A Smaller World And U.S. Defense Spending

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A Smaller World And U.S. Defense Spending

A Smaller World by Bill O’Grady of Confluence Investment Management

Being the global superpower is a great burden. There are military, political, economic and financial obligations that are costly to maintain. At the same time, history shows that when there is no dominant hegemon the world tends to suffer from instability and chaos. Although the superpower may wish to abandon the encumbrance, the consequence of an unstable world isn’t an attractive alternative.

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Since the fall of the Berlin Wall in 1989, the U.S. has been the sole superpower. The costs of that position have become increasingly apparent to Americans, leading to political factions calling for a retreat from the role. So far, the political elites remain committed to the hegemonic role, but it is unclear if it can be maintained.

One possible solution to the superpower problem would be to “shrink the world.” In other words, some nations may opt out of the international system the U.S. crafted since WWII, which includes open trade, free markets and democracy. As we saw during the Cold War, the communist bloc created a “smaller world” where economies were closed, markets were managed and authoritarianism was the primary governmental structure. Although the creation of a new bloc in opposition to the U.S. may appear to be a retreat from America’s hegemonic role, it may actually make the burden more manageable. This week’s report will review the burdens of superpower role. We will examine growing opposition to U.S. hegemony and discuss the impact of “shrinking the world” by allowing the creation of a competing superpower. As always, we will conclude with market ramifications.

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Being a Hegemon

The global hegemon has two major roles. The first, and perhaps most obvious, is that the superpower is responsible for global stability. The hegemon must be a dominant military power. It keeps the sea lanes open for trade. Often, it intervenes in local conflicts to prevent them from evolving into regional wars. It usually acts as a balancing power where it pairs off regional powers against each other and prevents either from dominating a region.

The role requires a nation to fund and man a large standing army and navy.

This chart shows U.S. defense spending as a percentage of GDP. We have placed a vertical line at 1950, which we estimate is when the U.S. became fully committed to the superpower role. As shown on the chart, from 1792 to 1940, excluding the wars, defense spending averaged a mere 1.2% of GDP. This pattern of defense spending, where there is very little activity until there is mobilization for war, is typical of a nonhegemonic republic. The spending since 1950 has averaged 6.1% of GDP, which is what a superpower is forced to spend due to its expanded global role.

This expanded military has affected America’s democracy. When President Eisenhower warned against the encroachment of the “military/industrial complex,” he was really warning about the pervasive effects of military spending on Congress, spending decisions, business influence on elections, etc. Although the U.S. has avoided fascism to date, a number of scholars have argued that the cozy relations of government and large business were a key element in the evolution of Nazism.

The other major requirement of being a superpower is financial, mainly, supplying the reserve currency. The reserve currency is the currency that other nations use for universal savings or for trade. Simply put, it is the global currency. In order to supply the reserve currency, the hegemon has to run persistent trade deficits. If the reserve currency nation runs a trade surplus, it has the same effect as a global tightening of monetary policy. Thus, the reserve currency nation, virtually by default, also becomes the “locomotive” for the global economy.

The economist Robert Triffin is credited with the best formulation of this problem, known as the “Triffin Dilemma.” As noted above, the reserve currency country must run trade deficits to supply enough global currency to provide ample liquidity to support global trade. As the global economy grows, unless the reserve currency nation can maintain a stable, proportional share of the world economy, the trade deficits will tend to become larger over time. The large rade deficits and the likely need to increase borrowing to absorb all the imports the world wants the hegemon to buy acts to undermine faith in the reserve currency itself. Thus lies the dilemma…the very act of supplying the reserve currency undermines its value.

Smaller World

This chart shows global trade, scaled to U.S. GDP along with U.S. debt, also adjusted to GDP. Note that as world trade as a percent of U.S. GDP has increased, the level of U.S. debt as a percent of GDP has increased as well. The recent period of deleveraging has also led to a sharp slowdown in global trade growth. Essentially, without strong U.S. economic growth, which has been fueled by debt since the early 1980s, global trade and global economic growth has slowed. Thus, the superpower role requires a large government, high levels of defense spending, and the need for persistent trade deficits. These requirements place substantial burdens on the citizens of the hegemon, forcing them to fight inconsequential wars and face strong foreign competition for domestic jobs.

Discontent with the U.S.

At the end of the Cold War, the U.S. was the undisputed leader of the world. The Bush administration engineered a large coalition to oust Saddam Hussein from Kuwait, signaling that the U.S. would not tolerate the forcible change of borders. The military prowess the U.S. exhibited in this short conflict shocked other powers. Capitalism and democracy were triumphant. Francis Fukuyama wrote an article titled “The End of History and the Last Man.”3 In that piece, Fukuyama argued that, with the fall of communism, there is no viable alternative to democracy and market capitalism. This notion became known as the “Washington Consensus.”

This position was not universally held. Samuel Huntington argued against Fukuyama’s position4, suggesting that the end of the Cold War would unleash cultural conflicts that had been subsumed by the ideological differences between capitalism and communism. For most of the 1990s, the intellectual consensus was that Fukuyama was right. However, over the following 15 years, with the rise of jihadist terrorism and the allure of authoritarian regimes, Huntington’s position has gained stature.

Russia under Vladimir Putin has become increasingly aggressive in opposing U.S. policy goals. The attack on Georgia in 2008 and the nearly constant interference in Ukraine’s affairs, which recently culminated in the annexation of the Crimea, are examples of direct threats to U.S. global hegemony. U.S. leaders have thought that as China’s economy modernizes, it would eventually turn to democracy and away from authoritarianism. After all, this has been the pattern of several Asian regimes, including South Korea and Taiwan.

However, after the 2008 financial crisis, China is increasingly arguing that the Washington Consensus doesn’t work, that its authoritarianism provides better government and stronger economic growth without all the volatility that capitalism seems susceptible to. Militarily, China has been encroaching on its neighbors’ territorial waters, threatening disputed islands and acting in a belligerent fashion.

Perhaps even more interesting are Russian and Chinese attempts to create alternative organizations to compete with those established by the U.S. over the past 65 years. China has recently chartered an Asian infrastructure bank to compete with the U.S.-backed Asian Development Bank. Both Russia and China have called for a different reserve currency.

Smaller World

At this point, there is no other nation on earth that could replace the U.S. as a global superpower. China, at best, is a regional power, and Russia may not be able to generate significant influence outside its near abroad. However, there is nothing to say that the U.S. couldn’t isolate Russia and China. Sanctions, to some extent, have already isolated Russia. Although China is well woven into the fabric of globalization, the U.S. could put significant trade sanctions on China, but not without considerable pain for both nations.

The Argument for Shrinking the World

The Triffin Dilemma is almost impossible to avoid in the long run. However, the reserve currency role is manageable if the providing nation is large relative to the global
economy for which it provides the reserve
currency.

This is a historical look at America’s share of global GDP. In the aftermath of WWII, the U.S. share of global GDP reached nearly 36%. As the world recovered, the U.S. share declined, but even by 1950, U.S. share was 28%. It has been steadily declining and is now around 18%.

However, one of the important factors during the Cold War was that the U.S. wasn’t providing dollars to the communist bloc.

Smaller World

By excluding China, the Soviet Union, Cuba and Eastern Europe, America’s share of Free World GDP is roughly five points higher. On this chart, we moved China into the Free World in 1979 when Deng Xiaoping opened up China’s economy. Because China’s economy was small until the late 1980s, this addition was not significant. We unified the series in 1990.

Removing China and Russia from global GDP would add five points to the U.S. share of global GDP. Given China’s strong export sector, the Chinese economy would be at a severe disadvantage until it adjusted. Other nations might join the China-Russia axis as well. If the Iranian nuclear talks break down, the Mullahs might join this group. Several of the former Soviet republics would likely join too.

Is a “smaller world” a possibility? It isn’t a highly likely outcome but the probability is greater than zero. This outcome is clearly less than ideal. Globalization as we now know it would come to an end. The risk of conflict at the borders of the new blocs would rise. On the other hand, like what was observed in the Cold War, nations would tend to align with one of the two camps. Managing geopolitical situations would be less complicated. It may actually become easier to manage conflicts; containing each bloc would become the primary policy between the two groupings. If China and Russia continue down the path of rejecting democracy and adopting authoritarianism, the leading democracies may simply decide that future relations will be limited. And so, a return to a Cold Warstyle world may be in our future.

Ramifications

The most obvious outcome if the “smaller world” scenario were to occur is that there would be a retreat from globalization as it has evolved since the end of the Cold War.

This will likely lead to higher inflation everywhere, increased competition for key commodities, driving those prices higher, and increased risk in overseas investing, especially in emerging markets. The U.S. will likely become the destination of choice for flight capital. Military spending will probably rise as states on the borders of the two blocs are forced to improve their security.

At this point, we still view this outcome as a low probability, although it may be rising. China and Russia are rebelling against American hegemony, and creating an alternative system to the U.S. isn’t out of the question. We would not expect investors to adjust their portfolios on a tactical or cyclical basis for this outcome. However, for very long-term strategic investments, this outcome should be monitored.

Bill O’Grady

November 3, 2014

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2 COMMENTS

  1. http://www.globalresearch.ca/the-us-dollars-fragile-reserve-currency-status-the-greatdeceiver-the-federal-reserve/5382184

    http://my.firedoglake.com/selise/2011/08/01/james-k-galbraith-the-final-death-and-next-life-of-maynard-keynes/ “James K. Galbraith “ we are at the end of
    the illusion of a market place in the financial sphere.”

    The Great Deceiver — The Federal Reserve.
    The US Dollar’s Fragile Reserve Currency Status

    Is the Fed “tapering”? Did the Fed
    really cut its bond purchases during the three month period November 2013
    through January 2014? Apparently not if foreign holders of Treasuries are
    unloading them.

    From November 2013 through January 2014 Belgium with a GDP of $480 billion purchased $141.2 billion of US Treasury bonds.

    Somehow Belgium came up with enough money to allocate during a
    3-month period 29 percent of its annual GDP to the purchase of US Treasury bonds.

    Certainly Belgium did not have a budget surplus of $141.2
    billion. Was Belgium running a trade surplus during a 3-month period equal
    to 29 percent of Belgium GDP?

    No, Belgium’s trade and current accounts are in deficit.

    Did Belgium’s central bank print $141.2 billion worth of euros in
    order to make the purchase?

    No, Belgium is a member of the euro system, and its central bank
    cannot increase the money supply.So where did the $141.2 billion come from?

    The money came from the US Federal Reserve, and the purchase
    was laundered through Belgium
    in order to hide the fact that actual Federal Reserve bond purchases during
    November 2013 through January 2014 were $112 billion per month.

    In other words, during those 3 months there was a sharp rise in bond
    purchases by the Fed. The Fed’s actual bond purchases for those three months
    are $27 billion per month above the original $85 billion monthly purchase and
    $47 billion above the official $65 billion monthly purchase at that time. (In
    March 2014, official QE was tapered to $55 billion per month and to $45 billion
    for May.)

    Why did the Federal Reserve have to purchase so many bonds above the
    announced amounts and why did the Fed have to launder and hide the purchase?

    Some country or countries, unknown at this time, for reasons we do not know
    dumped $104 billion in Treasuries in one week.

    Another curious aspect of the sale and purchase laundered through Belgium
    is that the sale was not executed and cleared via the Fed’s own National
    Book-Entry System (NBES), which was designed to facilitate the sale and
    ownership transfer of securities for Fed custodial customers. Instead, The
    foreign owner(s) of the Treasuries removed them from the Federal Reserve’s
    custodial holdings and sold them through the Euroclear securities clearing
    system, which is based in Brussels, Belgium.

    We do not know why or who. We know that there was a withdrawal, a sale, a
    drop in the Federal Reserve’s “Securities held in Custody for Foreign Official
    and International Accounts,” an inexplicable rise in Belgium’s holdings, and
    then the bonds reappear in the Federal Reserve’s custodial accounts.

    What are the reasons for this deception by the Federal Reserve?

    The Fed realized that its policy of Quantitative Easing initiated in order
    to support the balance sheets of “banks too big to fail” and to lower the
    Treasury’s borrowing cost was putting pressure on the US dollar’s value.
    Tapering was a way of reassuring holders of dollars and dollar-denominated
    financial instruments that the Fed was going to reduce and eventually end the
    printing of new dollars with which to support financial markets.The image of
    foreign governments bailing out of Treasuries could unsettle the markets that
    the Fed was attempting to sooth by tapering.

    A hundred billion dollar sale of US Treasuries is a big sale. If the
    seller was a big holder of Treasuries, the sale could signal the bond market
    that a big holder might be selling Treasuries in large chunks. The Fed would
    want to keep the fact and identity of such a seller secret in order to avoid a
    stampede out of Treasuries. Such a stampede would raise interest rates,
    collapse US financial markets, and raise the cost of financing the US
    debt. To avoid the rise in interest rates, the Fed would have to accept the
    risk to the dollar of purchasing all the bonds. This would be a no-win
    situation for the Fed, because a large increase in QE would unsettle the market
    for US dollars.

    Washington’s power ultimately
    rests on the dollar as world reserve currency. This privilege, attained
    at Bretton Woods following World War 2, allows the US
    to pay its bills by issuing debt. The world currency role also gives the US
    the power to cut countries out of the international payments system and to
    impose sanctions.

    As impelled as the Fed is to protect the large banks that sit on the board
    of directors of the NY Fed, the Fed has to protect the dollar. That the Fed
    believed that it could not buy the bonds outright but needed to disguise its
    purchase by laundering it through Belgium
    suggests that the Fed is concerned that the world is losing confidence in the
    dollar.

    If the world loses confidence in the dollar, the cost of living in the US
    would rise sharply as the dollar drops in value. Economic hardship and poverty
    would worsen. Political instability would rise.

    If the dollar lost substantial value, the dollar would lose its reserve
    currency status. Washington would
    not be able to issue new debt or new dollars in order to pay its bills.

    Its wars and hundreds of overseas military bases could not be financed.

    The withdrawal from unsustainable empire would begin. The rest of the
    world would see this as the silver lining in the collapse of the international
    monetary system brought on by the hubris and arrogance of Washington.

  2. Myth Accepted as History

    The accepted version of history is that the Federal Reserve was created to
    stabilize our economy. One of the most widely-used textbooks on this subject
    says: “It sprang from the panic of 1907, with its alarming epidemic of
    bank failures: the country was fed up once and for all with the anarchy of
    unstable private banking.” Even the most naive student must sense a grave
    contradiction between this cherished view and the System’s actual

    performance. Since its inception, it has presided over the crashes of 1921 and 1929; the Great Depression of ’29 to ’39; recessions in ’53, ’57, ’69, ’75, and ’81; a stock market “Black Monday” in ’87; and a 1000% inflation which has destroyed 90% of the dollar’s purchasing power.

    Let us be more specific on that last point. By 1990, an annual income of
    $10,000 was required to buy what took only $1,000 in 1914.4. That incredible
    loss in value was quietly transferred to the federal government in the form of
    hidden taxation, and the Federal Reserve System was the mechanism by which it
    was accomplished.

    Actions have consequences. The consequences of wealth confiscation by the
    Federal-Reserve mechanism are now upon us. In the current decade, corporate
    debt is soaring; personal debt is greater than ever; both business
    and personal bankruptcies are at an all-time high; banks and savings and loan
    associations are failing in larger numbers than ever before; interest on the
    national debt is consuming more than half of our personal income tax; heavy
    industry largely has been replaced by overseas competitors; we are facing an

    international trade deficit for the first time in our history; 75% of downtown
    Los Angeles and other metropolitan areas is owned by foreigners; and the nation
    is in economic recession

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