Practical Integration of Positive and Normative Approaches to Cost-Benefit Analysis of National Defense Spending

David Blau, George Mason University School of Public Policy, 2013

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The Value of Cost-Benefit Analysis: Providing an Empirical Measure of Policy Impacts

In A Guide to Benefit-Cost Analysis, Edward Gramlich writes that, “The first thing to

recognize in any intervention in a market economy, however much it improves the welfare of

society as a whole, is that it will probably make at least some people worse off.” In terms of

economic well-being, net national welfare can be maximized by a program choice if the winners

could compensate the losers to satisfy them sufficiently, while still improving their own welfare

even after making these compensatory payments, the Net Kaldor-Hicks rule. Gramlich notes the

simplification of this rule by Edith Stokey and Richard Zeckhauser which they termed the

“fundamental principle” of cost-benefit analysis: In any choice or situation, select the policy

alternative that produces the greatest net benefit (welfare) to society as a whole, considering all

affected groups, consumers, producers, and the government.1

Government investment, or foregoing making that investment, should be evaluated by

cost-benefit analysis and the Net Kaldor-Hicks welfare change, which uses financial analytical

techniques to estimate the distance between accounting impact (book cost or prices) and the

impact on overall economic welfare (social cost or benefit). Efforts should be made to

incorporate all financial and non-financial gains and losses likely experienced by any party. An

1 See Gramlich, Edward M. A Guide to Benefit-Cost Analysis. Waveland Press. Prospect Heights, IL. 1990. Pg. 30-33.

This approach to cost-benefit (or economic impact) analysis attempts to quantify factors of varying degrees of “softness” in financial terms, following the approach of classic texts like Benefits, Costs, and Finance in Public Higher Education by W. Lee Hansen and Burton A. Weisbrod (Markham Publishing Company, Chicago, IL. 1969.).

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appropriate interest rate for discounting should be determined.2 Using this interest rate, the net

present value of economic inflows and outflows, incorporated with a wide range of sensitivity

analysis, can give us an overall picture on the desirability and long-term consequences of any

government program, expanding purely financial net present analysis to an attempt to quantify

the impacts of soft, social, and public good factors. In an era where declining budgets

necessitate a means of differentiating among the benefits and costs (and on whom those costs

fall, and under what time frame) of government programs, such an empirical technique allows

for an attempt at most accurately determining the true impacts of spending items. This is vastly

preferable to budgeting through pork or crisis, and supersedes the false dichotomy of the two

prevalent in Washington at the moment.

National Defense, Public Goods, and Expenditure

The United States government spends 19%3 of its budget on national defense. US

government spending on national defense was 4.79% of Gross Domestic Product (GDP) in

2010.4 Spending by the United States Government on national defense has been a significant

2 The social rate of time preference is a subjective choice which can have a major impact on the overall profitability of a given venture. The particular rate that is most accurate or fair is nowhere near settled among economists. See Gramlich, pages 107-110. See also Hansen and Weisbrod, Benefits, Costs, and Finance of Public Higher Education, pages 26-28. They refer to the Joint Economic Committee, US Congress, Economic Analysis of Investment Decisions: Interest Rate Policy and Discounting Analysis, Washington, DC: US Government Printing Office, 1968, p. 16.

3 Samuelson, Robert J. “Defense is Under the Gun.” The Washington Post. March 5, 2012. Retrieved April 2, 2012 from http://pqasb.pqarchiver.com/washingtonpost/access/2601572151.html?FMT=FT&FMT=ABS:FT&date=Mar+5%2C+2012&author=Robert+J+Samuelson&desc=Defense+is+under+the+gun&free=1.

4 “United States: World Development Indicators.” The World Bank. Retrieved April 29, 2012 from http://data.worldbank.org/country/united-states.

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component of government spending, and of yearly GDP. The United States government provides

goods and services as a military presence around the world. It is the dominant purchaser of the

defense and aerospace industries in the US.5

In the case of national defense, the US government engages in market-altering behavior

with these purchases. The creation of national armed forces and strategic support is not left to

the private market. Government intervention in the general case is based on the idea that there is

a market failure in the private markets’ ability to reflect the true value of the good in question

accurately. In such a case, the private market left to its own devices produces a private quantity

provided and a price of a good which does not reflect its true social costs or benefits. A good

that is non-excludable, where a person cannot be excluded from consuming it or taking

advantage of its existence, and non-rivalrous, where one person’s consumption of it does not

diminish the ability of others to consume it, were defined as public goods by Mancur Olson in

The Logic of Collective Action.6 With a good that is both non-excludable and non-rivalrous, the

quantity produced by a purely private market will be less than the socially optimal amount,

because private firms lack sufficient incentive to produce the good. Firms cannot charge

adequately for a good or service when they cannot keep individual customers from enjoying its

benefits, either by excluding them from consumption, or by these consumers diminishing its use

to others by their own use.7 Thus, public goods typically provided by governments are services

with some perceived social benefit that the private market is undervaluing.

5 “The Aerospace and Defense Industry in the U.S.: An Economic Impact Study.” Deloitte. March, 2012. Retrieved April 19, 2012 from http://www.aia-aerospace.org/assets/deloitte_study_2012.pdf. Page 5.

6 Gramlich, Pages 11-17.

7 Olson, Mancur. The Logic of Collective Action. Harvard University Press. 1965. Pages 14-20. See also Gramlich, Pages 16-18 and 33-40.

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Figure 1: Public Versus Private Goods

Gramlich, Edward M. A Guide to Benefit-Cost Analysis. Waveland Press. Prospect Heights, IL. 1990. Page 17.

If left to its own devices, ceteris paribus, the quantity supplied of the public good will be

equal to the sum of the market demand (prices it can directly charge) of three theoretical

consumers that make up the “total citizenry,” if it were a private good. Private market prices of

these goods would not alone motivate sufficient provision, if the good produces benefits for

which the provider cannot directly charge recipients. By this logic, national defense is at least

somewhat a public good, with a rationale for beyond-market provision, and comes with a

constitutional mandate that other government services do not have. This constitutional mandate,

however, does not mean that it is not critically important at a time of fiscal pressure to better

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describe the benefits and costs, and net welfare impacts, of government spending on national

defense.8

National Debt: The Budget Control Act of 2011, Sequestration, and Political Arguments

Congress derives its authority to borrow money to pay for the federal deficit, the

difference between yearly revenues and expenditures, from the US Constitution, Article 1,

Section 8.9 The debt, the total amount borrowed over time, is subject to a maximum amount, a

debt ceiling, which is raised periodically by congressional vote. In June, 2011, this amount was

reached, and a newly-elected Republican majority in the House of Representatives decided to use

the vote to increase the debt ceiling as an opportunity to leverage their desire for reduced deficits

8 The Austrian economic view on public good rationales for government intervention, the definitive opposing theory to public good analytical welfare economics, is well summarized by Peter Kurrild-Klitgaard in The Dynamics of Intervention: Regulation and Redistribution in the Mixed Economy, JAI Press Inc., 2004, “…every government activity necessarily constitutes an intervention, ie., an act whereby resources (in the broadest possible sense) through the coercive intervention of the government are reallocated relative to what would have been the outcome if human beings had been allowed to interact freely, and where this intervention results in welfare losses for at least some of the parties involved and potentially for all.”

Kurrild-Klitgaard notes in criticism of the theoretical simplicity of this view that, “…if we consider the logic of the decision-making situation…then there is simply no necessity for the outcome to be either a totally free market economy or…where everything is regulated and redistributed; there are numerous other options and several other scenarios…the political decision-makers may consider not simply either intervening or not-intervening; rather, they may consider a broad range of policies, ranging from total Marxist-style intervention and all the way to a total…extinction of government activities in that particular area…as well as...an infinite number of other possible policy alternatives, including minor increases or decreases in existing interventions, and even not doing anything at all. At the next node in this decision-tree, to borrow a metaphor from game theory, “nature” will be responding to whatever the decisions of the political decision makers were, but since we have no exact knowledge of the preferences and resources of the agents in the market place (or in the political market), we cannot a priori determine…what the negative consequences will be, including whether or not they will…necessitate a further, future decision on whether to de-intervene or re-intervene, or not…This would indeed also seem to mirror real-world empirical experience fairly well.”

The point, reinforced by Kurrild-Klitgaard, is that the dichotomy between intervention and the free market is oversimplified. The dynamic nature of organic market reactions to government spending patterns (and defense buildup patterns) means that this type of analysis can only be done accurately if one tries to evaluate as many analytical approaches and as much data as is possible, while avoiding making any demonstrative or political conclusions prematurely.

9 “The Constitution of the United States: A Transcription.” The Charters of Freedom. Retrieved December 2012 from http://www.archives.gov/exhibits/charters/constitution_transcript.html.

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and debt going forward.10 Much of this spending is on entitlement programs, much is a result of

the global recession of 2008 and the stimulus response, and much is spent on national defense.

A paper published by Carmen Reinhart and Kenneth Rogoff at Harvard University,

entitled, “Growth in a Time of Debt (GITD)”11 gave some academic support to this political

momentum. Using national debt data for 44 countries over 200 years, this paper asserts that as

nations’ gross national debt12 exceeds 90% of GDP, average yearly GDP growth declines by

3.5%, and that “…there is a nonlinear response to market interest rates as countries reach debt

tolerance limits. Sharply rising interest rates, in turn, force painful fiscal adjustment in the form of tax

cuts or spending cuts, or in some cases, outright default.”13

10 “Federal Debt Ceiling.” The New York Times. January 27, 2012. Retrieved April 2, 2012 from http://topics.nytimes.com/topics/reference/timestopics/subjects/n/national_debt_us/index.html.

11 Reinhart, Carmen M., and Rogoff, Kenneth S. “Growth in a Time of Debt.” American Economic Review: Papers and Proceedings 100. May 2010. Pages 573-578. Retrieved April 18, 2012 from http://www.economics.harvard.edu/files/faculty/51_Growth_in_Time_Debt_aer.pdf. GITD will be analyzed more closely and compared to the Economic Policy Institute (EPI) paper intended as counterargument, when the true long-term benefits of a reduced debt to growth and reduced borrowing costs (interest rates) are analyzed later.

12 The sum of both private and public debt. Public debt is defined as intra-governmental debt, or debt owed from one part of the government to another. The EPI paper argues that “Because of limited data availability, the GITD paper is only able to base its conclusion on an analysis of gross debt rather than the more-appropriate measure, public debt. The debt that is economically relevant is the debt held by public, not the gross debt (page 2).”

13 See Reinhart/Rogoff, page 573

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US debt is approximately $15.7 trillion, 104% of current GDP of $15.1 trillion.14 The

implication of GITD is that increased doubt in the US’s ability to pay back a larger debt burden

would increase the risk premium on market interest rates required to compensate lenders for

lending to the US government. As a result, the cost of paying interest on government borrowing

would increase, further increasing the debt, and a vicious cycle could follow where the rate of

interest rate acceleration would increase exponentially, rapidly forcing default as creditors lost all

faith.

However, in The Dynamics of Intervention: Regulation and Redistribution in the Mixed

Economy, Peter Kurrild-Klitgaard offers a criticism of the Austrian school that can apply to

GITD as well:

“While government intervention indeed seems empirically overall to be overall hurtful

to growth and prosperity…it is less obvious that the interventionist regimes (as Mises and

Hayek put it) necessarily do extremely poor (sic). While the consequences of government

intervention are far from as positive as envisioned by the most optimistic champions of such

policies…even the most obvious of all types of government activity, the size of the public

sector, does not seem to have significant visible harmful (or beneficial) consequences with

regard to economic growth. In certain passages of Mises and Hayek it seems specifically to

sound as if there really are two and only two possibilities at each “decision node,” to

intervene or not to intervene, and two and only two possible final outcomes, either a

14 “U.S. National Debt Clock: Real-Time.” US Debt Clock.org. Retrieved April 29, 2012 from http://www.usdebtclock.org/. The inputs into this model reflect a certain point in time. However, if these numbers change, it is easy to simply plug the new numbers into the model (the framing of which in the first place is the hard part, and is the main focus here).

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completely free market economy or a completely regulated, planned economy…Hayek for

example…seems to suggest that there is a “point of no return” after which interventions

necessarily will lead to a total planned economy.”

The best approach to defense fiscal policy would be to develop a more accurate

framework for quantifying the relative net welfare gains or losses, and financial impact, of each

policy alternative, in order to improve governmental investment decisions.

The Budget Control Act (BCA) of 2011 was the resolution of the 2011 debt-ceiling crisis,

signed into law July 31, 2011.15 It enacts $2.4 trillion in cuts over 10 years, $900 billion of

which occurred immediately, including $487 in cuts in defense spending. The BCA created a

congressional committee to design a plan for the remaining mandatory cuts, or a sequestration

would occur with automatic spending cuts. The committee failed to reach consensus by its

November, 2011 deadline, and automatic cuts over ten years and four spending categories were

enacted. From a starting authority from 2013-2021 of $5.3 trillion, an additional $492 billion

was to be cut from defense spending under sequestration. Cuts in spending on national defense

represented 9.3% of the total amount budgeted for defense over this time period, and 42.6% of

the total sequestration cuts, although current year defense spending comprises only 19% of the

national budget. 16 The other three categories cut, entitlements, non-defense discretionary

spending, and net interest, comprise lesser percentages of sequestration as a whole.

15 “Federal Debt Ceiling.” The New York Times.

16 Samuelson, Robert J. “Defense is Under the Gun.” The Washington Post. March 5, 2012. Retrieved April 2, 2012 from http://pqasb.pqarchiver.com/washingtonpost/access/2601572151.html?FMT=FT&FMT=ABS:FT&date=Mar+5%2C+2012&author=Robert+J+Samuelson&desc=Defense+is+under+the+gun&free=1.

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Sequestration cuts across the board, without any attempt at determining the smartest investments

(with the worst combined social and financial return-on-investment) to cut.

Figure 2: Automatic Cuts By Sequestration from 2013-2021 by Spending Category 17

Spending Category

Total Amount of Spending

Authority, 2013-2021, Pre-

Sequestration

Amount Cut by Sequestration

% of Total Spending

Authority in this Category Cut by

Sequestration

% of Total Sequestration

Cuts

Entitlements $26.1 trillion $171 billion 0.66% 14.8%Non-Defense Discretionary

$11.3 trillion $322 billion 2.8% 27.9%

Defense $5.3 trillion $492 billion 9.3% 42.6%Net Interest $3.6 trillion $169 billion 4.7% 14.6%

Cutting this historically large a component of a major area of government expenditure

inspires impassioned arguments for and against. Defense Secretary Leon Panetta stated in

congressional testimony on February 16, 2012 that sequestration "would . . . inflict severe

damage on our national defense." Panetta wrote to Senators John McCain of Arizona and

Lindsey Graham of South Carolina that sequestration was, “devastating…the smallest ground

force since 1940, the smallest number of ships since 1915, and the smallest Air Force in its

history."18

17 Adapted from “Budget Control Act Sequestration Would Hit Defense Hardest.” The Heritage Foundation. Retrieved April 2, 2012 from http://www.heritage.org/federalbudget/budget-control-act.

18 See Samuelson, Robert J. “Defense is Under the Gun.”

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Some defense policy experts argued that sequestration signaled to China, Iran, and North

Korea that the United States was less committed to its interests.19 House Armed Services

Committee Chair Howard McKeon echoed those views in a speech on April 25, 2012, in

anticipation of the formal markup hearings on the 2013 Defense Authorization Bill on April 26th

and 27th. In an April 25 article covering the speech for the Army Times, McKeon is quoted as

saying that “the defense cuts in the law (The Budget Control Act of 2011) need to be rolled

back.”20 He mentions “mitigating end-strength reductions, and also preserving the key industrial

base.”21

Arguments for the cuts in defense spending center on either financial return; that defense

spending is a poor investment for the government and American people, or on strategy; that a

larger defense presence in and of itself is not necessarily the best way to achieve US goals.22

With regards to the domestic return on investment for government defense expenditure, the funds

not spent on defense could be used in any alternative program, or saved. The risk premium

19 Michael O’Hanlon at the Brookings Institute and Mackenzie Eaglen at the American Enterprise Institute. Noted by Robert Samuelson’s editorial in the Washington Post.

20 Brannen, Kate. “McKeon: No More Cuts to Army’s Heavy Brigades.” Army Times. April 25, 2012. Retrieved April 29, 2012 from http://www.armytimes.com/news/2012/04/dn-buck-mckeon-no-more-cuts-army-heavy-brigades-042512/.

21 This assumption that there is an associated industrial base created by defense spending and that this base contributes to net national welfare cannot simply be accepted without inquiry, and will be investigated further.

22 There is difficulty in defining exactly what “US goals” are in either a normative or positivist sense. We will do our best to account for this in as empirical and positivist an analytical framework as is possible, before later compartmentalizing and qualifying any attempt at a normative approach that would by definition entail what we “should” be paying (for).

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associated with US debt that increases our interest rates and our cost of borrowing, according to

Reinhart and Rogoff, has become prohibitive, and that could be a source of another economic

benefit from cutting defense expenditure, the impact on mitigating increased interest rates and

retarded GDP growth due to excessive debt.23

The second argument against spending on national defense, that defense spending in and

of itself is some combination of strategically ineffective and morally wrong, would ideally be

quantified in economic terms for the sake of comparability, which means quantifying the value

of achieving US strategic objectives, which is difficult. An increased national defense presence

may provide no real benefit on the world stage, or at least, to take for granted that it does so may

be too hasty in the interest of empirical honesty. The question requires substantive technical

backgrounds on global strategy and military operations, as well as operations research and

complicated mathematical/computer modeling.24

There is also a more normative isolationist ideal that relates to these questions, that

meddling in world affairs is not the business of the United States, and that in and of itself,

regardless of specifics of financial return, it is either an amoral new imperialism, or simply that

23 See Reinhart and Rogoff.

24 The possibility should not be prematurely ruled out that the value of the public good component of national

defense could be a negative number. Another approach to modeling competitive scenarios for military spending, which is integral to accurately assessing the economic benefits or costs from an increased presence, is that of an arms race based on game theory. For a classical game theoretic modeling of “likely” defense strategy undertaken by national actors, see chapter 2.6 in Bowles, Samuel and Kendrick, David. Notes and Problems in Microeconomic Theory. Markham Publishing Company, Chicago, IL, 1970. For a more recent approach to same, see chapter 10 for the perspective of an arms race/weapons stock buildup game, chapter 11 for the public good valuation and tendencies of military alliances, and chapter 12 for appropriation of resources as a determinant of strategy in Anderton, Charles H., and Carter, John R. Principles of Conflict Economics: A Primer for Social Scientists. Cambridge University Press. New York, NY. 2009.

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spending in the wake of the financial crisis should center on domestic rebuilding in various other

spending categories under the rationales of infrastructure or job creation.25 This overall

sentiment towards defense spending is shared by a diverse spectrum of political groups. The

website of Libertarian Presidential Candidate Ron Paul reads,

“Acting as the world’s policeman and nation-building weakens our country, puts our

troops in harm’s way, and sends precious resources to other nations in the midst of an

historic economic crisis. Taxpayers are forced to spend billions of dollars each year to

protect the borders of other countries, while Washington refuses to deal with our own

border security needs. Congress has been rendered virtually irrelevant in foreign policy

decisions and regularly cedes authority to an executive branch that refuses to be held

accountable for its actions. Far from defeating the enemy, our current policies provide

incentive for more to take up arms against us.”26

This argument has been given extra political fervor recently due to difficulties in

anticipating the practical logistics of a hypothetical theory of nation-building in Iraq and

Afghanistan. Following this line of reasoning raises another question: whether the goal of the

US in a net welfare analysis is prevention and mitigation of conflicts, or whether such an

endeavor is, in normative, “unquantifiable” terms, the “wrong” goal. For a net welfare analysis,

25 (See Gramlich, page 63). “Cases where a government project can actually move a market enough to cause price distortions may be relatively rare, but there could be significant distortions…most common involves the “jobs” issue. Politicians often favor projects because they entail construction or other jobs in a legislative district…counter to that of a benefit-cost analysis, which considers jobs as a use of labor and a cost, not a benefit.”

26 “National Defense.” Ron Paul 2012: Restore America Now. Retrieved April 29, 2012 from http://www.ronpaul2012.com/the-issues/national-defense/.

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which is the preferred assumption? Should the goal of global US military strategy be conflict

prevention, avoiding the negative economic effects of these conflicts on other nations, and

avoiding conflict escalation that could subsequently more directly threaten US interests? Or,

should it be a more selfish goal, where economic benefits are derived from the most resources

we can “conquer”? This makes it difficult to evaluate the sequestration cuts in this normative

sense, unless one can take the $979 billion to be cut and match it to each program that will be cut

(and then attempt to best quantify the “soft” benefits of military presence, one spending program

at a time).

Developing a Theoretical Model for Net Welfare Analysis of Sequestration Cuts in

National Defense Spending

Subtracting all purely pecuniary impacts and then using the remainder as an indication of

the valuation of the public component is a positivist approach. It indicates what we currently pay

for that public good component of national defense, describing things as they are. Quantifying

the ideal strategic benefit of defense spending, whether that ideal strategy be through carnivorous

maximization of resources, a presumption that all intervention is unjust imperialism, or simply

trying to determine the expected value of the cost of conflict avoided, is a more normative

approach, presuming an ideal best policy for defense spending choices.

If we can take for granted the assumption that the goal of any defense program is

prevention of a conflict, or the prevention of a quantifiable incremental degree of escalation of a

conflict, then one could match the cost of that particular defense item with the estimated value of

the theoretical conflict avoided through its use (the benefit of the military spending).27 This

27 Ideally multiplied by the percentage by which that particular spending item contributes to the prevention of that conflict. For example, if a particular missile defense system contributes 10% to the

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question may push the limits of an attempt to quantify the value of a defense presence, and we

may have to take for granted the normative preference that prevention of conflicts is indeed a

worthy goal. Thus, the return-on-investment of US government spending on national defense is

determined in part by the money saved by conflict (with an associated cost) being avoided due to

each defense spending line item in this initial model. This is a principal benefit. Various defense

programs, each attempting to provide security (and reduce the risk of financial loss) in a different

way, will provide a better conflict-avoided ROI than others. Multiplying the percentage

reduction in likelihood of occurrence of that conflict provided by each program with the total

cost of the potential conflict to get an expected value figure will better identify benefits beyond

purely pecuniary ones, and better prioritize defense spending in an era of more rigorous

standards for federal return-on-investment.

An initial theoretical model for analyzing the financial and social return-on-investment

(cost-benefit analysis) of national defense spending cuts could define the benefits of cuts28 as:

1) immediate savings to the government budget, SI, resulting from the $487 billion cut

from defense spending

overall deterrence of a conflict with total long-term net welfare costs of $50 million, then the “conflict avoided” financial benefit would be $5 million. It is obviously a strong assumption to think each program could be so linearly-traced. Again, ideally we would use an optimization model that incorporated both financial impacts and defense stock build-up game theory.

28 Important to reiterate the distinction that here we are looking at the financial and social impact of the decision to CUT spending (where the simple reversal of the signs of the components would give the impact of the decision instead to SPEND that amount).

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2) future economic benefits from a reduced debt, SF, resulting from 1) the discounted

present value of future cuts ($492 billion), and from 2) an improved fiscal outlook,

both in reduced borrowing costs (interest rates) and increased growth, measured by

the present value of improved future growth in GDP resulting from the $979 billion

saved on the long-term national debt.29

SI, “immediate savings,” represents a cash inflow to the United States government, which

naturally it can spend however it sees fit, affecting the welfare of a multitude of various

combinations of groups, depending on the alternative area where the money is spent.30 SF,

“future savings,” is the discounted present value of all future gains, reflected in improvements in

GDP growth from alleviation of the growth hindrance from excessive debt being somewhat

mitigated (to the extent of the money saved from the cut).31 The costs in this framework are the

29 Owing a little to the lack of specificity of any impacts of the borrowing cost OTHER than directly on the 3.5% decline in the GDP growth rate, or on the specific nature of the escalating interest rate curve in GITD (Reinhart and Rogoff), the reduced borrowing costs and GDP gains will be hopefully adequately accounted for simply in the benefits to GDP. As Gramlich indicates, in a net-welfare analysis, one would err on the side of conservatism and avoid double-counting. See Gramlich, Pages 79-83.

30 The choice of the government where this immediate cash inflow is spent no doubt affects the final distribution and efficiency of the welfare gains, especially if one accepts the principle that different groups (typically stratified and defined by income, wealth level, consumption, or other factors) should have different weights assigned for computing the net welfare gain to society as a whole, when each particular group receives a gain. See Gramlich, pages 117-121. However, because this paper intends to isolate the variable of the economic impacts of money cut from a defense budget, this issue will not be debated here. Such an evaluation would ideally encompass a welfare analysis of all possible alternative options for government expenditure. The benefits of money saved from a cut depend on where that money is then spent, or whether it is saved, and expands the analytical framework beyond a single paper.

31 Allowing for a wide range of sensitivity analysis on the true impacts of government expenditure foregone (saved) on GDP and IR rates over the long-term is important. These rates are also affected by a

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benefits of spending on national defense foregone by cutting that spending: including industrial

spillover effects (infrastructure, jobs, etc.), and the “soft” public good value of national defense.32

Segregating Positive and Normative: The Value of Peace, and How to Obtain the Best

“Peace Return-on-Investment”

Stopping with the equation of SI + SF – GS (immediate savings and long-term savings in

increased GDP growth and reduced borrowing costs, less the foregone industrial spillover

benefits, or “growth spillovers”) would give us a simple net welfare analysis of the financial and

more easily quantified impacts of a reduction in US government spending on national defense, at

least with regards to domestic economic welfare. This provides the return-on-investment of

spending on national defense, if there were no residual public good value. These purely

economic impacts are described first in an effort to avoid normative or hypothetical assumptions

that there is a peace-creating value to an increased national defense, or that the economic impacts

that result from strategic objectives exceed the cost of obtaining them. By calculating the more

easily computed economic costs and benefits first, the remaining value should represent the

current price of the public good component.33 This “remainder” is theoretically the value of

multitude of other factors, and the specific relationship between them is not an area where there is consensus. (See the EPI retort to Reinhart and Rogoff) For the purposes of the simplicity of this analysis of establishing a theoretical framework, static point estimates for likely values will be used, which is less than ideal, but more practical.

32 (If there are any) This could be a negative number, allowing for the possibility that the effects on the economy from increased government spending on national defense are negative. There is a no de facto reason to assume that the industrial multiplier effect, or the public good component, are positive.

33 Or a portion of that leftover component could go to rents, to defense contractors, corrupt government officials, or others. The dollar remainder used to quantify the public good component is an indication of how the world currently values the public good component through price information. This is not necessarily the “true” value of what the public good of national defense should bring to us, but it is

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national defense, in terms of the economic valuation of the public good component, or what the

market currently values as the premium after purely pecuniary financial return. Gramlich

considers this a recommended methodological approach for assigning values to factors that are

difficult to quantify with conventional economic analysis, essentially solving for the remaining

variable.34 This is the positivist approach, describing things are they are.

If national defense were a perfectly private good, then the calculation of SI + SF- GS

should equal zero, assuming that the national government is a rational decision-maker. If the

money saved now and in the future by not spending it on national defense is greater than the

direct domestic spillovers resulting from US government purchases, or, SI and SF > GS, then

defense spending, in terms of the prices paid for it as though it were a private good with no

intrinsic, non-price-reflected value, is a bad investment. The US should require a certain

approximately how the US values it.

An opposing view to the idea of the public good remainder is that put forth by James Buchanan in Cost and Choice. Positivist net welfare analysis of public goods is based upon the assumption that prices accurately reflect costs incurred, which is not always true. However, for simplicity’s sake, and in the interest of getting as much additional data and expanding the analytical framework as rigorously as possible, it is still worth trying to model these costs as best we can.

The variables in the equation in reality may take on highly non-linear patterns depending on a multitude of other, ever-changing, more organic factors. This framework is not intended to ignore these issues. An important question is whether or not macroeconomic data or other prices should account for all this information already, so that quantifying these specific factors individually may be redundant, or double-counting.

34 See Gramlich, page 225.

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additional minimum level of economic benefits from national defense due to strategic objectives

obtained, be they peace or war, in order to make it indifferent to this spending level. 35

Conversely, if GS is greater than SI + SF, beneficial spillovers in domestic government spending

on national defense enjoy such a high multiplier that they exceed the immediate and long-term

costs of these government purchases. In this case, one could apply the similar “remainder” logic

to identify the maximum negative allowable aggregate public (world) good impact of national

defense strategy, in order to make the United States indifferent that such a good financial

investment was wreaking so much havoc throughout the world. In the interest of avoiding

assumptions before looking at the data, this should not be ruled out prematurely as a possibility

of the true investment impact of national defense spending.

From a normative perspective, the public good impacts of defense, or GD, can be broken

down into two components. First, there are economic impacts in the United States as a result of

strategy or defense actions, GDd. While this analysis frames the Net Kaldor-Hicks benefit from

the perspective of the US, doing so does not preclude hypothetically assigning values to the

benefits or costs experienced by foreign nations and their citizens as a result of US defense

strategy and expenditure. This leads to the second component, the welfare change for foreign

35 In equilibrium, marginal utility and marginal cost of the purchasing level should equal. The result is indifference from changing spending patterns because total utility relative to cost is currently maximized. Even if this is not the current reality, it is the optimal arrangement, and one can try to estimate the difference between the two for the public good valuation.

19

nations as a result of defense spending, GDf.3637 There are also a number of other soft factors, or

affected related markets with associated social cost components affected by national defense that

affect net welfare of human beings. These market externalities may be captured fully in prices,

or not,38 and they may be relatively difficult to compute, or insignificant, or not. Reviewing the

literature and computing each of these soft factors would not be practical for this paper, and it

may amount to double-counting factors already included by the “remainder” framework. This is

consistent with Gramlich’s general advice for cost-benefit analyses of erring on the side of

avoiding double-counting.

An interconnected, organic optimization model that incorporated the true potential cost of

each stage or type of conflict (and thus the benefit of avoiding that conflict), as well as the

effectiveness (an impact that would come down to a specific contributory percentage) of each

defense spending program in preventing those conflicts, would be needed to ascertain the true

benefit of a given defense spending item. This is as much a question for generals as it is one for

36 This can be multiplied by different distributional weights (see Gramlich, pages 177-121), depending in large part on how one feels foreign welfare should be evaluated relative to domestic.

37 There are other frameworks and priorities for evaluating defense strategy. A truly rigorous cost-benefit analysis of national defense would incorporate long-term political-strategic implications with the impacts of such action. This paper aims to break down the rough correlative relationship between US government spending on national defense and all other economic impacts on the welfare of various groups in the US. So, other than cost-of-conflict avoided, and avoiding any assumptions about distributional weights for different countries, the impact to foregn welfare as a result of US defense spending will not be fully explored. See Anderton and Carter, and Bowles and Kendrick.

38 Because counting them separately from macro-economic indicators like GDP could be double-counting/redundant.

20

economists. But, some defense programs may be more easily traceable to a certain geographic

area or type of conflict than others, enabling an easier analysis that can at least be used for

illustrative purposes, or can even be fully effective, albeit only on those defense spending items

that match to a particular conflict with an identifiable cost-of-conflict avoided most clearly.

Computing the remainder in our equation gave us a positivist value for the premium paid for the

public good component of national defense. Alternatively, determining the impact of a particular

defense program on prevention of a conflict with a given potential cost if it were to occur, will

give us the normative value of what we should be paying. Ideally, one could then determine the

difference, if any; and adjust policy and spending accordingly. Idealistically, finally letting

optimal strategy from defense and economic perspectives dictate this policy would also let the

US achieve its goals far more effectively and efficiently.

A Practical Implementation: Using the Above Theoretical Framework to Calculate the

Economic Impacts of the $979 Billion Sequestration Cut to Defense Spending

The immediate savings resulting from a cut in defense spending, SI, is the exact amount

cut. There is no multiplier, because this money is an immediate cash inflow, relative to the prior

budgetary allotment. For the BCA, SI was $487 billion when the legislation was passed, an

immediate cash gain. Future savings, or SF, is comprised of the additional $492 billion as a

result of sequestration over 9 years (discounted by present value accordingly), and the present

value of the discounted improvements in long-term GDP growth due to the removal of the “3.5%

annual GDP growth” reduction noted by Reinhart and Rogoff in (GITD).

GITD’s debt-growth causality is still only a theory. There is a counterargument, voiced in

a paper written by Josh Bivens and John Irons at the Economic Policy Institute (EPI), entitled

21

“Government Debt and Economic Growth,” which argues that while there is a strong correlative

relationship, there is no evidence of causality between rising debt and slowing growth:

“There is considerable reason to believe that causality may run the exact

opposite direction. First, the theory that governs the relation between debt and growth

suggests strongly that causality runs more firmly from slower growth to higher debt

loads. Slow economic growth, and especially growth that is slower than policy makers’

expectations, will lead to higher levels of debt as revenues fall and as automatic-stabilizer

spending increases.”39 40

The other major criticism of GITD by EPI is that no modern country has experienced a

debt crisis, where interest rates escalated rapidly due to investor panics and the government

became insolvent. The EPI dismisses this as a complete impossibility.41 The debt crises in

Greece and potentially other European nations (Portugal, Spain, and Italy) undermine this

39 Bivens, Josh and Irons, John. “Government Debt and Economic Growth.” Economic Policy Institute. July 26, 2010. Retrieved April 19, 2012 from http://www.epi.org/publication/bp271/. Pages 6-7.

40 There are other smaller criticisms of GITD voiced in the EPI paper. GITD relies on gross debt in order to make its large sample size of 44 countries over 200 years more comparable. The EPI paper argues that private debt is a more meaningful economic indicator, as debt owed from one government agency to another is less damaging. The EPI paper also states that GITD does not allow for an organic analysis where other factors could also be impacting debt and GDP levels, and that the US has very little experience with debt levels over 90 percent, a six-year span in the 1940’s, so that the conclusions of GITD cannot be applied.

41 (See Bivens/Irons, page 6). “For example, Orszag, Rubin, and Sinai (2004) and Ball and Mankiw (1995) raise…that rising debt levels could make investors wary that a nation will not be able to make debt-service payments to its creditors. The resulting flight of investors from the nation’s debt could cause interest rates to spike as higher returns had to be guaranteed to creditors to persuade them to keep financing a nation’s deficits. The interest rate spike would then lead to financial market “disarray” and hurt growth through this channel. While nobody would dispute that financial crises caused by excessive debt have inflicted large economic costs on many countries through time, these crises have generally not afflicted modern economies, like the United States’, that can borrow in their own currency and that have independent monetary and exchange rate policies.”

22

argument somewhat, although the US may have some special standing as a currency of last resort

due to its overall hegemony in the world.

Still, the 3.5% reduction after 90% debt-to-GDP ratios cited by Reinhart and Rogoff is

conceptually and sequentially mostly distinct from the “tail risk” of a panic of disastrously

escalating interest rates as in Greece that is discounted in the EPI paper as impossible. If one

could establish the percentage level of debt relative to GDP where not only did GDP growth slow

(as the authors of GITD assert occurs at 90%), but where interest rates would rise so dramatically

that they would force the government to default on its debt (specifying the particular nature of a

likely non-linear curve), this would be most accurate. Ideally, the counterfactual of avoiding the

small probability of a complete government default (an event with difficult to compute but

dramatic costs) should be calculated as an additional benefit of reducing debt by cutting military

spending, but this will not be computed here, as it would require both sophisticated general

equilibrium modeling and subjectivity, and so will only be mentioned here.

While the EPI criticisms are important, and GITD is only one piece of academic support,

the underlying premise that debt levels above 90% lead to average reductions in GDP growth of

3.5%, and conversely that reducing debt levels down to this threshold level results in a

comparative acceleration in GDP growth, will be accepted for this model for simplicity’s sake. If

it is later proven that the actual GDP growth handicap is actually much smaller (or larger), one

could just recompute the analysis accordingly.

A simplified method to calculate the benefits to long-term GDP growth of a reduction in

debt using GITD is based on the premise that if the US immediately reduced the national debt to

23

90% of GDP from its current level of 104%, annual GDP growth will increase by 3.5%.4243 The

benefits of a budget cut of this size are the long-term improvements (using a 50-year discounted

time period)44 in GDP relative to the current base-case that assumes a 3.5% reduction in GDP

growth rates. Assuming a $15.1 trillion current baseline in GDP, and a baseline rate of GDP

growth of 2.4%,45 the benefits of a reduction in the US debt-to-GDP ratio to 90% will be a rate

of GDP growth that reflects removal of the 3.5% handicap, or .024 / (1-.035) = 1.02487, or

2.487%, as opposed to 2.4%.

However, since we are only computing the benefit of reducing debt by the $979 billion

cut by sequestration, this only represents 48.56% of the reduction in debt needed to get debt

down to 90% of GDP. So, assuming a linear relationship in the debt to GDP growth curve (an

admittedly strong assumption), this spending reduction would only cause 48.56% of the

42 90% is used as the key threshold because GITD states that debt levels over 90% are the problem. This approach where a reduction of debt to 90% of GDP automatically removes the 3.5% growth rate hindrance assumes that all GDP growth reductions as a result of debt-to-GDP ratios over 90% are constant and linear. However, GITD provides little guidance or depth beyond that same assumption. Again, assimilating the entirety of applicable historical data into an optimization/regression/predictive model would be optimal.

43 (See Reinhart/Rogoff). The 3.5% is not a reduction of aggregate GDP. GDP is not reduced by 3.5%. The growth rate (rate of increase) slows by 3.5%.

44 Assuming that there are no additional effects on debt-to-GDP ratios, other economic growth factors, and interest rates over a 50-year period is obviously unrealistic, but we are only trying to isolate the effect of this single variable here. Shorter time periods are included by default in this analysis.

45 United States Government: Congressional Budget Office. “Budget and Economic Outlook: Fiscal Years 2011 to 2021.” January 26, 2011. Retrieved April 25, 2012 from http://www.cbo.gov/publication/21999. Rate used by CBO for projections through 2021.

24

(2.487%-2.4%=.087%) increase in GDP growth, which amounts to an improvement to 2.44%

GDP growth, as opposed to 2.4% under the current debt level. Present values of the differences

in GDP resulting from this hypothetical higher growth rate will be computed out for 1, 3, 5, 20,

35, and 50 year periods, using the current interest rate on 20-year Treasury Bonds for discounting

and compared to growth under the current debt-to-GDP ratio (104%).

Figure 3: Annual GDP Growth Increase from Reducing Debt-to-GDP Ratio to 90%:

2012-2062, $ trillions)

Years

GDP ($ trillions), Base Case (2.4%

growth)PV (2.73%

IR)

GDP, Reduced Debt-to-GDP Ratio From Sequestra-

tion Defense Cuts (2.44% growth)

PV (2.73% IR)

Yearly GDP Gains After

Sequestration Cuts

Cumulative Discounted GDP Gains

2012 15.1000 15.1000 15.1000 15.1000 0.00002013 15.4624 15.0515 15.4688 15.0577 0.00622014 15.8335 15.0031 15.8466 15.0155 0.01242015 16.2135 14.9549 16.2336 14.9735 0.0185 0.0371 3-years2016 16.6026 14.9069 16.6301 14.9315 0.02462017 17.0011 14.8590 17.0362 14.8897 0.0307 0.0924 5-years2018 17.4091 14.8113 17.4523 14.8480 0.03672019 17.8269 14.7637 17.8785 14.8064 0.04272020 18.2548 14.7163 18.3151 14.7650 0.04872021 18.6929 14.6690 18.7625 14.7236 0.0546

2022 19.1415 14.6219 19.2207 14.6824 0.0605 0.335610-years

2023 19.6009 14.5749 19.6901 14.6412 0.06632024 20.0713 14.5281 20.1710 14.6002 0.07212025 20.5531 14.4814 20.6636 14.5593 0.07792026 21.0463 14.4349 21.1683 14.5186 0.08362027 21.5514 14.3885 21.6853 14.4779 0.08932028 22.0687 14.3423 22.2149 14.4373 0.09502029 22.5983 14.2963 22.7574 14.3969 0.10062030 23.1407 14.2503 23.3132 14.3566 0.10622031 23.6961 14.2046 23.8826 14.3164 0.1118

2032 24.2648 14.1589 24.4659 14.2763 0.1173 1.256020-years

2033 24.8471 14.1134 25.0634 14.2363 0.1228

25

2034 25.4434 14.0681 25.6755 14.1964 0.12832035 26.0541 14.0229 26.3026 14.1566 0.13372036 26.6794 13.9779 26.9449 14.1170 0.13912037 27.3197 13.9330 27.6030 14.0775 0.14452038 27.9754 13.8882 28.2771 14.0380 0.14982039 28.6468 13.8436 28.9678 13.9987 0.15512040 29.3343 13.7991 29.6752 13.9595 0.16042041 30.0383 13.7548 30.4000 13.9204 0.16562042 30.7592 13.7106 31.1424 13.8814 0.17082043 31.4975 13.6666 31.9030 13.8425 0.17602044 32.2534 13.6227 32.6822 13.8038 0.18112045 33.0275 13.5789 33.4803 13.7651 0.18622046 33.8201 13.5353 34.2980 13.7265 0.1913

2047 34.6318 13.4918 35.1357 13.6881 0.1963 3.656935-years

2048 35.4630 13.4485 35.9938 13.6498 0.20132049 36.3141 13.4053 36.8728 13.6115 0.20632050 37.1856 13.3622 37.7734 13.5734 0.21122051 38.0781 13.3193 38.6959 13.5354 0.21612052 38.9920 13.2765 39.6410 13.4975 0.22102053 39.9278 13.2339 40.6091 13.4597 0.22582054 40.8860 13.1913 41.6009 13.4220 0.23062055 41.8673 13.1490 42.6169 13.3844 0.23542056 42.8721 13.1067 43.6577 13.3469 0.24022057 43.9011 13.0646 44.7239 13.3095 0.24492058 44.9547 13.0227 45.8162 13.2722 0.24962059 46.0336 12.9808 46.9352 13.2351 0.25422060 47.1384 12.9391 48.0814 13.1980 0.25892061 48.2697 12.8976 49.2557 13.1610 0.26352062 49.4282 12.8561 50.4587 13.1242 0.2680

Total 7.183850-years

We are making the assumption here that reduced borrowing costs would be shown entirely in

GDP, and not in any additional lowering of the interest rate used as discount factor (2.73% for T-

bills for both scenarios). This is made less clumsy at least in part by the fact that GITD assumes

all interest rate premium on national debt is factored into the GDP growth handicap of 3.5%; and

we will again err on the side of avoiding double-counting.

26

Quantifying the Domestic Industrial Spillovers from United States Government

Purchases on National Defense, GS

According to Principles of Conflict Economics, by Charles Anderton and John Carter,

the effect of defense spending on economic growth for analyzing industrial spillovers would in

theory take on one of three possible forms. Crowding out may occur (a), where a society that

chooses to produce marginally more military goods relative to civilian goods under-invests in

other productive areas, leading to a small capital stock and diminished economic growth in these

areas. This is an economic cost. This is a more substantive version of the argument that defense

spending could be better spent on domestic areas instead. Crowding in may occur (b), where

increased defense spending could stimulate economic activity, because society is under-utilizing

its factors of production, like labor and capital, without such spending. It is on an inefficient

point within its production possibilities frontier. Consumers will then spend more income on

other industries, with a multiplier effect. This is an economic benefit. If the society is already on

the most efficient part of its production possibilities frontier, no benefits will occur. Growth-

spinoffs may occur as well (c), where new technology or education can be discovered through

investment in military goods.

27

Figure 4: Theoretical Economics of Defense Spending and Economic Growth

Anderton, Charles H., and Carter, John R. Principles of Conflict Economics: A Primer for Social Scientists. Cambridge University Press. New York, NY. 2009. Page 23.

Growth spin-offs will not be analyzed here separately from the fact that they may be a

contributing component of correlated long-term changes to an aggregate multiplier effect on

GDP. The pecuniary costs to be subtracted from SI and SF in order to obtain the net welfare

analysis of a cut in national defense spending include any positive spillovers the government

spending creates for the domestic economy, as measured by changes in real GDP, GS.

“The U.S. Economic Impact of Approved and Projected DOD Spending Reductions on

Equipment in 2013” by Dr. Stephen Fuller at the Center for Regional Analysis at George Mason

University, calculates an economic multiplier to determine the domestic industrial benefits of

government spending in the defense industry. When multiplied by the change in government

spending on national defense, this multiplier in theory gives the total economic impact of the

change on domestic industrial production. According to this study, domestic economic spillovers

from a cut in defense spending include both direct decreases in revenue for sellers to the

government of national defense products and services, and indirect impacts on 1) suppliers for

these firms, 2) impacts on the suppliers’ suppliers, and 3) decreased general purchasing in the

28

economy due to reductions in payroll and wages and in operating purchases.46 According to this

study, a reduction in government defense purchases as a result of the BCA has a large negative

multiplicative impact on US domestic industry. Fuller’s significant spillovers include “lost jobs

and income, reduced non-wage expenditures, and a decreased rate of economic growth.”

Additionally, Fuller asserts that

“…for each job lost by DOD’s prime contractors…as a result of DOD cutbacks for the

acquisition of military equipment, three additional jobs would be lost in other sectors…

job losses in non-military equipment manufacturing would occur in professional and

business services, financial, information and administrative services, retail trade, leisure

and hospitality services, education and health services, construction, and other

manufacturing.”

Fuller examines the economic impact of the immediate approved spending cuts resulting

from the BCA, $45.01 billion. Fuller claims that each $1 in reduced spending will have the

actual economic impact of an aggregate of $2.64 in lost economic activity (a 2.64 multiplier

effect). 1,006,315 full-time jobs would be lost, 352,745 as a result of direct contractors and the

rest from businesses related to those contractors. In addition, this $45.01 billion reduction in

defense spending would decrease annual GDP growth from 2013 from 2.8% to 1.8%.47

The industrial spillovers from government purchasing described by Fuller provide a

useful starting point, but the study itself does not provide specific insight into its methodology.

46 Fuller, Stephen S. “The Economic Impact of Sequestration Budget Cuts to DOD and Non-DOD Agencies as Modified by the American Taxpayer Relief Act of 2012.” Center for Regional Analysis, George Mason University. October 24, 2011. Retrieved April 2, 2012 from http://cra.gmu.edu/pdfs/Sequestration_Update.pdf.

47 Fuller, Stephen S. “The Economic Impact of Sequestration Budget Cuts to DOD and Non-DOD Agencies as Modified by the American Taxpayer Relief Act of 2012.”

29

Logical connections are described (suppliers of suppliers, for example, are affected down the

supply chain) and then final numbers are given, with little description as to how the study got

from start to finish. Specific computations were completed by Economic Modeling Specialists

International, EMSI, but there is no mention of the Fuller study methodology on its website (and

none more specific than that just described in the paper itself). Given that the Fuller study was

commissioned by, and is hosted on the website of, the Aerospace Industries Association (AIA), a

defense-industry trade association, the 2.64 multiplier should be viewed with skepticism and

alternative multipliers need to be reviewed. Trade association economic impact analyses like

Fuller’s provide useful information, but may suffer from an implicit bias and an incentive to

inflate gains. A key example of this is with the assumption in this analysis that employment

gains are a net welfare gain to society in and of themselves, and that these gains should be

computed in addition to GDP, premises that are directly at odds with Gramlich, who states that

jobs are a cost of labor, if anything, and are often a source of politicized claims, or at the very

least, a source of double-counting of gains.48 Similarly, another AIA-commissioned economic

impact analysis of defense spending is that by Deloitte in March 2012. While a thorough and

rigorous analysis of potential spending impacts, the study avoids making a conclusion about a

specific GDP multiplier, and instead focuses on a jobs multiplier.49

The AIA multiplier estimations are useful points of reference, but academic literature not

explicitly commissioned by the affected trade associations would more empirically determine the

most accurate industrial multiplier effect. Robert Barro at the Harvard University Department of 48 (See Gramlich, page 63)

49 “The Aerospace and Defense Industry in the U.S.: An Economic Impact Study.” Deloitte. March, 2012. Retrieved April 19, 2012 from http://armedservices.house.gov/index.cfm/files/serve?File_id=126226cd-bc54-4e4b-a9ec-1ea16e61a2dd.

30

Economics, and Charles Redlick, at Bain Capital, wrote a paper in October 2009 entitled,

“Macroeconomic Effects from Government Purchases and Taxes.” According to this research,

the estimated multiplier for defense spending is 0.6-0.7 at the median unemployment rate. This

multiplier reaches 1.0 when unemployment is around 12%. According to this study, greater

spending by the government tends to crowd out other components of GDP as a general rule, but

crowding out occurs less the higher unemployment is. This is consistent with Anderton in the

Principles of Conflict Economics above. Whether military spending crowds in or out is

dependent on the economy’s position on its production possibilities frontier.50 Private

investment, non-defense purchases, and net exports fall if unemployment is not high, ceteris

paribus. Only when there is slack in the aggregate economy is there even a one-to-one return in

terms of domestic industrial production.

A simple implementation of this multiplier effect again assumes a linear relationship, this

time between unemployment, and the extent to which government purchases crowd out other

spending and the resulting multiplier, using the current unemployment rate of 8.2%, average

historical unemployment of 5.85%,51 (Barro’s multiplier of 0.6-0.7, averaged for simplicity's sake

to 0.65, applies to average historical unemployment), and the point at which Barro and Redlick

claim that the multiplier reaches 1.0, 12% unemployment. On a linear scale between the 12%

50 This presumes that the unemployment rate is the authoritative, most indicative measure of economic health, which is dubious for any single point macro metric, especially this one. But Barro provides a methodology that gives us a simple framework for estimating multiplier effects based on the economic theory of the production possibilities frontier.

51 United States Government. Bureau of Labor Statistics. “Where can I find the unemployment rate for previous years?” Retrieved April 29, 2012 from http://www.bls.gov/cps/prev_yrs.htm. Annual average, 1948-2011. The mean is not the median, as Barro describes, but it will have to work as an approximation.

31

unemployment level, where the multiplier becomes 1.0, and 5.85% unemployment, where the

multiplier becomes 0.65, current unemployment (8.2%)52 would mean that an estimate of the

multiplier would be .7837 (1.0-((1.2-0.82)/(1.2-0.585))*(1.0-0.65)). Thus, the cost of the

immediate BCA defense cuts of $487 billion in terms of foregone industrial production (GDP), at

the current unemployment level of 8.2%, would be $381.66 billion ($487 * .7837), and the

discounted foregone industrial production from the $492 billion to be cut from 2013-2021 is

$337.81.53

In this model for the net welfare impact of cuts in government defense spending, we have

SI (immediate savings) + SF (future savings) of $487 billion + the present value of the $492 in

cuts to be spread from 2013-2021 of $337.81 billion + $7.19 trillion in long-term GDP gains

from decreased debt-to-GDP ratios (over 50 years, alternative time periods can be considered by

looking up the appropriate row on the rightmost column below). We also have the cost of the

foregone benefits in industrial production, GS, of $767.24 billion. Looking at these purely

economic factors, the net benefit of the BCA defense cuts can be seen at various time frames in

the table below.

Figure 5: Net Financial Impacts of $979 Billion Sequestration Cuts ($ billions)

YearsTotal Discounted Benefits ($

billions)Total Benefits - Costs (Foregone Indus-

trial Spillovers)2012 487.0000 -280.24002013 546.4266 -220.8134

52 If the current unemployment rate changes, a user can simply change this variable in the model. This also applies to interest rates for discounting, or amortization across time periods of items like the $492 cut from 2013-2021 (and any other input into the model should be similarly easy to change if needed).

53 This assumes the $492 to be cut from 2013-2021 would be an equal amount each year for simplicity’s sake. Multiplying each of these amounts by the .7837 industrial multiplier effect, and then discounting, gives the $337.81 billion figure.

32

2014 610.6143 -156.62572015 679.5636 -87.67642016 753.2740 -13.96602017 831.7443 64.50432018 914.9724 147.73242019 1002.9556 235.71562020 1095.6903 328.45032021 1193.1724 425.93242022 1253.6380 486.39802023 1319.9501 552.71012024 1392.0731 624.83312025 1469.9715 702.73152026 1553.6098 786.36982027 1642.9529 875.71292028 1737.9657 970.72572029 1838.6133 1071.37332030 1944.8610 1177.62102031 2056.6741 1289.43412032 2174.0183 1406.77832033 2296.8594 1529.61942034 2425.1631 1657.92312035 2558.8955 1791.65552036 2698.0229 1930.78292037 2842.5115 2075.27152038 2992.3280 2225.08802039 3147.4389 2380.19892040 3307.8112 2540.57122041 3473.4116 2706.17162042 3644.2075 2876.96752043 3820.1659 3052.92592044 4001.2545 3234.01452045 4187.4406 3420.20062046 4378.6921 3611.45212047 4574.9768 3807.73682048 4776.2628 4009.02282049 4982.5181 4215.27812050 5193.7111 4426.47112051 5409.8102 4642.57022052 5630.7841 4863.54412053 5856.6015 5089.36152054 6087.2313 5319.99132055 6322.6424 5555.40242056 6562.8042 5795.5642

33

2057 6807.6858 6040.44582058 7057.2568 6290.01682059 7311.4867 6544.24672060 7570.3453 6803.10532061 7833.8025 7066.56252062 8101.8282 7334.5882

This remainder represents the component of the price (the value) paid by the United

States government for national defense beyond its return-on-investment as a means of industrial

production, which in and of itself does not make a profitable investment. The benefits of the cut

greatly outweigh the costs, the foregone industrial production resulting from government

purchases in the defense industry. This implies that there is a public good component of national

defense spending. Purely pecuniary factors make this spending a poor investment. This

represents the positivist remainder, or the current public good valuation for this portion of

national defense spending. The underlying logic could be extended to any defense investment

decision, not just sequestration cuts.

The Economic Value of National Defense as a Public Good: Benefits of Conflict

Avoided: Forecasting the Costs of a Future Conflict

One can try to determine an incrementally more normative non-pecuniary value for

national defense spending by looking at the cost of the potential conflict avoided due to that

defense item. First, one would need a framework for analyzing the typical costs of conflict, and

how they would vary in magnitude and composition depending on the nature of the conflict and

actors involved, in order to make such projections most accurate. Joseph Stiglitz and Linda

Bilmes write in, “The Economic Costs of the Iraq War” that there are many unforeseen costs to

conflict. These include a hampered ability to engage in a separate conflict, increased resource

34

prices, veterans’ disability and economic re-integration, replacing military equipment, military

recruiting,54 and a loss of labor capacity.55

Principles of Conflict Economics notes that violent conflict involves three types of cost

(see Figure 6 below). Diversion, (a), is a re-allocation of a society’s productive resources from

civilian goods to military ones. Destruction, (b), is the destruction of goods, people, and capital,

causing the production possibilities frontier to shift inward. Disruption, (c), is the effect of

conflict on trade, where a nation enjoying net welfare benefits from free trade moves on the

production possibilities frontier back to a point in autarky.56

54 Which would imply, although the authors do not mention it, that human capital that could otherwise be more productively employed (or more abstractly, more productively self-actualized) is subverted from that path. This might be counteracted in part by elevating employment opportunities through military service for those with less exciting prospects. The extent to which one outweighs the other might depend on the initial socio-economic composition of the adult workforce, and may also be double-counted in cost-benefit frameworks that analyze the impact of military spending based on a nation's current position on its production possibilities frontier.

55 See Bilmes, Linda, and Stiglitz, Joseph E. “The Economic Costs of the Iraq War: An Appraisal Three Years After the Beginning of the Conflict.” Harvard University: Kennedy School of Government Faculty Research Working Paper Series. July 2006. Pages 4-19.

56 Autarky meaning trade isolation.

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Figure 6: The Costs of Conflict

Anderton, Charles H., and Carter, John R. Principles of Conflict Economics: A Primer for Social Scientists.

Cambridge University Press. New York, NY. 2009. Page 22.

Both Principles of Conflict Economics and, “The Economic Costs of the Iraq War”

describe economic costs of conflict when it happens, but do not express an opinion on whether or

not these conflicts are caused by aggression or pacifism, or strategic and spending policies that

emphasize one or the other. Strategic concerns like these are isolated as much as possible in this

paper as well. In the interest of an objective methodology, the issue of whether or not

incremental achievement of United States objectives or an incremental increase in US defense

expenditure contributes to peace or war (and which is better from a net welfare cost-benefit

perspective) will be largely ignored.57 The aggregate value of the public good component of US

national defense could theoretically be best achieved through a mix of conflict escalation and de-

escalation, depending on the optimal economic and political strategy for the given conflict and

nations involved. The widely-varying nature of the types of conflict, by size and intensity of

57 However, if every nation subscribes to such a non-normative/return-on-investment-dictated philosophy, the game-theory optimal strategy for all such actors may be to engage in aggressive behavior that would rapidly lead to unsustainable outcomes, to say the least. A more sustainable approach may be similar to those espoused by international organizations like the United Nations, that there are certain moral, even more than normative, thresholds; some that prohibit aggressive behavior, and some that necessitate intervention, like human rights.

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violence, as well as risk level or probability for a particular conflict descending into a more

violent or more economically disadvantageous state, need to be encompassed into a framework

based on the economic costs of that particular conflict type (sorted by intensity of violence and

country size).

Particular defense spending programs should be able to establish how, within this

framework, they contribute to a reduction in economic costs of conflict, relative to their cost

(return-on-investment). However, establishing regulatory requirements for every defense line

spending item to provide such a specific measure of ROI may be difficult, if the inability of the

Pentagon to provide audit transparency for how money is actually spent is any indication.58

Grouping all conflict types that exhibit similar economic cost structures is beyond the scope of

this paper, but if a single conflict type can be analyzed in terms of the costs of a possible future

war, the counterfactual value of conflict prevention can be approximately calculated. Historical

perspectives on the costs of conflict are helpful for establishing an initial methodology of all

economic costs over time. However, in order to best estimate the value of a conflict avoided, a

hypothetical future conflict is needed, at least to demonstrate the framework's applicability.

A study by Frontier Economics Limited, “The Cost of Future Conflict in Sudan” provides

such an analysis. The study is unique to a small nation at risk of civil war that is already

experiencing outbreaks of violence. However, this describes a number of countries in the

developing world. Because these nations' size, history, stage of economic development, and

causes of conflict may be similar, a cost estimation methodology could be determined for this

type of country and conflict within the classification system mentioned above, which would then

58 A requirement to provide an initial tactile pecuniary return-on-investment rationale may be more feasible than regular audit transparency akin to a publicly-traded company, or simply that of a government agency that actually complies with Yellow Book standards (as opposed to the Department of Defense).

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need to be established for each type of country and conflict, in order to empirically blend

economic impact analyses and strategy.59 But, this paper gives us a cost-forecasting

methodology for this classification of conflict.

The study follows the same framework noted in Figure 6 above, providing a practical

estimate of the costs of conflict: diversion, destruction, and disruption. Costs are computed for

Sudan, for neighboring countries, those with immediate borders and/or strong trade relationships

with Sudan, those with strong relationships with those related to Sudan, and for the international

community. The final metric, based on data that civil war reduces GDP by 2.2% for each year of

the conflict, is that conflict in Sudan would cost $53-81 billion.60 If one can then take this value,

and multiply it by the probability that conflict will occur, one would have the value of security,

or peace, to avoid that conflict. One needs to establish which spending items are used in which

area on the international stage, and apportion their costs accordingly so that they can be

compared directly to a goal of conflict prevention. This gives the normative value of what the

government “should” pay for avoiding conflict (while being wary of normative presumptions as

described above). The positivist value of what the government actually pays is the remainder

after accounting for purely pecuniary factors as done in our initial framework. The difference

may represent the distance to optimal policy that maximizes strategic and fiscal objectives.

59 “The Cost of Future Conflict in Sudan.” Frontier Economics Limited. 2010. Retrieved from http://www.frontier-economics.com/_library/pdfs/frontier20report%20%20the%20cost%20of%20future%20conflict%20in%20sudan.pdf. Since this paper was written, the resolution of this particular situation was that Sudan split into North and South nations. However, this study is useful as a methodology for assessing the economic impacts of a conflict that has not yet occurred (at the time it was written).

60 (See Sudan, pages 11-15) Impacts on neighboring countries include risk transfer, resource pressure, demand reduction, diversion, and associated negative spillovers. Impacts on the international community include humanitarian aid, peacekeeping, lost trade, refugees, and the risk of a failed state (page 12).

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Applying this model to the entirety of national defense spending would be a daunting

task. First, one would have to reconcile the above use of each defense spending item to a

particular goal of defense policy that could clearly be traced to economic impacts in conflict

prevention or escalation (or across a multitude of them). Additionally, the probability of

worsening conflict and the economic impact of the worsening state would need to be computed

for every possibility for every nation or other type of actor in the world.61 Such an undertaking

would require 1) an input-output model and/or a general equilibrium model, similar but arguably

more complex than those used in the economic impact analyses of the AIA, where complex

buyer-seller relationships are simulated in as organic an approximation of reality as is possible,

combined with 2) the most complex US war game simulations, in order to reconcile economic

and political-strategic goals.

61 There is a theoretical basis for modeling optimal defense policy on sorting the stages of conflict likely for actors of various types and size, and the likelihood of occurrence and impact of each (but without also considering the economic impacts). See Herman Kahn, “Escalation as Strategy,” in Henry Kissinger, Problems of National Strategy: Selected Readings. Praeger, 1968.

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