Geopolitical Issues That May Dominate International Situation by Bill O’Grady of Confluence Investment Management LLC

N.B. This is our last report for 2014. The next report will be published January 5, 2015.

As is our custom, we close out the current year with our outlook for the next one. This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international situation in the upcoming year. It is not designed to be exhaustive; instead, it focuses on the “big picture” conditions that we believe will affect policy and markets going forward. They are listed in order of importance.

Geopolitical Issues – #1: America’s Strategic Drift

This issue has dominated our thinking for the past several years. Essentially, the U.S. has struggled with developing a coherent foreign policy strategy since the end of the Cold War. Although terrifying, the Cold War at least led to a consistent strategy; essentially, communism had to be contained and all foreign policy decisions had to face that test. That doesn’t mean there were no policy disagreements during the Cold War.

Clearly, significant policy differences existed between Presidents Carter and Reagan. However, the general requirements of defending the Free World established a strategic constraint that all administrations followed from Truman to G. H. W. Bush.

America’s role as superpower isn’t one that comes naturally to a nation founded as a republic. The founders created a government with numerous checks and balances designed to protect its citizens from a tyrant, not create an efficient system.

Until the U.S. became a superpower, it had a very small federal government. The military only expanded during times of war and was demobilized after conflicts ended. Defense spending was low; the nation was mostly defended by two large oceans and enjoyed the global public goods that the reigning superpower, Britain, provided. These public goods included the reserve currency and a global military footprint that protected the sea lanes. America’s reluctance to accept more global responsibility after WWI was partly responsible for the Great Depression and WWII. Britain, whose economy was severely damaged by WWI, struggled to maintain the necessary services the global hegemon provides, like the reserve currency and global military projection. As such, Britain began to retreat from the position which left a power vacuum that the communist and fascist nations threatened to fill.

As WWII was coming to a close, America’s leadership generally decided that the U.S. must replace Britain as the global superpower or prepare to eventually fight WWIII. This sentiment was not universally held. Robert Taft (R-IL) argued vehemently that taking this path would change America in ways that would undermine its republican nature.

Government would expand, intelligence gathering would be required, a large standing military would be necessary and individual liberties would eventually be at risk.

However, the dictates of the Bill of Rights do not support torture. The recent revelation about CIA torture is a reflection of this problem. Clearly such behavior isn’t how many Americans believe their country should act. However, the temptation to engage in overly aggressive tactics to gain precious information, not just to protect the U.S. but the world as a whole, tends to rise for the superpower. It is much more difficult for the superpower to preserve national morals because so much is at stake; as a nation becomes supremely powerful, the tendency rises to justify the means to an end.

To a great extent, Taft’s warnings were born out. America has changed since it accepted the superpower role after WWII. The government has grown. The U.S. went from having no intelligence agencies to 17.

Scandals have occurred, with the U.S. actively involved in the overthrow or attempted ouster of unfriendly governments in Iran, Chile and Cuba. The U.S. also found itself fighting a parade of small wars in Korea, Vietnam and the Caribbean. These wars created the need for a large standing army and defense budget. These are actions the U.S. was able to avoid prior to 1945.

America exercised its hegemon role in a manner different than Britain. Instead of colonies, the U.S. created a series of treaty organizations (e.g., NATO, SEATO) and international organizations (U.N., IMF, World Bank, GATT, WTO) that allowed America to exercise power without colonization. For many years, the U.S. dominated these organizations and was able to use them as tools to further its geopolitical aims. Although using organizations to project power was probably less efficient than simple colonial control, it was probably less expensive and allowed the U.S. to maintain its image as a supporter of freedom and independence, an image created at the founding of the United States.

It should be noted that, over time, these international organizations have become increasingly independent and are less than reliable vehicles for American power projection.

At the same time, the U.S. took a direct role in ensuring that the belligerent nations that triggered WWII would not return to cause another world conflict. The U.S. solved the “German problem,” the issue of integrating a strong Germany into Europe by demilitarizing Germany and taking over its security. By wedding the German economy to the dollar’s reserve currency role and by permanently stationing troops in NATO, Germany ceased to be a threat to its neighbors. Similar policies were implemented with regards to Japan. The U.S. essentially wrote Japan’s post-war constitution which is pacifist by design.

And, the U.S. guaranteed Japan’s security, ensuring that the island nation would not be a threat to its neighbors. Essentially, America ended the persistent threats that Japan and Germany represented by demilitarizing both nations, allowing both to become export-promoting economies that were reliant on the U.S. consumer, and by shouldering defense responsibilities for both countries.

In the Middle East, the U.S. recognized that this area of instability held enormous oil reserves. President Roosevelt made personal contact with Saudi king and founder, Ibn Saud, and cemented U.S./Saudi relations even before WWII ended. One problem with the Middle East is that the borders created by the process of European colonization were designed to support foreign control, not create viable independent states. As the U.S. steadily reduced British influence in the region, it maintained the established borders even though they required the leaders of these rather artificial states to become increasingly authoritarian to maintain control. The U.S. has acted as a balancing power in the region,
becoming both directly and indirectly involved in numerous conflicts. Without U.S. influence, the region would likely evolve into new, self-determined states.

Although such an evolution would create a more stable region in the long run, in the short run it would be chaotic and vulnerable to outside powers’ influences. Thus, the U.S. has leaned toward stability and declared the region an area of vital interest, meaning that America is the primary defender and stabilizer.1 The primary reason for this policy was to protect the massive oil reserves in the region.

Despite the distortions to America’s selfimage that the superpower role caused, the majority of Americans were willing to tolerate these burdens because communism was seen as a mortal threat. However, after the Berlin Wall fell and the U.S.S.R. was no longer a hegemonic threat, Americans’ dedication to the superpower role came under pressure.

Populists on both the left and right wings increasingly call into question the burdens of

1, 234  - View Full Page