Warfare on the Installment Plan

America is financially overstretched at home more than abroad.

War finance is not rocket science. Wars are usually too costly to pay for exclusively out of taxation, particularly since they often depress economic activity, reducing tax revenues precisely when government expenditure is rising. So wars tend to be financed by a mix of new taxation and borrowing.

Broadly speaking, there are three ways to go about the latter. The first is to borrow from a subservient central bank, which prints the money to pay your soldiers and arms producers in return for IOUs called Treasury bills. This is easy to do, but the resulting monetary expansion nearly always leads to inflation.

The second method is to sell bonds to the public, which effectively diverts its savings into government debt. This avoids inflation and has the benefit of spreading the cost of war over time and between generations but may lead to the "crowding out" of private-sector borrowers and unpopular transfers from taxpayers to bondholders.

The third method is to sell Treasury bills, bonds and other financial assets to foreigners. Provided the various securities are denominated in your own currency, you retain the option of devaluing the war debt through currency depreciation. This may seem like the smartest way to proceed until you remember that he who pays the piper (or lends to him) may call the tune. And even if you end up fooling the piper by inflating away what you owe him, he is unlikely to fall for the same trick twice.

In his admirably comprehensive history of American war finance, Robert D. Hormats shows how U.S. administrations have made use of all three methods at various times of armed conflict, borrowing from abroad to secure independence, printing money in the Civil War and selling bonds at home during the world wars. "Sound national finances," he observes, "have proved to be indispensable to the country's military strength." The big question his book raises is this: How soundly are we financing the war on terror?Mr. Hormats is currently a managing director of Goldman, Sachs & Co., the firm that has produced two of the past five Treasury secretaries. As a former member of the National Security Council, deputy U.S. trade representative and assistant secretary of state, he has experience of public office as well as private finance. "The Price of Liberty" shows that he knows his history too.

Among the Treasury secretaries who win his accolade of "sound" are Alexander Hamilton, who consolidated the post-Revolutionary debt and made protectionist tariffs a keystone of federal revenue; Salmon P. Chase, who ensured that the Union won the fiscal and monetary war against the Confederacy; and William Gibbs McAdoo, who withstood the global financial storm unleashed when Europe went to war in August 1914. Mr. Hormats also gives credit to Congress where it is due. The federal income tax, for example, would not have made it onto the statute books in 1913 without the efforts of legislators like Cordell Hull.

Surprisingly, though, this book's real hero is President Dwight D. Eisenhower. As Mr. Hormats shows, Eisenhower's genius was to steer a middle course between the competing demands of an insatiable "military industrial complex" and an often irresponsible tax-cutting Congress. By restraining military spending and maintaining sensible tax levels, Ike made certain that the U.S., unlike its Soviet rival, waged the Cold War without ever losing its fiscal cool.

"Under conditions of high peacetime prosperity," Eisenhower declared in 1956, "we can never justify going further into debt to give ourselves a tax cut at the expense of our children." His farewell address was a paean of praise to sound finance: "We cannot mortgage the material assets of our grandchildren without asking the loss also of their political and spiritual heritage. We want democracy to survive for all generations, not become the insolvent phantom of tomorrow."

These are words that Mr. Hormats wishes President George W. Bush would learn and inwardly digest. For, in his view, the U.S. today is "liv[ing] beyond its means" and thereby "jeopardiz[ing] its ability to fund its national security requirements." Calling for "curbs on nonessential spending" and a "tax policy that avoids chronic deficits," Mr. Hormats laments the growing dependence of the U.S. Treasury on foreign capital. "Another terrorist attack," he argues, "could precipitate a dramatic reduction of capital inflows," not to mention "a spike in U.S. interest rates and collapse in the value of the dollar." The U.S., he concludes, "is living in a post-9/11 world with a pre-9/11 fiscal policy. . . . A heavily debt-laden, overobligated, revenue-squeezed government, highly dependent on foreign capital, creates major security vulnerabilities."

Such arguments have, of course, been heard before. In 1987, for example, the Yale historian Paul Kennedy warned of the effects of American "overstretch." As the Cold War reached its expensive climax, this pessimism was not unintelligible. The puzzle is that, by contrast, the U.S. today is far from overstretched by the costs of its military commitments. Indeed, seldom in the past 50 years has being a superpower been cheaper.That observation may surprise those readers who have seen alarmist estimates of the total cost of the war in Iraq, like the $2.2 trillion figure recently calculated by the economist Joseph Stiglitz. Yet even Mr. Stiglitz's figure, which is a projected total for the entire period from 2003 to 2015, is dwarfed by the vast size of the U.S. economy. With annual gross domestic product in excess of $13 trillion, the U.S. can readily afford to fight more than one small war--and, compared with the world wars, Korea and Vietnam, what is going on in Iraq and Afghanistan today is pretty small.

Still not convinced? Just consider the long-run U.S. defense budget as a percentage of GDP. In the 1960s, it averaged 8.4%; in the 1970s, 5.6%; and in the 1980s, 5.7%. Under President Bush, however, it has averaged 3.6%. We flatter al Qaeda when we bracket it along with the Red Army.

The fiscal problem today, as Mr. Hormats acknowledges, is not so much national security as Social Security--to say nothing of Medicare and Medicaid. Between them, these are the programs that threaten to undermine the long-term fiscal health of the U.S. as the baby boomers retire. In other words, the danger today is not external but internal overstretch. I support the reform measures that Mr. Hormats calls for, such as a "national drive to develop new sources of domestic energy" and an end to the use of supplemental appropriation requests to fund the Iraq war. But I am left wondering how he would tackle the vast unfunded liabilities of the Medicare and Social Security systems, which are the real hole in the boat.

In his farewell address, George Washington called on Congress "to discharge the debts which unavoidable wars may have occasioned, not ungenerously throwing upon posterity the burdens we ourselves ought to bear." The debts that currently menace posterity are the consequences not of warfare but of welfare. It remains to be seen if the U.S. can produce a Hamilton equal to the task of dealing with them.

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