Metal vs. Flesh

What, if anything, gives the West an advantage when it comes to waging war? Dan Denning tackles the War on Terror and its implications for investors in defense technology…

"It would be a gain to mankind if we could spread over that country the Idea of America – that all men are born free and equal in rights, and establish there a political, social, and individual freedom."

– Theodore Parker,
speech at the Melodeon
Boston, Massachusetts, June 7, 1846

On May 18, 1846, General Zachary Taylor crossed the Rio Grande into Matamoros, Mexico. And for the first time in its history, the government of the United States of America occupied a foreign city. Ten days earlier at El Palo Alto – under a tradition that Bernard DeVoto describes as having "emphasized marksmanship, steadiness under fire, and individual initiative, and courage" – Taylor’s men won the battle.

It was a small battle. But it’s hard to overstate its implications, even for today. First, let’s talk hardware. The American cannons consisted of brass six-pounders and cast-iron 12- and 18-pounders. Definitely a far cry from today’s 120 mm thermal-sighted cannons on M1A1 tanks. But the Americans had the Mexicans outgunned and patiently blew them to bits.

Aside from the tactical victory was a point that only students of history can appreciate. By most accounts, Taylor was no military genius. One of Taylor’s own colonels wrote in his journal that if Taylor were to succeed, it must be by accident. Fortunately for Taylor, there was substantial military talent within his ranks.

Taylor had a young officer serving in the 4th Infantry, one Lieutenant Ulysses S. Grant. And in the space of a few hours, Grant learned enough about massed firepower to ignite a revolution in military affairs (RMA) that Secretary of Defense Donald Rumsfeld would be proud of. Grant learned what Lee would forget at Gettysburg. Metal is superior to flesh.

It’s fair to say that the U.S. military has been employing that doctrine of superiority ever since.

Sometimes, in our effort to understand what’s going on in the world, we look to musty old history books – but not to avoid repeating the mistakes of the past. Rather, we hope to learn exactly how we got to where we are today, and what, if anything, it tells us about where we’re going.

The years 1846 and 2002 have a lot in common. Both years found America on the brink of historic changes in its relationship with the world. And in both years – here I’m getting ahead of things a bit, but indulge me – technology and capitalism played/will play the decisive part in the outcome.

I’m going to avoid any moral discussion of more efficient killing and just accept it as a fact. Likewise, I’m going to take it for granted that you know where I’m coming from philosophically: namely that war almost always makes the State stronger, and in that sense, is almost always detrimental to individual freedom. Still, our moral and ideological objections shouldn’t prevent us from understanding what’s going on, or, if possible, from profiting from it.

In 1846, America was trying on the clothes of a national power for the first time. Texas had been annexed two years earlier. New Mexico and California were next. The Oregon Territory would soon follow. America was a country just becoming self-conscious of its role on the North American continent, and perhaps in the world. It embraced that role with a vengeance. Bernard DeVoto tells the story in his book, The Year of Decision, 1846.

Thousands of settlers took off across the frontier for the West. The frontier was the edge of the unknown in 1846. There was no INS, BLM, or Transportation Security Agency. But when allowed, the free market finds solutions to almost any problem…even that of arming a vulnerable population on the frontier of an unsettled country.

From 1836 to 1846, Samuel Colt hand-manufactured about 6,000 of his patented repeating revolvers. Portable, easy to use, and capable of dispensing six rounds without having to stop and reload, DeVoto says, "the revolvers gravitated to the place where they were needed, the Western frontier."

Colt’s company had gone out of business due to bad management. But by 1846, America was entering the heart of its industrial revolution. Our own Dr. Kurt Richebächer often tells us that it’s production of capital goods which creates new wealth. And that is surely one big difference between America today and America in 1846. The America of 1846 was bursting at the seams with inventors, patents, and machines that could make machines.

Colt’s revolvers were a perfect example. When he closed his original factory in 1842, each manufacturing operation had to be performed by hand. But in 1846, Colt teamed up with the Whitney Arms company (the son of Eli Whitney, inventor of the cotton gin). Colt and Whitney built machine tooling to automate the manufacturing process.

Colt’s factory was one of the first of its kind. In fact, when he set up shop in England a few years later, there were no machine tools to make his guns, or craftsmen that could make the machine tools. The capital goods to build the arms industry in Europe had to be imported from America, where necessity, freedom, and an expanding nation were producing new goods and services at an astonishing rate.

DeVoto calls the American embrace of industrialism in 1846 the beginning of "the American System." The "American System" was best exemplified by the National Fair, which was held that year in Washington on May 22. At the fair, President James K. Polk reviewed an immense variety of manufactured goods. It’s doubtful that anyone realized the economic implications of a country that was suddenly producing everything from window shades and rice flour to portable steam boilers and tobacco presses. But the implications were immense.

America was beginning to get rich by turning raw materials into finished goods – capital goods that could be exported for profit and used to produce more goods. There was a tremendous boom in individual innovation – the kind that is only possible when a man owns the rights to his invention and is free to profit by selling an improved product or service to his friends and neighbors, or even to total strangers.

Part of what made the country such a dynamic place in 1846 – perhaps the greatest part – was the energy of its people. Henry David Thoreau tried to put his finger on what it was that was driving America. He knew it wasn’t the government. Of the government he said, "It does not [and will not] keep the country free. It does not settle the West…The character inherent in the American people has done all that has been accomplished; and it would have done something more if the government had not sometimes got in its way."

It was then, for lack of a better word, character – the same kind of individual initiative and courage that had served Americans so well in their war for independence. But as Thoreau sensed, an economy that has embraced technology and married it to a desire for foreign conquest – or at the very least, a dangerous belief in the rightness of one’s own convictions in foreign affairs – suddenly makes a free people a lot more dangerous, and lethal.

Of the Mexican War, John C. Calhoun said, "it has dropped a curtain between the present and the future, which to me is impenetrable…it has closed the first volume of our political history under the Constitution and opened the second and…no mortal could tell what would be written in it."

Calhoun may not have precisely known what it was he feared. But his fears turned out to be justified. The Western way of shock-infantry battle supported by mechanized artillery was destructive enough when deployed against Mexicans who weren’t equally armed. But once those cannons got bigger and more powerful and were turned against one another on the battlefields at Antietam, Chancellorsville, and Gettysburg, the horrible logic of what Grant had discovered hit home.

World War I took the grim reality of shock combat with heavy artillery to its logical and near apocalyptic conclusion. But what was that conclusion? And what made the Western way of war so different from anything else? Why was the carnage in the American Civil War and World War I so much worse than in other wars?

Victor Davis Hanson gives an interesting answer in his book, Carnage and Culture. Hanson identifies key elements in the tradition of Western warfare, starting with the Greek hoplites, through the Macedonian phalanxes, the Roman legions, the Spanish conquistadors, and the American military at Midway.

The argument is simple: capital wins wars. And free societies produce capital and capital goods in much greater abundance than non-free societies. Almost all instances of a non-Western power defeating a Western power in combat usually involve the use of Western arms by the non-Western power. In few cases has a non-Western army used its own weapons to defeat the West. And in fewer still has a numerically inferior non-Western force traveled a great distance and defeated an indigenous Western foe with non-Western weapons.

Vis-à-vis the current situation, the West still has an overwhelming superiority in the manufacturing of capital goods, especially sophisticated capital goods. Virtually all of the equipment used to pump the oil out of Arab wells was designed and built by Western-trained engineers.

Only in the West does the spirit of rational inquiry and scientific experiment produce such measurable technological progress…and therefore the ability to corral such incredible violence in support of its political ambitions.

Regards,

Daniel Denning,
for The Daily Reckoning
November 20, 2002

P.S. The West still produces the bulk of the world’s arms. And here, a genuine lover of freedom might feel some cause for shame. The numbers don’t lie. America is the world’s largest exporter of arms. It also devotes a larger portion of its gross national product to defense spending than any other nation on earth.

But for now, what gives the West its advantage over Iraq? What leads me to believe we’ll win a war there quickly, as we have in the past? And what can you as an investor do about it? I’ll debut 4 defense stocks which have cornered niche markets in the defense industry in the December issue of Strategic Investment.

Editor’s note: Dan Denning is the editor of Strategic Investment. You may remember Dan from his earlier investment advisory service. His focus on little-known stocks led investors to profits as high as 5,182%…as well as over 570% on Isle of Capri Casinos, 457% on Big Entertainment, 411% on Gentner Communications and 130% on Total Research Corporation. Today, Denning is the architect of Strategic’s winning portfolio – up across the board while Wall Street’s finest take it on the chin.

At the end of the last millennium, you will recall as well as we do, dear reader, the U.S. economy had reached near-perfection. Dynamic American capitalism was the envy of the world. As far as anyone could tell, things would just get better and better, for ever and ever – thanks to new technology, buy and hold investing, and enlightened leadership at the Fed.

But here we are, scarcely two years later, and something has gone wrong. Now, everyone seems to agree that capitalism needs to be fixed.

President Bush can fix it, wrote David Ignatius in the International Herald Tribune over the weekend. What’s more, Ignatius infers that Bush would have fixed it already had it not been for a few recalcitrant Democrats.

And yesterday, Alan Greenspan said he could fix it. True, he has already cut rates 12 times. True too, overnight bank lending, at 1.25%, is 2.35% below the inflation rate, meaning that banks can borrow at negative real interest rates. And true again, he admitted, that despite his efforts over the last 2 years, business investment was in a "very major fallback" position, in which "most everybody is doing nothing."

But that doesn’t mean he cannot still stimulate the economy, said the best-known public employee since Pontius Pilate.

And now comes John Crudele in the New York Post. If the man has not lost his mind completely, he has surely misplaced it. He offers his own plan to ‘fix’ the economy.

How?

By allowing people to take money out of 401k and Keogh retirement accounts and spend it without tax penalties.

The real problem in America is that on many yesterdays, people spent too much. Today, they find themselves with too much debt and not enough savings.

But don’t worry about tomorrow, writes Crudele, "America faces pressing problems today." Crudele thinks the unemployment rate is nearly 10% "when you count people too discouraged to even look for jobs."

And he thinks the nation needs another jolt of spending. But just to make sure the spending would be effective, he suggests that Congress should tell people what they can buy.

For example, Crudele elaborates his hallucination, people might be encouraged to invest in the airline industry…if the industry promises to create more jobs.

Almost all airlines are suffering because their expenses are too high as compared to their revenues. What good it would do to increase their expenses by hiring unneeded extra employees, Crudele fails to explain. But that’s the nice thing about having a plan to ‘Save the Economy’…or ‘Save the Planet’ for that matter. You can let someone else figure out the details.

The real problem with these ‘fix it’ schemes is that their authors do not understand or appreciate the genius of capitalism. "The Flaws of Modern Capitalism," heralds an article in the Financial Times. People are not getting rich; there must be something wrong, the paper presumes.

But the majesty of capitalism is not that it that it makes people rich, but that it makes them humble.

Of course, it doesn’t happen overnight…and never without pain. What’s more, adults resist instruction as much as a 9-year-old. They fidget and get distracted. Instead of learning from their mistakes, they lurch from one illusion to the next until the madness…and the money…is finally crushed out of them. "Investors are utterly convinced that policy can fix anything that ails America," writes Stephen Roach, "from deflation and asset bubbles to asset liability mismatches and geopolitical threats (i.e. Iraq and terrorism.)"

The latest ‘fix it’ illusion will be destroyed, too – sooner or later. But don’t worry. The march towards humility process poses no threat to the nation. On the contrary, it is nearly as morally uplifting as it is entertaining.

Right Eric?

————

Eric Fry in New York…

– The "Little Consumer That Could" is discovering that he simply CAN’T. This revelation is causing America’s largest retailers to sweat a bit. Home Depot announced yesterday that sales would increase less than expected this year. The downbeat forecast follows hard on the heels of a similarly pessimistic forecast from Wal-Mart on Monday. Also, the weekly sales report from the Bank of Tokyo Mitsubishi showed that chain-store sales fell a disappointing 1.2% last week.

– Clearly, the consumer is not buying baubles and widgets – nor even aluminum siding – with his habitual gusto.

– Home Depot’s gloomy forecast knocked the foundation out from under the home-improvement chain’s share price, which tumbled $3.69 to $24.91. The steep drop of Home Depot’s stock – a member of the Dow Jones Industrial Average – knocked 25 points off the blue chip index all by itself. The Dow fell 12 points yesterday to 8,475, while the Nasdaq dropped 1.4% to 1,374.

– We turn now to an evergreen topic: rumors of financial distress at J.P. Morgan.

– Yes, it’s true, the banking giant is once again doing what it does SECOND best: denying that it has incurred substantial losses in one of its areas of operation. What it does best, of course, is actually incurring all those substantial losses that it spends so much time and effort trying to deny. The big bank seems to excel at shooting itself in the foot.

– "If the denials are starting to ring hollow," the National Post recently remarked, "it’s because J.P. Morgan has had to issue so many of them in recent months."

– True. When the Enron crisis erupted last year, JPM repeatedly low-balled its exposure to the bankrupt "energy trader." Morgan’s CEO William Harrison insisted that Enron posed no serious risk to its finances. Nothing could have been further from the truth. The Enron fiasco not only took a big bite out of JPM’s balance sheet, it also dealt a body blow to its reputation. Next up, Morgan indignantly denied the prospect of a dividend cut…and then later acknowledged the possibility. Now the high- risk lender is at it again – adamantly denying rumors that it is saddled with sizeable wrong-way bets in the gold derivatives market.

– These troubling rumors swirled about the stock on Wednesday, November 6th, causing the shares to fall more than 6% that day. Immediately, Morgan’s PR department came out with its denial-guns ablazin’ by dismissing the rumors as "false and irresponsible."

– The rumors about Morgan’s outsized gold derivatives portfolio aren’t new, of course, they’ve simply gained a fresh intensity. They’ve also gained a fresh plausibility, given Morgan’s recent string of serial disasters.

– In theory, banks like JPM try to maintain a derivatives exposure that assumes very little risk. In other words, they are supposed to be ‘market-neutral’ most of the time. But as markets are markets and people are people, large speculative positions sometimes worm their way into the derivatives portfolios at financial institutions. – "As far as most analysts are concerned," says the Post, "J.P. Morgan’s massive derivatives program amounts to a short position on the price of gold." Therefore, ever since the yellow metal broke free of its bear-market moorings last year, suspicion about the bank’s exposure to gold derivatives has surfaced from time to time. Remember, these are "false and irresponsible" rumors.

– Morgan has assured one and all that it has "stress- tested" its derivatives portfolio and insists that, even in a worst-case scenario, there is nothing to worry about. Wow…that’s a relief! And by the way, the bank really, really wishes – honestly – that it were at liberty to divulge more details about its gold derivatives positions. Unfortunately, these are proprietary secrets.

– But there are a few clues that suggest reasons for concern. Foremost among them is JPM’s oversized presence in the gold derivatives market. "Pick a high-risk banking sector, any high-risk banking sector, and you are sure to find a large encampment – if not a tent city – of J.P. Morgan bankers," Apogee Research quipped several months ago.

– "In the derivatives market, in particular, Morgan exerts a particularly commanding presence…Drilling down a bit into Morgan’s titanic derivatives book, we find that it is the largest U.S. player in the gold derivatives sector (probably not a great thing to be in a rising gold price environment, but time will tell on that score). Based upon notional values, JPM holds nearly two- thirds of all the gold derivatives held by 369 U.S. banks and trust companies that hold derivatives of any kind."

– In raw numbers, Morgan’s balance sheet is only about two-thirds the size of Citigroup’s. Yet, Morgan’s $45 billion gold derivatives book is almost four times the size of Citigroup. Perhaps Morgan’s outsized gold derivatives exposure is not a MAJOR accident waiting to happen, but we wouldn’t be surprised to see the high-risk bank stub its toe…at least.

For more on JPM see: Apogee Research

————

Back in Paris…

*** In his speech yesterday, Alan Greenspan referred to the benefits of "25 years of extraordinary deregulation." The Fed chief thinks deregulation will help save the economy. David Ignatius, on the other hand, thinks that ‘real regulation’ is what is now needed.

We wouldn’t bet on either one.

Perhaps the U.S. economy was deregulated in some major ways in the last quarter century. But in many, many little ways, it seems there are more people telling us what to do than ever before…

"We are not close to the deflationary cliff," said Alan Greenspan. Inflation was clocked in October at a 3.6% annual rate. But then again, …deflation is an "Economist #1 Nightmare" says the International Herald Tribune.