The following is the testimony of Peter Morici to the US House Armed Services
Committee hearings on the economic consequences of defense sequestration,
October 26, 2011.
My name is Peter Morici, and I am an economist and professor of international
business at the University of Maryland. Prior, I served as Director of
Economics at the United States International Trade Commission. I thank you for
this opportunity to testify on Economic Consequences of Defense Sequestration.
Today, I would like to discuss with you the broader economic consequences of
further cuts in US defense spending, as
opposed to specific industry or regional impacts. These are largely systemic.
Should the United States fail to maintain military strength necessary to meet
its international security responsibilities, as well as those that may be posed
by a surging Chinese presence in the Pacific, the international economic
institutions that define the rules of the game very likely will change in ways
more hostile to American economic institutions, political culture and values,
diminishing prospects for US economic success and independence.
The United States offers the world a clear prescription for economic prosperity
and the protection of human rights - free markets and democracy. Yet, with the
US economy withering and the US ability to project power prospectively
diminished, US prescriptions appear increasingly less efficacious abroad.
China offers the world a very different model for economic development and
personal security. Its autocratic government intervenes considerably in
economic decisions to promote wide ranging development goals, and it limits
personal freedoms to ensure domestic order and stability. "Occupy Wall Street"
would almost certainly not be tolerated in China and would likely not be
permitted to emerge with Beijing's tight censorship of internal communications.
Suppression of such movements supports its strategy for tight economic
management, quite in addition to maintaining the Communist Party's grip on
political power.
China openly flaunts the letter and spirit of international economic rules
intended to foster free and open markets, and severely limits intellectual
dissent. With its state-directed economy growing at breakneck speed and America
struggling, a US failure to maintain a military adequate to meet China in the
Pacific will almost assuredly result in other emerging nations embracing,
albeit reluctantly or enthusiastically and in varying measure, China's model
for economic development and governance.
International institutions - like the World Trade Organization [WTO] - are
consensual, and interpret and make new rules by consensus. Perforce, those
rules will follow the tide of sentiment among more successful nations, and the
United States and its Atlantic allies will become more isolated and somewhat
marginalized. History teaches power balances do change, and often losers are
preoccupied with internal squabbling and chaotic dysfunction, and ultimately
surprised.
Without a strong economy and military capable of meeting the emerging challenge
posed by China in the Pacific, American values and the US economy cannot
succeed.
Origins of budget challenges
During the closing days of World War II the United States - in partnership with
Britain, Canada and others - crafted an international economic system intended
to promote democracy and economic globalization. The premise was clear -
democracies, integrated by trade and investment, would be much less inclined to
war. Military competition would be replaced by economic competition.
On the economic side, the United States encouraged the formation of the
European Community, which grew into the European Union, and promoted
globalization through the WTO, IMF [International Monetary Fund], World Bank,
and regional and bilateral trade and investment agreements. The West - as
defined by the OECD [Organization for Economic Cooperation and Development]
economies - is so intensely integrated today that the notion of armed conflict
among those nations is absolutely absurd.
On the political/security side, the United States became the de facto global
defender of free markets and democracy by forcing the permanent disarmament of
the third and fourth largest economies - Japan and Germany - leaving only
stalwart foes - China and Russia - as potential challengers on the global
stage.
Victory in the Cold War - without comparable contributions from the Japanese
and German economies - came at a heavy price. And now, dealing with global
terrorism and a more muscular China poses new perils and costs that Americans,
weary of leadership, seem unwilling and perhaps unable to bear.
Successive rounds of GATT [General Agreement on Tariffs and Trade] / WTO
negotiations substantially liberalized trade among the OECD nations, and
granted preferential market access in advanced industrialized countries to
developing regions. Through special and differential treatment the latter
economies have generally obtained open access to the United States, Canada and
EU [European Union] but are permitted to maintain high tariffs and
administrative barriers to Western exports, and subsidize domestic industries
in endlessly imaginative ways.
Through the 1990s, the North American and European economies were so much
larger and stronger that they could afford to give away industrial activities
and jobs, even when the dictates of sound economics and comparative advantage
would indicate wiser choices, to promote development in less fortunate areas of
the world. However, the emergence of China, and to a lesser extent India,
Russia and Brazil, has changed all that. By virtue of China's size and
ambitions to exert greater influence in the Pacific and to change the rules of
international competition, this calculation about the relationship between
western and developing nations becomes patently false and foolish.
China abuses the WTO system and flaunts free-market principles with high
tariffs and domestic institutions that systematically block US and EU exports,
aggressive subsidizes for domestic industries, intervention in currency market
to ensure an undervalued yuan and artificial cost advantages for its goods, and
unfair rules for foreign firms that establish production in China to sell
there.
All of this has imposed a large and growing bilateral trade imbalance that
destroys millions of US manufacturing jobs, transfers valuable US technology
cheaply to China, greatly diminishes US R&D, educational attainment and
potential growth, and makes the United States less capable of maintaining
defense capabilities necessary to meeting its security obligations and
accomplishes its legitimate security goals.
Successive administrations have tried diplomacy to open Chinese markets and end
currency manipulation and mercantilism more generally, but when rebuffed, they
have cautioned Congress against concrete action, and pursued more ill-fated
diplomacy.
Large American multinationals, which have invested in China to serve the
market, have become clients of Beijing's protectionism. Invested in Middle
Kingdom mercantilism, they council presidents and Congressional leaders against
taking concrete measures to counter China's unfair practices - to the point of
even denying members of Congress the opportunity to vote on such measures.
Those actions of self-directed capitalism have broad consequences for the
health and vitality of the US economy and ultimately national security.
On the global stage, failure to meaningfully confront Chinese mercantilism,
after diplomacy has failed over and over again, makes the United States appear
foolish, weak and inept, a civilization overtaken by one with a better economic
model and a more competent government.
Domestically, the United States has needlessly increased its dependence on
expensive foreign oil by failing to develop abundant domestic resources and
implement more effective conservation measures. Failure to develop domestic
energy creates no environmental benefits. It merely shifts the drilling to the
Persian Gulf and other unfriendly venues where environmental risks are no
better managed, and helps finance global terrorism. It is a fool's journey into
the darkness.
Economists agree: the US economy can't get out of its funk and grow robustly,
not because Americans can't make things cost effectively and well, but because
demand for what they make is inadequate.
There is no mystery about it. The trade deficit with China and on oil account
for the nearly the entire $550 billion US trade deficit, this deficit poses a
significant drain on the demand for US products and is the single the largest
barrier to economic recovery.
President Obama has said on more than one occasion China's currency policy
hurts the US economy and slows its recovery. The reasoning is simple. Every
dollar that goes abroad to purchase Chinese consumer goods that does not return
here is lost purchasing power that could be creating jobs. The same applies to
high priced oil.
Cutting the trade deficit in half would jump start the US economy, create up to
5 million jobs and lower the unemployment rate to about 6%. Without confronting
Chinese currency manipulation and broader protectionism with concrete actions
and without raising domestic oil production from less than 6 million barrels a
day to 10 million, the US economy won't grow fast enough, and taxes will be
inadequate to finance an adequate defense and vital domestic services.
Simply, the trade deficit - China and oil - is as much responsible for the US
budget crisis - through slow growth - as overspending and other cost issues.
Cost issues, overspending and popular myths
The US economy and government faces cost issues too. The US health care system
is more expensive and provides less favorable outcomes than more cost effective
private systems abroad, for example in Holland and Germany. Much the same may
be said for US education.
Health care and education are hugely uncompetitive by global standards, and
account for huge portions of combined US federal, state and local spending.
Most recently rising health care costs, coupled with a shrinking private sector
and tax base, is now crowding out education spending.
Together with rising Social Security outlays, mandated by an unrealistic
retirement age fixed at 66, the outsized cost of health care and education have
required curtailing basic government activities and targeting for cuts spending
categories the United States simply must undertake to compete.
Funds are lacking to adequately maintain roads, bridges and waterways, and to
replace National Weather Service satellites essential to monitoring and
forecasting severe weather. And, the United States has ceded manned space
flight to China and Russia.
Advocates of the burdensomely inefficient health care and educations systems
have perpetuated the myth that too much defense spending is the problem - that
is simply not the case.
In 2007, with two wars ragging and the Bush tax cuts in place, the deficit
stood at $161 billion, while in 2011, it will be about $1.3 trillion. Total
government outlays are up about $847 billion, when no more than $62 billion are
necessary to accommodate inflation. How can defense spending - with a baseline
budget of $553 billion in 2011 - be responsible? It only accounted for about
11% of the $847 billion increase.
Moreover, if Congress would simply cut by half the additional spending since
2007, it would accomplish a total of more than $4 trillion in budget reductions
over 10 years.
The myth also persists that the United States spends too much on defense and
winding down the wars in Iraq and Afghanistan will create great dividends. It
won't. Congress may have appropriated funds for those wars, but it is clear
those wars, as well as other conflicts, have been even more expensive that
those budget outlays indicated.
US defense systems are aging and becoming less functional and effective.
Examples have been cited of sons manning fighters once flown by their fathers.
Ask yourself how effective your staffs would be with 15-year-old computers and
if you would want to fight a cyber attack with such antiquated hardware.
And defense capabilities are thinner. The number of USAF fighters is down form
3,602 in 2000 to 1,990 today, and will be reduced to 1739 at current funding
levels. Navy ships are down from 316 to 288, and will have to be reduced to 263
at current funding levels. Sequestration would require cutting these figures
even further and reducing the number of Army maneuver battalions by 30 or 40%.
Changes in the nature of threats and the global economic power balance - who
will have economic power - will require more not fewer resources to protect US
strategic interests and preserve the influence of US values - democracy and
free markets - in the world.
Cyber-warfare and arming China, which is building a blue water navy to
challenge the United States in the Pacific, do not shift US security challenges
from one venue to another but rather add to those challenges. For example, US
and allied dependence on Middle East oil will continue for at least another
generation - even with best efforts to develop domestic fossil fuels and
alternative energy resources - and US naval assets cannot be depleted in the
Gulf Region to counter a Chinese buildup in the Pacific. Moreover, economic and
political upheavals in Europe and North Africa will make the US naval presence
in the Mediterranean and North Atlantic even more vital.
The myth persists that China will not be able to challenge the United States
anytime soon. After all China's reported military expenditures - at current
exchange rates - is only about 17% of US baseline outlays, but China does not
have troops, aircraft and naval assets tied up around the world with
established commitments. Moreover, China's currency is widely acknowledged to
be undervalued, making comparisons of spending at current exchange rates
deceptive.
Using IMF Purchasing Power Parity exchange rates, China's reported military
spending in 2011 becomes $148 billion or 27% of the US base budget. Based on
the growth of spending over the past two years, with sequestration, China's
military spending would be 37% and 43% of US levels in 2013 and 2015, and 66%
in 2021. Without sequestration, it would still be 60% of US levels in 2021 and
could effectively match US spending in the late 2020s.
Also US budget problems are much worse than Congress anticipates. The
President's February budget assumed economic growth in the range of 4% for 2011
to 2016. Even in the more euphoric days of 2010, private sector economists were
not assuming those kinds of figures.
Even if the Joint Select Committee reaches a consensus on budget cuts
acceptable to both chambers, slow growth will compel another budget crisis
after the 2012 election and then others further down the road.
Hard realities
America must address the world as it finds it, not as intellectuals and
advocates tell us it should be.
Hard reality number one is the interactions between the health of the US
economy and these budget discussions are disquieting.
The United States is not in a Greek spiral - at least not yet - but cuts in
defense and nondefense spending will slow growth at a time when demand for what
the private economy produces is weak and a second recession that could thrust
unemployment into the teens threatens. Most certainly, budget cuts will breed
slower growth, lower tax revenues and the need for more cuts, until Washington
finds ways to get the private economy growing.
If Washington can't find a way to instigate private sector growth -
specifically, if it can't muster to challenge Chinese mercantilism and unleash
development of domestic energy resources - and the nation continues on the
assumption that budget deficits can be tamed with large contributions from
defense, real effective Chinese defense spending will surpass US defense
spending in the next decade.
The United States has many established assets - ships, planes and such built in
the past - that will continue numerical superiority in the ability to project
power, but those will be increasingly old assets or the numerical superiority
will decline more rapidly from retirements of assets. China's assets will be
newer and growing in number.
The myth persists that China's military will be technologically inferior for a
long time. Don't bet on that if the US industry and R&D keeps moving to
China through investments by GE and others, and the US hollows out its defense
industrial base through program cuts to meet unrealistic budget targets.
Slashing defense spending because the Congress can't agree to confront Chinese
mercantilism and develop domestic energy to rekindle economic growth, and to
cut and reform the domestic spending that has built up over the last four
years, and the tables will turn in the Pacific sooner than you think.
Then, China's violation of the norms and rules of the economic system put in
place by the United States and western powers after World War II will spread
like an epidemic through the developing world, troubled places in Southern
Europe, and so forth.
China's mercantilism, anti-democratic values and soft approach to civil and
human rights making will be seen an attractive comprehensive package, necessary
for ensuring economic prosperity and personal security. The rules of the game,
as defined by international institutions, will follow those broader sentiments,
and Americans and their values and institutions will become isolated and unable
to compete.
America will be more isolated and dramatically weakened. Marginalized, it will
resemble Italy or Greece. Charming and quaint but hardly able to independently
sustain its standard of living or ensure its own security, or worse bankrupt
and at China's doorstep for a bail out.
Peter Morici is a professor at the Smith School of Business, University
of Maryland School, and former Chief Economist at the US International Trade
Commission.
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