I have considerable respect for John Mauldin and Kenneth Rogoff. But when they go back 100+ years or six centuries, respectively, in search of useful economic precedents to help understand problems today, I draw the line. I am sorry; the world is so different now…. So in this article, I only go back 60 years to gain a better understanding of the reasons for the slow US recovery. 

Looking Back: The US in the Global Economy

At the end of WWII, the US economy was the only major country “left standing”. US leaders were so concerned about the Soviet Union that they launched the Marshall Plan to rebuild economies of Europe and Japan. Maybe we did it too well[1]. Over the last 30 years, the US has lost market share to countries with lower labor costs. First, it was Japan; more recently, China and many other countries in Asia and Latin America.

The effect of this growing competition has been a downward pressure on US wages. Since 1974, the average real weekly wage of US production workers has fallen 12%. Despite cheaper US labor, US manufacturing employment has fallen by 39% since 1973.

Other adjustments have occurred. For example, as Americans increased their purchases of cheaper foreign products, the US trade balance has gone from surpluses in the 1960s/early ‘70s to huge deficits in the 21^st century. The current account deficit exceeds $400 billion and is approximately 35% of the total of all countries running current account surpluses. The dollar has also weakened. In 1970, a dollar would get you 358 Japanese Yen and 4.373 Swiss Francs. Today, it will get you 85 Yen and about 1 Swiss Franc.

How can such international imbalances exist with a strong dollar, little inflation, and low interest rates in the US? The answer is foreign purchases of U.S. dollar denominated assets, and more specifically, US equities and debt. Table 1 provides data on foreign holdings of US Treasuries for recent years.

Table 1. – Foreign Holdings of US Treasuries (in bil. US$)

Source: US Treasury

China and Japan have purchased US securities to keep the dollar strong so as to give their exporters a competitive edge. The US has countered by establishing an import quota on Chinese clothing. Measured by the clothing imports blocked, the quota is the largest trade barrier in the world. The US also continues to jawbone the Chinese to let their currency gain value against the dollar.

It is notable that China and Japan have continued to purchase Treasuries since 2008. But with the US government deficit of $1.4 trillion in 2009, and projected deficits of $1.3 trillion in 2010 and $980 billion in 2011, it is unlikely that China and Japan can afford to buy significant portions of this debt. Why? Because together, China and Japan’s international reserves are about $3 trillion, and of that amount, they already hold $1.6 trillion of Treasuries.      

The Silver Lining – An Accelerated Reduction in US Labor Costs

This article is supposed to be about a silver lining. That is coming. First, a summary of what has just been said:

• For the last 30 years, the US has not been competitive in world markets, primarily because of high labor costs;
• There have been adjustments – US wages in real terms have fallen and the dollar has weakened;
• China and Japan have slowed this competitive adjustment by purchasing US dollar denominated securities.

Consider now the Recession effects. Remember that only Europe, Japan, and the US are still in recession. The rest of the world is back to rapid growth. 

Recessions tend to accelerate processes already in motion. One such process are lower wages to make the US products more competitive globally. And the recovery is lagging in part because people are reluctant to buy in on this process by taking lower paying jobs. It will take time.

Here is how the Recession helps reduce US labor costs: 

• The 10% unemployment rate puts downward pressure on wages;
• Companies are finding they can get by with fewer workers and will not rehire all they let go; this puts further pressure on wages;
• The GM and Chrysler bankruptcies allowed them to break their costly union contracts, thereby lowering their labor costs;
• Massive US government deficits to stem the recession should weaken the US dollar, thereby making US workers more competitive;
• The unwillingness and perhaps inability of China and Japan to buy up a significant portion of US deficits going forward should result in a further dollar weakening.

A weaker dollar has numerous attractions: goods produced in the US become more competitive globally, the debt burden in real terms falls, and foreign companies invest more heavily in the US. Foreign direct investment (FDI) in the US in 2007 was $233 billion, more than any other country. FDI generates jobs, good for the US. And companies like to produce in the US: few electricity blackouts and a trustworthy legal system. German, Japanese, and Korean auto companies all have non-unionized factories in the US. These and companies in other industries will expand production in the US as their currencies gain value relative to the dollar.

For example, consider the following table for a Japanese auto company. Assume that at 100 yen to the dollar, yen production costs in the US and Japan are the same. But with a rate of only 50 yen to the dollar, it is much cheaper to produce in the US.  

Who is hurt by a weakening dollar? Those holding dollar-denominated assets. And as I have been suggesting for more than a year, get out of dollars: you should be holding as few dollar-denominated assets as possible.  

Will the Silver Lining Be Enough?

A weaker dollar will improve the competitive position of the US, but will it be enough to put the US on a sound economic footing? I wonder. Further problems to be considered include: a poor education system and apparently unmotivated students; energy dependence; health/obesity; and Washington corruption as reflected in health, finance, and military legislation. 

1. Ineffective Lower Education and Unmotivated Students

The OECD tests reading, science and mathematics in more than 50 countries. The US does not participate in the readings tests, but the results of the science and math tests are given in Table 2.

Table 2. – OECD Science and Math Test Results, 2006

Source: OECD Programme for International Student Assessment (PISA )

The US scored significantly below the OECD average in both Math and Science. Note the emergence of Asian countries in test score performance. Keep in mind that only 70% of US high school students graduate. Not good. Bad system? Unmotivated students? Probably some of both.

 2. Energy Dependence

As I wrote in an earlier piece:

Unlike Japan and China, the US was richly endowed with energy resources. It is even today the third leading producer of energy from oil, the second leading producer of energy from coal, the second leading producer of energy from natural gas, and by far the largest producer of nuclear energy (http://www.bepress.com/ngs/vol2/iss1/art5/). But because of its voracious energy consumption, it must supplement its own production of energy with imports. It imports 21% of all oil traded internationally. Unlike the European countries and Japan who have imposed heavy taxes on motor vehicle fuels, US government policy has been to keep the gas price as low as possible. This has resulted in the US consuming almost four times as much as much oil per capita as the other OECD countries.

3. Health/Obesity

Obesity has become a global epidemic.  The UN reports there are now more obese people in the world than hungry people. But obesity in the US leads all developed countries (30% of all Americans are obese), and childhood incidence suggests it will get worse. Obesity contributes to most medical problems, and it will remain a spur to growing US health costs.

4. Washington Corruption

Open Secrets reports that the health industry spent $545 million lobbying in Washington in 2009. And they got what they wanted: a bill that makes them all health stakeholders happy except for their clients. Open Secrets reports that the Finance industry spent $467 million lobbying in 2009, and they got what they wanted: a bill that allows banks to continue trading. And trading cauysed them to effectively collapse in 2008. 

5. The US Military

The US military is also well-connected in DC. In addition to spending over $150 billion in the two lasts years in Afghanistan and Iraq, it has more than 700 bases worldwide. According to Chalmers Johnson, those bases employed 196,975 uniformed personnel as well as an equal number of dependents and Defense Department civilian officials. The bases employed an additional 81,425 locally hired foreigners. And then there are the military contractors such as Halliburton. They are also well-connected. And they want to keep their lucrative overseas contracts going.

Conclusions

The recession and resulting US budget deficits should weaken the dollar and make the US more competitive on world markets. That is good. But the US has other problems….

The article starts by summarizing economic findings on people’s wine selections. It then examines the US wine market. It finishes with suggestions on selecting wines.

How People Select Wines

Considerable economic analysis has been done on how people choose wine[1]. Summarized in an earlier article, the primary finding is that wine choices are rarely connected to taste. And further, price does not accurately predict taste. What do I mean by that? In carefully conducted large blind tastings, more expensive wines were not preferred. It appears that people buy wine based on its color, brand name, label, and ratings (experts frequently disagree on their ratings).

One other point: some people buy wine because it is expensive. There are two reasons for this: 

• If you are buying wine as a gift and you don’t know anything about wine, it is reassuring to buy an expensive wine;
• Some people want to be known as wine connoisseurs, and they believe that buying expensive wines will make others think they are wine connoisseurs.

The US Wine Market

The overriding point about the US market, made in an earlier article, is that wines from Argentina, Australia, Chile, New Zealand, South Africa, are gradually replacing European wines in the US market. Why? Because they are good and cost less to produce than their European competitors. And as the US buyer becomes more knowledgeable, the price edge European (especially French) producers enjoy by using the region, e.g,. Burgundy rather than the dominant varietal e.g., Pinot Noir, to market their wines will decline.

In another article, I reported on a survey of a large liquor store. The conclusion? Liquor stores do not have counter space for more wine. That means a new wine must replace an existing one. A tall order. Going forward, the US market will be hard to break into. It will take an extremely low price or a varietal that catches on, like Pinot Noir (US), Malbec (Argentina), Sauvignon Blanc (New Zealand) and Shiraz (Australia).

 Quality

There are a large number of relatively inexpensive wines available from Argentina, Australia, Chile, New Zealand, and South Africa in stores. But my survey article did not include anything on quality. This time I focused on ratings, so we could see the relationship between price and quality. Wine Spectator (WS) is one of several rating sources. WS describes an 85-89 rating as “Very Good”. I personally found most WS wines rated 88-89 to be even better than “Very Good”. WS rates anything over 90 as “Outstanding”. I normally don’t buy a wine WS rates less than 88 and I agree that wines rated 90 or above are normally outstanding. WS rates anything over 90 as “Outstanding” and I agree.

So I searched the WS database by varietal (see below) for wines (2004-2009) costing $10-$15 with ratings of 88 or higher. The findings suggest that high quality, inexpensive wines are available.

Heavy Reds

Under “Heavy Reds”, I looked at Cabernet Sauvignons, Shirazes, and Malbecs.

1. Cabernet Sauvignon

I included French Bordeaux in this category because its primary grape is Cabernet Sauvignon. The second column in the table lists Cabs priced at $10 or less with ratings of 88 or more. 15 fall under this category, led by Australia and Argentina. If we increase the search price to $15, 97 wines appear. For exceptional wines (rated 90 or more), 8 wines appear, 2 from Argentina and Australia, and 4 from the US. In my previous large liquor store survey, I found a total of 86 Cabs in the $8-$16 range, with no reference to quality; more than half were from the US.

The conclusion is there are plenty of high quality, low-priced Cabs available. They are not hard to find inasmuch as well-known brand names are included, e.g., Columbia Crest, Hogue, and Peter Lehmann.

Table 1. – Cabernet Sauvignon

Source: Wine Spectator Ratings

Of course, if you are a wine buyer that likes to purchase expensive wines, Cabs are the wines for you. Zachys, a wine auctioneer, is estimating that 6 bottles of Romanee Conti (1990) will be sold in Hong Kong in the HK$460,000-700,000 (US$59,100-90,070) price range, or $9,850-$15,012 a bottle.

 2. Shiraz

Australia made Shiraz a popular varietal, and their wines dominate the inexpensive, high quality Shiraz listings. I came upon 56 in my store survey.

Table 2. – Shiraz

Source: Wine Spectator Ratings

There are plenty of good, inexpensive Shirazes available, with 15 rated 90 or more costing $15 or less. Again, well-known brands show up, e.g., Lindemans, Jacob’s Creek, Penfolds, and Greg Norman.

 3. Malbec

Argentina has popularized Malbecs, and their wines dominate the wine rating table. Again, good, inexpensive Malbecs are available with 11 rated 88 or more costing $10 or less.

Table 3. – Malbecs

Source: Wine Spectator Ratings

The $10 or less group includes brand names readily available: Alamos, Doña Paula, and Terrazas de Los Andes.

Light Whites – Sauvignon Blanc

Sauvignon Blanc is the dominant light white varietal. It is also the dominant grape in the French Sancerres and Pouilly Fumés. They are plentiful  in the US – I found 69 of them in my store survey. Table 4 indicates high quality, inexpensive Sauvignon Blancs are widely available, with New Zealand the leading provider.

Table 4. – Sauvignon Blanc

Source: Wine Spectator Ratings

Many widely-known and readily available brand names are represented in the table, including: Babich, Santa Rita, Neil Ellis, and Chateau Ste. Michelle.

Heavy Whites – Chardonnay

Chardonnay is the dominant heavy white grape. There are plenty in stores – I found 78 in my survey. And again, as Table 5 indicates, there is no problem in finding inexpensive, high-quality Chards.

Table 5. – Chardonnays

Source: Wine Spectator Ratings

The US has 8 Chards rated 90 or higher, along with 2 each for Australia, Chile, and New Zealand. These 90+ rated wines are widely available. Well-known brand names include: Columbia Crest, Thorne-Clark, and Babich.

Country Competition

Argentina, Australia, and New Zealand became large wine exporters because of one grape: Argentina (Malbec), Australia (Shiraz) and New Zealand (Sauvignon Blanc). There is a marketing problem here: becoming associated with only one varietal. Chile and South Africa do not have such a reputation. This should help them in future years.

Concluding Thoughts

There are people in the world who can actually tell the difference between a Romanee Conti vintage 1990 and vintage 1991. Amazing! For the wine expert, a good part of the enjoyment in drinking wine is the ability to make such fine distinctions.

But the vast majority of people who drink wine (myself included) have difficulty distinguishing between a wine rated 88 and 95 by WS. My suggestion: choose a varietal you like, pay for a month’s subscription for wine ratings -  Parker, Wine Spectator, or some other, to see if you can tell the difference between wines rated very good and outstanding.

 This is the second in a two-part series on the economics of US military interventions. The first part provided cost and fatality numbers of past and current wars. This one focuses on the most recent interventions – Afghanistan and Iraq. It asks if these wars have contributed to achieving America’s global strategy objectives.

For this article, I have again asked Jerry Silverman to help me address these issues. Jerry has worked overseas for most of his career and has written extensively on foreign policy issues. He wrote on the Afghanistan situation in a “National Interest” piece.

The following assessments of Afghanistan and Iraq each have two parts: motivation for intervention and what is happening now. The article ends with a broader discussion of what should be done moving forward.

Afghanistan

1.       Motivation

Elliott: After 9/11, the US government believed Bin Laden was in Afghanistan. At the time, I publicly urged that we drop a small nuclear bomb in some desolate area of Afghanistan and be done with it. Why did I take that position? I wanted to avoid a ground war in that country. What happened? It took Bush 6 weeks to launch a ground war and then he lost interest.

I speculate that Obama’s interest in support of the war stemmed primarily from domestic political considerations: he was on record in opposing the Iraq War, and he (or the advisors he listened to) did not want him to appear as a peacenik. So he emphasized the importance of winning the Afghan War.

Jerry: Well, I certainly would not have subscribed to your “nuclear” solution – either then or now. However, your desired objective was spot on. There is a sense in which we won the war in Afghanistan following the expulsion of the Taliban from Kabul and the installation of Hamid Karzai as Head of an Interim Authority at the Bonn Conference on December 5, 2001. As for Osama bin Laden, it is much more likely that we could have successfully found and prosecuted him — or dealt with him “extra-judiciously” — during the few months after our initial success in Afghanistan if we had accepted Pakistan’s view that Afghanistan fell within its sphere of influence. That acknowledgement would no doubt have resulted in closer cooperation by the Pakistani’s early on. And although that would not have been to India’s liking, such a posture toward Pakistan would have been a bigger problem for Iran than for us.  

But that is the past. With respect to President Obama’s motivation in the present, your analysis is plausible as at least a partial explanation of his current policy. Nonetheless, it should still be kept in mind that he inherited a full-blown and complex military conflict in Afghanistan. That said, he would not be the first President to feel the need to prove his bona fides as a “liberal” civilian Commander-in-Chief, as I was reminded while re-reading David Halberstam’s The Best and the Brightest first published in 1972.  It is perhaps not surprising that the narrative fits the situation we face today – all one needs to do is change the names of the principal actors or labels: Obama for Kennedy, al-Qaeda for international communism; the cold war for the war on terrorism; and Viet Nam with Iraq and Afghanistan.

2.                  Current Situation

Elliott: In our last interview, I suggested negotiating our way out by telling both Afghanistan and Pakistan we would leave if they gave us Bin Laden. You made a pretty convincing case that at this point, having Bin Laden in US custody would create more problems than it would solve.

So I pose the following question to you. The Defense Department is spending $9.1 billion per month in Afghanistan. So far, 1,206 Americans have died. In 2010 the death rate is 38 monthly. Is it worth continuing this war? What are the benefits? And what can be accomplished in this politically divided country with corruption out of control?

Jerry: I am neither a fan of Karzai, his Government, or corruption. Nonetheless, whether or not Karzai is corrupt misses the core issue of political legitimacy and distorts our understanding of it. Indeed, being corrupt does not automatically mean the loss of political legitimacy or negate the ability to establish it. Thus, insurgent groups from Colombia to Afghanistan are effective despite, and sometimes because, of their corrupt involvement in, for example, the drug trade. Our own experience of integrating immigrants of many different cultures through “machine politics” in our own cities during the first decades of the twentieth century suggests that exchanging benefits for political support in culturally and politically un-integrated political environments has worked as often as not. Further, Afghan history is replete with examples of short-term alliances among various tribes, clans, and more secular political factions in response to the unifying presence of foreign troops.

Thus, the more relevant question must be — is Karzai’s Government in Kabul viewed as sufficiently legitimate by a sufficient number of Afghan citizens to cause them to obey its laws, rulings, or other edicts and, if necessary, lay down their lives to defend it?  If not, is there any reasonable prospect that Karzai or anyone else in Kabul could achieve such legitimacy while being supported by the direct intervention of American or other foreign military forces? Or are we trapped by the conundrum that our military intervention in and of itself is an important catalyst for unifying a wide-range of Afghan factions against the Karzai or any other possible government in Kabul? If so, the withdrawal of our military forces would be a necessary pre-condition for any future possibility of a stable US-friendly government there. That might not be as far-fetched as it might seem, as illustrated by the dramatic shift in the relationship between the US and Viet Nam between 1975 and today. The withdrawal of our military forces from Afghanistan would almost certainly presage the end of the Karzai Government and increased violence at least during the short-term. But the retention of the Karzai Government surely cannot be the objective of our military intervention there nor does the fall of Karzai presage a Taliban victory. To the contrary, our withdrawal and the fall of Karzai’s Kabul Government would almost certainly increase the intensity of Afghani’s multi-directional competition for power. Nonetheless, our own entry into what is at root intra-Afghani violence has not resulted in reducing such violence either — nor is there any reasonable promise that it might do so.

Iraq 

1.                  Motivation

Elliott: It is pretty clear we did not go into Iraq for the stated reasons – to spread democracy in the Middle East or because Iraq had weapons of mass destruction that posed a threat to the US. I believe I stumbled upon the real reason in doing research on a recent article on energy: Iraq’s oil reserves are huge: second only to those of Saudi Arabia.

Jerry: If oil was the reason, then the Bush Administration’s miscalculation was even more egregious than even I had thought. As it turns out, the primary beneficiaries of Iraq’s increasingly restored oil capacity now appears to be the Chinese state-owned oil companies that are frequently displacing the American and British there. But whatever that case might be, I don’t think there was a single reason for going to war in Iraq. The 9/11 attack was the catalyst for a perfect storm. It fueled explosions of American patriotic machismo and intellectual hubris rooted in growing frustration with the ongoing air war in the skies over Iraq and an increasing number of attacks on American military and diplomatic targets in the Middle East and Africa since the end of the first Gulf War in February 1991. But that is neither here nor there now.  The more important issue is that we were this last week celebrating a supposed “victory” in Iraq defined by the removal of main-force combat units – an action that would not have occurred if we had not inserted those troops into Iraq in the first place. And that, in turn, is once again evidence that we had no clear understanding of America’s core and priority secondary national interests in the first place.

Even now, although asserting that “the Department of Defense balances resources and risk among four priority objectives,” those “priorities” are much too broad to provide useful guidance with respect to strategic security threats or prioritization of secondary interests. If you don’t believe me, read their formulation of the four priority objectives yourself: “prevail in today’s wars, prevent and deter conflict, prepare to defeat adversaries and succeed in a wide range of contingencies, and preserve and enhance the All-Volunteer Force.” 

2.                  Current Situation

Elliott: So far, 4,402 Americans have died. In 2010, monthlies are: 

• death rate 22;
• military expenditures $4.5 billion.

The US is in the process of an orderly withdrawal. When I was in Argentina last November, I regularly listened to once-a-week show on Al-Jazeera where the heads of the various Iraqi power groups were interviewed. In essence, they all said we will wait for the US to leave and then we will resolve things in our own way. At the insistence of the US, Iraq held an inconclusive election in March. And despite US pressure since then, a new government has yet to be formed. By removing Saddam, we destabilized the Middle East where historically, Iraq and Iran focused hostilities on one another. As the Iraq leaders said last November, shortly after the US exits Iraq, the power groups will resolve issues in their own way. The Shiites are the majority in Iraq, so it will come under the influence of Iran, and US access to its oil reserves will end. So what good is served by keeping US troops in Iraq? I don’t see it – retreating in an orderly fashion is the best option.

Jerry: What to say. I only wish that I could agree with the American soldier of the 42nd Stryker Brigade who, upon crossing the border from Iraq to Kuwait just this last Wednesday shouted “We’re out of Iraq. The War is Over. We Won.” Unfortunately, that conclusion is premature for many reasons, not least of which is that we still do not have an unambiguous formulation of our objectives in Iraq, how such objectives might fit into a broader American strategic framework, or even whether or not achieving any such objectives might be possible. Indeed, the most likely outcome for the indefinite future is that Iraq will continue to be governed by a weak authoritarian regime in Baghdad. And whether or not that regime turns out to be relatively benign or actively anti-American — or antagonistic to or allied with Iran — is anyone’s guess. But even in the most benign case, Iran’s position would be better than it was in March 2003 when we actually invaded Iraq (as you point out below).

What Should Be Done?

Elliott: Jerry, to this point, our focus has been on what should be done in Afghanistan and Iraq. In this final section, I would like you to consider these two wars in the context of our broader national security interests.

Jerry: You are correct in thinking we should look beyond Afghanistan and Iraq – both of which are symptoms of our Government’s broader strategic assumptions and objectives. From that broader perspective, it is useful to differentiate between threats that would deprive the United States of its independence as a sovereign-state and threats to achievement of desired, but secondary, interests. Thus, although threats to vital security interests require a state to — at least figuratively — “fight to the death,” threats to secondary interests are discretionary. That does not mean that secondary interests should not be defended – they too enhance America’s global political or economic position. But, determining that the defense of any specific secondary interest is achievable is not enough – calculating the relative cost-benefit of doing so is also necessary. Further, it is also essential to determine the credibility of the potential enemy. It is not enough for Osama bin Laden or others of his ilk to declare his intention to re-establish some mythical Caliphate from Spain to Indonesia unless they have a reasonable possibility of doing so. Thus, strategic threats must be thought of in terms of longer-term outcomes – not shorter-term tactical wins or losses.

But that sort of nuanced approach is not reflected in the Department of Defense’ most recent Quadrennial Defense Review (February  2010), which explicitly characterizes the United States as:

“a global power…deeply intertwined with the fate of the broader international system”…[that] therefore [must] be prepared to support broad national goals of promoting stability in key regions, providing assistance to nations in need, and promoting the common good.”

That view of the role and obligations of the United States, if taken at face value, portends a never-ending escalation in the number of military interventions. That, in turn, raises the question of whether or not Afghanistan and Iraq should be viewed in the conventional way as two distinct wars or, rather, as merely different battles within a single unconventional war of global scope against….. – well against whom exactly? The Review once again provides a clue:

“we must recognize that first and foremost, the United States is a nation at war. In Afghanistan, our forces fight alongside allies and partners in renewed efforts to disrupt, dismantle, and defeat Al Qaeda and the Taliban. In Iraq, U.S. military personnel advise, train, and support Iraqi forces as part of a responsible transition and drawdown. Above all, the United States and its allies and partners remain engaged in a broader war—a multifaceted political, military and moral struggle—against Al Qaeda and its allies around the world.”

Elliott: Al Qaeda is mentioned twice in the above statement. It is not clear to me how ground wars in the Middle East are an effective way to deal with this threat.

Jerry: You are missing the broader point. Getting out of Iraq and/or Afghanistan will not end the “militarization” of our Government’s capacity to pursue, capture, and punish terrorists, provide foreign aid nor, more broadly, respond to national emergencies ranging from hurricane damage relief and reconstruction to damage caused by oil spills. Nor is it likely to curtail the increasing tendency to base our military forces in substantially hostile overseas environments rather than in the more friendly political climes provided by Germany, Italy, Japan, or South Korea.

It is instructive to note that the 2005 Report of the Commission on Review of the Overseas Military Facility Structure of the United States sets forth the clear intention to expand America’s network of Cooperative Security Locations (CSLs), Forward Operating Sites (FOSs), Naval Support Facilities (NAVSUPPFAC), relatively small unconventional warfare bases, and other more conventional military facilities like airbases in locations closer to the world’s “arc of crises.” But basing our forces in ever more politically sensitive arenas is almost certainly viewed as provocative by both neighboring countries and locals who oppose those regimes that have agreed to accept American military contingents on their soil. Even the suggestion that the United States intends to substantially increase its presence in an area generates opposition that might not have arisen otherwise – as demonstrated by the failure to reach agreement with any Sub-Saharan Africa government (other than the mini-state of Djibouti) to locate the headquarters of a proposed American Regional Military Command within one or another of their borders. But that failure has been the exception rather than the rule. Indeed, it has recently been reported that America’s post 9/11 basing expansion into Bahrain, Djibouti, Kenya,  Kuwait, Kyrgyzstan, Qatar, United Arab Emirates, and Uzbekistan has been followed by recent anti-terrorist military and other clandestine attacks on targets in Somalia and Yemen.

An expanding number of interventions will almost certainly result in the generation of yet other new enemies and the increased probability that we will continue to be sucked-into other peoples’ conflicts. That is especially the case since, the rhetoric of international cooperation within the Quadrennial Review notwithstanding, our actions represent a dangerous unwillingness to accept the historical fact that our recent military superiority in a supposedly uni-polar inter-state system is the exception rather than the norm. Instead, the dominant view within the Department of Defense appears to be that, as “the only nation able to project and sustain large-scale operations over extended distances,” the United States must serve as “responsible stewards of the power and influence that history, determination, and circumstance have provided.” That core view is premised on the assumption that American dominance throughout the world is a good, necessary, and sustainable thing. But is that the correct view – or is it a distortion of our national priorities and an unnecessary drain on our human, material, and financial resources?

Beyond fundamental conceptual errors and the emotional desire for continued American military dominance, the all-encompassing and undifferentiated character of current military assumptions reflect plain old-fashioned intellectual laziness. Losing the ability to differentiate among policy objectives and the means employed to achieve them ignores Karl von Clausewitz’s (1780 – 1831) still valid aphorism that “Policy (politics) is the continuation of War by other means” as reinforced by another principle that “no one starts a war — or rather, no one in his senses ought to do so — without first being clear in his mind what he intends to achieve by that war and how he intends to conduct it.” Adhering to those principles require that objective(s) be clearly established, prioritized, understood in relative terms, and articulated.

 A look at the post-WWII history of United States military interventions strongly suggests that successive American governments have not established fundamental criteria for differentiating between vital core and priority secondary interests since the need for “Cold War Containment” policies began to decline during the 1980s. Although United States military forces were directly involved in combat during sixteen of the forty-two years from 1950 through 1991, they have been almost continuously engaged since the collapse of the Soviet Union. Relying on the continual deployment of our military forces in that way is clearly not sustainable for much longer. A more economical approach to defending our vital core and priority interests must be found.

Elliott: Jerry, thanks for your thoughts.

 I end with quotes from another person I respect – Robert Borosage

 The country finds itself constantly at war. New presidents inherit the wars of their predecessors. They are faced not with deciding to go to war, but whether to accept defeat in one already in progress….And slowly, the great power declines from the inside out. The wars are costly, running up national debts. Vital investments are put off. Schools decline. Sewers leak. For a long time, circuses distract from the spreading ruin….Other societies become productive centers, capturing the new industries. Some begin providing better education for their citizens, better support for their citizens. Their taxes, not drained by the cost of wars past and present, can be devoted to what we used to call “domestic improvements.” This is a very rich country, despite the years of conservative misrule. But even wealthy countries must choose. We can afford to police the world – to sustain 800 bases across the globe, to station troops in Korea, in Japan, in Bosnia, in Europe, fight wars in Iraq and Afghanistan, sustain fleets to police the seas….

South Waziristan, Yemen, Somalia, Kosovo, the Taiwan straits, the North Korean border, the seven seas – we can do this. But the result is that we are continually at war. And the wars cost – in money, in lives, in attention. And inevitably, domestic priorities, as well as emerging security threats that have no military answers, get ignored. A rich country, Adam Smith wrote, has a lot of ruin in it. We seem intent on testing the limits of that proposition.

As part of its public info/transparency policy, the Treasury Department invites financial bloggers for meetings with senior Treasury officials 4-6 times a year. A good idea. And as a blogger, I have considerable respect for the bloggers invited. Whatever their views, being invited means the Treasury believes they have a significant following and their opinions matter. One of the bloggers invited to a recent such meeting was John Lounsbury. And John just reported on it. Using John’s report as a backdrop, this piece will comment on some of the issues raised (or not raised) at that meeting.

Confrontational Questions

John reports: A number of guests raised confrontational topics….

It occurs to me there are some confrontational questions that can and should be raised while there are others that would sour the event. I will offer examples of each.

1. Appropriate Questions

I would put the following questions to Secretary Geithner about actions taken by the Federal Reserve Bank of New York (FRBNY) at the time he was President.

Secretary Geithner:

1. In the government’s first meeting with AIG to plan the bailout, do you think it was appropriate to have the CEO of Goldman at the meeting, the only outside party? Whose idea was that?
2. It was widely reported that AIG executives were willing to negotiate the firms they owed money to down to 60 cents on the dollar. Instead, the government insisted that AIG pay 100 cents on the dollar. That decision cost $37 billion. Whose decision was it, and what was the rationale?
3. The government then instructed AIG not to release the names of who got paid. The names finally came out when Jeffrey P. Riedler, Assistant Director of the SEC, send a letter to AIG requesting the details on who got paid. Who made the decision to withhold the names, and what was the rationale for it?

2. Inappropriate Questions

It would not have been appropriate to ask Geithner about the following report that appeared in the Washington Post at the time of his appointment:

Over several years, Treasury secretary nominee Timothy F. Geithner failed to pay Social Security taxes, even though he was advised by his employer to do so, signed an agreement indicating that he understood that such payments were his responsibility and received extra pay from his employer specifically for that purpose.

Mr. Geithner “came clean” only when he was caught, first by an IRS audit that found he owed Social Security taxes for 2003 and 2004 and then when additional tax liabilities for 2001 and 2002 were discovered after his nomination. He has been praised for repaying these additional taxes for the earlier years, which apparently may not have been required under a statute of limitations, but this raises another question: Why didn’t he voluntarily correct his 2001 and 2002 taxes once he found out that he had made the same error in 2003 and 2004?”

This is a clean cut issue: Geithner cheated on his taxes, like former VP Agnew. What point would there be in bringing it up again?

Financial Reform

Lounsbury reports that Treasury was very enthusiastic about the new Dodd-Frank Financial Reform Bill recently passed into law. Why? Depository institutions are still allowed to trade, and it was their trading that caused the bank collapse in the first place. And here is the killer: the bill calls for federal financial regulators to study the measure, and then issue rules implementing it based on the results of that study. The financial lobbyists will be all over the financial regulators. Binyamin Appelbaum wrote a great article in the New York Times on what will happen next. I quote from his article:

…Brett P. Barragate, a partner in the financial institutions practice at the law firm Jones Day, estimated that Congress had fixed in place no more than 25 percent of the details of that vast expansion….

Interest groups have been preparing for months. When the Consumer Bankers Association convened its annual meeting in early June, there was still plenty of time to lobby Congress. But the group’s president, Richard Hunt, told his board that the group should shift its focus to the rule-making process. The board voted to increase the group’s budget and staff. “Now we hope to have a good give and take with the regulators on the best interests of the consumer and the industry,” said Mr. Hunt….

One clear consequence is a surge in the demand for lawyers with expertise in financial regulation, particularly those who have worked for regulatory agencies. Most of the major trade groups are hiring lawyers. The major banks say they are employing more, too.

A question for Geithner: What happened to the Volcker Rule to ban trading in depository institutions? I can hear Geithner’s response now: “well, while trading was not banned completely, with our new regs in place….”

Too Big To Fail

Lounsbury was not satisfied with the discussion on this topic:

The sense I took away from this part of the discussion was that much depends on (potentially hundreds of) studies authorized by FinReg. The Treasury is charged with forming an Office of Financial Research to conduct research to guide future regulation implementation. This really translates to me that we are still in the process of conducting a Grand Experiment.

The Appelbaum points made above are relevant here as well. The lobbyists will be ready.

My view of too big to fail? A red herring issue. In the financial world, all we should care about is keeping our depository institutions safe. If we did that by not allowing them to trade and insisting that they manage their own loans, they would be safe. The only reason we had to bail out AIG was that our depository institutions would have collapsed if AIG went under. With Volcker’s rule in place, depository institutions would be safe. Let other financial institutions go under. Who cares? Caveat Emptor.

Conclusion

Despite the above commentary, I think it is great that the Treasury is meeting with bloggers. And I tip my cap to the bloggers who get invitations to the meetings.

The Asset Allocation Approach – we have all heard about how it is the most rational way to invest. But is it? And why do investment managers like it so much? This article reviews the arguments for the approach and why it is a favorite of wealth managers.

The Theory

Today’s dominant investment theory is derived from the writings of the mathematicians and philosophers of the 16^th Century[1]. Paul Samuelson[2] is credited with developing the mathematical theorem that “properly anticipated futures prices fluctuate randomly”. And Burton Malkiel has presented all of this work in a book with direct application to personal investing.[3]

And what does it all mean for the investor? It means that the best assumption to start with is that all available information on companies is reflected in their stock prices. Consequently, the price of every stock is just as likely to go up or down. When you invest, you are making a random bet. When new information comes out, prices will adjust immediately to reflect the implications of this information.

This means the investor has 50-50 chance of picking which way a stock will move – not a good bet because you don’t want a 50% chance that you will lose money on your investment. The sensible conclusion: Don’t bet all your money on one horse: diversify; the more you diversify, the more your chances of losing (or making) money on your investment will fall. And you can diversify by purchasing more stocks, or a mutual fund or an ETF.

There is an important corollary to this: stock recommendations are close to worthless for the retail investor: if new information is almost instantly reflected in stock prices, what makes you think you are going to get that information in time to “cash in”? For more on what the retail investor is up against, see my recent article.

The logic for using an asset allocation strategy is very powerful.

The Sector Scam

The people who want to charge you a fee to have them manage your money have taken the meaning of diversification further. They have developed categories for stocks/bonds. They say proper diversification requires that you have holdings in various sectors/categories. To give a sense of how far the sector/category business has developed, the following are most of the categories used by Morningstar to describe the approximately 25,000 mutual funds in their database:

 Bank Loan, Bear-Market, Conservative Allocation, Convertibles, Diversified Emerging Mkts, Diversified Emerging Mkts, Diversified Pacific/Asia, Emerging Markets Bond, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Growth, Foreign Small/Mid Value, High Yield Bond, High Yield Muni, Inflation-Protected Bond, Intermediate Government, Intermediate Government, Intermediate-Term Bond, Japan Stock, Large Blend, Large Growth, Large Value, Latin America Stock, Long Government, Long-Short, Long-Term Bond, Mid-Cap Blend, Mid-Cap Growth, Mid-Cap Value, Moderate Allocation, Money Market – Muni, Money Market – Taxable, Multisector Bond, Muni Single State Interm, Muni Single State Long, Muni Single State Short, Pacific/Asia ex-Japan Stk, Short Government, Short-Term Bond, Small Blend, Small Growth, Small Growth, Small Value, Communications, Financial, Health, Natural Resource, Precious Metals, Real Estate, Technology, Utilities, Ultrashort Bond, World Allocation, World Bond, World Stock.

Indicies and ETFs have been developed for most of these.

Callan Associates, an institutional money consultant, has chosen 8 sector indices. To show how these sectors have performed over the last 20 years, Callan has developed a chart with different colors for different indices. A great marketing vehicle: different colors are at the top in different years – the message – diversify – use our asset allocation method, and pay us for it!

 Assessment

 Boeckh just did a nice, representative piece on asset allocation. The article focused on correlations between different sectors. Their message? Good asset allocation means holding sectors that are not highly correlated with one another. No discussion of specific investment vehicles.

Consider how convenient it is for investment advisors to focus on these sectors/categories. This focus diverts the client’s attention from the important questions:

•  How has the portfolio performed?
• What stocks, funds, ETFs have actually been picked?
• How have these picks performed relative to other possibilities in the same categories?

 A Case In Point

 I recently received “Investment Reviews” from a major bank where I am a trustee on a Trust. The reviews were nicely presented in high-resolution color. The titles for the first four pages were: 

• p. 1 – “Strategic Asset Allocation Models” 
• p. 2 – “Hypothetical Model Portfolio Risk/Return”
• p. 3 – “Strategic Asset Allocation Philosophy”
• p. 4 – “Current Asset Allocation”.

There was nothing in these four pages on performance – nothing!

Only one page of these documents provided detail on performance, and that detail only broke down performance into three categories: “Equity”, “Fixed Income”, and “Cash”. But nowhere in the document was there any information on how each investment pick (stock or mutual fund) had done! Why? Because the Trust manager did not want me to focus on actual investment picks and how each pick actually performed.

The last few pages of “Investment Reviews” gave data on the individual investments, e.g., number of shares, market value, but without performance information on the individual investment.

It turns out that a significant portion of the Trusts were invested in the Bank’s mutual funds. I asked for and received performance data for these funds. I then compared their performance with mutual funds that fall into the same Morningstar categories.

 The essence of my review is contained in the following table. Each of the funds picked by the bank fits nicely into Morningstar categories. Columns 2 provides the annualized 3-year return on each fund. Column 3 provides the three year return ranking of each fund in the Morningstar category. For example, in the Morningstar category of large cap growth, the Large Cap Growth fund of the Bank ranked 500. This means there were 499 funds in the Morningstar category that had better three-year performance than the Bank’s fund. Column 4 provides the best three year return for a fund followed by Mornigstar in the category. For example, while the bank’s large cap growth fund has an annualized three year return of 10.44%, the Morningstar fund with the best return for that category was 24.59%. Column 5 provides the differential between the best return and the return on the Bank’s fund.   

Source: Data provided by the bank and the Morningstar Principia data base.

 This table demonstrates the sub-par performance of the Bank’s funds. The important message? Specific investment choices matter!  Remember that the people who invest your money want to keep you as far away as they can from how your portfolio is performing. And most definitely, they don’t want you to know how well each investment pick is doing relative to other possible investment picks in the same category. Every wealth/pension manager has favorites in the investment management industry s/he wants to give your money to. In the case of the bank example above, the bank wanted to keep the money in-house by putting it in their crummy mutual funds.

 In these circumstances, what to do? 

• Asset allocation logic is quite powerful.
• Picking individual stocks should be viewed as gambling, a form of entertainment.
• Find an investment advisor that has an audited 3-year performance record s/he is willing to share with you (hard to find).
• Once you have decided on an asset allocation strategy, make sure to pick relatively high performing vehicles in each sector.   

[2] Paul Samuelson, “Proof that Properly Discounted Present Values of Assets Vibrate Randomly”, Bell Journal of Economics, 1973, 369-374.

[3] Burton G. Malkiel, A Random Walk Down Wall Street: Including a Life-Cycle Guide to Personal Investing, (New York: W.W. Norton 1973).