Hypothetical scenario: Walmart orders $20 of a hot new toy from a company in Japan. That company goes to the central bank in Japan and exchanges its dollars for yen. The Japanese government doesn’t want its currency to appreciate vs. the dollar, so it prints new yen out of thin air and reinvests the U.S. dollars in dollar denominated assets (preferably government securities). This is why the financial and capital accounts have surpluses (nearly) commensurate to the trade deficit.

There you have it: the U.S. has a huge trade deficit and the inflow of those trade deficit dollars boomerang back into the American economy. Of course, you see that this causes a deluge of liquidity in both the United States and Japan (ultimately globally). It is keeping asset prices everywhere at artificial highs.

Unfortunately, this is also why Warren Buffet is wrong. Countries with trade surpluses will relentlessly debase their own currencies to maintain their trade advantage. This will continue until we have a worldwide currency meltdown.

I’m still not sure how to hedge against this (other than the usual precious metals platitudes). If you have any ideas, let me know.

Here’s where I have my hang-up: Despite the fact that the U.S. has strung together a multi-trillion dollar trade imbalance, if you look at the NIPA accounts in the GDP report, something odd pops out. In 3Q06, the income receipts from the rest of the world are reported as $682.3 billion and the income payments to the rest of the world were $665.7. Here’s the GDP link (see rows 2 & 3): http://bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=43&FirstYear=2005&LastYear=2006&Freq=Qtr. Another way of saying this is that the return on U.S investments overseas exceeded the return on foreign investments in the U.S. With a multi-trillion dollar trade imbalance this should not happen. The third quarter results are no fluke. U.S. investments have consistently outreturned foreign investments by about $50 billion/year since the 1980’s despite the growing trade imbalance. There are only two explanations for this discrepancy:

1) American investors get a better return on foreign investments than foreign investors get in the U.S. While this is quite likely, it would not explain the consistency in the U.S return (~$50 billion/year) while the accumulated trade deficit was soaring. For this to be the case, not only would U.S investors be getting a better return, but the spread in return would have had to be increasing year after year.

2) The more likely scenario is that the trade deficit figure is wrong. Let me state with absolute certainty that the trade deficit number is wrong; the only question is how much it is off. There are a number of weak spots in the trade deficit figure. The two biggest are transfer pricing and capital gains.

The biggest problem is transfer pricing. If a multinational company has plants in say Korea and the U.S. and they are going to move product both ways, it is in their best interest to maximize the transfer price of materials shipped from Korea to the U.S. and minimize the price of materials shipped from the U.S. to Korea. Why? Corporate tax rates are higher in the U.S. than Korea so it is in the company’s best interest to pay Korean rather than U.S. taxes. The U.S. has the second highest corporate tax rates in the industrialized world. As a result, imports are overstated and exports are understated.

The trade deficit ignores capital gains. A personal example is that I purchase stock in Rostelecom (ROS) shortly after the U.S. IPO and sold it in January of this year. I made a healthy profit because a French company was buying a large stake in ROS. From a big picture, I bought from the Russians and sold to the French and made a profit. From a trade deficit picture, this profit does not contribute to improving the trade deficit even though I transferred foreign cash to the U.S.

One other counterpoint to Buffet’s analysis is his statement about the historical trade imbalance for the U.S. He says that we have a long history of running surpluses. This is not correct. While we were the largest creditor nation for some time, in the 400 year history of our country, we have only run trade surpluses about 50 of those years.

Finally, Buffet used the example of two islands to make his point. I’ll use the example of an island that for years has run a trade deficit. Practically all of their food is imported. They have no manufacturing base to speak of. They import labor to do most of their work. Year after year they survive on imported capital. By Buffet’s analysis, they should have gone belly up long ago, yet the island continues to thrive. The name of the island is Manhattan.