With so much uncertainty hovering over markets and the global economy, investors are clamoring for guidance from the “Oracle of Omaha,” Warren Buffett.
Unfortunately, Buffett recently stated he wouldn’t comment on the current tariff-related negotiations and/or economic fallout until the Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) annual meeting in early May.
However, Buffett has commented on tariffs and the U.S. trade deficit in the past. While one might think the champion of free markets has a very clear stance on the market-distorting characteristics of tariffs, Buffett is also not a fan of the U.S. trade deficit. Overall, his position on protectionism is more nuanced than what one might think — with an elegant way to solve the trade deficit.
In his most recent comments on the matter in March of this year, Buffett didn’t appear to be a huge fan of the administration’s tariff strategy. In fact, after the first tariffs were first put on in February but before the controversial “Liberation Day” on April 2, Buffett called tariffs “an act of war, to some degree.” Buffett also acknowledged that the tariffs would act as a tax on all U.S. consumers, saying, “I mean, the tooth fairy doesn’t pay ’em!”
Back in the first Trump administration, Buffett also had negative things to say about tariff protectionism and the prospect of a U.S.-China trade war, noting in 2019 it would probably make all parties worse off:
If we actually have a trade war, it will be bad for the whole world. Everything intersects with the world… a world that adjusts to something very close to free trade. … More people will live better than in a world with significant tariffs and shifting tariffs over time.
These statements are not surprising given Buffett’s longtime full-throated endorsement of American capitalism, as well as free trade helping to lift standards of living globally — especially between the U.S. and its close geopolitical allies.
While Buffett has cautioned against the dangers of tariffs and trade wars, he is also not a fan of the large U.S. trade deficit. In fact, back in 2003, Buffett penned an editorial in Fortune Magazine, revealing that he had, for the first time, allocated a portion of Berkshire Hathaway’s cash holdings into foreign currencies.
Why had Buffett decided to do that? Because he was growingly concerned about the growing U.S. trade deficit and the potential for the dollar’s value to decline. And keep in mind, this was in 2003. Buffett wrote: “My reason for finally putting my money where my mouth has been so long is that our trade deficit has gradually worsened, to the point that our country’s ‘net worth,’ so to speak, is now being transferred abroad at an alarming rate.”
Buffett went on to describe a fictional parable of two island nations: Squanderville, a metaphor for the U.S., and Thriftville, a metaphor for foreign countries.
In the tale, both Squanderville and Thriftville citizens work eight hours a day and generate the same output. However, Thriftville eventually begins working 16 hours a day, doubling its output above what it consumes itself. Squanderville citizens are happy and stop working and buy the excess output of Thriftville in exchange for Squander-bonds, which are claims on the future output of Squanderville.
While Squanderville lives well for some time, eventually, facing ever-increasing debt payments, the government of Squanderville can either get its citizens to begin working again eight hours, plus additional time to service the debt to Thriftville, or devalue Squanderbucks by issuing more notes — essentially inflating away the problem. However, Thriftville citizens, if smart, may instead buy up land and/or other real Squanderville assets instead of bonds, as land would appreciate along with the inflation rate. If that were the case, then Thriftville could end up owning an ever-growing chunk of Squanderville.
Buffett saw Squanderville as 2003 America, which at that time had a trade deficit of 4% of GDP. By that time, Buffett estimated the rest of the world owned about 5% of the U.S. national wealth.
Of course, the problem doesn’t seem as great, and U.S. citizens don’t necessarily feel the loss of ownership, if GDP is growing, as it has over the last two decades. Still, if foreign ownership continues to creep up, it could turn into a serious problem for future generations, Buffett posed.
Some, such as the current administration, might think that the best way to solve the problem is through the use of tariffs. If the Squanderville government made those imports from Thriftville more expensive, it would theoretically incentivize the citizens of Squanderville to produce more things domestically.
However, Buffett believed tariffs were too blunt of an instrument, as they distort the workings of a free market and can have very dangerous geopolitical side effects. Instead, Buffett came up with an alternative idea: “Import Certificates.”
The dynamic goes like this: Any producer in the U.S. that sells goods abroad, boosting U.S. manufacturing and exports, would earn import certificates per unit of goods sold abroad. The exporter would then be able to sell these ICs either to foreign exporters or domestic importers, which would allow an equivalent amount of goods to be imported into the United States. The result would produce an even trade balance. Meanwhile, U.S. exporters would receive extra money from selling ICs, which would sort of act like a subsidy to either boost profits or lower costs.
ICs would trade in a liquid market, and not be allocated or restricted to any specific industry. Basically, any importers or foreign exporters willing to pay the market price would be able to import into the United States. In that way, the government wouldn’t dictate who got to import goods, so the composition of imports and exports would still therefore be determined by the free market, and thus the ICs would likely be purchased by importers with the best comparative advantage in producing a certain good.
Now, Buffett didn’t have any illusions about side effects from his solution. Like tariffs, the concept of ICs would also raise prices for U.S. consumers, just as tariffs do. However, there would also be significant advantages. In the Fortune article, Buffett elaborated:
My remedy may sound gimmicky, and in truth is a tariff called by another name. But this is a tariff that retains most free-market virtues, neither protecting specific industries nor punishing specific countries nor encouraging trade wars. The plan would increase our exports and might well lead to increased overall world trade. And it would balance our books without there being a significant decline in the value of the dollar.
Indeed, the reason there has been so much turmoil in the markets today is investors are now fearing the prospect of an escalating trade war leading to global instability, as well as rising bond rates — perhaps in anticipation of reemerging inflation.
While investors shouldn’t discount the current administration’s diagnosis of the problem — a yawning trade deficit — it’s the prescription, and how the administration is going about implementing it, that is ringing alarm bells.
Buffett’s solution seems like an elegant way to tackle the problem while mitigating its side effects. Perhaps if the administration moves closer to an import certificate scenario, the markets would calm down, and investors would feel better about buying U.S. stocks and bonds again.
In any case, investors should be attuned to the ongoing trade negotiations, and whether they are progressing toward a mutually beneficial solution akin to Buffett’s IC solution, or something more confrontational and dangerous.
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Here’s What Warren Buffett Thinks of Tariffs — and It’s Probably Not What You’d Think was originally published by The Motley Fool