the price of liberty

Spending taxpayers money on a massive military offensive has its own unique economic consequences, but borrowing money from abroad to finance sustained hostilities half-way around the world places the American executive in a vulnerable position vis-a-vis the international community. This moderated conversation, featuring Robert Hormats — currently Vice Chairman at Goldman Sachs International and a former Assistant Secretary of State, member of the National Security Council, and US Trade Ambassador — touches on the myriad economic and political challenges that emerge when war is funded by outsiders while policy projects from within…

The Price of Liberty: Paying For America’s Wars
Council on Foreign Relations, Washington, DC
May 16, 2007

department-of-defense-seal-metalic-gold_largeKORB: Let me talk about this important book. Now, when I read this book, at the end I’m kind of gloomy. You know, it looks like we’ve got problems, financial, things are not going well. But then when I listen to the news I see the stock market going up every day. Unemployment seems low. And I’m sure if Grover Norquist were a member of the council, he would say people like you that are going to cause us problems, Bush’s tax cuts were the way to go, this war is not that expensive. How do you respond to that?

HORMATS: I think it’s true that the economy is doing quite well at the moment for a large number of people, but certainly not for everyone. And it’s certainly true this war is relatively cheap as a portion of GDP in historic terms. And that is, just to give you a sense of proportion, World War II cost about 40 percent of GDP at its peak, Korean War 15 percent, Vietnam War about 10 percent, this war is less than 1 percent.

So it’s manageable for the overall economy and it’s not really taxing us to a great degree at this point. We’re financing most of it essentially through borrowing. And you can do that for a period of time. The difficulty comes not so much in paying for this war. And indeed the battle between the Congress and the president is called a war-funding battle. It’s really not about the money, it’s primarily about who has the power to influence policy, military policy, in Iraq.

The longer-term issue, however, is more troublesome because if you look out over the next decade, there are two big vulnerabilities that we’re not addressing. One is that we’re paying for a lot of this war not just with borrowed money but money borrowed from abroad. And second, over the course of the next decade we’re going to see a lot of discretionary spending crowded out by entitlement spending: Social Security, Medicare, Medicaid, and interest on the public debt, which is growing.

And it’s going to be very hard to finance the war on terrorism in the future and any other national emergency in the future because, first of all, as the budget deficit increases, as it inevitably will because of entitlements, then the government, the Congress, White House, they’re going to look to discretionary spending to cut parts of that in order to reduce the size of the budget deficit.

And while defense spending is a small portion of GDP compared to what it was, it’s 50 percent of discretionary spending, and I think there’s going to be a lot of pressure after the war on national security spending altogether. And these are at least two reasons why.

KORB: You mentioned the fact that we can borrow very easily these days, borrow a lot of money from abroad. People again would argue that, well, they want to lend us money because things are going great here; this is the best place in the world to invest. Do you have any concerns about, for example, the money that China holds?

HORMATS: I’m not so much worried that the conventional argument is that at some point the Chinese or the Japanese or others will pull the rug out from under the dollar. I don’t think they’re likely to do that, in part because they don’t want to see the dollar collapse because that makes their goods less competitive in our market and other dollar-denominated markets.

I think the bigger risk, though, is if something were to happen that disrupted the U.S. economy or the U.S. financial system, a lot of that foreign capital might not be available. For instance, heaven forbid if there were another act of terrorism in this country. We should recall that 9/11, we had a budget surplus and we were not nearly as dependent on foreign capital as we are today. If an attack were to take place now or sometime in the middle of the next decade, we would have a budget deficit and we would be a lot more dependent on foreign capital.

At that point a lot of the foreign investors might say to themselves, “Wait a minute, the U.S. is a more risky place to invest.” People who were buying stocks from abroad might decide they’re going to hold off doing that and might sell some of what they already own. A lot of buyers of bonds will say, “Well, maybe we’ll buy those bonds, but your budget deficit’s going to widen dramatically if there’s another attack and you have to pay for reconstruction and the economy slows, and therefore we’re going to demand a higher risk premium for buying those bonds.”

And therefore all this foreign capital which we’re getting now very cheaply could become a lot less reliable and a lot more expensive. And if that hit the economy at the same time we were already disrupted by a terrorist attack, it would cause a lot of havoc for our economy and our financial markets.

KORB: Some people have argued that if there should be another crisis over Taiwan like we had back in the ’90s where the United States moved aircraft carriers into the area, that if that were to happen again, China could basically say, “If those carriers come within X miles of Taiwan, we’re going to convert to euros.” I mean, is that likely? And what would be the impact?

HORMATS: Well, they would do it at a price. I mean, they could conceivably do that to put leverage on us, which it would. It would push interest rates up dramatically and cause a lot of turmoil in financial markets, just the mere statement of that kind of consequence. They would be hurt, too, because a lot of their exports to the United States would then be adversely affected. Among the effects would be decline of the dollar against a lot of currencies, their own included, and that would be a problem. They could do it if they’d gotten to a point where they really wanted to exert pressure on the United States, but whether they would do it, they would have to consider very carefully the economic consequences for their own trade and their own economy.

KORB: As somebody remarked, the relationship with China now is MAD, mutually assured depression.

HORMATS: Yes, I mean there’s something to that. They could put leverage on us but they would not escape the consequences for their economy, which is one of the reasons they don’t want their own currency to appreciate; they don’t want the dollar to rapidly depreciate against their currency or any other.

KORB: In your book you talk about the fact that because we don’t have a draft, we’ve actually cut taxes, we haven’t cut domestic spending, Americans don’t seem to have any emotional involvement in this war. Does that bother you? And should we have, for example, raised taxes even if it didn’t make economic sense?

HORMATS: One of the themes in the book is that war financing is not just about raising money. Clearly it is about raising money, because in a war you need a lot of money to pay the troops and get equipment and supplies. But it’s about something else, and it’s about engaging Americans in the war effort; calling upon them to make some sacrifices, calling on them to suffer some degree of economic inconvenience, in a way. In a curious sense that brings people into the war effort. It makes the country more war-minded, or at least more supportive of the troops abroad.

In this war we have the troops abroad paying a very high price in terms of lives and in terms of casualties; and their families do, many of them have to go on welfare or get food stamps; but the average American has really sacrificed nothing for this war, has suffered really no major inconvenience. And this is very different from the past.

World War I, President Wilson and his Treasury Secretary, William McAdoo, made a major effort not only to increase taxes, which they did, but had the wartime bond drive they called Liberty Bond drive to get people engaged. And they had bonds that were very small denominations. So it wasn’t so much about the money, although they obviously had to raise a lot, it was to get the average American, including school children with these stamps that they would buy and they’d stick them in a book and they’d buy a bond after they’ve got $5.

The same thing happened in World War II. It was to engage people, saying that while the troops are sacrificing abroad, people on the home front should be making some contribution to the war effort.

And the leaders then were very candid. They never tried to soft-peddle the cost of the war. Roosevelt at the beginning of World War II, his first State of the Union Speech in 1942, says: War costs money. And that means taxes and bonds and bonds and taxes. It means we have to give up the kind of things we’re used to, to make sacrifices for the war effort.

And I think that had this been done after the 9/11 attack, Americans would have understood we have a war on terrorism, maybe some domestic programs that we were used to will have to be cut back to make more room in the budget for the war. Or maybe after the beginning of the Iraq war — when it was, we shouldn’t forget, popular at that point — the president could have said: Look, we’re going to have a little check-off in your taxes, not so much to have a big tax increase, because the economy was weak, but contributions to ensure that the soldiers had sufficient body armor or sufficient armor for their humvees, or the families were taken care of, or sufficient money if they were injured, something that would give people some effort to contribute to the war effort.

Or if they didn’t want to do that, they could have at least said, “All right, we’ve got a war now, we’re going to have to cut back on these domestic social programs or at least cut back on earmarking.” And earmarkings have actually increased dramatically over the last several years.

That kind of sacrifice, I think, could have been asked for by Americans, and at least at the beginning of the war many people would have responded. I don’t think you can do it now because the war is so unpopular, but at the beginning some measure of contribution could have been asked for and I think responded to; or something on the energy front after 9/11, saying, look, the money came from the Middle East. We should have had a very bold response with a very bold energy bill.

I think Americans at that point were ready to do something to demonstrate their support for American security, but none of that was forthcoming.

KORB: You mentioned the war in Iraq. In the book you quote the now famous statements of people like Paul Wolfowitz and the head of AID about the low cost. Do you believe that they believed that, or they were concerned that if they told the Americans how much it would cost, popular support would have declined?

HORMATS: It’s hard to know the answer to that. At the beginning I think there was a general view that the war would be short and cheap. That’s what they were predicating their military strategy on, and they doubtless were predicating their fiscal strategy on that as well.

But I think as the war continued, it became clear it wasn’t going to be short, it certainly wasn’t going to be cheap, at that point they really should have done something more to ask for at least big cuts in non-essential domestic spending to make room in the budget for the war. I think that would have been doable.

The part that I find most disconcerting, though, is these projections that oil would pay for the war and for reconstruction. There was clearly ample evidence from many, many sources that that was not the case. And not only was it not the case, a lot of information they were provided indicated that it was not going to be the case.

First of all, you need an electric grid to produce oil. The electric grid in Iraq was in terrible shape. Why? Because the sanctions had hurt the ability to refurbish the electric grid for 10 years. The energy-gathering facilities, the energy facilities, had been hurt by sanctions and by mismanagement. And when Bremer got in there he sent something, telegraphed to the administration very quickly, saying: The oil infrastructure is in terrible shape; don’t rely on it for a lot of money.

And the Baker Institute was asked to do something. They did a report, too, that said the same thing. The State Department did a report that indicated that the oil facilities were in terrible shape. So for them to go out and say, “Oil is going to pay for this” was in my judgment — it was very misleading. And it was not as if they didn’t have information to the contrary. And that, I think, was an effort to sort of soft-peddle the costs, and it was, I think, an exercise in wishful thinking, hoping that oil would pay for it when there was a great deal of evidence that that was simply not going to be the case. In addition, we’ve seen a lot of the oil money has been siphoned off for other nefarious purposes.

KORB: People like — speaking about the costs of war — people like Joe Stiglitz have estimated that the real cost of the war in Iraq, as opposed to the global war on terror, is going to be close to $2 trillion. Is that a reasonable estimate?

HORMATS: It’s hard to know. I mean, I’ve talked to Joe about this. It’s certainly going to cost a lot more than the numbers that we’ve seen. If you look at the actual numbers of what does the war cost, about $430 billion, give or take, and the whole war on terrorism, the war in Iraq, Afghan war, has cost about $530 billion altogether. But then you have to add in a lot of things that don’t get counted in those numbers.

One is the long-term care of wounded veterans, which are very much part of Stiglitz’s analysis. Second, you’ve got rebuild the military. A lot of weaponry has been destroyed or worn out. That has to be refurbished. Also a lot of the programs for restructuring military, a lot of the modern equipment, has simply been postponed. The government, the military, hasn’t bought a lot of things because it has to put more money into paying for the Iraq war.

And then you get a number of other issues. The notion that the best defense is a good offense, which is part of the administration’s strategy here, has meant that a lot of the homeland defense spending requirements that were pointed to by the 9/11 commission simply haven’t been paid for. The appropriations haven’t been provided for a lot of the homeland improvements that were suggested by, recommended by the 9/11 commission. So you have a great backlog of security issues that simply have not been addressed, and they’re going to cost a lot more over the next 10 to 15 years.

KORB: You mentioned offense, defense, and people would add the third category of prevention in terms of providing financial security. As I look at the baseline budget, aside from the wars in Iraq and Afghanistan, we’re spending 91 percent on offense, the Department of Defense; and obviously only 9 percent on defense, which is Homeland Security; and prevention, which is the State Department. Can we adjust those? For example do we need an FA-22 or DDG-1000 to fight this war on terror?

HORMATS: Well, we need — do you want to explain what those are? (Laughter.)

KORB: Okay, the super-sophisticated next generation fighter that was built to deal with the Soviets, the DDG-1000, which is open-ocean warfare. I mean, other people have argued that it’s not just adding money, as you talk about, but readjusting priorities.

HORMATS: Oh, absolutely. I think we do have to readjust priorities, and I think we’ve got to find ways of dealing with such things as how do you enhance — first we have to enhance intelligence capabilities. That’s quite clear from the record of the last several years. Second, a lot of modernization of military equipment. It’s not just modernizing the same kinds of technology, it’s developing new technologies to deal with new needs, rapid-strike anti-terror forces, better equipping Special Forces to go in and do what they do behind the lines. A lot of the new equipment is not simply taking old equipment and making it better, it’s new-generation materials. And that has to be done too.

But the point is, the cost of this has just not been spelled out. And my worry is that as a result of the fact that most Americans think that this war is relatively easy and cheap to finance, a lot of them are not prepared for the fact that there’s probably not going to be a big peace dividend, because a lot of the money is going to have to go into a lot of these programs that simply have been underfunded or not funded at all. The military calls it recapitalizing the military. And even if it’s not into the military, a lot of it has to go into homeland defense.

And most Americans think, you know, we haven’t had another attack, we’re very safe. It’s going to be hard to get that money unless the political leaders are willing to explain to Americans that it’s needed. And there’s going to be, as there was after Vietnam, an almost certain souring of support for military spending altogether after this war. And obviously, the pendulum always swings after a war, but sometimes it swings too far in the other direction. That’s going to be a big challenge.

KORB: In your book you compare the so-called global war on terror a lot to the Cold War and the way we handled that, sort of the long war. Is it really — when calling the struggle against these violent extremists, should we elevate that to the same levels as we did to deal with Soviet Communist expansionism?

HORMATS: I made the comparison in large measure because of the duration of the war rather than the nature of the war per se. And the duration of the war, we tend to forget that prior to the Cold War we had had periods of mobilization and demobilization. There’s a very clear line. When America went to war it mobilized, built a lot of military equipment; at the end it cut back very dramatically on military spending.

And everyone hoped that because the United States was a continent, was an ocean away from the troubles in Europe and the troubles in the Pacific, you know, we would have time to remobilize if there were a war that we had to enter into. So this notion of protection by oceans was part of American financial strategy. We would cut way back; if we needed to rev up again, we would have time to do it. The Cold War convinced us, particularly the Korean War, that we didn’t have that option. So we had to maintain a strong and a global military, which we did not really have before really the Cold War. The second analogy, which — and we need it still because anything could happen in various parts of the world and we have to be prepared.

The second point is the long-haul argument. The critical point at the beginning of the Cold War was to make sure — and this is really Truman and Eisenhower both understood that to make sure that we spent enough on the military to deter Soviet incursions in various parts of the world, but not so much that we had big budget deficits, because there was a feeling that if the Cold War seemed to Americans to be too expensive or if it led to inflation or if it led to huge budget deficits, Americans would then turn toward isolationism.

And there were a lot of people, Senator Taft in particular, a number of very conservative people said, “We don’t need to have a big military budget after World War II. We should let the foreigners deal with their problems, we’ll deal with our domestic problems; we want big tax cuts.”

There were a lot of people who felt this way, so Eisenhower and Truman had to walk a tightrope. They had to have enough money in the budget to pay for the military but not so much that they caused the economy to weaken and as a result would lead Americans in effect to retreat from international responsibilities because they thought it was too expensive.

And one little irony in this that comes about as a result of this was there was a feeling among many Americans — including General Bradley as chairman of the Joint Chiefs, chairmen of the big committees, and the Appropriations and the Foreign Relations Committees and the Congress — that the Russian goal, the Soviet goal was not at that point to start a war with us, a third world war, it was to force us to increase our defense spending, that they called preparedness spending at the time, to the point where we would — they called it bankrupt the country or cause a lot of inflation, and then America would retreat from the Cold War and the Soviets could do what they wanted to do in Eastern Europe or other parts of the world. So it was in a way to sort of bankrupt the U.S. or force us by poor economic policy and excessive spending to back off from the Cold War. The irony is, the bookend of this is that’s exactly what happened to the Soviet Union at the end of the Cold War. It was a great irony.

And one of the great quotes in the book comes from the commander of the Red Army in Afghanistan, who said, “You know what happened to us, why we have to leave Afghanistan?” It was only one reason. “It’s because the people in the Kremlin have fallen into the American trap. They have tried to outspend the U.S. ruble for dollar and tried to keep up with Reagan’s Star Wars program, and our economy was too weak to do it.” So the irony is that the Americans thought that the initial Soviet goal was to bankrupt us and force us to retreat; in fact that’s just what happened to the Soviet Union.

KORB: Last question. I want to bring it up to the contemporary debate we have going on between the Congress and the executive branch about using the power of the purse to change the policy. Not in the book but in your Washington Post op-ed, you seem to say, well, this debate they’re having about timelines and benchmarks and all that is the wrong one; they ought to focus on this. Is it really wrong? Should not the Congress be concerned about the process of the war and the way it’s being waged?

HORMATS: Well, absolutely they should. I was — you’re right. In fact, they put that in to get — partially for effect. But it was —

KORB: Oh, they wouldn’t do that.

(Cross talk.)

HORMATS: But it was essentially to say that there’s another debate that we ought to have, and that is the debate over how we’re going to meet the national security spending goals going forward. And the point I was trying to make in that piece was that we haven’t really had a dialogue in this country about that. That there’s a sort of notion that if you get out of Iraq either now or a year from now or two years from now, we won’t have a substantial national security spending requirement.

And I was trying to make the point that you need to — as we’re debating this question of benchmarks and whether the Congress has the right to or the will to cut off funding or threaten to cut off funding, we need to also have a similar debate that we didn’t have for 10 years after Vietnam about how we pay for some of the other national security requirements that the country is inevitably going to face.

Now, the question of whether you cut off money for the soldiers or cut off money while American troops are abroad, this has really never happened in this country. And therefore, I think the chances are it probably won’t happen this time in terms of an absolute cutoff.

We tend to forget in Vietnam, as bitter as that was, the Congress did not cut off money for American troops while they were at war. The Congress used its power of the purse in 1974 after American troops left. They left in ’73. They were very well funded throughout the war; in fact, the big issue in the Congress was how much domestic spending was to be cut and how much taxes we’re to be increased to pay for the added cost of the military. They never used that power of the purse to limit military spending while the war was on. It was after the war.

Then they did two things. The Congress did use the ceiling, the power of the purse, in effect to establish ceilings for the number of Americans that were allowed to be in Vietnam or would be funded to be in Vietnam in 1974. And then in 1975, they cut off all funding for the South Vietnamese government and then the Saigon government fell. But the debate at that point was not at all similar to the debate at this point. This is a very interesting thing.

The only time the Congress has ever tried to and succeeded in cutting large amounts of military spending was in the War of 1812. The Federalists tried to undermine the ability of the Madison government to raise money, and it did it by trying to prevent it from borrowing money and tried to cut tax revenues for it. In the end, even though the war was deeply unpopular, most Americans did not go along with the Federalist policy. And the fact that they did this was seen as unpatriotic, and the party 20 years later ceased to exist. So no Congress has done that since.

KORB: (Laughs.) On that happy note, I think, all right, let me open it up to the audience. And again let me make a couple of comments.

Please, when I recognize you, wait for the microphone to come, speak directly into it, and if you would state your name and your affiliation. And please keep your questions and comments as concise as you can so we can get as many people in in the next half-hour.

Congressman Moody. Wait, here comes the mike.

QUESTIONER: Thank you. You talked about the 90:10 — sorry, I haven’t read your book, so please forgive —

KORB: But your name and —

QUESTIONER: Jim Moody from Merrill Lynch. Merrill Lynch, you’ve heard of Merrill Lynch?

HORMATS: I’ve heard of it, yes. An esteemed firm.

QUESTIONER: (Laughs.) You talked about the 90:10 ratio, or the 91:9 ratio of, you know, military versus preventative, what we might loosely call preventative. You mentioned the State Department.

We all know how influential George Kennan’s piece was to help us frame the strategy and the thinking about the Cold War, containment as opposed to, you know, aggressive — excessive aggressivity or passivity. If someone assigned you the task of writing a kind of George Kennan kind of outline of how we would think about the global war on terrorism, what are some of the key pieces that — including their financial implications, obviously — the different strategies are very different — what wisdom could you share with us?

HORMATS: Well, it’s interesting. I mean the interesting thing about the Kennan piece — which really did have NSC-68 influence, the whole process of the containment — and the interesting thing was even Kennan, his piece was read but most people did not believe that the Soviets were a big threat until after the Korean War. That changed everything.

The draft was about to expire, in fact, and it came up for renewal on the day that North Koreans invaded the South, and it was extended even then for only one year. And then it was extended again when the war was prolonged. But the basic point at that point was that even containment was considered a very radical move at that point, and particularly spending a lot of money to keep a large number of troops in Europe as part of a containment policy.

I think today it’s a vastly different thing. First of all, there was mutually assured destruction at that point; that neither side was going to hit the homeland of the other guy for fear that their homeland would be hit.

This war is entirely different; it’s totally asymmetrical. It cost very little money for al Qaeda to do the attacks on 9/11. It’s going to cost us — cost a lot of money to respond and to do the rebuilding. And the same is true now. It’s costing them relatively little money; it costs us a great deal of money to do the following. And these are the kinds of things it seems to me would be in a new anti-terrorist strategy.

One is you clearly need very good intelligence. If intelligence isn’t good it’s very hard to fight the war on terrorism. It has to be a lot better than it has been. Second, you do need a lot of these very mobile (cell forces ?) with very, very good equipment to go behind the scenes and do what they have to do.

Three, you need a lot more concentration on homeland defense. Larry’s right, it’s sort of a nine-to-one ratio. And if you talk to people who were involved in the 9/11 commission, Republicans and Democrats alike make the point that there’s just been insufficient spending on first responders, on public health services, on police, firemen; all these things have simply been under-funded.

So you need a much more multifaceted strategy than you had in the late 1940s — (inaudible).

KORB: Okay. Let’s —

(Cross talk.)

HORMATS: (Inaudible) — have diplomacy to get a coalition behind it.

KORB: Okay. All right. Over here.

QUESTIONER: Bob, I haven’t read your book either.

KORB: Please identify yourself.

QUESTIONER: Allen Holmes, Georgetown. Many people say that a major engine of our economy is continuous consumerism, while at the same time our savings rate is about the lowest among all the industrialized economies. I’d like to hear you comment on whether you see this as a problem for our future ability to carry out our international tasks.

HORMATS: Yes, I do. I think that the low savings rate is certainly a problem because it means first of all that among other things we’re very dependent on foreign capital. And as I say, I don’t think that is intrinsically a risk, or it doesn’t need to be a risk as long as foreigners are willing to supply that capital at a very low cost, which they are, and they’re likely for some time to continue. The question is, are they going to do it indefinitely?

And the more dependent we are, the greater the consequence is of their deciding for some reason, act of terrorism or some other reason, not to supply that capital. In other words, either the Chinese decide for some reason they don’t want to do it, or the Japanese decide or some other country. And don’t forget, we’re getting a lot of it, as you know well, from the Middle East. And let’s suppose one of those countries decides for some reason that they’re going to withhold capital or diversify.

So that dependence is very substantial. And in fact the reason — the title of this book, “The Price of Liberty,” comes from Hamilton. And Hamilton made the point that we’d accumulated a lot of debt during the revolution, and a big portion of that debt, the critical factor, was foreign money, mostly from France, some from the Netherlands. And he made the point that this debt has to be repaid faithfully and we have to keep faith with our creditors and demonstrate that our finances are sound, because if there’s another war we’re going to have to borrow again. And so he said this debt is the price of liberty and has to be repaid and repaid faithfully, and we have to restore or at least establish our creditworthiness as a new country.

It’s not so different today. Obviously, we’re a very creditworthy country. We have the highest bond rating in the world, and we’ll probably continue to have that, but the fact is we still have to maintain, in the eyes of foreign suppliers of capital, a sound domestic creditworthiness so that they’re going to continue to lend to us on relatively good terms.

If we lose that, either through profligacy at home or through an act of terrorism which causes problems in the economy, then that money may not be available on a reliable basis for a period of time or as cheap, and then it would be very destructive. So that low savings rate coupled with continued spending, consumer spending and government spending, does have longer-term — potential longer-term consequences.

KORB: Back there.

QUESTIONER: Fred Bergsten from the Peterson Institute for International Economics. First, congratulations to Bob —

HORMATS: Thanks, Fred.

QUESTIONER: — for doing a book on a very important topic that had not been done before; very creative and innovative to do that. It’s an insightful book. It’s very timely. So it’s a home run.

Two comments on what you were just saying about the foreign part of the financing and back to the early part of your interchange with Larry. I think everything you said was right; I’d just add two points to it.

On the famous question, will the Chinese pull the plug, not only are Bob’s reason’s correct for why they won’t, but they know that if they did, the Congress would immediately retaliate with sharp market closure measures here. If any country attacks the dollar through seriously diversifying or partly so to try to take economic aggression against the United States, the U.S. would retaliate in the way it can by closing access to its markets. The Chinese have an export-oriented economy; they know that, they would be crazy to do it. It adds further to what Bob said.

However, in terms of the longer-term risk to our external financing, which as Bob says is absolutely central to this whole picture, the risk is not from the foreign official holders, it’s in the private market.

HORMATS: That’s right.

QUESTIONER: And one reason, which does not get much attention, is a structural change in the global financial system; namely, the creation of the euro. U.S. external financing, for all its wars and consumption and everything else, has been facilitated for a century by the dominance of the dollar in world finance. Why has the dollar been dominant for centuries? No competition.

Even when we had lousy economic performance, even when we had lousy economic policy, the dollar remained supreme. Why? No other currency was based on an economy anywhere near our size, sophistication, financial markets, et cetera, et cetera, et cetera. That has changed with the creation of the euro.

The euro is based on an economy bigger than ours, trading more than ours, that has reserves more than ours. Already more euros are held in currency terms than dollars; already more bonds are financed in euros than in dollars. It’s moving up rapidly aside the U.S. as a global currency. So when the next crunch comes, the old question, “Where else can they put their money?” has a very cogent answer. There is somewhere else they can put their money.

And so we can no longer, I think, be as complacent as we have been about the external dimension of our financing. As Bob said, it would probably end at some point anyway because of something going wrong here, but what really changes the circumstances is the presence of a rival currency for the first time in our modern history, indeed through almost all the wars that Bob has analyzed here. And that, I think, is something we have to really bear very much in mind.

HORMATS: One thing. I think Fred is exactly right, and it does give them an option. It gives them an option under even normal circumstances. Under critical circumstances, if the American homeland’s attacked with catastrophic terrorism, it’s even more.

I also should say, since Fred has made such a cogent statement, the reason I ever got to Washington in the first place was due to Fred. Fred was my first boss and my first mentor and has been a friend for a long time. And he gave me my first job in this town, so I want to particularly express my appreciation.

KORB: If he didn’t, would you disagree with him? (Laughter.)

HORMATS: Never. Never.

KORB: Okay. I saw a hand over here. Yes, right there.

QUESTIONER: Rick Gilmore, GIC Group. Hi, Bob. My question is brief. And I too have not read your book. I apologize. But do you take a look at the structure of the economy in terms of the sectors of our economy and the impact of the Iraq spending and now what you’re describing, as what, if we’re responsible, what could follow in terms of the budgetary allocations for the defense sector? What is the impact on the structure of our economy — service versus manufacturing and so forth? That seems to be problematic.

HORMATS: Yes. In the book I did not get into that. I mean I only had a certain number of pages and wasn’t able to get into that. But it obviously does. I mean, in an interesting way, just to take the foreign funding element for a moment, one of the huge beneficiaries of the foreign funding, ironically, is that we’re able to finance the government much more cheaply than we otherwise would be.

But the second thing is it’s been very beneficial to the housing sector. And the housing sector, there’s sort of a love affair between the People’s Bank of China and the American housing sector.

The war itself is, as I say, a relatively small portion of the GDP, and therefore its sectoral impact has not been enormous. Obviously, it has been very beneficial to spending, has been very beneficial to companies that make guns and artillery and weapons. And it’s also been very beneficial to the reconstruction industry, which has gotten a lot of business in Iraq.

But as a consequential element of the U.S, economy it’s still relatively small, unlike World War II, which had huge impact on manufacturing. The government actually bought factories, allowed the private sector to run them and then turned them over to the private sector afterwards. It had a huge benefit for the southern manufacturing industry, as did World War I. They made a lot of the uniforms and things. The textile industry boomed during these wars because they made a lot of the stuff for the soldiers. But this war has really not had too much of a sectoral consequence except for those sectors that I mentioned.

KORB: Yes.

QUESTIONER: Don Peretz. This is perhaps a simple undergraduate question. The Chinese are loaning us trillions of dollars, or is it billions?

HORMATS: Billions so far.

QUESTIONER: Only billions so far, of which —

HORMATS: Hundreds of billions, right.

QUESTIONER: — of which we’re spending a large proportion of that to buy goods from China. What makes the Chinese so much more optimistic about our economy than we’ve heard from many Americans here?

HORMATS: Well, that’s an interesting question. You have to look at where they’re — first of all, they want to be optimistic because they want to sell us things. For the reasons that Fred and I have both mentioned, a strong American economy is very good for them, as is a strong Chinese economy for us because we’re selling them more and more as well.

But I think you have to look at where they’re putting their money. Most of the money goes into fixed income assets. Relatively small portions go into equity or to direct investment. In fact we, as you know, had a certain number of incidents where we discouraged some kinds of Chinese direct investments, particularly oil facility investment. So the Chinese are mostly — their confidence is less — in their investment strategy — much less in the American economy per se and much more in the strength of American capital markets and the ability of the capital markets to return their money with interest.

And we still do have a very deep and very broad capital market. So much of their money is going into either government treasuries or into agency paper like Fannie Mae or Ginnie Mae or in some cases into corporate bonds. Relatively little is an investment in the equity sector of the American economy. So they have confidence in the Fed, they have confidence in the fixed income market, but it’s not so much growth oriented; it’s much more stable return oriented.

QUESTIONER: (Off mike.)

HORMATS: Well, because it’s our economy. And we should worry in part because — I mean there are lots of reasons why the Chinese at this point are doing it, in part because they don’t want the dollar to go down. We should worry because of the long-term consequences of a very large budget deficit projected over the next decade because of growing entitlements, and we should worry because we’re increasingly dependent on foreign capital, which might be available for a long period of time but it might not be, for the reasons Fred and I were discussing. And the more reliant we are on it, the more destructive and harmful it would be if there were a contraction of that foreign capital. That’s a concern.

And the last point is something I touched on in the book, essentially is we’re more and more reliant on oil. And that presents yet another vulnerability, which I’ve discussed in the book and we can talk about, but essentially, as I mentioned, after 9/11 it would have been a great time to have a very bold energy policy, which we didn’t have, sadly.

KORB: Over here.

QUESTIONER: My name is Henri Barkey from Lehigh University and the Woodrow Wilson Center. I was just going to ask you about the oil. But before I say that, Stiglitz is on to something, by the way, on the $2 trillion number. I heard from a very good friend of mine that one of the top Pentagon officials estimated the cost of the war as $2 trillion. So he’s on to something.

But yes, the issue of oil. In a way, the Bush administration gave us all these wonderful tax cuts but now there is a tax on it, and the tax is coming in the form of higher oil prices, but they’re not paying into the Treasury, we’ll be paying it to the OPEC countries. I wanted you to address also the impact of the increase and continued increase in oil prices on balance of payments and the pressure on the dollar as a result of that.

HORMATS: Well, it’s certainly a big problem in the balance of payments. If you look at the widening of the balance of payments gap, which is as you know very large — the amount of capital we import from the rest of the world’s between $700 (billion) and $800 billion, something in that order, net — a big portion of the increment has been higher oil demand and higher oil prices.

If you go back to Jimmy Carter, he said reducing oil dependency is the moral equivalent of war. That was when we were 30 percent dependent on foreign oil; we’re 60 percent dependent now. So it is a huge drain of resources.

And as the price goes up it constitutes two things. One is a tax — in effect a tax increase, and it skims purchasing power away from the average consumer. And the other thing it does is pushes up interest rates. It hasn’t had a big impact on interest rates, but at the margin it certainly has. And then it adds to vulnerability also.

So these are very significant numbers. And if you look at who is selling us the oil, a number of the countries that are selling us oil are vulnerable themselves to acts of terrorism.

So the reliability factor clouds our own economic and our own financial horizon. There have been two attempts in the last year by terrorists to attack Saudi facilities. If one of those had succeeded, you wouldn’t be paying $3 a gallon at the pump, you’d be paying $5 or $6 almost overnight. So this constitutes a fiscal and an economic and a security vulnerability.

KORB: Congressman Kolbe.

QUESTIONER: Jim Kolbe, German Marshall Fund. In response to the last question from Larry, you did talk a little bit about Vietnam, but it was in the context of the Congress supporting the troops there. You didn’t really talk about it as one of the examples of the war, how it was paid for. Isn’t Vietnam really the first example, the one that set us off on the path of we could do war on the cheap?


QUESTIONER: That you could do war without really having to make sacrifices at home?

HORMATS: Yeah, absolutely, Jim. It is, yeah, it is a quintessential effort — a quintessential exercise in poor fiscal planning and a lack of candor for the American — by the administration for the American people. I mean, just to highlight a few of the themes. And some people in this room lived through this period. But it was essentially the administration downplayed the cost of the war. It didn’t just downplay the cost of the war to the American people. Secretary Fowler, the Treasury secretary, was not told by McNamara and Johnson what they were planning to do in terms of a military buildup. So there was no planning in the normal budget process for addressing a number of these issues.

Second, there was, as I alluded to, a very big debate with the Congress, particularly Wilbur Mills, who was the key guy in the Ways and Means Committee. He kept saying, “We’ll fund the war, Mr. President, but you are going to have to go for a tax increase, but more importantly, you’re going to have to accept big cuts in Great Society spending programs.”

Johnson knew, and he told — there are great discussions between Johnson and McNamara where McNamara at one point said, “You should go try to get a tax increase.” He began to realize this budget deficit was getting out of hand. Johnson said, “I don’t want to do that because the conservatives then, they will give me the tax increase and they’ll give me the money for the war, but they’ll cut the Great Society.”

And Johnson kept saying what happened is that the World War II killed the New Deal, the Korean War killed the Fair Deal, which was Truman’s version of the New Deal, “and I’ll be damned if I’m going to have the Vietnam War kill my Great Society program.” So the reluctance he had was to go for this tax increase because he knew what was going to happen.

The other thing was that he just — they never really leveled with the American people. And the notion, Johnson said, is our GDP is strong enough so that we finance the war abroad and pay for the Great Society at home. It turned out not to be the case. And by not leveling with the American people or the Congress or his own economic team, he lost enormous credibility.

Now, the war itself became a quagmire relatively — ’68, ’69, and then there was the draft, which we don’t have now, which caused further angst among the American people because the draft was widening and more and more people were being killed or drafted or more casualties were occurring.

And then the cost of the war. We forget one thing in addition to all those human tragedies that occurred was that we had a big budget deficit and inflation and high interest rates, and a lot of Americans were troubled by that, as well.

So on all counts, things turned very sour very quickly, and the fact is they didn’t build it into the normal budget. The difference is that it cost a lot more as a portion of GDP, therefore the economic pain for the average American was a lot more than it is today. We don’t have a draft, so most Americans are not touched by it. We don’t have high inflation, we don’t have high interest rates, we don’t have a big budget deficit; it’s been declining. So the economic pain is considerably less, which gives more — has given up until recently more latitude to pay for the war.

KORB: Right there.

QUESTIONER: Alex Watson from Hills & Company. Bob, you’ve talked a couple of times about the tension between national security demands and entitlements in the future, and about the huge deficits. And you seem to imply that the entitlements will put tremendous pressure against the national security requirements. Can you imagine that it would work the other way, that there will be tremendous pressure on the entitlement situation so there will have to be some rather serious restructuring of those? And if so, what would those be?

HORMATS: That’s an interesting question. I think if we get into a debate, a sort of either/or debate or a zero-sum debate between defense spending and entitlements, in the end entitlements are going to be more popular and probably win the day. My view is that entitlements have to be reformed anyway. If the defense budget were zero, they would still have to be reformed because they’re unsustainable and they have to be put on a sustainable basis. That means Social Security, Medicare, Medicaid.

And Social Security, I mean, can be done with some adjustments, as we saw in 1983, the Greenspan Commission. Medicare and Medicaid are more complicated because it’s not just about adjusting government programs, it’s about the fundamental way American medicine is provided, and the cost structure is rising quite considerably every year. So that process of reforming entitlements needs to be done anyway, and it’s a very difficult process.

The added dimension is that if this is not done in a reasonably expeditious way, not necessarily overnight but over the course of the next several years, it’s going to squeeze out almost all of the discretionary spending.

Now, if that does not happen, you’re simply going to have to have bigger budget deficits to pay for it or a tax increase to pay for it, both of which will impose major burdens on the economy, not this year or next year but sometime toward the end of the next decade. And therefore you’ll get back into what Eisenhower and Truman were worried about, that if you do get a big bloating of the deficit and you have to have tax increases and interest rates go up, it forces Americans — it will discourage Americans from being willing to finance military spending because they’re going to say, well, we can’t afford this because we have all these other burdens in our financial system.

So at some point there will be a clash between the two. Entitlements need to be reformed anyway, but one particular reason for it in this context is that if we’re fighting a war on terrorism and we don’t provide sufficient resources for intelligence, for new equipment, for refurbishing or recapitalizing military and for dealing with a lot of other points on our foreign policy agenda, it will just cause further problems down the road and undermine American security down the road.

So it’s not necessarily either/or, it’s that you’ve got to deal with entitlements, and one reason for it is you’ve got to at least put — assure that there are sufficient funds in the budget to make sure that the military and other national security programs are properly funded. If you don’t do that then we have a lot of problems similar to the ones we’ve had when we pulled dramatically back from international fronts so that we — (inaudible).

KORB: In the back, last row.

QUESTIONER: Yes. Dave Ahern with Space and Missile Defense Report. You mentioned taxes. Basically, if we have a problem financing with debt, with borrowing, does this then indicate that what we have to do is to get more money? The government, whether it’s defense or entitlement programs, parks, whatever, the government needs more money, and either we increase taxes now or the Democrats let the 2001 and 2003 tax cuts expire as scheduled in 2010.

HORMATS: Well, it’s almost certain that unless one assumes that growth is going to provide all the additional revenues we need for entitlements plus national security plus a whole range of other domestic programs, unless you assume that growth is going to do all of it — which even the CEA and the White House has said is not likely to happen — then you have to find some way either of cutting back dramatically on these programs or other programs to make room in the budget for the additional spending, or you have to find some way of raising additional revenues. And then the question is, what is that method?

Now there’s a wide range of methods that can be used. One is to allow the tax cuts to expire, or sunset, as is built into current legislation. I don’t think the Congress is going to allow that to happen 100 percent. I think they’ll cherry pick and they’ll let some of these taxes go back to where they were; maybe put a ceiling — allow a ceiling to be put on the inheritance tax, for instance, so that people in the upper-income brackets pay the old way and people in the lower income brackets pay a lower rate.

Ronald Reagan, don’t forget, and we tend to forget this, after the big 1981 tax cuts signed several tax increase bills. That tends to be forgotten, but he did, and because the budget deficit got so large. So there are a lot of ways to take — to go back to the Reagan analogy, and many of those were removing tax subsidies from certain corporate activities. He raised some taxes on the corporate sector. There are ways of doing this without necessarily raising the marginal tax rate or the dividend tax rate or the investment tax rate.

There are a whole range of permutations that can be used. But I think that it’s almost inconceivable that you can meet the government’s requirements for the kind of programs that I’m talking about, entitlements and maybe a marginal increase in the national security, without some way of enhancing revenues, and you can’t rely on growth to do the whole thing.

KORB: Reagan called them revenue enhancement.


QUESTIONER: Hi. I’m Barry Blechman.

HORMATS: Hi, Barry.

QUESTIONER: (Off mike) — DFI. Well, the solutions are very difficult politically, and it’s really hard for me to see a Democratic administration coming in and wanting either to cut back on defense. And even if they get rid of Larry’s favorite program, it doesn’t make much of a difference. They’ll certainly want to increase, as you’ve said, the homeland security part and the preventive part of national security. Doing the tax cuts — or reversing tax cuts or even the marginal things that you talked about would be difficult. And I don’t see anyone willing to step up to the entitlement issue, which means we have a rising deficit.

What’s the relative point to GDP where the deficit starts affecting the financial markets, where foreign investors or Americans start worrying about it? I think a couple of years ago it got up 4.2 percent, something like that. How high does it have to go before people start really worrying?

HORMATS: That’s a very interesting question. The question I get frequently is that, and why, if this is such dire outlook for the budget deficit, why have the financial markets not caught on to this and started building it into the yields on the 10-year bonds and beyond?

And the answer is, most people hope against hope at this point that either growth will resolve the issue or that somehow politicians down the road will resolve this issue. And the other thing is, the budget deficit actually is shrinking, so that it doesn’t look like a problem, but if — currently — but if you look at Bernanke’s testimony a couple months ago, he said this is probably the calm before the storm. And he was right. And I think that where the markets start anticipating this — it doesn’t even have to happen in the magnitudes I’ve talked about — once the markets start anticipating this, then they build it in to the yield curve and rates start going up.

Now when could that happen? It’s hard to know when it will, but I think if it appears in the new administration, whoever’s the president, whenever the Congress — (inaudible) — if it appears that politicians are not tackling at least one of these issues, at least Social Security, then the more dire circumstances of the bloated deficit look more imminent. And then I think you do get — then the market starts to react. And that would probably be not this year, probably not next year, but probably in 2009 when these things look more imminent and therefore the concerns grow.

Now if there’s a terrorist attack between now and then, a lot of these concerns get triggered and a lot of the financial distortions or disturbances or consequences that I’ve talked about could cause the market to be much more concerned much more quickly. But barring that, I think 2009 is the time when markets begin to focus on this, because then they’re not going to focus just on the 2012 year where the president wants to have the budget deficit almost eliminated, but when you get to 2015, ’16, ’17, the baby boomer retirement starts to take place in earnest, Social Security benefits begin to rise, Medicare benefits begin to rise, the market consequences then and the interest rate consequences become much more serious.

And then I think you do get a lot of trouble in the economy and financial markets. But it probably won’t be for the next couple of years, just because people feel comfortable about this budget environment for the time being.

KORB: David, last question.

QUESTIONER: Thank you. David Calleo from SAIS. Both you and Fred mentioned the existence of the euro as a new structural weakness for the dollar. I wonder if there isn’t a second one, which is the end of the Cold War, when most of our creditors, I guess all of our creditors, in fact, were also our protectorates.

And I know we in a sense tried to turn the war on terror into a similar kind of builder of solidarity, but I wonder if that’s very successful, in the sense that the Europeans, for example, don’t really agree with our strategy for dealing with terror. And you could argue that that’s also true now in terms of relations with Russia, relations with Iran, the Middle East in general, China. In other words, there’s a decay of the sort of geopolitical solidarity which was also a major support for the dollar in the past.

HORMATS: Well, that could well be. I mean that’s another element that they don’t really — they’re not as — at that point, except for the French — you know, de Gaulle took his gold back but every one else really had an interest in doing this. But don’t forget there was still a lot of friction between the United States and the Europeans in 1971, I mean, and throughout this period. They weren’t necessarily supportive of American monetary policy. There were lots of currency crises.

QUESTIONER: (Off mike.)

HORMATS: Yes. They didn’t want a big currency (inaudible).

The other part of it is that the vast amount of capital that comes in here, in contrast to that period when it did come primarily from Japan and from Western Europe, a lot of it now comes from countries that are not part of any alliance with the United States; from the Middle East, a lot of Middle East money, a lot of money from East Asia countries that are not primarily American allies. So that political binding is not quite what it was either.

So this dependence is important. And the irony is that it does go back, as I mentioned earlier, to the Hamilton period where he was very concerned about making sure that supplies of foreign capital were available to the United States when needed at reasonable prices.

Just one little element of history to end this. Hamilton and Jefferson disagreed on virtually everything except one thing. Jefferson in fact wanted to have an amendment to the Constitution so that the federal government couldn’t borrow at all. That’s what he wanted. He didn’t like debt. But the one thing they agreed on is, and one of the very few, is that they, both of them felt that you needed to be creditworthy in eyes of your own people, in the eyes of the world, in order to pay for national security needs of the United States.

So from the beginning of the founding of the Republic, strong finances was linked to strong defenses, strong military capability, strong security capability. Both Hamilton and Jefferson understood this. And I think the further we depart from sound domestic finances today, the more vulnerable we are, the more vulnerable we are if there should be a terrorist attack and the more vulnerable we are should there be some national emergency which required us to spend a lot more money. We would just have less room fiscally and less flexibility in the way to do it. So that link between sound national security and sound national finances is as important today as it was during the time of Washington and Hamilton; it’s just that we don’t think about it as much and pay as much attention to it.

KORB: Well, on that happy note, Bob, thank you very much. (Applause.)