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Friday, May 22, 2009

War spending is the 800 lb. Gorilla

In all the reams of commentary about the economic crisis, there's one glaring omission--and that is the role of war spending. The Democratic-controlled Senate just voted in another $90 billion dollar supplemental to pay for Iraq and Afghanistan.

You don't need a degree in economics to understand that "defense" spending is out of control. Iraq is sucking in $400 million a day. This reflects a huge amount of borrowing.

I've devoted a good deal of this blog to explaining why our Iraq intervention won't succeed for strategic reasons. Then starting last fall, I exposed the real reasons behind the financial meltdown--over-expansion of the money supply by the Fed, and inadequate regulation by Bush neo-conservatives, with some help from the Democrats. What I haven't done is spend much time on the effect of war spending on our economy.

The size of war spending is so large that most Americans can't likely imagine. The federal budget has bloated, so much so that the numbers really don't mean much any more.

Rather than look at how war spending is awarded, I'd rather look at the ways government borrows, to assess just how viable borrowing will be going forward. How soon will it be before the antiwar movement can starve the Federal hobgoblin? Well, I guess when the last dollar is lent to us by the Chinese. Also, tax revenues depend on a healthy private sector. No amount of government spending can replace the benefits of healthy competition, though a transition to unrestricted free trade might be too much to handle politically.

At this point, any spending analysis needs to be realistic. We've reached a point where we can no longer control our spending. The only way the excess spending will end is when it's forced to end. Whether the Chinese lend to our government to pay for a bomb or a much needed improvement in the end won't matter much. In essence, nothing else really matters that much when the Treasury runs dry, as our whole concept of government and its relationship to us will disintegrate, likely causing ripple effects for many years. We've come to depend on government spending, and some libertarians would argue that it's created moral hazard, or the false assumption that we can outsource responsibility for our future financial situation to government.

Let's look at the basic numbers. Our 2009 federal budget deficit is on track to be the largest ever, at perhaps $1.8 trillion. That figure doesn't include the approximately $11 trillion lent through Federal Reserve discount windows--some of that we will most likely get back.

Taxes don't begin to bridge the amount we owe, not to mention the future expenditures that our government is contractually obligated to provide. Taxes which flow into the coffers of the Federal Reserve, don't even cover interest on the debt our government is accruing. One interesting footnote: it's not a coincidence that the Federal Reserve were created in the same year 1913--our taxes go to repay the bankers for buying our government debt.

Fortunately for the Feds, they have an infinite money supply they can use to simply buy government-issued bonds. This approach does have two main problems: 1) it's unsustainable and 2) the more debt that's issued, the harder it is to sell new debt. 2) is actually the same as 1), the difference is how cheaply government debt can be issued, and how much government-issued debt will have to provide in interest in order to attract buyers.

The more expensive it gets to borrow, the greater the interest burden, and that much sooner the debt becomes unattractive. Like any commodity, the price of bonds reflects the scarcity of bonds--its supply. Money is a commodity as well. Imagine if one day we elected to distribute one million dollars to everyone in America. The money might everyone a millionaire, but then again prices on everything we buy would just go up--it'd be just like before everyone got their million, except of course the value of most people savings would crumble, with so many new dollars around.

Our government has turned to foreigners and their central banks to buy its debt. As the money supply inflates, those creditors will be increasingly uneasy about the effect of inflation on their investments.

To compensate potential investors for the risk of holding dollars, U.S. government-issued bonds will need to provide more interest. As the interest on government debt goes up--a near certainty--the private sector will have to offer increasingly attractive rates of return in order to remain competitive. As it is now, corporate issuances might only yield 5 or 6 percent, about 3-4% above the "risk-free" Treasuries yield of 2-3%.

I say risk free because the U.S. government will honor its obligations, by printing up the cash to repay creditors if necessary. I put quotation marks around "risk-free" because government debt is only less risky than corporate debt because the latter lack money- printing machines. If good financial stewardship were the sole measure to assess risk, surely private corporations would score better than government, especially one like ours that cannot exhibit any fiscal restraint yet nonetheless scores as less risky, with its printing presses all inked up and ready to go.

Paradoxically, the ability to run the printing press is what makes government debt risky. Sure, government-issued debt will be repaid, but just how much will those bonds buy when they mature? Inflation erodes purchasing power, and over let's say 20 years even an inflation rate of 4 percent could more than halve the real value of the initial investment.

Of course the market takes the rate of inflation into consideration, so longer-term bonds pay better in order to compensate investors for the risk associated with long-term uncertainty.

If inflation goes beyond a certain point, investors won't want to buy Treasuries at all, as they'd soon discover that their investments could scarcely compete with the rate of inflation. And if inflation were high, few lenders would be willing to settle for corporate debt.

The ability to produce cash is paramount and this right is reserved to government. Government printing presses will be able to operate so fast that by the time people figure out how large the money supply has grown, they're stuck holding cash or Treasuries that yield far less income than is needed to keep up with inflation.

Arguably, it won't be until the government can no longer borrow that it will have to live within its means. Several key economic events could restrain government borrowing, like continued economic contraction, a war, or simply spending too much on wars, bailouts, and expenses like Medicare.

Now the neoconservatives, under the anti-government hubris of people like Grover Norquist, who claimed his intent to shrink government to the size of a bathtub, then drown it, intend to shrink spending (really spending they don't like, as I don't see "defense" programs being targeted for elimination by the Right) by "starving the beast." That expression refers to depriving Washington of funds, encouraged perhaps by overspending (since self-restraint doesn't appear to work), leading to forcible contraction in government spending.

Without money, it's thought that government would cut all those wasteful and counterproductive "social spending" programs that GOP traditionalists moan on about. In actuality, starving the beast could really cut military spending, which would be quite the opposite intent of the war lovers. After all, if it comes down to your retirement, or a parent's health care, would you cut them off before you'd cut off Halliburton, or submarine production? Better that budget cuts come down on war profiteers than the people in need of government services.

The ugly reality for the Right wing is that the self-immolating fiscal condition of government means that they'll be far fewer bombs to drop, or tax cuts down the line. The latter should be a particularly painful loss for the Right, as they count on keeping taxes low for the investment class so that they, along with a good number of Democrats, can reward wealthy campaign donors with lower taxes, even as they authorize trillions in wasteful spending on wars and bailouts.

If something can't go on forever it won't. Eventually money available to buy Treasuries will run out. The foreigners who own large pools of dollars might simply repatriate their holdings, or convert them into their domestic currencies--kind of like what we saw happen to the Yen, hardly an enviable outcome for the Japanese, whose appreciated currency makes export growth difficult.

Now, the Federal Reserve raises cash by selling bonds back to the government, a system which might not last if investors don't continue to buy the Treasuries. We could resort to self-purchase, and that might increase demand for and the price of government-issued debt, but only in the short-run. The more the government faked it, and the more it spends on its own bonds in this way, the less appeal the dollar has. A weaker dollar diminishes the appeal of Treasuries due to the fact interest rates need to rise, and the pries of bonds to fall, in order to make purchases of government-issued debt attractive in the inflationary environment.

No government can continue deficit spending forever. They'll be stopped, largely from inflationary consequences--too many dollars entering circulation.

If the government resorts to printing cash to buy bonds, it will likely damage investment in the private sector. Unable to borrow, corporations would be less likely to expand and economic growth could stagnate, called stagflation.

Even if the government could buy its own bonds forever, or foreigners willingly finance our budget and trade deficits to infinity, the economy would hardly prosper.

Strike one: Government jobs

Creating jobs in the public sector, it turns out, doesn't do a very good job at stimulating the economy over the longer term. The reason is simple--people are more productive when forced to compete. Free enterprise and the competitive spirit brings out the best in us. Far more effective is for the private sector to produce jobs.

Private sector job creation depends on the financial health of the consumer--so it becomes politically necessary to take some of the edge off the correction by creating jobs in the public sector.The political imperative to sustain economic growth makes government jobs vital in reducing unemployment.

Jobs created by the government tend to be less beneficial to the economy than private sector one but they are preferable to mass unemployment, especially considering the status of the US labor market these days, damaged as it has been by cheaper foreign competition and unrestricted trade. Private sector employment has fallen, and many of those jobs were in higher pay, or manufacturing, and many are likely gone forever.

Sustaining government employment gets increasingly burdensome. Federal employee unions negotiate perhaps too effectively, wages rise, and few get fired. As the Federal payrolls swell, the budget bloats with employees hired during every the last recession who never went away. Productivity sags.

Of course swollen payrolls damage the budget. But most spending is generated painlessly by government borrowing. Whatever the longer term cost might be, maintaining a large base of stable government jobs helps avoid political fallout caused by the shrinking economy and higher unemployment. We know politicians can't think past the next election, so what happens to our budget in the future just isn't a priority.

Government jobs serve as more than a release valve for the societal pressures that emerge during down times in capitalism's boom and bust cycle. Government jobs have become an economic dependency, the primary way of preventing a decline in wages and unemployment.

Perhaps not by coincidence, the shocks caused by economic crises tend to be most threatening to the political class, and economic strife threatens the status quo. Avoiding the societal impact of an economic contraction therefore becomes a political objective. And once political priorities take precedence over economic issues, look out, for manipulation of public perception is on the agenda.

Keynes explained government job creation as a worthy expenditures in times of economic contraction. Plus, we could probably use a few good civilian labor programs building our infrastructure, etc.. Yet we've taken to a state of permanent subsidies, not just in times of economic contraction, but as standard operating procedure. Most troubling is the reality that a state of permanent war economy serves as purpose of perpetual spending, a raison d'etre for the massive expenditures needed to keep our economy, so dependent on the war economy, from collapsing. Can the debt train continue forever?

Strike two: Inefficient Government spending

Much government spending flows to contractors. And these days with no-bid and cot-plus contracts, there's far less competition between contractors. So when government spends money, it's not encouraging competition, it's actually destroying it.

Typically the corporate recipients of large federal contracts exist by virtue of their relationship with government--nowhere is this relationship clearer than in military spending. Retired general serve on the boards of these contractors; they exchange their influence with active duty military personnel assigning the contracts.

So bad has the spending on private contractors got that the Pentagon has actually asked Congress not to continue funding certain military programs. In short, military spending is the ultimate pork--it flows to those districts whose representatives have the most influence in Washington. Jobs are traded, and the corporations keep making profits, a portion of which they devote to campaign donations for their politician friends.

Yes, some weapon systems are good. But just look at how inefficiently government spending is allocated. The influential Chris Dodd (D-Conn.) gets his fleet of submarines built at Groton despite their questionable value in fighting terrorists. Various districts get F-22 Raptors, and countless other military systems. Meanwhile the Army can't get mental health screenings done, and five die at the hand of a fellow American soldier seeking help--or rejecting it?, while an ex-soldier gets life for raping and killing a 14-year-old Iraqi girl.

These behaviors aren't normal, and don't just happen. I'm reluctant to believe that the people involved would have killed had they been diagnosed with Post-Traumatic Stress Disorder, and treatment begun. Instead our soldiers are sent to do multiple tours with limited support both on their jobs and at home. Still, we send all those billions out to private corporations, to feed their bottom line despite the real, urgent needs lying elsewhere.

Government spending is therefore misdirected, and subject to lobbying influence which creates a positive feedback loop for the politicians who get jobs and donations that then allow them to keep getting reelected. Nothing really changes, so change can't come even if politicians sell themselves on its power.

Government spending on buying bombs or building aircraft carriers is inherently inefficient.

A bomb, can do little good. Once built it can offer no benefit--like nuclear waste, it must be safely housed, creating a financial liability. The bomb's utility is also questionable, being that it will likely result in collateral damage, civilian deaths, which in turn will likely strengthen the insurgency, making a peaceful resolution that much harder, an outcome that in turn will make the dropping of more bombs--and their ongoing production and sale to government--all the more likely.

Military hardware has a lower "multiplier effect," meaning that kind of spending will generate less economic activity than private sector spending. Even direct "social welfare" payments tend to circulate around the economy, at higher velocity than big ticket military money. If we gave a million dollars to one thousand people, they'd like enter circulation and spur spending. If we spend a million dollars on one contractor, the money would likely disappear--there'd be far fewer direct economic impacts.

Maybe the contractor will buy a nicer house, or vehicle, so the money isn't wasted, it's just not as stimulative. Although, oddly, when George H.W. Bush placed a surcharge on US-built yachts, the impact on yacht-builders, dock services, painters, and other Middle Class people was significant. The US-economy might be stimulated by spending by the rich more so than other places, so maybe spending on luxuries isn't bad after all.

Building an aircraft carrier typifies the excesses of waste and inefficiency in government spending. The builder of an aircraft carrier will likely be spending indiscriminately, through many layers of subcontractors, each of whom will take a certain percentage off the top. When all is said and done, at the end of the day, when the carrier stands built, a good percentage of its overall cost will be attributable to waste.

Private sector business activity is more efficient. Products made for consumption need to appeal to the consumer's timely wants and needs, not the arcane stipulations of government. Now there's a big system in place to manage contracts and spending, but this doesn't translate into efficiency.

Government expenditures aren't meant to make the economy more efficient--they are directed towards alleviating a problem generated by the exercise of free market capitalism. Societal ills are meant to be fixed by government spending, which considers itself a more noble redistribution of wealth from the less needy to those in trouble.

Crowding out

There's good reason to avoid excessive government borrowing, beyond the obvious stupidity of military occupations of indeterminate length with questionable results. An economics phenomena called crowding out occurs when government spending goes up. Money ends up flowing into government-issued debt instead of private sector investment.

Government expenditures produce less real economic growth than money invested in private companies. So very dollar lured away from the private sector and into government bonds is one that could do a lot more to help the economic recovery. This problem becomes far more acute when governments control spending and have to actually balance their books every year, like what we see in places like California.

The major impact of higher borrowing costs is that corporations are a lot less eager to borrow as it has to pay out a lot more in interest. If they can't attract capital as cheaply, they will likely hold back on plans to expand employment, invest in new factories, and start up new operations. Without those things, the recessionary environment could continue, which would make old debts that much harder to pay out of operating profits.

The Political Price of Economic Inequity

Now the costs to society of unregulated free market capitalism, called also hyper-consumerism and American-style capitalism, are quite immense. The wealth of the richest 1% soared under Bush; rather than address the growing wealth gap, a sort of Ayn Randian belief swept the halls of power which said the rich deserve to get richer--as they were doing things right--while the poor deserved all they got--nothing--as they weren't doing what they needed to in order to get ahead.

As it turns out, the rich weren't getting richer because they were smarter or more hard-working, but instead because they exercised political influence, and deregulated the markets, which made them richer at the expense of the public. Now, as all the bills for previous irresponsibility come due, the true cost of deregulation is becoming apparent. The rich, with all their billions sequestered away in the Caymans, did profit. Yet they too have been caught up in the market downturn, so they haven't emerged unscathed from the after-effects of government by and for the benefit of the wealthy.

Somewhere along the way the investment class lost their way. One characteristic of greed--the "healthy" emotion that was supposed to encourage success in a capitalist environment--is that the rich can never be rich enough. Once wealthy, the ambitious climber can only be satisfied by becoming ultra-rich. Clearly this approach is like chasing the wind as no amount of money can fulfill bottomless greed.

Far better is an investment environment which nourishes investors at all levels. We saw this during the 90s, when middle class people got involved in the stock market. As ownership spread out, people of lower income were able to enjoy the benefits of investment. As a result, tax revenues went up.

Then after the stock market dotcom burst and in the subsequent Bush years, something changed. By narrowing the practice of investing, fewer Americans participated. Public sentiment for investing went from overinflated expectations about rising internet stock prices to abject defeat.

Volatility is part of the free market capitalist experiment. Well-coached investors should be told--but rarely are--that higher potential rewards bring with them higher risks. Instead, in the fervor of the high-pitched, high-flying trading environment, Americans deluded themselves into thinking the market would go up forever then, when the inevitable crash came--they pitched back to reality as margin calls came in, dotcom millionaires went bust, and day traders went back to day jobs.

The nasty consequences of this unpleasant market shock have made themselves felt now, years later, as we face a recession. While the wealthy got rich, most people actually lost much of their net worth, which has become tied to residential real estate.

Like the dotcom bust, everyone got euphoric about their rising home values. Incapable of restraint in a consumer society were spending is the highest virtue, millions of people proceeded to cash in on rising home values by borrowing through home equity loans. They believed the rising resale value of their homes would cover the cost of their consumptive indiscretions.

Now, in this sort of bipolar American swings between excess despair and glee, people realize investing in their homes wasn't "where it's at." Home prices plunged, and foreclosures skyrocket. We've begun the long swing to the next extreme, one in which people dump real estate and seek out some hot new bubble to throw their money. Prices need to go down in order to make homes more attractive, all the federal subsidies directed at Freddie Mac and Fannie Mae may do little to invigorate housing prices.

The real economy

Whatever you might think about the capitalist system and its flaws, it is still the best we know of. Does it need tweaking? Yes. Can we simply de-regulate and assume the economic growth will be sustained? No. Nor can we throw huge sums at our military and prison industrial complexes and say our economy is growing. No, our economy is not growing, Catherine Austin Fitts might say, just consuming itself, as if a tapeworm were devouring the source of its sustenance.

One characteristic of the Bush years is that the share of GDP (itself a misnomer as we don't really "P"--produce much at all) attributable to financials is 40%. If you ignore the piles of money being shoved around as not constituting real production, you'd have to say goodbye to more than one third of our "growth." It's even possible that our real economy has been contracting for years, and that the growing size of the financial industry--in paper profits--has disguised the underlying weakness of our economy.

Coupled with manufacturing decline, the growth of the financial sector in profits and incomes--until recently--means that it contributed a large portion of the so-called "growth" in the economy. And we know a good chunk of revenues in the financial sector were produced in their recent past through accounting gimmicks and derivatives sleight of hand. As the much lower, real values of financial assets is made known--piercing the veil of government statistics--so too does much of the vaunted growth in our economy over the past decade disappear.

Ironically, the democratization of investing brought less risk of increased tax burdens on the rich, who now wear bulls-eyes on their back for the tax man. The richer the average man became, the less likely he was to need help. Now with the economy collapsing, the less wealthy grow even more dependent on government. And those with political influence need to exert more and more in order to continue to receive government contracts. Also, tax loopholes for the rich could dry up as the imperative of increasing tax revenues begins to outdistance the level of influence the investor class can exert.

Interestingly, we can hope for some justice perhaps in the eventual decline of the investor class--at the mercy of the taxman, who will likely turn to the rich once the meager wealth of the lower classes is drained, either by higher taxes or inflation, coupled with a lack of housing appreciation, upon which middle class people very much depend. It's also possible that the American people will wake up, and vote out the political system which is destined to impoverish them by over-burdening them with debt. Far more politically expedient it could become for the politicians to villify the rich. Yet that would take considerable political change and turmoil, which won't bode well for the wealthy (i.e., the scene on the upper west side in Gangs of New York.

We could change how government spends, and how much it spends, to relieve future Americans of the burdens of higher taxes and diminished benefits. But we don't. the status quo is bent on maintaining a society where wealth increasingly congeals around the investor class, which in turn helps fund the campaigns of incumbents. To get control of our spending, and our government, we'll ultimately need to revise the system that allows such self-destructive practices to take root and prosper. One quick way to rectify the situation would be to reduce war spending.

Further Reading

From truthdig comes an excellent article by Chris Hedges on the state of permanent war that our leaders have decided we need.

About the bankers is Simon Johnson's article in The Atlantic, "The Quiet Coup."


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