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					“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.