Defense, Budget Deficits and Inflation

The Republicans in the House of Representatives have put together a task force to study U.S. and Chinese military capabilities. In reporting on their findings, Representative Liz Cheney (R-WY) explains that Congress needs to increase defense spending by 3-5 percent per year – in real terms – to keep our military on top of the game.

This is a tall order, but a necessary one: national defense is the first priority of government, one that we should fund in full before any other functions are considered. That, of course, is not the case today, which reduces defense spending to an item in the budget like any other: less than 15 percent of federal spending goes to defense today, compared to half of the budget 60 years ago.

In other words, by promising to do almost everything under the sun, Congress has already made it harder for itself to fund defense. However, there is another problem that Representative Cheney and the others in the Republican leadership need to consider if they want to reach their necessary but difficult funding goal: inflation.

As I explained recently, there are forces at work in our economy that point to higher inflation going forward. It is entirely possible that we will see four percent inflation next year; higher numbers are unlikely this side of 2022, but over the long term, higher inflation is more likely than lower inflation.

An inflation rate of four percent would of course make real increases in defense spending very hard. For every percentage point of inflation, Congress needs to add approximately $7.5 billion to the defense budget just to protect the military’s purchasing power. At two percent inflation – which is basically where we are today – that means $15 billion more for defense, without even adding any new real money into their budget.

Currently, Congress is giving $45-55 billion more per year to the Department of Defense, which means about four percent in real terms. However, the increase in appropriations is scheduled to taper off as we go forward, falling below two percent beyond 2022. In real terms, this means that defense spending is actually going to go backward.

And that is at the current inflation rate.

The problem is, as mentioned, that there are forces at work in the economy that are driving the inflation rate higher. To make matters worse: Congress is responsible for both of them:

  1. Cost-push inflation. As I explained recently, the cost of labor is going up at rates we have not seen in at least ten years. This increase is not caused by high growth or rapid gains in productivity, but by the wage toll that the federal government has placed on the labor market. That toll, of course, is the bonus that Congress is paying out to the unemployed: the $600 weekly compensation on top of regular unemployment has dropped to $300, but it is still there. To motivate workers to come out of idleness, employers therefore need to pay their workers more than what is motivated by the value they add to the business. The only way employers can make up the balance is by raising prices.
  2. Deficit monetization. Congress is borrowing money at rates we have not seen in peacetime, and the Federal Reserve is printing money faster than it has ever done on record – and everything suggests that they will keep the monetary printing presses working overtime for the foreseeable future. Even if the money-supply growth rate tapers off, it will nevertheless keep growing for as long as Congress maintains its enormous budget deficit. Money printing eventually leads to monetary inflation – the most dangerous form of inflation.

To add yet another warning signal of pending inflation, the Federal Reserve has “modified” its inflation goal. It is no longer looking to maintain a two-percent cap on inflation: the goal is now to keep inflation at an average of two percent, without any specification of the period of time over which that average will be calculated.

In plain English, the Federal Reserve has decided to prioritize the funding of the budget deficit over low inflation. This will have serious consequences for the economy over time; for now, it is a major problem for Congress itself – where the monetized inflation originates. Looking again specifically at the defense budget, to protect the real value of DoD procurement and employment checks, at four percent inflation our elected officials will have to add $30 billion per year to the defense budget.

If we get bad monetary inflation, in other words prices go up around ten percent per year, that $30 billion becomes $75 billion. And those numbers are calculated solely based on current spending; compound inflation is not considered. Then comes the fight to actually increase the defense budget by 3-5 percent in real terms.

Common sense – and a dollop of political cynicism – suggests that with the defense appropriations being less than 15 percent of the federal budget, and the welfare state consuming more than two thirds, it is fairly simple to see where the Congressional priorities will be – especially if inflation starts eroding entitlement checks. Therefore, the message to Republicans in Congress is clear, cold and unmistakable:

Entitlement reform – now. Roll back your promises of economic redistribution.

Otherwise, your only choices will be from the list of three bad options I discussed earlier. Not one of them will benefit our national defense.

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