November 18, 2003 Interesting Warren Buffett article on Trade imbalance and US Dollar
America’s Growing Trade Deficit Is Selling the Nation Out From Under Us.
Here’s a Way to Fix the Problem-And We Need to Do It Now.
Sunday, October 26, 2003
By Warren E. Buffett
I’m about to deliver a warning regarding the U.S. trade deficit and
also suggest a remedy for the problem. But first I need to mention two
reasons you might want to be skeptical about what I say. To begin, my
forecasting record with respect to macroeconomics is far from inspiring.
For example, over the past two decades I was excessively fearful of
inflation. More to the point at hand, I started way back in 1987 to
publicly worry about our mounting trade deficits-and, as you know, we’ve
not only survived but also thrived. So on the trade front, score at
least one “wolf” for me. Nevertheless, I am crying wolf again and this
time backing it with Berkshire Hathaway’s money. Through the spring of
2002, I had lived nearly 72 years without purchasing a foreign currency.
Since then Berkshire has made significant investments in-and today
holds-several currencies. I won’t give you particulars; in fact, it is
largely irrelevant which currencies they are. What does matter is the
underlying point: To hold other currencies is to believe that the dollar
Both as an American and as an investor, I actually hope these
commitments prove to be a mistake. Any profits Berkshire might make
from currency trading would pale against the losses the company and our
shareholders, in other aspects of their lives, would incur from a
plunging dollar. But as head of Berkshire Hathaway, I am in charge of
investing its money in ways that make sense. And my reason for finally
putting my money where my mouth has been so long is that our trade
deficit has greatly worsened, to the point that our country’s “net
worth,” so to speak, is now being transferred abroad at an alarming
A perpetuation of this transfer will lead to major trouble. To
understand why, take a wildly fanciful trip with me to two isolated,
side-by-side islands of equal size, Squanderville and Thriftville. Land
is the only capital asset on these islands, and their communities are
primitive, needing only food and producing only food. Working eight
hours a day, in fact, each inhabitant can produce enough food to sustain
himself or herself. And for a long time that’s how things go along. On
each island everybody works the prescribed eight hours a day, which
means that each society is self-sufficient.
Eventually, though, the industrious citizens of Thriftville decide
to do some serious saving and investing, and they start to work 16 hours
a day. In this mode they continue to live off the food they produce in
eight hours of work but begin exporting an equal amount to their one and
only trading outlet, Squanderville.
The citizens of Squanderville are ecstatic about this turn of
events, since they can now live their lives free from toil but eat as
well as ever. Oh, yes, there’s a quid pro quo-but to the Squanders, it
seems harmless: All that the Thrifts want in exchange for their food is
Squanderbonds (which are denominated, naturally, in Squanderbucks).
Over time Thriftville accumulates an enormous amount of these bonds,
which at their core represent claim checks on the future output of
Squanderville. A few pundits in Squanderville smell trouble coming.
They foresee that for the Squanders both to eat and to pay off-or simply
service – the debt they’re piling up will eventually require them to
work more than eight hours a day. But the residents of squanderville
are in no mood to listen to such doom saying.
Meanwhile, the citizens of Thriftville begin to get nervous. Just
how good, they ask, are the IOUs of a shiftless island? So the Thrifts
change strategy: Though they continue to hold some bonds, they sell most
of them to Squanderville residents for Squanderbucks and use the
proceeds to buy Squanderville land. And eventually the Thrifts own all
of Squanderville. At that point, the Squanders are forced to deal with
an ugly equation: They must now not only return to working eight hours a
day in order to eat – they have nothing left to trade – but must also
work additional hours to service their debt and pay Thriftville rent on
the land so imprudently sold. In effect, Squanderville has been
colonized by purchase rather than conquest. It can be argued, of
course, that the present value of the future production that
Squanderville must forever ship to Thriftville only equates to the
production Thriftville initially gave up and that therefore both have
received a fair deal. But since one generation of Squanders gets the
free ride and future generations pay in perpetuity for it, there are –
in economist talk – some pretty dramatic “intergenerational inequities.”
Let’s think of it in terms of a family: Imagine that I, Warren
Buffett, can get the suppliers of all that I consume in my lifetime to
take Buffett family IOUs that are payable, in goods and services and
with interest added, by my descendants. This scenario may be viewed as
effecting an even trade between the Buffett family unit and its
creditors. But the generations of Buffetts following me are not likely
to applaud the deal (and, heaven forbid, may even attempt to welsh on
it). Think again about those islands: Sooner or later the Squanderville
government, facing ever greater payments to service debt, would decide
to embrace highly inflationary policies – that is, issue more
Squanderbucks to dilute the value of each. After all, the government
would reason, those irritating Squanderbonds are simply claims on
specific numbers of Squanderbucks, not on bucks of specific value. In
short, making Squanderbucks less valuable would ease the island’s fiscal
pain. That prospect is why I, were I a resident of Thriftville, would
opt for direct ownership of Squanderville land rather than bonds of the
island’s government. Most governments find it much harder morally to
seize foreign-owned property than they do to dilute the purchasing power
of claim checks foreigners hold. Theft by stealth is preferred to theft
by force. So what does all this island hopping have to do with the
U.S.? Simply put, after World War II and up until the early 1970s we
operated in the industrious Thriftville style, regularly selling more
abroad than we purchased. We concurrently invested our surplus abroad,
with the result that our net investment – that is, our holdings of
foreign assets less foreign holdings of U.S. assets-increased (under
methodology, since revised, that the government was then using) from $37
billion in 1950 to $68 billion in 1970. In those days, to sum up, our
country’s “net worth,” viewed in totality, consisted of all the wealth
within our borders plus a modest portion of the wealth in the rest of
the world. Additionally, because the U.S. was in a net ownership
position with respect to the rest of the world, we realized net
investment income that, piled on top of our trade surplus, became a
second source of investable funds. Our fiscal situation was thus similar
to that of an individual who was both saving some of his salary and
reinvesting the dividends from his existing nest egg.
In the late 1970s the trade situation reversed, producing deficits
that initially ran about 1% of GDP. That was hardly serious,
particularly because net investment income remained positive. Indeed,
with the power of compound interest working for us, our net ownership
balance hit its high in 1980 at $360 billion. Since then, however, it’s
been all downhill, with the pace of decline rapidly accelerating in the
past five years. Our annual trade deficit now exceeds 4% of GDP.
Equally ominous, the rest of the world owns a staggering $2.5 trillion
more of the U.S. than we own of other countries. Some of this $2.5
trillion is invested in claim checks – U.S. bonds, both governmental and
private – and some in such assets as property and equity securities. In
effect, our country has been behaving like an extraordinarily rich
family that possesses an immense farm. In order to consume 4% more than
we produce – that’s the trade deficit – we have, day by day, been both
selling pieces of the farm and increasing the mortgage on what we still
own. To put the $2.5 trillion of net foreign ownership in perspective,
contrast it with the $12 trillion value of publicly owned U.S. stocks or
the equal amount of U.S. residential real estate or what I would
estimate as a grand total of $50 trillion in national wealth. Those
comparisons show that what’s already been transferred abroad is
meaningful – in the area, for example, of 5% of our national wealth.
More important, however, is that foreign ownership of our assets
will grow at about $500 billion per year at the present trade-deficit
level, which means that the deficit will be adding about one percentage
point annually to foreigners’ net ownership of our national wealth. As
that ownership grows, so will the annual net investment income flowing
out of this country. That will leave us paying ever-increasing
dividends and interest to the world rather than being a net receiver of
them, as in the past. We have entered the world of negative compounding
– goodbye pleasure, hello pain.
We were taught in Economics 101 that countries could not for long
sustain large, ever-growing trade deficits. At a point, so it was
claimed, the spree of the consumption-happy nation would be braked by
currency-rate adjustments and by the unwillingness of creditor countries
to accept an endless flow of IOUs from the big spenders. And that’s the
way it has indeed worked for the rest of the world, as we can see by the
abrupt shutoffs of credit that many profligate nations have suffered in
recent decades. The U.S., however, enjoys special status. In effect,
we can behave today as we wish because our past financial behavior was
so exemplary and because we are so rich. Neither our capacity nor our
intention to pay is questioned, and we continue to have a mountain of
desirable assets to trade for consumables. In other words, our national
credit card allows us to charge truly breathtaking amounts. But that
card’s credit line is not limitless.
The time to halt this trading of assets for consumables is now, and
I have a plan to suggest for getting it done. My remedy may sound
gimmicky, and in truth it is a tariff called by another name. But this
is a tariff that retains most free-market virtues, neither protecting
specific industries nor punishing specific countries nor encouraging
trade wars. This plan would increase our exports and might well lead to
increase overall world trade. And it would balance our books without
there being a significant decline in the value of the dollar, which I
believe is otherwise almost certain to occur.
We would achieve this balance by issuing what I will call Import
Certificates (ICs) to all U.S. exporters in an amount equal to the
dollar value of their exports. Each exporter would, in turn, sell the
ICs to parties – either exporters abroad or importers here – wanting to
get goods into the U.S. To import $1 million of goods, for example, an
importer would need ICs that were the byproduct of $1 million of
exports. The inevitable result: trade balance.
Because our exports total about $80 billion a month, ICs would be
issued in huge, equivalent quantities-that is, 80 billion certificates a
month-and would surely trade in an exceptionally liquid market.
Competition would then determine who among those parties wanting to sell
to us would buy the certificates and how much they would pay. (I
visualize that the certificates would be issued with a short life,
possibly of six months, so that speculators would be discouraged from
accumulating them.) For illustrative purposes, let’s postulate that
each IC would sell for 10 cents-that is, 10 cents per dollar of exports
behind them. Other things being equal, this amount would mean a U.S.
producer could realize 10% more by selling his goods in the export
market than by selling them domestically, with the extra 10% coming from
his sales of ICs.
In my opinion, many exporters would view this as a reduction in
cost; one that would let them cut the prices of their products in
international markets. Commodity-type products would particularly
encourage this kind of behavior. If aluminum, for example, was selling
for 66 cents per pound domestically and ICs were worth 10%, domestic
aluminum producers could sell for about 60 cents per pound (plus
transportation costs) in foreign markets and still earn normal margins.
In this scenario, the output of the U.S. would become significantly more
competitive and exports would expand. Along the way, the number of jobs
Foreigners selling to us, of course, would face tougher economics.
But that’s a problem they’re up against no matter what trade “solution”
is adopted – and make no mistake, a solution must come. (As Herb Stein
said, “If something cannot go on forever, it will stop.”) In one way
the IC approach would give countries selling to us great flexibility,
since the plan does not penalize any specific industry or product. In
the end, the free market would determine what would be sold in the U.S.
and who would sell it. The ICs would determine only the aggregate
dollar volume of what was sold.
To see what would happen to imports, let’s look at a car now
entering the U.S. at a cost to the importer of $20,000. Under the new
plan and the assumption that ICs sell for 10%, the importer’s cost would
rise to $22,000. If demand for the car was exceptionally strong, the
importer might manage to pass all of this on to the American consumer.
In the usual case, however, competitive forces would take hold,
requiring the foreign manufacturer to absorb some, if not all, of the
$2,000 IC cost.
There is no free lunch in the IC plan: It would have certain
serious negative consequences for U.S. citizens. Prices of most
imported products would increase, and so would the prices of certain
competitive products manufactured domestically. The cost of the ICs,
either in whole or in part, would therefore typically act as a tax on
That is a serious drawback. But there would be drawbacks also to
the dollar continuing to lose value or to our increasing tariffs on
specific products or instituting quotas on them-courses of action that
in my opinion offer a smaller chance of success. Above all, the pain of
higher prices on goods imported today dims beside the pain we will
eventually suffer if we drift along and trade away ever-larger portions
of our country’s net worth. I believe that ICs would produce, rather
promptly, a U.S. trade equilibrium well above present export levels but
below present import levels. The certificates would moderately aid all
our industries in world competition, even as the free market determined
which of them ultimately met the test of “comparative advantage.”
This plan would not be copied by nations that are net exporters,
because their ICs would be valueless. Would major exporting countries
retaliate in other ways? Would this start another Smoot-Hawley tariff
war? Hardly. At the time of Smoot-Hawley we ran an unreasonable trade
surplus that we wished to maintain. We now run a damaging deficit that
the whole world knows we must correct.
For decades the world has struggled with a shifting maze of
punitive tariffs, export subsidies, quotas, dollar-locked currencies,
and the like. Many of these import-inhibiting and export-encouraging
devices have long been employed by major exporting countries trying to
amass ever larger surpluses-yet significant trade wars have not erupted.
Surely one will not be precipitated by a proposal that simply aims at
balancing the books of the world’s largest trade debtor. Major
exporting countries have behaved quite rationally in the past and they
will continue to do so-though, as always, it may be in their interest to
attempt to convince us that they will behave otherwise.
The likely outcome of an IC plan is that the exporting nations –
after some initial posturing-will turn their ingenuity to encouraging
imports from us. Take the position of China, which today sells us about
$140 billion of goods and services annually while purchasing only $25
billion. Were ICs to exist, one course for China would be simply to fill
the gap by buying 115 billion certificates annually. But it could
alternatively reduce its need for ICs by cutting its exports to the U.S.
or by increasing its purchases from us. This last choice would probably
be the most palatable for China, and we should wish it to be so.
If our exports were to increase and the supply of ICs were
therefore to be enlarged, their market price would be driven down.
Indeed, if our exports expanded sufficiently, ICs would be rendered
valueless and the entire plan made moot. Presented with the power to
make this happen, important exporting countries might quickly eliminate
the mechanisms they now use to inhibit exports from us.
Were we to install an IC plan, we might opt for some transition
years in which we deliberately ran a relatively small deficit, a step
that would enable the world to adjust as we gradually got where we need
to be. Carrying this plan out, our government could either auction
“bonus” ICs every month or simply give them, say, to less-developed
countries needing to increase their exports. The latter course would
deliver a form of foreign aid likely to be particularly effective and
I will close by reminding you again that I cried wolf once before.
In general, the batting average of doomsayers in the U.S. is terrible.
Our country has consistently made fools of those who were skeptical
about either our economic potential or our resiliency. Many pessimistic
seers simply underestimated the dynamism that has allowed us to overcome
problems that once seemed ominous. We still have a truly remarkable
country and economy. But I believe that in the trade deficit we also
have a problem that is going to test all of our abilities to find a
solution. A gently declining dollar will not provide the answer. True,
it would reduce our trade deficit to a degree, but not by enough to halt
the outflow of our country’s net worth and the resulting growth in our
Perhaps there are other solutions that make more sense than mine.
However, wishful thinking and its usual companion, thumb sucking, is not
among them. From what I now see, action to halt the rapid outflow of
our national wealth is called for, and ICs seem the least painful and
most certain way to get the job done. Just keep remembering that this
is not a small problem: For example, at the rate at which the rest of
the world is now making net investments in the U.S., it could annually
buy and sock away nearly 4% of our publicly traded stocks.
In evaluating business options at Berkshire, my partner, Charles
Munger, suggests that we pay close attention to his jocular wish: “All I
want to know is where I’m going to die, so I’ll never go there.”
Framers of our trade policy should heed this caution-and steer clear of
Squanderville. FORTUNE editor at large Carol Loomis, who is a Berkshire
Hathaway shareholder, worked with Warren Buffett on this article.