Monday, March 18, 2013

Military Keynesianism and the War on Terror

. Monday, March 18, 2013

Dan Drezner twitter-paged me this weekend regarding military Keynesianism. I suspect this is because he knows that I am writing a book on the political economy of American hegemony in which military Keynesianism plays the leading role. And as this is the second (third?) time Dan has pinged me about this, it is (past) time to respond. Dan's post this morning over offers the perfect opportunity.

On the occasion of the 10th anniversary of our invasion of Iraq, Dan asks, "How did Operation Iraqi Freedom affect the international system? The surprising answer is, not all that much." He concludes the post as follows:
So does this mean Operation Iraqi Freedom doesn't matter? Of course not. Affecting the international system is a really high bar. World wars, economic depressions, industrial revolutions -- these things matter at the systemic level. It's rare that a conflict smaller than that would have systemic implications (though the Soviet invasion of Afghanistan does come to mind). Rather, the conflict's primary effects were at the national level. Iraq did have a profound effect on American foreign policy thinking. Which is the subject I'll tackle in my next blog post.
Military Keynesianism suggests that Operation Iraqi Freedom had such systemic consequences in the form of the global economic and financial crisis of 2007-13. As I know people resist a direct attack, let me back into it with an analogous case: Vietnam.

There is pretty broad scholarly agreement concerning three aspects of the Vietnam War. First, the US financed the war by running large budget deficits. Second, the deficit-financed war buildup sparked an inflationary boom in the US economy, which worsened the balance of payments position and led to a rapid increase in foreign claims on the American gold reserve. Third, the budget deficit-financed economic boom collapsed the Bretton Woods system as individuals, private institutions, and governments lost confidence in the dollar's peg to gold. The collapse began with the first massive speculative attack against the dollar in March of 1968 (an attack which led the Johnson administration to suspend all private dollar convertibility and sharply limit official convertibility). Thus, the US decision to finance the Vietnam War by borrowing rather than by raising taxes had severely negative consequences for the international system: it undermined global monetary stability.

Now consider the Iraqi case. The sharp increase of military spending sparked by 9/11 and Iraq followed a massive tax cut (and coincidentally, we had a massive tax cut in 1964). Like Vietnam, therefore, the US borrowed to pay for the War on Terror. If the Vietnam War experience is any guide, this budget deficit must have had consequences for US macroeconomic and financial performance. The deficit was larger and persisted for longer than the Vietnam case. I argue that the choice to finance the War on Terror by borrowing rather than by raising taxes worsened the US external imbalance and the resulting "capital flow bonanza" triggered the US credit boom. The credit boom generated the asset bubble the deflation of which generated the great global crisis from which we are still recovering. Obviously, it takes a lot of heavy lifting to get from the war-related budget deficit to the global financial and economic crisis. (That's why I am writing a book. I will begin posting chapters in the next week or so here if you are interested).

Regulatory considerations and the global savings glut may be important conditioning factors. But, the more I research this the more I conclude that these factors are less important than most of us believe. Hence my decision to compare the case to the Vietnam War experience and to the Carter-Reagan buildup sparked by Soviet invasion of Afghanistan in 1979. This was financed in the same way as the other two (budget deficits) and had the same economic consequences (housing bubble and the savings and loan crisis) as the War on Terror buildup.

So, I would argue that Operation Iraqi Freedom had a huge affect on the international system: it generated the largest economic and financial crisis the world has experienced since 1929. This massive shock continues to ripple through the global economy four years later, as the EU's current efforts to resolve the banking crisis in Cyprus demonstrate.

11 comments:

Vladimir said...

Professor neither you nor Dan specify whether you mean the structure or the patterns of interaction in the international system. Clearly (at least to me) neither the Vietnam War nor the Iraq War altered the structure of the international system. Of course I am using structure in the Realist sense. Second was the chief failure in the late 60's or in the last decade in fiscal or monetary policy? I am not sure that one can convincingly argue that US foreign policy determined monetary policy and its contribution to macroeconomic management. Furthermore an early reaction to reaction to the crisis might have led us to conclude as financiers from the Mid East and Asia refinanced Western banks that this was evidence of a major structural shift..... until the Fed began extending swap lines and everyone wanted US denominated assets.

Thomas Oatley said...

I can't speak for Dan, but I do not mean the distribution of power. I mean simply have large global consequences. Many analysts believed, as you point out, that the 2008 crisis would accelerate ongoing structural change; similar discussions emerged in the early 1970s as Bretton Woods fell and the US withdrew from Vietnam.

As for fiscal vs. monetary policy. In the 1960s, the general consensus is fiscal policy was too expansionary and monetary policy too accommodating.

In the 2000s, I blame the GSG for the supply of credit and fiscal policy for the initial spark that triggered the surge of US demand for credit. The asset bubble was the fueled by an oxygen rich environment. I remain uncertain whether the Fed could have done anything within reason to prevent the boom from beginning.

In both instances, then, I guess I would say that monetary policy was reactive to and supportive of fiscal policy. In that way, it was perhaps shaped by foreign policy.

Anonymous said...

I'd be interested in an expansion of your theory that increased government borrowing from abroad leads to increased private borrowing from abroad. Seem to me it should be the other way around. If there is some excess Chinese savings, they could lend it either to government or to the private sector (for mortgages, etc.). So shouldn't an increase in government borrowing crowd out the private borrowing, rather than increase it?

Thomas Oatley said...

Dear anonymous,

Given your premise (that the supply of savings is exogenous to the demand for savings), then I agree that an increase of US government borrowing must crowd out borrowing elsewhere. My research suggests that borrowing in the global south gets crowded out not US private sector borrowing.

David L. Smith said...

It is “heavy lifting,” indeed to get from the war-related budget deficit to the global financial and economic crisis. Oakley gets his causality backwards and leaves out two critical causal factors pumping up the housing bubble (surplus funds from rich Americans made stupendously richer by Reaganomics, and a overly-accommodative Fed eager to avoid recessions at all costs).

Unfunded military spending has certainly pumped up U.S. Government debt during American wars since time immemorial -- Vietnam, Afghanistan and Iraq being no exception. But household debt is the root of the problem. Military spending does not pump up household borrowing; a governing set of rules does (Reaganomics, mostly) making the rich stupendously richer, the poor, desperately poorer and the middle class mark time, impelling the rich to lend and the middle class to borrow.

The connection is illogical linking military spending and the “U.S. External imbalance and resulting ‘capital flow bonanza’” triggering the U.S. credit boom and the credit boom generated the asset bubble the deflation of which generated the great global crisis.” Oakley is grafting the coincident event of increased military spending on to the central narrative of the credit boom and its implosion — giving his account some factual credibility at the end but creating a false chain of causation.

What generated foreign capital inflows into the American credit markets (both government and private sector) were the trade advantages gained by American’s trading partners through currency manipulation, cheap labor made very productive by foreign investment in Asia, and policies calculated to restrain the flow of U.S. goods and services into their markets (by discouraging consumption and impeding the influx of imported goods). To keep their trade surpluses coming, foreign exporters recycled them back into U.S. Credit markets, underwriting the borrow-and-spend Americans demand for foreign goods.

Using their surpluses to buy up U.S. government debt was just one parking place for their surpluses — essentially a portfolio decision as to where to lend. The portfolio decision made possible increased U.S. military spending, not the other way around. Foreigners were not compelled by the fact of increased U.S. military spending to create trade surpluses so they could lend money to the U.S. Government and American households as Oakley seems to be saying. Somebody should clue the man in before he embarrasses himself by publishing his book.

David L. Smith
Author The Predicament www.the-predicament.com
david@davidlsmith.com
www.cassandra-chronicles.blogspot.com

Thomas Oatley said...

Dear David,

Thanks for stopping by. A couple quick points and then a couple on substance. First, my name is Oatley with a "t" not Oakley with a "k". If you are going to mock me, you can at least spell my name right.

Second, I am glad you have such strong opinions about research based on a two-paragraph blog post. Some people might wait to make up their mind until after they had actually read the book and considered the evidence. I guess you are not one of them.

Third, I understand the dynamics of the global financial system and the recycling of China's surplus as it played out over the decade. My response would be that although China's surplus certainly requires a deficit somewhere in the world, it doesn't require a deficit in the US. And I don't understand how China's demand for Treasuries generates the supply of Treasuries. Surely the supply is on us, no? And might China's surplus have been smaller had we bought and borrowed less? So, could one suggest that US behavior contributed to the size of China's surplus?

You seem to be suggesting that there was nothing the US government could have done in order for the US economy to run a smaller current account deficit or even a current account surplus between 2001 and 2008. Do you really believe that? That even though the US is the world's largest economy it was somehow forced to import capital from China in order to buy China's exports? Don't we have economic models that help us understand how changes in fiscal policy might affect the external balance?

My argument seems rather sophisticated in comparison to the one you propose. I emphasize the twin deficits story, which is a pretty standard story, plus positive feedback. And yes, I argue that we could have avoided it if in fact we had opted to restrain rather than encourage consumption. And this would seem a pretty standard implication of a pretty standard IS LM model.

At the end of the day, and as I am certain you know, these macroeconomic dynamics are woefully under-determined. We can reach the same outcome through multiple paths. As a consequence, the fact that you adhere to a different causal explanation for the crisis than the one I am developing implies nothing about either the logical coherence or the empirical validity of my explanation.

David L. Smith said...

Dear Dr. Oatley:

Sincere apologies for misspelling your name. Your piece came to my attention through a colleague in a discussion group who misspelled your name and I simply followed suit. My comment was excerpted from a longer post to the discussion group, essentially cut and pasted in your site with only a cursory look. I should have double-checked.

It was not my intention to mock you, but rather to offer a straightforward rebuttal to what I consider to be a tortured and fallacious explanation for the credit boom that fueled the housing bubble -- the bursting of which, we agree, triggered the financial crisis and Great Recession. While you may argue that your analysis is more sophisticated, I would refer you to Occam’s razor.

Moreover, I see nothing in your post or comment which dissuades me from thinking you have mistaken covariance for causality and overlooked two critical sources of funds inflating the housing bubble (rich Americans and the Fed). Maybe these are included in your book. From what I have gathered so far, I remain persuaded that your efforts to link military Keynesianism to the global economic and financial crisis of 2007-13 will not stand up to peer review, will certainly be viewed as inadequate, and may ultimately prove embarrassing.

I understand your righteous indignation at the thought that your broader research should be challenged on the basis of a two-paragraph blog post. Nevertheless, you posted the two paragraphs online and invited comments, so I think it fair to challenge the contents of that post, as I have, without waiting for the full opus. Likewise, you might consider that your conclusion about the relative sophistication of our arguments is similarly based on my brief comment, truncated by the limitations imposed by your site.

Tell you what. I’ll read your book if you will read mine, "The Predicament – How did it happen? How bad is it? The case for radical change now!" (www.the-predicament.com 2nd edition due out in about a month) and we’ll compare notes. In the meantime, I’m happy to debate these issues offline if you will e-mail me at david@davidlsmith.com.

Kind regards,
David L. Smith

Ronan said...

Just out of curiosity, (as I came across your article on this topic online a while ago), when is the book out? And when do you think the chapters are available online? (This sounds like a really interesting position, all comments above notwithstanding)

Srikanto Bormon said...

I like your post this is such a help full for me keep going on thanks for posting.
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Ronan said...

"(That's why I am writing a book. I will begin posting chapters in the next week or so here if you are interested)."

If you don't mind me asking, have these been published anywhere? Im interested in seeing the argument fleshed out (and have only been able to find a draft from 2010 online)

Thomas Oatley said...

Ronan, shoot me an email.
Thoatley at gmail

Military Keynesianism and the War on Terror
 

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