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March 26, 2006

The Investor's Mind: Anticipating Trends Through the Lens of History
by Doug Wakefield

Oil and Water Do Not Mix
By Doug Wakefield with Ben Hill

[The following is the first five pages of our March newsletter. The entire newsletter is offered at no cost those who subscribe through our website.]

Introduction

In the February newsletter we dealt with the growing threat of military and financial warfare that is building around Iran. Part of that discussion centered on a March 20th, 2006 opening of an Iranian Oil Bourse, which has been delayed. Actually, the 2006 opening was a one-year delay of an earlier date. And frankly, with all that's involved in bringing an exchange online, the delay doesn't really surprise me.

So, what does that delay mean? It means that the decline in the value of the dollar may not occur as quickly as it otherwise would. I say "may not" because the problems that our economy is experiencing, and the concomitant rapid increase in the U.S. trade deficit, still bring with them the distinct possibility of a sharp decline in the value of the U.S. dollar and the U.S. financial markets. Consider Fed Chairman Ben Bernanke's statement to this end.

"In particular, the budget is expected to come under severe pressure as impending demographic changes fuel rapid increases in entitlement spending. By holding down the growth of national saving and real capital accumulation, the prospective increase in the budget deficit will place at risk future living standards of our country." ¹

What has not changed is this. The Iranian Oil Bourse and the effects that it will have, though postponed, are still valid concerns that we will be forced to reckon with one day in the future. More importantly, the issues at hand, i.e. oil reserves, the reserve currency status an ever-inflating U.S. dollar, and military objectives that demand significant funding, haven't changed at all.

In this newsletter, we will speak to the precarious position in which the U.S. finds itself. Specifically, we will address the extraordinary financial costs of wars, the current financial risks the U.S. military brings to bear, and the blurred lines between ally and adversary as nations maneuver to fortify their positions in currency and oil reserves. Ultimately, we conclude with the fact that the current environment is increasingly unstable, and therefore, it presents additional risk to all who participate in the markets.

The Costs of Wars

As we should, we most often measure the cost of wars in lives lost. And by that measure wars are, indeed, expensive. Yet, their economic costs are staggering as well. As such, wars go hand in hand with fiat currencies, which readily lend themselves to funding such massive costs. Our current juncture is one that the U.S. has seen many times before. Consider the financial costs of the following brief history of a few U.S. wars.

In order to finance the Revolutionary War, the Continental Congress issued fiat paper currency, which was supposed to be retired in seven years by levying heavier taxes on its citizens. But, enamored by the ability to print money whenever it was "needed," the Continental Congress soon forgot its pledge to retire the paper, and printed increasingly more.

"The total money supply of the United States at the beginning of the Revolution has been estimated at $12 million. Congress issued $6 million [in paper] in 1775, $19 million in 1776, $13 million in 1777, $64 million in 1778, and $125 million in 1779. This was a total issue of over $225 million in five years superimposed upon a pre-existing money supply of $12 million. The result was rapid price inflation and corollary depreciation of the paper in terms of specie [coin]. At the end of 1776, the Continentals were worth $1 to $1.25 in specie. By the spring of 1781, the Continentals were virtually worthless, exchanging on the market at 168 paper dollars to one dollar in specie. This collapse of the Continental currency gave rise to the phrase, 'not worth a Continental.'"²

Our nation's debt expanded rapidly during the Civil War as well. After that, it stood virtually still for close to half a century. In 1865, the U.S. debt was at $2.68 billion. In 1913, it was $2.91 billion. However, from the creation of the Federal Reserve, in 1913, until 1919, the national debt of the United States grew from $2.91 billion to $27.39 billion - an increase of 841 percent.³ Most of this increase came from our first Federal Reserve Chairman, Benjamin Strong, opening the financial spigot to finance the efforts of World War I.

Vast amounts of paper money allowed many countries to fund their militaries during World War I. Yet, this massive expansion came with a price.

"While the pound sterling in February 1920 was depreciated by 35 percent compared to its 1914 gold par, the French franc was depreciated by 64 percent, the Belgian franc by 62 percent, the Italian lira by 71 percent, and the German mark by 96 percent. At the end of World War I, only the United States dollar remained on the old gold-coin standard."⁴

Last in our condensed history of the costs of U.S. wars, we'll look at the financial price tag of World War II. The Bureau of the Public Debt states that from July 1941 to July 1945, our nation's debt went from $48.9 billion to $258.6 billion - an increase of 429 percent in 4 years.⁵ Though we had come off of the gold standard in 1933, with the establishment of the Bretton Woods Agreement, in 1944, the U.S. was the only country still on the gold-exchange standard after World War II.

Clearly, Ludwig von Mises was right when he wrote, "A great part of war expenditure is financed by an increase of currency in circulation and by borrowing."⁶

Retaining the status of reserve currency of the world has allowed the inflationary effects of our ever-expanding national debt to continue. We were the only country on the gold standard after World War I. As such, we were the reserve currency. As the only country on the gold-exchange standard after World War II, the Bretton Woods Agreement formalized the U.S. dollar's reserve currency status. For the events that led to the retention of the dollar's reserve currency status in the 1970s, we turn to an explanation by William Clark.

"After August 1971 when the dollar lost its 'gold backing' and became a floating currency, the following three years were periods of volatile dollar devaluation with escalating inflationary pressures. Subsequently, elite US and UK banking interest, in conjunction with Saudi Arabia, created an oil-backed dollar. By 1975 all of OPEC adopted a petrodollar recycling system in which the dollar transitioned from being - 'as good as gold' - to being 'as good as black gold.' For better or worse, this also meant that the printing on US Federal Reserve notes could have been changed from 'In God We Trust' to the more accurate descriptor 'In OPEC We Trust,' or most specifically, 'In Saudi Arabia We Trust."⁷

Yet, at our current juncture, the reserve currency status of the dollar is in question, U.S. military spending is at its highest level ever, and the U.S. economy is experiencing record government deficits, record trade deficits, record government and consumer debt, record low consumer savings, a depletion of our manufacturing base, and anemic (and questionable) employment and wage growth. And all the while, the majority of the American public sleeps. Clearly, this is unsustainable.

In the words of Thomas Jefferson:

"If a nation expects to be ignorant and free, it expects what never was and never will be... The People cannot be safe without information. When the press is free, and every man is able to read, all is safe."⁸

U.S. Military Expansion

In his book, The Rise and Fall of the Great Powers, Yale historian Paul Kennedy points out the need to balance military strength with a strong economy which can bear the costs of the military and guarantee the continuance of a sound economy.

"If, however, too large a portion of the state's resources is diverted from wealth creation and allocated instead to military purposes, then that is likely to lead to a weakening of national power over the longer term. In the same way, if a state overextends itself strategically - by, say, the conquest of extensive territories or the waging of costly wars - it runs the risk that the potential benefits from external expansion may be outweighed by the great expense of it all - a dilemma which becomes acute if the nation concerned has entered a period of relative economic decline."⁹ (Emphasis mine)

That being said, let's look at the increasing amounts of money the U.S. government is spending on defense, how this compares to other nations, and the sustainability and desirability of the plan upon which our current defense spending appears to be based.

To begin with, let's look at the growth in the amount of U.S. government military spending. According to the Office of Management and Budget (OMB), the Department of Defense's (DOD) fiscal budget for 2005 was $401.7 billion. The OMB states that this number represents an annual increase of 7 percent, for a total increase in defense spending of 35 percent since 2001.¹⁰ According to the Library of Congress, by February 2006, Congress had already approved an additional $300 billion for expenses incurred in U.S. operations in Iraq and Afghanistan.¹¹ In fact, in the second week of March 2006, the House Appropriations Committee approved an additional $67.5 billion in funding for the wars in Iraq and Afghanistan.¹² When we compare these increases in the amount of military spending with the rising levels of debt throughout our nation, over the same period of time, we are confronted with the reality that this course is not sustainable.

So, how does U.S. military spending compare to that of other nations? The numbers to the left were taken from the Stockholm International Peace Research Institute (SIPRI). SIPRI was established by the Swedish Parliament in 1966, for the purpose of conducting research "with the aim of understanding the conditions for peaceful solutions of international conflicts and for a stable peace." Here is their table of the top fifteen military spenders in 2004.

Military expenditure in PPP dollar terms
Rank	Country	Spending ($b)
1	USA	455.3
2	China	[161.1]
3	India	81.8
4	Russia	[66.1]
5	France	51.2
Sub-total, top 5		815.6
6	UK	46.2
7	Germany	36.9
8	Japan	35.2
9	Italy	34.5
10	Saudi Arabia	29.1
Sub-total, top 10		997.4
11	Turkey	24.3
12	Korea , South	23.1
13	Brazil	20.7
14	Iran	18.5
15	Pakistan	16.1
Total, top 15		1,100.2

The Purchasing Power Parity (PPP) dollars, shown in this table, are calculated by the World Bank and are based on comparisons of gross national product. As such, PPP is an estimate that attempts to equalize the purchasing power of different currencies. The brackets are used to designate estimates.¹³

The first thing we see is that the U.S. spends more on its military than any other nation in the world. As a matter of fact, in these terms, we spend more than the 6 next largest militaries combined, with room to spare. Or, stated another way, though it does not mean that they pose no threat, the U.S. military spends 24 times as much as Iran. As we stated in the February newsletter, Iran's threat to the U.S. falls more along economic and nuclear lines.

In order to understand how we arrived at this level of military spending, we need to review a document that looks to have greatly influenced the policies of the current administration.

The Project for the New American Century (PNAC), a non-profit educational organization whose goal is to promote American global leadership, produced a report titled, Rebuilding America's Defenses: Strategy, Forces, and Resources for a New Century, which was released in September of 2000.

To carry out PNAC's core missions, the opening pages of this document note, "The United States must increase defense spending gradually to a minimum level of 3.5 to 3.8 percent of gross domestic product, adding $15 billion to $20 billion to total defense spending annually." Again, the 2005 OMB notes a 7 percent annual increase, without inclusion of an additional $300 billion for the Iraq and Afghan wars. The stations of those who are listed under PNAC's Statement of Principles and the fact that their goals have been so handily achieved, lends evidence to the influence PNAC has had on U.S. military spending.

My concern pertains to the sustainability of the report's assumptions. Consider the following excerpts that seem to show little regard for the financial ability of the American people to pay for these actions.

"America's armed forces, it seemed, could either prepare for the future by retreating from its role as the essential defender of today's global security order, or it could take care of current business but be unprepared for tomorrow's threats and tomorrow's battlefields."¹⁴

"At present the United States faces no global rival... The United States has been letting its ability to take full advantage of the remarkable strategic opportunity at hand slip away.

With this in mind... we did not accept pre-ordained constraints that followed from assumptions about what the country might or might not be willing to expend on its defenses."¹⁵

"The surplus expected in federal revenues over the next decade, however, removes any need to hold defense spending to any preconceived low level."¹⁶

"While the unresolved conflict with Iraq [remember, this was released in September 2000] provides immediate justification, the need for substantial American force presence in the Gulf transcends the issue of the regime of Saddam Hussein."¹⁷

Parts of this document attempt to cast the U.S. military as a dilapidated institution in dire need of renovation and repair. The fact that we are the pre-eminent military power leaves me questioning the validity of such posturing. On the other hand, if our military personnel are "undermanned, and inadequately equipped and trained," or are under-compensated, is this because of a lack of funds or a misallocation of current funding?

This document, which looks to be calling for a strong military that would function without boundaries in furthering U.S. interests, presents many moral issues, which are beyond the intended scope of this newsletter. As stated earlier, my objection concerns itself more with the financial viability of assuming the role of "essential defender of today's global security order." According to the DOD, the U.S. military has over 725 military installations in 120 countries.¹⁸ The financial demands of such outlays are clearly not sustainable for a country that has become the world's largest debtor.

Still, the events in the Middle East appear to be telling of a much larger story than many of us would care to acknowledge.

To read the entire March Newsletter, you can sign up, at no cost, through our website. If you would like a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds, visit our website. This will also give you access to our new monthly newsletter, which is at no cost, titled The Investors Mind: Anticipating Trends through the Lens of History.

Sources:
¹ http://www.msnbc.msn.com/id/11826746/
² A History of Money and Banking in the United States(2002), Dr. Murray Rothbard, pg 60/61
³ http://www.publicdebt.treas.gov/opd/opdhisto3.htm
⁴ A History of Money, Rothbard, pg 356
⁵ http://www.publicdebt.treas.gov/opd/opdhisto3.htm
⁶ Bureaucracy (1944) Ludwig Von Mises, pg 34
⁷ Petrodollar Warfare: Oil, Iraq and the Future of the Dollar (2005) William Clark, pg 33
⁸ http://freebowen.bravepages.com/quotes.html
⁹ http://news.goldseek.com/DailyReckoning/1139516111.php
¹⁰ http://www.whitehouse.gov/omb/budget/fy2005/defense.html
¹¹ http://thomas.loc.gov/cgi-bin/cpquery/T?&report=hr016&dbname=109&
¹² http://www.airforcetimes.com/story.php?f=1-292925-1586761.php
¹³ http://www.sipri.org/contents/milap/milex/mex_major_spenders.pdf
¹⁴ Rebuilding America's Defenses: Strategy, Forces, and Resources for a New Century, A Report of The Project for the New American Century, September 2000, pg i
¹⁵ Ibid, pg ii
¹⁶ Ibid, pg iii
¹⁷ Ibid, pg 14
¹⁸ Petrodollar Warfare, William Clark, pg. 13

Doug Wakefield,
President
Best Minds Inc., A Registered Investment Advisor

Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology.

Copyright © 2005-2007 Best Minds Inc.

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