November 16, 2003

Thoughts on Buffett’s Article.   Many of you have asked for my thoughts on Warren Buffett’s recent article in Fortune.  In the article Buffett warns that our “trade imbalance” (i.e. current account deficit) is a cause for major concern.  In order to convince the reader Buffett tells a story of two simple economies, Thriftsville and Squanderville.  Each economy produces food, but Thriftville working hard, produces more than it needs and sells the excess food to Squanderville who pays for the food with bonds.  Eventually the people in Squanderville have to work twice as hard to service the debt:  with the interest paid to the people in Thriftville, the Thrifts turn around and buy up the land in Squanderville.  Thus, the Thrifts wind up owning Squanderville.  The only other option for the Squanders is to create inflation and thus make it easier to pay back the bonds.

From this simple story Buffett goes on to argue that since the U.S. been running a current account deficit for the past three decades we are now Squanders.  Thus, he concludes we will either be owned or run by rest of the world soon as they will own most if not all of our assets, or we will need massive inflation.  The solution to all of this, Buffett suggests, is to issue Import Certificates to American exporters, one for every dollar of goods they export.  These Import Certificates, actually import permits, would be needed to import goods into the United States.  This, he argues would result in a “balanced trade” with the rest of the world.

One of the (many) problems with Buffett’s analysis is that it suffers from a common problem that has plagued similar mercantilists (16^th century protectionist) arguments for centuries:  static versus dynamic analysis.

Buffett’s Thriftville versus Squanderville does work if one assumes that that Squanderville is truly squandering its imports.  This does, in fact, sometimes happen. Examples include:  Argentina before its collapse in 2001, South East Asia before its collapse in 1998, Russia before its collapse in 1999, and many argue a current example is China.  What often happens in these cases is that an asset bubble builds, spurring on what appears to be rapid economic growth, only to result in a financial meltdown when the bubble burst.  These countries squandered the capital they were importing, but the same logic holds.  More about this later.

Buffett’s story runs into difficultly when you apply it to the United States.  Here is why.  Trade is not a static, zero-sum game.  It is a dynamic process.  Think of it this way:  the United States buys products from a poorer country call it Country A.  We, the Americans, pay for imports from Country A, either with exports or with bonds (to keep with Buffett’s story).  By our trading with country A, even if it is in a current account deficit for the U.S., Country A will experience economic growth.  They are producing more, thus economic growth.

Since Country A is poor they might want to be paid in bonds (capital) that they can use to increase the amount of physical capital in their country.  This capital when used by labor may increase labor productivity and thus wages.  As wages increase, spending increases, all of which will result in more economic growth in Country A.  As Country A grows they can buy more of the things we produce.  Also with trade comes advancements in technology which allows Country A to produce more and better stuff for us Americans to purchase.  This means Country A’s income increases again and they can buy even more stuff from us!  We are better off and they are better off.

What I have just described is not some purely academic theory it is, in part, how we rebuilt Europe after the Second World War.  It is, in large part, how Japan was also rebuilt after World War II.  This brings up an interesting point.  Remember back in the 1980’s we heard similar (stupid) mercantilist arguments that our current account deficit with Japan was going to lead to the Japanese “owning America.”  Do you remember articles in publications like Fortune, Forbes, Business Week, etc. all during the mid to late 1980’s bemoaning how the Japanese were buying up land in Wyoming and Rockefeller Center in New York City?  Strange isn’t it…we don’t hear these stories much any more do we?  We ran very large current account deficits in the 1980’s and the economic sky did not fall in did it?

Oh, of course there were the economic “chicken littles” out there who were saying we were experiencing “false growth” in the U.S.  during the 1980’s.  We were all told how the economic policies of the Reagan Administration were going to lead to economic disaster and the large current account deficit was just the beginning.  It didn’t turn out that way, did it?  Why not?

It is because, as always, everything is relative.  The capital continued to flow into the U.S. during the 1980’s as the rest of world viewed the U.S. as a sound place for investment.  The U.S. economy grew with mild inflation and we saw significant increases in our level of productivity.  One could argue we are currently setting the stage for another 1980’s or 1990’s economic expansion.  More on that later.

This brings me to another point.  Current account imbalances do matter…sometimes.  As I described above, you have to dig beyond the numbers to really see what is going on in various economies to see if the current account imbalances are a sign of trouble or merely an accounting outcome. For example, small relatively weak economies that run continuous current account deficits will probably see the value of their currency devalue. This will raise questions as to why is the currency currently overvalued?  What else is going wrong in the economy?

That is what is so dangerous about Buffett’s suggested “remedy” for the problem. What he sees as a “problem” is usually more of a signal of other underlying issues. He seeks to throw sand in the gears of international trade, a very dangerous move, if one does not understand how all of the gears are related.

Some more important international trade issues Buffett should be concerned about are things like the growing asset bubble in China, the U.S. blocking of agricultural imports from Latin America and Africa, Japan and Europe’s blocking of agricultural imports, destructive export subsidies by nations around the world, the poorly thought out U.S. steel tariffs and farm bill, attempts to continue to prop up the dollar in the foreign exchange market and these are only the tip of the iceberg.

Colleagues tell me that Warren Buffett avoiding buying technology stocks because he admitted he does not understand technology.  I respect him for that.  One should avoid making risky moves in areas one does not understand.  Buffett should apply that same logic to his willingness to give “advice” and policy suggestions on international trade issues.

 -MB