“Warren Buffet cries wolf over the trade deficit for the second time.” By Russell Redenbaugh and Natalia Davis1 While reading an October Fortune magazine, we stumbled across Warren Buffett’s article on America’s growing Trade deficit2. We concluded that one should not follow his advice. Following Warren Buffet’s advice to short the dollar and buy foreign currencies may accidentally lead to a profit, but if you follow this logic for future investments you are bound to be in trouble. Buffet may be right in his current action, but he is certainly wrong in his interpretation. Buffet may be right about the dollar declining. For one thing, it has declined. It is down approximately 18 % versus the Japanese Yen since its peak levels in January 2002. Gold, other precious metals and commodities have all rallied from the very depressed levels of gold at $280 per ounce during the same time period. Nevertheless, if he is right, he is right for the wrong reasons. Also Buffet is getting help from an unlikely corner, the Bush administration. They are trying to talk the dollar down and limit imports. Both will hurt jobs. Both will help Buffet’s short position. Neither will improve the trade deficit. Buffet, arguably the best investor of our lifetime, is someone with whom we disagree rarely and with some hesitation. What made him great, however, was his ability to understand companies and valuation, not his ability to understand the economy and international finance. By his own admission, he says he does not understand economics and in this case he is confused by the difference between a trade outflow and a capital inflow. Let’s look at the facts. His argument is that the dollar must decline because the U.S. is running a trade balance deficit. He further points out correctly that the U.S. trade balance ran surpluses much of the time from 1946 to 1970. In this he is accurate but not relevant: 1. Trade balance deficits don’t cause currencies to rise or fall 2. Currencies rise or fall due to changes in their relative attractiveness. What makes a currency unattractive is a poor monetary policy. A poor monetary policy in one country will cause its currency to fall relative to that of another. 3. Capital flows cause trade flows. 4. Capital flows into countries with superior after tax rates of return. 5. A trade balance deficit is not a budget deficit. This does not generate liabilities of the government; it generates an asset owned by foreigners. 1 Editorial assistant Melissa M. Sharp contributed to this article. 2 s s Buffet, Warren. “America' Growing Trade Deficit Is Selling the Nation Out From Under Us. Here' a Way to Fix the Problem—And We Need to Do It Now” FORTUNE Magazine, October 26, 2003, http://www.fortune.com/fortune/investing/articles/0,15114,525644,00.html Here’s how it works. Capital flows to where it is wanted and remains where it is treated well. Trade deficits are not bad, and trade surpluses are not good. This is especially true if the country, like the U.S., is the producer of the world’s reserve currency. But even if it is not, any country that runs a trade balance deficit is importing capital. Importing capital is not bad if in fact global investors want to invest in a country. Any country that is importing foreign capital must run a trade balance deficit. That is in fact the only way external investors can acquire domestic assets in that country. Trade account deficits and capital account surpluses in fact measure the same thing. They are an identity. Imagine an accountant sitting dockside in Tokyo measuring the export of Toyotas and the smaller import of western goods. He would observe a trade balance surplus. The Japanese economy in running a trade balance surplus is running a capital account deficit. It is accumulating assets denominated in the currencies of other countries. The same accountant sitting dockside in Long Beach records the inflow of Toyotas and the smaller outflow of U.S. products. In the U.S. the difference between all of the imports and all of the exports is a negative number or trade balance deficit. When the U.S. imports more goods and services than it exports, it imports foreign capital. It allows foreigners to invest in the U.S. When Japan exports more than it imports, this is a trade balance surplus and it acquires foreign capital. Japan invests in foreign economies. Capital is flowing into the U.S. not because Americans are buying more abroad than foreigners buy from us, but because in the aggregate foreigners wish to acquire dollar assets so they can invest in U.S. stocks, bonds, factories, real estate, et cetera. Trade flows and capital flows are different sides of the exact same coin. Buffet misses this. In fact, we believe it is capital flows that drive or cause trade flows and not the other way around. Buffet should know: Growing companies absorb more capital than they generate. They need to finance externally with debt or equity. The U.S. which is growing faster than the rest of the world is importing capital like a growth company. In Buffet’s portfolio of companies, he moves capital around exporting from those that grow more slowly and importing it into those that grow more quickly. Surpluses in fact can be bad. Japan can be likened to one of Buffet’s no growth companies. Sometimes permanent trade surpluses are not a virtue but an economic necessity. Japan is disinvesting in its currency. Its pension system is in crisis, and its future shortage of workers means that it must acquire non-yen assets outside of Japan3. If Japan didn’t run a trade surplus it wouldn’t be able to export capital. If it ran a trade deficit it would in fact be reinvesting in Japan. Japan with a workerless future would be like Bethlehem steel, using its cash flow to build more steel mills. Instead Japan is selling us Toyotas, and we are selling Japan financial instruments. Both sides are getting what 3 For additional insight please see: “Japan’s Death of Birth” Lexington Institute Brief, April 3, 2002, www.kairos-inc.com/Articles.htm they want and Japan is investing in our future. The accounts taken together are not in deficit but in balance. Enough about theory Let’s look at Buffet’s assumptions. In his examples and his basic way of framing the problem he is more than a little confused. He mixes up a trade deficit with being a debtor. Look at some of the quotes from his article. “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.” “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. “ “Our national credit card allows us to charge truly breathtaking amounts. But that card's credit line is not limitless.” As we said earlier a trade balance deficit is a capital inflow. It is not debt of the government or debt of the citizens; this capital surplus or capital inflow is used by foreigners to invest in the U.S. It’s used by Toyota to build plants or by BP to open gas stations. Some of the capital may be invested in US government bonds, in corporations, stocks, in real estate, or even in private business. Buffet is wrong to insinuate that we are losing our national wealth to foreigners. Do we really care if the Mercedes plant in AL which employees 2,400 Americans is owned by a foreign corporation? Are we damaged when a Japanese company purchased Rockefeller center? Should we in fact insist that these assets be only owned by U.S citizens? Would Buffet’s existing shareholders be better off if foreigners were forbidden to purchase Berkshire Hathaway We are Berkshire Hathaway shareholders, and we see no difference if the other shareholders are citizens of Germany, Tokyo or Ohio. Buffet so mis-specifies the problem. The only thing more remarkable is his solution. In order to offset the trade deficit he advocates implementing a strict quota limit on imports where the size of the quota is equal to the dollar value of exports. He first represents this as a free market solution, when it’s clearly a command and control mechanism. Specifically he recommends that the government issue “Import Certificates” (IC) to each exporter at the dollar value of their exports. Then in order to import goods to the U.S., importers would be required to buy IC’s from exporters valued at the dollar value of their imports thus creating a controllable trade balance. This means that imports would never be greater than exports. This perfect balance of imports and exports would then of course mean that foreigners could never acquire dollar balances to make investments in our stock market, bond market, or real estate market. Foreigners would also be blocked from buying and investing in American businesses, because the owners of theses assets need to be paid in dollars. Buffet sees no problem with this interference with trade. He ignores the fact that this form of export subsidy is illegal under the World Trade Organization rules. He’s dismissive of the concern that this would produce any trade retaliation and argues that this is in everyone’s best interests including our trading partners. All of this shows us that Buffet is right when he says he’s a bad economist. The dollar isn’t necessarily weak. As Europe and Asia are strengthening, these currency relationships are returning to their norms. In fact, there is some recent evidence that the dollar decline is coming to an end. If gold continues to rise above $400 and the dollar continues to fall, Buffett will of course then be right. But we think it’s smarter to listen to him for his company selections not for his economic insights.
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