The U.S. economy enjoyed an especially attractive 1990s, with middle-class wages even increasing substantially, because of the Peace Dividend that followed the Cold War’s ending. Regrettably at present the U.S. and its allies appear to be facing a combination of threats combining the worst of the 1980s with the worst of the 2000s. In that case, a negative Peace Dividend will be necessary, and the U.S. economy will be correspondingly affected, although there will be some winners.
During the Cold War, the Western Alliance was faced with an antagonist that was very nearly equal in military power and superior in terms of aggression and coherence (it was spectacularly weaker economically, but that was not obvious until the last few years.) The Soviet Union could if it wished, have destroyed the nucleus of the U.S. and European economies with nuclear weapons, without equivalent damage being inflicted on its own more dispersed and much less sophisticated economy.
Conversely, there were relatively few “asymmetric” threats during those years. Before 1979, there were no radical religious regimes in the Middle East, and the secular dictators like Saddam Hussein quelled any nascent ones pretty effectively. Even in the 1980s, Iran was too preoccupied with its war with Iraq to attempt to nurture terrorist activity outside the region. Outside the Middle East, terrorist groups like the IRA and FARQ were purely local in their activities, in spite of attempts to bring them together by anti-Western troublemakers like Muammar Gaddafi.
After a decade-long holiday from history in the 1990s, which allowed U.S. defense spending to be run down from 5.5% of GDP in 1989 to 2.6% of GDP in 2000, the threat to Western countries assumed its present form with the 9/11 attacks in 2001. One can argue whether the initial reaction to 9/11 was excessive; to some extent the 9/11 attacks were simply a case of a relatively insignificant terrorist group getting very lucky indeed. However, the over-reaction (if such it was) with the invasions of Afghanistan and Iraq, and the decade-long occupations of both, with defense spending rising to 4.7% of GDP in 2010 (before declining to 3.6% of GDP in the year to September 2014) produced their own reactions from the local populations and in the region as a whole that made the terrorist threat considerably more serious, in the form of the Islamic State in Iraq and Syria (ISIS).
The jury is still out (or should be) on just how serious a threat ISIS represents to Western interests as a whole. Clearly it has established control over much of Syria and Iraq, and is extending that control against the disorganized local armed forces and their unpopular governments. Economically, ISIS is having difficulty running an oil refinery, but on the other hand by returning to first principles and establishing a gold-based currency it may be avoiding some of the mistakes of the fiat-money West. Still, any application of the precautionary principle suggests that Western armed forces should treat ISIS as a serious threat, both locally and, with the partial failure to control the spread of nuclear weapons, potentially globally.
If ISIS were the only threat facing the West, a modest rebuilding of defense capabilities to the mid-2000s level – say an additional percentage point of GDP — would probably suffice. However it isn’t. Vladimir Putin’s Russia is very opaque indeed in its motivations, and it’s possible that its expansionist ambitions extend only to areas in which vital Western interests are not concerned (though it’s unclear why we should be more interested in Syria and Iraq than in Ukraine.) However by betting on Putin’s moderation we may be making the same mistake as the appeasers made against Hitler’s Germany in the 1930s.
In 1938, every consideration of reason and civilization led against bringing Britain into yet another destructive world war, only 20 years after the previous one. Yet with hindsight we know that Hitler was insatiable and war was inevitable; the only question was whether Britain might have the option of delaying conflict until the United States was ready to join it immediately, rather than leaving Britain to maintain the unequal struggle alone for more than two years.
Putin is probably not Hitler reincarnated; therefore a stronger defense posture and more active foreign policy should deter him from his more extreme ambitions, just as the United States’ strong defense posture of the 1950s deterred the Soviet Union. Putin’s Russia is not as strong as the Soviet Union, yet it is more rationally managed economically (a low hurdle!), and if it is able to achieve some key early successes in Ukraine and central Asia, the difference in strength will be insignificant. Accordingly, there is every reason to believe that the West must rebuild its defenses to the level prevailing in the late Cold War, simply to deter Russian aggression.
The two requirements, of deterring Putin and combating ISIS, however require quite different military structures. Both can make use of drones, software and certain other high-tech capabilities, but Putin’s threat is primarily conventional, requiring conventional (and nuclear) forces to combat it, whereas ISIS’ capability is primarily terrorist, guerilla and asymmetric, requiring quite different capabilities to combat it.
As well as these two threats, there are also other threats that did not exist during the Cold War or its immediate aftermath. One is China, whose military spending is already coming to exceed that of the United States, and whose capabilities are correspondingly greater, since many of China’s costs (primarily labor, but also welfare, healthcare and environmental costs) are far below U.S. costs.
China cannot clearly be labeled an “antagonist” of the West; for one thing, to a far greater extent than the simple resource-oriented Russian economy, its economy is intimately bound up in the world trade system, so damage to that system would damage China itself. On the other hand, were it to become fully antagonistic, China would become a more dangerous adversary than was even the Soviet Union, since its gigantic reserves of manpower and highly efficient economy would eliminate the Soviet Union’s two major weaknesses. In addition, it appears to be developing capabilities such as that of eliminating an opponent’s satellites that the U.S. may not fully possess or be actively developing.
Another threat, even more difficult either to combat or to quantify, is that of cyber-warfare. Here the antagonists may not be states as such (though both Russia and China appear to be involved). Thus the capabilities needed to combat it are those of both conventional and asymmetric warfare. In addition, we do not yet have ground rules for what is acceptable in this area, nor a good feel for the likely threats. Indeed, we are in many respects in the same position as were environmentalists before the Cuyahoga River caught fire in 1969; we know there is a problem, but not what form it might take, nor where the greatest threats might arise. Nevertheless, the U.S. Internet network is clearly highly vulnerable to an EMP attack (or even a natural event such as the solar flare “Carrington Event” of 1859, which knocked out much telegraph service.) Combating the various possibilities in this area will require much further expenditure.
Rebuilding U.S. defense expenditure from the current 3.6% of GDP to the 4.7% of GDP of 2010 won’t be sufficient; that would allow us to combat the asymmetrical threat of ISIS but not the conventional threat of Putin’s Russia. Equally the 6% of GDP peak of 1986 will also not be enough; that sufficed to combat one well known threat from a sclerotic superpower, but gave no significant asymmetric warfare capability (as was sadly demonstrated in Lebanon in 1984 and Somalia in 1993.)
If we decide that China is worth worrying about, it is a threat more akin to Josef Stalin’s mighty Soviet Union of the early 1950s than Mikhail Gorbachev’s shrunken Soviet Union of the 1980s, and defense spending needs to be adjusted accordingly. Conversely, the U.S. economy is bigger than it was in the 1950s, and European and Japanese economies are also substantial and should be expected to bear a significant part of the burden, as they could not afford in the 1950s. Hence defense spending lower than the 1955 peacetime peak of 10.5% of GDP may suffice, but it is difficult to argue for defense spending lower than the 1966-70 average of 8.3% of GDP. That allowed the U.S. to fight one medium sized war that was partly asymmetric, while defending against the Soviet Union close to the apogee of its power as well as a resurgent and hostile but still primitive China.
That implies a negative “peace dividend” of additional defense spending from 2014’s level of an additional 4.7% of GDP, more than doubling the current spending level. Since the U.S. budget is already in substantial deficit and about to become more so through baby boomer retirement, there can be no question of financing this from additional deficits. However the additional defense spending itself will have a knock-on effect in increasing GDP (quite apart from its arithmetically correct but economically unhelpful addition from being included in GDP itself.) This will be additionally the case, since much of the increase should be in areas such as cyber-war and space technology in which there will be substantial knock-on effects on civilian research and development, as there were from the defense buildups of the 1950s and 1960s.
The more rapid growth in GDP from additional defense spending will itself yield tax revenues that pay for part of the cost. The remainder will have to be paid for by additional taxation (which itself will depress GDP growth, as has recently been demonstrated in Japan) and by cuts in other spending programs (which if concentrated in areas such as financial and environmental regulation, could be positively helpful to GDP.)
We can assign blame later, but it is now clear that we have entered a much more dangerous world than that of 1991-2000. Heaven forbid that we should therefore become more militarily active – the Iraq and Afghanistan experiences have surely demonstrated that ill-chosen military activity can be highly counterproductive. However, we must rebuild our defenses in order to deter adverse activity by others – and the economic effects of that rebuilding will be considerable, albeit not all negative.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)