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How War's Expense Didn't Strain Economy - WSJ.com …
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February 5, 2007
PAGE ONE
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WASHINGTON -- Since President Bush took office, he's boosted
annual defense spending by 50% -- including $500 billion over five years for fighting in Iraq and
Afghanistan -- and doubled spending on homeland security. At the same time, he's cut taxes,
expanded Medicare to cover prescription drugs, approved $100 billion to clean up after Gulf
Coast hurricanes, and signed bills that spend a little more each year on domestic programs.
For years, critics said it couldn't last, backed by some historical precedent: President Johnson is
blamed by many for triggering inflation in the 1970s by spending on both guns and butter.
· The Issue: President Bush has managed to But this time, it's been nearly painless. Inflation is in
wage a war, cut taxes and boost other spending check. The federal budget deficit is down from its 2004
without triggering Vietnam-era inflation.
peak, and rests near its historical average of 2% of gross
· The Background: The spending spree has
been aided by foreign borrowing and a strong domestic product, a measure of the nation's total output.
economy. Long-term interest rates are relatively low.
· What's Next: While economically painless so
far, war and military spending will soon collide
with looming entitlement obligations. What's Mr. Bush's secret? Ingredient one: strong revenue
growth driven by an economy distinguished by surging
profits and rising incomes at the top, which are taxed
more heavily than incomes at the bottom. Ingredient two: tax cuts and spending increases, which
arrived when the U.S. economy needed a boost. Ingredient three, and perhaps the most significant:
the willingness of foreigners to lend to the U.S., which finances the budget deficit without pushing
up interest rates at a time when Americans don't save very much.
"This situation is what you'd call an exorbitant privilege," says Menzie Chinn, a University of
Wisconsin economist. "We've gotten a pretty good deal so far."
No one knows when this bonanza might end, although end it must. For the
coming year, Mr. Bush is expected to shave costs from programs and
agencies unconnected to defense. In the future, the flow of cash from
foreign lenders could dry up. Health care and Social Security could swamp
the federal budget. In the shorter term, the combination of military
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spending and tax cuts could collide with spending priorities outlined by
the capital's newly empowered Democrats.
For now, the budget the president will offer today essentially counts on continued good luck. Both
he and Congress recognize that neither the war in Iraq nor the buildup in homeland-security
spending is a one-time-only expense. Both sides are talking about the need for a larger military, a
sharp contrast to the decline in post-Cold War defense spending that helped produce Bill Clinton's
surpluses.
Mr. Bush's budget estimates Iraq and Afghanistan over the next two years alone will cost about
$300 billion, and analysts say the five-year price tag could reach $500 billion. Mr. Bush is seeking
to add 92,000 troops to overall Pentagon forces over the next five years. Democrats are even more
eager to increase homeland-security spending than Mr. Bush. Indeed, the Congressional Budget
Office last week estimated a bill the House has passed to improve aviation security and implement
other recommendations of the 9/11 Commission would cost $21 billion over six years, a sum
equal to roughly half the Department of Homeland Security's current annual budget.
Democrats also have a long list of other domestic priorities to
fund, which include lower student-loan rates and more
science and health research. They've pledged to balance the
budget and adhere to rules that require tax cuts and benefits
increases to be offset somehow.
"It will be hard to attain those goals because of the squeeze
that the defense budget, and in particular that the cost of war
in Iraq, is placing on us," says House Budget Committee
Chairman John Spratt, a South Carolina Democrat. "These
expenditures at this sort of level are consequential -- they
necessitate trade-offs."
In the budget for fiscal 2008, which begins Oct. 1, Mr. Bush
has said he will show how the deficit can be eliminated by
2012 without raising taxes. The budget will give the
administration's best guess (about $141 billion) at the cost of
Iraq and Afghanistan for 2008, a departure from past
practice, and what one administration official calls "a plug
number" for 2009 -- an estimated $50 billion -- but nothing
beyond that.
The president is also expected to project spending less, in inflation-adjusted terms, on annually
appropriated spending outside of defense and homeland security. Much of that squeeze is
expected to come in proposed freezes or cuts to federal agencies and programs.
"It's going to be the tightest budget we've seen," says Brian Riedl, a budget expert with Heritage
Foundation, a conservative think tank. He predicts a call for "freezing most discretionary
programs for the next five years."
The big problem, however, remains the government's entitlement programs. Treasury Secretary
Henry Paulson says the budget deficit is "well below where anybody would have expected it to be
several years ago" despite the costs of war and hurricanes. He credits a strong economy and record
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tax receipts.
But he warns of "a looming collision with entitlements," and adds: "I have no doubt we will deal
with it. But the longer we wait to deal with it, the more expensive and the more painful it's going
to be to do it."
Some academic economists are beginning to gauge what the sums spent on Iraq could have
financed -- a down payment on a Social Security fix, for instance. Nobel laureate Joseph Stiglitz
predicts Iraq will cost at least $1 trillion, assuming troops are withdrawn by 2010. "Half that sum
would have put Social Security on a firm grounding for the next 75 years," he wrote last year in a
paper. "If we spent even a small fraction of the remainder on education and research, it is likely
our economy would be in a far stronger position."
Comparisons to Vietnam are tempting but Iraq isn't, at least yet, as costly as Vietnam, when
compared to the overall economy. It's running about $100 billion a year, or about 1% of GDP. By
the time it was over, Vietnam cost the equivalent of about $660 billion in today's dollars.
Overall defense spending today is higher than it was during Vietnam, when adjusted for inflation,
but is just about 4% of GDP. That's an increase from when Mr. Bush took office, but far from the
Vietnam peak of 9.5% of GDP in 1968, and less even than the 1980s Cold War buildup. Even
with the planned troop surge, the U.S. will have about 160,000 troops in Iraq, well below the
550,000 Vietnam peak.
It was the combination of military spending and President Johnson's
"Great Society" programs -- Medicare health insurance for the elderly and
Medicaid for the poor -- that many say led to the "Great Inflation" of the
1970s. Like Mr. Bush, Mr. Johnson at first tried to fund the war through
supplemental spending bills, a move historians and contemporaries believe
was aimed at cloaking the true costs so Congress wouldn't scale back his
ambitious domestic agenda. Inflation, which had been below 2% in the
early 1960s, was running at above 6% in 1970. By 1970, the U.S. was in a
recession.
Vietnam-era defense spending added fuel to an economy that was already
running at full employment and producing at capacity. Mr. Johnson
resisted calls for tax increases to reduce the inflation risk, fearing Southern
Democrats would instead insist on cutting social programs. The Federal Reserve, partly under
pressure from Mr. Johnson, but also because it mistakenly believed the economy had spare
capacity, was reluctant to raise interest rates. To control inflation, it had to raise rates higher later
on. By the time Mr. Johnson imposed a 10% surcharge on individual and corporate income taxes
in 1968, it was too late.
Although the government borrowed heavily in the 1960s, most of its borrowing came from inside
the U.S. Interest rates rose as a result. The yield on 10-year Treasurys, a benchmark interest rate,
began the 1960s at 4.72%; it ended the decade at 7.65%. But the private sector saved enough to
offset government borrowing, and the U.S. economy was a net lender to the world.
This time, interest rates haven't risen as much, because foreigners, particularly in Asia, are eager
to lend to the U.S. economy at fairly low rates. The economy as a whole is a heavy borrower from
the rest of the world.
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In fact, the U.S. government is particularly dependent on the willingness of foreigners to lend it
money. As of November 2006, foreigners owned about $2.2 trillion of U.S. Treasury securities --
or about 52% of the public debt not held by the U.S. government, compared with about 20% in the
early 1990s. (The total U.S. debt, which includes what the government owes itself, is about $8.7
trillion.)
Mr. Bush's ability to sustain spending and tax cuts depends largely on the willingness of
foreigners to continue lending the U.S. money. Mr. Chinn, the economist, says that at some point,
global investors will lose their appetite for ever-larger amounts of American debt. That would
trigger a decline in value of the U.S. dollar and an increase in interest rates.
"So far it's not a problem because foreigners are willing to lend, but you've got to wonder what
happens when the rest of the world says, 'We're tired of taking paper that loses value pretty
quickly,' " says Mr. Chinn.
The Bush era upturn in defense and homeland-security
spending came not during a 1960s-style boom, but in a lull
in the U.S. economy, which had tumbled into recession
even before the Sept. 11, 2001, attacks. That meant the
economy had plenty of slack to absorb increased
government spending without sparking inflation. Lee Price,
an economist who until recently was research director at the
Economic Policy Institute, a liberal Washington think tank,
says defense spending created 1.3 million private-sector
jobs between 2001 and 2005 while all other private-sector
employment fell by 1.2 million.
At the same time, the Bush administration cut taxes in 2001
and 2003 on individuals, dividends, capital gains and
estates, among other areas. The administration and some
economists credit the cuts with spurring economic growth,
saying they provided incentives to business to invest and
buoyed consumer spending.
The moment of economic slack may be in the past, which
raises the specter of inflation. Unemployment is about as
low as the Fed will tolerate, and there are some hiring bottlenecks of the sort that were common
during Vietnam. "We're starting to see tightening up in the high-tech market, and people who
were tied up with defense or homeland security are not available," says EPI's Mr. Price.
War has other costs, too. Some companies are struggling to keep jobs open for military reservists.
A 2005 Congressional Budget Office report found that "some businesses may absorb the loss of
personnel at little cost, but others may experience slowdowns in production, lost sales or
additional expenses as they attempt to compensate for a reservist's absence." The problems are
more severe for small businesses or those that employ highly specialized workers, the CBO said.
At Fallon Ambulance Service in Quincy, Mass., more than 20 of the company's 500 full-time
employees are reservists, and several have been deployed for stints lasting as long as two years.
"It does at times put a strain when we have large deployments," says Stephanie Eastwick, director
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of human resources for the family-owned company.
In the end, it may be Johnson's ballooning programs that prompt tough decision making. The
government has expanded greatly since the 1960s and has made all sorts of promises to pay
benefits, particularly to older Americans, in coming years. As war costs preoccupy official
Washington, the retirement of the baby boom generation is growing closer; the oldest boomers
turn 60 this year. There is no sign of a political consensus on changing Social Security, which has
expanded since Roosevelt launched it, or on making more affordable Mr. Johnson's health-care
programs.
Social Security, Medicare and Medicaid already consume 36 cents of every dollar that the
government spends, about $1.2 trillion this year, and are growing faster than the economy as a
whole. Defense accounts for about 20 cents of every dollar, up from 16 cents when Mr. Bush took
office in 2001, more than the government spends on education, transportation, scientific research
and housing aid combined.
"We can continue doing what we're now doing subject to foreigners being willing to finance it but
eventually it's going to do us in because Medicare and Social Security are going to overwhelm the
budget," says Charles Schultze, a Brookings Institution economist who was among Jimmy Carter's
advisers.
The Fed is watching carefully, the lessons from the 1960s inscribed in the minds of today's policy
makers. "There were plenty of signs in the 1960s that inflation was accelerating, yet monetary
policy wasn't fundamentally changed," says former Fed Governor Edward Gramlich. "Today, [the
Fed] would be more alert and is more likely to react forcefully to signs of accelerating inflation."
---- Greg Ip contributed to this article.
Write to Deborah Solomon at deborah.solomon@wsj.com1
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