Financing Issues and Economic Effects of Past American Wars

Publication Date: November 2001

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

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Abstract:

The increased government outlays associated with wars can be financed in four ways: through higher taxes, reductions in other government spending, government borrowing from the public, or money creation. The first two methods are unlikely to have an effect on economic growth (aggregate demand) in the short run: the expansion in aggregate demand caused by greater military outlays is offset by the contraction in aggregate demand caused by higher taxes and/or lower non-military government spending. The latter two methods increase aggregate demand. Thus, a by-product of American wars has typically been a wartime economic boom in excess of the economy's sustainable rate of growth. This has occurred in part because the American homeland has never been directly at risk in the conflicts discussed. Just as wars typically boost aggregate demand, the reduction in defense expenditures after a war typically causes a brief economic contraction as the economy adjusts to the return to peacetime activities.

The economic effect of World War II stands in a class of its own. More than one-third of GDP was dedicated to military outlays. Budget deficits were almost as large; these large deficits were made possible through policies that forced individuals to maintain a very high personal saving rate. Money creation was a significant form of financing, but the inflation that would typically accompany it was suppressed through widespread rationing and price controls. Private credit was directed towards companies producing war materials. There was a significant decrease in non-military outlays and a significant increase in taxes, including the extension of the income tax system into a mass tax system and an excess profits tax. President Truman attempted to avoid financing the Korean Conflict through borrowing from the public or money creation - budget deficits were much lower than during any other period considered - but the economy boomed anyway. Tax increases and a reduction in non-military spending largely offset the increases in military outlays. President Truman relied on price controls to prevent the money creation that did occur from being inflationary.

Neither Vietnam, the Reagan buildup, nor Desert Storm were large enough to dominate economic events of their time. The beginning of the Vietnam Conflict coincided with a large tax cut. Non-military government spending rose throughout the Vietnam era. Budget deficits were used for most of the financing, although tax increases occurred at the peak of the conflict. Inflation rose throughout the period, and President Nixon turned to price controls to suppress it. The beginning of the Reagan military buildup also coincided with a large tax cut, as well as an effort by the Federal Reserve to disinflate the U.S. economy. Thus, borrowing from the public, and later a reduction in non-military outlays, offset most of the rise in military spending. Unlike earlier conflicts, liberalized international capital markets allowed the U.S. to borrow significantly abroad for the first time, which many economists believe caused the large trade deficits of the mid-1980s. Desert Storm took place among rising budget deficits and rising taxes. It was the only military operation considered to largely occur in a recession. At present, military outlays would have to increase significantly as a percentage of GDP before they became similar in size to the smallest episodes considered in this report. This report will not be updated.