Monday Morning: War, it seems, is a very taxing affair

During the 1960s, President Lyndon Johnson tried to achieve his vision of “The Great Society” and simultaneously fight the Vietnam War without raising taxes. His successor, Richard Nixon, also resisted raising taxes during wartime.

Their decisions resulted in more than a decade of high inflation and economic stagnation following the war. Inflation, which was only 1.2% in 1964, surged to 4.7% in 1968, to 12.2% in 1973 and to 13.3% in 1979.

Along a similar vein, President Bush has decided to fight a war in Iraq while still pursuing deep income tax cuts.

What is the likelihood of his decision causing similar long-term damage to the economy? The answer depends on several factors.

First, it depends on the duration of the war and the expense of any rebuilding program. In addition to costing more than 50,000 American lives, the Vietnam War lasted more than a decade and chewed up vast amounts of money and real resources. The consumption of those resources caused an excess of demand, resulting in higher prices.

The economic impact of a war in Iraq will also depend how long it lasts, including how long the United States is heavily involved in rebuilding the country. If the war lasts longer than is currently expected, or if rebuilding absorbs substantially more money and resources than the Bush administration has estimated, inflation could result.

all eyes on the fed

A second key factor is what action the Federal Reserve takes. In the 1960s and ’70s, the Fed accommodated the Johnson and Nixon strategies with easy-money policies. The money supply grew significantly faster than real economic output, causing inflation. For example, while real gross domestic product grew at an annual rate of 3.9% from 1964 to 1975, the money supply rose at an 8.3% annual rate.

If Alan Greenspan and his Fed colleagues accommodate the federal spending on the war and the rebuilding of Iraq with an easy-money policy, inflation could result. If they don’t accommodate the federal borrowing, interest rates will spike, slowing the economy.

However, while there are parallels between the Vietnam War era and today, there are also significant differences.

First, as noted, the Vietnam War was a long one. There is a good chance that a war with Iraq will be short. Even if it isn’t as short as the 1991 Persian Gulf War, it doesn’t figure to last 10 years.

Second, the economy is weaker today than it was during the buildup of the Vietnam War, meaning it has spare capacity. In 1964, as Vietnam War spending started to build, the real GDP was already growing at a 5.8% rate. It then accelerated to a 6.4% rate in 1965 and to 6.6% in 1966. There was less spare capacity then.

Today, the GDP growth rate is much lower. In 2002, real GDP grew at only a 2.4% rate, and estimates for the first quarter are even lower. In fact, GDP growth for the first half of 2003 seems likely to be relatively slow. That means the economy can accept increased war spending without overheating.

But since the war will be fought with equipment on hand, the danger may come when that which is expended has to be replaced after the war, especially if that replacement occurs while the economy is surging from consumer or corporate spending.

If the economy is still weak when the war ends and rebuilding begins, the spending may be just what the economy needs to drag it out of the recession.

In terms of long-term investment strategy, the key will be to watch what the Fed does with the money supply as the economy begins to recover.

If it doesn’t reel it in quickly to offset government spending, then look for investments that protect against inflation.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.