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How to Wreck the Economy

America’s New Beginning: A Program for Economic Recovery Budget

from the Executive Office of the President/Office of Management and
US Government Printing Office, 270 pp., $7.50

Fiscal Year 1982 Budget Revisions Budget

from the Executive Office of the President/Office of Management and
US Government Printing Office, 159 pp., $5.00

The recent discussion of President Reagan’s budget has largely overlooked its most alarming feature, so far as the US economy is concerned. Reagan is proposing to increase defense expenditures by $142 billion, from $162 billion for the fiscal year 1981 in the current budget to $304 billion in fiscal year 1985, the last budget of his first term. If re-elected he is planning a further $39 billion increase, to $343 billion in fiscal 1986.

This $181 billion increase over five years can be understood only if it is compared with the build-up of military spending during the Vietnam War. In the five years between 1965 and 1970 military spending rose by $24.2 billion, and soon after rose to a peak of $26.9 billion. After correcting for inflation, a $26.9 billion increase then would be equivalent to a $59 billion increase now.

As a result the military build-up that is currently being contemplated is three times as large as the one that took place during the Vietnam War. Whether an increase of this magnitude is really necessary depends on an analysis of foreign affairs and military readiness that is beyond this review. Some defense experts and legislators are questioning whether many items in the new military budget are actually needed and whether some of them endanger national security more than they protect it. Such questions are certainly important and must be raised. But if such a build-up is necessary, then it is important that it be done in such a way that it does the least possible damage to the economy.

The Reagan budget has not been clearly understood because, perhaps deliberately, it has been presented as a set of subtractions from or additions to the Carter budget. The policies of President Carter are now irrelevant. It makes no difference what he proposed. Everything that is in the budget is now a Reagan proposal. The only questions to be resolved turn on what President Reagan wants.

In addition to the increase in the military budget, civilian expenditures are scheduled to rise by $76 billion—from $493 billion to $569 billion. After correcting for inflation, we can see that civilian expenditures are down substantially by 16 percent, although they rise in money terms. As a result the total budget increases from $655 billion in fiscal 1981 to $912 billion in fiscal 1986. In addition, President Reagan is proposing a 16 percent reduction in federal tax collections—$196 billion in fiscal 1986—in order to stimulate savings and investment.

President Johnson’s refusal to raise taxes to pay for the Vietnam War is legitimately remembered as one of the key factors leading us into our current economic mess. He wanted both the Great Society and the war. But if he was to have both and not wreck the economy, his only option was to raise taxes sharply. He chose not to do so, and he wrecked the economy.

President Reagan wants both dramatic tax cuts to encourage investment and an even more extensive military build-up. But he cannot have both without wrecking the economy further unless he is willing to raise taxes dramatically on private consumption. He has chosen not to do so. If his current program is carried out, he too will wreck the economy.

Military spending is a form of consumption. It does not increase our ability to produce more goods and services in the future. While it may be necessary, it is consumption nonetheless. And as in any private budget, if you allocate more to one form of consumption, you must allocate less to some other form of consumption.

This means equivalent cuts must be made in other forms of consumption. The proposed military increase is so large that it cannot be fully paid for with cuts in civilian expenditures unless the president is willing to abolish major social programs such as Social Security. If he is not willing to do this, taxes must be raised to cut private consumption.

While President Reagan is only preparing for war and not actively engaging in one, the economic problems of military spending spring from the rapid production of weapons, not from their use. The capacity to produce capital goods and equipment, skilled manpower, and raw materials must all be quickly redirected to military production. In shifting both human and capital resources from civilian to military activities tremendous strains are placed on the domestic economy, unless measures are taken to restrain private consumption. Without tax increases the military can get only the necessary capital capacity, skilled manpower, and raw materials by paying more than the civilian economy is willing to pay. This drives up prices and creates civilian shortages.

The problem is compounded if tax breaks are to be given for investment, as is contemplated by Reagan’s economic plan. The capital goods industries cannot produce enough equipment to build both military factories and civilian factories. The investment tax reductions therefore encourage private investors to get into a bidding war with the military for the industrial equipment that is available. The result would be a rapid rate of inflation in capital goods that would eventually lead to inflation in consumer goods. Inflation would break out, as it did during the Vietnam War, but this time the US would be adding inflation to an economic system that already has an 11 percent rate of inflation rather than to a system that had an inflation rate of less than 2 percent.

Unfortunately the negative effects of such a military budget and such a tax policy do not emerge quickly. Remember the acceleration in inflation during the Vietnam period. It was very slow but very persistent. During 1965 inflation stood at 1.7 percent per year. From there it rose to 2.9 percent in 1966-1967, to 4.2 percent in 1968, to 5.4 percent in 1969, and to 5.9 percent in 1970. President Nixon temporarily stopped inflation with wage and price controls in 1971, but when those controls were lifted inflation broke out in an even more virulent form, and has continued to this day.

As with President Johnson, the mistakes of President Reagan will only become obvious long after they have been made. By the time they are obvious, it will be too late to correct them. If the mistakes are to be corrected and the undesirable effects avoided, the correction must be made now—not two to three years from now.

President Reagan talks as if his cuts in civilian government consumption are going to pay for the extra military spending. But he also talks as if those civilian budget cuts are going to pay for the loss in revenue from business tax cuts and from the 30 percent cut in personal income taxes called for by the Kemp-Roth plan. But the sums that will be spent and saved do not match. A $138 billion cut ($43 billion of which has not yet been announced) in civilian expenditures—not an absolute cut but one relative to the Carter budget—simply does not counterbalance a $196 billion tax cut and a $181 billion increase in military spending.

If the Reagan administration were to carry out its current plans, it would have no rational alternative to a large tax increase on private consumption. If we were actually to fight World War III, we would instantly increase taxes to pay for it. If we want quickly to buy the equipment the administration claims is necessary to fight World War III, we have to be willing to do the same.

If the administration is unwilling to raise taxes on private consumption, it will repeat the Vietnam experience. Initially output will rise and unemployment will fall. But eventually a sustained inflation will result from the economy’s inability to produce both the civilian and military goods that are being demanded of it. But the economic problems of a large increase in military spending go far beyond that of simply keeping total consumption under control. The defense department does not demand exactly the same commodities that civilians give up when their after-tax income goes down. Even if taxes are raised by the requisite amount, essential supplies will have to be directed to military uses without completely disrupting the civilian economy.

To do this, most countries when they decide to wage war or prepare for war traditionally impose controls over production, wages and prices, raw materials, and capital equipment. In this respect, the Korean War is a model of what to do. The Vietnam War is a model of what not to do.

During the Korean War America raised taxes dramatically at the beginning of the war and imposed a full range of wartime controls. When the war proved to be smaller than was first expected, those controls could be gradually eased with no disruption to the civilian economy. Instead of rising during the war, inflation fell from 6.6 percent in the first year of the war to 1.6 percent in the last year of the war.

By contrast, during the 1960s the US did none of the things that would have been necessary to fight the Vietnam War without economic damage. Military spending reached a peak of 13 percent of the gross national product during the Korean War and only 9 percent in the Vietnam War, but the economic damage was far greater during the Vietnam War. The economics of war production calls for planning for the worst possible economic effects and then being pleasantly surprised if the worst does not occur. Perhaps our economy will be able to take the current build-up without being wrenched out of shape, but no one should count on it.

The economic problems of the military build-up planned to take place between 1981 and 1988 are complicated by the current weakness of the American economy and the economic strength of the countries that are our military allies but our economic adversaries. When a nation such as the US sharply increases its military forces, it generally does so at a time when its industrial competitors are also attempting to increase their own military establishments, and are experiencing comparable economic strains. But the Reagan build-up is to take place in a time when our allies are not raising their military expenditures at anything like our pace. Germany has just announced plans to cut back on its defense budget.

This difference poses the problem of how the US can maintain the industrial strength to compete with other countries in civilian production and sales. The basic problem here is not so much one of obtaining critical raw materials and equipment, although there may be shortages of both, but is one of skilled workers—craftsmen, engineers, and scientists. Such people will tend to be attracted to military production. Defense contractors will entice workers away from civilian firms by paying higher salaries as they build up their work forces on a crash basis. But even if the salaries were identical there would be a tendency for the most highly qualified people to move into defense. For most engineers, such work is simply more exciting.

Would the typical engineer rather work on designing a new missile with a laser guidance system or on designing a new toaster? To ask the question is to answer it. Military research and development are more interesting since they are usually closer to the frontiers of scientific knowledge and are not limited by economic considerations such as whether the product can be sold in the market. The military is willing to pay almost any premium to have a superior product. The civilian economy is not. As a result the most skilled technicians and scientists move into defense.

But suppose you own a civilian computer firm in Boston and many of your best people leave to work in Boston’s higher paying and more exciting aerospace firms. How do you compete with Japanese computer firms that will not be losing their most brilliant employees? The Japanese engineer might also like to work on missiles but he does not have the opportunity to do so. The result is that you cannot compete; the Japanese computer industry could well drive the American computer industry out of business.

A military build-up of the magnitude proposed by President Reagan almost demands that the US insist that its military allies, who are also its economic competitors, engage in a similar military build-up. From the point of view of equity, the American taxpayer cannot be expected to accept a large reduction in his standard of living while taxpayers abroad continue to improve their standards of living. But even more importantly, America cannot afford to destroy the competitive strength of its none-too-strong domestic economy. If the skilled workers and funds that are used for defense here are used for civilian production abroad, it should not come as a great surprise if we are driven out of civilian markets. What will happen to the United States if the industries that manufacture semiconductors, micro-processors, and computers are forced out of business while the nation is busy rearming itself? What good does it do us to dominate the world in missile production if we are at the same time being defeated in toasters? In the long run, a civilian economy that consistently fails in competition abroad will be unable to produce missiles for an effective military economy.

According to the Reagan economic scenario, the burden of total government spending will shrink not because of a decrease in that spending, but because there will be an explosion of economic output. After we correct for inflation, output is supposed to grow 23 percent during the next five years.

This explosion in output is predicted for an economy where growth in productivity has been gradually slowing down since 1965 and has in fact been negative during the last three years. The Reagan administration assumes that productivity is going to return to a 3 percent rate of growth almost instantly, but what will make this happen? Such an increase in productivity has never happened before in our history, and there are good technical reasons for believing that it will not happen now.

Our slowdown in productivity is caused by many factors, including an increasing movement toward services, and sharp declines in construction and mining productivity. These are not going to end suddenly. And the same slow transition will occur in the part of the economy on which the Reagan administration is focusing most of its attention—investment. New investment takes time. Major new industrial facilities typically take from five to ten years to complete, so we will have no output from them for five to ten years. Consequently they will not be raising productivity for five to ten years.

If a little extra investment would cure our productivity problem we would not have such a problem at all. When productivity was growing at more than 3 percent per year, from 1948 to 1965, Americans invested 9.5 percent of their GNP in industrial plant and equipment. While productivity was falling 0.5 percent a year from 1977 to 1980, Americans invested 11.3 percent of their GNP in industrial plant and equipment. We need more investment, but investment cannot cure the productivity problem in the short run.

But in planning a major military build-up, a wise economic general does not argue about whether there will, or will not, be a dramatic rebound in the growth of productivity. He plans such a rapid increase on the conservative assumption that there will not be a sharp change in productivity and hopes to be pleasantly surprised if productivity does in fact dramatically improve. No permanent damage occurs if he plans for slow productivity and finds that productivity is actually growing rapidly. He can always easily cut taxes if the economy has extra unused productive capacity. But if he plans for rapid growth in productivity and it does not occur, the economic damage will be great. Taxes can be raised later on, but as the Vietnam War demonstrated, a tax increase in 1969 does not substitute for a tax increase that should have occurred in 1965.

If vigorous growth resumes, as the Reagan administration assumes it will, the defense budget will generate the kinds of economic stress that we experienced during the Vietnam War. Under Reagan’s assumptions about economic growth, the military budget will consume an extra 1.5 percent of the Gross National Product. Vietnam consumed an extra 1.7 percent. But if vigorous growth does not resume, the strains will be far more serious. The military will be absorbing an extra 2.4 percent of the GNP. As a result we should plan for those larger stresses but hope for the smaller ones.

These economic difficulties will also be magnified by the plans for the civilian budget. A 16 percent cut in taxes is supposed to stimulate savings and investment but it is directed at the wrong targets. Any across-the-board tax cut such as Kemp-Roth must confront the fact that the average American family saved only 5.6 percent of its income in 1980. Past experience strongly suggests that given a $100 tax cut, the average American will save and invest $5.60, but will also consume $94.40. In view of our needs for investment and of the military program the administration demands, we simply cannot afford to add private consumption of this magnitude to our economic system. We should be cutting consumption.

Similarly, many of the investment tax cuts proposed by Reagan are poorly conceived. A cut in the capital gains tax that includes both investment in plant and equipment and speculative investment—in land, homes, gold, antiques, paintings, etc.—may suck investment funds out of productive investments and into speculative investments, since speculative investments pay off faster than productive investments. But we need productive investments not speculative investments. If supply-side economics were to make sense, it would include tax increases for speculative investments.

The current proposal for accelerated depreciation on a “10-5-3”* basis gives the largest breaks to commercial buildings and may well encourage the construction of more shopping centers rather than industrial factories. Here again the largest tax breaks should favor new industrial facilities.

The administration’s cuts in the civilian budget have relatively little to do with economics. They are good or bad depending upon your view of what constitutes adequate provision for the needy in a good society. My ethics tell me that there is something wrong with cutting nutrition programs for poor pregnant women. Mr. Stockman’s ethics tell him that they are precisely the group whose benefits should be cut. Perhaps that is the difference between learning ones’ ethics and economics in a department of economics rather than at a divinity school.

There is, however, one major economic problem with the proposed cuts in expenditures. Most of the cuts focus on the working poor—essentially the group that is above the poverty line but within $3,000 of it. This group is going to be faced with a choice. The Reagan administration assumes that a cut in the social welfare benefits for the working poor will force them to work more. It is more likely that it will encourage them to work less to regain eligibility for the programs that they have just lost.

Suppose you are one of the working poor and have a sick child. One choice is to work harder—perhaps by taking a second job—in order to pay the necessary medical bills. Another is to quit working to make yourself eligible for Medicaid. To pose the choices is to give the likely answer. If the second choice prevails, the remaining social welfare programs will have to expand and will cost more than expected. The cuts in the civilian budget will therefore be smaller than the ones now projected. The result will be that the grave strains imposed on the economy by Reagan’s military build-up will become graver still. The dangers of this budget are such that I can think of no priority higher for the nation’s economic welfare than close and skeptical scrutiny of all new military expenditures to determine whether they are really needed.

April 6


Reagan’s Deficit September 24, 1981

  1. *

    This means that autos and light machinery can be depreciated over three years; other, generally heavier, machinery over five years; and a variety of real estate over ten years.

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