Thriftville and Squanderville: A True Story

Thriftville and Squanderville: Our generation's greatest investor and thinker Warren Buffett came up with these names in an article in Fortune magazine October of 2003. The names depict a scenario in which Warren Buffett foresaw the crisis we are now encountering.

It is an analogy of the U.S. and its trading partners.

More now than ever, Buffett's analogy has the potential of coming to a greater reality.

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.

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.

The current reality is that Sovereign Wealth Funds have been purchasing U.S. assets (though not always to great success, e.g. China with Blackstone (BX), and Citi (C) with Abu Dhabi), the US dollar has fallen dramatically and, worse, lost some of its stature and credibility, there is a housing bust, there is a subprime catastrophe or to state it more accurately, a CREDIT CRISIS, there was the Bear Stearns evaporation, and the tanking markets have dented household wealth. However the biggest issue alluded to by Buffett is the unsustainable trade deficit.

The 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.

China ended its currency peg in mid-2005. The yuan has risen 17% against the dollar and hit an all-time high last week, but the trade deficit with China hasn't budged.

The reality of the trade deficit is that Americans spend too much and save too little.

Is the outcome as inevitable as in Buffett's story?

Unfortunately,.... very possibly Yes!

If the financial crisis in the U.S. continues, and prices fall all over, from real estate to stocks, then a weakening dollar makes the U.S. cheaper and cheaper to foreign investors and warehouses of dollars will acummulate. This is just the catalyst. U.S. assets are unbelievably cheap to foreign investors as it is right now!!!

The U.S. is considered one of the most stable countries in the world and with that one of the most desirable place to own property, companies or stocks. Why would America's trading partners only want U.S. Treasuries?

The garage sale of the U.S. has already begun last year with the Sovereign Funds purchases. It is obvious that foreign investors will continue to see the crisis as a golden opportunity to buy prime pieces of real estate at bargain-basement prices as well as stocks and companies. The U.S. could become one giant liquidation sale, where the buyers are Sovereign Funds, Japanese banks, Chinese state-run investment funds and oil-rich Arab sheikdoms.

I do not see any short term remedy for this situation for America. The reality Americans are in is upsetting and you might not want to believe me, but maybe you'll believe Warren Buffett.

The debt collectors from around the world are knocking at America's doors. The CREDIT CRISIS they are experiencing could possibly end in a massive transfer of wealth from America to the rest of the globe.