Day: November 4, 2003

Yuvaraj Galada alerted me to the October 26th, 2003, edition of Fortune in which Warren Buffet worries that “America’s Growing Trade Deficit Is Selling the Nation Out From Under Us.” Then he suggests a remedy for the problem. The solution he says is to balance imports and exports. It is an interesting article and I would recommend reading it. Buffett does some amateur model-building and I think he gets it right. He does not do any deep analysis, and rightly so. Deep analysis confuses people and the main message may easily be lost. The choice is between clarity and comprehensiveness. It is better to be clear than to be comprehensive, when one is dealing with the unwashed masses (so to speak) who read the popular press.

The problem, he says, is that the US foreign trade is out of whack. Exports are way behind imports. Too much is being imported from China, for instance, and too little is being sold to China. So the Chinese hold IOUs that they will come around asking for payment on and when that happens, the present pleasure of current consumption will be transformed into future pain of non-consumption. He raises the matter of inter-generational equity — that those who enjoyed the pleasure of consuming will be tranferring the pain of repayment to future generations.

So how does one balance trade? Make imports equal exports. So if imports exceed exports, reduce imports and increase exports. Any second grader could have told you so. How does one achieve that? Raise the price of imports and lower the price of exports. Any Chicago economist could have told you that. How do you raise prices? Tax the stuff, as any econ undergrad would say. Lower the price? Subsidize the stuff, as any … Anyway, it is not rocket science so far.

OK, so we need to tax imports and subsidize exports. One way to do it is to change the price of the US dollar so that it is relatively cheap for exports and relatively expensive for imports. In short, have two different exchange rates. How wide should the wedge be between the two rates? Buffet suggests that the market should determine that. By having what he calls “Import Certificates”, or ICs. Let the number of ICs depend on the volume of exports. That is, the supply of ICs is determined by the exports. Then, require that for any one to import stuff, one has to have ICs that equal the volume of the imports. Thus the demand for ICs is determined by the total volume of imports. The market price for ICs then is determined by the demand and supply of ICs.

I leave the rest to his article. I will take the article as read from this point on and build on it.

In his model, the folks at Squanderville enjoy a life of luxury by borrowing from (i.e., running a trade deficit with) the folks at Thriftville (who have a trade surplus.) Since in his model, Squanderville folks merely consume the difference, the future generations of Squandervillians have to pay for the profligacy. But what if the present generation of Squanderville were not so stupid? What if instead of merely gazing at the ceiling they used the spare time (from not having to work for a living) to do research and develop fancy technology? That way, the people of Thriftville would be financing the R&D going on in Squanderville and in the future, the Thriftville people would have to import that technology from Squanderville and pay for that with the IOUs they hold.

The story takes on a different complexion then. Now Squanderville very cleverly leave the manufacturing to Thriftville and run up a trade deficit by importing stuff from Thriftville. Not having to spend time manufacturing, Squanderville people devote more time to creating intellectual property (IP) and later make their living by selling the IP to Thriftville. So what you have is that Thriftville is doing the dirty work and extending credit to Squanderville. Squanderville uses that credit to create IP that creates wealth, that is, they move up the value chain.

It all comes down to the all-important credit-constraint that I keep talking about. The poor are credit-constrained and the rich have lots of credit. The poor, in effect, finance the rich. This is true not only at the level of individuals, but also at the level of nations. Poor nations such as India that run a trade surplus with the US are effectively financing the rich. The rich use that credit to create stuff that they sell at a premium to the poor.

Or as Leonard Cohen notes in his song Everybody Knows

… The poor stay poor, the rich get rich
That’s how it goes
As everybody knows…

So the lesson is this: if you have credit, and you use it wisely, you can continue to live off the fat of the land for a very long time. The question is therefore this: Is the US using the credit it has wisely or not? I think that it is doing so. The US is in the business of creating IP and that is why it is so vehement in its insistence on the protection of IP rights. It becomes the cornerstone of all their trade negotiations.

What should India do in this case? I have a simple and elegant solution
that I will leave for a later date.