Macroeconomic Impact of Military Spending

What effect has war spending had on the U.S. economy? What would the U.S. economy have looked like without war spending?  War spending has probably stimulated the national economy to a degree. But the extra income attributable to war spending has been partially offset by the negative macroeconomic consequences of increased deficits and debt used to finance the wars. The net effect on GDP has probably been positive but is small and declining. An important impact of war spending has been to raise the nation’s indebtedness.

The increased military spending following 9/11 was financed almost entirely by borrowing.  According to standard macroeconomic models and evidence, rising deficits have resulted in higher debt, a higher debt to GDP ratio because debt has risen faster than income, and higher interest rates. 

The ratio of federal debt held by the public to national income (gross domestic product, or GDP), a good indicator of the sustainability of government spending, was 32.5% at the end of fiscal year 2001. It rose to 36.2% after 2007 and to 69.4% at the end of 2011, an increase of almost 37 percentage points since 2001. The nonpartisan Congressional Budget Office (CBO) projects that under current law, debt held by the public will rise to more than 75% by 2020, an increase of greater than 40 percentage points since 2001.

How much of the increase in federal indebtedness is due to war spending? By the end of 2011, deficit spending on OEF/OIF will have raised the ratio of debt to GDP by about 10 percentage points, or between a quarter and a third of the total increase. By 2020, the increase will be 20 percentage points if war spending and the rest of the budget continue as forecast.

There are many other reasons the debt has grown since 2001, including tax cuts, increases in other government spending, and the effects of the largest postwar recession and the policy response.  But military operations in Iraq and Afghanistan have raised annual deficits by about 1 percent of GDP, a trend that the Congressional Budget Office expects to continue through 2020.

Does the U.S. government have to pay interest on borrowing for the wars? How much?  Interest is due because the government chose to finance the wars by borrowing rather than raising taxes or reducing other spending.  The U.S. has already paid about $200 billion in interest on war spending over the last decade.  If war spending continues as forecast by the CBO, the country can expect to have paid about $1 trillion in interest by 2020. That number grows if the effect of increased debt on interest rates and thus the cost of servicing all other debt are also included.

What are the effects of deficit spending on interest rates? An increase in the debt-to-GDP ratio of 1 percentage point raises long-term interest rates about 3.5 basis points.  Assuming this relationship holds, then long-term interest rates are currently about 35 basis points above what they would have been in a counterfactual scenario with no war spending.  By 2020 they will be about 70 basis points higher if war spending continues.

Interest rates charged to borrowers by banks and other creditors tend to move one-for-one with interest rates paid on government securities. For a 30-year fixed rate mortgage on a home priced at the median of $250,000 with 90% borrowed funds, an increase of 35 basis points would cost new homeowners roughly an extra $50 per month or about $600 per year given the current rate of 5%. While not large compared to income, this amount is not insignificant. By comparison, the 2001 tax cut rebate checks, which stimulated aggregate demand, were typically $600 per household.

How would the nation's GDP, debt, and interest rates have evolved had there been no wars in Iraq and Afghanistan?  It is impossible to know with certainty because we have not and will never live in the counterfactual world without the wars and the war spending. But economists can make educated guesses based on estimates provided by peer-reviewed empirical research.

The net effect on GDP is a combination of several countervailing influences. Current and projected war spending pushes GDP higher because it increases aggregate demand. But deficit spending crowds out capital investment spending, which ultimately lowers the nation’s stock of productive capital and also reduces GDP. War-related deaths and injuries also reduce the nation’s supply of human capital, which reduces GDP. Estimates suggest that in total, war spending has probably raised GDP by 0.5% in 2011, but the net effect will fall to zero by 2020 and turn negative as the full effects of the reduced capital stock emerge.