Commodity prices have always been sensitive to geopolitics, but this has particularly been true over the last few weeks and months as the Western powers very nearly got involved in yet another costly military conflict in the Middle East. They may yet do so in the near future, sending the prices of oil and precious metals considerably higher. Today’s post examines the economic phenomenon of deflationary gap which is at the heart of the growing militarism of the western powers and their increasing propensity to resort to war as the key foreign policy tool.
Over the past few weeks we’ve witnessed a disconcerting spectacle of geopolitical maneuvering around the ongoing Syrian conflict. The escalation of military confrontation could have grave and unpredictable consequences. One of the more perplexing aspects of this crisis is the keen appetite for war displayed by the western leaders, particularly those of the US, UK and France. Regardless of the merits of their case, most of us who have grown up in the west were raised to believe in certain values where the political leaders are meant to respect the will of their constituents, where law – including the international law – is upheld whether this is convenient or not, and where war is always the solution of last resort, engaged only in the event of national defense or in response to a clear and present threat. Now, for some reason this has all been turned upside-down. Western leaders seem indifferent to their constituents’ will, international law is routinely and casually ignored, and war is used as the main tool of international policy. Suddenly, the democratic west is rushing headlong to intervene militarily around North Africa and the Middle East with barely any debate about these costly adventures.
The systemic causes of the growing militarism in the west
Following the day-to-day events, the rationale for war is always apparent to a casual observer. Colonel Gaddafi was a bad guy oppressing his own people, so we had to go and help the Libyans. Al Qaeda terrorists were about to take over in Mali and we had to go there and free the people. Now Bashar Al- Assad is killing his own people so we must go and help the Syrians. But while we can always come up with an immediate reason to wage war, what if there was a deeper, more systemic cause that inclines western nations toward armed conflict?
In meticulously tracing the events leading to last century’s two world wars, Carrol Quigley devotes much space in his book “Tragedy and Hope” to an economic phenomenon called the deflationary gap. Quigley considers the deflationary gap as “the key to twentieth century economic crisis and one of the three central cores of the whole tragedy of the twentieth century”.
To explain this phenomenon, and how it can give rise to militarism, we have to go back to economics for a moment. The subject of analysis is a closed economic system in which the sum total of goods and services appearing in the market equals the income of the system and the aggregate cost of producing the goods and services. The sums expended by the businesses on wages, rents, salaries, raw materials, interest, lawyers’ fees, and so on, represent income to those who receive them. The profits are entrepreneur’s income and his incentive to produce the wealth in question. The goods are offered for sale at a price which is equal to the sum of all costs and profits. On the whole, aggregate costs, aggregate incomes and aggregate prices are the same, since they represent the opposite sides of the same expenditures.
However, the purchasing power available in the system is reduced by the amount of savings. If there are any savings, the available purchasing power will be less than the aggregate asking prices by the amount of the savings, and all the goods and services produced cannot be sold as long as savings are held back. In order for all the goods to be sold, savings must reappear in the market as purchasing power. Normally, this is done through investment. But whenever investment is less than savings, purchasing power will fall short of the amount needed to buy the goods being offered. This shortfall of purchasing power in the system, the excess of savings over investment, is the deflationary gap.
Methods of bridging the deflationary gap
Deflationary gap can be closed either by lowering the supply of goods or by raising the supply of purchasing power, or by a combination of both methods.
The first solution will stabilize the economic system on a low level of economic activity. The second will stabilize it on a high level of economic activity. Left to itself, a modern economic system would adopt the former alternative, resulting in a deflationary spiral: the deflationary gap would lead to falling prices, declining economic activity, rising unemployment, and a fall of national income. In turn, this would cause a decline in the volume of savings, until savings reached the level of investment, at which point the economy becomes stabilized at a low level of activity.
This process was not allowed to unfold in any industrialized country during the great depression of 1929-1934 because the disparity in the distribution of income between the rich and the poor was so great that it would cause a considerable portion of the population to be driven to absolute poverty before the savings of the richer segment of the population could decline to the level of investment. Moreover, as the depression deepened, the level of investment declined even more rapidly than the level of savings. To avert social uprisings, governments of all industrial nations attempted to generate a recovery through two kinds of measures: (a) those which destroy goods and (b) those which produce goods which do not enter the market.
Averting depression through destruction of goods
The destruction of goods will close the deflationary gap by reducing the supply of unsold goods. While this is not generally recognized, this method is one of the chief ways in which the gap is closed in a normal business cycle. In such a cycle, goods are destroyed by the simple expedient of underutilizing the system’s production capacities. The failure to use the economic system at the 1929 level of output during the years 1930-1934 represented a loss of goods worth $100,000,000,000 in the United States, Britain, and Germany alone. This loss was equivalent to the destruction of such goods.
Destruction of goods by failure to gather the harvest because the selling price is too low is a common phenomenon under modern conditions, especially in respect to fruit and vegetable crops. While the outright destruction of goods already produced is not common, it has occurred in the depression years 1930-1934: stores of coffee, sugar, and bananas were destroyed, corn was plowed under, and young livestock was slaughtered to reduce the supply on the market. The destruction of goods in warfare is another example of this method of overcoming deflationary conditions in the economic system.
Producing goods that don’t enter the market The second method of bridging the deflationary gap, by producing goods which do not enter the market, supplies purchasing power in the market (the costs of production of such goods enter the market as purchasing power), while the goods themselves do not drain funds from the system, as they are not offered for sale. New investment would be the natural means to accomplish this, but modern economic systems in depression do not function this way. Rather, private investment tends to decline considerably. Alternatively, purchasing power must be supplied to the system through government spending. Unfortunately, any program of public spending quickly leads to the problem of public debt and inflation, which tends to compound the problems rather than solving them.
War: the irresistible solution
Approaches to public spending as a method of financing an economic recovery can vary depending on its objectives. Spending for destruction of goods or for restriction of output, as under the early New Deal agricultural program is hard to implement in a democratic country, because it obviously results in a decline in national income and living standards. Spending for nonproductive monuments or prestige projects like space programs is somewhat easier to justify but is not a long-term solution. The best approach, obviously is investing in productive capital goods, since it leads to an increase in national wealth and standards of living and constitutes a long-run solution.
Unfortunately, this approach runs into ideological head-winds in modern economies as it constitutes a permanent departure from the system of private capitalism. As such, it is easily attacked in a country with a capitalistic ideology and a private banking system. Instead, developed nations tend to favor the most dangerous method of bridging the deflationary gap: spending on armaments and national defense.
The appeal of this method is always rooted in political and ideological grounds. Military spending tends to help heavy industry directly and immediately. Heavy industry suffers earliest and most drastically in a depression, which absorbs manpower most readily (thus reducing unemployment). This tends to make it very influential in most countries. Defense-related spending is also easily justified to the public on grounds of national security. But increasing defense spending enhances the political clout of the military-industrial complex and tends to increase a nation’s reliance on the military in the conduct of its foreign policy and an escalation of conflict which leads to further increases in military spending. The vicious cycle ultimately results in the emergence of fascism: the adoption by the vested interests in a society of an authoritarian form of government in order to maintain their vested interests and prevent the reform of the society.
In the last century in Europe, the vested interests usually sought to prevent the reform of the economic system (a reform whose need was made evident by the long-drawn depression) by adopting an economic program whose chief element was the effort to fill the deflationary gap by rearmament.
Quigley’s analysis, based on the historical developments in the aftermath of the economic depression of the early 1930’s closely parallels today’s events. The economic crises which germinated from the same systemic feature present in the modern economic system followed a similar pattern in economic and political developments that we are witnessing today.
To avert a deflationary depression, US Government ramped up military spending
In the last 100 years, we have seen similar developments lead to two world wars, the second of which included the use of nuclear weapons. Today, as we seem to be sliding in the same direction, the question is whether we can extricate ourselves from this destructive path. If the day-to-day events are shaping the outcomes, then no one can tell. But if they are shaped by systemic attributes inherent to our socio-economic system, then we should expect further expansion and escalation of military conflicts around the world in the following years.
Escalation of military conflict and investor risks
Sadly, we have to consider this problem from investor point of view as well – and here, while the outcomes are unpredictable, the key risks to investors are rather clear, and they include:
- sharp rises in commodity prices
- high inflation
- sustained rise in interest rates
- deepening economic recession, and
- increasing asset price volatility