The distinction goes back to Hans Delbruck, although Delbruck picked it up from Clausewitz, who died before he could develop it himself. The notion is that there are two strategic traditions, concentrating on victory through the annihilation of the enemy or victory through the exhaustion or displacement from vital positions of the enemy. The former - the strategy of annihilation - was thought to be virtually the only one in 19th century military thought, in the long, long shadow of Napoleon, particularly as interpreted by Jomini and (how people read) Clausewitz. That shadow stretched far past the 19th century, into the incredibly persistent obsession with the climactic battle that made WWI's western front nothing more than a great big field exercise in pointless butchery.
The strategy of exhaustion, by contrast, doesn't aim at the annihilation of the enemy, but at whatever short of it that might lead to a satisfactory conclusion of a presumably limited war. Delbruck listed among masters of the strategy of exhaustion Pericles, Gustavus Adolphus, and (though it got him in a lot of polemics in Germany!) Frederick the Great. Pericles, for instance, proposed to win the Peloponnesian War by withdrawing the Athenian population inside its walls, with a secure walled harbor in the Piraeus, and letting the Spartans come and campaign there season after season until they either suffered Helot revolts at home, or finally granted Athens recognition as another Greek power out of simple exhaustion with the war effort. It sounds really crazy, and I'm sure our instincts for go-for-the-throat warfare make it sound all the more perverse, but the Athenian situation - those walls, that secure harbor, wealth, and massive naval superiority, combined with massive land military inferiority - would have made it possibly successful had the Athenians been able to stick to the diplomatic posture Periclean strategy required (standing firm by previous Spartan treaty agreements, to establish Athens as that power to respect).
I've been thinking that the strategy of exhaustion gets even less attention at sea than on land, and less still in space or FOTS than at sea. The American military tradition has largely forgotten the strategy of exhaustion, given our typical material superiority and/or strategic naivete. Any other power would have been structurally better suited to understand the role of the strategy of exhaustion in a limited war like Korea, and its absolute necessity in Vietnam. It's really sad when you realize that Delbruck could have very fairly included George Washington in that list of masters of the strategy of exhaustion - North Vietnamese leaders were more his students than US leaders (or "leaders" - they merit scare quotes). No climactic battles for him, no plans to secure independence by the annihilation of British military power - no, he was aiming at wearing them out while preserving an army in being and picking off detachments. But instead, we've had the tradition of Grant and Sherman of victory through the destruction of the enemy at least, and often beyond their military to their entire ability to support a military. We got frustrated for not having that as a conclusion to the First World War, and carried it through with gusto in the Second. Since then, we've had a very hard time managing without that hunger for annihilation; the Cold War was fought (or thought) in large part as a matter of the sustained threat of annihilation; there was no plan to speak of for Vietnam; and we've been unsettled by the fact that the Gulf War was in the end a limited one that "only" restored the status quo antebellum (minus huge portions of the Iraqi military!).
But at least on land we've had that tradition of the strategy of exhaustion, whether or not it's been an arrow in the quiver of American strategic thinking. At sea, we've had as a sustained idea that of a great battle of capital ship to capital ship, with victory at sea coming from being the clear victor in such a conflict, from Jutland to Pearl Harbor to Midway. Jomini's shadow stretched out over the water through Mahan, and I don't believe Fisher, Halsey, Nimitz, or Yamamoto quite escaped that tradition.
However, while I don't think it's been a powerful influence over strategic thought at sea, at least in the Anglo-American tradition, I think the strategy of exhaustion has been a very powerful influence in its practice. The French guerre de course, its American cousin in the War of 1812, and the commerce raiding (submerged usually, surface occasionally) practiced against Britain, Britain again, and Japan in the world wars certainly fall into that tradition. In each case, they were carried on against opponents when a plain annihilation victory wasn't practical - the French couldn't challenge the British directly at sea, the Americans certainly couldn't, the High Seas Fleet was never more than a threat fleet to the Royal Navy, the German navy in WW2 even less so, and the key waters of Japan's Pacific holdings weren't subject to American surface domination until much later in the Pacific war.
Coming around to FOTS, I don't think that the strategy of exhaustion has had much of a role there. I don't know if that's a matter of it being more subtle than most gamers care to be, or if it's a matter of the skewed American strategic tradition, but there you go. I suppose some of it might be that it's hard to target hearts and minds in a wargame, which is often a part of the strategy of exhaustion, as are economic vulnerable points which the abstract FOTS economy conceals. But it occurred to me that commerce raiding just might open up that possibility. You can practice it without an ability to meet an enemy fleet in stand-up combat, and you can practice it without an ability to take on even smaller squadrons or local defenses, although that will make it more difficult. Part of being able to pull it off as a large-scale strategy is an ability to survive what the enemy fleet can do to you in the meantime. But that's consistent with distinct fleet inferiority, if you've got effective local defenses (gunboat fleets, for instance, like the one FOTS B5 has in Minbari hands, or what web technology tends to give you) or if you've got the drives to fight an enemy at a greater distance than he can fight you effectively (akin to the Rrowlk'aa against the Swarm). (I had a strategy of exhaustion in mind at times; I just had less application for it than I'd thought, compelling reason for the strategy of annihilation in a hurry, and an ability to aim for that due to material success that surprised me.)
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