As we all know and have experienced, the world has been in a prolonged economic uncertainty since 2008. Although many countries had economic recoveries starting from the second half of 2009, the world now seems to be falling into further economic hardship with the European Sovereign debt crisis and housing bubble bursting. For the former, I’m referring to the ongoing problems in Greece, Ireland, Portugal, Spain and Italy. For the latter, I’m mainly referring to the housing market problems in China, Australia and Canada. In such harsh economic climate, the debate of military expenditure is important for not just America and NATO countries, but all of the countries around the world. Both China and America are facing possible leadership changes in 2012. At the same time, governments around Western countries are facing the possibility of collapsing over austerity measures and general discontent toward banker bailouts. The topic I’ve been thinking about in the last few weeks are whether leadership around the world is up to the task of handling the problems that are facing us.

I often talk about the reasons behind the buildup of the PLAN fleet. My message has been that the Chinese economy is so much dependent on energy security and maritime trade that it needs a strong blue water fleet to protect the sea lanes. Of course, that’s not the only reason we are seeing larger budget for the navy. Other reasons include the desire for projecting soft and hard power (achieve political influence), national pride, buying support from the military and supporting the military industrial complex. Even though I’m an avid military follower, I tend to believe that military buildup should only happen to support and ensure an environment for economic growth. Contrary to what the military industrial complex would like people to believe, spending toward the military does not naturally help the economy. If the weapons that are produced are not used in a way to enhance the economy, then they don’t help a country’s productivity. (Similarly, if a government spends the same amount of money on building roads that lead to nowhere, they will also be wasted.) In cases where a government puts too much spending into the military for non-economical reasons for a long period of time like in USSR, you eventually see a complete collapse where neither the economy nor the military survive. For all of the faults of the Chinese leadership, the one thing it did realize after Cultural Revolution is that economic development must take place before it can build a stronger military. Amongst many of its policies to liberate the market in the 80s, Deng Xiaoping also liberated the Chinese economy from the weight of military expenditure by cutting it 10 years in a row (or something like that). During this time, many domestic military projects had to be abandoned due to lack of funding. Even J-10, the most important project in PLAAF history, almost got axed in the 90s. I’m sure many people in PLA complained loudly back then, but it is hard to argue against the success of such policy now. Comparing this relatively orderly retreat in military budget to that of the complete collapse in Russia, I think most people would prefer to go down China’s path. I’m not here to just applaud China and put down Russia, but rather to show the importance of keeping military expenditure in check even during times of security needs.

By now, many of us have the freedom to move to different countries around the world for better economic prospect. All of us want to be in a land where we can live comfortably and be prosperous. More than ever, countries around the world need to keep economic security so that it can attract the best talents around the world while keeping its best at home. For example, I moved from Canada to New York, because the job prospects are better here. However, I may move to a place like Singapore in the future that is well developed and has low taxes. Countries that can provide economic security and development will become more prosperous, technologically advanced and militarily strong. Clearly, America has always been one of such nation and has also benefited tremendously from absorbing the brightest around the world. In the past, a country’s economic security is provided by a strong military, but that’s no longer the case. Now, they can also be threatened in the major manufacturing industries, commodities markets and banking systems. Even though these threats generally don’t kill people with bombs and bullets, they do bring hardship and eventual overthrow of governments.

For an example of threat to financial systems, the Icelandic economy collapsed a couple of years ago and the nation’s banks were saddled with debts from market speculation. The Icelandic government initially bowed to IMF pressure to impose austerity measures and pay back the debts owed by the banks to British and Dutch creditors, but the Icelandic people revolted and overthrew their elected government. The new Icelandic government has since rejected all proposals that it views as unfair to payback foreign creditors. The similar drama is playing out in Greece except that they have not overthrown the government yet. At the moment, everyone in the country is striking over the austerity measures and Greece is barely functioning as a nation. They will definitely default (even if it’s called voluntary) and probably will leave the Euro zone. In fact, the current debt problems along Southern European countries will probably result in the end of Euro as we know it. The more fiscally sound nations like Germany and Austria will use a new currency, whereas the remaining countries will use a much weakened Euro. Along the way, millions of people will suffer due to sovereign debt problems brought about by public sector debts and private sector debts that are guaranteed by government. Of course, the same threat is looming for China and America, which I will talk about later.

For example of threats from commodities markets, we only need to look at the Arab spring. From late 2009 to early 2011, there were a lot of inflation in the commodities market. Such inflation never shows up in our CPI (which does not include food and energy), but is clearly felt by everyone around the world. While some of that inflation is caused by demand in China, much of that is caused by speculation in the global commodities market and debasement of currencies around the world. So as a result of living in a globalized food and commodities market, Arab countries faced high inflation despite being mired in an economic slump. When faced with stagflation and lack of freedom, the local population rioted and threw out the dictators. I do want to point out that when people are faced with extreme hardship of stagflation (inflation + depressed economy), they will protest and riot against their government regardless of whether they are elected or not.

A large part of the reason behind inflation in global commodities market came from the so called currency war. For the past few years, most major currencies around the world have been eagerly debased by central banks in a way in order to stimulate the export sector. Some of the most well known cases of such currency debasement include the many rounds of QEs by the Federal Reserve, the pegging of RMB to USD, the efforts by BOJ to keep Yen down, the QE efforts by ECB and the hard cap set by Swiss national bank to hold up EUR/CHF exchange rate. Basically, every country kept loose monetary policies in order to not rise too much against USD and Euro. Contrary to what the politicians may tell you, this is not just a Chinese policy, but something that central banks of most major currencies try to keep their export industries competitive. When you combine this with cheap money and excessive lending practices in growing countries like China and India, the world faces an expansion in credit that results in inflation in spite of economic downturns in many countries.

At the same time, we are also facing the prospect of trade war between major economies. During good times, large trade distortion as we see now with China and US results in political tension. During bad times like the great depression, we see protectionism amongst the world economies and result in extended period of economic pain. When governments around the world put in stimulus packages in 2009, many of them put in “buy-at-home” clauses to try to stimulate the manufacturing industries at home. In spite of such clauses, we’ve seen recovery amongst major manufacturers around the world due to trading. With the recent rhetoric coming out of US senate, it appears that we are facing a looming trade war between China and America. I will talk about later why I think policies of politicians from both countries are not helpful.

And finally, we also face this sovereign debt war. Due to the abandonment of gold backed currency, countries around the world have been able to run prolonged period of fiscal deficits through fiat currency. It’s safe to say that most countries around the world have lived beyond their means and now the market is punishing some of them with ever increasing interest rate. In the case of Greece, the country is on life support and will default at any moment now. The last minute voluntary haircut deals simply can’t rescue the country from the ever increasing borrowing cost. And when it does default, the two main groups that will suffer are the Greek Pension fund and banks. The former leads to the collapse of social safety net and the latter leads to bank insolvency. The same problem is also facing other PIIGS countries, some peripheral European countries and states like California and Illinois. Even though pension fund reforms and some bank insolvency may be the best way to go, a lot of people will experience pain in the short term. My point is that perpetually running up deficits will catch up to a country sooner or later.

As I’ve watched the primary season for the past few months, I cannot help but be disappointed with the current political discussions. We have an economically illiterate president who cannot move past blaming all of his problems on the Republicans. The Republican primary debates never seem to move past who flip-flopped, who was once a democrat, how fast they will repeal the Obamacare and how much taxes they want to cut. Other than Ron Paul, it’s hard to find any honest politician not completely bought by Wall Street, the Koch brothers or the military industrial complex. There seems to be a belief from the democrat that the economy cannot start up again without more stimulus packages. And the republican belief seems to be that the economy will magically start to expand as soon as tax and regulations are cut. While I do generally side with conservative positions on lower taxes and regulation, I think the politicians really do underestimate the effect of the debt issues around the world. People in America are not going to start spending money again until they start to save more money and feel more optimistic about job prospects. As importantly, demands around the world are going to remain down with Euro sovereign debt crisis, political unrest in the Middle East and housing bubble bursting in China/Australia/Canada. And probably just as importantly, nobody is talking about what would happen to America once states like California, Illinois and New York face the same debt pressure from bond market that the Eurozone countries are facing. Will the federal government bail these states out like they’ve already done with the auto industry and Wall Street? And what would happen if the market turns its attention to the US treasury market? On the face of it, American public debt is even worse than many of the Eurozone countries that are already in trouble, but the interest rates are now at an all-time low due to the market perception of US dollar as the safe haven. If the interest rate goes up at all, that would have huge impact on federal budget. Just think about how many American individuals, banks and pension funds would be affected if the values of their government or state bond drop? Clearly, neither the US federal government nor the state governments can perpetually run up deficits. Numerous municipal governments have already filed for bankruptcy. Yet I continuously read about apocalyptical scenarios if defense spending or medicare or social security gets cut. The reality is that the excessive spending now will eventually have to be balanced somehow by either depreciated currency or default. By justifying certain things can’t be cut now, the price will be much harsher later when austerity measures and inflation are forced upon the population as we are seeing in PIIGS countries. Once that happens, there will be rioting on the street like what we saw in so many other countries in the past 2 years. Instead of telling the truth to the country, most politicians only want to stay in power and blame other sides. Similarly, we are seeing the same blame game put on Chinese currency manipulation, because China is an easy target to go after. Aside from the fact that many major currencies are engaged in currency manipulation to try to increase export, it is also impossible to determine whether RMB is really undervalued or overvalued. As I explained in previous articles, on top of the 25% appreciation against USD in the past few years, China has also seen minimum wage go up 20% in many of the export dominated provinces in the last year. The minimum wages were increased due to rising inflation across the country caused by credit expansion. My point is that Chinese gov’t cannot control laws of economics. Rather than blaming the currency manipulation, other reasons like cheap credit, business friendly labour laws, less regulation, lower taxes and market access contribute more to the trade imbalance. American gov’t should fight for equal market access for its companies, but it should also try to be more pro-business.

At the same time, China is also nearing leadership change, since the next generation of leaders lead by Xi jinping will be taking over in 2012. In the past couple of months, we are really starting to see the housing bubble bursting in different cities around the country. The reality is of course the housing prices in many cities have gone up too much in the country due to cheap money and speculation and they need to come down to a more reasonable level. At the same time, many small businesses in the export provinces have gone under due to rising labour cost. Chinese banks are also on the hook for a lot of debts from cheap credit to big companies and local governments. It seems like China is heading into an economic downturn at the same time it is also fighting inflation issues. If past is precedent, inflation issues normally go away as soon as the economy slows down and unemployment rate goes up, so the latter may become a smaller concern. Hu jintao and the other leaders that are retiring next year would most likely not want any kind of economic turmoil to blemish their political legacy, which means they could try to bail everyone out, when they should allow for correction in the housing market and for certain local governments and businesses to fail. In the event of an economic downturn, Chinese leadership should allow for correction of imbalances caused by the boom period rather than trying to stimulate the economy further. It was painful in the late 90s in China when the government let many SOEs fail, but that became one of the major reasons for the past 10 years of economic growth in China. It was also painful for some people when China cut down the size of the government and stopped communist era food rationing, free housing and “universal health care”, but the liberalization of market has been an overwhelming success for most people. So, will Chinese leadership do the right thing this time and allow the market to correct itself? Unfortunately, I think China will try to further stimulate the export sectors and increase infrastructure spending.

Contrary to popular belief around the world, running a perpetual surplus is not a good thing. The two most popular examples to look at are the trade distortion between China/USA and Germany/Rest of Eurozone. In the former, China is exporting a lot of good to America without getting the same amount of goods back. In an ideal trading environment, that would lead the Chinese exporters to convert the currency back to RMB and increase the value of RMB vs USD. Eventually, the currency exchange rate move back and forth to reflect the productivity of the country’s work force. In the case of China/USA, China has very strict capital control, so exporters who get paid in USD would have to exchange with Chinese banks to get RMB back to pay its workers. As a result of trade imbalances, China has a huge reserve of USD. Unfortunately, China has to use that USD to buy things denominated in USD like natural sources or exchange it for another currency like EUR or JPY. In both cases, the transaction would simply depreciate the USD (and RMB as a result of currency peg) and increase the cost of the living for Chinese people. The other scenario is for China to take that and invest in USD denominated investments like treasury bonds, other fixed income securities, US Equity market or US companies. Those investments may go up or down. So the result of a huge Chinese reserve of USD is inflation for any currency tied to USD (including RMB) and a lot of USD held in America. We are already seeing the result of the inflation in China, where labour costs are going up 20 to 30% and low cost manufacturers are going out of business. If the large amount of USD is not eventually used to purchase more American goods for Chinese people, then that huge reserve will be wasted. And since the great American demand for foreign product results in spending beyond its means, you see large amount of private and public sector debts that are also held by China and other foreign creditors. America can either further debase USD or it can default on its debts. Either way, China’s USD holding will lose large portion of its value. So instead of getting back American products that can improve the lives of Chinese people, America ends up getting all the Chinese products for essentially free. In the case of Germany vs the rest of the Eurozone, the adoption of the common currency has allowed Germany to consistently run up trading surplus vs peripheral Eurozone countries due to its competitive advantage over them. Since the PIIGS countries cannot use export to grow their economy, many of them have grown through housing bubbles which have now burst. At the same time, German banks continually invested in these economies to help maintain the trade imbalance. We now get to the point where PIIGS countries are in heavy debts from the trade imbalances and are attacked by the bond market, because they don’t have a competitive domestic industry to export out of this debt. The German banks will suffer huge losses in the PIIGS countries, because they borrowed money to keep this trade imbalance going. Please note that US, Japan and UK have worse public sector debt (and also worth private sector in the case US) than PIIGS countries, because all of their debts is in their own currency that they can simply just print more.

What I’m saying is that China should not continue this export and investment driven growth, even though the Chinese politicians may find it easier just to continue this “formula for success”. I see that even though they publicly say that they do not want trade surpluses, their policies in the past have been to help the export industry whenever the economy is heading toward a slowdown. In the past, they have also invested in a lot of public infrastructure project that have helped grow the Chinese economy, but more and more of the new infrastructure projects in the recent years have proven to be wasteful. More importantly, China has recently adopted policies that are different from Deng’s time. It is adopting policies that are more confrontational with its neighbours. I think that Chinese leadership is throwing more weights around its neighbours, because it developed new confidence during the economic downturns of 2009. While I do think that China will eventually establish hegemony in its backyard like America have done in the Americas, it will have to do this slowly through greater economic integration and spread of its culture to neighboring countries. Many of the neighbours surrounding South China Sea have large Chinese expat population and similar culture to China and would probably support Chinese leadership better than other countries around the world. During a period of economic uncertainty as China is going through right now, it should concentrate more on building economic relationship with neighbouring countries rather than throwing its weight around. As China’s military grow with its growing economy, China will bound to make its neighbours feel uneasy. That’s why it has to work extra hard to have confidence building measures with its neighbouring militaries.

So, as I look at political situations in China and America, I see both countries facing similar issues with economic downturn looming. The major currencies of the world are already engaged in a currency war that is causing inflation, economic stagnation and political uncertainty. At the same time, the senate is passing a bill that could trigger a trade war with China, which will cause pain for all of us. The cheap exports that China sends to America would likely be replaced by other low cost third world countries while American consumers would face more expensive goods. There are structural issues that America needs to make to have less debt and become more competitive in the world market. At the same time, China also needs to make policy changes to shift away from export and investment based economic growth. Both countries are facing such economic firestorms that they need to spend less time thinking about how to preserve its leadership in the world and more time on solving economic issues facing the world. If the two countries spend more time on the former, we will continue to move in a path of confrontation. If the two countries spend more time on the latter, we could have more engagements, better relationships and better livelihood for everyone around the world. I also think that the economic problems that are now hitting Eurozone will spread to China and America, which will force both countries to spend more time shoring up domestic debts problems. At which time, I don’t think either military will be happy about their reduced influence.

This brings us to possibly the most shocking part of the recent debt crisis -> what I call the war against sovereignty. In the past week, we have seen democracy and sovereign completely removed from the hand of Greek people. For the past year, Greek Prime Minister Papandreou has been bowing to ECB, IMF, Sarkozy and Merkel by continuously imposing austerity pressure on Greek people and selling off any remaining profitable Greek assets. Austerity measures have only imposed more taxes on Greek citizens and choked life from the economy. Instead of reducing Greek debt, these continuous rescue packages only simply kicked the can down the road. Papandreou and his government has practically been stripped of all power and forced to do the bidding of unelected officials of ECB. When I look at Greece in the past year, I can only see politicians from both parties comply with the demands its EU creditors, whose only goals are to protect the European banks. The prolonged process has not only choked the life out of the Greek economy and its people, but also made Greek debts situation more unsustainable. The moment Papandreou tried to give power back to the Greek people to let them decide their own fate, Eurocrats from both inside and outside of Greece jumped in to crush any hope of referendum. Instead of giving Greek people a chance of voting for their future, the opposition party and Papandreou’s own cabinet revolted to comply with the wishes of Sarkozy and Merkel. The worst part is that Greece is now certain to default and will be forced out of Eurozone. Greece should have defaulted much earlier and went back on the drachma, but now the entire nation has grounded to halt from all the austerity measures and strikes. Even if Greece had the strongest military in the Eurozone, it would not have been able to defend itself against this intrusion of its sovereignty by international banks and Eurocrats. Not a single bullet was ever fired, but the Greeks have lost all sovereignty and democracy. Similar attacks against sovereignty are occurring in all the other PIIGS countries. The bond market has started to attack the public sector debts in Italy, the third largest economy in Eurozone. When Silvio Berlusconi dared to land at the G20 meeting without any new austerity and reform plans, European leaders sent in officials to Rome to look over Italy’s books to check the progress of previous reforms. Berlusconi is already facing charges of bribery and tax fraud; the added pressure from failing to please the Eurocrats has basically put his coalition government on the edge of collapse. The pressure on Italy will not stop after Berlusconi resigns. There will simply be more pressure on Italy, Spain, Ireland and Portugal to give up on their sovereignty and comply with the demands of ECB and Eurozone. All of these measures will only kick the can down the road and impose more unbearable austerity on the people. Right now, the financial market’s attention is on the Eurozone, but the EU sovereign debt issues will eventually be resolved in one way or the other. After which, the market will turn its eyes on the unmanageable public sector debts in US, Japan and UK. These countries have the ability to print their own money endlessly, so it will be interesting to see how the debt situations in these countries will play out.

What I want to show is that aircraft, submarines and tanks cannot save a country from a war against on sovereignty by the financial markets, so addressing the debt issues is imperative. Greece has already lost sovereignty to the unelected ECB/IMF. Other PIIGS nations are losing sovereignty. China and America really cannot afford to get into an arms race when looming economic issues can bring both countries’ debts situations to the forefront. The two countries should work together to balance out trade distortion. That means China should loosen some of its capital control and market access, while America needs to create better environment for its business to grow. Having closely followed the American election season coverage and the incoming Chinese leadership shuffle, I feel like we will simply get more politicians who are not willing to make the tough decisions needed to avoid the problems we have already seen in Middle East and are seeing in Eurozone. Fiat currencies have allowed governments around the world to run up huge public debt. Cuts have to be made in all sectors of the government, while failing banks/enterprises should not be bailed out. Military spending must be part of the cut. If that means reduced global ambitions, then the country must be prepared for a more humble foreign policy.