Warren Buffett: Inflation on the horizon

OMAHA, Neb. (Fortune) -- Berkshire Hathaway chief Warren Buffett defended the government's handling of the economic crisis, but warned that the purchasing power of the dollar may fall as policymakers stretch to finance expensive rescue plans.

Reflecting on the near implosion of the financial system last fall, Buffett said officials should be judged more leniently when facing "as close to a total meltdown as you can imagine."

But he warned that efforts such as the Treasury's $700 billion Troubled Asset Relief Program and the $787 billion fiscal stimulus plan passed this year by Congress will have to be paid for, one way or another.

And with political leaders showing little inclination to raise taxes, one sure way to pay for excess spending is to inflate the value of the currency, Buffett said. The biggest losers in a surge of inflation, he added, would include holders of bonds and other fixed-income assets.

"I haven't had my taxes raised," said Buffett, who has run Berkshire for more than four decades. "My guess is the ultimate price will be paid by a shrinkage of the value of the dollar."

The billionaire investor made the comments Saturday morning at the annual meeting of Berkshire Hathaway (BRKA, Fortune 500) shareholders.

Buffett and Berkshire Vice Chairman Charlie Munger addressed investors on subjects ranging from the company's executive succession plans to Berkshire's derivatives portfolio and the strength of Buffett's biggest financial sector holding, Wells Fargo (WFC, Fortune 500).

Much of the discussion centered on who will take Buffett's place one day. Buffett, 78, hasn't set any plans to step aside but has noted that the Berkshire board spends considerable time planning for his eventual departure.

Buffett affirmed in response to a shareholder question that all three executives who have been identified by the board as candidates to succeed him as CEO are working at Berkshire now. Buffett said as much in the letter to shareholders Berkshire issued in February, declining to identify the candidates.

Buffett shrugged off a question asking whether the next CEO should spend more time at his side. All three CEO candidates are "ready for the job right now," he said. Each is running a big business within Berkshire, which owns numerous insurance, utility and retail companies.

Buffett also said the company's reinsurance chief, Ajit Jain, would be "impossible to replace" and that were he to depart, the company wouldn't expect to invest as much authority in his successor. Jain has been mentioned in press accounts as a leading candidate to replace Buffett as CEO.

Buffett also serves as Berkshire's chief investment officer, and he said that the four candidates to eventually replace him in that role come from both inside and outside the company. None of their identities have been disclosed.

Asked whether any of the candidates' investing portfolios had outperformed the market during last year's rout - the S&P 500 fell 37% in 2008 - he said none of them had, though he didn't view that as disqualifying.

None of the four "covered himself in glory" during last year's market rout, Buffett said. "But then, neither did I," he added, referencing the 10% decline in Berkshire's net worth last year.

Buffett said he still expects Berkshire to make money on the lion's share of the derivatives contracts it has written in recent years. Berkshire has taken substantial mark-to-market writedowns on those contracts as worldwide stock indexes have plunged, raising the odds that Berkshire will eventually have to make payments to its trading partners when the contracts expire.

But Buffett noted that Berkshire - unlike unsavvy derivatives players such as AIG - has no obligation to post collateral with its trading partners in most cases.

He added that the company recently restructured two of its so-called equity put contracts - agreements that give an investor the right though not the obligation to buy a bucket of stocks from Berkshire at a specified date in the future. Those contracts have emerged as a subject of some debate since the stock market's plunge last fall.

Under one of the restructurings, the S&P 500 would have to rise just 13% over the next 10 years for the put to expire worthless. Before that deal, the S&P would have had to rise 72% over 18 years to preclude Berkshire from having to make a payout.

Buffett also said the bank stress tests whose results are due to be released next week shouldn't punish stronger banks such as Wells Fargo, a major Berkshire shareholding that Buffett described as a strong earner.

Some analysts have speculated that regulators may push Wells to sell more stock to increase its capital cushion against future loan losses. The bank last month posted a $3 billion first-quarter profit, though some observers said Wells may not have added enough to its loan loss reserves given rising joblessness and falling asset prices.

Buffett said he would ideally own all of Wells Fargo, though bank ownership rules prevent Berkshire from owning more than 10%.

Buffett defended federal efforts to support the economy, ranging from last fall's financial rescues to the the $787 billion stimulus plan enacted earlier this year.

"Government does need to step in," Buffett said, referring to the 6% contraction of the U.S. economy in the fourth quarter of 2008 and the first quarter of 2009.

That's not to say he is pleased with the earmarks Congress has attached to some of the rescue legislation. Inevitably, Buffett said, when big organizations turn massive resources on a problem, "there's a fair amount of slop."