But since 2001, a remarkable shift towards higher expenditure on national security has taken place. For the calendar year 2003, defense expenditure was already up by 0.7 percentage points of GDP on its 2000 trough. And this is unlikely to be the end. Excluding supplemental appropriations, current plans call for an increase in annual defense resources by 15 % in real terms between 2004 and 2009 (Holtz-Eaking 2003). This increase in resources has to be seen not just as a response to the 9/11 terrorist attacks, though they have certainly accelerated the process, but within the framework of an overall transformation of the US armed forces from a "threat-based" to a "capabilities-based" strategy (Wolfowitz 2004) that was the underlying concept in the Pentagon's (DoD) Quadrennial Defense Report of 2001 (Department of Defense 2001).
America’s lost peace dividend: some macroeconomic implications
In this paper we undertake an assessment of some major macroeconomic implications of this reversal in defense expenditures from a steeply downward-sloping path relative to GDP to a more constant ratio. Especially, we will try to assess whether the current approach for deficit-financing this process is superior or inferior to financing it by taxes. In this respect, we deviate from the bulk of most recent literature on the subject of interaction between peace and economic performance (cf. Gupta et al. 2002) which tries to empirically assess the costs of armed conflict in terms of for-gone GDP. Instead we take up similar questions as John Maynard Keynes did in his 1940 essay "How to pay for the war" in which he argued a) that due to the adverse distributional effects of financing World War II by deficits that would arise from the inevitable inflation, higher taxes would be the more appropriate financing method and b) that price caps and rationing would undermine economic performance by distorting the optimal allocation of resources (Keynes 1940, King 1998).
We would also like to stress that the focus on the lost peace dividend does not imply any judgement on the appropriateness of the underlying political course. The concept of improved national security goes beyond our ability for economic quantification so any cost-benefit analysis is not included in our reasoning.
The paper is structured as follows: First, we outline our analytical framework which consists of a small monetary model for the US economy with endogenous money-supply and an exogenous fiscal policy based on 1990 to 2003 quarterly data. Second, we provide two simulations for the altered stance of fiscal policy as a result of higher defense expenditures. In simulation A we assess the effects of an entirely deficit-financed expansion of the defense budget. In simulation B the in-creased defense expenditures are completely balanced by correspondingly higher taxes. Third, we draw some conclusions on the appropriate stance of fiscal policy given the administration's determination to ratchet up defense spending.