With the recent surge of capital infusion from foreign investors into American financial juggernauts, I was reminded of Warren Buffet’s classic analogy of Squanderville and Thriftville. Warren Buffet wrote an article about the trade deficit in November 2003. Here is the analogy that he used in the article:
“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. 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 doomsaying.
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."
Since 2003, when Warren Buffet wrote this article, the trade deficit has grown. Here are some charts on the trade deficit, the drop in the personal savings rate, and the growth in U.S. National Debt. You can click on the charts for a larger view.
As Buffet forecasted, the residents of Thriftville are opting for direct ownership in record fashion. Sovereign wealth funds, which are investment pools backed by governments, already have invested about $27 billion in Merrill, Citi, Switzerland's UBS AG and Morgan Stanley. Now Merrill Lynch and Citi are going back for seconds.
I don't know what is more striking about this news: the fact that two of our largest financial institutions are in such bad shape they're seeking additional bailouts from foreign governments, or how little controversy these investments are stirring.
It wasn't long ago that politicians went bananas when foreign governments tried to get their mitts on U.S. companies. In 2005, a proposed acquisition of Unocal by an oil company 70 percent owned by the Chinese government ran into so much opposition that the Chinese company withdrew its bid, citing "the political environment in the United States." Unocal accepted a lower offer from cross-state rival Chevron.
In 2006, the takeover of seven U.S. ports by Dubai Ports World, a government entity in the United Arab Emirates, raised such a political and media firestorm that Dubai immediately sold its newly acquired ports - including those in New York and New Jersey - to a U.S. firm.
Sen. Chuck Schumer, D-N.Y., a leading opponent of the ports deal, was quoted as saying, "The question that needs to be answered is whether or not (Dubai) can be trusted to operate our ports in this post-9/11 world."
Yet recent investments in ailing U.S. financial firms by sovereign wealth funds have been generally well received. Schumer welcomed the Abu Dhabi investment, saying it "will bolster Citigroup's capital and competitiveness, and thereby help preserve New York's status as the world's financial center."
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