Squanderville vs. Thriftville: Buffett Simplifies Trade Imbalance Problems

By Addison Wiggin and Kate Incontrera

[The following essay was adapted from the book, “I.O.U.S.A.: One Nation. Under Stress. In Debt,”a companion offering to the critically acclaimed documentary “I.O.U.S.A.”]

Although still seen as the world’s economic superpower, the United States has found itself with a myriad of problems: Skyrocketing federal debt, growing annual budget deficits, an almost nonexistent personal savings rate, and the dubious honor of being the country with the largest current account deficit, of which trade makes up the largest part.

A trade deficit occurs when you are importing more than you are exporting — in other words, you are consuming more than you are producing. So the next time you are at Wal–Mart (WMT) or Target (TGT), take a look around. Just about everything you can purchase there comes from another country.

Economists are generally split over what the economic impact of a trade deficit is on a country. Those who defend running a trade deficit argue that when the United States sends money to another country for its goods or services, that country will take that money and invest it back into the United States, in one way or another. In economist Milton Friedman’s opinion, having a large trade deficit meant that your country’s currency is desirable. He believed that a trade deficit simply meant that consumers had an opportunity to purchase and enjoy more goods at lower prices; on the flip side, a trade surplus implied that a country was exporting goods its own citizens did not get to consume or enjoy, while paying high prices for the goods they actually received.

However, as those on the other side of the argument point out, countries with large and long-term trade imbalances also maintain a low national savings rate. Conversely, those countries with trade surpluses (such as Germany, Canada, and Japan) have a high national savings rate. Those arguing against trade deficits believe that gross domestic product (GDP) and employment will be pulled down by a large trade deficit over the long run. As goods flow into the United States from other countries, the country is losing opportunities to produce these goods domestically, which subsequently has an adverse effect on U.S. jobs.

Somewhere in the middle of these two sides is the world’s richest man, Warren Buffett. Buffett believes that, on a whole, trade is a good thing for America, but that over the long term, running “large-and-persistent” trade imbalances will be problematic for the United States.

Buffett realizes the importance of having the average American understand big economic issues, like the trade deficit. As a result, he wrote an article in 2003 for Fortune magazine, called “Squanderville vs. Thriftville.” This parable of sorts was designed to simplify for the readers the problems inherent in trade imbalances.

“Economics tends to put people to sleep,” Buffett told us when we sat down with him in his office at Berkshire Hathaway Inc. (BRK.A, BRK.B), where he is CEO and the largest shareholder. “And I thought by creating a couple islands with inhabitants of quite widely different activities that it might get across a point that otherwise they get lost on.”

In Buffett’s story, he outlined two side-by-side islands: Thriftville and Squanderville. On these islands, land is the capital asset, and these primitive people only need food and produce only food. At first, the citizens of both islands work eight hours a day and produce enough to sustain themselves. However, as time passes, the Thrifts realize that if they work harder and put in longer hours, they can produce a surplus of goods and then trade what they produce with the Squanders. The people of Squanderville like the idea of working less — and all the Thrifts want in exchange for these goods are “Squanderbonds,” which are denominated in “Squanderbucks.”

As time goes on, these Squanderbonds begin to pile up and it is clear that the Squanders will have to put in double time to eat and pay off their growing debt. “Meanwhile,” writes Buffett, “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 they must also work additional hours to service their debt and pay Thriftville rent on the land that they so imprudently sold. In effect, Squanderville has been colonized by purchase rather than conquest.”

In a nutshell: Buffett’s story illustrates that any short-term actions have long-term consequences that sometimes people don’t think about in the short run. This is true of the United States.

“Our country’s ‘net worth’,” Buffett writes in the introduction of his Fortune article, “is now being transferred abroad at an alarming rate. A perpetuation of this transfer will lead to major trouble.” And it may be more than just economic trouble. History shows that countries with similar trade and debt problems are fertile ground for political movements we’re not accustomed to in a democratic society.

In 2007, the total U.S. trade deficit was $738.6 billion, which was down 9% from 2006. Much of the decline could be attributed to a decline in the value of the U.S. dollar. The popular argument suggests that a lower dollar makes production of goods in the United States cheaper and therefore more attractive to buyers of U.S. goods overseas. Exports would go up. And in fact they are, each year.

Some would argue that the dollar is being kept weak to help close the trade gap.

“If I could finance all my own consumption today by handing out something called Warren Bucks or Warren IOUs and I had the power to determine the value of those IOUs over time, believe me, I would make sure that when I repaid them 10 or 20 years from now that they were worth less, per unit, than they are today. So any country that piles up external debt will have a great temptation to inflate over time, and that means that our currency, relative to other major currencies, is likely to depreciate over time.”

And this is just what the United States is doing. From November 2002 through August 2008, the dollar has fallen more than 50% against the euro. Some experts will argue that a weaker dollar benefits the United States — at least where the trade deficit is concerned.

What is not pointed out in this argument is that a falling dollar – paired with low domestic productivity – means that the country is consuming more than it produces. In that sense, since the dollar is losing purchasing power, Americans are paying more for these imports, and the rise in these import costs erases any sort of benefits the country would have seen because of a falling dollar. In other words, America is getting fewer goods for the same amount of money — but that isn’t slowing down the rate of American consumption.

“In the past six or eight years,” Buffett explains, “the United States has started consuming considerably more then it produces. It’s relied on the labor of others to provide things that are used every day. Because the country is so rich, this can continue for a long time, and on a large scale — but not forever.”

Buffett likens it to a credit card. “My credit’s pretty good at the moment,” he says, which usually draws snickers from the audience. “If I quit working and have no income coming in but keep spending, I can first sell off my assets and then, after that, I can start borrowing on my credit card. And if I’ve got a good reputation, I can do that for quite a while. But at some point, I max out. At that point, I have to start producing a whole lot more than I consume in order to clean up my debts.”

The trade deficit aside, Buffett doesn’t believe that the economic situation in the United States is as dire as many of the other experts with whom we’ve spoken have made it out to be. While he warns to not “bet against America,” because he believes that we have a healthy overall economy, what does keep the Oracle of Omaha up at night is the imbalance between imports and exports.

“The rest of the world is buying more and more of our goods all the time, but at an even greater rate, we’re buying more and more of theirs. More trade, overall, is good — as long as it’s true trade. If it’s ‘pseudo trade,’ where we’re buying but not selling, I do not think that’s good over time.”

This is why the U.S. trade deficit remains high. The United States is consuming more than it is producing. The country’s dependence on foreign oil, automotive parts, and cheap consumer products from China accounts for almost the entire deficit.

Original post

Comments

[Smarty_Pants:]

Seems to me that Squanderville only gets into trouble because they issue debt to trade for food from Thriftville. If they traded food for food they would never have to worry about paying off the debt or selling land to meet it.

Assuming the food is perisable, the 'value' of Thriftville food would fall because they grew more than they could use. Eventually it will spoil so they would have an interest in trading it for Squanderville food at 'rates' beneficial to Squanderville or risk losing it entirely.

Even if Squanderville trades half it's home grown food for an equivilent 60% of Thriftville food they will come out ahead without the problem of debt and a more varied diet.

It's the creation of artificial 'money' in the form of debt being traded for the food that causes their problems. Nobody can force them to trade at prices they don't perceive as in their own interest, but if they have to pay now they will avoid the problems noted in the example.

Our trade deficit wouldn't be such a big problem if the FED wasn't printing money like crazy and issuing IOUs to support the habit.

2008 Nov 25 11:34 AM

[moonbat1775:]

The inexpensive goods from China suppressed price inflation in the US. Apparently this led Greenspan to think he could keep interest rates low to spur investment. This bypassed savers. But according to the Austrian Economists, true investment can only come from savings. Being denied an honest interest rate at the bank, would-be savers were encouraged to borrow themselves to "invest" in their houses and the stock market. Their paper gains also encouraged consumption. When the bubbles burst, the American consumer was left broke and in debt. The morale: Read Rothbard and Mises.

2008 Nov 25 12:27 PM

[Moon Kil Woong:]

LOL trade deficits, government deficits, consumer credit. It all inflates the money supply. The fact that we have become more prudent is causing a headache because when we do the money supply shrinks causing a de-leveraging a and money supply contraction.

What is good for the individual and long term sustainability is bad for the short term and the wider economy. Funny isn't it. Welcome to economics. You will know the downturn is over when the government and officials stop trying to figure out how to get you start squandering your money like you used to or try to squander the government's money to make up for your recent fiscal prudence.

In the meantime, we should be figuring out what else the US can sell to the world besides overpriced Hollywood shows and movies, weapons that may be used against us, drugs that we sell cheaper overseas than we do at home, computers and electronics we manufacture overseas, Microsoft and Apple OS', Qualcomm phones (that's what the US embassy is for), and overpriced medical equipment that only the US will use because only in America does the medical practice try to figure out a way to weasel you out of everything you own or ever will own (providing you live) even though the medical establishment is rated below 42 other countries in longevity, infant mortality ratings, death from heart disease, surgical death under 40 years old, and other medical statistics (lower than Canada, France, UK, Taiwan, Japan, Sweden, Chile, S. Korea, Australia, S. Africa, Saudi Arabia, Kuwait, etc.) Last I knew of those countries only the US will let you die from treatable cancer because you don't have $50,000 (maybe that's why the US has such a bad average expected life span).

2008 Nov 25 09:50 PM

[farmer448:]

People keep thinking they can violate the First Law of Economics, TINSTAFEL.

There is no such thing as a free lunch.

Arguments aside, imbalances will occur.

Being a good worldly neighbor we should correct the imbalances with trade with the world and out domestic economy. Their is always some Flim Flam (lobbyiest, industry leader, politician) man who will promise you the sky. These people who steal with their words should be treated no differently than a person who robs a bank.

The financial/Investment industry has managed to destroy all credibility in itself. Without credibility any leader, economic or political, has no value to the United States of America.

2008 Nov 26 03:05 PM

[Kunst:]

It's surprising that foreign dollar holders haven't used them to systematically buy up assets, such as property and companies, in the US. Instead they park them in US treasury bonds, gaining less in interest than they lose in depreciation.

They had better hurry. Squanderville could have "solved" its problem by just creating a whole bunch of Squanderbucks, say 100 times as many as they owed to Thriftville. Then the Thrifts couldn't have bought up all the Squanders' land, reducing them to economic slavery. Of course, Thriftville would no longer accept Squanderbonds for food, but in the mean time, the Squanders have come out way ahead, getting the Thrifts to work for them, producing their food, essentially for free. Yeah, the game is over at that point, but I guess it was fun while it lasted, and they never have to pay back all that debt, at least not at its real value.

The US dollar is going to be devalued substantially by creation of new money (dollars) which will avoid the need to borrow what all these bailouts require. We could add insult to injury by redeeming the existing debt for new dollars too. The bottom line is that existing debt loses a substantial part of its value, and we don't get to borrow any more. Then, like the Squanders, we have to work for our consumption. Needless to say, our standard of living will suffer greatly.

2008 Nov 26 10:01 PM