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Thursday, April 10, 2008

War and the Economy

Are wars good for the economy?

America’s War-Torn Economy, by Joseph E. Stiglitz, Project Syndicate: ...It used to be thought that wars were good for the economy. After all, World War II is widely thought to have helped lift the global economy out of the Great Depression. But, at least since Keynes, we know how to stimulate the economy more effectively, and in ways that increase long-term productivity and enhance living standards.

This war, in particular, has not been good for the economy, for three reasons. First, it has contributed to rising oil prices. ... Higher oil prices mean that Americans (and Europeans and Japanese) are paying hundreds of millions of dollars to Middle East oil dictators and oil exporters elsewhere in the world rather than spending it at home.

Moreover, money spent on the Iraq war does not stimulate the economy today as much as money spent at home on roads, hospitals, or schools, and it doesn’t contribute as much to long-term growth. Economists talk about “bang for the buck” – how much economic stimulus is provided by each dollar of spending. It’s hard to imagine less bang than from bucks spent on a Nepalese contractor working in Iraq.

With so many dollars going abroad, the American economy should have been in a much weaker shape than it appeared. But, much as the Bush administration tried to hide the true costs of the war by incomplete and misleading accounting, the economy’s flaws were covered up by a flood of liquidity from the Federal Reserve and by lax financial regulation. ...

In a sense, the strategy worked: a housing bubble fed a consumption boom, as savings rates plummeted to zero. The economic weaknesses were simply being postponed to some future date; the Bush administration hoped that the day of reckoning would come after November 2008. Instead, things began to unravel in August 2007.

Now it has responded, with a stimulus package that is too little, too late, and badly designed. ...

With home prices falling (and set to continue to fall), and with banks uncertain of their financial position, lenders will not lend and households will not borrow. So, while the additional liquidity injected into the financial system by the Fed may have prevented a meltdown, it won’t stimulate much consumption or investment. Instead, much of it will find its way abroad. China, for example, is worried that the Fed’s stimulus will increase its domestic inflation.

There is a third reason that this war is economically bad for America. Not only has America already spent a great deal on this war – $12 billion a month, and counting – but much of the bill remains to be paid, such as compensation and health care for the 40% of veterans who are returning with disabilities, many of which are very serious.

Moreover, this war has been funded differently from any other war in America’s history... Normally, countries ask for shared sacrifice, as they ask their young men and women to risk their lives. Taxes are raised. There is a discussion of how much of the burden to pass on to future generations. In this war, there was no such discussion. When America went to war, there was a deficit. Yet remarkably, Bush asked for, and got, a reckless tax cut for the rich. That means that every dollar of war spending has in effect been borrowed.

For the first time since the Revolutionary War, two centuries ago, America has had to turn to foreigners for financing, because US households have been saving nothing . The numbers are hard to believe. The national debt has increased by 50% in eight years, with almost $1 trillion of this increase due to the war – an amount likely to more than double within ten years.

Who would have believed that one administration could do so much damage so quickly? America, and the world, will be paying to repair it for decades to come.

Recall that an increase in government spending can be paid for in one of three ways, we can raise taxes, we can borrow the money, or we can print the money needed to finance the spending. (In a given year, the government budget constraint is Government spending + Interest on debt- Taxes = Change in money supply plus Change in bond supply). This administration didn't raise taxes to pay for the war - taxes were lowered - so that means that changes in the money supply and changes in borrowing needed to make up the $1 trillion spent on the war plus the hundreds of billions of revenue lost due to the tax cuts.

Normally, an increase in borrowing (government debt) has two costs, First, it raises interest rates because the government competes with private investors and other governments for available funds, and that increases the price of borrowing. The increase in interest rates causes investment to be lower, that in turn lowers growth, and that means output will be lower in future time periods. In effect, output has been shifted from the future to the present through borrowing. Second, the interest payments themselves are a cost to the US if they are made to people living outside the US (payments made within the US redistribute income, but they are not a net cost to US citizens). Since recent borrowing was from foreigners, all the interest paid on the debt will flow out of the US and represent a cost to US citizens.

One of these costs, interest payments flowing outside of the US, has occurred and will continue to occur, but the other, an increase in interest rates brought about by competition from the government for saving has not. Why? One reason is the "savings glut" in the world that allowed us to borrow money from the foreign sector without pushing up interest rates. But a second reason is Federal Reserve interest rate targeting. With a constant interest rate target, deficit spending that puts upward pressure on interest rates is automatically "monetized," i.e. the Fed buys up the debt and replaces it with money to keep the interest rate on target, and the increase in the money supply holds down interest rates. But there is a cost here too, by increasing the money supply to hold down interest rates, inflation pressure is created, and inflation acts as a hidden tax by lowering the value of money.

I think the spending on the war and low-interest rates that have been brought about by Fed policy and the savings glut have helped to keep our economy from sputtering, but it has not been costless. First, as noted above, spending on the war may have some had stimulative effect, but if that is the goal, there are much better ways to do this. So, relative to spending the money domestically on, say, infrastructure, we have not gotten as much for our money as we might have otherwise.

Second, increases in the money supply and the influx of funds from foreigners to finance debt kept interest rates low and financed a housing bubble, but the result was a misallocation of resources to the housing sector. We stimulated the economy with low interest rates and a housing bubble, but we built things that didn't need to be built and are now sitting idle wasting resources. That is a cost to the economy, and we'd be better off now if some of that spending had been in other sectors.

Third, the interest costs. As noted above, we have borrowed from foreigners to pay for the war, so the interest on the debt will be a net drain to the US economy.

Fourth, inflation. Keeping interest rates low is inflationary, and inflation imposes a cost. I'm not sure how much of the $1 trillion has been financed by printing money, but to the extent that it has been financed in this way, the consequence is potentially higher inflation in the future.

Fifth, the increase in the price of oil as detailed above.

There are also the human costs, and the costs to the Iraqis, which are not included in these figures.

Because we have paid for the war by borrowing and printing money, and because of delays in the appearance of many of the costs associated with the war, e.g. the cost of paying for permanently disabled soldiers will come largely in the future, inflation only appears with a long lag, interest payment to foreigners will be ongoing, etc., many of the costs are not evident yet. But the costs are there and they will need to be paid.

Are there any costs that I've overlooked, misstated, or forgotten?

    Posted by on Thursday, April 10, 2008 at 11:25 AM in Budget Deficit, Economics, Fiscal Policy, Iraq and Afghanistan, Monetary Policy | Permalink  TrackBack (0)  Comments (114)

          

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