Friday, July 08, 2011

Public Finance and National Security

Frank Pasquale

In his last post, Jack Balkin explains that "The framers feared that a government unable to meet its financial obligations would be unable to meet its national security obligations as well." The Pentagon has already “war-gamed” the kind of financial instability default may bring, and participants explained how tightly coupled US financial and military capacities are:

Several . . . said the event had been in the planning stages well before the stock market crash of September [2008], but the real-world market calamity was on the minds of many in the room. “It loomed large over what everybody was doing,” said [Yale professor Paul] Bracken. “Why would the military care about global capital flows at all?” asked another person who was there. “Because as the global financial crisis plays out, there could be real world consequences, including failed states. We’ve already seen riots in the United Kingdom and the Balkans.”

I want to back this idea up by discussing a few trends in today's political economy. These include the commoditization of power, the critical role of oil, and the limits of military force. Each counsels against the type of disruption (or rechanneling) of world financial flows that debt brinksmanship could spark.

From Cyberwar to Financial War

Thought leaders at the Pentagon are already focused on the field of “cyberwar,” which includes the misuse of computers to compromise critical infrastructure like electric grids, communications, banking, and water supplies. The US has engaged in forms of financial cyberwar against other countries, and is beginning to steel itself against the abuse of computers in its own banking system.

The cyberwar literature tends to have one critical oversight. Modern financial markets are not merely worrisome because a computer virus could sabotage intended trades or unravel recordkeeping systems. They are also increasingly out of control and destabilizing when all components operate as designed, within the law. High frequency trading caused the US stock market to drop by nearly a thousand points in a few minutes on May 6, 2010, and continues to worry policymakers.

Herd behavior in markets also creates chaotic and unpredictable outcomes. Suspicions of a government’s insolvency can quickly become a self-fulfilling prophecy. Indebted and politically gridlocked, the US is increasingly vulnerable to speculative attacks on the value of its currency, debt, and manufacturing and service sectors. Once these attacks reach a certain level, they threaten to disrupt supplies of basic resources, and the nation’s ability to support (and thus maintain the loyalty of) its own military and law enforcement personnel. It is difficult to imagine how the Pentagon could effectively operate on its current budget in a world where oil is two or three times its current price.

Authors like Ian Bremmer, Eric J. Wiener, Stephen Cohen, and Paul Bracken have articulately described how “state capitalist” regimes of Russia, China, and Arab petro-states are using their extraordinary stores of wealth to achieve strategic ends. They are part of a growing literature on the politicization of finance, which assesses how broad trends in global markets affect the power of states, and vice versa. This literature also considers the power of cliques within advanced economies to undermine their home country's position in order to enhance their own fortunes. Debt brinksmanship can be interpreted in that way, especially given the growing influence of gold bugs in the GOP (and the House Majority Leader's investments).

War, Crisis, and Debt

Both the US government and many US citizens are reliant on credit from abroad. When the US went to war in Afghanistan and Iraq, it did not raise taxes to cover the enormous expenses involved (including spending on military services and hardware). Rather, it borrowed hundreds of billions of dollars, much of it from abroad. The borrowing has increased as conflict drags on, and as financial crises devastated tax receipts. Financial markets have mediated that borrowing, and many other lines of credit, long blessing the U.S. with relatively low interest rates and a relatively stable value for the dollar.

The financial crisis of 2008 marked a sudden lack of faith in the creditworthiness of many Western banks, including leading US-based ones. In order to maintain global confidence in the increasingly fragile and interconnected financial institutions that enable US borrowing, the US government has repeatedly “backstopped” private entities (or stepped in to alter markets) when their potential failure threatened to undermine investor confidence. As the current financial crisis unfolds, monetary policy has taken on this role, subsidizing the US’s largest banks (and, by implication, the many parts of the “shadow banking system” that are their counterparties) by buying bonds in order to keep interest rates low. But what happens if global investors lose faith in the US government’s ability to keep its banks afloat? Some have worried that the economy of Ireland could collapse because of the Irish government’s blanket guarantees (in 2008) of the country’s banks. Could a similar crisis afflict the US? As noted above, the Pentagon has already “simulate[d] what would happen if the world disintegrated into a series of full-fledged financial wars.”

America's Fiscal Trap

The National Security Strategy of the United States of 2002 baldly stated that “The United States possesses unprecedented -- and unequaled -- strength and influence in the world” in military affairs. For many years after World War II, the same could be said of the US’s relative economic position. The war had left the European and Japanese economies shattered. China, India, and Russia detoured into unproductive and insular politico-economic arrangements. In the late 1940s, the US controlled two-thirds of the gold reserves in the world and dominated manufacturing.

By the late 1960s, German and Japanese manufacturers were putting enormous competitive pressure on US businesses. By the 1990’s, China and Russia had largely abandoned communist and socialist policies for state capitalist arrangements, and India’s economic liberalization began in earnest. China in particular has used mercantilist policies to consolidate enormous currency reserves. As they became more integrated into the world economy, India and China effectively added 2 billion more people to the global labor force, pushing down wages in a variety of occupations in the developed world. Russia and petro-states have become rich from oil sales, particularly in times of commodity speculation like the summer of 2008, when the price of oil hit over $140 a barrel.

The oil price spike of 2008 recalled an earlier, rapid rise in the price of this essential commodity in 1973, which helped set the United states on a path to its current fiscally precarious situation. While it was clear that US reserves of oil could not support its trends in consumption, the presidency of Ronald Reagan decisively turned the US against conservation measures. The 1980s also saw increasing trade and budget deficits for the United States. The twin deficits are a frightening reminder of how much the “American way of life” has become dependent on goods and credit from abroad. As military historian Andrew Bacevich writes,

For the United States the pursuit of freedom, as defined in an age of consumerism, has induced a condition of dependence—on imported goods, on imported oil, and on credit. The chief desire of the American people . . . is that nothing should disrupt their access to those goods, that oil, and that credit.

Cutting taxes while demanding a stable amount of services from government, the US has developed an enormous budget deficit. Unlike Germany and other countries with more powerful unions, it did not try to keep jobs from moving overseas. Rather, both the public sector and consumers became increasingly indebted to increase levels of public spending and consumption.

The accumulation of private and public debt has now put much of the developed world in a precarious position. In the United States in particular, personal and public finance have become increasingly dependent on the willingness of global creditors to continue buying Treasury Bills, funding loans, and purchasing securitized blocks of payment streams from other debt obligations. Creditors could stop this process if they become convinced that the US is unlikely to pay. If the US were suddenly “cut off,” it could be caught in a spiral of stagflation, as it raised interest rates to attract more funding, cut spending and thereby increased unemployment, or some combination of the two.

What has prevented these dynamics from prevailing thus far? Most economists agree that it would not be in the economic interests of the US’s largest creditors to suddenly “dump” their treasuries on the market. If they did so, the resulting decline in the value of the dollar would devalue their own reserves. The inevitable disruption to the US economy would undermine exporters from their countries. As long as the US appears capable of making political decisions to cut spending and raise taxes adequately to cover its debts, it does not appear to be in anyone’s national interest to spark a disorderly sell-off of Treasuries.

Herd Behavior in Financial Markets

But this rather simplistic story about rational, value-maximizing countries carries to the collective level a model of human behavior already questioned on the individual level. The U.S. has recently proven itself incapable of achieving normal OECD-level taxation of its wealthy, in either good times or bad. A culture of tax-avoidance among America's wealthy is approaching Greek levels. While it is too early to say for certain, the December deal between Congressional Republicans and President Obama featured massive giveaways of tax revenue to the wealthiest and lagniappe for middle class taxpayers.

As creditor nations watch the spectacle of a Republican party elected on deficit-cutting rhetoric immediately turn to budget-busting tax cuts, they are doubting the political seriousness of the US about repaying its debts. Moreover, the owners of the debt have mixed political and economic strategies. The US and China are not just trading partners, but competitor powers attempting to expand their spheres of influence. China operates a state capitalist economy, with a level of government control of the market that is less dirigiste than a pure "command economy," but far more heavy-handed than the social market institutions of Europe. Chinese business enterprises may be expected to act politically rather than as purely profit-maximizing entities. State-owned or "national champion" banks and funds may try to destabilize the U.S. and other political rivals in retaliation for any move their governments disapprove.

It is not just the value of US instruments that affect the US economy. Increasing amounts of securities, debt, and currencies are moving into what Eric J. Wiener calls a “shadow market,” unregulated and unmonitored. If that shadow market “loses confidence” in US creditworthiness, it could spark a larger sell-off; there must be some point at which America’s largest creditors decide to cut their losses and decouple from the US.

We have tended to “naturalize” these conditions; to treat the ups or downticks of rates or prices as a natural phenomenon resulting from the spontaneous and uncoordinated action of millions of investors acting to balance risk and reward in their portfolios. But as the US learned to its chagrin in the early 1970s, an “oil shock” can be plotted by a cartel. It is easy to imagine how the interaction between oil (as foundational commodity) and the dollar (as foundational currency) could lead to fundamental disruptions in the US:

[Given current trends in the dollar's value, one can imagine] OPEC oil ministers, meeting in Riyadh, demand[ing] future energy payments in a “basket” of Yen, Yuan, and Euros. That [would] only hike[] the cost of U.S. oil imports further.. . . .The oil shock that follows [would hit] the country like a hurricane, sending prices to startling heights, making travel a staggeringly expensive proposition, putting real wages (which had long been declining) into freefall, and rendering non-competitive whatever American exports remained.

Admittedly, it is beyond the military’s competence to fight long term economic trends that demand some rebalancing of global economic power away from a country with a population of roughly 300 million to nations with billions of residents. If a loss of confidence in the US arises organically out of the decisions of thousands or millions of investors, military surveillance can do little to stop it because military power cannot ultimately abate it. However, the essence of national security is “managing strategic surprise,” and there are several indications that market manipulation rather than ordinary market developments could lead US debt-driven policy to a disastrous denouement.

If key players were to stop buying U.S. T-Bills (or to sell large quantities of them), the Federal Reserve would need to raise the interest rate on such instruments in order to keep borrowing. Rising interest rates would again endanger the flow of money in the United States, as individuals saved instead of spent, and investors found saving money more attractive than risking it in going concerns. For example, Mexico’s high post-crisis interest rates achieved stability, but also “led to growing unemployment, a significant drop in real wages, and severe impairment of bank balance sheets . . . [and] a full-blown depression that lasted several years and entailed . . . social disintegration, including the proliferation of criminal activities. . . .which became one of the few growth sectors of the economy” (according to Walden Bello). Stagnation and a "Greater Recession" could affect the United States in a similar fashion.

Commoditized Force

Military strength depends on economic strength. Many "war futurists" have described the long-term, unintended consequences of technological arms races in war. At least two aspects of these developments deserve further attention. First, increasingly technologized warfare puts us on a treadmill of technological development. We can't stay ahead without investing more. But misallocation of science and math talent to the financial sector (and its own woeful record of allocating capital over the past two decades) is rapidly eroding the human capital behind our preeminence. Moreover, as the NAS reports, a number of other trends have undermined (and continue to menace) US science, engineering, and technological education.

Second, the "revolution in military affairs" in the US has featured increasing "contracting out" of core military capacities. According to Jeremy Scahill (in the book Blackwater: The Rise of the World's Most Powerful Mercenary Army), by 2008 "the number of private contractors in Iraq was at a one-to-one ratio with active-duty US soldiers" (480). Blackwater recently was in the news for "creat[ing] a web of more than 30 shell companies or subsidiaries in part to obtain millions of dollars in American government contracts after the security company came under intense criticism for reckless conduct in Iraq." The trend toward "private security" ultimately portends a market-based outsourcing of sovereignty. If a foreign government (or even coalition of very wealthy persons) were to outbid the increasingly strapped US government for the best technology, its military advantages could fade.

Langdon Winner has observed that "It is somnambulism (rather than determinism) that characterizes technological politics—on the left, right and center equally." That's one reason why he contemplated the possibility that "modern technics, much more than politics as conventionally understood, now legislates the conditions of human existence." As a master modern technic orchestrating a system beyond the control of democratic lifeworlds, global finance makes that observation truer now than ever. Debt limit brinksmanship ignores those constraints at our peril.

X-Posted: Concurring Opinions.