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Geopolitics Part 1 -
US Domination and the New Cold Skirmish
by Alpha and Vega, an Investor and a Trader
July 11th, 2010

In this issue:
1) What is Geopolitics?
2) Expect the Absurd
3) Key Trends
4) US Domination
5) The Cold Skirmish

Dear Friends, Colleagues, and Investors,

Politicians come and go, economies boom and bust, but geopolitics helps us
see the forest for the trees. In this newsletter I'll provide an introduction to
geopolitics and explore the key trends that defined the 20th century and will
define the 21st. I'll argue that the US' global military and economic dominance
will continue to grow over the next 30 years. Next, I'll examine the current "Cold
Skirmish" with Russia, similar to the Cold War but more limited in scope. In Part
2, I'll explore the (potential) political disintegration of China, the rise of Turkey
and Poland, and how demographic trends will lead to a reversal of immigration
politics and kill off "traditional family values" for good.
Much of this newsletter is inspired by George Friedman's, "The Next 100
Years." Friedman is the CEO of Stratfor and he provides keen strategic insight.

1. What is Geopolitics?
Geopolitics is the study of...
the effects of economic geography on the powers of states.
how countries make choices.
patterns of behavior, and understanding why patterns repeat.
the world as a giant chessboard. Like pieces in a chess game, countries can't move at
will, rather, they have a small range of reasonable choices.

Geopolitics is a way of describing the world that emphasizes military and economic
power and sovereign states as rational actors. Both military and economic power are directly
influenced by geography (e.g. defensible borders and access to shipping lanes), demography
(e.g. availability of labor), and culture (e.g. xenophobia and tolerance of war casualties).
Many people were surprised that Obama has followed a nearly identical foreign policy to
his predecessor, President Bush. A student of geopolitics understands that political leaders
have little real power when it comes to foreign policy; they are constrained by the interests of
their country, which dramatically reduces their available options.

I probably need to defend one claim in greater detail. Does military power really matter
that much today? The US Navy is larger than the next six navies combined; are we wasting
our money? The short answer is no. As Americans, we've been relatively immune from war
on our soil for two centuries. We occupy land that is hard to attack and impossible to
successfully occupy. More recently, our dominant military has extended an umbrella of peace
over most of Europe (via NATO), to Taiwan, Japan, South Korea, and many other allies.
Nations that were weak militarily and not under our umbrella of protection have not faired so
well. In 2008, Russia attacked Georgia. Ask a Tibetan or Chechnyan if military power
matters. Humanity is no more "enlightened" today than on the eve of the First and Second
World Wars. Nations reasonably believe that without sufficient military power, their national
security is at risk.
Military power is about the projection of force. During the Cold War, Russia had a
powerful army but lacked the ability to transport it; as a result, the US was unable to conquer
Russia but could easily contain it by controlling major ports. The US Navy currently controls
every major ocean and sea around the world. Every shipping vessel that leaves a port
anywhere in the world does so with US knowledge and tacit permission. Our dominance of
the oceans gives us dominance of the air via aircraft carriers. This means that the US, and
only the US, is capable of waging a major war across continents.
National defense is quite a bit easier than the projection of force. An airplane can easily
cross mountain ranges, but tanks and troops cannot. Natural boundaries like mountain
ranges, seas, and jungles remain near-impassable obstacles for armies. Many wars are
fought to gain control of natural boundaries so that a country can be safer from invasion (e.g.
Russia in the Caucasus)

2. Expect the Absurd


In 1900, the Russian Empire, German Empire, and Ottoman Empire, were powerful
players on the world stage. Many European elites believed that war in Europe was
impossible because of the interdependent economies. Just 20 years later, Europe faced a
devastating world war and the three great empires lay in ruins.
In World War II, Germany and Japan were decimated and their economies obliterated.
Just 35 years later they were the 2nd and 3rd largest economies in the world.
Think of 1980. The mighty US had been defeated by communist North Vietnam. The
Soviet Union threatened world domination. By 2000, the Soviet Union had collapsed
completely and NATO had even expanded into Eastern Europe. "Communist" China was one
of the
These examples should demonstrate that the big problems of the day are frequently
irrelevant in 20 years. Empires can rise and fall with staggering speed. Most importantly, the
consensus can be very wrong.

3. Key Trends
If the big issues of the day often ending up being irrelevant, to what should we pay
attention? We need to identify the handful of new trends that will provoke global change.
Once we have identified the trends, we can estimate their effects by applying a geopolitical
lens to understand how nations will react to changing circumstances. Before I start, let me
again give credit to George Friedman who provided many of these ideas.

In the 20th century, the three key themes were:


1. The quadrupling of the world's population. Agricultural technology and transportation
infrastructure increased food production and allowed food to be shipped great distances.
Better medicine for young and old decreased infant mortality and increased life expectancy.
The primary effect of the population boom was to cause tremendous global economic growth
with cheap labor and a constantly growing number of consumers. As populations exploded,
access to land and resources became more important.
2. The collapse of the European Imperial System. The birth of a modern Germany and
Italy in the 19th century set the stage for power struggles in the 20th. As the UK, Spain, and
France lost their empires and weakened, Germany and Italy sought greater power in Europe.
The result was two world wars.
3. Technology. There was a transportation revolution in the first half of the 20th century, and
a communications revolution in the second half. Technological advances allowed labor
productivity to rise at tremendous rates. One effect of these technological revolutions were
that Japan, with no natural resources and little land for population growth, became the second
largest economy in the world.

Analyzing the past is relatively easy compared to predicting the future. So what are the
Key Trends that will define the 21st century?
1. Complete US domination. I'll discuss this at length in the next section.
2. The End of the Population Boom. The global population quadrupled in the 20th century
and will likely be unchanged in the 21st. More dramatically, the populations of Europe,
Russia, and Japan are collapsing. A shrinking population produces huge problems. The
most obvious is the issue of growing entitlements supported by fewer tax paying workers.
However, another major dynamic is that aging retirees will continue consuming, but there will
be far fewer laborers to produce. This generally results in labor inflation. The US will face a
similar, but much milder demographic crunch. I'll explore the political and economic effects of
this in my next newsletter.

4. US Domination
US geopolitical power is unprecedented in world history. As I discussed in the first
section, the US has complete control over the oceans, which means it dominates the globe
both militarily and economically. The global economic system is the US economic system.
Only a handful of countries choose not to participate and things don't go well for them - take
a look at North Korea.

Second, the US outperformed other developed nations for reasons that will continue to
lead to its future outperformance. For the last 500 years, the Atlantic Ocean was the avenue
of world trade. Trade between Europe and the rest of the western hemisphere defined most
of global trade. Around 1980, transpacific trade surpassed transatlantic trade. North
America is ideally situated to profit from both transatlantic and transpacific trade. The
fastest growing nations are in Asia today so Pacific trade is likely to continue growing faster
than Atlantic trade. This means that US growth will likely continue to outperform European
growth. Another advantage we have is demographic. The USA remains underpopulated and
with easy access to new immigrants from Mexico. In contrast, Japan is facing demographic
collapse with no good solution.

Third, our sovereign debt levels are relatively low, compared to other large economies.
The US is in better shape than most of the EU and Japan. As money flees those regions,
it has to go somewhere. UK, Eurozone, and Japanese debt holders are likely to continue
shifting their money into US bonds. In other words, even though our debt levels are high and
rising, they are relatively attractive compared to most of the other biggest debt issuers around
the world. We may look back on this global crisis as the final transition from a European
centered world, to a North American centered world.

Fourth, the upstarts are not doing as well as people think. China's growth in the last
decade is reminiscent of Japan's in the 1980s. They've been growing by keeping savings
artificially high, interest rates artificially low, and using that cheap money to make artificially
cheap loans to companies. Municipalities and banks are accumulating bad loans. It's
impossible to come up with accurate estimates, but some smart analysts are guessing that
35% of Chinese GDP is bad debt that will be written off. I think China is likely to do quite well
over the next 30 years, but their growth will slow considerably, and they fill face major
setbacks like everyone else. In the shorter term, their credit bubble will burst and cause a
recession. India's problems are of a different nature. India is one of the most unequal
economies in the world, and that tends to produce serious political problems. They are facing
double digit inflation. Their worst problem is a political culture of red tape. Starting a
company in India is incredibly difficult. Lawsuits, both criminal and civil, routinely take a
decade to make their way through the court system. A significant portion of Brazil's growth
has come directly from exporting commodities to China. As Chinese demand for
infrastructure building wanes, so will Brazil's growth rate.

The economic fate of countries will depend on their relationship with the US. If the
US "blesses" a country with technology transfers and special terms of trade (e.g. Israel and
Turkey), that country is likely to grow faster than its peers. Similarly, if the US decides to
sanction a country (e.g. Iran), it will underperform.
Our position as sole global superpower means that other countries will continue to
subsidize our interest rates by buying US bonds and holding US dollars. It also means that
the US is likely to remain a breeding ground for international competitive companies.

5. The Cold Skirmish


It's easy to dismiss Russia as irrelevant today, but that would be a huge mistake. Russia
has far more power than appears at first glance and they are using that power aggressively.

As the major natural gas exporter to Western Europe, Russia has the power of the pump
and are using it to serve their geopolitical aims. In 2007, Russia turned off the Druhzba
pipeline over a dispute with Belarus; that pipeline is a major supplier of crude oil to Germany.
In 2009, Russia shut off a natural gas pipeline that supplied much of Western Europe in a
dispute with Ukraine. By flexing its muscle, Russia demonstrated to Western Europe that
they have the power that comes with being a primary source of natural resources, and they
are willing to use that power aggressively to pursue geopolitical goals. Russia's control over
European energy is a major reason why Europe just sat on the sidelines as Russia invaded
Georgia in 2008.

Geographically, Russia is in terrible shape. The Soviet Union had excellent defensible
borders. They had the Caucasus Mountains to the south, the Carpathian Mountains to the
west, and large tracts of inhospitable land to the east. Now Russia is exposed on its southern
and western flank. They're scared and they want to gain defensible borders as soon as
possible.

In 2005, Ukraine was on track to join NATO. NATO arose to contain (and potentially go to
war with) Russia. The Russians could not allow Ukraine, which shares a border with Russia,
to join NATO. They used their intelligent services to politically infiltrate Ukraine and by 2006,
NATO membership was off the table. By infiltrating Ukraine and maintaining control over
Belarus, Russia mitigates its problem in the Carpathian Mountains to the west. To deal with
the Caucasus exposure, Russia attacked Georgia and occupied Chechnya despite great cost.

Unlike in the Cold War, Russia is not competing with the US for global domination. Russia
just wants defensible borders, which requires domination of central Eurasia. The flash point
is likely to be the Baltics.
Latvia, Lithuania, and Estonia are too close for comfort, and they're NATO. If Russia
threatens these countries (either with covert ops, a troop buildup, or barricading their
imports/exports), will NATO react? Germany does not want to get involved in any kind of
confrontation with Russia and they will feel safe with Poland as a buffer. If Germany blocks
NATO action, NATO could dissolve. Alternatively, the US could find a political solution that
allows it to pour money and defenses into the Baltic countries without explicitly calling on and
perhaps fatally testing NATO support.

Geopolitics is just one lens, but it is a highly useful tool in trying to predict
the future actions of countries. In the next installment, I'll apply the geopolitical
lens to China, Turkey, Poland, and the Islamic world.

Your "Born in the USA" trader,


Vega

Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk
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