Wednesday, August 06, 2003

The esteemed Kevin Drum, owner/operator of CalPundit and a kind link-up supporter of the Globblog, has gotten some heat lately from passing on my analysis of the affect of the Iraq war and occupation on second quarter GDP.
A few days ago I wrote a post suggesting that if you removed the $40 billion cost of the Iraq war from the second quarter GDP numbers, GDP growth would have been only $16 billion, an annual rate of .67%. Bill Sjostrom took me to task for treating the problem too simplistically, and I've been meaning to post a correction ever since.
So what exactly is Sjostrom's complaint?
Kevin is doing arithmetic here, but not economics. Defense spending rises by $40 billion. How does it get paid for? Given Kevin's assertion that it additional deficit spending, then it comes from the sale of bonds. People who buy those bonds have $40 billion less, which means they do not buy the things they otherwise would have bought. This could mean that the extra military spending had no effect on GDP at all, and the war made no difference. Suppose alternatively that the $40 billion spent on bonds came from people who, because of economic uncertainty, had kept the cash hidden in their mattresses. In this case, the money is now being spent that otherwise would not have been, and the spending raises GDP by $40 billion. My point is that how the money would have been spent otherwise determines how much the military spending contributes to GDP.
Fair enough. Let's do a some further thinking on the matter.

How exactly is the Iraq occupation being paid for? We all know it isn't out of current revenues, so the government has two choices: by borrowing or by printing money. If it's Americans buying the T-bills for war, we can't say exactly how much of this $45.6bn was dragged into GDP. Perhaps all of it would have been spent or plowed into productive investments (i.e. building up society's means of production and reproduction, not into debt instruments alone) and contributed to GDP anyway. Perhaps not.

What we can say for sure is that any amount of money supplied by foreigners is a clear addition to GDP. And since foreigners currently hold almost 40% of US treasury securities, we could estimate that at least $18bn went straight to the 'bottom line' as it were.

Or maybe Bush is paying for the occupation by printing money? M1 is up around $53bn -- about 15% annualized -- over the last 15 weeks (April 7 - July 21) after rising 8% over 2001 and just 3% over all of 2002. This free money, if paying for Iraq, would also go straight to the bottom line.

While probably not all the $45.6bn was generated out of 'thin air' (through foreign borrowing or printing money), a goodly proportion certainly was. If just half of it came into GDP this way -- say, $23bn -- that would mean GDP growth in 2003:II without the occupation would have been a mere 1.5%. Surely this is a conservative estimate as well.

Or perhaps we could use the estimates of a guy who's written for Business Week and thus supposedly knows what he's talking about.
The evidence is that economic activity expanded during each war but by less than the amount of wartime spending. My estimate is that each $1 worth of military outlays led to a 60 cents-to-70 cents increase in GDP. To put it another way, while military spending raised output, there was no free lunch. The spending had to be paid for by decreases in other forms of spending, especially business investment (and by more work effort).
If we go with Barro's figures, the net effect of the extra $39.2bn (in 1996 dollars) in military consumption in 2003:II was between $23.5bn to $27.4bn in GDP growth. Replace the $39.2bn with these figures and you get a 2003:II growth rate of between 1.7% and 1.9%.

Thus to be more an "economist" than an "arithmetician" the General would happily back off 0.7% for 1.7% -- and thus but for Iraq, 2003:II was a near repeat of 2002:IV and 2003:I.

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