'Finance has its own Peter Principle, by which a successful model will be adapted to progressively riskier cases until it fails.' - Roger Lowenstein, Origins of the Crash.
Picture it: You are a top-level security adviser to the president of the United States. The issue at hand is whether or not to attack Iran, by military means or otherwise, in a last-ditch effort to prevent Tehran from obtaining nuclear weapons if United Nations channels fail (which they almost certainly will). Your fellow advisers are divided, leaving you to break the tie.
If you decide to attack, brute force is not the only choice - there is also an indirect option. The first action you can take is attempting to cripple Tehran by cutting off its supply of refined petroleum products, i.e. gasoline. (Ironically, while Iran is a major crude oil exporter, it does not have the necessary refinery capacity to meet internal demand for finished product.) If you choose to cut off Iran's access to gasoline, this would in essence be a game of economic chicken: Either you cripple the regime and take away the mullah's popular support by forcing economic implosion or they hang on and cripple you first by cutting off crude oil exports - a matter of who cries uncle first.
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You are aware that if you attack Iran, the consequences could be dire no matter what happens. Along with the long-anticipated 'super spike' that takes oil into triple digits, there would be the ramifications of an economic unravelling in Asia to contend with. China's totalitarian leaders are dependent on rapid economic growth to maintain civil stability, and the central bankers of the region collectively hold $1 trillion-plus in dollar denominated assets.
In short, if China implodes, it would not be a stretch to see the United States sucked into the vortex as the chain reaction leads to massive financial backlash.
There is too much riding on the vendor-finance relationship, and the extreme amounts of leverage within the system (credit default swaps and excess dollar balances in central bank accounts etc) have rendered the system fragile and unstable.
China's leaders know all this, of course; if worst comes to worst, they can pull down the pillars of the temple. It would not be at all surprising for Beijing to have an unspoken understanding with Washington: 'If we go down, you go down - our survival are your burden too.'
Another option, of course, is conventional warfare - hitting Iran hard with military force. Such a course of action raises the stakes even higher. But the nuclear workshops cannot be taken out through air strikes alone; the mullahs have had too much time to 'harden' their targets (make them tougher to destroy), and the facilities are anyway too dispersed and too well hidden to uncover without boots on the ground.
Stretched as thin as the United States already is, and considering the moth-eaten financial state of the Western powers in general, physical invasion hardly seems an option at all. Nor does this take into account the potential backlash of the Islamic world any military efforts would bring about. We have seen a frightening preview of Muslim anger in the fury of the Danish cartoon row; giving the West such a preview, in fact, may be the political raison d'etre for the orchestrated outbursts in the first place.
The name of the game Tehran plays, then, is 'How Crazy Are We - and Do You Really Want to Find Out?'
Strategists seem to be of two minds on the subject: The first camp argues we should take Mahmoud Ahmadinejad at his frightening word and assume he really is driven by madman visions of ushering in a 12th Imam; the second camp argues that Iran is still a rational actor at heart, spewing out the fire-and-brimstone stuff for show. If the first camp's assessment is correct, invasion could be warranted no matter the short-term cost, because the stakes are just as high as they could possibly be. If the second camp's assessment is correct, coolheaded pressure and a firm backbone in the face of bluster - the equivalent of JFK staring down Khrushchev - could be the best course of action.
Then there is the option of doing nothing, putting off the risks for another day... and virtually ensuring the proliferation of nuclear weapons across the Middle East.
If Iran becomes a nuclear power, Saudi Arabia will follow, as will Egypt, Syria and so on. It has been pointed out that Iran has roughly 20 years worth of energy reserves left - in this, it is like an oil major spending down reserves (without the ability to replace them).
The mullahs cannot sit idly by - at some point down the road, fiscal implosion awaits. Thus, nuclear capability could come in quite handy when it comes time for Iran to appropriate assets from one of its weaker neighbours. How would the first Gulf War have turned out against a nuclear-armed Saddam? Not a pleasant thought.
The assumption that Israel could take care of the Tehran problem is similarly wishful thinking. Once again, air strikes would not do the trick alone, and Israel does not have the capability of initiating a full-scale ground invasion. A half-hearted strike would only incite greater desire for vengeance; even if Israel pulled off the impossible, dismantling all facilities and neutralizing the mullahcracy, there would still be the rest of the Middle East to deal with. It is about as close to a no-win situation as one can get.
One of the remarkable elements of this grave situation is how effectively the broad market has managed to ignore it, even though energy issues address the very core of modern life. The truly ugly what-if scenarios are no longer found at the tail end of an accidental chain of events; they are increasingly tied to a deliberate series of provocations, which increases the probability of their occurrence significantly. It could be said that the price of gold and oil reflects this reality - which is perhaps why the price of crude continues to bump along below $70 and why gold is in the high $500s...
But that does not explain the consistently low risk premiums and Pollyannaish attitudes elsewhere. In large part, we are still riding the global liquidity wave; the bluebird is on Mr Market's shoulder, with few, if any, worries in sight. In most cases, it is probably a good thing that Wall Street is so resilient - a tribute to the strength of capitalism that Mr Market can shrug off painful or uncomfortable events. Toil we shall, shop we must, life soldiers on and so forth. Resilience in the face of hardship, though, is a different animal than recklessness in the face of risk.
Consider another pleasant scenario: You are the incoming chairman of the Federal Reserve. Alan Greenspan has passed the baton (which is actually a stick of dynamite, as a US Economist cover recently depicted). You know that there are serious risks before you: As consumer spending grinds to a halt under the pressures of broad wage stagnation and ballooning housing payments, you may end up forced to stimulate (by cutting short-term
rates) to save America from its backbreaking load of accumulated debt.
On the other hand, with gold at multidecade highs and your inflation-fighting credentials still unproven, you will not be able to indulge your stimulus desires so easily. By a combination of choice and circumstance, you have relinquished the rhetorical power wielded so effectively by the previous chairman. With productivity figures headed in the wrong direction, you cannot justify policy as glibly as your predecessor once did.
And last but not least, you have a hawkish board looking forward to a democratic policy-setting environment, rather than the stifling autocracy that kept it muzzled for so long.
These two scenarios - the Iran and the Fed chairman questions - share an unpleasant characteristic: They both put the decision maker between the devil and the deep blue sea. There are no shortcuts or pat answers.
Unfortunately, Wall Street and Washington are geared to supply pat answers, and to behave as if such answers have merit. This is why we hear about frivolous theories like the existence of financial 'dark matter' to explain away our growing burden of non-productive debt. It is why the US BusinessWeek touts the virtues of the 'we think, they sweat' argument, blithely overlooking the fact that intellectual property gains apply to specific industries, not entire economies. It is why we pretend that the Bretton Woods II arrangement can go on forever, like a perpetual motion machine, and why we convince ourselves that it is our moral and God-given right to enjoy infinite credit lines.
All this comes back to market action by way of the Peter Principle. In his book Origins of the Crash, Roger Lowenstein sheds light on the concept:
'By the latter part of the '80s, every investment bank - not just Drexel Burnham - was underwriting LBOs [leveraged buyouts], often with management participating. Many of the early buyouts succeeded, and there is no doubt that some achieved efficiencies and that Corporate America had been in need of a belt- tightening. But the details became steadily, then recklessly, more leveraged. Finance has its own Peter Principle, by which a successful model will be adapted to progressively riskier cases until it fails.
Ultimately, borrowers such as Federated Department Stores (acquired by the blustery Robert Campeau) promised to pay far more in junk bond interest than they had in earnings. These later LBOs were - by simple arithmetic - doomed to fail.'
Different names, same game. Lowenstein was describing the build-up of market excesses that began in the '80s, but the same basic logic applies to the situation today.
Our entire economy, and arguably the market as a whole, has become a sort of massive LBO. The Peter Principle illustrates why a bad ending is virtually inevitable - we are determined to push our luck until it fails us. If our current debt load is not enough to do the job, we will accumulate more. If the most recent straw is not enough to break the camel's back, then, by golly, we'll get more straw.
Our markets will benefit from the stomach-churning volatility that is coming - in fact, they already have, and will continue to do so. Patience and perseverance will pay off in spades over the long haul. In the short to intermediate term, however, we will not be able to escape the downside entirely. Expect rough waters and plan accordingly.
By Justice Litle for The Daily Reckoning
Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. For more on Outstanding Investments, see below...
