Asymmetrical Frogs

By Bob Wood

No one questions that investing in today’s markets is a challenge. Every upside rally seems quickly followed with a drop of equal size. At the end of July, gains in domestic stock indices like the S&P 500 or Dow were meager on an absolute basis and miserable on a risk-adjusted basis. But the biggest investor challenge may well be trying to get usable information via the media. As a rule, I think they do more harm than good.

The problem with media reporting is that we find as many opinions about the health of the economy and viability of the stock market as we find people offering views. And many seem utterly convinced that they are absolutely right, which adds to audience confusion. Yet opinions differ significantly on what actually determines investor success.

Topics like the actual level of unemployment, the true rate of inflation and the danger of running massive fiscal deficits (while rapidly adding to the National Debt) fail to get much air time. And while loading up our collective debt burdens with even more debt and adding to the compounding effects at a rapid clip seem disastrous over time, many assure quickly that these are really not problems at all!

One argument for this perspective comes from those who think we’ve been hearing about the evils of a huge debt burden forever, yet, here we are, still living the good life! The “doom and gloom” crowd has been harping on this issue for decades, right? And haven’t it been obviously wrong? Can’t the annual federal budget deficits be taken as a sign of our superior growth dynamics vs. those of the world’s other developed nations?

Ask yourself where your household or small business would be, using this kind of financial thinking. Doesn’t personal debt have a way of catching up with you at just the wrong times, regardless of how much better you seem to be doing? Maybe you could go out and buy a bigger home, a new Lexus and expensive new clothes. But if you add to your debt to pay for them, how much richer did you really become?

This thinking brings to mind the anecdote about the best way to cook a frog. Since I’ve never cooked a frog, I’ll accept the anecdote as true to illustrate that our current domestic financial situation is anything but ideal, as the Bulls contend, simply because nothing in the economy has blown up yet. The idea is simple: if you place a live frog into a pot of boiling water, he will jump out immediately. Frogs aren’t stupid.

But if the frog goes into the water when it is cooler than room temperature, he might find being in the pot rather comfortable. Or he might even ask you to raise the heat a bit to make the water even nicer. You, of course, would wait until the frog becomes chilled before increasing heat under the pot. Eventually, the frog notices that he’s getting uncomfortably warmer, but you simply tell him that he is getting a spa treatment, one like rich frogs enjoy from time to time. Soon, the frog gets too tired from the heat to complain and feels so relaxed that he falls asleep. At this point, you increase the heat, bringing the pot to a boil. Season to taste, since, by that time, it’s all over for the frog, who didn’t see the end coming.

I think this illustrates exactly what is happening with the fiscal ineptness coming from the Bush administration and the Federal Reserve. The rapid increases in deficit growth, national debt and money printing would raise alarms anywhere else. And they should, since we know, “It’s never a problem until it’s a problem, and then it’s a big problem.” The economy was enough of a problem when both Reagan and Bush Sr. tried stimulating it by using borrowed money to compensate for tax cuts. Both were forced to raise taxes when costs began increasing with predictable vengeance.

But for those thinking that this fiscal policy is a sign of strength, check out the many signs pointing to massive vulnerability. Oh, we’ve had no trouble borrowing money from other countries, but does that seem like strength to you? Alan Greenspan called it ‘‘a conundrum’’ when long-term bond yields refused to move higher after the Fed’s successive interest rate hikes. Demand for holding our debt and other assets is as strong as ever, the Fed says. But with U.S. investors increasingly buying into international markets for better profit potential, how long will it be before their own investors decide to invest in home markets?

Why in the world would anyone pay such a high premium for 10-year or 30-year Treasuries yielding less than very short-term bonds—or even the Fed Funds rate? Doesn’t it seem odd? What would motivate a bond buyer to take less interest along with much higher time risk? But it’s not a problem until it’s a problem. But would you raise the water temperature in the cook pot a little more, please?

The Chinese and the oil producers are the biggest buyers of U.S. debt—our largest lenders. Now why would they want to lend us so much money at rates that seem to guarantee losses? Could the nations loading up on our debt and other financial assets have non-financial reasons for doing so?

China is aware that U.S. political leaders see its emergence as a problem—even a threat. And with some like Larry Kudlow calling for war with China and Neo-cons such as William Krystol of The Weekly Standard calling for war with oil producers like Iran and Venezuela, what other motives could these countries possibly have for gathering our debt and other hard assets? Might they be looking for leverage to use against our seemingly unlimited desire to use our military power, possibly against them? Since these countries could not possibly defeat us militarily, could they defeat us economically, without suffering even one casualty on the battlefield?

Of course, we hear that China would never try hurting our economy, since its own growth relies on our continued spending. But China sells even more to the European Union, and its largest trading partner is now Japan, not the U.S. So perhaps we are overstating our importance, once again. When its internal consumer demand increases, how important will the U.S. be to China?

We also hear that oil producers like Venezuela will never cut our oil shipments, since they need the money from their biggest oil buyer. But could Venezuela simply sell less oil at higher prices, due to decreased supply? The same goes for Iran. We are told that Iran will never cut energy production due to its need for income. But Iran holds billions of dollars made from energy sales at record nominal prices—with no end in sight. How long could Iran afford a cut in sales and income? And if Iran cuts oil production, who would make up the difference in the market? Without a supplier to make up the shortfall, prices would rise, and all energy producers would benefit.

Such a move would also increase the amount of money going out of this country, in terms of our monthly trade deficit. And it would also increase the leverage available to countries high on our “potential enemies” list—Iran, Venezuela and, of course, Russia, which is less than pleased about U.S. encroachment on its borders. Might Putin consider using his stockpile of dollars and energy if the U.S. threatens him further?

And like our hapless former friend, the frog, we see the heat of energy prices creeping up so slowly that Bulls seem to think that record high prices are not nearly as bad as feared when oil reached previous highs like $50 or $60 per barrel. Little by little, the heat in the U.S. collective pot rises, and we’re close to the point where the spa seems a bit too hot. But we’re really relaxed!

Some bullish promoters will always label going deeply into debt to countries that Bush calls ‘‘strategic competitors” as a sign of strength. They encourage us to think that rising cost pressures from higher energy prices are a good thing, and bullying our main suppliers into submission is a smart thing to do, even if it means war.

That Venezuela and Iran are now using excessive amounts of our dollars to buy sophisticated weapons like advanced missiles and jet fighters offer more reasons to distrust them and increase our own military hardware spending. This adds, of course, to our fiscal shortages and increasing debt, thanks to those same countries considered a threat!

Like frogs, the Chinese, Venezuelans, Russians and Iranians are not stupid. Most likely, they have read the Neo-Con papers promoting an aggressive foreign policy agenda. Neo-Con options include wars of choice against these countries, as seen in “The Clean Break,” written in 1996 for the Israelis, or in the Project for the New American Century (PNAC) paper on “Rebuilding America’s Defenses,” which provides a road map for extending military dominance over all potential adversaries.

Weak leaders often find that their narrow approaches fail in situations that become more difficult than they originally thought. Perhaps the Bush team assumed potential U.S. enemies would just sit there, waiting for us to invade, just as Saddam did. The PNAC paper, for instance, assumes that budget surpluses of the late 1990s would continue to be available for increased military spending. And while it also assumed that no one country posed a threat in itself, the writers seemed oblivious to the idea that several countries could band together to get the job done, using asymmetrical methods.

Since the same countries continue to buy our debt and pump oil as fast as it will come out of the ground, maybe the Neo-Con plan is working, after all? But suddenly, these countries are buying more than just our bonds. They are now snapping up American highways and bridges to own important parts of our infrastructure. Those living in the Detroit area may already know that an Australian firm collects tolls at the U.S. side of the tunnel linking your city to Windsor, Ontario. Indiana and Illinois are also negotiating to sell infrastructure projects originally paid for by taxpayers. Where does it end? How many of our assets, financial and otherwise, will soon belong to other countries, who are enjoying unbeatable leverage?

The Chinese, in particular, are big fans of the concepts of asymmetrical warfare. For example, it would be foolish to fight a superior army head-on or try to outspend the U.S. while building a competitive army. So how better to confront a superior military power than to cut off its access to funding? After all, the Chinese lend us money to fight the Iraq War, and they surely know how that war is going—and how much safer they would be with our failure in Iraq.

Using the media is another effective tool, and showing film clips of the carnage in Iraq—and now in Lebanon and Gaza—adds to Chinese fears about the threat the U.S. poses and what needs to be done to counter these actions. Perhaps they might supply these pictures to media outlets in their best markets, Europe and Japan, to add strength to their overall positions.

Perhaps the strongest part of China’s plan for countering aggressive U.S. behavior is the ineptitude of our current administration. We seem to beat ourselves routinely, spending far in excess of our means and weakening our military in wars of choice that cannot be won, such as those in Vietnam and Korea that were lost in much the same way as we are losing the war in Iraq.

Other countries feel the heat rising and are, therefore, also increasing the heat on the U.S. in almost imperceptible ways. We borrow what we’ll never be able to repay; we waste energy like no other, and we cut taxes while running massive deficits. It seems we try constantly to make ourselves more vulnerable. And while none of our potential adversaries can hope to beat us by themselves, collectively, they are amassing a financial arsenal that we could never hope to counter—except with massive dollar printing, which would send us into an inflationary spiral, making this country poorer than ever.

We are feeling the heat now, yet the Bulls find ways to create the illusion of a luxurious spa. Our adversaries have all they need to keep raising the heat, just a little at a time, so we don’t really notice. But together, they have us in a really hot pot, and they know it. Yet we continue to give them more and more to use for fending us off. So how smart are we? And are we really the strongest economy in the developed world?

Perhaps we are, for now, but the future is really out of our control. We can talk tough, but the battle could be lost before it ever starts. We’ll be beaten in the next war by traders pushing buttons, selling dollars and bonds, and decreasing energy production, very slowly, just as we begin to think that oil at $75/barrel oil is manageable. And we continue to help, turning up the heat in our own cooking pot, so they don’t even have to move from their chairs.

And you wonder why I’m bearish?

Have a great week,
Bob

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