Thomas Oatley is the author of “The Political Economy of American Hegemony: Booms, Buildups and Busts.” His book argues that when America goes to war it borrows money from the rest of the world, creating booms that then lead to economic crises. I asked him four questions about his book.
Henry Farrell: Your new book argues that the most important cause of the recent financial crisis wasn’t financial deregulation but the aftermath of the Iraq war. How could a war create an economic crisis?
Thomas Oatley: I argue that the way the U.S. chose to fund its military buildup for the wars in Iraq and Afghanistan produced an economic boom, out of which emerged a housing bubble. When the bubble deflated, it caused the financial crisis. The basic idea is the following. The U.S. funded the wars in Iraq and Afghanistan by borrowing rather than by raising taxes. The resulting budget deficit had two consequences for the American economy. First, it provided a persistent fiscal stimulus of about 2 percent of GDP that sustained the economic expansion. As a result, unemployment fell from 6.25 percent in 2002 to 4.5 percent on the eve of the crisis. Second, the capital inflows that financed the budget deficit strengthened the dollar, thereby reducing the competitiveness of American manufacturing. As commonly noted, American manufacturing shed 3 million manufacturing jobs during this period.
Now this creates a bit of a puzzle. If the economy is expanding but manufacturing employment is shrinking, then where are these new jobs being created? The simple answer is that growth and job creation occurred in industries sheltered from foreign competition, especially in housing. So as manufacturing employment fell, the American economy added jobs in housing and related activities: 1 million new construction jobs were created, along with another 600,000 new jobs to finance the housing boom. The housing boom pushed home prices up, leading investors to invest even more in housing in the quest for capital gains.
The financial crisis itself was a fairly predictable consequence of these broader economic conditions. Every asset bubble must pop, and when it did the institutions that held the mortgage-backed securities experienced significant weakness in their balance sheets. And while we think of this crisis as a unique event, it isn’t. The Reagan Administration’s deficit-financed military buildup created almost identical economic conditions with almost identical consequences: first a housing bubble and then a banking crisis (the Savings and Loan crisis). And though a bit different, the Johnson Administration’s deficit-financed Vietnam buildup was the central factor driving the collapse of the dollar’s peg to gold. Thus, throughout the postwar period, America’s reliance upon deficit-financed military buildups has generated economic booms and eventually financial instability. The Korean War is the only exception.
H.F.: Why does the U.S. persistently borrow money in order to fund its wars rather than either cutting spending or raising taxes?
T.O.: The U.S. borrows because of three interacting processes. First, the events that trigger large military buildups are unexpected — think here of the 9-11 attack or the 1979 Soviet invasion of Afghanistan. By providing clear and compelling evidence of a threat, these events generate wide consensus among the political elite that the U.S. must increase its military power.
Second, American politics transforms these military buildups into budget deficits. Deficits emerge because the key actors who must approve the required budget adjustments (Congress and the president) typically have very different preferences about how to pay for the additional military power they all agree to be necessary. Some want to cut nonmilitary programs, while others prefer to raise taxes. Thus, political consensus on the need to increase military power allows a large increase in the defense budget while dissensus over how to pay for this larger military prevents post-buildup budget adjustments. Buildups thus yield deficits.
Third, America’s global financial power makes it cheap to finance these deficits. The ability to draw capital from abroad keeps U.S. interest rates low even in the face of increased government borrowing. Moreover, because the U.S. can readily import foreign capital equal to the additional military spending, the budget deficit does not “crowd out” private investment. Politicians thus feel little urgency to bring the budget back into balance.
Read the full piece at The Washington Post.
- Publication Type:Other Writing
- Publication Date:10/15/2015