Thursday, January 22, 2009

US-China Relations and Economic Strategy

Some highlights from today's New York Times:

"Timothy F. Geithner, who moved closer to confirmation as Treasury secretary on Thursday, told senators that President Obama believed China was 'manipulating' its currency, suggesting a more confrontational stance toward that country than under the Bush administration.

...An administration official said that Mr. Geithner was only repeating what Mr. Obama had said during the campaign, and pointed out that his statement also emphasized that the president intended to use 'all the diplomatic avenues available to him' to address the currency question...

...The Bush administration purposely did not use the term 'currency manipulator' to avoid antagonizing the Chinese, even when it was criticizing China’s trade policies....

...Prices of Treasury debt fell modestly after news of Mr. Geithner's comments, reflecting worry among investors that China might be less willing to buy United States debt if the new administration pushed the country to further revalue its currency."

Unsurprisingly, I think most of us feel that Bush was a pretty subpar president, but his economic treatment of China was actually pretty well run. Before this crisis, China was slowly reducing the level at which they manipulated their currency while still purchasing US treasury bonds at a rapid rate.

This is important because Chinese government decisions about capital allocation (US treasuries vs. not US treasuries) have the potential to significantly raise interest rates and inflation in this country, both of which would be substantial long-term negatives for US economic growth, and thus political strength. China's already buying fewer US bonds than before, which is bad given that our budget deficit is growing. I'm all for trying to get China to appreciate the Yuan, but it seems kind of dangerous to verbally assault them right now until we can start shrinking the budget deficit instead of growing it.

Interestingly, by the way, getting China to appreciate the Yuan is good for businesses who export goods (and their employees and shareholders) and good for people who work in manufacturing domestically, but it's bad for people who need to buy goods as cheaply as possible. In effect, this screws the unemployed, underemployed, and those who work in domestic service positions in the short to medium term, before growth from higher exports kicks in and starts improving the lot of everyone, long term.

In a sense, it's a pretty fiscally conservative step if it works without adverse political effects on Chinese treasury purchases. Although there's a general consensus that Chinese currency is absurdly undervalued (making US goods more expensive in China and Chinese goods cheaper in the US), transferring greater economic short-term hardship onto many low-income families is somewhat unexpected from a Democratic president, even if this policy does help unions.

In the long run, it's not necessarily a bad policy given our trade and budget deficits, because the longer we put that off the worse it'll be for the low-income families when it happens. But that's the case with Social Security (which, ironically, Bush tried to address - in a mediocre way - and failed to get legislative support, and Obama has not indicated any solid proposed policy to fix), Medicare, and the budget deficit/national debt in general. Politicians, ever election-focused, usually look at shorter term results. Just in terms of economic short-term results, and ignoring political rhetoric and stance (especially, but not exclusively, Democratic ties to unionized labor), this aligns more with Republican ideology than Democratic. In long-term results, it should be good for everybody.

This isn't to imply that Obama took a big political risk doing this, because it's not popularly obvious where each party stands on China and how Chinese relations compare to economic ideology (and unions offer lots of political support). But I just thought it was kind of cool, nonetheless.

(I'll try to keep my political views - currently socially liberal, foreign policy moderate, economically moderate to conservative, though I'm in college and have a lot to learn - out of my posts. If they shine through somewhat, I apologize).

Political risk from Chinese and Japanese purchases of US treasuries goes away with a balanced budget, but that's for another day.

Wednesday, January 21, 2009

Executive Compensation

From the Berkshire Hathaway 1991 Annual Letter to Shareholders:

"A distinguishing characteristic of H.H. Brown is one of the most unusual compensation systems I've encountered - but one that warms my heart: A number of key managers are paid an annual salary of $7,800, to which is added a designated percentage of the profits of the company after these are reduced by a charge for capital employed. These managers therefore truly stand in the shoes of owners. In contrast, most managers talk the talk but don't walk the walk, choosing instead to employ compensation systems that are long on carrots but short on sticks (and that almost invariably treat equity capital as if it were cost-free)."

That's the first executive compensation plan I've ever seen that actually makes sense to me. You want good executives to be paid very well, because there's a limited number of good executives out there, and transitioning in new people is expensive. Therefore, you want every good executive's salary to exceed the salary they could get anywhere else. Limiting executive compensation makes no sense.

However, this also leads to inflated salaries for people who aren't great managers, but can give the appearance of being good managers, or for people who are friends with the board of directors, or whatever else. Variations on this system can reward great managers well if you make the baseline just high enough to live on (greater than $7,800, admittedly, but not excessive), percentages paid appropriate and ensure some of it is in the form of equity. The system doesn't reward poor managers, and gives them only enough salary to do a better job next year.

This can be transitioned to lower level managers by treating their division or their shift as its own entity, and providing salary proportional to profits minus capital that they were responsible for, plus a cost-of-living bare minimum. The only problem is convincing managers to take this system and not the golden parachute-laden guaranteed windfalls of other corporations. But if the percentages are good enough, a good manager with confidence may actually take it.

I'm a fan!

Zombie Socialism and Choosing Recipients of Bailouts

I don't necessarily agree with the "American consumers are zombies" bit but the general idea of this article is the right one. (I do agree with the notion that stricter bankruptcy laws are a bad thing... but that's because I prefer minimizing risk aversion in entrepreneurship.)

In this light, it's depressing Detroit got the type of bailout it did. Chrysler isn't viable, GM probably isn't, Ford may not be... so why are we giving them money again?

Incentivizing Green Construction

My friend Brandon had some interesting information. Turns out the ROI for green construction can be quite high:

"It's a week or so old, but I was quickly reading your blog (when I should be working) and was reminded of it by the NASA post:

It's based off of Harvard's Green Campus Loan Fund, which, I don't know if I've told you about it before, but it has been getting an annual return on investment of 30+% a year:
We're talking major retrofits of buildings- for example, installing a green roof can significantly lower both heating and cooling costs. Replacing old boilers for newer, higher efficiency ones can reduce energy consumption. Replacing showerheads for an entire house saves water and heating costs. "


The stimulus plan will fund some of that (via the first link), but certainly not all. So given that, it becomes an interesting question of market design. How do you get people to actually go out and do that on a mass scale in for-profit, as well as non-profit, environments?

There are three major challenges: Firstly, you need to overcome the cost of business interruptions, which will be major for many companies. It will stop others from proceeding for executive compensation or other reasons, even if a profit maximizing firm should proceed.

Secondly, the return can be great but if you don't have the seed capital, it's not going to happen. Oil's in contango right now (meaning a contract for oil in 6 months is more valuable than oil today), and until today, if you'd given me $8 million I could have earned you ~40% on your money in 6 months via arbitrage, plus or minus oil tanker rental fees. I could have bought oil at the $36 it was trading at yesterday and locked in a sale for $51 in six months, if I were willing to rent an oil tanker to store the oil (which requires roughly $8million worth of current oil). But because I don't have $8 million, I can't do it myself. This is a vast oversimplification of how to profit from contango via storage, but I think you get the point.

Finally, while an electricity tax increases incentives to do "green" renovations in a simple manner, the low cost of electricity in this country is a major reason for its progress, so you don't wanna tax it too much, especially given the recession.

Solution: Reclassify building codes to require green construction. If companies don't want to do it themselves, then have public utilities fund the construction in exchange for a bond worth half of the electricity savings. Companies receive low-cost relocation loans so they can work in another building til renovations are complete.

The business interruptions and inertia problem is overcome by a mandate. Business interruptions are expensive for companies, and even more so for the executives who run them. Building codes are the best way around that. You start by reclassifying building codes (All buildings need to have boilers meeting X specifications and roofs meeting Y specifications).

You then still have three problems. One, we're in the middle of a recession and you don't want to interrupt businesses' operations or you'll make it worse. Two, capital's still an issue - we're in the middle of a recession and capital is hard to come by. Three, redeployment of that capital and interruption of your business means you probably have to lay off some workers, even if just temporarily, which is bad for a recession. These things won't be easy outside of a recession, but are brutally difficult in one.

Solution to business interruptions comes in the form of low- or no- cost (inflation adjusted, of course) loans to businesses to rent real estate for the duration of construction. In many cases, that's a few days while a new boiler is put in, with no loan needed. If you need a new roof, it's probably longer, so you loan them money to rent commercial real estate and keep working with a much smaller interruption. That's money that will get paid back into the treasury, so it's pretty low-cost to the public. It also rejuvenates a struggling market for commercial real estate.

A cool way around the capital issue would be to require electric utilities to fund all that construction in return for a ~10 (5, 8, 12, 14, whatever, depending on the actual ROI) year commitment for companies to pay 50% of their energy savings to the utility. If the ROI is really 30-40%, utilities should be perfectly willing to do it, especially if they had access to more low-cost loans (a bank if one will do it, Federal if one won't in this environment) to fund it initially.

Some companies will want to fund green construction themselves and benefit from 100% of the savings immediately, and they can. However, for those who don't want to do it themselves, you're hurting those companies far less with this plan than by just requiring them to find the capital to do it themselves, because you're basically giving them a major energy cost reduction and a low-cost relocation loan just to vacate their facilities for a short period, with no capital required. As with all of my proposals, the actual numbers aren't the important part, and can get worked out - it's the structure.

Make all of those federal loans senior secured and the default rate on them should be quite low, representative of US business prospects in general post-recession (arguably a much better default rate than TARP-related loans, which are mostly tied to subprime mortgage payments and exclude the reliable prime payers). Ideally, a large bank would do the initial funding of the construction, if not the relocation, but because we're in a capital crunch, the Fed may have to do.

Tuesday, January 20, 2009

Tax Cuts vs Government Spending

There's been a lot of debate about the stimulus and its use of tax cuts as opposed to a pure government spending stimulus.

When you want to stimulate the economy, traditional economic canon says that tax cuts are less effective than government spending, especially with bad trends in unemployment or GDP. Most of the models predict that a certain percentage of a tax cut gets saved and not put into economic effect. Government spending all gets put into economic effect, so traditional economic models prefer government spending to tax cuts.

For the United States, however, I don't see how an increased savings rate is a bad thing. Americans have a negative savings rate (meaning, if someone in America makes $100, they'll typically spend it all and borrow a few dollars as well), and this credit crisis is one that has made it much more difficult to borrow. Therefore, it seems unlikely to me that a tax cut will result in a true savings boost. Given Americans' preferred past and present spending habits, you'll likely see one of two outcomes:

1) Americans will use a tax cut to spend the way they would have if credit were available but they didn't receive a tax cut. That means they'll spend all of their tax cut, plus or minus a little bit, depending on credit conditions and overall level of confidence.
2) Americans will save their tax cut, which doesn't mean putting it into a bank for most, it means paying off their debt. A major source of this crisis is bad bank balance sheets. A tax cut therefore lowers the default rate on loans, helping get Americans out of debt while reducing trouble at banks almost as effectively on a dollar for dollar basis as a government bailout of bad assets.

Additionally, there's evidence (put forth by Greg Mankiw in a recent NYT article) that a tax cut may be more effective than government spending without these factors. He claims:

1) Government spending isn't that effective in stimulating GDP.
2) Government spending REALLY isn't effective in utility-economic terms (even if it shows up in GDP) if you don't use it on smart things, which often happens with infrastructure spending.
3) Government spending sets a terrible precedent for future government spending, which is already dangerously high.
4) Via a paper by Christine Romer, tax cuts even with some savings are doubly as effective in stimulating the economy as government spending in normal conditions. I suspect that even increasing that savings rate bc of poor economic conditions may not wipe that effect out, especially given that we save so little anyway.

Given these factors, then, why are we using government spending at all?

This one's a bit simpler. The US has significantly underinvested in its infrastructure since the '70s. Many energy experts are amazed we've had as few transmission problems as we have, and expect major brownouts and blackouts in the next 10 years. Our roads are in trouble, our water infrastructure is in trouble, we don't have enough nuclear scientists to service the projected demand for nuclear power plants. If we're going to grow after this recession, we need to fix these issues.

The typical response against that (espoused by Eugene Fama) is that stimulus transfers employment to public projects from just-as-legitimate-and-employment-heavy private ones ("crowding out"). That is a legitimate concern, but in this particular case, it may be ok as long as the crowding out isn't complete.

Some of the stimulus will transfer engineers and construction workers to public projects, but as long as the government projects only partially replace private ones, not completely (which I get the sense is likely, from reading a few too many oil and infrastructure company 10-Ks), it also leads to training of more engineers and construction workers. In the medium and long run, that training will provide us with more bodies to help us fix our much-larger-than-this-stimulus infrastructure problem, and may help us get off of fossil fuels faster because of less constraints on construction.

Overall, we do need some stimulus in the form of government spending, not just for getting out of this recession, but also for making sure we have the necessary infrastructure and people to sustain growth after it. However, that government spending should have a cap at what can be applied usefully and efficiently. Any stimulus level beyond that should be in the form of highly temporary tax cuts.

Slimming the Budget Deficit & Improving Basic Science Research

Problem: There is a large federal budget deficit and too little spending on basic science research.

Solution: Ironically, one small way to help the federal budget deficit while helping science research is to substantially increase NASA's budget.

Estimates of the Annual Return on Invested Capital (ROIC) over NASA's history range from 30% to 80% (In general, a US company that pulls a 15% return on capital is considered significantly above-average). NASA research directly led to the laser and compact disc, kidney dialysis, CT and MRI scans, types of physical therapy machines, some types of quick-service food preparation equipment, athletic shoes, freeze-dried food, mylar insulation materials, water purification, coatings for protecting metal, cordless power tools and appliances, hazmat/racecar suits, gas sensors, and many other pivotal everyday products.

NASA patents belong to the department of the treasury, so royalty income goes to the US Federal Budget. The US underspends on basic research and has a budget deficit... increasing NASA's budget is one of the better investments the US can make in its own economy.

Monday, January 19, 2009

Social Security and Budget Deficit

Social Security is projected to go into deficit within the next decade. This would be devastating to the US Federal Budget, which already draws a $1 trillion annual deficit.

Solution: Increase the Social Security retirement age and create a better sliding retirement age. Reduce Social Security benefits and reduce the lowest-bracket income tax for seniors over the retirement age.

Current Social Security regulations, according to Wikipedia, are as follows: Those born before 1938 have a normal retirement age of 65. Normal retirement age increases by two months for each ensuing year of birth until the 1943 year of birth, when it stays at age 66 years until the year of birth 1955. Thereafter the normal retirement age increases again by two months for each year ending in the 1960 year of birth, when normal retirement age stops at age 67 for all born thereafter.

These ages were settled upon 30 to 40 years ago. People are healthier for longer. Increasing the baseline 2009 retirement age, and then making it increase by 1-2 months per year (for everybody) ensures that Social Security can remain solvent, while acknowledging trends in lifespans.

An additional method of preserving Social Security would be to reduce benefits slightly, but decrease income tax in the lowest tax bracket for seniors over the social security retirement age. Functionally, then, a senior who works only a few hours a week at a job, no matter how low-paying, would see functionally the same social security payout, before counting income from a few hours of work. This increases economic productivity, reduces boredom by seniors (which has been linked in some studies to senior health problems, another issue) and keeps Social Security solvent.

Prison Overcrowding & Recidivism, and Military Recruitment Rates


1) Prisons in the United States are ridiculously overcrowded (often at 200% of capacity in places like California) and jail sentences increase, not decrease, criminal behavior after release.

2) The military has trouble meeting recruitment goals.

Solution: Eliminate mandatory minimum sentencing and introduce military alternatives to jail sentences.

Mandatory minimum sentences were initially created (and still most widely used, as far as I know) in drug cases. According to, the law that initially introduced mandatory minimum sentencing increased time served for the average drug related offense from 22 months to 66 months. Mathematically, this must lead to more crowded prisons. Meanwhile, in the decade after introduction of the law, the number of drug violations increased 48.2 percent. While this isn't conclusive evidence that mandatory minimum sentencing doesn't work as a deterrent, it is suggestive. This increases prison crowding without reducing crime.

Meanwhile (also, in 2000, the federal government spent $1,910 per inmate per month to keep them in prison. This cost has only gone up since then.

To make things worse, prison doesn't seem to rehabilitate prisoners into society. According to BBC Radio 4 (via the wikipedia article on recidivism), the US recidivism rate in 2005 was ~60%. If the goal is to take criminals and make them productive members of society instead of drains on society, prison may not always be the answer.

I propose an alternate solution: for non-violent criminals, the choice to enroll in the military may be a good option. If somebody is caught in possession of drugs, committing white collar crimes, or perhaps even distributing drugs, and he or she is in the proper physical condition, a 2-year military sentence may instill a sense of discipline and purpose while providing usable skills. The military has trouble meeting recruitment goals as it is, so this may provide a source of troops who can pay their debt to society while rehabilitating themselves. This would not have to be mandatory (that would amount to conscription), but it could be an option that many would take, especially if choosing it led to fewer consequences of record.

Former felons in the military right now actually win more distinguished service medals and get through boot camp at a higher rate than non-former felons. Meanwhile, the rate of disciplinary incidents is only marginally higher, and AWOL rates are at historic lows even as former-felon waivers increase. (This was in the news recently... can anyone send me a link?)

Of course, in the case of certain violent crimes, prison is the only answer, and the military may not be appropriate for criminals who are too young or old, out of shape, etc. But for other crimes (Drug possession, some white collar crimes, etc), there should be alternatives to unproductive prison.


Simple Ones: Ethanol, Stadium subsidies, Schoolteachers

These are all pretty simple, so I won't go into great detail.

Problem: Corn ethanol is highly inefficient.

Stop subsidizing it. Instead, subsidize research into switchgrass/cellulose ethanol, which can be much more economically and carbon efficient.

Problem: Subsidies of sports stadiums don't provide economic return of the magnitude of the subsidies to cities and are highly inefficient.

Solution: Make them illegal or subject to some sort of national (i.e. not that-local-sports-team-oriented and not-dependent-on-that-locale-for-elections) oversight board

Problem: We don't have enough good public schoolteachers.

Solution: An ROTC-style program where people take education classes outside of college, and then enroll as a public schoolteacher for 3-5 years (you can make it "in neighbourhoods whose need is large, defined by some permutation of graduation rates") in exchange for a tuition grant equivalent to the amount of tuition at a typical in-state public school (or more, if that's efficient).

The exact numbers of years and magnitude of tuition-waivers at which this is efficient can be figured out pretty easily with data, but the structure can make sense.

Killing Negative Externalities and Improving Bank Balance Sheets

1) ~20% of Americans smoke. Smoking is horrible for your health. This devastates Medicare (who we all pay for and who has to pay for smoking-related health issues), jobs where smokers work, smokers themselves and smokers' families. All around, a no-win.

2) Trans-fats cause heart disease and stroke, the number 1 and 3 (I believe) killers of Americans. See problem 1.

3) We are addicted to foreign fossil fuels, leaving us with no energy security and producing enough carbon to cause global warming whose effects we can't predict well but we can be pretty certain are negative.

4) We're in the middle of one of the worst economic crises since the Great Depression.

Levy taxes on:
CO2 emissions,
roads (tolls),
incandescent (non-CFL) lightbulbs,
water bottles,
single-pane windows,
cigarettes/smokeless tobacco

As an offset, we reduce income taxes across the board.

Additionally, subsidize:
water filters (to replace water bottles),
compact fluorescent lightbulbs,
double+ pane windows
electricity derived from wind, solar, tidal, geothermal or (arguably) natural gas sources.

We want people to smoke less, eat less trans fats and generate less carbon. We also want people to have more money in their pocket. Tax producers of cigarettes and packs of cigarettes, tax corporations for trans-fats in their foods, tax consumers for anything carbon-emission heavy, and then give money back in the form of income taxes and subsidies on alternatives. No overall economic income effect, large substitution effect away from products with big negative externalities.

Taxing these goods and giving people more of their income may increase savings rates. While traditionally, that's bad for recessions because savings don't stimulate an economy, in this particular case, banks are having balance sheet trouble, which seems to be prolonging the recession by creating credit trouble. Savings are therefore not a bad thing and could do a lot to stabilize the economy.

I'm sure people are wondering about the water bottles, windows and the light bulbs. Water bottles consume MUCH more energy than water filters on taps, non-CFLs consume much more energy than CFLs, and double-pane windows are much more energy efficient than single-pane windows. There's not much impact on most people by making these substitutions, so it makes them easy to implement.

The Trade Deficit

Problem: We have a massive trade deficit, which means we are bleeding wealth. This results in an increased national debt and decreased political power and economic well-being.

Solution: Issuing Import Certificates (ICs) to all U.S. exporters in an amount equal to the dollar value of their exports. Each exporter would, in turn, sell the ICs to parties--either exporters abroad or importers here--wanting to get goods into the U.S.

Credit for this one goes to Warren Buffett. I have copy-pasted details of his solution here. Traditional economists won't like it, because it necessarily results in more expensive foreign goods for Americans, but ultimately, we're going to be worse off anyway, and this is a pretty benign way to accomplish balance. The article is from 2003, so all numbers are outdated:

"...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.

So what does all this island hopping have to do with the U.S.? Simply put, after World War II and up until the early 1970s we operated in the industrious Thriftville style, regularly selling more abroad than we purchased. We concurrently invested our surplus abroad, with the result that our net investment--that is, our holdings of foreign assets less foreign holdings of U.S. assets--increased (under methodology, since revised, that the government was then using) from $37 billion in 1950 to $68 billion in 1970. In those days, to sum up, our country's "net worth," viewed in totality, consisted of all the wealth within our borders plus a modest portion of the wealth in the rest of the world.

Additionally, because the U.S. was in a net ownership position with respect to the rest of the world, we realized net investment income that, piled on top of our trade surplus, became a second source of investable funds. Our fiscal situation was thus similar to that of an individual who was both saving some of his salary and reinvesting the dividends from his existing nest egg.

In the late 1970s the trade situation reversed, producing deficits that initially ran about 1% of GDP. That was hardly serious, particularly because net investment income remained positive. Indeed, with the power of compound interest working for us, our net ownership balance hit its high in 1980 at $360 billion.

Since then, however, it's been all downhill, with the pace of decline rapidly accelerating in the past five years. Our annual trade deficit now exceeds 4% of GDP. Equally ominous, the rest of the world owns a staggering $2.5 trillion more of the U.S. than we own of other countries. Some of this $2.5 trillion is invested in claim checks--U.S. bonds, both governmental and private--and some in such assets as property and equity securities.

In effect, our country has been behaving like an extraordinarily rich family that possesses an immense farm. In order to consume 4% more than we produce--that's the trade deficit--we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.

To put the $2.5 trillion of net foreign ownership in perspective, contrast it with the $12 trillion value of publicly owned U.S. stocks or the equal amount of U.S. residential real estate or what I would estimate as a grand total of $50 trillion in national wealth. Those comparisons show that what's already been transferred abroad is meaningful--in the area, for example, of 5% of our national wealth.

More important, however, is that foreign ownership of our assets will grow at about $500 billion per year at the present trade-deficit level, which means that the deficit will be adding about one percentage point annually to foreigners' net ownership of our national wealth. As that ownership grows, so will the annual net investment income flowing out of this country. That will leave us paying ever-increasing dividends and interest to the world rather than being a net receiver of them, as in the past. We have entered the world of negative compounding--goodbye pleasure, hello pain.

We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits. At a point, so it was claimed, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders. And that's the way it has indeed worked for the rest of the world, as we can see by the abrupt shutoffs of credit that many profligate nations have suffered in recent decades.

The U.S., however, enjoys special status. In effect, we can behave today as we wish because our past financial behavior was so exemplary--and because we are so rich. Neither our capacity nor our intention to pay is questioned, and we continue to have a mountain of desirable assets to trade for consumables. In other words, our national credit card allows us to charge truly breathtaking amounts. But that card's credit line is not limitless.

The time to halt this trading of assets for consumables is now, and I have a plan to suggest for getting it done. My remedy may sound gimmicky, and in truth it 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. This 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, which I believe is otherwise almost certain to occur.

We would achieve this balance by issuing what I will call Import Certificates (ICs) to all U.S. exporters in an amount equal to the dollar value of their exports. Each exporter would, in turn, sell the ICs to parties--either exporters abroad or importers here--wanting to get goods into the U.S. To import $1 million of goods, for example, an importer would need ICs that were the byproduct of $1 million of exports. The inevitable result: trade balance.

Because our exports total about $80 billion a month, ICs would be issued in huge, equivalent quantities--that is, 80 billion certificates a month--and would surely trade in an exceptionally liquid market. Competition would then determine who among those parties wanting to sell to us would buy the certificates and how much they would pay. (I visualize that the certificates would be issued with a short life, possibly of six months, so that speculators would be discouraged from accumulating them.)

For illustrative purposes, let's postulate that each IC would sell for 10 cents--that is, 10 cents per dollar of exports behind them. Other things being equal, this amount would mean a U.S. producer could realize 10% more by selling his goods in the export market than by selling them domestically, with the extra 10% coming from his sales of ICs.

In my opinion, many exporters would view this as a reduction in cost, one that would let them cut the prices of their products in international markets. Commodity-type products would particularly encourage this kind of behavior. If aluminum, for example, was selling for 66 cents per pound domestically and ICs were worth 10%, domestic aluminum producers could sell for about 60 cents per pound (plus transportation costs) in foreign markets and still earn normal margins. In this scenario, the output of the U.S. would become significantly more competitive and exports would expand. Along the way, the number of jobs would grow.

Foreigners selling to us, of course, would face tougher economics. But that's a problem they're up against no matter what trade "solution" is adopted--and make no mistake, a solution must come. (As Herb Stein said, "If something cannot go on forever, it will stop.") In one way the IC approach would give countries selling to us great flexibility, since the plan does not penalize any specific industry or product. In the end, the free market would determine what would be sold in the U.S. and who would sell it. The ICs would determine only the aggregate dollar volume of what was sold.

To see what would happen to imports, let's look at a car now entering the U.S. at a cost to the importer of $20,000. Under the new plan and the assumption that ICs sell for 10%, the importer's cost would rise to $22,000. If demand for the car was exceptionally strong, the importer might manage to pass all of this on to the American consumer. In the usual case, however, competitive forces would take hold, requiring the foreign manufacturer to absorb some, if not all, of the $2,000 IC cost.

There is no free lunch in the IC plan: It would have certain serious negative consequences for U.S. citizens. Prices of most imported products would increase, and so would the prices of certain competitive products manufactured domestically. The cost of the ICs, either in whole or in part, would therefore typically act as a tax on consumers.

That is a serious drawback. But there would be drawbacks also to the dollar continuing to lose value or to our increasing tariffs on specific products or instituting quotas on them--courses of action that in my opinion offer a smaller chance of success. Above all, the pain of higher prices on goods imported today dims beside the pain we will eventually suffer if we drift along and trade away ever larger portions of our country's net worth.

I believe that ICs would produce, rather promptly, a U.S. trade equilibrium well above present export levels but below present import levels. The certificates would moderately aid all our industries in world competition, even as the free market determined which of them ultimately met the test of "comparative advantage."

This plan would not be copied by nations that are net exporters, because their ICs would be valueless. Would major exporting countries retaliate in other ways? Would this start another Smoot-Hawley tariff war? Hardly. At the time of Smoot-Hawley we ran an unreasonable trade surplus that we wished to maintain. We now run a damaging deficit that the whole world knows we must correct.

For decades the world has struggled with a shifting maze of punitive tariffs, export subsidies, quotas, dollar-locked currencies, and the like. Many of these import-inhibiting and export-encouraging devices have long been employed by major exporting countries trying to amass ever larger surpluses--yet significant trade wars have not erupted. Surely one will not be precipitated by a proposal that simply aims at balancing the books of the world's largest trade debtor. Major exporting countries have behaved quite rationally in the past and they will continue to do so--though, as always, it may be in their interest to attempt to convince us that they will behave otherwise.

The likely outcome of an IC plan is that the exporting nations--after some initial posturing--will turn their ingenuity to encouraging imports from us. Take the position of China, which today sells us about $140 billion of goods and services annually while purchasing only $25 billion. Were ICs to exist, one course for China would be simply to fill the gap by buying 115 billion certificates annually. But it could alternatively reduce its need for ICs by cutting its exports to the U.S. or by increasing its purchases from us. This last choice would probably be the most palatable for China, and we should wish it to be so.

If our exports were to increase and the supply of ICs were therefore to be enlarged, their market price would be driven down. Indeed, if our exports expanded sufficiently, ICs would be rendered valueless and the entire plan made moot. Presented with the power to make this happen, important exporting countries might quickly eliminate the mechanisms they now use to inhibit exports from us.

Were we to install an IC plan, we might opt for some transition years in which we deliberately ran a relatively small deficit, a step that would enable the world to adjust as we gradually got where we need to be. Carrying this plan out, our government could either auction "bonus" ICs every month or simply give them, say, to less-developed countries needing to increase their exports. The latter course would deliver a form of foreign aid likely to be particularly effective and appreciated.

I will close by reminding you again that I cried wolf once before. In general, the batting average of doomsayers in the U.S. is terrible. Our country has consistently made fools of those who were skeptical about either our economic potential or our resiliency. Many pessimistic seers simply underestimated the dynamism that has allowed us to overcome problems that once seemed ominous. We still have a truly remarkable country and economy.

But I believe that in the trade deficit we also have a problem that is going to test all of our abilities to find a solution. A gently declining dollar will not provide the answer. True, it would reduce our trade deficit to a degree, but not by enough to halt the outflow of our country's net worth and the resulting growth in our investment-income deficit.

Perhaps there are other solutions that make more sense than mine. However, wishful thinking--and its usual companion, thumb sucking--is not among them. From what I now see, action to halt the rapid outflow of our national wealth is called for, and ICs seem the least painful and most certain way to get the job done. Just keep remembering that this is not a small problem: For example, at the rate at which the rest of the world is now making net investments in the U.S., it could annually buy and sock away nearly 4% of our publicly traded stocks.

In evaluating business options at Berkshire, my partner, Charles Munger, suggests that we pay close attention to his jocular wish: "All I want to know is where I'm going to die, so I'll never go there." Framers of our trade policy should heed this caution--and steer clear of Squanderville."

For Warren Buffett's original description of the solution plan:

Gazan Food and Medical Aid

Problem: Gazan civilians are starving and need medical aid, but Hamas can smuggle weapons and seize (and take credit for or use) aid, so Israel and Egypt need to keep the borders closed.

Solution: Keep borders closed, search everything going in, but allow in Israeli-branded food and medical aid...with bombs strapped to the bottoms of the trucks that can be detonated if food or medicine is seized.

As mentioned before, reducing the violence in the long term requires undermining popular support of Hamas, who gain power every time a Gazan civilian dies by Israeli bombing.

If instead of starving people, you sent them medicine and food branded "Given to the people of Gaza by the people of Israel in their struggle against their Hamas terrorist leaders" or something of the like... and create a remote detonation system such that if the food and medical aid are given to the people, the people get food and medicine and are saved, but if Hamas touches the trucks, the trucks blow up, you:

a) get food and medicine to starving people in a manner Israel, not Hamas, gets credit for
b) make it quite clear to people that playing ball with Israel means food and medicine, and playing ball with Hamas means no food and medicine and more bloodshed.

This would not eliminate civilian casualties from starvation, etc, because Hamas would undoubtedly adapt their tactics (bring civilians on truck raids where you have to blow up the trucks anyway, etc), but it would probably reduce them, while also undermining Hamas' support.

Hezbollah and Hamas Terrorism

Problem: Lebanon and Gaza shoot rockets and send suicide bombers into Israel, requiring Israel to respond by militarily fighting terrorists who hide among their populace, resulting in civilian casualties.

Solution: Create a tariff/subsidy system on specifically chosen Lebanese/Gazan goods whose amount determined by the number of terrorist attacks on Israel within a given period.

As my friend Kyle points out often, the leadership of a country doesn't always represent the populace of a country. Therefore, the goal of a military operation against a terrorist leadership should be to weaken the government, both directly, and by aligning popular support against the government and in favor of peace.

Bombing Lebanon, however, galvanizes Lebanese support behind Hezbollah, because the US/Israel bombs the populace and Hezbollah gives the populace food and infrastructure.

One partial solution is to target goods whose producers are particularly important to Hezbollah's popular support, and create a tariff or subsidy directly related to the number of terrorist attacks.

For example (all numbers and goods arbitrary), if the producers of wheat are absolutely necessary for Hezbollah to stay in power, then enact a subsidy of 10 - (X/2) cents per bushel of Lebanese wheat, where X is equal to the number of rockets fired into Israel in the last year+the number of casualties of terrorist acts originating in Lebanon in the last year.

If no rockets are fired and nobody dies in Israel as a result of terrorism, Lebanese wheat gets a 10 cent subsidy, and Lebanese wheat producers do really well. If 20 rockets are fired, they have to compete on equal ground with everyone in the rest of the world. If 40 rockets are fired, Lebanon faces a 10 cent per bushel tariff on their wheat, which cripples their economy until a year has passed.

Hezbollah needs to maintain power, so they need to cater to the wheat producers, who are pivotal to their support. They stop firing rockets. By necessity, this diverts funds towards peaceful reconstruction. As they build more, they have more to lose, so this policy strengthens in deterrence over time.

You can simultaneously do this to goods whose production involves the people who are currently building/firing rockets. If people who fire rockets are the type of people who mine coal, then enacting this type of structure with coal means that Lebanese coal mines do better with no rockets, so there's a greater demand for laborers, so coal mines pay better and hire more, diverting people from rocket making to coal mining.

I don't know what goods Lebanon exports, but this sort of structure could become quite powerful if they have good ones. All numbers entirely arbitrary (if you want it to be just a penalty, you could start at no subsidy and increase the tariff. Just a reward doesn't work for the power base tariffs, because there's no more incentive once you hit 0, but it does work for the substitute-jobs subsidies, because you dont want to create disincentives for terrorists to switch jobs)

Incentivizing R+D by corporations

Problem: Incentivizing R+D by corporations.

Problem detail: One of the major scientific challenges for the United States is a reduction in the level of basic research by corporations. Universities can't do it all themselves, and companies have cut basic research in the interest of improving their bottom line.

My solution: Instead of expensing R+D on GAAP (accounting) financial statements, capitalize it.

Capital expenditures, like renovating buildings or buying machinery, are not listed as "expenses" but instead get capitalized, which means they are added to a corporation's investment base, and get subtracted from the representation of a company's profits as they decrease in value (Depreciation and Amortization, instead of Sales, General and Administrative expenses). Capitalizing R+D means that current R+D doesn't directly affect current earnings, and the R+D you spend now gets amortized over a period of time where (presumably, because of inflation) overall earnings are higher. This reduces executive incentives to cut current basic research to juice a company's short term bottom line for investors. US scientific strength is pivotal to its economic and social strength, so we want corporations to discover things!

This also further incentivizes executives to focus on R+D efficiency because capitalizing R+D means it shows up on balance sheets, which means it shows up in commonly used investment metrics like Return on Equity, Return on Assets and Return on Invested Capital.