The Perfect Financial Storm - Part 8: Storm Tactics for Inflation & Stagnation

In the fall of 1991, three storm fronts were gathering off the North American continent. A cold front was building off the Canadian Shield, a major tempest was forming over the Great Lakes, and a hurricane was in its formative stage off Bermuda. These three storm fronts would collide and merge into one off the Grand Banks. Hurricane Grace was a late-season fluke. Grace was forecasted to hit somewhere in the Carolinas. Unexpectedly, the hurricane ran into a cold front that blocked its path and forced Grace northward into the path of the other two storms. This collision created a pressure gradient that led to "The Perfect Storm", a phenomenon seldom seen by meteorologists.

Sailors heading out to sea must be prepared for any kind of weather. A balmy day on a calm sea can quickly give way to a storm. The same holds true for today's investor. A booming economy can drop into a recession just as a bear market can follow a bull market. Economic and financial conditions never remain constant. They are as seasonal as the weather. Forecasts change depending on the patterns that emerge.

Just as mariners must consider different weather and sea conditions, investors must be alert to different economic scenarios. In my last installment I discussed the deflation scenario. This installment acknowledges three other possibilities - inflation, stagflation and what I call "The Perfect Financial Storm". In Part 7, I suggested that deflation was a possible outcome of today's credit-induced economic boom as witnessed in the US during the 1930s and present-day Japan. A review of these terms from The American Heritage Dictionary may be helpful:

• de-fla-tion: A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit
• in-fla-tion: A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money caused by an increase in available currency and credit beyond the proportion of available goods and services
• stag-fla-tion: Sluggish economic growth, coupled with a high rate of inflation and unemployment
• The Perfect Financial Storm: The collision of three financial storm fronts: the economy, the stock market, & the international monetary system

The Seven Fat Years

Most American economists don't acknowledge the possibility of stagflation or inflation sighting our current low rates of inflation reflected in the PPI and CPI numbers. Inflation by definition is nothing more than an increase in the supply of money and credit in relation to the supply of goods and services available in the economy. As this graph indicates, the money supply has been expanding at above-normal rates for the last seven years. Money supply multiplies through the banking system by the expansion of credit. Rising CPI numbers don't always manifest these credit excesses. Instead these credit excesses create economic imbalances and dislocations such as we now have in the technology sector. They also help to fuel asset booms and over-indebtedness.

Keynesian vs. Austrian

American economists widely subscribe to the Keynesian view that economic growth depends on the expansion of demand through money and credit creation. Austrian economists believe differently. The Austrian school believes that a credit expansion has three potential outlets. These outlets for increased credit are used 1) to purchase goods and services, 2) to purchase imported goods, and/or 3) to purchase financial assets.

Source: Federal Reserve Board

US Inflation Demonstrated by Its Definition

When the money supply is inflated, and credit is used to buy more goods and services, the price of those goods and services rise - thereby reflecting inflation. The supply of money created by credit can also be used to buy foreign goods. This is reflected in our record trade deficits as shown in this graph. If Americans could only buy domestic-created goods, then the excess demand created by an expansion of credit would soon drive up prices - again reflecting inflation. However, prices have not gone up. Why not? The excess demand was tempered by foreign imports. This tempering has helped to keep domestic prices low because of global competition. We have seen throughout the nineties that the excess demand of American consumers not fulfilled by domestic producers was made up by foreign imports.

Because foreigners chose to recycle the dollars earned from their exports into US assets, the US dollar has remained strong. We haven't had to deal with a declining dollar as we did during the 1970's. A declining dollar would have clearly reflected the inflation caused by an expansion of the supply of money.

Another outlet for the expansion of credit is financial assets. As illustrated in the graph of the Dow, S&P 500, and the Nasdaq, the financial markets have expanded at above-average rates over much of the last decade. Between 1997-99, financial credit expanded by .8 trillion. Over .2 trillion went into various financial institutions in the form of asset-backed securities; while another 0+ billion went to Security Broker/Dealers.[1] The result has been that our financial markets have expanded at above-average rates since 1995. Whether it was GSEs like Fannie Mae, major Wall Street brokerage firms, or the general public borrowing money in the form of second mortgages or margin debt, credit helped to fuel an explosion in financial asset prices.

Mortgage debt is still expanding as evidenced by the number of new debt offerings coming from Fannie Mae and Freddie Mac. This debtor money is fueling real estate prices.

As this graph indicates, the financial sector ended the third quarter of last year with over .15 trillion in debt. Financial sector debt has expanded by over .7 trillion over the last three years. For all of 2000, the aggregate debt of domestic non-financial institutions increased by an estimated 5.5%, 8.5% for nonfederal debt and by 10% for commercial banks. At the end of 2000, total non-financial, governmental, state, local and private debt stood at .3 trillion, while financial sector debt rose to .2 trillion.[2]

Chart Source: Prudent Bear

As the following table illustrates, we have experienced the greatest credit expansion in history. I call this period "The Seven Fat Years." The explosion of credit and the corresponding explosion of the money supply have created the greatest asset bubble in history. What the above graphs and table below show is that we are living in inflationary times. That inflation is reflected in the parabolic rise of our stock market, exploding real estate prices, a burgeoning trade deficit, a negative savings rate created by excessive consumption and the expansion of both non-financial and financial debt. All of these examples reflect various forms of financial inflation.

The Seven Fat Years

Where We Stand Today

Debt levels continue to expand in 2001. Consumers still spend more than they earn. Government-sponsored entities increase their balance sheets by the issuance of mortgage-backed securities. The trade deficit remains at record levels absorbing excess consumer demand. However, after last year's collapse in the Nasdaq, that credit is being channeled into two primary areas. The first is mortgage debt, which is helping to fuel real estate prices. The second channel is personal consumption, which is behind our record trade deficits and rising consumer debt levels.

We are now experiencing the last year of the seven fat years. The real estate market and consumer spending continue to hold up the economy, but their effects are diminishing. The manufacturing sector is already in a recession. The technology sector is starting to contract. Meanwhile personal consumption remains strong thanks to retail markdowns and excess cash generated from refinancing mortgage debt. Personal consumption and the boom in the real estate market are the last legs propping up the economy. Real estate and personal consumption are the last vital signs of "The Seven Fat Years."

Stagflation

History shows us that busts always follow credit booms. The excesses themselves sow the seeds of their demise. The severity of the bust is predetermined by the associated imbalances created in the economy and the financial system. A deflationary bust that led to the Great Depression replaced the credit boom of the 1920's. A similar bust that continues today followed the credit boom in Japan during the 1980's. The Japanese Nikkei has recently hit a new 16-year low. The busts in the US during the 1930's and present day Japan were deflationary. Both countries were creditor nations at the time of their busts. The result of the bust was the credit excesses were replaced by deflationary contractions.

The current credit boom in the US may not lead to immediate deflation. In fact, another intermediate storm front may erupt, which economists call stagflation. As discussed in Storm Tactics for Deflation, there are several forces within the economy that are deflationary. However, several of the assumptions for the deflationary scenario may not play out. America is no longer a creditor nation. Instead, the US has become the world's largest debtor nation. Foreigners now own vast amounts of US financial assets. What they do with their dollar holdings could greatly alter the deflationary scenario. If they dump their investment holdings, the dollar would collapse. This would be inflationary through the increased cost of foreign goods.

The Austrian School of Economics believes that deflation is the market's solution to the mismanagement of the money supply. Busts follow booms. But this isn't always the case. The government has vast powers to thwart deflation. They have a plethora of tools to keep the debt pyramid from collapsing. They can extend or alter the boom by expanding the money supply, changing bank reserve requirements, nationalization or declaring bank holidays. Inflation and deflation are two sides of the same coin under a fiat money system. Whether we have deflation or inflation will depend on various factors ranging from perception to public confidence. It will depend on whether market forces prevail over government inflationary maneuvers. It is for this reason that investors must be alert to alternate outcomes.

Extra-Ordinary Circumstances

Other deflationary forces seen in the cuts in defense spending, shrinking government deficits, and a slowdown in the rate of growth in government spending may be dramatically altered due to extraordinary circumstances. Due to the malinvestments that took place during The Seven Fat Years, an inordinate amount of capital was directed towards investments in technology and real estate. The result has been a glut in the technology sector, which now has excess capacity. Real estate has also expanded, especially residential and commercial real estate.

While the recent credit boom channeled billions of dollars into technology and real estate, other sectors of the economy have been dangerously ignored. Investment in America's infrastructure has been under-funded. This has led to a vacuum in investments that are key to the functioning of our economy and the defense of this country. They will require trillions of dollars of new spending that may create an inflationary environment while at the same time, the rest of the economy is experiencing a decline. Economists call this scenario, "stagflation." Stagflation is defined as sluggish economic growth coupled with a high rate of inflation and unemployment.

The special circumstances that now exist in three key sectors of our economy could lead to inflation at a time of declining economic growth and could lead to the next asset bubble. These under-funded areas are 1) Energy and Power, 2) Water, and 3) Defense. Their very existence raises the possibility of stagflation and an interim storm leading up to The Perfect Financial Storm.

I. Energy and Power

For the last two decades, investments in finding and producing energy, tankers to export oil, refineries for producing oil by-products, pipelines to transport it and power plants that utilize it have been under-funded and under-invested. The result is that we have run out of spare capacity in oil, natural gas and electricity. In the words of Matthew R. Simmons, President of Simmons & Company International,

"Today's energy crisis is the equivalent of a Perfect Storm! The energy crisis is a convergence of pending shortages in all three forms of energy: oil, natural gas and electricity."[3]

The prosperity of the last century was driven by inexpensive oil-based energy. We aren't running out of oil and natural gas. We've simply run out of spare capacity and cheap forms of energy. Oil discovery peaked in the 1960's. Oil production peaked in the US in 1971 and for rest of the world outside the Middle East in 1997. We are now finding only one barrel of oil for every four that we consume. We are at a key inflection point in history. The power shortages in the Midwest last summer and the current energy crisis in California are but the first tremors that are about to send shockwaves through the world's economic system. These tremors won't be temporary. They will reflect the onset of a new permanent condition of energy constraints. Future shortages are in the formative stages.

As these graphs illustrate, oil discovery peaked in the US during the 1930's while production peaked 40 years later in 1971. For the world as a whole, discovery peaked in the 1960's while production has peaked outside the Middle East in 1997. Middle East production is expected to peak by 2005 before production begins to decline.

The Decline of US Supply of Oil

In the US, despite a dramatic increase in oil and natural gas rig counts, oil and natural gas production continues to decline. Inventory levels of natural gas and oil continue to decline as a result of demand exceeding supply. Demand is being driven by economic and population growth and the advancement of technology. The Internet, which is run on servers, and PCs are adding to the demand for electricity. Last year in California, electricity demand grew by 10%.[4]

The US was blessed by an abundant source of energy with coal, oil, and natural gas. Its abundance in a variety of energy sources was unmatched by any other region of the world. It enabled the US to become the richest and most powerful nation in the world. That abundance of natural resources allowed us to supply our industrial economy, power our factories and win wars. But that abundance is quickly evaporating. Up until 1971, the United States was energy self-sufficient. Today we make up 5% of the world's population and use about a third of the world's annual energy supplies.

Estimated World Oil Distributed
(Billions of Barrels)

We must now import close to 60% of our oil.[5] We have depleted most of our original oil endowment and are down to about a third of our original reserves. As the above table indicates, we have consumed much of our oil endowment - making us more dependent on Middle East oil.

Over the next decade, the challenge of meeting our energy demands is going to require vast amounts of investment dollars. We will need to build more tankers to bring imported oil to the US, more refineries to process it, thousands of miles of new pipelines to transport it, and new power plants to produce electricity. The investment will be formidable.

The Need for a Millennium Infrastructure in Oil

Once again, we are not running out of oil and natural gas. We have simply run out of spare capacity and the ability to deliver it. This nation is short on energy reserves, tankers, pipelines, and power plants and has an underdeveloped power grid to deliver electricity. There are many experts who have spoken about this issue - most notably Dr. Colin Campbell. More recently Walter Youngquist, Michael Economides and Ronald Oligney have written books about these very issues. The investment-banking firm of Simmons & Company International led by Matthew Simmons has raised a clarion call on the crisis we now face. With California's energy crisis making front-page headlines, their warnings will hopefully not go unanswered.

Oil's Potential for Geopolitical Conflict

One of the unacknowledged realities of today's present political environment is the world's growing dependence on Mideast oil. As the world transitions to a decline in global oil production, global tensions are bound to rise. This could produce another oil war as various western and eastern states may consider military intervention as a means of securing oil. Until the oil wells run dry and a new energy source is discovered, this small group of Middle East nations will exert a growing influence over world economic affairs.

This growing importance of Middle East oil will cause a major geo-political shift of power among regions and nations. The most visible sign of this power shift is the United States moving from a creditor nation to a debtor nation. In the short run and until this crisis is resolved, the US standard of living will continue to fall. Our energy dependence will alter our own ability to control our own destiny. With no new continents to explore, nations will increasingly confront each other over dominion of the earth's remaining natural resources. Future military conflicts are more likely to be over energy, water, minerals and fertile soil. It will take consummate statesmanship by world leaders to avoid a future conflagration.

I have only scratched the surface on the energy crisis the world and in particular, the United States now face. It is going to take massive amounts of money to correct it, requiring a large investment infusion by government and industry to rectify it. Matthew Simmons believes it will take the equivalent of another Marshall Plan to solve it. Its relevance to stagflation is that it will raise the level of inflation in the United States at a time of declining economic activity. Higher energy costs translate into higher production costs. Just look at the number of companies from DuPont, Procter & Gamble, to Gillette who have sighted higher energy costs behind their profit shortfalls. Higher energy costs will also mean higher utility bills and higher food costs since energy is required to fertilize crops and produce food.

II. Water

There are three things of absolute importance to mankind's survival. We just talked about one of them - energy. The other two are fertile soil and water. Without soil and agricultural water, we wouldn't have food. Without drinking water our bodies couldn't survive. Water is the medium that connects life to the minerals in the soil, which become the nutrients for all plant life. There is no substitute for water.

Increasingly, we are seeing chronic water shortages around the globe in close to 40% of the world's population centers. It is severe enough that last year water ministers from around the world met at a summit in the Netherlands to discuss a pending water crisis. The US Central Intelligence Agency, in its "Global Trends 2015: A Dialogue About The Future With Non Government Experts," listed water problems as possible reasons for international tensions and war during the next 15 years.[6]

In fact, Middle East tensions are currently rising over water rights between Turkey, Israel, Syria and Iraq. Turkey's eagerness to sell water to Israel, while reducing the flow of the Tigris and Euphrates to its Arab neighbors, is placing Ankara in a dangerous position. Water is more important in the Middle East than oil. The current dispute over the water rights of the Tigris and Euphrates could be a casus belli for years to come. Last year Sudan's former Prime Minister Sadiq al-Mahdi threatened war over the water rights of the Nile. In the end, the ultimate battle in the Middle East may be over water—not oil.[7]

In April of last year, a bipartisan House caucus was convened to discuss the growing problems with our nation's water infrastructure. Municipalities that face a growing water crisis are calling for major Federal legislation similar to the TEA-21 Transportation Bill and the AIR-21 Aviation Bill. Over the next two decades, it is estimated human water consumption will increase by over 40% and water demand for agriculture will grow by 17%. The impetus behind these various public interest groups is for federal funding to repair and meet existing water infrastructure and meet standards of the Clean Water and Safe Drinking Water Acts. According to the Water Infrastructure Network (WIN), America's water and wastewater systems will have to invest billion a year over the next two decades to meet the standards of the Clean Water and Safe Drinking Acts. [8] Yet while government statutes require new standards, federal contributions to water and wastewater continues to decline. According to WIN, current federal funding is about billion a year when billion a year is needed. In essence, we have been legislating new standards without the funding necessary to meet them.

According to WIN, there are three major areas of core water infrastructure needed to meet this country's demand for clean safe water. 1) drinking water supply systems, 2) domestic wastewater management systems, and 3) wet weather runoff control systems and management practices. To meet these needs will require cooperation among federal, state, and local authorities. The private sector will also play a growing role. The problem with cooperation today is that the water industry is made up of an amalgamation of several sectors. They range from municipal water districts, water utilities, filtration and equipment companies, to the beginnings of a water resource commodity market.

The government will be reluctant to fund the entire needs of upgrading and replacing the nation's aging and deteriorating water infrastructure. This opens opportunities for the private sector. Water utilities are expanding into the home and commercial water treatment market. There is growing acceptance of private water utility operators, especially as municipal budgets become constrained. There are over 55,000 water systems in the US Most of them are small and inefficiently run. The potential for consolidation is wide open. Faced with an aging water system, many municipalities are turning to the private sector. Some are selling their systems in an effort to privatize, while others are seeking joint ventures.

Water: Opportunities for Development

As water gains national attention, it will afford new opportunities for investor-led water utilities. The future will be favorable for private sector companies connected to the needs of our nation's water infrastructure. There will be opportunities for water utilities, water treatment equipment and systems management companies, construction and engineering firms.

The water-related industry is relatively small. It is made up of US water utilities, international water utilities, water filtration and treatment companies, and water resource management companies. The capitalization of the whole sector is small in comparison to most S&P 500 companies. Most of the companies in the industry are small to mid-cap. The foreign companies are the largest. However, consolidation within the industry affords investors many opportunities. Buyouts will continue and eventually a few giants will emerge to dominate the industry. Right now it is in its infancy. It would surprise most investors to discover that the water industry has been outperforming the market.

Energy and water are key resources to any nation's prosperity. Today's nation states will increasingly find themselves in conflict over access to the earth's vital resources. Minerals, energy, and water have been involved directly and indirectly in warfare. We have already fought two world wars and one regional war during the last century over oil. Oil was at issue in two of these wars and the victors were those who had access to oil -- and controlled it. The one resource that is essential to all sides in warfare is water. Water, along with oil, are key resources for which wars have been fought over in the past and will be fought over in the future. Which brings me to the next area of under-investment - defense.

III. Defense

Defense in Hibernation

The Cold War was over in 1989. The Gulf War was won in 1991. There were no major military threats on the horizon. The Peace Dividend was at hand. It was time to downsize the nation's military, which had been designed to fight and win the Cold War. America was confident that there were no more foes to be vanquished. Like the British before us, we would retrench. As a result of victory on the diplomatic front and the battlefield, US military thinking began to change. The Doctrine of Containment designed to deter Soviet aggression was no longer needed. The Cold War did not end in a decisive battle. There was no Waterloo or formal surrender. There were no peace treaties to signal its end, but it resulted in the collapse of the Soviet Union. The August 1991 coup in the Crimea failed and ended with declarations by various states, leading to the formation of the Commonwealth of Independent States.

For all of the dangers posed by the Cold War, the bi-polar world of two superpowers kept aggression in check. Each power policed its own sphere of influence. The US and the Soviet Union had dampened Arab-Israeli wars, kept the Balkans in line, and China passive. Now with the demise of the Soviet Union, American policy leaders thought it was time to relax our guard, thinking any immediate threats would be minor and could be contained. The size, power, and invincibility of America's military displayed during the Gulf War were terrifying. No one would dare challenge us.

Shifting Budget Gears

With an economy in recession, large budget deficits and a growing national debt, Washington policymakers felt it was time to cut the defense budget. The military became the victim of its own success. In fact, many on the left mistakenly blamed our large deficits on the Reagan military buildup. With the Soviet threat removed, politicians minimized the dangers of regional conflicts and the type of force structure needed to contain them. Two camps emerged in Washington on the future size, role and strategy for the US military. On one side were Les Aspen and Sam Nunn. Secretary of Defense Dick Cheney, Under Secretary of Defense Paul Wolfowitz and General Colin Powell led the other side.

The 90's Base Force Concept

The Cheney-Powell Camp designed the concept of the "Base Force." It was designed to meet four strategic objectives and would consist of four major packages. The Atlantic Force (largest) was designed to deal with Europe and Southwest Asia. The Pacific Force would deal with Japan and Korea. A third force would control our nuclear arsenal. The final package would be made up of a highly mobile Rapid Deployment Force. It was well thought out and designed to deal with any threats in an uncertain world.

The Base Force concept wasn't perceived well on Capital Hill. Since it was impossible to predict who America's enemies would be, it lacked a ready villain. Without a ready villain, the left saw the Base Force as being unnecessary and too large. They attacked its strategic premises. Whereas the Cheney-Powel Camp saw the armed forces playing an active and integral role in shaping foreign policy, the Aspen-Nunn Camp saw the US military as global cops. Cheney argued for a strong enough force to remain engaged in the world and to repel would-be aggressors. The Cheney plan looked well into the future. It was impressive strategic thinking for its time. It reflected the Bush administration's understanding of geopolitics and the force necessary to back foreign policy. The Aspen plan looked only at the present.

The Bush Administration won the initial debate. The Base Force became the blueprint for the post-Cold War defense reductions. The military began to redefine its force structure and strategy. Unfortunately, the Base Force wasn't given enough time. It was abandoned and replaced by the Aspen plan when Bush lost the Presidency. Les Aspen became President Clinton's Secretary of Defense. His plan became the blueprint for subsequent reductions of our military forces.

Eight Years of Neglect

The new president had no interest or understanding of foreign affairs or military strategy. His administration pursued a policy of acting as the world's global cop, relying on the United Nations for direction. The US military became the UN's 9-1-1. Missions multiplied in number from Somalia, Haiti, and Bosnia, to Kosovo. While mission creep expanded, the Clinton Administration pursued aggressive reductions in America's force structure. Research and development to keep our technological edge was gutted. The concept of missile defense was abandoned. And our military infrastructure was allowed to deteriorate. As a result of the cutbacks, America's defense industry contracted and consolidated.

Upon assuming office, President Clinton proposed his first budget in 1993. It recommended cutting defense outlays by 2 billion on a nominal basis during FY 1994-1998. The figures below illustrate the extent of the cutbacks. The US military shrank by more than 48% compared to its position at the end of the Cold War. During the Cold War, with a much larger force, the US military engaged in 16 small-scale operations. Between 1990 and 1997 we engaged in 45 such missions. Like the British government at the end of World War I, there has been a clear mismatch between foreign policy and the means to implement it. Today, our military is stretched to the limits.

US Force Elimination (Clinton Administration)

• 10 Army Divisions (1 million troops)
• 20 Air Force/Navy Wings (2,000 aircraft)
• 4 Aircraft Carriers (12 = 10)
• 121 Surface Ships/Attack Submarines
• 232 Strategic Bombers
• 13 Ballistic Subs (2,114 warheads)
• 500 Intercontinental Ballistic Missiles (1,950 warheads)

Military Cutbacks in the Nineties

Where We Are Today

Today the U.S military force structure is running out of its useful life. Much of the present force was inherited from the Cold War. It is aging and breaking down. Equipment has a finite life span and the cost to maintain aging equipment increases each year. The repairs, breakdowns, and maintenance tempo has increased by over-extended missions. Maintenance requirements are growing faster than maintenance budgets. It has been well over two decades since we have undertaken a procurement modernization cycle. We are now rapidly approaching a time period where we will no longer have the force capabilities to carry out foreign policy.

Recently General Shelton commented that the current state of American readiness has declined. The following conditions reflect the decline of our fighting force over the last decade:

• The US Army is running out of bullets. There is a worldwide shortage of 9mm ammunition.
• Military departments are experiencing higher wear and tear, cost of maintenance escalating.
• Congress changed priorities in budget that altered delicate balance of the force.
• Recruitment and retention rates continue to decline.
• Ten Army combat divisions do not have a full complement of officers, tankers and gunners.
• The Air Force lacks 700 pilots to man its planes.

With trillion in assets accounting systems are breaking down. The Defense Department can't keep track of assets.[9]

In the words of former General Larry Skippy, "History tells us a war is in our future."[10]

The Kagan's warn in their book, While America Sleeps, that America is in danger! We are now in an interwar period. It is up to us to determine how long it will last and how will it will end. [11]

As the map below indicates, there are a variety of regional conflicts around the globe. They range from major conflicts in the Balkans and the Middle East to the South China Seas. On March 6th China announced the largest increase to its defense budget in two decades. China's leadership justified the expenditures citing that conflict with the US over Taiwan was inevitable. They also issued a warning that selling weapons to Taiwan would carry grave consequences for America. The following day, US-led NATO troops advanced against Albanian rebels to contain the Kosovo conflict from spreading to neighboring Macedonia. Currently there are four carrier battle groups deployed near the Middle East and the Pacific. None of which are currently protecting our shores. Remarkably, these events do not make front-page headlines.

Wars and Rumors of Wars

The following table depicts what Richard Maybury calls "Cataclysm in Chaostan." Source: US & World Early Warning Report for Investors chaostan.com

History teaches us that weakness encourages aggression. Our current military weakness and lack of a coherent foreign policy has served to encourage the development of hostile states. Weapons of mass destruction proliferate and rogue nations multiply while strategic alliances formed against us continue to grow. The message we have sent would-be aggressors is one of neglect. The result is the current conflicts over the last eight years have multiplied: Somalia, Haiti, Rwanda, Bosnia, Kosovo, Iraq, North Korea and now, an emerging and more threatening China

Missile Arsenals of the World

Source: Clinton's Legacy: The Dangerous Decade, A Special Report by the Center of Security Policy and the Blanchard Economic Research Unit blanchardonline.com

Many on the left argue against a strong defense, preferring diplomacy. Lest we forget the appeasement policies of Neville Chamberlain, the cost of deterring war is infinitely cheaper than fighting one. America's status as the last remaining superpower requires being engaged in the world. Effective foreign policy requires a strong military force to back it. Contrary to popular opinion, the world has become a far more dangerous place since the end of the Cold War.

We are now rapidly running out of time to repair the damage done by a decade of neglect. If we are to remain engaged in the world, if we are to deter would-be aggressors and provide for our own defense, drastic actions need to be taken. Should we fail in this effort, we may find ourselves in the same position as Great Britain during the late 1920's and the 1930's. There are no Hitlers and Mussolinis on the horizon, but there are plenty of madmen hankering for great things. As we become weaker, we become more vulnerable. We may find ourselves engaged on the battlefield by events not of our own choosing.

Present-Day Defense Proposals

Recognizing the foreign policy mess it has inherited, the new Bush Administration has initiated a thorough review of the nation's military by Secretary of Defense, Donald Rumsfeld. An assessment will be made, a strategy will be formulated, and a budget will be drawn to match that strategy. But as Daniel Goure and Jeffrey Ranney argue in their book, Averting the Defense Train Wreck in the New Millennium, we are likely to underestimate the cost of providing for our national security. They believe that President Bush and the 107^th Congress represent one of the last opportunities for defining the military forces and capabilities for US defense in the next decade. ^xii

Procurement

A massive procurement program will be needed in order to repair and maintain our technological lead. On February 13, the President outlined a new strategic vision. Bush defined military power not by size but by mobility and swiftness. The Bush Administration will attempt to leapfrog existing technologies and challenge the status quo. The President defined the new military saying, "On land, our heavy forces will be lighter and more lethal. Airpower will be able to strike across the world with pinpoint accuracy, using both aircraft and unmanned systems. Naval forces will focus on network centric warfare that connects information and weapons in new ways."[13]

Increased Budget

Not since Ronald Reagan assumed the presidency has such a reformulation of US military strategy been undertaken. Bush will cut many major weapon systems inherited from the Cold War to make way for the high tech wars of the future. A missile defense system will be deployed. New lethal technologies will be developed and new weapon systems will be utilized. The result will be an increased defense budget.

Political Inroads

The Bush team has the experience and the expertise to rebuild America's declining military. It will take tremendous political skills to carry it through. At the moment the general public believes we live in a peaceful world. There are no villains to focus our attention on and build our resolve. The mainstream media naively believes in appeasement and that diplomacy will make the world more peaceful and keep America safe.

But as the Kagan's warn in While America Sleeps, it may already be too late. The cost of repairing the military will be staggering. America has begun to allow the world stage to slip through its hands. Coalitions and alliances have broken up or are drifting apart. The public doesn't understand the risk. So if a recession develops, they may not be willing to pay the cost. Just as Great Britain withdrew from its responsibilities after World War I to tend to its own domestic affairs, America has followed similar pursuits. Wars are inevitable. They are more constant than peace. The next one will be more brutal. In the age of missiles, the oceans no longer separate us from the battlefield.

Summation

In this installment of Storm Tactics, I have argued that several of the assumptions made in the deflationary scenario are not yet apparent and may not yet materialize. The deflationary scenario cited a cutback in government expenditures, an end to the Cold War, a strengthening dollar and central banks fighting inflation. The sector imbalances in energy, water and defense cited above argue for increased government spending. If the US slips into a severe recession (which is what I believe is coming), then fiscal spending may become Washington's prescription for economic relief. If fiscal policy is combined with the current runaway monetary policy, then stagflation may be the more likely outcome.

We may indeed be in an interim period that results in stagflation. The combination of an ever-expanding monetary policy along with increased fiscal spending produces inflation at a time of declining economic growth. The malinvestments created during the credit boom continue to unwind creating a contraction within the economy. At the same time, those under-investments in infrastructure have created capacity constraints that drive the prices of raw materials and energy up, thereby creating the next asset bubble in raw materials due to scarcity in aboveground resources. As this graph shows, this may already be taking place. The money created through the credit system has simply been channeled into hard assets.

A Look at Our Investment Future

I give the stagflation scenario a 50% probability. It may be the final leg of "The Seven Fat Years." Governments and central banks take desperate measures to ward off a recession by priming the pump with fiscal stimulus and easy money. However, instead of a robust economy, their efforts result in higher prices for hard goods, energy and raw materials. During this interim period, investments in energy, utilities (electricity, water and natural gas), food and precious metals such as gold and silver start to shine. Selected defense stocks should also do well as global tensions heat up.

The final outcome could become "The Perfect Financial Storm." It is the result of two storm fronts colliding with each other. The one storm front is deflation, while the other is inflation. The collision of the two storm fronts merge together to create "The Perfect Financial Storm" which will bring to an end the present monetary system resting on the US dollar. The financial pressure gradient will create severe stresses to the world's financial system. It will be unlike anything we have experienced before. It will be both deflationary and inflationary in nature and it requires its own separate chapter. This perfect storm includes many of the ingredients listed above. Under this scenario, a series of events and policies would undermine the dollar and precipitate a crisis. The likely culprits have been articulated in Rogue Wave/Rogue Trader. They demand further explanation.

Future Installments

Because of the amount of material and length of Storm Tactics for Inflation & Stagflation, I have broken it into two installments. The next installment will be Storm Tactics for The Perfect Financial Storm. It will be followed by the conclusion of the Storm Series, Riders on The Storm. Before heading out to sea, mariners take a barometric reading. Before fighting a battle, a general surveys the battlefield. Before investing, a wise investor seeks to understand the investment environment. It's time to do your homework. Prepare for the storms—they're coming.

References

[1] Federal Reserve Monetary Report, February 13, 2001
[2]Federal Reserve Board of St. Louis
[3] Simmons, Matthew R., The Earth in Balance: Has Energy Capacity Maxed Out?, Bridgewater Hourse London, November 6, 2000, p. 6.
[4] 4000 Reported Oil and Natural Gas Production Trends - Production Growth... What Production Growth?, Simmons & Company International
[5] "USA's Triple Energy Whammy in Electric Power, Natural Gas & Oil"
[6] "Global Trends 2015, A Dialogue About The Future With Non-Government Experts"
[7] "Middle East: Threats, Programs, Prospects," Janes International Defense Review, Vol 33, November 2000.
[8] "Water Infrastructure Now, Recommendations for Clear and Safe Water in the 21st Century
[9] Ray, Diana, "The Big Mess in Rumsfeld's Attic".
[10] Kagan, Donald and Kagan, Frederick W., While America Sleeps: Self-Delusion, Military Weakness and the Threat to Peace Today, St. Martins Press, 2000.
[11] Gouré, Daniel & Ranney, Jeffrey M., Averting the Defense Train Wreck in the New Millennium, Center for Strategic and International Studies, 1999s
[13] Koch, Andrew, "Bush Reveals Vision of a Mobile Stealthy Force," Janes Defense Weekly

Book Reading Recommendations:

• Averting the Defense Train Wreck in the New Millennium by Daniel Goure and Jeffrey M. Ranney
• The Prize by Daniel Yergin
• The Coming Oil Crisis by C.J. Campbell

Internet Resources

TreasuryDirect, Silver-Investor, FallStreet, Gold-Eagle, Prudent Bear

Notes for Readers:

CAUTION: This article is for information purposes only. It is general in nature and does not take into consideration any reader's personal circumstances and/or investment objectives or needs. Therefore, it has limitations and you should be aware of this. You should always seek competent, experienced professional advice before acting on anything you are unsure about. Few forecasts or strategies are ever one hundred percent correct. Most every consideration, action or strategy involves a particular or unique type of risk. Seldom is anything really a sure thing. No specific individual advice is implied or offered to any reader. This article and others on this web site deal with possibilities and unfortunately, not certainties.