Paying For the War


Thomas E. Nugent


In rapid-fire succession, the adversaries of President Bush's economic programs have left no turn unstoned. Here are two key complaints:

  1. The budget deficit will be too large with the tax cuts; interest rates will rise dramatically

  2. How are we going to pay for the war? The President is hiding how much it will "cost."

Let's take a deeper look at these two complaints that are coming from both Democrats and Republicans and put them into the proper perspective.

  1. "The budget deficit will be too large with the tax cuts; interest rates will rise dramatically."
    1. In previous recessions, the deficit reached 5% of GDP before the economy began to improve.  Today it is about 2% of GDP. Using history as a guide, until the deficit gets to 5%, the economy will have too much fiscal drag to maintain a reasonable growth path. We need a bigger budget deficit!
    2. Interest rates are controlled by the Fed, and the market's anticipation of what the Fed will do down the road.  They do not respond directly to government spending or tax policy.  The following exhibit demonstrates this fact:

                                              Prepared by the Federal Reserve Bank of St. Louis


Note the close relationship between the target Fed funds rate and the 3-month Treasury bill rate. The correlation is not a coincidence. If the Fed wanted to determine long-term interest rates, all it would have to do would be to announce at the Fed Open Market Committee meeting in March that the Fed funds rate would be maintained at 1.25% for the next ten years. Where do you think the yield on the 10-year Treasury note would be? Right! It would be close to 1.25%. The recent swing from a huge budget surplus to a rising federal budget deficit has had no impact on interest rates.

If our recent 50-year low in short-term interest rates is not enough to refute the interest rate—budget deficit connection, look at Japan's finances.  The Japanese government is running the largest absolute debt in the history of the world, their deficit is approaching 150% of GDP with annual deficits equaling 7% of GDP, multiple downgrades to something below Botswana, and 3 month Japanese government bonds (jgb's) yield 0.0001% and 10 year jgb's are at 0.70% 

    2.   "The President is hiding the cost of the war." 

How does the government pay for the war?  Does anyone asking that question actually know how the government pays for anything?  Essentially, just one way--it credits a member bank account!  

Let's do the math. The federal government writes a check to a defense company to pay for a fighter aircraft. The defense company deposits the check at its bank. When the check clears, the Fed credits the bank's reserve account at the Fed, and the bank credit's the company's bank account with ‘good funds.' (The Fed also debits the treasury's account at the Fed, but this accounting on ‘their' side of the ledger alters nothing in the private sector.) 

Bottom line:  Operationally, virtually all of the federal government's spending per se consists of the Fed crediting an account--and that's all!  There is no distinction between ‘printing money' and not ‘printing money.'  No gold bars get moved around in the basement of the Fed of New York.  The federal govt. doesn't have any ‘box of money' that gets ‘filled' from tax collections and new treasury securities and ‘used up' by spending or lending.  This is not an economic theory--it is an operational reality.  In today's world of non-convertible currencies, spending is necessarily nothing more than ‘score keeping.'  (If one football team scores a touchdown, and 6 points are added to its score, does anyone ask where the scorekeeper gets the points?) 

Likewise, tax payments simply reduce account balances in the private sector.  Nothing ‘goes' anywhere.  Sure, it's all ‘accounted for' with debits and credits on the government side of its ledger, but again, that's ‘their accounting business' and has no effect on the private sector.  

In other words, the entire spending process is not constrained by government "revenue." Whether or not the government has collected taxes or borrowed is not the relevant process. Any constraints on the process can only be ‘self imposed,' such as the government debt ceiling, ‘no overdraft rules' for the treasury at the Fed, etc.  Federal government checks will never bounce unless it decides to bounce it's own checks!

So, the actual "paying for the war" is NOT the issue!  The issue is the real economic ramifications of the proposed spending. Are the concerns of the opponents of the president's fiscal policy agenda real? Let's take a look:

Inflation? Not likely, given the amount of excess capacity in the system. Economists have been warning about deflation, not inflation.

Higher interest rates? We have provided real world evidence that there is no correlation between interest rates, government spending and budgets. Since the Fed determines interest rates, it won't begin to increase the Fed funds rate target until there is an "overheating" in the economy--when the Fed thinks the economy is too strong and needs to be cooled off. It's not a case of interest rates jumping up on their own in order to keep a weak economy down.  Rates go up or down only when the Fed thinks it's a good idea.

The real economic cost is the real resources committed to fighting the war that otherwise could have been used domestically.  With today's excess capacity (unfortunately!), there is currently virtually no opportunity cost to fighting this war.  In other words, the war with Iraq will not result in domestic shortages of goods and services.  In fact, with today's excess capacity, the increase in government spending may very well contribute towards the massive net boost in domestic demand needed to lift the U.S. economy out of recession.   


posted 3/12/2002