LegiStorm

Summary:

The increased government outlays associated with wars can be financed in four ways: through higher taxes, reductions in other government spending, government borrowing from the public, or money creation. The first two methods are unlikely to have an effect on economic growth (aggregate demand) in the short run: the expansion in aggregate demand caused by greater military outlays is offset by the contraction in aggregate demand caused by higher taxes or lower non-military government spending. The latter two methods increase aggregate demand. Thus, a by-product of American wars has typically been a wartime economic boom in excess of the economy's sustainable rate of growth. Wars may shift resources from non-military spending to military spending, but because military spending is included in GDP, it is unlikely to lead to a recession. Just as wars typically boost aggregate demand, the reduction in defense expenditures after a war removes some economic stimulus as the economy adjusts to the return to peacetime activities. The economic effect of World War II stands in a class of its own. More than one-third of GDP was dedicated to military outlays. Budget deficits were almost as large; these large deficits were made possible through policies that forced individuals to maintain a very high personal saving rate. Money creation was a significant form of financing, but the inflation that would typically accompany it was suppressed through widespread rationing and price controls. Private credit was directed toward companies producing war materials. There was a significant decrease in non-military outlays and a significant increase in taxes, including the extension of the income tax system into a mass tax system and an excess profits tax. President Truman attempted to avoid financing the Korean Conflict through borrowing from the public or money creation—budget deficits were much lower than during any other period considered—but the economy boomed anyway. Tax increases and a reduction in non-military spending largely offset the increases in military outlays. President Truman relied on price controls to prevent the money creation that did occur from being inflationary. Vietnam, the Reagan military buildup, and the two wars in Iraq were not large enough to dominate economic events of their time. The beginning of the Vietnam Conflict coincided with a large tax cut. Non-military government spending rose throughout the Vietnam era. Most of the conflict was deficit financed, although tax increases occurred at the peak of the conflict. Inflation rose throughout the period, and President Nixon turned to price controls to suppress it. The beginning of the Reagan military buildup also coincided with a large tax cut, as well as an effort by the Federal Reserve to disinflate the U.S. economy. Thus, borrowing from the public, and later a reduction in non-military outlays, offset most of the rise in military spending. Unlike earlier conflicts, liberalized international capital markets allowed the United States to borrow significantly abroad for the first time, which many economists believe caused the large trade deficits of the mid-1980s. Desert Storm took place among rising budget deficits and rising taxes. It was the only military operation considered to largely occur in a recession. The ongoing wars in Iraq and Afghanistan took place at a time of sluggish economic recovery, tax cuts, and rising budget deficits. This report will be updated as needed.