This is the final post of a four part series. For those of you who want to read it in one piece, you can find it here.

In September of 2000, at the height of the Presidential election campaign, The Project for the New American Century (PNAC) released a report entitled, Rebuilding America’s Defenses. PNAC was comprised of the major neoconservatives including Don Rumsfeld, Dick Cheney, Paul Wolfowitz, Doug Feith, William Kristol, John Bolton and Richard Perle. They were not interested in letting the end of the Cold War slow down America’s military buildup.

At present the United States faces no global rival. America’s grand strategy should aim to preserve and extend this advantageous position as far into the future as possible…At no time in history has the international security order been as conducive to American interests and ideals.The challenge for the coming century is to preserve and enhance this “American peace.”

Underlying the failed strategic and defense reviews of the past decade is the idea that the collapse of the Soviet Union had created a “strategic pause.” In other words, until another great power challenger emerges, the United States can enjoy a respite from the demands of international leadership. Like a boxer between championship bouts, America can afford to relax and live the good life, certain that there would be enough time to shape up for the next big challenge. Thus the United States could afford to reduce its military forces, close bases overseas, halt major weapons programs and reap the financial benefits of the “peace dividend.” But as we have seen over the past decade, there has been no shortage of powers around the world who have taken the collapse of the Soviet empire as an opportunity to expand their own influence and challenge the American-led security order.

In sum, the 1990s have been a “decade of defense neglect.” This leaves the next president of the United States with an enormous challenge: he must increase military spending to preserve American geopolitical leadership, or he must pull back from the security commitments that are the measure of America’s position as the world’s sole superpower and the final guarantee of security, democratic freedoms and individual political rights.

This is the “Pax Americana”– laid out in stark terms. Four months later, the authors of this document took over the National Security Strategy of the United States and immediately began to implement the “American Peace”. Their formula was based around four core missions.

• defend the American homeland;
• fight and decisively win multiple, simultaneous major theater wars;
• perform the “constabulary” duties associated with shaping the security environment in critical regions;
• transform U.S. forces to exploit the “revolution in military affairs;”
  

As clear as their vision was for the future of American force projection, the neoconservatives were not unrealistic about the power of domestic politics to slow down their transformational strategy. The first year of the Bush Administration met with considerable resistance both inside and outside the Pentagon to the strategy of “The Vulcans” , as Wolfowitz and Feith’s team were called. Buried deep on page 63 of the 90 page PNAC document was an acknowledgement of the need for a catalyst.

Further, the process of transformation, even if it brings revolutionary change, is likely to be a long one, absent some catastrophic and catalyzing event – like a new Pearl Harbor.

Conspiracy theorists have seized upon these two lines to show that Cheney and his teams knew that 9/11 was being planned and they let it happen to provide the catalyst. But it is not necessary to buy into this line of thinking to understand that the planning to overthrow Saddam Hussein had been in Wolfowitz’s head since probably 1976. Because they had studied Leo Strauss, Walter Lippman and the “manufacturing of consent”, they were well prepared to use the public’s hysterical reaction to 9/11 to move the country behind the Iraq War. Our task here is not to review the propaganda mission of the Bush Regime or its egregious strategic blunders, but rather now to turn to the economic effects of a $2 trillion “war of choice”. The reality of Bush’s huge military buildup began to put more stresses on the debt markets.

Fourteen months after the 9/11 attacks, Ben Bernanke, then a Fed Governor, gave a speech to the National Economists Club in Washington entitled, “Deflation: Making Sure “It” Doesn’t Happen Here”. The combined shocks of the Dot Com crash and 9/11 had drastically weakened demand and the Fed had studied the ten year Japanese battle with deflation as a cautionary tale. Bernanke, also a student of the punishing deflation of our Great Depression, was genuinely worried that corporations were losing all pricing power. Bernanke laid out the dangers of deflation.

Suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.

For Bernanke, this situation was a central banker’s worse nightmare, and he urged the Fed to get out ahead of this disaster by drastically cutting rates. His boss Alan Greenspan bought into the argument. Although rates were already historically low, the Fed continued to cut, ending at a 1% Fed Funds rate in June of 2003. As James Grant pointed out in the Wall Street Journal, this deliberate “reflation” of the economy had a number of effects.

The central bank pushed the interest rate it controls, the so-called federal funds rate, all the way down to 1% and held it there for the 12 months ended June 2004. House prices levitated as mortgage underwriting standards collapsed. The credit markets went into speculative orbit, and an idea took hold. Risk, the bankers and brokers and professional investors decided, was yesteryear’s problem.

The historically low rates in 2003 and 2004 were also very helpful for George Bush in that they made financing the Iraq War relatively cheap by historical standards. On May 15, 2003, The New York Times noted that the 10 Year T Bill had fallen to a 45 year low yield of only 3.52%. But as the war moved into its second full year and the Treasury borrowing continued to mount the once mighty dollar began to fall. From an economic point of view it was first noticed in the oil market as Mid East oil traders kept raising prices to make up for the dollar’s fall. As 2005 began the fall of the dollar accelerated. Warren Buffet disclosed he had a major short position in the dollar on global currency markets and the price of oil continued its relentless climb, especially if you were buying it with dollars. The continuing fall of the global reserve currency posed an especially tricky problem for the governments of China, Japan, Korea and Saudi Arabia. They were all selling a huge amount of goods and commodities to the U.S. and thus were taking in far more dollars than they needed for domestic uses. The Chinese and the Saudis were essentially pegging their own currencies to the dollar in order to keep prices stable and U.S. demand strong. But as the value of their dollar reserves was being marked down on a daily basis, they began to contemplate spreading their reserve holdings into Euros.  But they were caught in a trap. If they sold a lot of dollars their remaining reserves would plummet, U.S. interest rates would rise rapidly and a global recession might start, thereby harming their export industries. All through 2006 they tried to avoid this problem, but by mid 2007, they had no choice. This relatively benign diversification of risk on the part of sovereign wealth funds could have easily been absorbed in a global market with oceans of liquidity, except for one problem. The four year long housing bubble was rapidly deflating.

The world financial markets might have been able to handle the effect of yet a second bubble bursting in 6 years except for the fact that most Wall Street firms had been more profligate in their borrowing than their hapless sub-prime mortgage holders. As James Grant explains, they were leveraged to the gills.

For every dollar of equity capital, a well-financed regional bank holds perhaps $10 in loans or securities. Wall Street’s biggest broker-dealers could hardly bear to look themselves in the mirror if they didn’t extend themselves three times further. At the end of 2007, Goldman Sachs had $26 of assets for every dollar of equity. Merrill Lynch had $32, Bear Stearns $34, Morgan Stanley $33 and Lehman Brothers $31. On average, then, about $3 in equity capital per $100 of assets. “Leverage,” as the laying-on of debt is known in the trade, is the Hamburger Helper of finance. It makes a little capital go a long way, often much farther than it safely should. Managing balance sheets as highly leveraged as Wall Street’s requires a keen eye and superb judgment. The rub is that human beings err.

So we had the perfect storm: A U.S. Government needing to borrow $50 billion a month; a banking system needing to replace perhaps $1.2 trillion in capital losses;rapidly rising delinquencies in consumer mortgages, credit cards and auto loans. This could not end well.

The British economist Baron Robbins wrote that “economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses.” In a sense, politics is the process by which we decide which alternatives we will dedicate our ”means” to. Dick Cheney’s idea of a “Pax Americana” has brought us to this perfect storm. The chart on the left, of the 2007 discretionary budget, could not make our priorities more clear. In an era of global liquidity and easy money, we might, like the condo-flipper of 2006, have been able to avoid the hard choices between guns and butter. But the next two years and beyond will not afford us that luxury. As our country’s most important bond manager, Bill Gross has pointed out, the only exit strategy from our current economic nightmare is an old fashioned Keynesian stimulus plan.

To provide a stable recovery path, government spending needs to fill the gap – not consumption. Public works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of our path to recovery.

But that stimulus will not be possible as long as the Military continues to hog 56% of our discretionary budget. Yesterday in Jordan, Barack Obama noted that the President must make hard choices that go beyond the responsibility of regional military commanders, including,

“what’s adequate for our security interests, factoring in the fact that not only do we have Afghanistan, which I believe is the central front on terror, but also the fact that if we’re spending $10 billion a month over the next two, four, five years, then that’s $10 billion a month that we’re not using to rebuild the United States.”

This is a start in the right direction, but the ultimate question of where the source of America’s power resides is yet to be addressed in the current Presidential campaign. The answer for the neoconservatives that make up John McCain’s National Security brain trust are clear. They all were members of the Project for the New American Century and the “constabulary duties” they see for American forces are endless. But a new vision of American power that resides in its economic, cultural and technological power has yet to be clearly defined by the Democrats. Perhaps a Presidential campaign is not the place to introduce America to the notion that spending more on the military than all our rivals and allies combined is folly. But at some point in the not too distant future this is a conversation we must have. I say this not because of some idealistic notion of peace, but rather from the hard bitten realism that comes to anyone who circulates in the world’s capitals. We are engaged in a global commercial competition of such scale that unless we are able to rebuild our schools, our health care system, our energy system, our transportation and digital networks we will surely become a second class power.

In 1997 the Yale historian Paul Kennedy, author of The Rise and Fall of Great Powers wrote,

The United States now runs the risk, so familiar to historians of the rise and fall of Great Powers, of what might be called ‘imperial overstretch’: that is to say, decision-makers in Washington must face the awkward and enduring fact that the total of the United States’s global interests and obligations is nowadays far too large for the country to be able to defend them all simultaneously.

Saying this less than eight years after the fall of communism brought ridicule from the Conservatives then planning their return to power. How ironic that a mere ten years later it all came true. But this story does not have to end like some sad tale of Nero-like decadence at the fall of Rome. Those of us that have spent our life in business know that “creative destuction” can unleash the powers of imagination. It will be our task to imagine a way to free our country from the grip of a permanent war economy.

It will not be easy, but it must be done.