Peter Schiff: "We're in the Early Stages of a Depression"

This well-known bear warns us about the country's heavy debt burden, rising interest rates, surging oil prices and more problems brewing.

Fears of a double-dip recession have moved to the back burner, and most forecasters see a slowly improving economy this year. But Peter Schiff, CEO and chief global strategist of Euro Pacific Capital, a brokerage based in Westport, Conn., says that the majority is way off base.

Known for his bearish views on the U.S. dollar and bullish views on gold and foreign stocks, Schiff has also made forays into the political arena. He served as an economic adviser to Ron Paul’s campaign for the Republican presidential nomination in 2008 and unsuccessfully sought the GOP nomination to run for the U.S. Senate in Connecticut in 2010. He is the author of Crash Proof 2.0: How to Profit from the Economic Collapse (John Wiley & Sons, 2009) and How an Economy Grows and Why It Crashes (John Wiley & Sons, 2010).

Here’s an edited transcript of our conversation.

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KIPLINGER: What is your current take on the U.S. economy?

SCHIFF: I still think we’re in the early stages of a depression. People assume the economy is recovering because the numbers look better. But the numbers only look better because of the additional debt we’ve accumulated. When you borrow and spend trillions of dollars, the numbers look better in the short run. People will spend that borrowed money, so there will be some jobs created in the process.

But once that borrowed money is spent, it’s gone. The interest burden, however, remains. So the economy ends up in worse shape, and we end up digging ourselves into a deeper hole.

So we’re living on borrowed time. When do you think the effects of the stimulus will run out? I don’t know. Can we make it through 2011? Maybe. It would be a long shot for us to go through 2012 without returning to a recession.

Then what happens? Over the course of the next several years, a hangover will set in and interest rates will rise. Interest rates are rising now. They’re still low only because they’re rising from such a depressed level.

The next downturn will be worse because we never allowed the economy to recover from the damage caused by the housing mania, and economic imbalances were never fully addressed. We put too much of our resources into housing, education and health care through government subsidies and debt guarantees. Interest rates were too low for too long, so consumers were able to borrow too much.

What’s your assessment of the housing market now? Home prices are still too high. Housing prices need to fall to a level where the average home buyer can put 20% down and get a mortgage without a government guarantee.

But aren’t houses more affordable? Affordability is only getting better because mortgage rates are artificially low. The federal funds rate [the short-term interest rate that the Federal Reserve controls] is at 0%. The rates for 30-year fixed-rate mortgages are almost identical to rates on 30-year Treasuries. Basically, the government is absorbing all the risk of mortgage lending.

What needs to be done? We need to do something relatively quickly about our debt because we’re adding $1 trillion to $2 trillion of red ink each year. But the economy also needs to be restructured. For instance, the government has to get out of the housing market completely.

You’re suggesting phasing out Fannie Mae and Freddie Mac. But won’t that destabilize the economy? Yes. But do we want to continue inflicting more damage, or do we want to correct the problem? The problem is that real estate prices are too high. If the government gets out of the housing market, prices will come down.

How will higher oil prices affect the economy? They’re hurting the economy already. Our trade deficit has risen sharply from last year -- roughly 30% -- largely due to higher oil prices.

How much of the rise in oil prices is due to the turmoil in the Middle East? The Middle East is not the cause of higher oil. It’s the catalyst. Oil prices are moving up because money supply is growing rapidly around the world. What will happen now is that the Fed will conclude that higher oil prices will hurt consumer spending, which will hurt the economy, and so it will print even more money. The result will be oil prices rising even further.

And that will boost inflation. Inflation is already out of the bottle as a consequence of low interest rates designed to prop up the housing market and keep this phony expansion going. The Federal Reserve is creating inflation. The problem now is that the impact is being felt more broadly by our trading partners. Countries such as China are absorbing the lion’s share of the dollars that the Fed is printing. So we’re causing prices to go up in China. To combat inflation, the Chinese could raise their own interest rates or simply allow their currency to appreciate. Or China could get rid of the dollar as its reserve currency.

Will China let the yuan rise? I think we’re getting very close to that. The alternative is runaway inflation in China. And when the yuan goes up, watch out. The standard of living for the average American is going to tumble. The vast majority of what Americans spend money on will be energy and food. I don’t think there’ll be money left over for things such as new clothes.

What should investors do to protect themselves? People have to think outside the box. Municipal bonds, Treasuries, CDs and high-quality corporate bonds are usually considered safe investments, but I think they’re among the riskiest investments right now.

Assuming the federal government bails everybody out, so no one is left to default, the risk is not that you’re going to lose your money, but that your money loses value. If you have a $10 million bond portfolio and prices go up ten times, that’s the same thing as losing 90% of your money. So you have to be willing to assume a different type of risk -- that is, buying foreign stocks that pay dividends or buying foreign government bonds.

Where are you investing overseas? We try to find the countries that have trade surpluses, high savings rates and sound monetary policies. We’re invested most heavily in Canada, Australia, New Zealand, Norway and Sweden. We also have money in Germany, Switzerland and the Netherlands. We also have a lot of money in Asia -- mainly in China, but also in Singapore and Hong Kong.

What kinds of companies are you looking for? I’m pursuing two themes. One is resources and raw materials. For that we like energy, agriculture and mining companies.

The other theme is that the world is going to change dramatically over the next decade as far as distribution of wealth, purchasing power and living standards. Americans have been living beyond their means, while others have been living beneath their means. That’s going to switch. So we’re focusing on companies that are already active in the markets where purchasing power is going to grow. For example, we want companies that are targeting the Chinese middle class. If investors want to invest in the U.S. at all, they need to focus on multinational export groups that derive some of their income overseas.

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Jennifer Schonberger
Staff Writer, Kiplinger's Personal Finance