Forecasting the Effects of Reduced Defense Spending

By Ireland, Peter; Otrok, Christopher | Economic Review, November/December 1992 | Go to article overview

Forecasting the Effects of Reduced Defense Spending


Ireland, Peter, Otrok, Christopher, Economic Review


I. INTRODUCTION

The end of the Cold War provides the United States with an opportunity to cut its defense spending significantly. Indeed, the Bush Administration's 1992-1997 Future Years Defense Program (presented in 1991 and therefore referred to as the "1991 plan") calls for a 20 percent reduction in real defense spending by 1997. Although expenditures related to Operation Desert Storm have delayed the implementation of the 1991 plan, policymakers continue to call for defense cutbacks. In fact, since Bush's plan was drafted prior to the collapse of the Soviet Union, it seems likely that the Clinton Administration will propose cuts in defense spending that are even deeper than those specified by the 1991 plan. This paper draws on both theoretical and empirical economic models to forecast the effects that these cuts will have on the U.S. economy.

A. ECONOMIC THEORY

Economic theory suggests that in the short run, cuts in defense spending are likely to have disruptive effects on the U.S. economy. Productive resources--both labor and capital--must shift out of defense-related industries and into nondefense industries. The adjustment costs that this shift entails are likely to restrain economic growth as the defense cuts are implemented.

Economic theory is less clear, however, about the likely long-run consequences of reduced defense spending. The neoclassical macroeconomic model (a simple version of which is presented by Barro, 1984) assumes that all goods and services are produced by the private sector. Rather than hiring labor, accumulating capital, and producing defense services itself, the government simply purchases these services from the private sector. Thus, according to the neoclassical model, the direct effect of a permanent $1 cut in defense spending acts to decrease the total demand for goods and services in each period by $1. Of course, so long as the government has access to the same production technologies that are available to the private sector, this prediction of the neoclassical model does not change if instead the government produces the defense services itself.(1)

A permanent $1 cut in defense spending also reduces the government's need for tax revenue; it implies that taxes can be cut by $1 in each period. Households, therefore, are wealthier following the cut in defense spending; their permanent income increases by $1. According to the permanent income hypothesis, this $1 increase in permanent income induces households to increase their consumption by $1 in every period, provided that their labor supply does not change.

However, the wealth effect of reduced defense spending may also induce households to increase the amount of leisure that they choose to enjoy. If households respond to the increase in wealth by taking more leisure, then the increase in consumption from the wealth effect only amounts to $(1 - alpha) per period, where alpha is a number between zero and one. That is, the increase in wealth is split between an increase in consumption and an increase in leisure. In general, therefore, the wealth effect of a cut in defense spending acts to increase private consumption, and hence total demand, by $(1 - alpha) per period.

The increase in leisure from the wealth effect, meanwhile, translates into a decrease in labor supply. This decrease in labor supply, in turn, translates into a decrease in the total supply of goods and services. In fact, the increase in leisure acts to decrease the total supply of goods by a per period (Barro, 1984, Ch. 13). Thus, the number a measures the magnitude of the wealth effect's impact on leisure and the supply of goods relative to its impact on consumption and the demand for goods. The higher alpha is, the larger the decrease in supply and the smaller the increase in demand.

Combining the direct effect of the permanent $1 cut in defense spending, which decreases total demand by $1 per period, with the wealth effect. …

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