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US Trade Deficit and the inevitable decline of the US dollar

Don Boudreaux criticizes Warren Buffett for confusing trade deficit with debt.

Buffett no doubt believes that dollars held by foreigners represent debt owed by Americans to foreigners.  Only in the most irrelevant and formal sense is this belief valid.  Each U.S. dollar is a Federal Reserve Note, issued by a U.S. government institution (the Fed) and formally redeemable by that U.S. institution.  But redeemable for what?  Answer: another Federal Reserve Note of the same value.

In fact, dollars held by foreigners are not debt in any economically relevant sense.

"But can't foreigners spend these dollars on U.S. goods, services, or assets?!" I hear someone (Buffet, perhaps) asking.  Of course dollars can be spent in this way; that's the only reason foreigners accept dollars in exchange for the things they sell.  But this fact doesn't make dollars debt.

He argues that there is no difference between purchasing something from your neighbor vs importing something from abroad.

Suppose my next-door neighbor in Virginia agrees to mow my lawn for $10.  He mows my lawn and I immediately give him a $10 bill.  No debt is created.  I owe my neigbor nothing; my neighbor owes me nothing.  My neighbor can now spend this $10 bill on whatever he chooses.  I no longer have this $10 to spend.

Does anyone worry that my neighbor has an additional $10 bill in his wallet that he might whip out at any time to buy something priced in dollars?  This $10 can indeed be used as a claim on ten-dollars worth of U.S. output or assets.  But it ain't debt.  No one owes my neighbor anything as a consequence of his ownership of that $10 bill.

Change the example only slightly.  Suppose I live, not in Virginia, but in Maine just barely on the U.S. side of the Canada-U.S. border.  My next-door neighbor is a Canadian citizen living in Canada.  He mows my lawn; I pay him ten U.S. dollars.  As long as my neighbor holds that $10 bill, the U.S. current-account deficit is higher by $10.  (I outsourced my mowing to Canada -- importing $10 worth of services from abroad.)

Let's see what Warren Buffett really wrote in his annual letter to Bershire Hathaway's shareholders.

Berkshire owned about $21.4 billion of foreign exchange contracts at yearend, spread among 12 currencies. As I mentioned last year, holdings of this kind are a decided change for us. Before March 2002, neither Berkshire nor I had ever traded in currencies. But the evidence grows that our trade policies will put unremitting pressure on the dollar for many years to come  so since 2002 weve heeded that warning in setting our investment course. (As W.C. Fields once said when asked for a handout: Sorry, son, all my moneys tied up in currency.) Be clear on one point: In no way does our thinking about currencies rest on doubts about America. We live in an extraordinarily rich country, the product of a system that values market economics, the rule of law and equality of opportunity. Our economy is far and away the strongest in the world and will continue to be. We are lucky to live here.

But as I argued in a November 10, 2003 article in Fortune, (available at berkshirehathaway.com), our countrys trade practices are weighing down the dollar. The decline in its value has already been substantial, but is nevertheless likely to continue. Without policy changes, currency markets could even become disorderly and generate spillover effects, both political and financial. No one knows whether these problems will materialize.

Thus, Warren Buffett doesn't seem to worry about impact of trade deficit on US economy. He is only worried that US currency (dollar) will decline in the future.  He also makes clear that trade deficit can be "funded" either by borrowing or by selling assets.

If the U.S. was running a $.6 trillion current-account surplus, commentators worldwide would violently condemn our policy, viewing it as an extreme form of mercantilism  a long-discredited economic strategy under which countries fostered exports, discouraged imports, and piled up treasure. I would condemn such a policy as well. But, in effect if not in intent, the rest of the world is practicing mercantilism in respect to the U.S., an act made possible by our vast store of assets and our pristine credit history. Indeed, the world would never let any other country use a credit card denominated in its own currency to the insatiable extent we are employing ours. Presently, most foreign investors are sanguine: they may view us as spending junkies, but they know we are rich junkies as well.

Our spendthrift behavior wont, however, be tolerated indefinitely. And though its impossible to forecast just when and how the trade problem will be resolved, its improbable that the resolution will foster an increase in the value of our currency relative to that of our trading partners.

Why should Berkshire Hathaway continue to hold huge amount of US currency when atleast a part of the massive current account deficit is funded by the expansive monetary policy of the Federal Reserve? I would agree with Warren Buffett that the US dollar is likely to decline in the future. In fact, the US dollar has already declined compared to other currencies, such as the Euro.

Don Boudreaux continues to disagree with Buffett after having re-read his letter. 


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