Washington: Defense, Taxes, and the Budget

There are still fears that Reagan’s plans will increase inflation instead of controlling it


CERTAIN BASIC PRINCIPLES have gone unstated during the economics debates in Washington, perhaps because experts consider them too obvious to mention and non-experts may be embarrassed to ask. Two of the principles, however, have a direct bearing on the Reagan Administration’s plans to restrain inflation while increasing the defense budget and reducing federal taxes.

The first principle is that defense spending is inherently more inflationary than other kinds of government spending—a fact of some importance, considering the administration’s proposals to raise the military budget by 50 percent, measured in constant dollars, within four years. The problem with military spending, simply put, is that it adds to the demand for goods without adding to the supply. When public money is used to build bridges, subways, airports, it adds to the economic structure upon which other productive activity depends. When it is used to operate schools, clinics, and even some regulatory agencies, it contributes to a higher level of production than would be possible without a healthy, educated work force or an orderly market. The productive effect may be direct, as when the government develops higher-yielding hybrids at agricultural-experiment stations, or indirect, through tax incentives that encourage private businesses to invest in new machinery. Such public spending adds to demand (by providing wages to employees and profits to contractors) and helps increase the supply of goods and services on which money might be spent.

To a degree, that productive effect is also true of the military. Economic activity ultimately rests on an army to defend against invasion, in the same sense that it rests on a police force to maintain order and a department of public health to prevent epidemic disease. But when it comes to the “marginal” effect that is so often stressed by conservative economists these days— the effect of the next dollar, or, more realistically, the next billion dollars, that the government spends—paying a soldier or building a submarine will not add to the supply of goods. Other types of government spending, such as building a dam or giving a tax write-off for a new coal mine, will. Military and nonmilitary spending add to demand; military spending does not add to supply.

In its failure to add directly to productive capacity, military spending resembles the category of spending with which it is most often contrasted—welfare and the various pensions and subsidy programs that together are known as “transfers.” As recently as ten years ago, the “unproductive” nature of defense and welfare was not considered a fatal liability, because the prevailing economic doctrine held that the only limit to the nation’s production was how much the public could afford to buy. John Maynard Keynes himself had said during the 1930s that a government might prudently pay people to dig holes and fill them back up again, since the wages they received and spent would generate prosperity throughout the rest of the economy. When people spoke of “war booms,” such as the crash production effort for World War II that finally ended the Great Depression in the United States, they were referring to the ability of military spending— though it is not productive in itself—to stimulate the economy.

In the past decade, the major schools of political-economic thought have, with predictable differences in emphasis, all grown apprehensive about the effects of Keynesian “demand management" through spending that does not add to productive capacity. The economists who dominate the Reagan Administration have rejected such practices on principle, saying that increasing the supply of goods, rather than merely stimulating demand, is the crucial factor in restoring the nation’s economic health. (This is the origin of the term “supply-side economics.”) Most liberal economists agree in practice, conceding that America’s low rate of savings and reinvestment has aggravated inflation and eroded the nation’s ability to compete with the Germans and the Japanese. Both sides argue that less money must be consumed—or spent “wastefully”—and more reinvested in productive machinery. Every dollar spent for the military, or for welfare, is a dollar unavailable for that purpose.

The administration has made the case for increasing supply rather than demand as it applies to many domestic programs of the federal government. The same logic applies even more forcefully to military spending, because the peculiar structure of the defense industry means that increases in the defense budget often generate more inflation than the same amount of money spent anywhere else, including welfare.

Nearly every student of the subject, most recently Jacques Gansler in his book The Defense Industry, has pointed out that defense contracting operates outside the realm of normal patterns of supply and demand. There is only one purchaser, the government, and only a handful of suppliers. Because of complicated technical and bureaucratic obstacles, few new companies can freely enter the field. Therefore, when demand goes up—because the government has decided to spend more on the military—the most immediate result is that prices go up too. Only later, and to a minor degree, does increased demand draw new, competitive producers into the market and thereby moderate the increases in price. Time and again, government reports have emphasized that inflation among defense producers is chronically worse than in the rest of the economy, and that higher budgets drive that level up more. In 1980, for example, the overall price of parts, labor, and overhead for the military rose by 25 percent. So, not only does increased defense spending fail to add to the supply of goods but it also provokes an important industrial sector to behave in precisely the inflationary fashion the government is trying to thwart.

THE SECOND PRINCIPLE is that the administration’s hopes for reducing inflation through its supply-side policies rest on an iffy assumption. This assumption is not the one that has been most broadly publicized—that reductions in the tax schedules will encourage people to work instead of relax, and to save instead of consume, because they will be able to keep more of their rewards. Rather, the administration assumes that even if the federal government has to spend more money than it takes in, the damage to the economy will be slight.

According to the purest version of supply-side theory, this will never happen. Apostles such as Paul Craig Roberts, the former editorial writer for the Wall Street Journal who is now the assistant secretary of the treasury for economic policy, point out that the greatest engine of federal spending is the series of pensions and automatic benefit programs whose costs are driven out of control by two factors: unemployment, which makes more people eligible for benefits, and inflation, which raises the cost of Social Security and every other transfer program that is “indexed” to the inflation level. These apostles contend that cutting tax rates is the best way to restrain federal spending, since it will hold down unemployment (by inspiring new entrepreneurial efforts) and reduce inflation (because more goods will be produced). That is why the true supply-siders view tax cuts and budget cuts not as contradictory efforts—one tending to increase the federal deficit and the other to reduce it—but as complementary policies that together can reduce federal spending. It is also why the supplysiders have emphasized tax cuts as the fundamental element in the administration’s economic program, whether or not the budget can be cut enough to offset revenue lost through lower taxes.

But suppose for a moment that something does not work out exactly as predicted. Suppose that the tax cuts do not inspire as much new activity as they should. (The cruel fact is that even if tax rates are reduced by the full 30 percent of the “Kemp-Roth” plan, marginal tax rates for most people will be higher in 1984 than in 1980, because inflation will push people into higher tax brackets, and because sharp increases are already scheduled for Social Security taxes.) Or suppose that the stimulative effects are felt only after an unforeseen delay. In such cases, the government will likely take in less money than it is paying out. That is the definition of a federal deficit, and the crucial argument concerns its significance.

IN PRACTICAL TERMS, two things happen when the government spends more money than it takes in. One is that the money supply may expand —in effect, the government can print the money it needs to pay its obligations. The other is that the government can borrow money to cover its deficit by issuing Treasury notes or other securities. Increasing the money supply represents “inflation” in the classic sense, since it leads to more money chasing a fixed amount of goods. When the government takes the other course, borrowing money, it raises interest rates, because it is competing for the same pool of savings that industries draw from when they issue stocks and bonds and that homebuyers draw from for mortgages. This phenomenon is known as “crowding out.” Higher interest rates, in turn, can devastate industries that rely on credit—especially housing, automobiles, and many small enterprises—and raise prices in all other industries by increasing the cost of one important “raw material”: credit.

It is because of these risks that Democrats, long the partisans of deficit spending, have opposed the administration’s tax cuts. The administration has argued that there is no risk, and has rested its case on assumptions about will and about equilibrium. “Will” in this case is that of the Federal Reserve Board. Technically, a deficit can lead to inflation only if the Federal Reserve prints money to cover the government’s debts. Many in the administration say that if the Fed had the will to restrict the supply of money, there would be no need to worry about inflation. “Equilibrium” refers to the effect of interest rates on the desire to save. The administration’s theorists assume that if interest rates rise because of “crowding out,” the supply of savings will increase as well. There will be some equilibrium point at which people will be willing to save exactly the amount of money that the federal government and private companies want to borrow.

Perhaps the administration’s fearless assumptions will be borne out; if so, they will have overcome several practical obstacles. For instance, many people consider that the “will” of the Federal Reserve Board is a less serious issue than the technical difficulty of knowing exactly what the money supply is at any given moment, or of controlling it with any precision. To give just one example, there are about a trillion dollars in the currency known as “Eurodollars” — American money used for trade outside the United States but capable of flowing back into the country at any time and upending efforts to “hold the line" on the supply of money.

Prospects for ideal equilibrium are similarly chancy. The history of economics is full of “natural” equilibriums that turned out not to exist. Keynes made his name by showing how pessimism about economic prospects could destroy one kind of equilibrium: interest rates could go so low that people would have no incentive to save, and yet not be low enough to encourage businessmen to borrow and invest. That was the story of the Great Depression. It is possible that chronic inflation could produce another form of disequilibrium: interest rates could go so high that no one could afford to borrow and invest, and yet not be high enough to persuade people to save rather than consume.

The administration’s economists are assuming that there will be an equilibrium point, as they are assuming that increased defense spending will not be wildly inflationary, and that the Fed will “hold the line.” If they are right, better times lie ahead for all of us. If they are wrong, the consequences hardly bear thinking about, except perhaps by campaign strategists of the Democratic Party.

—James Fallows