United States

Stratfor's readers are aware that we have been consistently bullish on the U.S. economy. Our basic view of the U.S. market remains the one put forth in our recent decade forecast: "Our expectation is that the massive growth spurt will continue for the first half of the decade. Though it would not surprise to see a sudden, very frightening downturn in the markets or a short, sharp recession, not dissimilar to 1987, the basic upturn will continue until at least 2005 and probably for several years hereafter." [http://www.stratfor.com/services/giu/FORECAST/decadetocome/us2.asp] Last week we started to see some indications that the "short, sharp recession" that wouldn't surprise us may be ready to not surprise us.

Our attention was riveted last week by the behavior of the "yield curve" on U.S. Treasury instruments. The yield curve is simply the interest rate that purchasers of these instruments would receive, depending on the maturity date of the bill or bond. Under normal circumstances, the yield curve is positive. That means that the shorter maturities pay lower interest rates, while longer maturities pay higher ones; the 30-year Treasury Bond pays the highest. The reason is simple: People who buy longer-term bonds take greater risks because the government doesn't have to redeem these bonds for 30 years. If interest rates rise, the value of the bonds on the secondary market could fall. People buying short-term bonds can be paid off in months or even days, and they don't risk their investment principle.

One of the important precursors of recessions is a negative yield curve, in which short-term rates are higher than long-term ones. And one of the triggers for a recession is a rise in interest rates. Higher interest rates cause businesses to try to avoid long- term borrowing and seek short-term borrowing. The result: Short- term interest rates rise even higher than increases in long-term rates. This inversion of the normal yield curve is a classic sign of impending recession.

What we saw last week was a truly weird yield curve. The three- month rate closed at about 5.7 percent, and the curve rose steadily until the one-year yield was at a little more than six percent. The yield curve was flat through three years, fell a bit at 10 years, and fell again at 30 years to a yield of about 6.3 percent. There was a lot of argument during the week about what this meant, with people arguing that there was simply a lack of demand for the 30- year bond, and that it therefore didn't mean anything, since there was no piling on at the short end.

There may be some truth to this argument, but it misses the key point, which is that the yield curve is getting very flat. A year ago, the spread between the short-term rate and the long bond was about 22 percent of the short bond's yield. Last week, it was about 10 percent. As striking is the shift in just one week. Short-term rates rose about 0.2 percent while the long bond's yield fell a little more than 0.3 percent. The fact of the matter is that the short-term and long-term rates behaved as they would prior to a recession. The mid-term rates did not conform.

And all this took place this week, taking us from a fairly normal positive curve to a dramatically strange curve - indeed, an unsustainable one. The question here is whether it will flip back to positive or proceed to a negative curve. Our bet has to be that it will move to an inverted, negative curve, because we cannot explain what happened this week except as part of a transition. Healthy bond markets do not produce these strange results and then flop back to normal.

That is particularly the case with the Federal Reserve Bank clearly following a policy leading to higher interest rates. Since the Fed's operations have much more control over short-term rates than long-term ones, we expect that the flight from the long-term last week - coupled with Fed policy - will push up short-term rates at the expense of mid-term ones, giving us a classic negative yield curve fairly quickly. Since that will pull not only borrowers, but lenders as well, on the short side of the curve, the final outcome should be a classic inversion - and a classical capital shortage.

The U.S. stock markets were also acting recessionary last week, with a massive divergence developing between the highly speculative NASDAQ, which reached new heights last week and the other indices, which were fairly weak. The S&P 500, for example, crashed below its 50-day moving average and wound up close to the 200-day moving average. In simple terms, that stinks. And if the S&P were to crash below the 200-day moving average, by following through on its decline this week, that would stink big time.

A classic indicator of market tops is a divergence in indices. In previous markets, people looked for divergence between the Dow Jones average and the Dow Jones Transportation Index. Today, the two critical economic sectors are high tech and everything else. With the NASDAQ representing high tech, we see a tremendous divergence now developing between the two sectors. Worse, the NASDAQ seems caught in a classic buying climax that can't be sustained for very long. Either the rest of the market resumes its trend upward, or the NASDAQ is going to be highly vulnerable.

One of the factors propping up the markets for the past half-decade has been the lack of alternative places to park money. With commodities at historically low prices and short-term interest rates unattractive, buying stocks has seemed the only prudent course. With short-term government interest rates moving toward six percent and corporate paper even higher, the safety of money funds is no longer quite so unattractive.

Even more interesting, of course, is the fact that commodities, long languishing, are now booming, with gold leading the pack last week. Higher commodity prices are also a precursor to recession, since they raise the cost of production. Indeed, surging global production has helped raise commodity prices, in a self-correcting process. Virtually all commodities, with the exception of oil, moved higher last week. Apart from being a recessionary sign in itself, the dramatic moves in commodity prices give speculative money an alternative arena in which to play, other than the stock markets.

If our thinking is correct, then we expect this to trigger a market sell-off in the near future. The market is a leading indicator to the economy, tending to move three to six months before the economy as a whole. Thus, if we are to begin to see a substantial downturn in the market in the next month or so, we could reasonably expect a recession to hit during the summer and fall of 2000.

There are certainly indicators that argue against a market decline. First, net free reserves, the measure of how much liquidity there is in the banking system, remain heavily positive. That means that the Fed, regardless of its management of interest rates, has not yet dramatically tightened banking liquidity. Second, for all the talk of speculative fever, the price-to-earnings ratio of the S&P 500 is no higher than it was last year, and is in fact somewhat lower, reflecting solid profits. By that measure, there is no reason for a correction. Finally, in Stratfor's absolutely unscientific survey, everyone is convinced that the boom cannot go on much longer. There is such absolute conviction that the good times must end, that we tend to think they won't.

Nevertheless, there is one good argument in favor of a short-term recession: We are way overdue for one. Certainly there have been major structural changes in the economy that have made the current expansion possible. But the laws of the business cycle have not been abolished; they've only been stretched. Tremendous inefficiency has crept into the very sector that has driven the boom - small businesses. These businesses are experiencing severe structural shortages, from skilled labor to office space, that limit the ability to expand. Consider how the shortage of programmers inhibits the ability of the software industry to expand, multiply it over other industries, and you begin to see the limiting factor. It is time for a pause.

Regardless of what the covers of Time and Newsweek may say in a few months, it is not the end of the world, nor even the end of capitalism - nor the end of prosperity. If what we think is happening is indeed happening, then this is merely a downturn in an economic expansion that began in 1982, and it will resume after a few rough quarters. We do believe there is more serious trouble looming later in the decade, but to paraphrase Redd Foxx, "This ain't the big one."

However, this does open a very interesting political vista: the 2000 presidential election being fought out in the context of a recession. Recall how a minor downturn in 1991-92 cost George Bush the presidency and delivered Bill Clinton to the White House. One of the mainstays of the Democrats' polling numbers is the fact that the economy has performed splendidly during Clinton's presidency. It is not clear that his policies made this possible, but nothing he did prevented it. Voters have short memories. A recession, no matter how mild, would make a Republican victory almost certain.

It would also awaken other sleeping issues, such as the trade deficit. The deficit is massive, but tolerable in the context of a booming economy. If the United States does go into recession later this year, with rising unemployment and increasing business failures, the question of foreign competition would certainly move to the fore. This would dramatically increase tensions with Asia. A recession would also close the door on any serious support for Russia's economy, assuming that door is not already closed.

If we knew what the stock market was going to do we wouldn't be working for a living, would we? And the stock market isn't the economy. Nevertheless, when we lay all the accumulating facts side by side, it is difficult to avoid the conclusion that some serious problems are developing. Obviously, the yield curve could correct itself next week, and all this could go away. But with the Fed policy being what it is, we find it hard to see how that curve can regain a healthy upward angle. The more we look at it, the more it appears that it may be time for a recession.

On Dec. 15, Richard Bush, managing director of the American Institute in Taiwan, sent a very clear message to the frontrunners in the upcoming March elections. "If the new Taiwan administration's policies converge with our own interests, then there will be no problem. If they do not, then we will discuss the differences in a spirit of friendship," Bush said. Bush added that the United States will adhere to the one-China policy, which views Taiwan as a Chinese province.

Bush's statement was a friendly warning from Washington's diplomatic arm into Taipei. Bush was clearly warning Taiwan's presidential candidates: If they antagonize China during their upcoming campaigns, they risk U.S. support for Taiwan. The statement revealed two important elements in the U.S. position. First, Washington's interests demand continued peace in the Taiwan Strait. Second, Washington sees China as increasingly cantankerous and unstable, ready to pounce if provoked.

The United States has many reasons to anticipate an escalation of tensions during the run-up to Taiwan's March 18 elections. The most compelling may be historical precedent. Just before Taiwan's 1996 elections, China launched missiles into its Taiwan's coastal waters, prompting the United States to speed two carrier battle groups into the region to defuse the crisis.

In recent months, President Lee Teng-hui has revived antagonism by declaring that Taiwan has "special state-to-state" relations with China; China promptly took this as an affront to its official one- China policy. The president's statement has re-popularized the notion of autonomy for Taiwan. Now all three presidential contenders have at least stated that Taipei needs to negotiate with Beijing on equal footing.
[ http://www.stratfor.com/asia/commentary/m9912062245.htm ]

Bush's statements make clear that the United States is reluctant to see cross-straits tension escalate. Both domestic and international factors determine this stance. First, 2000 is an election year in the United States as well, and China has already become a hot topic because of espionage and campaign finance scandals. If the United States is involved in a military confrontation with China, China will be the determinant issue in the American presidential campaign.

In economic terms as well, the United States does not want tension to burn the bridges that connect U.S. business interests to the mainland. Only weeks ago, Washington's 13-year diplomatic initiative to open China's markets to the world culminated in the signing of a bilateral trade agreement which will help China become a member of the World Trade Organization. The United States doesn't want a conflict in the strait to trip up the agreement before investors reap the economic benefits of access to China.

The United States has yet another reason to want peace in the Taiwan Strait. The waters between China and Taiwan are the most important shipping route in the region; cross-straits tension could halt the flow of trade through the region, potentially endangering Asia's faltering export-driven economic recovery. During the 1996 imbroglio, shipping was disturbed for over two weeks. Japan was forced to divert one-third of its ships from the area.

But it appears Washington senses that China is on edge. Beijing could very easily respond to provocation with hostility. There are some obvious reasons for this concern. Later this month, China will regain control over Macau, freeing China to focus efforts on Taiwan, its last unresolved territorial issue. Chinese President Jiang Zemin pointed this out himself after his Dec. 10 summit with Russian President Boris Yelstin.

Washington may finally be sensing as well that confrontation with Taiwan could be a handy release valve for the pressures building up within China. A nationalistic campaign to recover what is viewed as a renegade province could successfully distract the Chinese people from the economic malaise and dissatisfaction that have triggered over 60,000 protests this year. China's instability has become increasingly apparent during the past year. The government has lead a crackdown on Falun Gong and other organized "threats" to stability, while methodically sealing off its borders.

In a full-blown crisis, the United States would probably not abandon Taiwan outright. Strategically, the island is too essential to U.S. policy in the region, which centers on containing China. The waters around Taiwan are the gateway into the South China Sea, an important shipping route and the link to the Koreas and Japan. If China were to control these waters, it could effectively control the region. But Washington is clearly going to do what it can to dampen the sentiments that favor autonomy or independence for Taiwan.

Last week, the United States launched a missile from Vandenberg Air Force Base in California toward Kwajalein Atoll, several thousand miles away in the Pacific. A few minutes later, an interceptor missile was launched from the island. Its mission was to destroy the incoming intercontinental ballistic missile (ICBM) in a test of a new anti-ballistic missile (ABM) system. The interceptor missed. The test failed.

The responses were predictable. Opponents of an ABM system claimed that the failure proved the inherent unreliability of a missile defense system. Whatever the virtues of an ABM system, the claim that this test proved its non-viability is absurd. Early tests of any system are expected to fail. That's why they are called tests. You only have to think about the failures of missiles early in the space program to realize that. This failure tells us nothing. Which is not to say that an ABM system of this sort is a good idea. It just means that this failure should not influence anyone's opinion, one way or another.

Let's consider how we got to this position. In 1972, the United States and Soviet Union signed an agreement banning the creation of an ABM system. The treaty was meaningless; no one really knew how to build such a system. The Soviets deployed some hardware around Moscow, but calling it an anti-missile system would have been charitable. The 1972 treaty, therefore, was a classic in diplomatic irrelevance, banning what was effectively impossible.

By the 1980s, missile defense capabilities appeared to have evolved to the point that a serious defense was possible. Ronald Reagan's Strategic Defense Initiative (SDI), or Star Wars, was a project intended to reconsider the question of whether an effective defense against missiles was possible under new technology. Opponents of SDI argued (a) that it would not work and (b) that it would de- stabilize the balance achieved by Mutual Assured Destruction, the doctrine that deterrence rested on assurance that an attack by one side would result in an annihilating attack by the other side. Now, If (a) were true, then (b) would not be. Nonetheless, the same people who criticized SDI for being ineffective were frequently the ones arguing that it was destabilizing.

The defenders of SDI managed to get as tangled in logic as the opponents. The primary criticism of a missile-based ABM system was that it was like hitting a bullet with a bullet. A secondary criticism was that the interception would likely take place inside the atmosphere, with results as nasty as if they weren't intercepted. Finally, since each ground-based interceptor would have a very limited range, the number of interceptors needed to protect the United States from incoming missiles was mind-boggling. All of these were good arguments.

SDI therefore focused on a new class of weapons. These weapons were to be based in space rather than on earth, so that they could intercept launches as they left the atmosphere or in mid-flight, rather than on the last seconds of their trajectory. More important, these weapons would consist of laser beams, particle beams, X-rays and other speed-of-light weapons. These speed-of- light weapons would take care of the problem of hitting a bullet with a bullet. A missile moving at seven miles per second was virtually standing still. Space-based, speed-of- light weapons would be able to handle any missile.

That was probably true, yet the SDI initiate failed to generate an effective missile defense. In the 1980s, no one knew how to build weapons able to generate sufficient energy to fry an ICBM thousands of miles away. The generation, storage and release of huge amounts of energy was theoretically possible, but no one knew how to do it with sufficient speed so that thousands of missiles could be dealt with between the time they left the atmosphere and the time they reentered. Ideas like using giant mirrors to focus the light of the sun were floated, but the fact was that this was a great idea with a single defect. No one knew how to build it. Other ideas, like Brilliant Pebbles, in which thousands of little rockets with sensors would be deployed, were floated. But by now, the time for exotic technologies has passed.

SDI hit its technological stonewall, serendipitously, it spawned a range of technologies that generated a revolution at the operational level of warfare.

The old idea of a ground-based missile defense system resurfaced. This resurrection coincided with a transformation in geopolitical realities. A ground-based system would be impotent in the face of a Soviet attack. But by the time the idea of ground-based system was reborn, the Soviets were on their last legs. As important, during Desert Storm, the single most feared weapon in the Iraqi arsenal was the Scud missile, a fairly primitive, relatively short-range missile - that killed more American soldiers than any other single system when it hit Saudi Arabia.

Attention turned to two missions. Defending a theater of operations against incoming missiles was one. The other was defending the United States against ICBMs launched one or two at a time by lesser powers like Iraq, Iran, Libya or Syria. With the collapse of the Soviet Union, the primary objection to ground-based missile defense systems evaporated. The United States no longer had to defend against 5,000 incoming warheads. It only had to defend against a handful. The developing technologies could also be used to defend against shorter-range systems within a theater, like the Persian Gulf or the Balkans.

Enter the current series of tests. Consider that the primary argument for the current system is that it will defend against "rogue" states that might launch a missile attack against the United States. The list is short of nations with motive to attack the United States and with the potential ability to build both atomic weapons and ICBMs: Iraq, Iran, Libya, North Korea and Syria.

It is far from clear that any of these nations have nuclear technology that can be married to an effective ICBM. More important, contrary to popular myth, none of these nations is ruled by lunatics. Quite the contrary, when we look at the leadership of Iraq, Libya or North Korea we see people who are in the business of surviving. Iraqi President Saddam Hussein took a calculated risk with a big potential payoff in 1990. The gamble failed, but it wasn't a reckless act, just a bad bet. He didn't know the United States would intervene. He left himself room for retreat, hung on and survived. He may be a brute, but he is not a moron. Saddam knows that if he launches two or three ICBMs at the United States, his country would be turned into radioactive glass, and he would be playing a leading role in a Geiger counter.

The primary motive for these nations to build nuclear-capable missiles would be the same as that of the great powers: deterrence. The United States would certainly think twice before bombing an Iraq with several survivable, nuclear-tipped ICBMs. But as with all deterrence, the value is lost at the moment of launch. Moreover, if the United States genuinely believed that someone was planning to launch an ICBM at the United States, U.S. satellite intelligence would pick up the construction of the site months or even years before it was intact. The low-cost response would be to destroy the launch site, the missile factory and the nuclear facility with preemptive, preferably conventional, air strikes. If necessary, the State Department could claim that it had discovered a secret plan for genocide. That would be the low-cost missile defense, both more effective and immediately available.

There is a much more serious problem. We are now in the year 2000. The assumption that the primary threat facing the United States comes from a handful of rogue countries is simply no longer true. Russia and China are both major nuclear powers whose relations with the United States are rapidly deteriorating. We do not expect a nuclear exchange, but we do not think that the only challenges facing the United States come from a handful of isolated countries.

The strategic environment changes daily. The real issue facing the United States is its ability to maintain a presence in Eurasia in the face of Russian and Chinese animosity. In the future, interventions against countries like Serbia will likely occur in the context of their receiving backing, political and material, from other great powers. It is no longer reasonable to expect that - as has been the case in Haiti, Iraq, Panama, Serbia, Somalia and others - the defenders will be strategically isolated.

This means two things. First, Western interventions will become much less frequent, as risks rise. Therefore, the concept of the isolated, rogue state is going to be replaced by coalitions grouped around great powers. The probability of one or two missiles launched by a rogue power decreases from its already low probability. One of the consequences of coalitions is that the great power at the center not only supports the lesser power, but also imposes discipline. Serbia, allied with Russia in two years, will be more difficult to attack but more predictable in its response.

Second, the ongoing debate over national missile defense consistently draws focus away from the real battlefield necessity: space strategy's role in supporting conventional forces. U.S. conventional forces have become dependent on space-based systems for communications and intelligence, as illustrated by the 1999 NATO conflict with Yugoslavia. The Joint Direct Attack Munition (JDAM) dropped by B-2 bombers depended on guidance from U.S. Global Position System satellites (GPS). Targeters relied on reconnaissance satellites for target selection. Orders inside the theater, as well as between the theater and Washington and Brussels, depended upon satellites. Even weather forecasting was managed by satellites.

Any serious opponent of the United States knows that it cannot win a conventional war while these satellite systems function. An opponent also knows that if that satellite system is destroyed, the United States will be left deaf, dumb and disoriented. Destroying just a handful of the 24 GPS satellites currently in orbit could leave infantry patrols lost and munitions undeliverable.

The fundamental issue in missile defense is not defending U.S. cities against ICBMs launched by North Korea. The launch sites can be destroyed in a week, and there is nothing North Korea could do about it. That is a side issue. The central issue is defending U.S. satellites against enemy missile, laser and other attacks. The problem with the current program is that it is fighting yesterday's war. It is focused on random missile attacks on the United States from isolated powers. The real issue is going to be fighting conventional wars at the lowest possible cost. That means that U.S. space-based systems are indispensable.

Obviously, we have no idea what defensive capabilities have been added to U.S. satellites. We assume that critical reconnaissance satellites can maneuver to avoid anti-satellite systems and are hardened against ground-based laser systems. One would assume that serious thought and investment has gone into both the defense of satellites and redundancy in the event of attrition. At the same time, no one knows what surprises a clever enemy can devise to get around defenses. Such surprises can be catastrophic to units as far down the chain as the infantry squad on patrol.

Defending American cities against rogue states seems the wrong mission at the wrong time. Preemptive strikes and the promise of nuclear annihilation is a sufficient defense. The new mission is sustaining and operating forces in the back yards of enemies with sufficient sophistication and capabilities to pose a real threat. These forces will strike at U.S. satellites in order to massively reduce the capabilities of conventional forces. Defending U.S. space-based assets is critical for U.S. geopolitical interests.

Ample reports exist of Chinese, Russian and other nations developing ground-based lasers designed to destroy satellites. Undoubtedly, anyone thinking about conflict with the United States is spending a great deal of time contemplating the vulnerabilities of U.S. communications, navigation and intelligence satellites. They undoubtedly are forming their battle plans. These plans have to include space-based attacks on U.S. systems. That means that there has to be space-based defenses for satellite systems. A purely defensive posture on the most valuable and scarce military resources cannot work. Anti-satellite systems can only be countered actively.

Which brings us back to SDI. The revolution in sensor technology had a great deal to do with SDI. Now, SDI may be re-applicable to its original mission. SDI failed because speed-of-light technologies were not available to complement its sensor technologies. Over the coming decade, speed of light may well come into its own. Certainly it will be used as an anti-satellite system. It can be used to defend satellites. By extension, it may now be applicable to a working anti-missile system.

In the 1980s, SDI was premature and was focused on an unlikely threat. Now, the threat against U.S. satellites is far from unlikely and is potentially crippling. As important, many of the technologies being contemplated in the early 1980s are not as farfetched a generation later. From energy weapons to Brilliant Pebbles, concepts that could not be operationalized in 1985 may be possible by 2005. Within this context, an effective space-based anti-ICBM system might well be feasible. The failed test over the Pacific gives us an opportunity to reconsider what is possible and necessary in the next generation. Decisions made in the wake of the collapse of the Soviet Union and Desert Storm need to be rethought under any circumstances.

The real issue is not defense against rogue nations, but a general reconsideration of U.S. space strategy in an age of increasingly great power tension and the likelihood of ongoing conventional operations far from the United States. The dollars spent on defending against the threats of the 1990s might be better spent in preparation for the wars of 2010 and 2020. If planners simply think through how U.S. capabilities would be affected if space-based systems suddenly were destroyed, the importance of a practical space control strategy would become apparent.