Jon Taplin’s Blog

A printable version of this can be found here.

Boom and Bust

Paul Krugman wrote an interesting piece  recently on the boom and bust nature of recent American capitalism.

These prolonged recession-like episodes probably reflect the changing nature of the business cycle. Earlier recessions were more or less deliberately engineered by the Federal Reserve, which raised interest rates to control inflation. Modern slumps, by contrast, have been hangovers from bouts of irrational exuberance — the savings and loan free-for-all of the 1980s, the technology bubble of the 1990s and now the housing bubble.

Ending those old-fashioned recessions was easy because all the Fed had to do was relent. Ending modern slumps is much more difficult because the economy needs to find something to replace the burst bubble.

The chart at the top of this article is the S & P 500 for the last ten years. As you can clearly see, if you had all of your money in an index fund you would be right back to where you started from ten years ago. So it appears that the only way America can grow wealth is by creating low interest-fueled financial bubbles. Because our consumer spending (chart at left for the last 20 years), which is 70% of our GDP flucuatates in the same boom and bust cycle.

The next 6 months will be the most severe test of our bubble-driven economy as the Fed’s ability to lower interest rates is constrained by the inflationary pressures of high gas prices and the falling dollar. Although some have asserted that the rush of fast money into commodities is creating yet another bubble, it is not one that can be enjoyed by the average citizen, the way Internet stocks or flipping condos did in the last ten years. This fact actually increases social tensions as can be seen in the numerous congressional hearing investigating commodity speculation.

In classic economic terms, an economy ought to create enough surplus wealth to grow without resorting to excess borrowing–we ought to be able to live on what we earn. But since 1983, we have been unable to do that. So what differentiates the American economy from the rest of the developed world since 1983? The only rational answer is in the chart below which demonstrates how far beyond any possible rival our military budgets have travelled. The fact that the DOD’s own inventory of worldwide bases is more than 189 pages long cannot lead one to any other conclusion than the American taxpayer is supporting the infrastructure of empire.

NSC-68

The roots of American Empire began with President Woodrow Wilson’s decision to enter World War I “to make the world itself at last free”, which set in motion a kind of messianic foreign policy of American Exceptionalism, which echoes in the righteous speeches of President Bush today. As Henry Kissinger once observed, “It is to the drumbeat of Wilsonian idealism that American foreign policy has marched since his watershed presidency, and continues to march to this day.” Although contemporary politicians have used the shattering events of September 2001 to explain that everything has changed, their neoconservative mentors know the real story. “America did not change on September 11,” Robert Kagan wrote. “It only became more itself.” He went on to note that “over the last six decades, it is an objective fact that Americans have been expanding their power and influence in ever widening arcs.” Though historians could reach back to the British retreat from Kabul in 1882 to point to the perils of such expansive empires, the past seems to be lost to our country’s leaders. The effective result of this was a permanent militarization of American policy in a way that now puts us in peril economically and culturally.

I will argue that the initial source of our problems stemmed from a document, NSC-68, which remained secret from the day it was issued by the Truman administration on April 7, 1950 up until the day that Henry Kissinger declassified it in 1975. Written by Paul Nitze for the National Security Council, it laid out in Manichean terms the coming conflict with the Soviet Union that has echoes in today’s call for a war against Islam.

The Soviet Union, unlike previous aspirants to hegemony, is animated by a new fanatic faith, anithetical to our own, and seeks to impose its absolute authority over the rest of the world…The assault on free institutions is worldwide now, and in the context of the present polarization of world power, a defeat of free institutions anywhere is a defeat everywhere.

It was one thing for President Wilson to proclaim the principles of freedom, but here in a stroke, the U.S. took upon itself the responsibility to defend “free institutions” everywhere on the globe without creating any hierarchy of American interests as to which of these “free institutions” was worth shedding our blood and treasure for. At this point in the early 50’s with troops still deployed in Germany and many more to be deployed in Korea, it was only a matter of time that the Pentagon’s desire for “global force dominance” would find the necessary funding from a fearful Congress. Almost 60 years later the result is a worldwide command structure with U.S. troops deployed on every continent.

From an economist’s point of view, having just survived a Great Depression, the notion of military spending as a boost to jobs and production was given credibility and the theory of “guns and butter” became the conventional wisdom. Especially during the boom times of the fifties the notion was that spending money on guns did not take money away from civilian infrastructure. In fact civilian infrastructure like the Interstate Highway System was justified as a civil defense system for evacuating cities in a nuclear attack. President Eisenhower, who has been called a “nuclear schizophrenic” for his role in both enabling the gigantic growth of the military industrial complex and his prescient warnings about it, knew that the notion of guns and butter was patently false as he said in his famous speech to the newspaper editors in 1953.

Every gun that is made, every warship launched, every rocket fired signifies, in the final sense, a theft from those who hunger and are not fed, those who are cold and are not clothed.

This world in arms is not spending money alone. It is spending the sweat of its laborers, the genius of its scientists, the hopes of its children. The cost of one modern heavy bomber is this: a modern brick school in more than 30 cities. It is two electric power plants, each serving a town of 60,000 population. It is two fine, fully equipped hospitals.

It is some 50 miles of concrete highway. We pay for a single fighter with a half million bushels of wheat. We pay for a single destroyer with new homes that could have housed more than 8,000 people.

This, I repeat, is the best way of life to be found on the road the world has been taking. This is not a way of life at all, in any true sense. Under the cloud of threatening war, it is humanity hanging from a cross of iron. These plain and cruel truths define the peril and point to the hope that comes with this spring of 1953.

Even though Eisenhower ended his term by warning about the unchecked influence of the military on our democracy, it was probably too late. Military spending had come to be seen as a jobs program by every congressman and the big military contractors spread their plants into every state in order to curry influence. As we will see, this could last only as long as the country had a current account surplus with the rest of the world.

Living in Fear

Life in 1950’s America was lived under the twin fears of annihilation and depression. Annihilation because the constant threat of a Soviet nuclear attack was drummed into the populace from the day you practiced your first duck and cover drill in Kindergarten. I will never forget my second grade teacher’s warning that we should not open our eyes until she gave the all clear signal, for we would surely be blinded by the nuclear flash. The very idea that blindness would not be our biggest problem was not something a seven year old mind could wrap itself around. The second threat, unknown to a kid, but ever present in the minds of our parents and grandparents had been the 12 year world-wide annihilation of the capitalist economy known as The Great Depression. For economists and planners the biggest shock of the thirties had been the deflationary spiral. Excessive margin borrowing for stock speculation in the late 20’s led inevitably to debt liquidation as stock prices fell sharply. This in turn led to slowing of consumer purchasing. Once demand for new products dried up, prices started to fall and the Federal Reserve was unable to stimulate demand by lowering interest rates. It was “pushing on a string”.

The almost two decades of austerity ending in 1947 unleashed a good deal of pent-up demand for consumer products, but by 1954 demand growth for both automobiles and appliances (“consumer durables”) began to flatten. That year at the conference of American advertisers in Minneapolis, Studebaker Auto’s chief designer Brooks Stevens gave a talk on how to use “planned obsolescence” to prevent another fall in demand. Heretofore products had been sold on durability and quality, and even though the British economist, Bernard London had proposed in 1932 that planned obsolescence would be the way out of the depression, it wasn’t until Stevens began touting the idea that it was embraced by American companies. What was necessary he said, was “Instilling in the buyer the desire to own something a little newer, a little better, a little sooner than is necessary.” From this point on, from Chevrolet cars to Amana refrigerators to RCA televisions the annual “model change”, introduced in September with the start of the new television season became a fact of American life. Ironically, the one American TV manufacturer, Allen Dumont, that sold his more expensive sets based on a high quality “5000 hour picture tube” was forced out of business by 1958.

A much greater irony rests in the fact that at the same time Steven’s idea of disposable consumer durables (the irony) was being widely accepted in the U.S., the two defeated powers of World War II were rebuilding their industrial plant on a very different model. In Tokyo a young entrepreneur named Akio Morita was building the first transistor radio for a small start-up called Sony, based on licenses he had obtained from Bell Labs. From as early as the invention of radio, the U.S. and firms like RCA had always been in the forefront of consumer electronics. But now as most U.S. government R & D funding in electronics was going into the military economy, we began to cede our front rank in consumer electronics in order to concentrate on military electronics. Within 15 years, the Japanese firms would completely dominate the consumer electronics business. Not far away, Eiji Toyoda, had recently returned from a visit to Ford Motor’s River Rouge plant, convinced that his small Toyota Motor company could build cars more efficiently. He put forth to his board the outrageous idea that they sell their new Toyota Crown (left) outside of Japan, targeting Brazil and the U.S. At the same time the factories in Germany of Mercedes Benz, BMW and Volkwagen were slowly beginning to turn out cars based on a principle that they could be run for at least 150,000 miles with the original engine. So as the American manufacturing culture of durability was being hollowed out by a marketing aesthetic of disposability, our former enemies were creating a culture of quality goods that would come to have lasting appeal for publics around the world. This disparity of course would come to haunt our country to an extent unrecognized at the dawn of the cultural revolution of the 60’s.

This cultural revolution affected the ability of all business to continue to market in the aspirational style that had been the hallmark of the consumer durable business. For those companies working with the Pentagon, it was even more problematic. Dow Chemical was no longer known as the producer of miracle fabrics, but rather of incendiary Napalm weapons, capable of searing the flesh off young Vietnamese children. It would not be until 1971, when soon to be Supreme Court Justice Lewis Powell wrote his notorious memorandum to the head of the U.S. Chamber of Commerce, that business fought back. The Powell Manifesto was a call for the Chamber and it’s allies to fund a counter revolution against the cultural and political forces of the 60’s and recapture the country for the political forces of big business.

In an extraordinary prefiguring of the social goals of business that would be felt over the next three decades, Powell set his main goal: Changing how individuals and society think about the corporation, the government, the law, the culture, and the individual became, and would remain, a major goal of business.

Powell’s plan of attack was for big business to fund think tanks like the American Enterprise Institute, the Heritage Foundation and others who would provide policy papers to begin the rollback of the power of unions, students, consumer and environmental groups. Of course in the intervening 25 years since America had introduced it’s planned obsolescence manufacturing system, the lure of foreign quality goods had begun to catch on. By 1975, the U.S. was running an annual merchandise trade deficit, which would never be eliminated. With the election of Ronald Reagan, a full scale war against the unions began, but at the same time new thinking at the top of many corporations began to coalesce around the idea of outsourcing manufacturing to countries with lower labor costs and little or no environmental legislation. These two factors began the wholesale deindustrialization of America.

Of course the only industries not outsourced were the defense contractors. Eisenhower’s prescient warning of “the unwarranted influence of the military industrial complex” had come true. With factories in almost every state, military contractors had remarketed their closed bid contracts as “job programs” and legislators were eager to protect some of the few manufacturing facilities left in America.

Reagan had convinced us by 1984 that he was presiding over “Morning in America” and for the conservatives that Lewis Powell had urged into battle, it certainly seemed that victory was at hand. All attempts to regulate business such as passing further auto mileage standards had been beaten back and even American car manufacturers were winning converts to their new SUV’s. But there was one part of the puzzle that was being ignored, even though Jimmy Carter had pointed it out during the oil embargo. The U.S. domestic oil supply had passed it’s peak and was declining even as low mileage SUV’s were burning gas at an unprecedented rate. As we will see, the combined forces of imported oil, skyrocketing military budgets, growing trade and current account deficits were powering Battleship America towards a sea of icebergs.

 

The Walls Come Down

The neoconservative narrative on the Ronald Reagan Presidency is that he raised our military spending and sent the Soviet Union into an arms race they could not afford. On their knees economically, they were forced to give up their empire. Thus the Berlin Wall came down.

But who really brought down the Berlin Wall? I say it was not Ronald Reagan and his $800 billion military buildup, but rather a courageous Pope named John Paul II who in 1979 journeyed to his native Poland, embraced the embattled trade union leader Lech Walensa and declared,

The future of Poland will depend on how many people are mature enough to be non-conformist…There is no need to be afraid. The frontiers must be opened. There is no imperialism in the Church, only service.

Within weeks a million people were in the streets in support of Solidarity. He had given the Polish people the will and courage to be non-conformist, even at the risk of imprisonment. Long before Reagan was even in office, the Pope had created the conditions for freedom. It is clear that that Soviet President Gorbachev also must take some credit for pushing through the basic reforms that led to the freedoms that followed.

It is of course one of the defining articles of faith of the conservative movement that Reagan militarily spent the Soviets into bankruptcy. But it is a Big Lie. Of course the Soviet economy was a hollowed out shell in 1989, but it also held an extrordinary number of assets including one of the world’s largest oil reserves and an well educated work force. Freed from the need to compete in an arms race, the Russians were able to turn their talents to business. Today, the Russian central bank and the Central Bank of China, our other cold war foe, now control over 20% of the U.S. Treasury debt, and we control none of theirs. Exactly who spent who into bankruptcy? As if in some epic match of “rope a dope”, our rivals, freed of the military burdens of imperialism, have allowed us to spend our selves deep into debt. Worse than just government and military profligacy, the consumer also went on a binge in the Reagan Era. The easy regulatory environment of the Republicans allowed banks to market credit cards with formerly illegal usury interest rates to almost anyone. The consumer who had maintained debt levels at near 12% of assets since the 60’s suddenly went into hock. This of course meant a declining personal savings rate (below zero for the last two years), which in turn meant the U.S. Government had to call on the more than ample savings of the rest of the world to fund its debt for military expenditures.

It wasn’t that there weren’t people making money during the Republican reign in the 80’s. It was just a certain class of people–the richest 0.01% (chart below). I remember having a meeting at Drexel Burnham Lambert in 1986, soon after it had been revealed that Mike Milken’s take home pay for the year was $550 million. I was working for Merrill Lynch’s media mergers and acquisition group and Milken demanded we show up at 5:15 AM in their Beverly Hills office in a glassed walled conference room right off the trading floor. Milken has spread another $150 million around to his colleagues on the trading desk, so the sense of bonhomie and entitlement was pretty thick. They “owned” the junk bond market, but as Bob Dylan once said, “to live outside the law, you must be honest.” Milken went to jail and had to pay a huge fine, but he’s out now, still with billions in the bank. By “cashing out at the top”, Milken is one of those bubble players who have done well in the last 30 years of Republican rule, even if he did have to “disgorge $400 million and pay a $200 million fine, he had billions left over.

The mid eighties were also a very profitable time, if you were a defense contractor or lobbyist. It is not the purpose of this relatively brief summation to review the elaborate rationalizations for Reagan’s defense build-up–to critique the work of Cap Weinberger, Richard Perle, Paul Wolfowitz or any of the lobbyists and intellectuals who contributed to the build up. Suffice to say, when Perle advocated unilaterally abrogating the 1972 ABM treaty so that we could begin building what was to become the Star Wars anti-ballistic missile system, he said he felt no reason to keep treaties with a barbaric people like the Soviets. As James Carroll writes in his classic , House of War,

Perle blithely declared that the Soviet Union would willingly sacrifice twenty million of its own citizens in a nuclear war with the United States, a prediction the President had often made in after-dinner speeches as a private citizen.

Historians have since proven that many of the claims of the Reagan administration about Soviet power were constructs of the imagination with no basis in fact. But men like Perle and Wolfowitz had been schooled in the political philosophy of Leo Strauss, the spiritual father of neo-conservatism. Deception was part of their job description.

Not only did Strauss have few qualms about using deception in politics, he saw it as a necessity. While professing deep respect for American democracy, Strauss believed that societies should be hierarchical – divided between an elite who should lead, and the masses who should follow. But unlike fellow elitists like Plato, he was less concerned with the moral character of these leaders. According to Shadia Drury, who teaches politics at the University of Calgary, Strauss believed that “those who are fit to rule are those who realize there is no morality and that there is only one natural right – the right of the superior to rule over the inferior.”

What should be noted is that this philosophy of deception did not end when the Berlin Wall fell. During the Bush I Gulf War both the Pentagon and Raytheon claimed that their Patriot Missle had knocked down dozens of Iraqi Scud Missiles. This of course was not true and the Patriot was so hapless the Israelis refused to take them, even when offered at no cost. Media scholars of the Gulf War claim it was but a commercial for U.S. smart bombs and of course large contractors like Raytheon were happy to sell their wares to any country. But the tradition born of Woodrow Wilson’s Committee on Public Information, honed by the early propaganda work of Walter Lippmanwas alive and well. Lippmann assumed a public that “is slow to be aroused and quickly diverted . . . and is interested only when events have been melodramatized as a conflict.” Even Bill Clinton in his campaign against George Bush for President was not above using “melodramatized evil” in his campaign advertising. “Saddam Hussein still has his job. Do You?”, intoned one ad with ominous background music.

To study a new Democratic President arriving in office in 1992, at a time of peace is to reach into the core of our story. For if ever there was a time when our military commitments could have been cut back to give us a “peace dividend”, it would have been in 1993. The sad story of Clinton’s colossal failure to reign in the military is best encapsulated in an incident reported in House of War. Shortly after he had unveiled his “don’t ask, don’t tell” order on homosexuals in the military, Clinton visited the aircraft carrier USS Theodore Roosevelt.

As he was piped aboard, he passed a young sailor at the head of the gangplank. The sailor pointedly declined to salute his commander in chief. Instead of rebuking such disrespect to the office of the presidency on the spot, or afterward, Clinton let the slight pass, as if it did not matter. The President’s refusal to enforce due deference to authority was a graver offense against the military ethos than the sailor’s contemptuous act, and every member of the armed forces took note.

Whether intimidated by his own draft dodging past, or merely incapable of standing up to the generals, Clinton’s regime can be seen as an abject failure when it came to taming the military industrial complex. He took office in a recession and almost immediately had to deal with intense pressure from Congress and the military industrial complex to expand NATO. Both Reagan and Bush had made commitments to the Russians not to let the former Warsaw pact countries into NATO. As Carroll notes,

But the Pentagon had never accepted that. Getting former Warsaw Pact members into NATO, beginning with Poland, Hungary and the Czech Republic, was less a security question, now that Russia was in decline, than an economic one, for Moscow’s former satellite nations, needing an arms buildup from scratch, represented a major new market for the Pentagon’s industrial partners. That was an argument Clinton could understand, and as a politician he saw a benefit of pleasing U.S. voters with ties to Eastern Europe.

Needless to say defense contractors showered money on new Democratic committee chairmen and their allies, spending almost $50 million in one year to lobby for NATO expansion. The benefits of not crossing the military industrial complex could be shared by both political parties. And in the area of nuclear disarmament, Clinton ended up with a far worse record than either Reagan or Bush 1, under whom the nuclear arsenal had been cut in half. Under Clinton, partially because of his embrace of NATO expansion almost no cuts in nukes were made.

As our story moves towards the present, we must acknowledge one insight of the Clinton administration into the problems that will confront the Bush administration after the turn of the Millennium. Treasury Secretary Rubin was well aware that running a $3 billion per day current account deficit was unsustainable. And by a combination of raised taxes and fees along with spending cuts, he was able to bring it to a surplus in the last year of the administration. This lesson in fiscal responsibility was of course lost on the idealogical tax cutters of the Bush-Cheney administration. As we will see, Eisenhower’s early warnings that “the disastrous rise of misplaced power exists and will persist” would come true in a way that perhaps only a poet of the apocalypse could have imagined. As W.B. Yeats had written in 1920,

Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned.
The best lack all conviction, while the worst
Are full of passionate intensity.

 

Imperial Overstretch

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 effect of Bush’s Military buildup was dramatic.

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.