KWR Special Report

Globalization and the End of the Guns and Butter Economy
By Scott B. MacDonald

NEW YORK (KWR) - October 26, 2007 -- Over the past thirty years, the United States has sought and to some extent achieved a guns and butter economy; that is the pursuit of both political-military objectives and an affluent lifestyle. On the political front, it has dominated the international system, presiding over the defeat of the Soviet Union, its hegemonic rival during the Cold War, and forming a successful military coalition to liberate Kuwait in the first Iraq war. It became even more unilateral under the Bush the younger administration, with aggressive policies against militant Islam and Iraq in Middle East and South Asia.

At the same time, the consumer-driven U.S. economy continued to expand, with the last great burst being the spike in homeownership in the 2003-2006 period. Homeownership since the mid-1950s was long stuck at 65 percent of the total population, but by year-end 2006, on the back of cheap credit and lax underwriting standards, it reached 69 percent. Significantly, countries such as China, Japan and Germany benefited from the U.S. guns and butter economy, content to sell their exports and finance their purchases via the buying of U.S. debt. This was the upside of globalization.

But in July 2007 the U.S. financial system signaled that the era of cheap money and lax standards was over. Two Bear Stearns hedge funds collapsed and panic hit credit markets, pounding the stock and bond values of any company associated with mortgage lending and housing. By August the rout filtered into the derivatives market (especially those structured financial products that contained exposure to U.S. sub-prime debt), negatively impacting European and Asian bank and insurance investment portfolios.

The contagion eventually rippled into London's inter-bank market, forcing central banks to inject considerable amounts of liquidity to keep the system running. Even then, nervousness about the standing of banks, especially those dependent on short-term commercial paper for mortgage lending, forced the UK's Northern Rock into a government rescue. This was the downside of globalization.

The U.S. economy is edging toward a significant slowdown in what is left of 2007; it will take concerted effort and luck to avoid a recession. The housing sector is hitting depths associated with the 1930s. The Fed's September 18th cuts in the discount window and in Fed Funds gave markets a temporary relief, a situation helped along by private sector actions to consolidate the financial sector. This is reflected in Bank of America's purchase of Countrywide Financial shares and Citigroup's stepping up with credit lines for GMAC. But there remains a long distance to the shore of economic safety.

A shadow is being cast by a deficit of unresolved problems in an economy overloaded with debt, a retreating federal responsibility for national infrastructure, and large (and seemingly unending) overseas burdens. In the short-term, the problem that looms on the horizon is that the housing meltdown is finally chipping away at the consumer, who in the butter part of the U.S. economy, accounting for about 70 percent of GDP. The consumer relied on home equity (and foreign capital) to finance the ongoing parade of goods and drove many households into negative territory in terms of savings. Why save when you are penalized (taxed) on savings amidst an unrelenting society-wide pitch to consume? Easy money during the Greenspan years helped keep the guns and butter economy afloat without too many major adjustments. That dynamic has changed.

On the short term side there is going to be further bad news on housing. There is a very real prospect of steeper declines in housing prices, pushed along by a growing inventory (already 9 months of new homes waiting to be sold not to mention those homes taken off the market by frustrated would be sellers). In addition, there is a huge resetting of adjustable rate mortgages over the next 12 months, with a large spike in March 2008. Adding to the list of woes is the increasing pace of personnel downsizing in the mortgage industry and declining profitability in the financial sector.

On the longer-term side of the equation, the economic landscape is chilling, considering the massive structural problems. The guns part of the economy is a concern - the war in Iraq and other missions (Afghanistan and Africa) cost somewhere between $3-5 billion a day. In August, the Congressional Budget Office (CBC) estimated as of June 2007 up to $500 billion has been spent on combat operations in Iraq. The CBO also noted that if the United States were to maintain 75,000 troops in Iraq over the next five years, the nation would have to pay an additional $900 billion. Moreover, there are further costs attached to training police and ground forces in Iraq and Afghanistan as well as long-term health costs associated with wounded personnel.

There are other structural problems - a long term imbalance between government expenditures and revenues (related to ongoing pressure for tax cuts). There is a massive problem with national infrastructure - it is aging rapidly and needs to be upgraded with a price tag of $1.6 trillion. That includes roads, bridges, ports and other public utilities.

Any doubt of the infrastructure problem one need only point to the July 2007 steam conduit that exploded in Manhattan - the piping was laid 83 years ago when Calvin Coolidge was president and was part of a system that started to provide energy to New York City in 1882. In August 2007, a 40-year old bridge in Minneapolis collapsed, leaving several dead in the accident's wake. The national infrastructure is literally falling down around the population, but the most recently passed Senate transportation and housing bill contained at least $2 billion for pet projects that include a North Dakota peace garden, a Montana baseball stadium and a Las Vegas history museum.

Equally important is the issue of Medicare, Medicaid and Social Security, the combined basis of which is expected to grow 22 percent faster than the economy over the next decade. This should come more sharply into focus next year when the first of 78 million baby boomers become eligible for early Social Security benefits.

American politics have reached a very dysfunctional stage, with considerable energy given to the indulgence of maintaining an economy and the debt required to keep it going, with little thought being given to the adjustments now in motion. Along these lines, it is easier to blame the outside world for troubles at home, hence the turn to protectionism (with a number of bills pending in the U.S. Congress). The plunging value of the U.S. dollar and the huge sell-off in U.S. securities by foreigners in August ($163 billion) should convey the message that not all is well and that unless there is an effort to start living more within one's means, the rest of the world is going to stop financing the North American credit glutton. The days of guns and butter for the U.S. economy are over; what is going to replace it is a much more volatile world, with substantial questions over the U.S. dollar as the major international currency and the ability of the U.S. consumer to absorb the world's exports. As the U.S. adjusts to this changing scenario, so will the rest of the global economy. It is not going to be an easy transition.

While the information and opinions contained within have been compiled from sources believed to be reliable, KWR does not represent that it is accurate or complete and it should be relied on as such. Accordingly, nothing in this article shall be construed as offering a guarantee of the accuracy or completeness of the information contained herein, or as an offer or solicitation with respect to the purchase or sale of any security. All opinions and estimates are subject to change without notice. KWR staff, consultants and contributors to the KWR International Advisor may at any time have a long or short position in any security or option mentioned.

KWR International Advisor

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Publisher: Keith W. Rabin, President

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