4/22/13 – What Is the U.S. Spending Money On?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 22, 2013 9:42:28 AM

and tagged Politics and the Economy

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I was in Virginia late last week, speaking to a group of clients, and had a couple of interesting conversations that are worth expanding on here. To start off, we talked about what the U.S. is actually spending its money on, and how and whether it made sense to cut. This is a slightly different take on the spending discussion than you normally see. Typically, the discussion is based on the assumption that spending is more or less set; the issue is how to cut, rather than whether cuts make sense.

In this case, the two areas we focused on were social security and U.S. defense spending. I want to address defense spending first, as there’s no doubt that it will be an easier target, politically.

The question, at its root, was whether the money we invest in patrolling the world is well spent. What benefit do we get, in the end, from maintaining a worldwide Navy, from maintaining troops in Korea, and from all the other commitments we have made? Is it worth it?

Based on counterfactuals, I believe so. Let’s imagine a world without, say, the U.S. Navy. You may remember the disruption the Somali pirates made in global markets not that long ago. A handful of people with automatic rifles managed to cost the global economy millions, disrupt trade, and drive military deployments from China and Japan, among others, to areas they had never been before.

Let’s think about that for a moment. A very small, ill-equipped group managed to cause massive disruption and large costs, drawing China and Japan to the other side of the world.

Economically, if you scale that up substantially, the costs incurred to global trade would be astronomical. The U.S. depends on global trade, not least in oil. No trade, no U.S. economy. Someone has to be a policeman and suppress the many actors that would prey on trade. If it’s not us, someone else will step in, as the costs are too high.

It doesn’t have to be us, though, which brings me to geopolitics. Are we really happy that China and Japan, particularly China, are expanding to have a global military footprint? Will the costs to us of such a shift be greater than the savings? This is the way we have to think about the problem. U.S. military dominance, particularly of the sea lanes, is not currently at risk globally. In certain areas, however, it is, particularly around China. Further cuts would erode our position elsewhere in the world.

One of the key questions about the future of the U.S. economy relates to the status of the dollar as the world reserve currency. A part of that is military predominance. U.S. military spending, especially in the absence of actual conflicts, can be interpreted in two ways. First, as insurance for our reserve currency status—insurance against the emergence of a global competitor, insurance against disruptions in trade, insurance against a world where others are able to damage the U.S. without us responding. And second, as maintenance costs for the world trade infrastructure. As we are seeing with roads in the U.S., infrastructure does need to be maintained.

History shows that a world without a predominant power is generally much more violent—and much poorer. The most violence comes when a reigning hegemon is declining and rising powers are fighting for a piece of the power left behind. East Asia is starting to shape up along these lines, which is why the Obama administration is pivoting military force in that direction and encouraging Japan to rearm more extensively.

Insurance payments disappear unless the bad event happens, but that doesn’t mean they are wasted. Infrastructure maintenance can be deferred, but, eventually, the bridge collapses or the potholes get big enough to swallow cars. Military spending can, and probably to some extent should, be cut, but not without understanding the costs.

Because none of us have ever lived in a world where the U.S. did not dominate, we don’t appreciate what we have in U.S. global predominance. Military spending is the cost we pay for not finding out. While we certainly need to spend that money wisely, which will probably allow some degree of cuts, the core costs are necessary to maintaining our position in the world, both politically and economically.

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