Life During Wartime

The Daily Reckoning PRESENTS:If you feel like things are rumbling out of control and that something big and important is happening, well, then, you’re not alone. But what does all of it mean for gold, for the dollar, for oil, for America? In fact, is there more at stake than just the price of oil? Dan Denning explores…

LIFE DURING WARTIME

When I got back from my excursion to the Far East in late 2004 and sat down at my desk in London to write up the story, I emphasized three major trends that would create danger and opportunity for investors. First, the bull market in energy (oil, gas, electric, nuclear) was going to be one of the longest and strongest you and I would see in our investment lifetimes.

The big drivers are the growth in demand from China and India. Since then, of course, through the work of Whiskey & Gunpowder editor Byron King, we’ve seen how Peak Oil – the exhaustion of all the world’s cheap, easily recoverable oil – is driving up energy prices even higher and faster than I thought, and also has complicated things geopolitically.

Second, the general rise of Asia into the developed world was causing huge demographic and economic dislocations – and creating enormous investment opportunities as Asian economies began to consume as well as produce, to spend as well as save.

Third, I wrote that the rise of the East was accompanied by the simultaneous collapse of the ruling currency regime of the last 30 years, the dollar standard. This last point is still so inconceivable to many people that they refuse to entertain the possibility. Too much would have to change. Too much wealth would be destroyed. Too many vacations would have to be canceled. Yet the inexorable rise of gold shows that this revolution in money is slowly but surely eroding the dollar’s status.

Iran Nuclear Threat: Possible Effects

The current situation with Iran doesn’t change any of those three main trends. It accelerates them, however, and adds the dangerous new element of nuclear holocaust to the table. Let’s be clear about one thing, though: Even if Iran developed a nuclear device tomorrow, it would not likely be the sort of thing they could put on a missile and fire off to Tel Aviv…or Rome…or London. It would be a large, unwieldy thing that they might be able to put on a jetliner. (Incidentally, Iran recently announced the resumption of commercial flights to the United States.)

Still, it’s not a secret anymore what Iran is trying to do. The question is, can anyone stop it? Another question is does everyone really want to stop it? I would argue that both China and Russia, though they might be deeply uncomfortable with having a nuclear Iran, see it as an enormous strategic blow to the United States and a key element of their respective energy alliances with Iran. China and Russia, in other words, are more than willing to let the world’s nuclear club expand. Doubtless, they feel like they’d have some measure of control over Iran, especially since both countries have helped Iran with its weapons program. Whether they will have any control or not remains to be seen.

Let’s leave aside all the speculating about if the United States or Israel can or will attack Iran. I have no idea. Nobody does. In analyzing the whole situation, I found it useful to head to the bookshelf and dust off a copy of Paul Kennedy’s The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500-2000. I’m going to quote from a few sections that I think help explain how what’s playing out across the globe today is a result of both globalization and Peak Oil.

Unfortunately, if we follow Kennedy’s analysis, it’s very bad news for America and for Americans who fail to understand what’s motivating our main economic and strategic competitors. Emphasis added is mine. In the introduction, Kennedy writes:

“The triumph of any one Great Power in this period, or the collapse of another, has usually been the consequence of lengthy fighting by its armed forces; but it has also been the consequence of the more or less efficient utilization of the state’s productive economic resources in wartime, and, further in the background, of the way in which that state’s economy has been rising or falling relative to the other leading nations, in the decades preceding the actual conflict. For that reason, how a Great Power’s position steadily alters in peacetime is as important to this study as how it fights in wartime.”

Iran Nuclear Threat: The War on Terror

If you date the war on terror to its beginnings, you could conceivably go back to the Iranian hostage crisis of 1979-80. But let’s use Sept. 11 as our start date. Since that time, how efficient has the United States been at using its productive economic resources? Not very, as I have mentioned ad nauseam. That’s because America continues to consume more than it produces. Debt has driven a boom in American consumption right alongside a war that doesn’t seem to interrupt the daily life of many Americans. If countries rise or fall based on the efficient use of productive economic resources, then China, with its 9.9% growth, is rising and America, with GM’s $8.6 billion loss last year, is not. America has been falling relative to China and India for the last 10 years. Kennedy continues:

“The relative strengths of the leading nations in world affairs never remain constant, principally because of the uneven rate of growth among different societies and of the technological and organizational breakthroughs which bring greater advantage to once society than to another. For example, the coming of the long-range gunned sailing ship and the rise of the Atlantic trades after 1500 was not uniformly beneficial to all the states of Europe – it boosted some much more than others. In the same way, the later development of steam power and of the coal and metal resources upon which it relied massively increased the relative power of certain nations, and thereby decreased the relative power of others.”

My first essay for Whiskey & Gunpowder, “The Birth of Cultural Siege Engines,” made the simple observation that nuclear proliferation would alter the world’s political structure by making it nearly impossible for one country to invade another. Such as it is, this might actually reduce the incidence of war. It might also mean a very nasty but realistic situation where dictators and tyrants are free to terrorize their populations without fear of being toppled by invasion. After all, King Jong Il is around because he has nuclear weapons. Saddam Hussein will be executed sometime this year because he did not.

Iran Nuclear Threat: Economic Strategy

In historical context, nuclear weapons are the long-range gunships of the Atlantic. They are the great military equalizers. With the technological breakthroughs on the nuclear black market, you can expect more nations to get them. In a strange way, their spread might also dilute their leverage. Once everyone has them, there will be no urgency to get them. Military competition will turn back to economic competition.

For America, this means that we are less likely to be able to use our military as a means to achieve our economic strategy. True, aircraft carriers and long-range bombers still give America the unique ability to project force anywhere in the world. But a nuclear weapon and the means to deliver it, that’s really an army of one isn’t it? How well will America compete now that its great growth is behind it? And what about China and India? They will be boosted, in Kennedy’s terms, by the proliferation of nuclear weapons to the extent that global competition will be more economic than military. And of course, resource-rich countries will enjoy the greatest rates of growth and have the largest advantages of all:

“Once their productive capacity was enhanced, countries would normally find it easier to sustain the burdens of paying for large-scale armaments in peacetime and of maintaining and supplying armies and fleets in wartime. It sounds crudely mercantilistic to express it this way, but wealth is usually needed to underpin military power, and military power is usually needed to acquire and protect wealth.”

Here we just find more somber questions for America. America’s productive capacity is being systematically dismantled and shipped to China. If you don’t make anything, how can you sell it? And if you can’t sell it, what will you use to pay for your military? Without the means to generate wealth, how will America maintain its power? By selling bonds to our strategic adversaries? Come again?

In an energy-scarce, nuclear-abundant world, the surest ticket to wealth, and thereby to power, is energy. Those who have it – Russia, Iran, Venezuela – have tremendous leverage – provided they can survive as nation-states. Those who don’t – America, the United Kingdom, Western Europe – will find themselves not only less wealthy but less powerful. The free ride to power, luxury, and apathy that the Peak Oil age provided the West is emphatically, undeniably over.

Kennedy writes of this weakening of national power, “If, however, too large a portion of the state’s resources is diverted from wealth creation and allocated instead to military purposes, then that is likely to lead to a weakening of national power over the longer term.” You might add that if states’ resources and capital and their creative energies are diverted and devoted to buying and selling houses and filling them with trinkets bought on eBay, national power is weakened. The consumption lifestyle to which America has grown addicted does not produce capital. It does not produce wealth. It does not produce power:

“In the same way, if a state overextends itself strategically – by, say, the conquest of extensive territories or the waging of costly wars – it runs the risk that the potential benefits from external expansion may be outweighed by the great expense of it all – a dilemma which becomes acute if the nation concerned has entered a period of relative economic decline.”

If there have been benefits to the war in Iraq, cheap oil is not one of them. The war is not paying for itself with Iraqi oil exports. That war is not paying for itself at all. It has become a major and costly national undertaking, at just the time when America finds itself on the wrong side of the wealth = energy = power equation and in the fight of its economic life with rising powers India and China.

Kennedy writes:

“The strengths and the weaknesses of each of the leading powers are analyzed relatively, in light of the broader economic and technological changes affecting Western society as a whole, in order that the reader can understand better the outcome of the many wars of this period.”

In the last few years, we’ve seen how the broader “economic and technological changes” of globalization are making the world more competitive and changing social structures everywhere. Indeed, many of the great social and economic institutions on which the postwar world was built are falling like dominoes…GM, the pension system, the United Nations, the dollar standard…the beat goes on. In fact, about the only thing preventing this migration of wealth and power IS the dollar standard.

It allows America to fund its wars and consumption with a depreciating currency. It is a tremendous advantage Kennedy does not ignore:

“Since the cost of standing armies and national fleets had become horrendously great by the early 18th century, a country which could create an advanced system of banking and credit (as Britain did) enjoyed many advantages over financially backward rivals.”

England survived its many wars with France largely because of the creation of a funded national debt, the issuance of bonds whose interest was paid by the efficient collection of taxes. The modern warfare state is simply not possible without “an advanced system of banking and credit,” and that, for now, is exactly what is keeping America afloat. The world still wants our bonds. China has nearly $800 billion in currency reserves, its resource war chest.

But how long will this advantage last? I suspect a lot will have to do with the price of oil. As oil rises in dollar terms – whether from geopolitical tension or the growing realization that Peak Oil is real – the run on the dollar will grow. Hard assets like gold won’t just be fashionable: They will be indispensable to wealth preservation.

Soaring gold and oil prices will be accompanied by soaring interest rates and inflation. The convenient fantasy world where prices don’t rise and the dollar doesn’t lose purchasing power will collapse. One day, Americans will wake up and find that the money in their wallets buys three-quarters or half as much as it did the day before. The dollar will have lost status. America will have lost power. And in the new world that emerges, possession of energy, not a printing press, will be the key to wealth.

Regards,

Dan Denning
for The Daily Reckoning
February 9, 2006

P.S. You can get your own copy of Paul Kennedy’s book here:

The Rise and Fall of the Great Powers

Editor’s Note: Dan Denning is the editor of Strategic Investment, one of the most respected “big-picture” investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 – where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends.

The above essay has been adapted from this month’s issue of Strategic Investment.

Iran Nuclear Threat: Life During Wartime
by Dan Denning
The Daily Reckoning
Thursday, February 9, 2006

“If you feel like things are rumbling out of control and that something big and important is happening, well, then, you’re not alone. But what does all of it mean for gold, for the dollar, for oil, for America? In fact, is there more at stake than just the price of oil?

We were wondering yesterday about the debt bubble. Can debt levels continue to rise forever? And what happens when a debtor cannot pay? No harm done, right?

Our head aches and our knees wobble at the thought of it. Even without thinking, we know it can’t be so. Nature has her limits, her penalties and her dirty tricks. In debt, as in dollars, quality and quantity vary inversely. The more debt a man takes on, the more he has to struggle to keep up with it. The quality of his IOU declines. “Will he really be able to make good on his commitments?” lenders ask themselves.

Logically, if not consistently, lenders demand higher rates of interest. Higher rates increase the weight of debt throughout the economy. A man who must borrow to continue living in the style to which he has become accustomed must shoulder more debt at higher rates – making him even less able to pay. At the margin, debtors begin to buckle at the knees. Credits go bad. Bankruptcy courts and workout companies start hiring extra hands. That is what we see happening in Britain and America today.

But, apart from the overburdened lender, is anyone really worse off? The credit may have been created “out of thin air” by central banks…doesn’t it vanish just as painlessly? Alas, no.

When a lender doles out a million pounds to a borrower, both of them now feel they have money to burn. Imagine next that the borrower takes an extravagant vacation around the world. The money does not vanish into thin air. Instead, it goes into travel expenses: jet fuel, swanky hotel rooms, pricey bar tabs. It goes not up to heaven, but down to earth, where it is used up, and vanishes forever, like a lover’s last kiss or a smoked cigarette. And it does not vanish without a trace. You are left with a bitter aftertaste and the burnt-out stubs.

First, the borrower goes broke. Then, when the lender goes to collect, he finds that he is broke, too. And somewhere in Sri Lanka or San Martin is a hotel proprietor standing in front of a brand new wing of rooms. He wonders what’s happened to his free-spending customers. What happened to the sound of ice cubes at cocktail hour and the smell of foie gras at lunch? He worries about how he’ll pay the mortgage he took out to pay for his new addition.

As the credit cycle continues to turn down, there are fewer people with money in their pockets, and more capital investments that don’t really make sense anymore. In short, the money doesn’t ascend into money heaven at all. Instead, it becomes a steel ball and chain clamped to the ankles of investors, businessmen and consumers…one they’ll drag around for years. Not only have the borrower and the lender no more money to spend, but now the hotel owner has thrown away his money on that suite of luxury rooms that no one wants. He’ll either have to eat into his own income or capital to keep the thing going…or go bust, too.

Fraud begets fraud…swindle begets swindle…error begets error and the whole cycle soon becomes woebegotten. In America today, the Fed’s phony new money – created out of thin air – feeds phony house price increases that turns into phony consumer demand that coaxes businessmen in China to make bad capital investments. When the cycle tops, almost everyone everywhere will feel the pain, because the funny money drew out real resources – oil, labor, steel – that might have been put to better use.

Don’t get us wrong; we love the Fed as much as everyone else. In the Soviet Union, resources were misallocated by force. In the Fed’s empire, they are misallocated by fraud. This is undoubtedly a big improvement; for one thing, it is much more entertaining.

More news from Aussie Joel and The Rude Awakening…

————–Chris Mayer, reporting from Gaithersburg, Maryland:

“A-plus investors, just like A-plus students, think long-term. They don’t mind foregoing one cookie today, for the sake of eating two cookies tomorrow…or ten cookies five years from now.”
For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.

————–

Bill Bonner, back in London with more thoughts…*** A quick note from our currency counselor, Chuck Butler:

“2006 will be a more difficult environment to define clear U.S. dollar trends, according to Morgan Stanley economist, Stephen Jen.

“He points out that the technical picture is beginning to point toward U.S. dollar shorter-term strength against the euro in the completion of a wave ‘B’ move, which would then signal a larger wave ‘C’ weakening of the U.S. dollar.

“OK. So, we’ve got short-term dollar strength, followed by a larger move down in the dollar. I would prefer to eliminate the short-term dollar strength, but I can’t always get what I want!”

[Ed. Note: The dollar may be strong in the short-term…but we wouldn’t bet on it staying that way for too long. In fact, our friends at EverBank recommend diversifying globally with their World Currency CD’s to protect yourself from a weakening dollar.

Check out their latest edition to these CD’S – the Icelandic Krona CD. In the last two years alone, the krona has gained almost 14% against the U.S. dollar, and the krona edition comes with a cool 8.24% APY, a 3-month term, FDIC insurance, and no account fees.

*** Here’s a juicy bit of irony. Somebody’s giving us kudos for our website. Heh. Heh. The folks at Mequoda Library, an electronic source for the latest research on website publishing and Internet marketing, has released the results of their yearly website design rankings…and The Daily Reckoning is tied for the number two slot – ranked above eBay and WSJ.com.

Their review begins: “The Daily Reckoning website, a network hub for its financial newsletters and services, demonstrates effective website design and site architecture that supports user tasks and goals…Agora [Financial] is hands down one of the most successful online publishers in the financial newsletter industry.”

*** We checked the chart. Gold looks as though it “should” correct to about $500. The trouble is, markets don’t always do what they “should” do. Often they do the opposite.

And while long suffering readers of The Daily Reckoning were probably breathing a sigh of relief on Mr. Greenspan’s retirement from the Fed and congratulating themselves that they wouldn’t have to read any more of him, we came across this remarkable headline on page 45 of the Wednesday Times of London: “Terror threat responsible for high gold price – Greenspan.”

The former chairman may have left his post behind, but he also left his mark. And he hasn’t yet left the public limelight. In his first private sector speech since being let off the leash of officialdom, the ex-maestro, and erstwhile most powerful man in the world, “blamed the threat of terrorism for the soaring gold price.” According to the article, Mr. Greenspan earned $120,000 for his one-hour speech.

A rush of questions came over us. Why would he say such a thing? Is the threat of terrorism twice as high as it was on 9/11? Did the threat of terrorism go up 25% last year?

Is the man now managing his own investments (they were in a trust while he was in office)? Could he be short gold and just trying to drive the price down to cover his trade? Or is it possible that he is still on some leash? Or…is the 79-year-old going out of his mind?

We may never know the answer, but while the price of gold tumbled on Wednesday, Thursday brought no follow-through. Gold was stable. Here at The Reckoning, we watch…and wait.

*** We pity poor Ben Bernanke. We have a feeling he doesn’t know quite what he’s gotten himself into. Greenspan was wily, cynical, and opportunistic. He had been an objectivist, and an acolyte of Ayn Rand. He knew how the Fed worked and he knew how to look out for Number One.

But Bernanke, from what we can tell, is a believer. He earnestly believes he can regulate the economy by jiggling rates. He thinks running a central bank is a matter of skill and judgment. Greenspan knew it was just luck and treachery. The former chairman must have blessed his predecessor every day of his reign for providing him with such a delightful economic balance sheet to run down. The present chairman is likely to curse his predecessor every day of his – when he finally figures out what it is that Mr. Greenspan has really accomplished.