The War and the Economy Will Iraq Put Pressure on the Bush Tax Cut? By Jonathan Weisman Washington Post Staff Writer Tuesday, September 16, 2003; Page E01
In 1966, with spending in Vietnam on the rise, social programs growing and interest rates edging dangerously higher, Georgia's venerable Sen. Richard B. Russell Jr. asked "whether this nation, for all its wealth and resources, can fight a war . . . and carry on a broad range of domestic spending -- without a tax increase or a dangerous deficit." "The president apparently believes that we can," the Democrat told his state's legislature. "For the sake of the country, . . . I hope and pray that he is right." Within two years, inflation was galloping, the federal deficit was climbing, and Lyndon Baines Johnson was forced to slam on the brakes with an unpopular tax hike to finance the war and slow the economy. In Johnson's experience, some see a cautionary tale for President Bush. Again, a president is pursuing his domestic priorities -- in this case, tax cuts -- even as he tries to finance a war that he insists will be limited and affordable. Administration officials say neither the amount of war spending nor the size of the budget deficit is enough to damage an economy they are still trying to push into high gear. But some economists and historians see enough of a parallel between the "guns and butter" debate of the 1960s and the nascent "guns and tax cuts" debate of today to raise the question of whether the administration is right. "Right now we're in our unrealism phase," said historian Robert Dallek, author of the Johnson biography "Flawed Giant." "But they're going to have to face reality. There is the Lyndon Johnson moment coming down the road." The economic backdrop of the Vietnam War is very different from the economy backstopping the fighting in Iraq. Back then, with unemployment at rock bottom, the economic engines were already revving hot when Vietnam spending slammed on the accelerator. Now, the engine is just coming out of idle, with plenty of room for acceleration. Most economists say that under these conditions, the extra war spending probably will have an overall positive effect on the economy in the coming year. But whether the impact turns sour over time will depend on how long the war in Iraq lasts and how much it costs, they say. No one knows just how much slack is in the economy or how quickly it could give way to a blown gasket. "Economists are notoriously bad at predicting turning points," said Lee Price, an economist at the liberal Economic Policy Institute in Washington. "We can tell you the underlying factors that will push the change, but we can't say when it's going to happen." War spending has already become a driver of the economy, most economists agree, although they disagree over its relative importance. Defense expenditures surged in the April-to-June quarter of 2003 by 45.9 percent over the first quarter, to an annualized rate of $519 billion, according to the Bureau of Economic Analysis. The economy expanded at a surprisingly brisk 3.1 percent annual rate in the second quarter, of which 1.75 percentage points were attributed to defense spending. Bush's $87 billion request to fund the wars in Iraq, Afghanistan and elsewhere will push defense spending near $500 billion in the fiscal year that begins next month, well over the height of Ronald Reagan-era defense buildup, in today's dollars, and considerably higher than the inflation-adjusted $433 billion spent at the peak of the Vietnam War. Although employers shed 93,000 jobs in August, it may well have been worse but for the war. The military's mobilization currently has called into active duty 174,403 National Guardsmen and reservists, 20,000 of them in Iraq and Kuwait. Those troops are guaranteed their jobs when they return, but while they are on duty, someone else may be filling their post who otherwise would be jobless. "It's fair to say what [growth] we've seen to date is largely defense driven," said Dean Baker, co-director of the Center for Economic and Policy Research. The theoretical fear is that once the economy is growing at a healthier pace, large, sustained increases in defense spending would exacerbate federal budget deficits already in record territory, drive up interest rates, rekindle inflation and distort the economy by directing investment to defense industries, which are inherently less productive than civilian ones. During Reagan's defense buildup of the 1980s, "scientists took jobs at General Dynamics instead of General Electric," Price said. "I think we paid a price in technology, and government deficits crowded out private investment." Economists also note that this extra defense spending comes just five years before the first of the baby boomers start receiving Social Security and Medicare benefits, further straining the government's resources. A small minority of economists are already sounding warnings that interest rates and inflation will rise to unacceptable levels by the end of next year or early 2005. "And when it all unravels, it will unravel fast," said Diane Swonk, chief economist at Bank One Corp. When economics forecasters at Macroeconomic Advisers recently crunched the numbers, they indicated economic growth above a 6 percent annual rate for the second half of this year, a number not seen since the boom months of 1999. Spooked by the number, Chris Varvaras, president of the prominent St. Louis firm, said they simply lowered their growth forecast and "banked the upside risk." If growth rates like that continue, economic problems are inevitable, some economists say. The only question is when. "We almost always overheat," said Laurence H. Meyer, a former Federal Reserve Board governor who has been studying the Iraq war's potential impact on the economy for the Center for Strategic and International Studies. "It's one of the charms of the U.S. economy." The political parallels between the Johnson era and today are striking, Dallek said. Like Bush, Johnson enacted a large tax cut as one of his first acts as president, then oversaw significant increases in federal spending. In January 1966, Johnson proposed spending $10.5 billion to fight the war in Vietnam, $59.6 billion in today's dollars, but he assured Congress the war would be over by June 1967. The federal budget deficit would be only $1.8 billion, or $10 billion in inflation adjusted terms, he promised, hardly enough to raise interest rates or inflation. But defense spending kept climbing, and it came on top of already enacted "Great Society" anti-poverty programs. By 1967, federal deficit forecasts for the coming year had reached $29 billion for fiscal year 1968, or $153 billion in today's dollars. The "guns and butter" debate had come to dominate Washington by then. Jump 36 years into the future, and "this time, the butter is tax cuts," said Edward McKelvey, an economist at Goldman Sachs Group. After three tax cuts and discretionary spending increases of 27 percent since he took office, Bush is seeking $87 billion more in wartime spending. The budget deficit is likely to exceed $500 billion in the fiscal year that begins next month. Like Johnson in 1966, Bush has steadfastly denied any conflict between his defense spending and his tax cuts. "I heard somebody say, well, what we need to do is have a tax increase to pay for this; that's an absurd notion," Bush said Wednesday. "You don't raise taxes when an economy is recovering. Matter of fact, lower taxes will help enhance economic recovery." But the analogy breaks down when the analysis shifts from political parallels to economic ones. In terms of the economy, said Charles Schultze, Johnson's budget director in the late 1960s, "that was a different world." For one thing, the economy is far larger and therefore can more easily absorb defense increases. In 1968, defense spending equaled 9.4 percent of the economy. The second-quarter surge of defense spending this year notched it up to just 4.8 percent of the economy today, considerably higher than the 3 percent of 2001 but well below the Vietnam era. The true wartime economy of World War II saw defense spending closer to 38 percent of the economy. Johnson had no room to maneuver, while for now, any defense spending can only be positive. By 1968, unemployment had slid to 3.6 percent, compared with 6.1 percent today. The economy was growing at a rate of 4.8 percent in 1968, compared with this year's rate, expected to be around 2.6 percent. "The economy is just so weak," Baker said. The war "has been a source of stimulus, and at this point, it's not obviously pulling anything away from anything else." White House officials say they are not worried because by the time the economy is again running on all cylinders, wartime spending will not be an issue. A senior administration official said last week that next year's war expenditures will be "overwhelmingly one-time spending" and not a long-term drain on the federal budget or the economy. Many economists agree. Iraq war spending is likely to consume 1.5 percent of the nation's total economic output over the next four years, said William D. Nordhaus, a Yale University economist and wartime economy expert, or half the take of Vietnam or the Reagan buildup. "My sense is what's going on right now will not have a very big effect," he said. Others are not so sure. Meyer warned that the economy would soon adjust to the level of war spending and lower tax cuts, which will then lose their stimulative effect. "Looking out into next year, we're going to see a stunning decline in fiscal stimulus that the economy is going to have to deal with," he said. If the economy hasn't kicked into gear on its own, a major hangover is inevitable, he said. McKelvey said long-term deficits are inevitable without a change of course. Goldman Sachs warned clients on Friday, "The deficit issue is now on the radar screen of bond investors. They will be looking to see whether the policy of 'guns and butter' will persist or whether the Bush administration is now prepared to make some tough choices." Although administration economists have downplayed the link between deficits and interest rates, many others believe the link is real. McKelvey expressed no doubt that higher interest rates and more government borrowing will push aside some private-sector investment. The question is only how much. "The government is going to be in a position where it's borrowing $400 billion and $500 billion a year," McKelvey said. "It's first in line for borrowing. The notion that that guy can get first in line without shoving out the guy in the back of the line just doesn't pass the smell test. You don't have to be an economist to understand that."
