Earlier this week, the US government, under the Trump administration, announced a Reciprocal Tariff policy. The policy imposes a minimum tariff of 10% on all of the US’s trading partners, with higher rates – some significantly so – for many countries. For example, China’s rate is 34%, Taiwan’s is 32%, India’s is 27%, and the European Union’s is 20%. Officially, the reciprocal tariff rates are half of what the Trump administration says are “tariffs charged to the U.S.A, including currency manipulation and trade barriers.” In reality, the formula used was laughably simple and has nothing to do with trade barriers or tariffs charged to the US:
A country’s reciprocal tariff rate = (US’s trade deficit with the country) divided by (US’s imports from the country) divided by (2)
If the formula spits out a lower number, a reciprocal tariff rate of 10% was applied.
The sweeping tariffs have created widespread fear in the financial markets. So this is an appropriate time to revisit Warren Buffett‘s November 2003 article titled “America’s Growing Trade Deficit Is Selling the Nation Out From Under Us. Here’s a Way to Fix the Problem—And We Need to Do It Now” where he laid out his thoughts on tariffs. From this point on, all content in italics are direct quotes from Buffett’s article.
The danger of sustained trade deficits
The first part of the article discusses the reasons why Buffett even thought about tariffs: He saw risks in the American economy from sustained trade deficits. To illustrate his point, he used a hypothetical example of two islands – Thriftville and Squanderville – that only trade among themselves.
At the beginning, the populations of both Thriftville and Squanderville worked eight hours a day to produce enough food for their own sustenance. After some time, the population of Thriftville decided to work 16 hours a day, which left them with surplus food to export to Squanderville. The population of Squanderville are delighted – they could now exchange Squanderbonds (denominated in Squanderbucks) for Thriftville’s surplus food. But this exchange, when carried out for a long time, becomes a massive problem for Squanderville. Buffett explained:
“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.”
To ground the hypothetical example in reality, Buffett then discussed the US’s actual trade deficits back then and their economic costs:
“Our annual trade deficit now exceeds 4% of GDP. Equally ominous, the rest of the world owns a staggering [US]$2.5 trillion more of the U.S. than we own of other countries. Some of this [US]$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 [US]$2.5 trillion of net foreign ownership in perspective, contrast it with the [US]$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 [US]$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 [US]$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.”
The solution to sustained trade deficits
In the next part of his article, Buffett shared the solution he has for the US’s problem with trade deficits: Import Certificates, or ICs. Each exporter in the US will be issued ICs in an amount equal to the value of its exports, meaning $100 of exports will come with 100 ICs. Each importer in the US will then need to buy ICs when importing products into the US – to import $100 worth of products, an importer will need to purchase ICs that were issued with $100 of exports.
Buffett thought that the ICs would (1) have an “exceptionally liquid market” given the volume of the US’s exports, (2) likely trade for $0.10 per dollar of exports, and (3) be viewed by US exporters as a reduction in cost, in this case, of 10%, given the likely trading price of the ICs. The reduction in cost from the ICs would allow US exporters to sell their products internationally at a lower cost while maintaining profit margins, leading to US exports becoming more competitive.
But there are costs that the American society has to pay for the IC plan. Buffett explained:
“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.”
Those costs, however, are necessary when compared to the alternatives, as Buffett illustrated:
“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.”
Tariff in nature, ICs in name
So now we understand Buffett’s view with the US’s sustained trade deficits and his solution for the problem. But where do tariffs come into play? Buffett actually recognised that his IC solution “is a tariff called by another name.” In other words, Buffett thought that a good solution for the US’s trade deficits is to implement a tariff, which he named ICs. But crucially, the IC plan “does not penalize any specific industry or product” and “the free market would determine what would be sold in the U.S. and who would sell it.”
Buffett also discussed the implications of ICs on global trade and geopolitics in his article. In short, he thought the risks were minor and manageable, that foreign manufacturers would absorb the extra costs from the ICs, and that the eventual outcome would be the US exporting more products around the world:
“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…
……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…
…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…
…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.”
Buffett also pointed out that in his IC plan, the value of ICs is designed to approach zero if the plan works, since if the volume of US exports grows significantly, the volume of ICs in existence would also grow proportionally, driving down their price.
An unknown future
It’s clear that Buffett thought intelligently-designed tariffs are a good solution for the US’s trade deficit problem. The US is still running a trade deficit today (interestingly, the trade deficit in 2024 was 3.1% of the US’s GDP, which is a lower percentage than when Buffett published his article on his IC plan) and this dynamic is a driving force behind the Trump administration’s Reciprocal Tariff policy. Unfortunately, the policy is poorly designed, as evidenced by how haphazardly the calculations were made. Moreover, the policy comes in the form of increased tariffs (according to investment bank Evercore, the Reciprocal Tariff policy “pushes the overall U.S. weighted average tariff rate to 24%, the highest in over 100 years”), which Buffett pointed out in his article had a low chance of success. So although some form of well-designed tariffs may be a good idea for the US economy – following Buffett’s logic** – the way they are currently implemented by the Trump administration is questionable at best.
All these said, anyone who thinks they have a firm idea on what would happen to the US economy because of the Reciprocal Tariff policy is likely lying (to others and/or to themselves). These things have second and third-order consequences that could be surprising. And as the late Charlie Munger once said, “If you’re not a little confused about what’s going on, you don’t understand it.”
** It’s worth noting that even Buffett’s logic that sustained trade deficits have negative consequences may not be correct. In Buffett’s article, he noted that he had been worried about the US’s trade deficits since 1987 and had been wrong from then up to the point the article was published. It has been more than 20 years since the article’s publication, and the US’s GDP has grown to be around 2.5 times larger today. So sustained trade deficits may not even be a bad thing for the US economy.
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