Two essential texts in the theory and practice of financial warfare

Summary:  Fourth generation warfare takes place in a virtual space of the mind as earlier generations of war were waged in physical space.  The battle for the moral high ground occurs in the media.  Another battlefield are the markets, with flows of money replacing blitzkriegs by panzers.  Here are excepts from two works about financial warfare, one old (Unrestricted Warfare) and one new (“The Strategic Consequences of American Indebtedness”).  Both take us to the frontiers of thinking about modern warfare.  This post is a follow-up to my July 2008 post Words to fear in the 21st century: Lǎo hǔ, lǎo hǔ, Lǎo hǔ.

The first break-though text of 4GW was Unrestricted Warfare, by two Colonels in the China’s Air Force:  Qiao Liang and Wang Xiangsui.  They describe the 1997 attack by western hedge funds on the currencies of Southeast Asia as the first example of this new generation of warfare.

When people begin to lean toward and rejoice in the reduced use of military force to resolve conflicts, war will be reborn in another form and in another arena, becoming an instrument of enormous power in the hands of all those who harbor intentions of controlling other countries or regions. In this sense, there is reason for us to maintain that the financial attack by George Soros on East Asia, the terrorist attack on the U.S. embassy by Usama Bin Laden, the gas attack on the Tokyo subway by the disciples of the Aum Shinri Kyo, and the havoc wreaked by the likes of Morris Jr. on the Internet, in which the degree of destruction is by no means second to that of a war, represent semi-warfare, quasi-warfare, and sub-warfare, that is, the embryonic form of another kind of warfare. …

Financial War

Now that Asians have experienced the financial crisis in Southeast Asia, no one could be more affected by “financial war” than they have been. No, they have not just been affected; they have simply been cut to the very quick! A surprise financial war attack that was deliberately planned and initiated by the owners of international mobile capital ultimately served to pin one nation after another to the ground–nations that not long ago were hailed as “little tigers” and “little dragons.” Economic prosperity that once excited the constant admiration of the Western world changed to a depression, like the leaves of a tree that are blown away in a single night by the autumn wind. After just one round of fighting, the economies of a number of countries had fallen back ten years.

What is more, such a defeat on the economic front precipitates a near collapse of the social and political order. The casualties resulting from the constant chaos are no less than those resulting from a regional war, and the injury done to the living social organism even exceeds the injury inflicted by a regional war. Non-state organizations, in this their first war without the use of military force, are using non-military means to engage sovereign nations.

Thus, financial war is a form of non-military warfare which is just as terribly destructive as a bloody war, but in which no blood is actually shed. Financial warfare has now officially come to war’s center stage — a stage that for thousands of years has been occupied only by soldiers and weapons, with blood and death everywhere. We believe that before long, “financial warfare” will undoubtedly be an entry in the various types of dictionaries of official military jargon.

… Today, when nuclear weapons have already become frightening mantlepiece decorations that are losing their real operational value with each passing day, financial war has become a “hyperstrategic” weapon that is attracting the attention of the world. This is because financial war is easily manipulated and allows for concealed actions, and is also highly destructive.

Now Brad Setser, economist and expert on global capital flows at the Council on Foreign Relations, provides an analysis of America’s strategic weakness in this new dimension of war. As an economist, he writes mildly about a profound strategic weakness that could have terrible consequences.  I highly recommend it.  (Here is Setser’s blog at the CFR)

Sovereign Wealth and Sovereign Power – The Strategic Consequences of American Indebtedness“, September 2008, 69 pages — Introduction:

In the 1870s, the scope of Great Britain’s financial empire exceeded the scope of its political empire. Dependence on British investors sometimes was a precursor, though, to informal — or even formal — political control. When Egypt’s khedive needed to raise cash to cover his personal debt to private British banks, he sold his large personal stake in the Suez Canal to the British state. Egypt’s ruler did little better managing Egypt’s public debt: difficulties making payments led Britain and France to assume control over Egypt’s treasury and, by 1882, to full British political control.

In the 1950s, Egyptian president Gamal Abdel Nasser’s decision to nationalize the Suez Canal led Britain — together with France and Israel — to occupy the Canal Zone. But Britain’s financial position had deteriorated, and it now depended on external financing to sustain the pound’s peg to the dollar. The United States — then Britain’s most important creditor—indicated that its willingness both to provide direct financial support to Britain and to back an International Monetary Fund (IMF) loan hinged on Britain’s willingness to respect a UN General Assembly resolution calling for Britain, France, and Israel to withdraw from the Suez. The U.S. ultimatum forced Britain to reconsider its position. British prime minister Anthony Eden explained: “We were therefore faced with the alternatives, a run on sterling and the loss of gold and dollar reserves till they fell well below the safety margin — or make the best we could of UN takeover and salvage what we could.”2 Britain’s decision to withdraw from the Suez duly prompted the United States to back a larger than expected IMF loan.

The lesson of Suez for the United States today is clear: political might is often linked to financial might, and a debtor’s capacity to project military power hinges on the support of its creditors. The United States is militarily far stronger than Britain was in the 1950s — and unlike Britain, it is not committed to maintaining the dollar’s external value. However, in some ways the United States’ current financial position is more precarious than Britain’s position in the 1950s. While Britain ran a small current account surplus in 1956, the United States ran a $750 billion current account deficit in 2007 — 5.5% of gross domestic product (GDP). Britain’s main source of financing was a close political ally. The United States’ main sources of financing are not allies. Without financing from China, Russia, and the Gulf states, the dollar would fall sharply, U.S. interest rates would rise, and the U.S. government would find it far more difficult to sustain its global role at an acceptable domestic cost.

To date, the fears concerning reliance on foreign governments for financing have not been borne out. … Because the United States’ ability to borrow huge sums at favorable rates seems unlimited, many have come to see reliance on foreign finance not as a source of vulnerability but as a sign of strength. Others argue that the United States is simply too big an economy to fail. Foreigners cannot withhold credit from the United States because the resulting decline in the dollar and fall in U.S. consumption would undermine their own exports.

This report takes the opposite position. It argues that the United States’ current reliance on other governments for financing represents an underappreciated strategic vulnerability. The willingness of foreign central banks … to build up dollar reserves has long provided a stable, but limited, source of external financing. But the United States increasingly relies on financing from central banks that already hold far more reserves than are needed to assure their own financial stability. It is true that foreign central banks have an interest in keeping the dollar strong. But the United States might have more to lose from a disruption of this relationship: financial flows create mutual interdependence, but the interdependence is asymmetric. The longer the United States relies on central banks and sovereign funds to support large external deficits, the greater the risk that the United States’ need for external credit will constrain its policy options.


This is perhaps the key aspect of the problem:  “To date, the fears concerning reliance on foreign governments for financing have not been borne out.”  So we do nothing to prepare ourselves against this danger.

“On September 23 his fleet hove in sight, and all came safely to anchor in Pevensey Bay. There was no opposition to the landing. The local fyrd had been called out this year four times already to watch the coast, and having, in true English style, come to the conclusion that the danger was past because it had not yet arrived had gone back to their homes.”
— A description of William the Conqueror’s arrival, from History of the English Speaking People by Winston S. Churchill

Let’s hope that someone senior in the new Administration reads Setser’s article.  And Unrestricted Warfare.  Forewarned is not prepared, but a step in the right direction.

“Surprise is an event that takes place in the mind of a commander.”
   — From Prince of Sparta, by Jerry Pournelle and S. M. Stirling (1993)

Other posts about national security

  1. America’s grand strategy: lessons from our past (30 June 2008)  – chapter 1 in a series of notes
  2. President Grant warns us about the dangers of national hubris (1 July 2008) – chapter 2
  3. America’s grand strategy, now in shambles (2 July 2008) — chapter 3
  4. America’s grand strategy, insanity at work (7 July 2008) — chapter 4
  5. Justifying the use of force, a key to success in 4GW (8 July 2008) – chapter 5
  6. The world seen through the lens of 4GW (this gives a clearer picture) (10 July 2008) — chapter 8

Click here to see a list of all posts about strategy and military theory.

15 thoughts on “Two essential texts in the theory and practice of financial warfare”

  1. I’m not sure that I agree that we haven’t already seen a financial attack. There are persistent rumors that the Chinese and Japanese were very concerned about Fannie and Freddie and basically forced the US government to take over the companies to ensure that the Asian governments would get paid.

    If true, wouldn’t this essentially amount to an unsigned Versailles treaty with us playing the role of the Weimar republic that paid huge amounts of money and goods to compensate France and Britain for WWI?.
    Fabius Maximus replies: Don’t bother asking me to loan you money if I insist on repayment and you consider it an “attack”. We are borrowing hundreds of billions of dollars in new money every year from foreign central banks, in addition to rolling over a few trillion in old loans. Should we expect to get new money after we stiff them?

    The analogy with Weimer seems a bit weak. We borrowed the money; a bit different from war reparations — esp the moral difference, always a key factor in 4GW. And the sums are far smaller than the burdens imposed on Weimar.

  2. Great post Fabius:

    It’s no surprise that Asia resents the manipulation of their currencies. Which is in effect the manipulation of their economies and the lives of their people. China calls their ability to dump US Treasuries and sink our economy their “nuclear option”.

    When they inevitably stop buying our securities, we will lose more than our ability to borrow. We dont even make computer keyboards in this country anymore, let alone the digital infrastructure which runs our country and our military. We import 75% of our oil, and virtually all of our manufactured goods.

    The Chinese will not make our cell phones and flat screen TVs, and the Middle East will not sell us oil in exchange for worthless paper.
    Fabius Maximus replies: The 1997 event was an attack on weak Asian currencies. The current situation is called the “Bretton Woods II system”, in which emerging nations in effect manipulate their own currencies — keeping them at below market levels.

    An end to this will probably not happen suddenly (at least, I hope not). Central bankers are a cautious, reactive breed. They prefer to act in small incremental steps. It is no more likely that the head of the Peoples Bank of China would suddenly decide to press the red button to destroy the world’s financial system than a US President would press his red button to physically end life on earth.

    Also, as the graph in this post shows, the US is generating increasing amounts of foreign exchange through exports. So we have ability to buy foreign goods.

    It is a high risk situation, and imprudent (aka nuts) to have gotten ourselves into this hole. But with luck and care we can climb out of it. But we have yet to take the first step: stop digging.

  3. I cannot fathom comment #1 because I think he cannot fathom what happened. No need to do a lot of research. NPR repeated it about 10 times today: If fannie and freddie were to go bankrupt their outstanding debt would exceed the outstanding debt of any nation on earth in history were it to go bankrupt save one; the U.S. When the U.S. sneezes other nations experience earth quakes. They also had interviews with finance ministers from around the world who coincidentally we’re assembled for a conference. The universal wisdom? Mr. Paulson did the right thing because he had no other wise choice. The world’s credit markets would have collapsed. F&F represent trillions (Yes thats a T) of equity. I don’t think most Americans understand how powerful we have become. and the cavalier attitude most Americans apply to it. I had a friend once from Sweden when I was young.. He was unbelievably eager to see Ronald Reagan speak. I asked him why. He said because he is the most powerful man on the planet and he wanted to understand him. We continued to talk about this thing “power” and I realized we were on different wave lengths. His wavelength was dollars and influence and mine was military exersion. What an eye opener. Today: Great Depression averted. Now let’s talk about pigs and lipstick.

  4. Thank you for the pointer to “Unrestricted Warfare”. I was unaware that this was publicly available, translated into English, on the ‘Net. The trail of breadcrumbs was easy to follow from the Wikipedia link. I’m reading through the PDF now.

    I particularly like the way the authors refused the temptation of simple “answers” to deep questions. For example, they wrote …

    “The complex interrelationships among self-interests make it impossible to pigeonhole the Gulf War as having been fought for oil, or as having been fought for the new world order, or as having been fought to drive out the invaders.”

    Reductionists, they’re not. A nice change, since we get fed a constant diet of reductionism in this country. Particularly during an election year. And my gorge rises at it.

    I don’t see the PRC as an immediate threat. They “go nuclear”, to borrow The Populist’s metaphor, and they lose the ability to keep the Yuan’s value artificially low, if I’m seeing this aright.

    But that doesn’t mean we’re safe if we leave our creditors in the lurch.

    What it does mean is that we need to show the next bunch of charlatans who talk about “permanent booms” to the door, quickly and without too much courtesy.

    And not just because of our foreign investors.

    This is the second major economic crash I’ve seen in the last decade. I got through the first one relatively unscathed, on pure luck. This time, my luck may have run out. And I’m far from the only bystander who got caught in the collateral damage. Folly has a price, and we’re paying it again.
    Fabius Maximus replies:

    “I don’t see the PRC as an immediate threat. They “go nuclear”, to borrow The Populist’s metaphor, and they lose the ability to keep the Yuan’s value artificially low, if I’m seeing this aright.”

    (1) Setser’s point is exactly the opposite; the essay written in opposition to this dangerous notion. (2) China’s leaders know that the Yuan (i.e., the RMB/USD ratio) must move to market rates, and are allowing it to increase a few percent per year. (3) Leveraging their status as a creditor has risks to China, they are hardly symmetric with the potential damage done to the US.

    More importantly, it is irresponsible to allow ourselves to slip into such a weak and vulnerable position. And our creditors can — and imo will eventually — exploit this. Believing that they will not is imo delusional.

    It need not be anything large or dramatic, but could be a slow loss of relative power (typical for debtors).

  5. “We dont even make computer keyboards in this country anymore…”

    FM, The Populist et al : forgive my ignorance. But what exactly does the US manufacture these days? Besides BodyGlove T’s (even that I’m skeptical, made in china? : tag says made in US).
    Fabius Maximus replies: This is not the reference desk at your local library. Look it up.

    Just off the top of my head. Drugs (biotechnology). Entertainment (movies, music, computer games). Software. Aircraft, both civilian and military.

    This graph of exports as a rising fraction of GDP tells its own story. That so many folks are unaware of it, or even in denial, tells another story.

  6. As you point out, there is a difference between a currency “raid” by vulture capitalists like Soros, and the gradual divestiture by China and Russia of US debt. One is truly an act of warfare, or piracy; the other a normal dynamic of self-correcting capital.

    US financial elites couldn’t have been ignorant of our impending financial weakness, and some segments of it, under Bush, thought they could avert it by military means. It would be pleasant to believe they have learned a lesson, though you couldn’t prove it from the statements of our two presidential candidates.

  7. FM, three of the four major things you quoted as exports are totally dependent on protection of intellectual property in order to generate appreciable cash flows. In the internet age, that’s not a good foundation to build an economy upon. Ask the RIAA, and be thankful they don’t have a standing army.
    Fabius Maximus replies: That is a powerful point, but a commonplace of history. Think of China’s effort to prevent other nations from getting silkworms, and the long history of nations attempting to preserve a monopoly on some industrial technology. It never works over the long-term. We — everyone — need to be constantly adapting and innovating. That’s just life!

    BTW — I am not a polyanna about globalization. As mentioned above, the global arbitrage of labor costs could benfit the world but severely damage US living standards. There is no easy answer. The usual panecea, education, is almost ineffectual. Limiting immigration might help, and has the advantage of being (perhaps) almost the only available tool.

  8. Sorry, but what graph? Have used both Mozilla and IE and can’t find one..
    Fabius Maximus replies: My apologies! I am having major computer problems, and posting with difficulty and much bad language. I meant this graph (the link was omitted).

  9. Ah! Well, that graph might be telling, but it needs also something that compares
    a) GDP per person, i.e. GDP can go up in absolute terms but might be going down relatively speaking, which also leads to
    b) as measured in relation to gold, the EU, or in barrels of oil, or a basket of things rather than raw dollars.

    Furthermore, a case can be made to balance out GDP raw figures with amount of debt incurred, on top of currency depreciation, which is of course related.

    It seems a little too easy to maintain GDP is going up whilst deficits are as well and to compare the GDP of one nation in debt with another in surplus without taking those factors into account, no?

    So that graph might be telling a very positive tale and if so, good for America. But it certainly is not substantiated by the line alone which resembles the Dow Jones still near all-time highs but in fact having not made ‘real’ money in purchasing value terms for more than 10 years. Drawn that way, it has been steadily descending for some time. I suspect a properly configured GDP chart might show a similar trajectory but have no way of knowing.

    This sort of measurement/analysis reminds me of the debates last century about different systems such as communism, capitalism, socialism etc. Hitler turned Germany around in a miraculous fashion by essentially going against a finance/banker-based monetary system and redesigning value around the notion of human productivity. No matter what the results of the war, which it is now acknowledged he neither wanted nor started, the early reformations he crafted and led were extraordinary. The point here being that by basing value on work versus $$$, you can get very different results. The US nowadays values symbols, not actuals. Very dangerous.
    Fabius Maximus replies: I have no idea what you are attempting to say. All sorts of things might be possible, but if you have a specific case to make — rather than this sort of general “what if’s” — please make it, with some supporting detail.

    This graph is a simple one, representing an increase inexports. We need the money. When you bring more pay home one can carp all day about what if’s, but the cash remains the important thing.

  10. As I’ve said before, we need another Bretton Woods agreement. All the major players to get together to work out a smooth transition to a more balanced World economy. The original one gave us 30 years of prosperity, sure it needed to be changed by the 70’s (no system can exist forever and the World economy had changed massively), unfortunately what we changed it to has not proven to be viable (as was warned by many people at the time). Basically it has a bit too much idiology (a deliberate misspell), too much short term thinking and is a fundamentally unstable system.

    A problem is attitudes: Too many is the US elite still seem to think that they can get through this and then go back to the good old ways. The EU is too politically fractured (and the UK will always side with the US, their elite also believe that they can get through all this without any changes). China doesn’t have the strength or (probably) the confidence, Japan will do what it always does .. nothing.

    So, before we can have solutions (and there are many) there has to be acceptance. Right now we are in the 7 stages of grief over the loss of our old way of living … currently we are at the Denial part, unfortunately we still have the:

    2. Pain and guilt
    3. Anger and bargaining (a dangerous phase this one, a big war is all too likely)
    4. Depression

    stages to go through yet. Then we will finally move onto:

    5. Upward turn
    6. Reconstruction and working through, and finally
    7. Acceptance and hope.

    phases (though I’d reverse the order of 6. and 7.).

    One problem is societies are not homogenous. Different parts of it will go through these stages at different rates. The elites, unfortunately, will do this at a far slower pace, basically because they are so much better insulated from the pain. Mass public pressure will be an important element in how fast our societies adapt. But here lies another danger, which adds yet another (possible fatal) timelag. My reading is that in many countries (US, UK, etc) the elites will stay in denial, then quite possibly switch to repression of dissent, delaying necessary change even further, perhaps beyond the point of no return. Recent examples of this danger is the USSR and Zimbabwe, in both cases the elites managed to repress any moves for change well past their point of collapse.

    One of the reasons for the success of free societies is that they are fundamentally more flexible and adaptable (both economically and societal). Our moves in recent times to more repressive societies bodes ill for the significant economic and societal changes that we need to undertake, in any sort of reasonable timeframe.

    Me? I’m a pessimist, I’m giving it only 50:50 that a few major countries won’t collapse into a sort of repressive, police state, permanent economic depression, with the rest in a long recession.
    Fabius Maximus replies: This seems to be a purely US-centric view. Is China unhappy with this situation? Are they suffereing pain and guilt — or whatever — as their incomes rise year after year at the astonishing rate of 10% – 15%? Perhaps they feel anger at their $1.5 trllion in currency reserves.

  11. Erasmus : “No matter what the results of the war, which it is now acknowledged he neither wanted nor started…”

    Curious as to where you got your sources from. I know that for most of us , we’ve been readin’ comic – book versions of history, where the victors are usually the “good guys” & the vanquished the “evil ones”.
    Fabius Maximus replies: This is a common theme in revisionist history. Most recetnly, in Pat Buchanan’s Churchill, Hitler, and “The Unnecessary War”: How Britain Lost Its Empire and the West Lost the World (2008). It makes sense, if one ignores the contrary evidence.

  12. Gabor Steingart on the West’s Asian competitors — “It would be more honest to see them for what they are also: attacker states”.

    Old Skepticthinks “reasons for the success of …free societies… is they are fundamentally more flexible and adaptable”

    Chinese are flexible and adaptable in the economically useful sense; they do as they are told. US investment into China’s economy is “freeing” Westerners from working in manufacturing and soon service jobs while generating healthy profits for those investors. It is a mistake to refer to a free society without recognising that it consists of different interests; the “US” can be doing well while 30% of the people in it are excluded from the world of work.

    China was the biggest economy in the world up until 1800, India was also sizable. We send our kids to school how could anyone think we can compete with countries who send their kids down the mine. On the level playing field, the flat earth of free trade we can not.

  13. FM, it is a largely Anglo-Saxon viewpoint, but no one is going to get off scot free from the current financial meltdown. Basically a depression in the US and UK and a moderate to nasty recession everywhere else. And many places are going to have to undertake fundamental change to pull themselves out of the mess, ‘business as usual’ is dead and no amount of bandaids is going to change that.

    Plus nearly all countries are facing some nasty storm clouds in either the near future (e.g Anglo Saxon) or the more middle future (e.g. 5-15 years). The list is almost endless, financial system instability, population/demographics, climate change (and its nasty cousin rising sea levels), resource constraints, energy constraints, water issues, even food constraints. The effects and proportions vary from place to place, but nearly everywhere is facing some .. interesting … challenges. What makes this even more … interesting… is that many are global in nature and will require significant international cooperation to fix (e.g. financial systems). Trouble is international cooperation is at a new low and never have the international institutions been weaker, largely thanks to the US (and its Anglo Saxon camp followers, the UK and Australia) in recent years.

    So it is all going to be harder and take much longer than it should.

    The best ‘Grand Strategy’ the US could have followed would have been to strengthen international institutions during its very brief time at the top, basically because it is a lot cheaper than guns. A simple example of this is weaponisation of space, the US has killed any chance of international agreements on this, but it now faces an arms race for which it will have to borrow money to pay for, from the very people it is competing with! Treaties are much much cheaper than hardware and institutions are excellent ways to solve problems without the guns coming out (jaw jaw vs war war).

  14. Barry, China is much freer that is commonly thought. Basically they have taken a leaf out of the Singaporese, you have great freedom in business, just dont get into politics (unless it is the approved State version). They also seem to be ruling politically with a reasonably soft hand. In fact the average Chinese is probably freer in facts on the ground than the average Singaporese (at least you can get chewing gum in China). The way things are going they will be freer than the UK, which is my first bet on the developed country most likely to turn into a totalitarian state.

    The incredible dynamism seen in recent years in China indicates the change, if it was still a command economy none of this would have happened. There is also a difference between ‘official’ freedom or ‘de facto’ freedom and history is replete with places with great ‘official’ freedom, the reality was very different for normal people (e.g. USSR, had an amazing Constitution .. just never followed it).

    As for the coal mine stuff, if it happens (which I doubt) it is dying out rapidly as the country develops. We had our children doing that not too long ago as well, where I come from (and when I was young) most kids left school at 16 and went stright into work, in my parents time it was 14-15. They now need Physics PHDs far more than child labour and they know it. Remember how low a base China has come from, basically from a 17th century peasant country to an industrial powerhouse in a generation. Even now 75% of the population are still basically peasants. Compared to the challenges they face, our troubles in the developed countries are trivial. Can they manage it and keep it all together? We watch and see.

    As for the loss of jobs, well I’m not going to criticise them for taking advantage of a system WE designed and set up. I have no rancour at a Chinese guy trying to make a living. My anger is aimed at those who set up the current ‘labour arbitrage’ system which means a race to the bottom for ordinary Joe Soaps, instead of the climb to the top system we could have built! Might have meant a few less billionaires in our countries, but hey, I can live with that.

  15. Oldskeptic : the citizens of that state supposedly call ’emselves “singaporeans”. & ’tis true, there is obviously more freedom in “communist” China in contrast to that despotic isle. Pity the fools who suffer there. “singaporese”, funny.

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