This is Part 3.
A country’s financial position is not so different from the financial positions for you and I.
Countries, like you and I, are dependent on income and earnings.
You and I derive income from some combination of labor and investments / capital (and luck).
Countries are the same. Countries are ultimately made up of people. The collective income and earnings power of a country is therefore a combination of the outputs of available labor and capital (and productivity) within its borders.
For you and I, we call our income paychecks.
For a country, we call it GDP.
However, since every country’s financial position is not only not so different from you and I, this also means that every country’s financial position faces the same problems that you and I face.
You and I may have incomes, but whether we are financially stable or not depends on our cost of existence.
If you make $100k and live in San Francisco…well, you probably are not having the time of your life. In fact, if you make $100k and live in San Francisco, you are almost guaranteed to have less lifetime wealth than someone making $50k and living in Mexico. It’s a painful truth, but I can almost guarantee that that statement will hold true even though the future is uncertain.
Countries are the same. There are nice and tidy tables that list very clearly the GDP of every country. And every politician in every country pays attention to them.
Except it’s crazy.
It’s crazy because you and I would never solely look at our own incomes to determine the health of our own financial situation without considering our cost of existence such as housing, food, transportation etc.
Similarly, it’s crazy for any country to focus solely on GDP without considering their cost of existence.
One of the most important conclusions of Peter Zeihan’s book, The Accidental Superpower, (which I highly suggest reading if these topics are of interest to you…I only wish I read it sooner to save me years of having to inefficiently research all of these areas as standalone topics) is that the US is head-and-shoulders above others in this regard stemming from its superior geography.
And it is primarily because of relative differences in cost of existence that the US was almost guaranteed to become the world’s dominant empire soon after founding.
However, while Zeihan argues that the US’ position is secure, by the end of this post, I will also argue that the US (and all empires of the physical world) are now facing an existential crisis because the new technological empires of the 21st Century are head-and-shoulders above all others in terms of cost of existence. The greatest threat to US hegemony is not China or Russia, but the digital empires of the 21st Century. And, ultimately, these digital empires of the 21st Century need to find ways to coexist with the empires of the physical world or risk existential conflict.
While we currently live in an industrial world, the world was largely agrarian until just about 150 years ago. Even at the turn of the 20th Century, more than 40% of the US labor force worked on farms. Despite what image you may have about how industrialized the world was leading up to World War I and World War II, the US still had 40% of the labor force on farms despite the fact that the US was already one of the world’s leading industrial powers at the time.
Intuitively, you probably understand that command and mastery over food and the food supply chain probably ranks pretty high in terms of importance and cost of existence.
It turns out that the US is truly one of the best positioned in this regard.
The US has the most arable land in the entire world.
This is and was a very important advantage. The more arable land you have, the less dependent you are on food from somewhere else (and the generosity of others). The more arable land and domestic food production possible, the less you need to spend on transportation (and other people’s labor) in order to provide for your own existence. Ultimately, it means food ends up being cheaper compared to others.
But the US doesn’t just have more arable land than any other nation on earth, it also has some of the most productive lands in the world.
150 years ago, the world’s economies were all essentially agrarian, and the US happens to have the most productive and best farmlands in the world. Of course, this would mean that the US was destined to become a world economic power. Of course, it would mean the US would quickly ascend the global GDP tables when your ability to produce the leading products of the day is head-and-shoulders better and easier than others.
But more importantly, the US’ advantage in agriculture effectively also lowers the cost of existence for the industrial economy that would come after it. Not only is the cost of food cheaper because of this advantaged position, it also quickly freed up labor for industrialization. Most people tend to think of the era of industrialization as an era of labor versus machinery / capital, but industrialization was really an era that required labor and machinery. People marvel at China’s rapid labor-driven ascent over the last 3 decades…the US underwent the exact same process 100-150 years ago. The European powers including Britain, France, and Germany went through this industrialization process even earlier, but none of the powers before or after had / have as large of an agrarian advantage that the US had / has.
And it is precisely because of this agrarian advantage that the US was quickly able to close the industrialization gap with the leading powers of the day, despite starting later.
The US also had a significant advantage in labor in a way that no other country has, even today. Although the US has had rocky periods of immigration policies, the US has consistency attracted immigrants in a way that no other country has. This is a very, very important advantage in terms of cost of existence because it lowers the ultimate cost of the labor force. Most people think the cost of any labor force is what you can see, such as wages. This is wrong. The greatest cost of any labor force is the 15-25 years of time and capital investment that is necessary to turn any organic labor force addition (e.g. babies) into a workable unit of labor. The US’ superior advantage is that by consistently attracting people that are already somewhat mature (e.g. 5 year old+), the US has consistently maintained materially lower cost of existence for the labor force. The most expensive part of the labor force is not paying $15 / hour to someone that hopefully produces $15+ hourly value (the benefit is still net positive)…the most expensive part of the labor force is spending $25k+ on a baby per year that will not produce any output until far into the future. Not only does the US consistently have an advantage in growing the labor force in a way that is almost entirely disconnected from biology (a problem that every country faces), but the US has a cheat code around the whole thing.
In addition to labor, one of the most important inputs and cost of existence for any industrial economy is the magic substance known as oil. Industrialization is basically impossible without it. It turns out that most countries in the world that have an advantage in either agriculture or industrialization have a very hard time finding enough of this stuff within their borders. The places where this substance is found tends to be very far away and hard to get to. For example, China and India need to import a lot of oil. While they may have a significant advantage in terms of labor, the cost of existence of their industrial economies are higher than otherwise because the other inputs like oil are not easily accessible. Similarly, most of Europe has a hard time sourcing this as well, forcing most of continental Europe to be dependent on Russia even though they would vastly prefer otherwise.
However, through sheer luck, it turns out that the US is one of the few countries in the world that has an abundance of oil within its borders. You may think of Saudi Arabia or the Middle East when you think of oil, but the US is actually currently the world’s largest oil producer by a decent margin. And you may not know this, but the US has always dominated global oil markets and production.
In fact, back in the 1880s, the US controlled an astounding 85% of the world’s crude oil production and refining. That was the era of Rockefeller. And the abundance of cheap oil along with the advantages mentioned above almost guaranteed that the US would not only catch up with other industrialized nations but would far, far exceed them. Saudi Arabia may seem threatening today because it controls ~10% of global production, but the US has always been the elephant in the room. And today, even the Saudis are failing to cope with the resurgence of cheap oil in the US with the explosive growth of fracking.
When I was younger and more naive, I similarly believed that the US invaded Iraq for oil. Maybe there is a grain of truth there, but logic and hindsight suggests otherwise. The US has an abundance of oil (the US actually exports oil at the moment). The US has been involved in the Middle East for a long time, and history suggests it is more about ideology and energy security for our partners rather than ourselves. Such as our partners in Europe. And even including our partners like China. Everyone but the US effectively relies on Middle East oil. And part of the unspoken contract of the post-World War II global order required painful US involvement for the benefit of others.
There are many other advantageous elements, but it ultimately comes down to the vector of “energy”. As I’ve written before, the two most important long-term vectors driving almost everything in the world is “energy” and “computation”. The US has a unique advantage in “energy” such as lower food costs and lower oil costs. And these advantages ensured its ability to excel in the industrial era.
Returning to our personal examples, you and I not only have to consider income and costs in our daily lives. One of the most important considerations (whether you actively consciously think about it or not) is our own personal security. When our incomes exceed our cost of existence, we have a stable / positive financial situation. But that means nothing if we do not have personal security. Without personal security, what we have may be taken away at any time.
Similarly, countries are no different. As discussed in Empire(s) of the 21st Century, one of the most popular ways for countries to grow faster than they can muster organically has been to take the means of growth from other countries.
As a result, part of any country’s cost of existence is the cost of security and defense. This is a true cost. While it creates GDP because it creates demand for labor and goods, this is ultimately an expenditure that does not produce compounding effects (unless used offensively). Every dollar spent on the military is only a dollar spent on the military. It is not an investment like an investment into machinery or an investment into education, where every dollar spent can lead to even more GDP output in the future.
Despite the relatively capital-inefficient outcome of spending on the military, military spending is the ULTIMATE spending need of all successful civilizations. All civilizations in history that have any relevance at all, only survived to become relevant because they prioritized military spending. Military spending is THE necessary cost of existence. And the spending towards military / defense often comes before spending on other important things like R&D and education. Unfortunately, when your life and freedom is at stake, everything else is pretty discretionary…
The cost of military / defense cannot be understated. Yet, wondrously, the US also somehow managed to inherit two of the greatest defense assets the world has ever known – the Pacific and the Atlantic Oceans.
Source: Transpacific Project
And the best thing of all, the defense power and mechanisms of the Pacific and Atlantic Oceans are entirely FREE to the US.
Through sheer happenstance, the US had the benefit of the greatest national security positioning of any country in the world without having to spend a dime on it. The cost of existence is materially lower than any and all empires that came before it.
To illustrate, here’s a chart of military expenditure as a % of GDP of leading world powers up until World War I. The US was already a “world power” at that time, but literally had to spend nothing defending itself. All of that money could be devoted to real investment areas such as capital equipment and education.
Assuming the data is accurate, China also had a low military spending rate, but of course China did not and does not have the benefits of the Pacific and Atlantic Oceans. History would suggest that China’s low military spending leading up to World War I was a monumental mistake, especially in the face of significant spending by an aggressive Japan.
None of that may be news to you. You may have already been aware that the US largely kept itself out of global affairs until World War II (with a brief stint in World War I)…all enabled by the massive defense barriers of the Pacific and Atlantic Oceans.
But what may be news to you is that even after World War II, in which the US engaged in a number of questionable wars (Korea, Vietnam, Iraq, etc), while maintaining sizable military and naval forces all around the world, the US’ expenditure on military / defense is actually still frighteningly low.
Compare the US expenditure vs the Communist bloc (Russia and China) during the height of the Cold War. Of course, they would not win the long game. They needed to spend so much simply to protect themselves. Neither of them had or have the benefit of the FREE defense mechanisms of the Pacific and Atlantic Oceans. And the money that was required to go into defense obviously did not go into important things like scientific R&D and education.
The US naturally does not need to spend on military / defense. And even when it does in order to create Pax Americana abroad, its expenditures are still shockingly low compared to the Old Empires during their imperial days.
When the US looks beyond its borders to the rest of the world, it mostly sees blue skies and open seas. The rest of the world does not have this luxury.
When China looks beyond its borders, all it can see is that it is boxed in. Boxed in by Korea, Japan, Taiwan, and Southeast Asia. And all of this is ring fenced by the US Pacific fleet.
Similarly, when Russia looks beyond its borders, all it can see is that it is boxed in. Boxed in by Korea, China, India, former Soviet buffer zones, and Europe. And Russia likely cannot help but feel pushed up against the (Arctic) wall behind it.
Source: Geopolitical Futures
In fact, other than in the Americas, the European and Asian continents are arranged in such a way where no one can feel safe. The geographies of those continents essentially condemn their nations to forever spend on defense, yet never feel safe.
So if you put this all together, the US was almost guaranteed to outstrip the Old Empires. Not only did the US have the conditions to create the largest income stream the world had ever seen through advantages in labor, capital, and productivity, it has materially lower cost of existence.
The US does not have to spend as much on military as others. The US does not have to spend as much on transportation as others. The US also does not have to spend as much on food security as others. Every single cost advantage allowed the US to push further and faster along the dimensions that matter including education and R&D / technology. In contrast, even “successful” nations like Germany, and, especially China have had to spend significant sums on large scale infrastructure projects just to make the environment workable (and level the playing field with the US). All of these investments are important and have allowed Germany and China to accelerate their own development, but the returns on those investments will always pale in comparison to never having to make those investments to begin with.
This all sounds great, but unfortunately the world is changing.
And to understand why, we have to understand how the empires of old were forged.
Throughout most of history, humans largely fought with their neighbors on foot. Most of the world’s early empires were therefore land empires. However, ultimately land-based battles are a game of numbers. The side with the most soldiers likely win. Geography also plays an important role. Countries that commanded superior terrain (e.g. hills) could more easily defeat armies in valleys.
Technology played a relatively small role for most of early history because technological advances were far and few. Most land empires could not consolidate much before hitting the limits of what was governable and controllable through land-based armies.
There was only one major exception during the land-based era.
One of the greatest empires to ever get stitched together was the Mongol Empire during the 13th Century.
The Mongols certainly did not have a numbers advantage that would allow them to conquer most of the known world of the 13th Century.
But what the Mongols had was new technology – the stirrup. The stirrup, ultimately, allowed the Mongols to fully take advantage of horses not only for movement, but to become devastatingly powerful combatants. Armed with the stirrup, the Mongols effectively changed the rules of the land-based game and transformed into a highly mobile land-based force that engaged in a type of speed warfare that would not echo again until World War II.
But that was the exception.
What’s interesting is that after the Mongols, every single empire since has been naval based.
First, the Spanish and the Spanish Armada.
Source: Royal Museums Greenwich
Then, the British and the British Royal Navy. The British Royal Navy also perfected the addition of cannons to ships.
Source: Historic UK
Then, Japan and the Japanese navy. A few centuries after the British started adding cannons to ships, the Japanese perfected the battleship. Japan’s Yamato battleship during World War II had the longest strike range of any battleship in history with the ability to attack a target of up to 25 miles away. To understand how obscenely powerful that is, consider this fact – If you stand anywhere on Earth at sea level, the horizon line is roughly about 3 miles away (and maybe up to 20 miles away if you are high up on a ship). The Yamato therefore had a strike range beyond the horizon line. The Yamato had the ability to strike targets that didn’t even know they were being targeted.
Source: Warfare History Network
And, then, of course, the US Navy. While I refer to the US Navy as a navy, it really is a hybrid navy + air force. What the US brought to the table was the aircraft carrier, which ultimately proved that air power was superior to standalone naval power, and the combination of naval and air power would allow the US Navy to project power around the world in a way never possible before at a lower cost compared to the empires of old.
What is important to understand is why mastery and command of naval power is and was so important for establishing imperial dominance over the last 500 years. If we go back in time, there were two major arteries connecting trade in the Old World – The land-based Silk Road and the sea-based route connecting China / India to Europe.
The land-based route is inefficient and slow. But more importantly, not only was it inefficient and slow, it created uncomfortable interdependencies. China may want to sell to Europe, but China could never directly oversee the shipments of their goods via the Silk Road. The ultimate success of any trade therefore was highly dependent on middlemen and countries that may or may not have aligned interests.
The naval route eventually superseded the land routes in importance because the ocean is open. Not only is it easier to move goods over water, any sufficiently powerful navy could directly oversee the shipment of goods for a greater part of the journey than possible through a land-based route. Very few nations had / have the ability to invest in a navy, and hence, sea routes were also less susceptible to interference (other than from the occasional pirate).
In fact, sea routes have become so important to trade that all global trade is effectively sea trade, even today. According to the International Chamber of Shipping, 90% of the world’s trade involves sea freight today.
Over the last 500 years, any empire that controlled the sea, therefore, also held the rest of the world within its palm. Almost all trade globally required the blessing of the naval power of the day. Not only did this give the dominant naval power significant influence over trade, it often led to significant influence over the strength and health of domestic economies as well. For example, on a number of occasions, the naval imperial powers of old effectively utilized their navies to establish naval blockades around hostile nations, depriving them of necessary resources and potentially inflicting starvation.
And this is a position that the US holds today. And the US Navy is the primary power responsible for keeping global shipping lanes free and open and free-of-charge for all allies and partners that cooperate under Pax Americana.
Contrary to popular opinion, from a purely trade perspective, the US Navy really is doing this mostly for partners rather than for the benefit of the US. Whatever assumptions you may have about American consumption, Americans aren’t really reliant on trade at all.
For example, US imports as a % of GDP is actually materially lower than peers like Germany, UK, China, and India. The vast, vast majority of what the US consumes is produced domestically.
Okay, well maybe the US is doing this to protect export trade?
That’s an even weaker argument. US exports as a % of GDP is even less relevant.
In fact, of all of the empires that have ever controlled the pole position, the US is probably the least dependent on global trade and least integrated with global trade flows. American efforts to protect the free flow of goods have primarily benefited our partners, especially China, Germany, and the UK, all of which are highly dependent on exports.
A careful study of the world almost seems to suggest that the US is almost in an unassailable position over the long-term. Any long-term decline almost has to be a result of internal mismanagement (which we unfortunately already have plenty of including…rising population of unproductive adults due to drug addiction and poor land-planning / zoning policies that have increased the cost of existence from a real estate perspective).
But the world has changed in ways that people are only barely beginning to comprehend.
One of the most important changes is the establishment of a global internet. Although you may think of the internet as mostly just a communication and information tool, the creation of a global internet has also dramatically weakened the defensive power of the Pacific and Atlantic Oceans.
From the founding of the US in 1776 to modern day, the only way for a foreign nation to attack the US is by crossing the Pacific or Atlantic Oceans with a navy. However, mastery of naval power is a very rare thing. History seems to suggest there is never more than a single dominant navy at any given time. While practically every country on Earth has suffered numerous foreign invasions, the US has only been invaded once (War of 1812 by Britain) and has only suffered an attack on continental US soil twice in its history (War of 1812 and 9/11 World Trade Center attack). Given how wealthy the US is, the peoples of antiquity would absolutely marvel at how few invasions the US has suffered.
But the global internet has changed this. Whether you realize it or not, the global internet has exposed the US to constant attacks by adversaries in a way that the US has never had to deal with before. It has allowed foreign adversaries to take the modern sources of wealth and economic growth (technology and intellectual property) without ever having to cross the ocean or outgun the US Navy. It has also exposed US infrastructure (which are increasingly digitized but ill-protected) to digital attacks. It has also exposed the US populace to disinformation attacks.
What the global internet has done is raise the cost of existence for the US as a country and American Democracy.
This will potentially have a devastating impact over time, and the world is only beginning to realize what is happening.
One of Capital Flywheels’ contrarian opinions is that Democracy may be a uniquely American phenomenon (even Western Europe was never really as “into” Democracy as the US was…). This is because establishing a Democracy is very expensive. In order for a Democracy to work, it requires high investments into a lot of discretionary areas including liberal (as opposed to scientific) education. Most countries simply did not and do not have low enough cost of existence to entertain investing into such discretionary areas to allow the creation of a robust Democracy. The rising cost of existence because of the creation of a global internet is now also undermining the ability of the US to continue to operate with a healthy and robust Democracy.
From the US perspective, this would still be okay given the significant advantages we have elsewhere. While this is certainly a negative outcome, it does not fully erode our advantages vs other nations and certainly would not be enough to allow any other nation to outstrip the US by much (if at all) over the long run.
But this is only true when we consider other nations / empires in the physical world.
The establishment of a global internet not only undermines the cost of existence of the US, it has already created entities that truly do have superior economics and lower cost of existence compared to the US.
These are the digital empires of the 21st Century.
The GDP and economic earning power of any system is a product of labor, capital, and productivity within the system.
The digital empires of the 21st Century can produce output with effectively no labor, effectively no capital, and with significantly higher productivity.
The digital empires of the 21st Century either have captive un-paid labor (e.g. everyone that posts on FB / Instagram of their own accord, driving up engagement, yet get none of the advertising income streams created in the process) or have highly, highly (almost infinitely) scalable labor. A few coders or designers can get paid $200k to $5-10 million, yet not even capture a tiny fraction of the $billions of value that come from their work. China and India may have an advantage in labor and the US may have an advantageous method of growing the labor force inorganically, but the digital empires of the 21st Century have access to labor around the entire world and most of them contributing for free.
Unlike ages past where the creation of great economic value required great economic investments in machinery and capital, the digital empires of the 21st Century do not need to invest anywhere close to the levels of the past.
This is why the digital empires of the 21st Century are becoming enormous juggernauts that governments of the physical world are grappling to understand and control.
And, unfortunately, wealth created through these digital empires of the 21st Century mostly flow one-way (into the emerging digital empires and out of the majority of the peoples that comprise the physical empires of today).
In 1912, a little more than 100 years ago, China’s last imperial dynasty collapsed under a combination of domestic and foreign pressure. There are many factors that contributed to China’s problems, but one of the key contributors on the foreign side was foreign displeasure at China’s perceived mercantilistic policies.
Here is how Wikipedia describes Mercantilism:
Mercantilism is an economic policy that is designed to maximize the exports and minimize the imports for an economy. It promotes imperialism, tariffs and subsidies on traded goods to achieve that goal. The policy aims to reduce a possible current account deficit or reach a current account surplus, and it includes measures aimed at accumulating monetary reserves by a positive balance of trade, especially of finished goods. Historically, such policies frequently led to war and motivated colonial expansion. Mercantilist theory varies in sophistication from one writer to another and has evolved over time.Source: Wikipedia
Trade is “normal” and “balanced” when two trading nations have both things they want to buy and have things to sell.
If one of these are materially smaller than the other, eventually the imbalanced relationship leads to a build-up of debt within one of the parties. For centuries, prior to the fall of the Qing Dynasty, China had a lot to sell but not a lot they wanted to buy from the rest of the world (the current relationship between China and the US have similar echoes). And the resolution of that imbalance was highly disruptive.
Whether the world realizes this or not, Capital Flywheels believes the same Mercantilistic dynamics are being played out between the digital empires of the 21st Century and the “host nations” in which they operate. The digital empires have a lot to sell, but not a lot they want to buy from the “host nations” (either in the form of labor or capital equipment). The Mercantilistic positioning of these digital empires of the 21st Century is leading to a massive creation of wealth and value within the digital empires but is also leading to massive creation of debt and liabilities in the “host nations” (either through lost income or overconsumption).
These imbalances will increasingly build up, and it is up to everyone involved to find an amicable solution. And hopefully we do, because if history is a guide, time has a way of forcing resolutions…and they usually end up quite disruptive and violent.