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Thriftville & Squanderville -- A True Story

Thriftville and Squanderville: Our generation's greatest investor and big picture thinker--Warren Buffett--came up with these names in an article in Fortune magazine published in October of 2003.  As our politics deteriorate and our nation becomes increasingly fixated on culture wars--few seem to notice the huge asteroid (figuratively speaking) that is heading our way.

This asteroid may not be quite existential, but it may bring to humanity almost unimaginable consequences, though perhaps not as dire as those that faced by the dinosaurs. Like our predecessors, it may catch many if not most of us unaware. 

The asteroid I’m speaking of is our national debt, which is now spiraling uncontrollably upward--after a poorly timed tax cut--and amid the rapidly rising interest cost of servicing our massive debts. It is giving the US economy a temporary sugar high, even as the rest of the world begins to slow.

We narrowing escaped a smaller asteroid in 2008, thanks to extraordinary measures taken by central banks around the world.  Few saw that coming at the time and even fewer are prepared for the fact that may be coming again.   

More now than ever, Buffett's warning has the potential of becoming a greater reality quite soon.  Below is an excerpt from Buffett's 2003 piece:

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. They want quick and painless solutions to make Squanderville great again.

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 Squanderville companies. 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 and companies 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 welch 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. Worse yet, they might even give themselves a tax cut!  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 and companies 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.

The biggest issue alluded to by Buffett is the unsustainable trade deficit.  We (the US) have been getting too good of a deal for too long. Not the other way around!  Other countries have given us increasing supplies of valuable goods in exchange for more and more squanderbucks and squanderbonds of dubious value.

This deficit has created warehouses stuffed of dollars and dollar-based debt at America's most important trading partners. The dollar reserves are especially large in Asia, where export-oriented countries like China and Japan have run large trade surpluses with the U.S.

Demanding that their people buy more goods from us is a little like pushing water up hill.  You can’t force Thriftville residents to buy expensive Squanderville products when other nations produce them more cheaply.

The solution is not threats of tariffs on foreign produced goods. Even elimination of all tariffs on US goods has minimal effect.  We just have very little to export at the right price points to the thriftier nations of the world.  To the contrary, we ourselves are a consumer nation addicted to low priced goods and services offered by others who can typically build better, faster and cheaper than can the aging supply of American workers.  Immigration of low wage labor has kept us competitive in some industries like agriculture, but it is unlikely that we’ll be able to add enough immigrants fast enough to keep our goods and services competitive over time.  We desperately need more low-cost immigrant labor to compete, but that seems unlikely in the current political environment. 

The real problem: The reality of the trade deficit is that Americans spend too much and save too little.  We’ve been doing that for a long time, having accumulated massive debt and fully stuffed closets and garages which serve as circumstantial evidence. 

Threatening tariffs to beat up on our lenders and toughening immigration policies that discourage low wage workers from coming here only make our problem worse. The baby boom generation of Americans have become fat and happy thanks to our addiction to low cost foreign goods. Today, virtually everything sold in WalMart comes from overseas. Even without new tariffs, inflation is likely inevitable. Add a 20% tariff on top of the already rising prices, and it can ignite an upward spiral in prices last experienced during the stagflationary period of the 1980’s.  Tariffs are nothing more than a tax on the American people. When you’re addicted to cheap goods and up to your eyeballs in debt, adding tariffs is akin to pouring gasoline on a fire. 

The U.S. is still considered one of the most stable countries in the world and one of the most desirable place to own real assets such as real estate and businesses. Why would our trading partners only want U.S. Treasuries (squanderbonds), especially as we become more hostile to our lenders. Selling assets to foreigners offers at least a possible way out.

For the past fifty years, our trading partners around the world have been trading things of real value (goods and services provided with scarce materials and human labor) for pieces of green paper with no intrinsic value.  It is we, not they, who have been the greatest beneficiaries of this Faustian bargain. This has been a great boon to the current generation of Americans as they have enjoyed a lifestyle well beyond their means. But the clock is ticking as we head to a tipping point when the next generation must pay the bill. Tariffs and reductions in immigration are more likely to accelerate that process than delay it further. Pouring gasoline on a fire is not a reasonable solution. 

I do not see any short-term remedy for this situation for America. The reality we are in is upsetting and you might not want to believe me, but maybe you'll believe Warren Buffett. As the baby boom ages, and immigration declines, the gross domestic product of the US (by definition) must slide.  Simply put, GDP is the # of workers x productivity of workers. As the baby boom leaves the workforce, GDP will decline unless the workers are replaced by new immigrants.  This is Japan’s problem since their culture discourages immigration altogether.  In short, we need massive new immigration just to prevent a decline in economic activity.

Will current efforts to restrict immigration and threats of tariffs against our bankers push us to a tipping point?  Nobody knows when or how that will occur. When does the last grain of sand cause the pile to collapse?

The risks are high.  Investors would be wise to diversify into real assets with intrinsic value (real estate, infrastructure, farmland, water, timber, energy and inflation-protected bonds).  CMMS clients are already there, but some may wish to add to their holdings of real assets for even greater protection over the coming months and years.

All of us should cut our spending and increase savings to prepare for a long period of perpetual rain.  A storm is coming that few seem to notice, so there is still time to make adjustments and better prepare.

Eventually our debt collectors from around the world will be knocking at our doors. Rising interest rates on an already massive and growing debt (national, corporate and household), combined with increasingly hostile policies and angry rhetoric, make me very nervous.

Where is the tipping point, or the point of no return?  That’s the $71 trillion dollar question.  http://www.usdebtclock.org/

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