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ECONOMIC ADJUSTMENT AFTER THE COLD

WAR

TUESDAY, DECEMBER 12, 1989

CONGRESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTEE,

Washington, DC.

The committee met, pursuant to notice, at 10 a.m., in room 2359, Rayburn House Office Building, Hon. Lee H. Hamilton (chairman of the committee) presiding.

Present: Representatives Hamilton and Scheuer.

Also present: Richard F Kaufman, general counsel.

OPENING STATEMENT OF REPRESENTATIVE HAMILTON,

CHAIRMAN

Representative HAMILTON. The meeting of the Joint Economic Committee will come to order.

The purpose of this hearing is to examine the possible economic consequences of substantial reductions in defense spending.

Defense appropriations have been declining since 1985 when Congress effectively capped the military buildup initiated by President Reagan; actual outlays adjusted for inflation have been declining gradually for the past 3 fiscal years and will decline again in the current year.

Many are describing the current period of lessened superpower and East-West tensions as a winding down of the cold war. The recent actions by the Soviet Union to unilaterally withdraw some forces from Eastern Europe and its border with China, and the apparent evidence that Soviet defense spending is being cut back, are encouraging signs that it may be possible to reduce expenditures to something like peacetime levels.

But what are peacetime levels of defense spending in the present era, and if there are to be further and perhaps steeper reductions, how might they effect the economy? Obviously, the effects on the Federal budget and on the economy will vary depending upon the size, the rate, and the composition of the reductions. These factors will also influence how particular segments of society and individual communities and regions might be effected.

A central issue to be resolved is, what portion of the budgetary savings should be used to reduce the budget deficit, and how should the remainder be allocated? Equally important questions are, what should the Federal Government do to facilitate economic adjustment from defense cutbacks, and when should we do it?

It seems clear to me that the administration, the Defense Department, and Congress share responsibilities for making important decisions and for managing change in an orderly and constructive way.

The first order of business is to think about the changes taking place and how the economy is likely to respond. Today, we begin a new series of hearings on Economic Adjustment After the Cold War, and we are fortunate to have with us a panel of three widely respected experts on the defense budget to help us think about these matters.

Gordon Adams is the director of the Defense Budget Project, a nonprofit research organization that provides analyses of defense budget and policy issues. This organization has established itself as a nonpartisan and objective source of information and analysis since it was founded in 1983. Mr. Adams has written numerous studies on defense budget issues.

Jacques S. Gansler is senior vice president and director of The Analytic Sciences Corp., TASC, a defense consulting organization. He was formerly the Deputy Assistant Secretary of Defense for Material Acquisition, and prior to that, Assistant Director of Defense Research and Engineering. He has also held executive positions within the defense industry. Mr. Gansler is the author of two books about the defense sector, including "Affording Defense," published by the MIT press this year.

L. Douglas Lee is well known within the financial community, to the media, and to this committee where he served as a member of the staff from 1970 to 1980. Mr. Lee is vice president and chief economist of County Natwest USA, a financial consulting organization for institutional investors. Before that, he was a senior economist with Data Resources, Inc., where he managed DRI's Defense Information Services.

Doug, we are always very pleased to see our former staff alumni and you are especially welcome.

We would like each of you to spend about 10 minutes summarizing your views, and the rest of the time will be spent on questions from the committee.

Mr. Adams, we will proceed alphabetically, so you may proceed first.

STATEMENT OF GORDON ADAMS, DIRECTOR, DEFENSE BUDGET PROJECT, WASHINGTON, DC

Mr. ADAMS. I am grateful for the opportunity to testify on this subject, one that has evoked deep concern in recent weeks; that is, the impact of impending budget reductions on the Nation's economy and on local defense-related economies.

Let me summarize my statement briefly and then elaborate on each point in turn. First, although we lack final details on the proposed changes in the defense budget, the cuts currently under discussion are likely to be smaller and slower than suggested in recent public discussions and are likely to reduce force structure more heavily than weapons modernizations.

Second, because they are likely to be more limited and gradual than sometimes discussed, and because the defense industry cur

rently has a considerable backlog of appropriated but unspent funds, the macroeconomic impact of defense budget cuts is likely to be small.

Third, the defense planning preference apparently being given to military hardware spending could mitigate site-specific, local economic impacts, making the adjustment process more manageable. Finally, we have sufficient time before such changes take effect to define appropriate adjustment efforts, using America's experience of past economic adjustments. Even with defense spending cuts deeper than those under discussion in the executive branch, the transition for the defense sector of the economy would be complex, but manageable.

THE DEPTH OF THE PROPOSED BUDGET CUTS

Although there are no official documents, Secretary of Defense Richard Cheney has reportedly instructed the military services to respond to cuts in the defense budget of between $125 and $180 billion from Defense Department budget projections for fiscal years 1992 through 1994. Secretary Cheney's action is important since it is, I think, the first time since the early 1970's that a Secretary of Defense has informed the services that the outyears of the budget plan are unrealistic and need to be significantly reduced. This return to "fiscal realism" is to be commended.

The Cheney reductions, however, should not be overstated. They are not reductions from the current fiscal year 1990 budget level, but rather from Defense Department projections made earlier this year. The earlier projects would have increased fiscal year 1991 defense spending by 2.3 percent above inflation-above the fiscal year 1990 level agreed upon at the budget summit between the White House and Congress-followed by a 1 percent real-above inflation-increase in fiscal year 1992, and 2 percent real growth in both fiscal year 1993 and fiscal year 1994. Moreover, DOD appears to have adjusted this baseline to reflect higher inflation rates than were originally projected for fiscal year 1991 through fiscal year 1994 and to include slightly higher internal planning estimates.

Even reductions as deep as $180 billion would leave U.S. defense funding in fiscal year 1994 at roughly a "nominal freeze," meaning defense budgets would remain at approximately the fiscal year 1990 level, with no increase for inflation. U.S. defense funding would still be higher, in constant dollars, than the budget levels typical in peacetime between 1954 and 1980. Moreover, were the top end of the range of Cheney cuts to be enacted by the Congress, the average annual decline in the defense budget, after inflation, would be only slightly faster than the budget reductions which began in fiscal year 1986, as you pointed out, Mr. Chairman.

The defense budget project_calculates that budgets have fallen 2.8 percent per year after inflation since 1985; under the deepest Cheney proposal, they would fall roughly 3.5 percent after inflation. Were the Secretary to propose budget changes at the lower end-minus $125 billion-average annual reductions would be closer to 2 percent, slightly slower than the declines of the past 5 years. 1

1 See graph I, p. 22.

These numbers are consistent, moreover, with the reported changes in the fiscal year 1991 defense budget. Defense Department budget authority may be set at roughly $295 billion, which would represent a slight, nominal increase over the fiscal year 1990 level, while outlay targets of $292 to $300 billion would represent roughly 2 percent nominal growth over the 1990 level. The real budget or spending reduction would be on the order of 2.5 percent, consistent with the fiscal years 1986-1990 budgets.

Of course, budgets may be cut further by the Congress, and it is unrealistic to assume that the Secretary's figures will prevail. Congressional cuts are more difficult to estimate, however, since there are likely to be a variety of proposals. I would not expect that Congress would go deeper than a nominal freeze in fiscal year 1991, which would represent a cut of roughly 4 percent after inflation. Even a cut of this magnitude, however, would not be significantly out of line with the rate since 1986.

THE ECONOMIC IMPACT OF DEFENSE CUTS: RECESSION OR DIVIDEND?

Reductions in the defense budget are frequently either feared as a potential cause of recession, or seen as an opportunity to reap a "peace dividend" to the benefits of the national economy. The Cheney reductions under discussion, even deeper cuts, are not likely to be a source of major disaster nor of significant benefit; their impact will depend on the state of the wider economy and on Federal policy, which I will get to in a moment.

It is important to note, at the start, that the defense share of major economic aggregates has declined significantly over the past 40 years. Choosing only peacetime years, the defense share of GNP fell from 11.1 percent in 1955 to 7.5 percent in 1965 and 5.0 percent in 1980. After increasing to 6.5 percent in 1986 at the peak of the Reagan buildup, the defense share of GNP fell to an estimated 5.8 percent in 1989. Defense employment-public and industry-as a share of national employment has also fallen from 10.6 percent in 1965 to an estimated 5.3 percent in 1989.1

In other words, the role defense spending plays in the national economy has diminished since the 1950's. The kind of change under discussion today—an annual real decline of 2 to 4 percent-would have only a small effect on these measures. The quality of that impact depends greatly on the overall state of the economy at the time the changes occur, as well as on the nature of Federal macroeconomic policy. There has been considerable discussion in recent weeks of the possibility that cuts in defense spending might lead to lower interest rates, increased nondefense investment and economic growth.

A recent DRI analysis, for example, suggested that real cuts of as much as 5 percent in defense spending through 1994 "appear certain to bring an eventual 'peace dividend' to the United States in the form of lower inflation and interest rates, a declining budget deficit and faster growth." Though the details of the DRI model's assumptions were not made clear, the results seem to depend on their assumption about the uses made of the "savings" from lower

1 See graph II, p. 23.

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