investing in more viable economies.

The temporary effect of these technical moves—and the operative word here was always temporary—was a strong rally in the U.S. dollar and a severe pullback in foreign stock and commodity investments. Writing in March 2009 as these events still were happening, I advised readers to seize the opportunity to buy foreign stocks, gold, and other commodities at fire-sale prices and prepare to celebrate when primary trends resumed, as they inevitably would, and currency gains could be combined with capital gains and rising dividends again as the dollar weakened and basically sound foreign economies revived.

It is now summer and Crash Proof 2.0 is on its way to the printer. Though the opportunity to buy at fire-sale prices has passed, my arguments for getting out of the U.S. dollar and into foreign stocks and commodities are stronger than ever. The good news is that most foreign stocks still are trading at bargain, if not fire-sale, levels. The bad news is that the price-to-value gap is closing quickly; thus, it is urgent to act quickly in putting your plan into action.

In recent testimony before Congress, Federal Reserve (Fed) chairman Ben Bernanke claimed that aggressive Fed action and government intervention averted economic catastrophe. Not only is such a comment the equivalent of an arsonist taking credit for putting out a fire he started, but it is completely false. Recent market action proves that rather than being averted, the catastrophe I forecasted and that Bernanke denied was even possible merely has been postponed, and its severity has been worsened by the very policies Bernanke now extols. In fact, back in July 2005, as I began writing the first draft of Crash Proof, which included an entire chapter on the coming real estate debacle, Ben Bernanke was appearing on CNBC dismissing concerns over the housing bubble; he actually denied existed. He told Maria Bartiromo that a national house price decline was highly unlikely and that any future real estate-related slowdown would not cause the economy to veer from its full-employment path.

Like a compass pointing south, the Fed chairman’s prognostications of economic trends consistently have been dead wrong. Incredibly, however, for the critical role of systemic risk regulator (SSR) in the upcoming reform of the financial regulatory system, the Obama team is reportedly favoring, you guessed it, the Federal Reserve, the very group that failed to recognize and rein in the systematic risk that led to the current crisis. It is like making the Rolling Stones’ notoriously intemperate Keith Richards head of the Drug Enforcement Administration.

Whether Bernanke gets the SSR nod or not, familiar Pollyannaish reassurances continue. With all the talk of economic “green shoots,” one might confuse CNBC with the Garden Channel. Despite the optimism, the only light at the end of this tunnel is attached to an oncoming train.

To attempt to end the madness and take back our country, I am running for United States Senator in my home state of Connecticut. (See SchiffForSenate.com for details.) My goal is to put myself in a position to play a key role in the general election of 2012 and perhaps help prevent from coming true the worst-case scenario described in this book.

Preface

When I began this book early in 2006, I didn’t plan to have a Preface. My goal was to explain in a readably informal, easy-to-understand way why America’s persistent and growing imbalance of imports over exports—its trade deficit—would cause the dollar to collapse, forcing the American public to accept a drastically lower standard of living and years of painful sacrifice and reconstruction. Seven chapters would show the various ways the world’s greatest creditor nation had become, in the incredibly short space of some 20 years, the world’s largest debtor nation while the public’s attention was focused on other things. My challenge, as I saw it, was to create public awareness, where it didn’t exist, of an impending economic crisis for which I have been helping my clients prepare for years. My final three chapters would share investment strategies already being used successfully by my several thousand brokerage clients, so that readers could avoid the dollar debacle and position themselves to profit during the rebuilding.

That’s the book you are about to read. Why this Preface? Because as I write this in the final days of 2006, with the book scheduled for publication a month or so from now, everybody has started talking about the trade deficit. Virtually ignored for years, it has suddenly become a subject of public debate. And while there is a growing consensus that the problem is deadly serious, there’s a concurrently emerging consensus, mainly representing Wall Street with its vested interest in the status quo, making the opposite argument that trade deficits are a sign of economic health—that American consumption is the engine of economic growth. It’s this group that I want to take on at the very outset. Their arguments are self-serving nonsense. If I can convince you of that here and now, you can get the full benefit of the wisdom and guidance I humbly set forth in the coming pages.

I’ll get to some more comprehensive examples in a minute, but for sheer pithiness it would be hard to improve on a pronouncement made last week by Lawrence Kudlow, the genial host of CNBC’s daily program Kudlow and Company. Opening the program, Kudlow welcomed his viewers, and then brazenly intoned: “I love trade deficits. Why? Because they create capital account surpluses.”

In the way of background, the balance of payments, the bookkeeping system for recording transactions between countries, is made up, among other items, of a trade account, which is the part of the current account that nets out imports and exports, and a capital account, which nets investment flows between countries. Because dollars we send abroad in payment for goods and services are returned as investments in U.S. government securities and other assets, one account can be viewed as the flip side of the other. A country, like the United States, that is a net importer will therefore typically have an offsetting capital balance, the trade account being a deficit and the capital account a surplus.

But “surplus” as it is used here is a bookkeeping term meaning simply that more cash flowed in than flowed out. The reason cash flowed in is that an asset, say a Treasury bond, was purchased by a foreign central banker. But selling a bond doesn’t make us richer; it creates a liability. Sure, we initially have cash in hand as a result of the sale, but it’s money we are obligated to pay back with interest.

So the word “surplus” has a positive ring to it, but a capital surplus has the opposite meaning of, say, a budget surplus. Surpluses can be bad or good. A surplus of water in a reservoir during a drought is good, but when it’s in your basement during a rainstorm, it’s bad.

Now Larry Kudlow is a smart guy, and I’m not suggesting he doesn’t know what the word means. But in his opinion, a capital surplus is evidence of our country’s creditworthiness. The implication is that we can depend on that to keep the music playing. That’s where I think he’s wrong. Our trading partners are quite free to invest elsewhere, and that’s just what they’ll do when they realize the United States, with $8.5 trillion in funded debt ($50 trillion including unfunded obligations) and persistent budget deficits that add to that figure annually, is no longer creditworthy. It’s not as though they are getting higher yields by investing here; our markets are underperforming all the other major markets in the world, and that’s been true for six or seven years now.

The continued demand for U.S. government investments among central bankers has its explanation, I think, in robotic bureaucratic momentum. Private foreign investors steer clear. But for Wall Street and its media cheerleaders, who would get killed if trade deficits translated into market pessimism, “capital surplus” is a term coined in heaven.

Another, more comprehensive, argument that trade deficits are desirable was made in a December 21, 2006, Wall Street Journal op-ed piece titled “Embrace the Deficit” by Bear Stearns’s chief economist, David Malpass.

Mr. Malpass writes at some length, but his argument is pretty well summarized in his opening paragraph: “For decades, the trade deficit has been a political and journalistic lightning rod, inspiring countless predictions of America’s imminent economic collapse. The reality is different. Our imports grow with our economy and population while our exports grow with foreign economies, especially those of industrial countries. Though widely criticized as an imbalance, the trade deficit and related capital inflow reflect U.S. growth, not weakness—they link the younger, faster-growing U.S. with aging, slower growth economies abroad.”

With due respect to Mr. Malpass, I couldn’t disagree with him more. Although his point about demographics may have some limited validity, he ignores the fact that underlying the trade deficit is a shrinking manufacturing base, and relies heavily on the familiar but erroneous argument that declining savings rates are belied by high household net worth figures, which we know reflect inflated housing and paper asset values. He confuses consumption with growth and credits high competitive yields with attracting foreign investment, when we know major foreign markets outperform ours substantially when exchange rates are factored in. His view of inflation ignores past monetary policy. I could go on, but rather suggest that my entire book is a refutation of his point of view. His article is an exquisite example of Wall Street’s self-serving effort to gild the economic lily.

In general, the ridiculous notion that American consumption is driving the global economy is regularly reinforced by the mass media. On a recent airing of the Fox News business program Bulls and Bears the panelists were asked to nominate a “person of the year.” The unanimous choice: the American shopper.

In the same vein, I am always struck by how the televised media characterize the American economy by showing images of sales clerks frantically stocking shelves and shoppers swiping their credit cards. In contrast, the economies of Japan or China are portrayed with images of billowing smokestacks, busy production lines, robots assembling, and people actually making things. The most amazing part of the farce is that no one even recognizes just how ridiculous these segments are. If Longfellow was right that “whom the gods destroy they first make mad,” we must surely be on the eve of our economic destruction, as we are clearly a nation gone completely insane.

Fortunately, there are a few among us who still have their wits about them. Recently there has been increasing recognition from qualified and impartial opinion leaders that trade imbalances are in fact detrimental and that the resulting dollar decline could have serious consequences. Unfortunately, their cries fall on deaf ears and their warnings go unheeded.

In a December 11, 2006, Bloomberg article, former Fed Chairman Alan Greenspan, speaking now as a private citizen, was quoted as telling a business conference in Tel Aviv by satellite that the U.S. dollar will probably keep dropping until the nation’s current-account deficit shrinks. “It is imprudent to hold everything in one currency,” he was reported as saying. A Reuters report on the same conference quoted Greenspan as saying, “There has been some evidence that OPEC nations are beginning to switch their reserves out of dollars and into euro and yen [so a dollar moving lower] will be the experience of the next few years.”

Former Treasury Secretary Robert E. Rubin and former Federal Reserve Chairman Paul Volcker have reportedly expressed similar concerns about the dollar. Volcker was quoted in a November 1, 2006, New York Times article, “Gambling Against the Dollar,” as saying circumstances were as “dangerous and intractable” as any he can remember.

Warren Buffett had weighed in back on January 20, 2006, saying, according to an Associated Press report, “The U.S. trade deficit is a bigger threat to the domestic economy than either the federal budget deficit or consumer debt and could lead to political turmoil. . . . Right now, the rest of the world owns $3 trillion more of us than we own of them.”

To my knowledge, nobody has ever asked Warren Buffett, “If you’re so smart, why ain’t you rich?” If he and the aforementioned think there’s a problem, it’s pretty good confirmation that there is one. In the following pages, you’ll learn why the U.S. economy is in real trouble and how you can avoid loss and enjoy continued prosperity.

INTRODUCTION

America.com: The Delusion of Real Wealth

When business in the United States underwent a mild contraction . . . the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. The “Fed” succeeded; . . . but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market—triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in breaking the boom. But it was too late: . . . the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed.

The above quotation is not a forecast of what might happen, but a summary of something that actually did happen. It was written more than 40 years ago in reference to 1920s America. The writer was a young economist by the name of Alan Greenspan. (The article was “Gold and Economic Freedom,” The Objectivist, 1966, reprinted in Ayn Rand’s Capitalism: The Unknown Ideal, New York: Penguin, 1987.)

The former Fed chairman’s words apply to current conditions as aptly as they did to the Roaring Twenties, but with a major difference. The difference is that as Fed chairman between 1987 and 2006, Greenspan acted even more irresponsibly than the officials he was criticizing. Rather than “sopping up the excess reserves,” Greenspan added even more, morphing a stock market bubble into a housing and consumer spending bubble of unprecedented proportions.

According to Greenspan, the Great Depression of the 1930s resulted from the unwinding of the speculative imbalances caused by the excess liquidity created by the Fed during the 1920s. Given that Greenspan created even more excess liquidity during his tenure and that the speculative imbalances that resulted were that much greater, what dire economic consequences might the Maestro, as journalist Bob Woodward dubbed the one-time professional saxophone player, believe await the United States today?

From Greenspan’s perspective, that question will likely remain rhetorical, as his monetary high-wire act continues under his successor, Chairman Ben Bernanke, with the same apparent confidence that it can go on indefinitely.

But I see things differently. In the following chapters I will not only answer the question myself, but I will provide the reader with a comprehensive financial plan to help weather the coming economic storm. Make no mistake; extremely difficult times lie ahead. Our nation’s character will be tested like never before. Whether it will rise to the occasion or be found wanting remains to be seen. While we can all hope for the best, the pragmatist in me suggests that we had better prepare for the worst.

For years I have been conducting workshops entitled “America’s Bubble Economy: Implications for Your Investments When It Finally Bursts,” helping thousands of my clients prudently invest their savings, while making sure they steer clear of Wall Street’s many investment land mines. I have never allowed popular delusion to cloud my judgment, nor fads to influence my recommendations.

During the 1990s, as most of my colleagues eagerly bought into the “new era” tech stock hype, I held steadfastly to sound investment principles, urging all who would listen to sell. The outlook for the U.S. economy today is strikingly similar to the outlook for Internet stocks in the 1990s.

Just as stock market analysts believed then that traditional measures of valuation such as earnings, cash flow, dividend yield, price to sales, price to book, internal rate of return, and return on equity no longer applied, economists today dismiss as passé the concerns we traditionalists have about such economic fundamentals as savings rates, manufacturing activity, federal deficits, unfunded liabilities, counterparty risks, consumer debt, and trade and current account deficits. To modern economists, we are now living in a new era where Americans can consume and borrow indefinitely while the rest of the world saves and produces in their stead.

This book aims to shatter that myth once and for all, and show that this so-called “new era,” like all those that preceded it, will fade as quickly as it appeared—that “America.com” is no more viable than any of the now-bankrupt dot-coms that once populated the investment landscape.

When reality finally sets in, those who have read this book and followed my advice will be well positioned to profit during the difficult times that lie ahead.

While most germane to investors, this book is also written for a broader audience. My goal here is not simply to provide an investment survival guide, but to expose and illuminate the grave economic weaknesses that make survival the issue. A proper understanding of the true state of the American economy is vital to investors and noninvestors alike.

For our nation to travel the road back to true prosperity, we must first rediscover the road and understand how we got so far off course in the first place.

Nations are not served by citizens who refuse to face the truth. Blind optimism, shrouded typically in patriotism, abounds and is going to lead us to disaster.

My warnings are based on realism, and the passion I bring to them is the greater because I love my country and have no higher goal than to see it thrive. But to be viable and to enjoy its traditional glory, it has to return to traditional values.

Arguments such as mine are sobering and not calculated to be popular. As such, they tend to fall on the deaf ears of a brain-washed public that understandably would prefer to feel good about itself.

Because my positions are so unconventional and therefore sensational, I am trotted out by the media with increasing frequency to balance prevailing opinion. CNBC has labeled me Dr. Doom and gives me the friendly needle for being a modern-day Chicken Little.

I take it all in fun, but recognize our economic realities are hardly a laughing matter. I strongly believe my arguments are demonstrably valid and will soon become the prevailing opinion. I only hope that by then it is not too late. Unfortunately, this may finally be a case where the little chicken has it right. The sky actually may be falling after all.

The Slippery Slope: Consumers, Not Producers

If the United States economy was a prizefighter and I was the referee, I would have mercifully stopped the carnage while the old pug still had his champion’s pride and all his marbles. But the mismatch has been allowed to continue, round after bloody round. Past glory can get in the way of accepting present realities.

The economy of the United States, long the world’s dominant creditor, now the world’s largest debtor, is fighting a losing battle against trade and financial imbalances that are growing daily and are caused by dislocations too fundamental to reverse.

I’m not talking abstract economics here. Unless you take measures to protect yourself—and this book will tell you what those measures are—your dollar-denominated assets are going to collapse in value and your standard of living will be painfully lowered. I can’t pinpoint the date this will happen—the government has been successful in hiding the problem and buying time—but there is going to be a day of reckoning and it’s already overdue.

In the short space of a couple of decades, and causing surprisingly little anxiety among economists, the nation has undergone a radical transformation in terms of its economic infrastructure and its economic behavior. A society that saved, produced, created wealth, and was a major exporter has become a society that stopped saving, shifted from manufacturing to nonexportable services, has run up record national and personal indebtedness, and uses borrowed money to finance excessive consumption of unproductive imported goods.

On a national level, our circumstances are similar to those of a philandering playboy who inherits a huge fortune and then proceeds to squander it. During the dissipation period, he lives the good life, and by all appearances he seems prosperous. But his prosperity is a function of the hard work of his ancestors rather than his own. Once the fortune is gone, so too will be the gracious lifestyle that it helped support. The problem is that most Americans, including most economists and investment advisers, have confused conspicuous consumption with legitimate wealth creation. Our impressive gross domestic product (GDP) growth, dominated as it is by consumption, is not a measure of how much wealth we have created but of how much we have destroyed (see Figure 1.1).

The result: a trade deficit of some $800 billion annually, a budget deficit running $300 billion to $400 billion, and a national debt of $8.5 trillion. (Of course, when unfunded liabilities, such as Social Security obligations, are included, the real national debt exceeds $50 trillion, or over six times the official estimates). Had the past two decades been characterized by genuine prosperity, we would have run trade surpluses and still be the world’s largest creditor, rather than its greatest debtor. I believe that we are fast approaching a perfect storm scenario, with a monetary collapse the most likely way it will play out.

FIGURE 1.1 U.S. current account balance, 1990-2005. The U.S. current account deficit has exploded in recent years, with annual red ink now flowing at a rate close to $1 trillion. Such an abysmal economic performance is a national disaster of unparalleled proportions.

Source: Reprinted by permission from David L. Tice and Associates (www.prudentbear.com).

It’s analogous, I think, to a family—let’s call them the Smiths—whose breadwinners have lost their jobs. To keep up appearances and maintain the same lifestyle, the family resorts to borrowing and goes deeper and deeper into debt. It is a situation that cannot go on indefinitely. Unless the breadwinners get jobs that enable them to repay their debt and legitimately finance their previous lifestyle, the family faces painful and humiliating adjustment.

Contrast this to a family—let’s call them the Chins—who sacrifice, underconsume, and live below their means in order to accumulate a significant financial nest egg. During the accumulation period, they appear far less prosperous than their spendthrift neighbors, the Smiths, who live high on the hog on credit card and mortgage debt. To the casual observer, judging only by the relative consumption patterns of both families, the Smiths appear to be the more prosperous family. However, beneath the surface, the Chins’ current sacrifice allows them to build a bright future, while the Smiths’ shortsighted profligacy comes at a great sacrifice to their future lifestyle.

To consume, you have to either be productive or borrow, and you can only borrow so much and for so long. So it is with nations. But while an individual breadwinner might get lucky by finding a well-paying job or winning the lottery, an entire nation cannot, since replenishing depleted savings and rebuilding a deteriorated manufacturing base will take time and require great sacrifice.

Because Americans are not saving and producing but are borrowing and consuming, we have become precariously dependent on foreign suppliers and lenders. As a result, we are facing an imminent monetary crisis that will dramatically lower the standard of living of Americans who fail to take action to protect themselves (see Figure 1.2).

WHY THE GLOOM? THE GOVERNMENT SAYS THE ECONOMY’S FINE

If you’re wondering why you keep reading and hearing that the economy is doing just fine, don’t think you’re hallucinating or that I am. Modern politics is premised on the high expectations of American consumers, and the government has mastered the art of making bad economic news look like good economic news, thereby keeping the public happy and the politicians in office. (The midterm elections of 2006 that changed the leadership of the House and Senate might indicate the public is waking up.) Government officials—aided by an accommodative Federal Reserve empowered to create credit—manipulate economic data routinely to simultaneously maintain the domestic consumer confidence and foreign lender confidence required to keep the party going. But with every bit of time they buy, the basic problems worsen.

FIGURE 1.2 Rest of the world holdings of U.S. financial assets, 1985-2006. America’s unprecedented consumption and borrowing binge has put record amounts of liabilities in foreign hands. If not repudiated, servicing this debt will suppress national income and domestic consumption for generations to come.

Source: Reprinted by permission from David L. Tice and Associates (www.prudentbear.com).

For their part, the foreign central banks continue to use accumulated dollars to buy our Treasury and mortgage-backed securities, helping finance our growing deficits and keeping our housing market propped up (see Figure 1.3). They get the same sunny economic news we do, and they also have the naive belief, although there are signs that this belief is beginning to waver, that the U.S. economy is too big to fail. If they woke up to what’s actually happening and stopped buying our Treasury securities, our choice would be to further tax an already overburdened citizenry or default like Russia did in the later 1990s. We are in a real mess.

FIGURE 1.3 Foreign holdings of U.S. Treasuries as percent of total, 1980- 2006. Due to insufficient domestic savings and profligate government spending, an increasing percentage of U.S. Treasury debt is now held abroad. We certainly do not “owe it to ourselves” anymore.

Source: Reprinted by permission from David L. Tice and Associates (www.prudentbear.com).

That brings me back to my prizefighter analogy. Remember when Iron Mike Tyson wore the heavyweight crown, was knocking out everybody in sight, and was so fearsome it seemed inconceivable he could lose? Well, as always happens eventually, he finally met his match. Buster Douglas beat him, and after that he just kept getting beaten. It was the same Mike Tyson, but Buster had broken a psychological barrier.

Any reality check that pierces the myth that the American economy is too big to fail could begin the process of unraveling.

Our days as the dominant economic power are numbered. The dollar is going to collapse, and Americans are going to experience stagflation on an unprecedented scale in the form of recession and hyperinflation. Those of you who act smartly and quickly by taking measures I outline later in this book not only will avoid loss of wealth but also will have positioned yourselves to prosper while your neighbors suffer a painful period of reconstruction and reform.

It is important to remember that in market economies living standards rise as a result of capital accumulation, which allows labor to be more productive, which in turn results in greater output per worker, allowing for increased consumption and leisure. However, capital investment can be increased only if adequate savings are available to finance it. Savings, of course, can come into existence only as a result of underconsumption and self-sacrifice (see Figure 1.4).

The fatal flaw in the modern economy is that any attempt to save and under consume, which would surely bring about a badly needed recession, is resisted by government policy, the sole purpose of which is to postpone the inevitable day of reckoning. In their selfish attempt to secure reelection, American politicians have persuaded their constituents that they should indulge their every whim and that self-sacrifice or underconsumption are somehow un-American, a character flaw uniquely Asian.

As a result, those same American politicians, with the help of the Federal Reserve, will succeed in doing what no foreign power ever could have: They will bring the U.S. economy to its knees, as sacrifice and underconsumption will ultimately define the U.S. economy for generations to come.

FIGURE 1.4 U.S. savings rate, 1970-2006. The collapse of personal savings has led to the unprecedented accumulation of external liabilities and the demise of the U.S. industrial base. Rebuilding national savings and the capital investment it finances will be a hallmark of the coming economic austerity.

Source: Reprinted by permission from David L. Tice and Associates (www.prudentbear.com).

HOW WE GOT INTO THIS MESS

In a very real way, our success as a military and industrial power and the period of great affluence that followed World War II seeded the developments that have caused the fix we’re in and allowed it to fester.

Reserve currency status, a badge of America’s preeminence, has been both a blessing and a curse. Bestowed on the United States by the Bretton Woods agreement of 1944 (see Chapter 3) and still enjoyed by the United States today thanks to complacent central bankers abroad, the U.S. dollar’s status as the world’s reserve currency has shielded the United States from the consequences of persistent and growing trade imbalances.

The Bretton Woods accords made the U.S. dollar the currency used by other governments and institutions to settle their foreign exchange accounts and to transact trade in certain vital commodities, such as gold and oil. It thus behooved countries involved in international trade to accumulate dollars and build ample reserves. That the dollar was originally accepted by the world as its reserve currency was due to America’s unequaled industrial might, its status as both the world’s leading exporter of manufactured goods and its greatest creditor, and the fact that its currency was fully backed by, and redeemable in, a fixed quantity of gold. None of these attributes currently exist, and the dollar would not qualify for comparable status were a similar accord attempted today.

However, because its reserve currency function was inseparable from its own import/export activities, the United States was permitted to run trade deficits exempt from the free market forces that would otherwise have forced their adjustment. Thus we were spared the economic impact that a devaluation of the dollar would have caused.

Our trading partners could, under the Bretton Woods rules, force us to deal with the issue, but bureaucratic central bankers have so far been complacent and allowed our deficit to reach increasingly dangerous levels.

But that complacency could change. There is also speculation that reserve currency status might be transferred to the euro or to a combination of foreign currencies. In any event, the U.S. dollar’s status as a reserve currency immune from market pressures cannot last indefinitely. When it ends, all those surplus dollars will come home to roost, creating hyperinflation domestically.

The shift from manufacturing to services caused growing trade deficits. The erosion of our manufacturing base with its value as a producer of exportable goods and a source of high wages was the result of a number of factors. Aggressive labor unions demanding worker benefits, increased government regulation, higher taxation, aging plants and equipment, a “bigger is better” attitude that allowed too much waste and encouraged too little conservation and discipline, a smugness with respect to quality and design—these and other factors put U.S. manufacturing at a disadvantage to competitors abroad that were playing catch-up.

Abroad, in contrast, there was a spirit of rebuilding, an awareness that natural resources were scarce and must be conserved, lower taxes and wages, and generally fewer government obstacles to economic development. America’s most formidable overseas competitor was Japan, whose answer to America’s “bigger is better” was “higher quality is better.” Gas-guzzling, chrome-laden “Detroit iron” was suddenly challenged by durable, economical, electronically sophisticated competition from Toyota and others. Resources, human and natural, were to be used with more care, more skill, and more discipline not to make money but to make products of greater excellence that in turn would make money. Nor was the Japanese government averse to self-serving trade policies, which the United States was willing to tolerate in exchange for an ally in its all-consuming war in Vietnam.

David Halberstam, in his book, The Next Century (Morrow, 1991), observed:

America in the postwar years became a political society that assumed the essential health and bountiful quality of the American economy. Japan, by contrast, was an economic society, where wealth had to be renewed each day by the nation’s most talented people. . . . We were obsessed with the cold war then the hot war, but the Japanese were obsessed with commerce.

As our manufacturing base shrank, a service economy expanded in its place. Service economies do not reduce trade deficits. Consisting of businesses such as retailing and wholesaling, transportation, entertainment, personal services, and other intangible and intellectual property, the service sector not only produces fewer exportable goods but also makes us dependent on goods imported from economies that do save and produce. How would we otherwise stock our shelves?

The popular notion that in the postindustrial service economy money-valued services are an acceptable substitute for goods because both generate money ignores the distinction between money and wealth. Money is a medium of exchange. Wealth is what is received in that exchange.

I agree with those who argue that information technology can be an exportable product equal to goods, but I don’t agree that we can ever replace manufacturing with information. There is simply an insufficient quantity of such products, and the diversity of cultures abroad limits the marketability of the entertainment and educational output coming from the United States. The facts speak for themselves. We are simply not exporting enough information technology to pay for the real goods that we import. The resulting trade deficits prove that our so-called information/service economy is in reality a sham.

Another problem with an economy based primarily on services is that jobs in that sector pay less than manufacturing jobs. Making matters worse, there are high-end and low-end, skilled and unskilled jobs in the service sector, and in the United States the growth is in the low-end jobs. When we talk services, we’re talking mainly about flipping hamburgers.

Debunking a Popular Fallacy

A popular fallacy is that America’s transition from a manufacturing-based to a service-based economy is an example of progress comparable to its transition during the nineteenth century from an agrarian-based to a manufacturing-based economy. During the nineteenth century, efficiencies made possible by capital investment financed with savings enabled more food to be produced by fewer farm workers. This increased farm productivity freed up labor to make a transition into higher-paying manufacturing jobs similarly created by capital investment financed by savings. The growth in farm productivity that made the industrial revolution possible also resulted in huge exports of American agricultural products and agricultural trade surpluses.

Contrast that with the modern transition from a manufacturing-based to a service-based economy. In this case, labor was freed up because American manufacturers, increasingly burdened by high taxes, excessive regulation, and trade union demands tantamount to extortion, were driven out of business by more efficient foreign manufacturers, resulting in huge trade deficits as we imported all the stuff we could no longer produce competitively at home. The fact that those displaced factory workers were forced to accept lower-paying jobs in the service sector is indicative not of progress but of colossal failure.

Another fallacious comparison was made during an interview I had with Mark Haines, host of CNBC’s Squawk Box. Mark misinterpreted my position that the United States cannot hope to pay for imports solely through reliance on the service sector as my advocating that the country return to the equivalent of a buggy whip economy. His “buggy whip” reference is to the classic example of creative destruction, a concept of economist Joseph Schumpeter, whereby an innovation such as the automobile represents an improvement so major that it causes the destruction of a mature industry, such as whips for horse-drawn buggies.

The application of the creative destruction concept to the atrophy of manufacturing in the United States is flawed, however. When buggy whip companies went out of business, Americans did not start importing foreign-made buggy whips. American businesses stopped making buggy whips because the invention of the automobile made them obsolete. Today, the very same highly desirable, state-of-the-art consumer goods that were formerly produced in the United States are now being produced abroad.