Thursday, October 30, 2003

Squanderville versus Thriftville (2003) - Fortune Magazine

Summary:
Warren Buffet, writing in 2003. Predicts the dollar will decline in value and is therefore buying foreign currencies. Decline will have serious consequences for US economy. Growing trade-deficit is to blame. Explains this by means of tale: Squanderville vs. Thriftville. Thriftville owning Squanderville bonds. Government devalues Squanderville national currency to reduce value of IOUs (bonds). Thriftville sells bonds and buys Squanderville assets (direct ownership) with proceeds. Ends up owning all of Squanderville. One generation of Thrifters gets a free ride for which future generation pay (rent, interest) in perpetuity. Story similar to that of US since late 1970s. Declining dollar value not the solution. Buffet proposes system of Import Certificates in order to rebalance trade. (Published: 10/03)

Notes:

  • Buffett: "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. 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 will decline. 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."
  • 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 rate
    • a perpetuation of this transfer will lead to major trouble
      • see tale of Squanderville and Thriftville
  • Tale of Squanderville and Thriftville
    • two isolate, side-by-side islands of equal size
      • land only capital asset
      • communities primitive: need only food and produce only food
      • working 8hrs/day, each inhabitant can produce enough food to sustain himself
        • each society self-sufficient if everybody works 8hrs/day
    • Thriftville citizens decide to do some serious saving and investing
      • start to work 16hrs/day
      • continue to live of food produced in 8hrs, and export remainder to Squanderville
    • Squanderville citizens decide to live their lives free of toil and eat as well as ever
      • pay Thrifts with bonds
        • bonds at their core represent claim checks on the future output of Squanderville
      • a few Squanderers smell trouble coming but are ignored
        • the debt Squanderville is piling up will eventually require them to work more than 8hrs/day
    • Thrifts begin to get nervous
      • question the value of the Squanderville IOUs
      • sell most of the bonds to Squanderville residents for Squanderbucks
      • use proceeds to buy Squanderville land
      • eventually the Thrifts own all of Squanderville
    • Squanderers have nothing left to trade
      • must return to working 8hrs/day in order to eat
      • must also work additional hours to service the debt and pay Thriftville rent on the land imprudently sold
      • Squanderville has been colonized by purchase rather than by conquest
    • present value of the future production of Squanderville must forever ship to Thriftville
      • can be argued that both have received a fair deal:
        • equates the production Thriftville initially gave up
      • however, dramatic "intergenerational inequity" has arisen
        • one generation of Squanderers got a free ride and future generations pay in perpetuity for it
    • Squanderville government facing ever greater payments to service debt
      • sooner or later will decide to embrace highly inflationary policies
        • i.e. issue more Squanderbucks to dilute the value of each
          • Squanderbonds are simply claims on specific numbers of Squanderbucks, not on bucks of specific value
          • making Squanderbucks less valuable would ease the island's fiscal pain
    • in response, residents of Thriftville opt for direct ownership of Squanderville land rather than bonds of the island's governement
      • 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"
  • comparison with US
    • 1945 - ~1970: operated in industrious Thriftville style
      • regularly selling more abroad than purchased
      • invested surplus abroad
        • net investment increased
          • i.e. holdings of foreign assets less foreign holdings of US assets
      • country's net worth consisted of all the wealth within borders plus a modest portion of the wealth of in the rest of the world
    • late 1970s: trade situation reversed, producing deficits
      • running initially at ~1% of GDP
      • net investment income remained positive
        • net ownership balance hit its high in 1980 at $360b, due to power of compound interest
      • since then downhill
        • pace of decline rapidly accelerating
    • 2003:
      • trade deficit exceeds 4% of GDP
        • US consuming 4% more than it produces
        • roughly equal to $500b per year, at this rate
      • net foreign ownership of $2.5tr
        • rest of the world owns $2.5tr more of the US than US owns of other countries
        • roughly 5% of national wealth (~$50tr)
        • some of this $2.5tr investested in claim checks (US bonds, both private and governmental)
        • some of it invested in assets, e.g. property and equity securities
      • at current trade-deficit level (4% of GDP), foreign ownership will grow at about $500b/year
        • will be adding 1% annually to foreigners' net ownership of national wealth
        • as that ownership grows, so will the annual net investment income flowing out of the country
        • will leave US paying ever-increasing dividents and interest to the world rather than being net receiver as in the past
          • "We have entered the world of negative compounding - goodbye pleasure, welcome pain."
  • Economics 101:
    • countries can not for long sustain large, ever-growing trade deficits
      • at some point, 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
  • but: US enjoys special status
    • can behave today as it wishes because past financial behaviour was exemplary and because it is so rich
      • neither its capacity nor its intention to pay is questioned
      • continues to have a mountain of desirable assets to trade for consumables
  • Buffet: time to halt this trading of assets for consumables and to balance trade
    • proposal: Import Certificates
  • Import Certificates
    • issued to all US exporters in an amount equal to the dollar value of their exports
    • exporter can sell the ICs to parties wanting to get goods into the country
      • exporters abroad
      • importers here
    • inevitable result: trade balance
    • price of certificates determined by supply and demand
      • if our exports were to increase and the supply of ICs were therefore to be enlarged, their market price would be driven down
    • e.g. certificates selling for 1o cent
      • means 10 cents per dollar of exports behind them
      • means producer could realize 10% more by selling his goods in the export markets than by selling them domestically
        • extra 10% coming from sale of ICs
    • no such thing as a free lunch
      • foreigners selling to us would face tougher economics
        • not nice, but that's a problem they're up against no matter what trade "solution" is adopted
        • but: plan does not penalize any specific industry or product
          • in the end, free market would determine what would be sold in the US and who would sell it
          • ICs only determine aggregate dollar volume of what was sold
      • also negative consequences for US citizens
        • prices of most imported goods would increase
        • so would prices of certain competitive products manufactured domestically
        • cost of ICs would act as a tax on consumers
      • but: also drawbacks to letting the dollar continually lose its value or to increasing tariffs on specific products or instituting quotas on them
        • "The pain of higher prices for 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"
  • A gently declining dollar does not provide the answer
    • 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 investment income deficit
    • action to halt the rapid outflow of our national wealth is called for

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