Volume XI, No. III

Listen. Can you hear it? The gray, somber hum of winter is about to burst into the joyful song of spring. Get out from behind those iPhones, Pods and Pads so you don't miss the sounds and colors of nature – you know, the real world – OK?

Besides, things out there in the real world aren't that bad. The stock market keeps chugging higher, so things must be pretty good, right? Hey, maybe this is one of those times when we'll get to have our cake and eat it too. Ya think?

All right, so it's not perfect. In fact, if you ask Richard Russell, that rising stock market may be hiding some stuff rumbling around under the surface. Recently, on his "Dow Theory Letters" website, the 86 year old dean of investment newsletters said:

Housing is hitting new lows, unemployment remains chronically bad, food and energy prices are rising, gasoline at the pump is increasingly expensive, Japan, a major supplier to US manufacturers, is a basket case, the US has moved into semi-war mode in Libya, America is sunk deep in debts and deficits, and the dollar is in the throes of a drastic decline.

Russell does make some good points, doesn't he? In fact, so many we'd never be able to cover them all in one monthly letter. So tell you what, how about we focus on something we've hardly mentioned in the past: war. Even better, let's throw money and government into the mix to see what we come up with, OK? That should stir things up enough for this month: government, war and money.

After all, governments around the world have kept themselves pretty busy pumping out money and war even as their economies have struggled since the financial crisis hit and markets plummeted in 2007 – 2008. On the money side, we've had bailouts beyond anything ever conceived or attempted before. As for war, there's Afghanistan, Iraq, Libya and pretty much the rest of the Middle East, never mind dozens of smaller conflicts in Africa, the old Soviet Union, parts of Asia like the Koreas, the Philippines – and that doesn't count regional and local conflicts and riots that are just too numerous to mention.

Now since all of that really is too much to pile on our little monthly plate, it's best if we just stick with the U.S. for now. So with that in mind, we'll take a look at:

• Since When Did We Start Fighting All These Wars?
• Why Americans Keep Fighting Each Other Instead of Our Real Enemies
• When We Stopped Paying for Our Wars – and What That Does To Our Money
• How the Creation of War and the Creation of Money – Seemingly Without Limit – Threatens the Future of the Dollar and the Country

Let's start with a recent article by George Friedman of Stratfor.com: "What Happened to the American Declaration of War." In case you don't know Stratfor, they publish analyses on global matters – global intelligence reports. (You can check them out by clicking here.)

Since When Did We Start Fighting All These Wars?

World War II officially started in 1939 when Germany invaded Poland. After Japanese Imperial Navy airplanes bombed Pearl Harbor on December 7, 1941 the United States entered the war. On December 8th, President Franklin Roosevelt gravely announced:

Compare this with September 11, 2001, when the World Trade Center in New York City was destroyed by two airplanes flown by sworn enemies of the United States. While the attack was compared to Pearl Harbor, President George Bush did not ask Congress to declare war, in spite of the fact that the Constitution explicitly requires a formal declaration by Congress for the United States to engage in war. The President chose to circumvent this formal declaration. Why?

It could be claimed that the urgency of the moment required swift action. But Roosevelt was able to get Congress to act within a day of the Japanese attack. And this was in the face of active opposition to America's involvement in World War II, which had raged for over two years.

Whatever Bush's reasons, the fact is that he was following a pattern that began with the first undeclared war in American history: the Korean "conflict." When troops from Communist North Korea attacked American ally South Korea in 1950, President Truman established the precedent of not seeking a formal declaration of war by Congress. His reasoning was that he wanted the war against the Communists to be declared by the recently established United Nations rather than just the U.S. (Sounds something like the recent hand-off of command of the Libyan war from the U.S. to NATO, doesn't it?)

Since then, many smaller – and not so small – wars have been waged by the U.S., all without the formal Congressional declaration required by the Constitution, Libya being the most recent example. And, in fact, the number of wars initiated, as well as the number of wars being fought simultaneously, has been steadily increasing these past few years.

Friedman argues that, because of these increasing wars, it's time to take a critical look at the Constitution's provisions for fighting wars (emphasis added):

Why Americans Keep Fighting Each Other Instead of Our Real Enemies

We keep hearing how political discourse has degenerated in this country. Compared to the debates between Hamilton and Jefferson, Webster and Clay, or Lincoln and Douglas, what passes for debate today almost never gets beyond trite sound bites created by political "consultants" using slick marketing slogans designed to sway the emotions of the greatest number of people in the least amount of time – with little if any substance. But shouldn't we expect something as grave as war to be treated in a more serious manner?

Instead, we find that, almost from the first moment of any deadly engagement, a large, vocal opposition immediately attacks the party proposing and carrying out the war. Granted, most participants these days make an effort to "support the troops." (Contrast this with the disgraceful behavior many Americans displayed toward the soldiers and veterans of the ill-fated Vietnam War.) But in the end, more time and energy seems to be spent on attacks on other Americans, rather than attacks on the enemy. Is that any way to fight a war?

Let's consider George Friedman's comments regarding the importance of a return to the Constitution's process of formally declaring a war (emphasis added):

While Friedman's article points out the exceptions that have helped push aside the constitutional process of formal declaration of war by Congress, it seems clear that exceptions, while they exist, should not therefore become the rule. The founding fathers created a specific and restrictive process that served the country from the time of its founding up to and including World War II and their reasons for doing so still make sense.

But even if we all agreed to a more measured approach that respects the separation of powers originally authorized in the Constitution, we would still face a problem that a formal declaration of war won't solve. And it's here that we find the connection between war and money.

When We Stopped Paying for Our Wars – and What That Does To Our Money

As we've already seen, what began as an exception under Truman in committing our troops in Korea has progressed steadily under subsequent presidents – both Democrat and Republican. But if Truman first stepped around the Constitution, it was President Johnson who would simply turn his back on the Constitution to fight the Communists in Vietnam. Friedman explains (emphasis added):

But in addition to the Constitutional issue, Johnson's single-minded determination to escalate America's military involvement would shake the foundations of the world's monetary system – the same monetary system that had enthroned the U.S. dollar as the so-called "reserve currency." He set the country on a course that would ultimately end in the first, and almost fatal, U.S. dollar crisis.

How did Johnson manage to virtually emasculate what was once the almighty dollar? To find the answer, we'll focus on Friedman's comment that one of the benefits of a formal declaration of war by Congress was that such declaration "affirms to the people that their lives have now changed and that they will be bearing burdens."

Waging war makes a claim on both the blood and the treasure of a country. Soldiers place themselves in harms way, resulting for some in the ultimate sacrifice. Meanwhile, their fellow citizens are expected to make the economic sacrifices required to support them.

In past wars, the U.S. government raised taxes and/or issued "war bonds" to its citizens to raise money for its wars. During World War II, much of private industry was commandeered to produce war materials, and the people labored under a rationing system along with wage and price controls that limited their access to food, clothing, even shelter.

This is the classic choice made between "guns and butter" that a nation faces in war. But Johnson would have none of that. In fact, Johnson had decided that he would continue building his "Great Society" – basically a massive collection of welfare programs originally designed to help those in need, along with programs for the less needy known as "entitlement" programs, the biggest example being Medicare. With robust tax revenues flowing into the Treasury, generated by the "go-go" economy of the 1960's, Johnson decided he would be able to fund his social programs as well as meet the growing demands of the military as the war in Vietnam expanded.

The government would not call on its civilian population to sacrifice. No longer would government feel it necessary to choose between guns and butter.

Over time, government outlays increased to meet the growing demands. And while the war would eventually wind down after years of anti-war demonstrations, the commitment of the government to the Great Society social programs would not. So the federal budget grew with outlays eventually surpassing revenues – thereby creating larger and larger deficits.

Since the effects of Johnson's policies were hardly felt by the economy during his term in office, it was left to his successor, Richard Nixon, to deal with the consequences during the late 1960's and early 1970's. The federal budget deficit continued to grow under Nixon as the obligations of the government to meet the expenses of expanding social programs grew. The government borrowed money to meet its obligations. It borrowed money by issuing more and more treasuries, the way it always borrows money.

Countries around the world watched as the U.S. government ran its affairs by borrowing more and more money. With outlays regularly exceeding revenue, the government had the choice of becoming fiscally responsible and reducing its outlays. But it didn't.

While a detailed discussion of the events leading up to the first dollar crisis is beyond the scope of this letter, the point is that a crisis did occur. And as the crisis unfolded, our trading partners increasingly shunned the dollar, seeing the U.S. dollar as the currency of a government whose fiscal discipline had collapsed.

The value of the dollar fell. Worse, with the dollar crisis came the highest sustained inflation in American history, as the dollar increasingly lost purchasing power throughout the decade – the inevitable result of the Johnson administration's decision to pursue both guns and butter.

Not only would the declining purchasing power of our money grow increasingly worse as the decade wore on, but the economy would be stuck in the mire of a new economic sludge that came to be known as "stagflation": weak economic growth combined with high inflation.

While this first dollar crisis would ultimately be resolved – albeit it temporarily – the patterns developed then haven't changed.

Next time we'll get to how that 1970's dollar crisis was eventually resolved, and not just to satisfy curiosity. We need to understand what happened during the 1970's dollar crisis because we have already entered the next dollar crisis. You'll see why we think so next month. For now, let's take a quick look at how things stand today.

We find our government pursuing an even higher-octane version of those guns and butter policies, with multiple wars fought around the world, and federal deficits that make the deficits that precipitated the last dollar crisis look like chump change.

Over time, ignoring the Constitution's explicit process for declaring war has led to an increasing capacity by government to consider and pursue any number of military actions at any time, any place in the world. Meanwhile, these military actions cost a lot of money. The wars in Afghanistan and Iraq alone now approach a cost of $1 trillion. But following the pattern begun during the Johnson administration, the government finances its wars without calling on sacrifice from the American people. Printing money is so much easier.

And just as it took some years until the consequences of the 1960's guns and butter policies would manifest themselves in the 1970's, we may soon see the sort of inflation that plagued the country after the Vietnam War ended. Some feel the inevitable inflation has already begun, in spite of our being told that consumer price inflation is low. While many of us doubt the veracity of those CPI numbers, it's not unrealistic to wonder whether the price increases we've seen will prove to be but the tip of the inflation iceberg. We'd go so far as to say that the possibility – if not the likelihood – of runaway inflation must be taken seriously.

We started out this letter by saying that things out there in the "real" world aren't that bad. And they're not. If inflation is really here and getting worse, so be it. The idea is to face facts, to seek the truth, whether it feels good or not. You want to feel good, go out and catch that joyful song of spring we talked about when we started this month's letter. There's something real that feels good.

Well, it's time to go. And, what do you know, the sky is blue, the crocuses are poking out of the ground and our neighbor's magnolia tree looks just about ready to put on its spectacular annual show. Those gorgeous magnolias only last for a few days, so we'll have to hurry and catch it while it lasts. See you next month...

P.S. – If you think the wars we see are building up more and more, imagine the wars we don't see. I'm talking about the scary new world of "Cyberwar." It's here and it's spreading around the world. Worse, the first "cyber-shot" has been fired, and it appears there's no turning back. Check out this recent post for details.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com