The story we have all been reading:

The financial crisis and the depression that followed have had dramatic effects on the fiscal position of the United States. Federal deficits for the foreseeable future will be in the trillion dollar neighborhood, and that is a more expensive neighborhood than most CFAs can afford. As these deficits accumulate, the federal balance sheet will deteriorate, so in a decade government debt outstanding will reach 100% of GDP. The buyers of this flood of debt — China, Saudi Arabia, Russia, and other big exporters to the U.S.—are already getting publically nervous about buying all this dollar-denominated paper. Economic theory suggests that the dollar will depreciate, requiring the Treasury to pay high interest rates to place all this debt. Businesses and consumers will be taxed at very high rates in order to offset the deficit. The U.S. economy will not be able to recover and grow in a time of stagflation.

This negative scenario has been presented in many articles.

Yet, there is a second part of the story, one that has not been talked about much, but will be soon: Foreign policy!The United States has had a muscular foreign policy for a century and has been victorious in three major wars. We were a late but decisive factor against imperialism in World War I, the victor on two fronts simultaneously against Fascism in World War II, and then we outlasted Communism in a 70-year “Cold War” (although Korea and Viet Nam were uncomfortably hot for those involved).

Today the United States and its allies are battling Islamist militants and have deployed major armies in Iraq and Afghanistan. These two fronts have involved American casualties, so there is a natural emphasis on Iraq and Afghanistan, but in addition there are a couple of dozen countries fighting Islamist rebellions of various sorts and sizes. One can claim that the conflict between Islam and the West has been going on for 14 centuries, and not showing any signs of ending.

Can we pay for our wars without borrowing money from other countries? All wars are expensive, and as technology makes every soldier more capable, the cost per soldier goes up. Here is what has happened to jet fighter planes:

The F-22 program became so expensive that Congress recently stopped it. I suppose nobody could think of a target worth attacking if there was a 1% risk that we could lose a $137.5 million airplane in the process.

The logical limit on a weapons procurement program was in Star Wars, the Death Star planet destroyer, procurement quantity: one, despite having tax revenue from hundreds of planets. The unit cost was, of course, astronomical.

The United States of America can no longer afford to fight a war without borrowing the money for it.

The countries that have the money—China, Saudi Arabia, Russia, etc. — have their own foreign policy agendas. We would have to negotiate loans from people who may well oppose our policies. The Europeans, who controlled most of the world in 1914, lack the financial strength and the will to exert power in the world. They argue that using diplomacy is much more civilized. I suppose that diplomacy is more civilized, but diplomacy has not impeded the Iranian nuclear program -heck, it hasn’t even worked against the pirate kids in Somalia. Diplomacy works best with a carrier group sailing nearby.

If our creditors have veto power over our military power, we will end up like Switzerland but with sicker banks. Financial weakness means military impotence. Examples of countries that suffered this weakness include: Great Britain after the Great War; the Ottoman Empire in the 19thcentury; China in the 19th and early 20th century; and The Confederate States of America (C.S.A.) from 1861-65.

I was at a party in early July and saw a middle-aged Asian couple sitting by themselves. I went over to their table and introduced myself. I was pleased to meet the Japanese Ambassador to the United States, Fujisaki-san, and his wife. We had a very friendly chat because my wife Leah’s parents were saved from certain death at Auschwitz by the Japanese consul in Lithuania, Sempo Sugihara. Fujisaki’s grandfather was also a Foreign Service officer, posted in Czechoslovakia, and a friend of Sugihara. I asked the Ambassador about the financing of the Russo-Japanese War of 1904-05. Japan, a few small islands, was at war with the whole damn Russian Empire, and no one gave Japan much of a chance. Surprise! The Japanese Army and Navy performed with skill and valor, and was winning on the battlefield, but their country was out of foreign exchange, and so could not finance the war. The New York investment banking firm, Kuhn, Loeb, & Co., saved the situation by underwriting $260 million in Japanese bonds, allowing Japan to continue to fight. (The Russians were out of money too, but cut a deal with a French bank.)

The consequences of that loan were complex and farreaching. Japan was able to do well on the battlefield but felt screwed by the Portsmouth Peace Treaty dominated by Teddy Roosevelt. Proud of their martial spirit but angry at the European and U.S. nations that patronized them, Japan was set up for its aggressive policy of the 1930’s, climaxing at Pearl Harbor. The Russians, on the other hand, felt humiliated by their battlefield defeat. The realization of Romanoff incompetence generated popular disgust with the Tsarist regime, and encouraged the various left-wing revolutionary parties.

An All-American story of war finance was, of course, the Civil War. The Confederate States and the Union had identical technology at the start of the war, and the Confederacy raised a spirited army with excellent generals such as Stonewall Jackson and Robert E. Lee. The Southern cavalry was better. The North had a much stronger navy and better artillery. The Union had a bigger population and superior manufacturing and railroad systems, while the South was agrarian, and Dixie capital was invested in slaves, not lathes.

A typical statistic: miles of railroad track were 30,000 in the North, only 9,000 in the South. War financial ability had a similar ratio favoring the Yankees, and the Federals had a far superior banking system. The C.S.A. ended up printing money to pay their bills, resulting in hyperinflation and economic collapse. The Confederacy hoped that the North did not have the stomach for a long, bloody, and costly conflict, but when Lincoln persuaded the North to pay the price of victory, the Southern cause was doomed.

To repeat the lesson, without financial independence, you cannot be the hegemonic power.

Ralph Wanger, CFA, is Senior Advisor to Wanger Investment Management, Inc.