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The Price of Liberty: Paying for America's Wars

May 10, 2007

The Price of Liberty: Paying for America

Introduction

JOANNE MYERS: Good morning. I'm Joanne Myers, Director of Public Affairs Programs, and on behalf of the Carnegie Council I'd like to welcome you all to our breakfast program.

Today we are extremely pleased to welcome Bob Hormats, author of The Price of Liberty: Paying for America's Wars. I hope you have all had a chance to look at his résumé, which you should have received a copy of when you arrived this morning, and which is also online.

Since the time of the Revolutionary War, our nation's leaders have, without exception, adapted fiscal policy to meet military needs in order to ensure our freedom. Yet, soon after taking office, President Bush boosted annual defense spending by 50 percent in order to meet the needs of the armed forces in Iraq and Afghanistan. He also doubled spending on homeland security and approved $100 billion to pay for the cleanup in the aftermath of the Gulf Coast hurricanes. At the same time, he has, paradoxically, cut taxes and expanded Medicare to cover prescription drugs, while still signing bills that each year require a little more be spent on domestic programs—all which in the end could leave our country ill prepared to meet future needs.

Although military and homeland security costs have risen, as is necessary to meet the new demands of fighting the war on terror, our current fiscal policies appear to be more reflective of a pre-9/11 mindset, showing little concern for the future, even though we are living in a post-9/11 world. This is the argument offered by our guest today in his compellingly written new book, The Price of Liberty.

In The Price of Liberty, Mr. Hormats sets out to examine the methods used by past wartime presidents and congresses from the time of the American Revolution, through the Civil War, two world wars, and the Cold War, to see how they mobilized the resources needed to pay for the wars of their respective eras.

His objective, he says, is to seek "a sound fiscal policy that not only gives the president and Congress flexibility to meet future emergency needs, but will also involve Americans in a more personal manner in supporting the continuing high cost of protecting our nation's liberties from our enemies." It is believed that these objectives will enable the country to rebound quickly should there be another attack.

Meeting these needs will be difficult. After five years of fighting in Iraq and Afghanistan, America's costs for waging these wars has by all estimates reached nearly $500 billion, and is still growing. In fact, many have estimated that the ultimate expenditures could surpass the $1 trillion mark.

Some may say, "But hasn't President Bush managed to wage a war, cut taxes, and boost other spending without triggering Vietnam-era inflation?" Yet, be reminded that this has only been accomplished by relying on foreign borrowing and a strong economy, which has enabled the spending spree to go on.

While economically painless so far, war and military spending will inevitably collide with our having to honor payouts for looming entitlement obligations.

So, you may ask, "What can be done?" Well, for me, the immediate and obvious answer is to turn to our guest this morning, a person who has always been forthright in his approach to public matters, as his work and writings throughout the years reveal. Always sharing his perspicacity and solid concerns for maintaining the sound fiscal principles that have proven so reliable since the time of our Founding Fathers, Mr. Hormats demonstrates that the best prophet of the future is the past.

Please join me in welcoming our very distinguished guest, Bob Hormats.

 

Thank you for coming

Remarks

ROBERT HORMATS: Thank you very much, Joanne. And thank you all for attending this morning, getting up so early to hear what I have to say.

I also particularly want to thank my friends from Times Books Holt who are here to offer support. They haven't heard this speech before, although they have read the book probably more times than they care to.

It was a great experience writing it. The reason I wrote it—and I thought I would start out with this—is to identify some of the issues in current war financing and see what we might have learned from the way this was done in the past.

The title of the book, The Price of Liberty, comes from Alexander Hamilton in his First Report on Public Credit. I think it is important to go back to Hamilton, as I think we have to, to understand the very beginnings of our financial system and the roots of our economy. They all began with Hamilton.

Hamilton made the point right after the Revolution that we had incurred a great deal of debt during that period. The Continental Congress had borrowed from average citizens; state governments had borrowed money, because a large portion of the war was fought by state militias; and then, at the very end, a critical element was money borrowed from abroad, money particularly borrowed from France and to a lesser degree from The Netherlands. This was Adams and Franklin who had gone out to scrounge up these funds. They were critical in the end, because the United States did not have a great deal of wealth at the time, and this additional money was essential to buy the arms and pay the troops, many of whom were ready to mutiny after Valley Forge and after other setbacks. So foreign borrowing was a critical element of the success of the American Revolution.

Against the opposition from a number of people who wanted to pay only a few cents on the dollar—some said, "Well, we really don't need to pay much of this back, we'll start out with a fresh slate"—Hamilton said: "No. We have to pay this back faithfully. We have to pay this back to all the creditors of the United States, whether the money was borrowed by the Continental Congress or the states themselves."

Why did he say this? He said this for two reasons. One, because this was a new country, and he felt he needed to establish the creditworthiness of this country in the eyes of its own citizens and the eyes of foreigners. And second, he also realized that the United States might have to borrow again in the future. The United States, everyone believed, was going to be attacked at some point soon again by either the British or the French, or maybe even the Spanish, who at that point owned Florida. So there was a sense of anticipation there would be another war; if there were to be another war, the government would have to borrow; and for it to borrow, it would have to be seen as highly creditworthy. So he said the debt that we have accumulated during the Revolution was the "price of liberty," it must be repaid, and must be repaid "faithfully," and he set up what was called the funding scheme to do this.

Now, the very interesting thing involves Jefferson. Hamilton's views on this are relatively clear. Jefferson had the view that he wanted an amendment to the Constitution to prevent all government borrowing. He did not like the idea of government debt at all, first of all, because it piled up obligations for future generations, which troubled him; but, more importantly, he said it was "anti-republication," in the sense that it pitted those people who held the debt, who clipped the coupons, and the taxpayers who had to pay taxes to service the debt. So he thought it was very divisive between the investor class and the taxpaying class, and therefore he thought it would pull the country apart if the government had a lot of debt.

But one thing they agreed on. Even though Jefferson wanted this amendment to prevent all debt accumulation, he realized that it was practical for one reason, national security, because he also accepted the argument that there would be another war. He, Jefferson, thought it would be against Britain, not France, which turned out to be the case. Hamilton thought it would be against France, not Britain. But they both agreed that were there to be another war they were going to have to borrow, and the government had to be creditworthy, and therefore had to pay back its old debts, and had to make sure that it had the capacity to borrow, to incur new debts to fight the coming war that they all anticipated would occur.

This is a very important theme in the book—that is, that sound finances and strong national security go hand in hand. It starts out with Hamilton and Jefferson and permeates our history. Every war we have had, the United States has had to go borrow large sums of money in order to pay the extraordinary costs of the war itself. This element went on through the War of 1812, the Civil War, the two World Wars, up until today.

But the other side of it is they did not want to incur large debts. They wanted to hold the debt down, in part, because they all felt that they had this obligation to their posterity not to allow the debt to get too big. This is one of the very key themes almost throughout our history, up until the 1960s.

Hamilton made this point very clearly, that if you incur debt, you should build in the means for repaying the debt. This was something that was very important to him. So he built up this tax system, mainly excise taxes and tariffs, to repay the debt, to give the creditors the notion that the government has the revenues in order to repay the debt.

And George Washington made this point in his famous Farewell Address. People quote the notion of don't get involved in "entangling alliances." He said something else that we tend to have forgotten but perhaps should remember even more clearly than the entangling alliances part, and that is we should not "ungenerously," as he put it, throw debt onto the next generation; if we incur debt in this generation, we should do everything we can to pay it off, not impose that burden on the coming generations.

Jefferson said the same thing.

After the Civil War, Grant made the same point, that we have an obligation; we should pay that obligation off.

And that goes down through Eisenhower. Eisenhower made a very strong reference throughout his tenure in office, eight years, that if we have prosperity we should pay off our debt first and then cut taxes afterwards; we have an obligation to future generations.

And the Founding Fathers talked about their posterity. Even through the Eisenhower Administration it was a very key element of national policy: when you encounter debt and incur debt during a war, pay it off as quickly as you can after the war so you don't burden future generations. That theme, as I say, lasted up through about 1960.

A second key theme that you see throughout the history of wartime financing is fairness, the notion of equity. Wars generally are fought by people in lower-income groups. The Civil War is a good example. You had people coming off the boats in New York Harbor; they would immediately sign them up, draft them.

And there was another element. That is, if you were wealthy, you could pay people money so that you could get out of the draft. So you could get someone who needed the money and they would fight for you.

So upper-income people during that war were seen as profiting, because the war was very profitable for a lot of companies making equipment and uniforms for the Union Army and for the Confederate Army; but, second, it was seen as unfair because wealthy people could buy their way out of it.

Lincoln understood this and the Congress understood this. We had not had an income tax before the Civil War. We had one during the second year of the Civil War. The Congress and the administration put an income tax together—primarily, I should say, the Congress, although Lincoln liked the idea as well—mostly initially for fairness. It was not expected to raise very much money, but it was expected to demonstrate to lower-income people that upper-income people were doing their share.

Once they imposed the income tax, which, by the way, they borrowed from Britain—Britain had had one since the early 1800s to fight the Napoleonic wars—once they began to realize that this was doing something other than imposing criteria of fairness, they began to also realize it would raise a lot of money, and they kept raising it year after year after year. At the very end of the war, it was paying for roughly 20 percent of the war costs, as opposed to zero at the outset.

In 1872 it was allowed to phase out. It was seen only as a war tax. You didn't need to bend over backwards for fairness afterwards and you didn't need the money, so it was phased out, although there was a bitter debate about phasing it out.

The second thing they did during the Civil War was print money. We had not printed money in this country since the ill-fated Continentals during the Revolution. We don't even know in value how many Continentals were printed. It could be close to $1 billion. They just churned out the printing press. And the Continentals, of course, lost a lot of their value.

But they realized that Americans were not willing to be taxed. In fact, the Revolution was fought against taxation from the British. So it was very hard for any government—the Continental Congress, which itself was very weak—to impose taxes.

There is one wonderful quote from a guy who said, "Well, why should I go impose taxes when all we have to do is send out to our printer for wheelbarrows full of money?" And that's just what they did.

Well, during the Civil War they realized the government had very few sources of money. It had the income tax; it did borrow, and it did borrow very heavily; but it also printed money. The back of it was green. We had never had a currency at all. They used green ink—there is no recorded reason why; it just happened to be available—so they called them greenbacks. We hadn't had a currency before that. And the Confederate currency was printed with blue ink and called bluebacks. Huge amounts of this were churned out during the war on both sides.

But the idea, again, was to demonstrate fairness, to sort of demonstrate that this war was not just being paid for by lower-income people, that there were a lot of sources of finance used in the process.

At the end of the Civil War, something very interesting occurred. The government had borrowed so much money—even though it tried to avoid borrowing with taxation and greenbacks and a lot of other devices—the government at the end had a debt of $1.3 billion. Now, this was enormous. Think of a little country, very small population. The highest debt it had had before the Civil War was $100 million, that was the highest, and now it was $1.3 billion.

Virtually no one believed it could be repaid. There were newspaper articles—"Why should we repay this debt? This was incurred in a civil war to put down this insurrection. Surely people will understand if we don't pay this debt."

There were a number of politicians who said, "No, that's unacceptable. We have to pay it." Most of the debt was valued in gold. "Not only do we have to pay it off, we cannot pay it off in devalued greenbacks, we have to pay it off in gold." That view prevailed against a lot of popular sentiments—"Don't pay them back at all." "Pay part of it."

And not only did it prevail, they added a portion to the Fourteenth Amendment to the Constitution, very rarely cited these days. It said the debt incurred in putting down the "insurrection," which they called it—they didn't call it a civil war; they called it an insurrection—"shall not be questioned." This is a constitutional amendment, mind you.

And, sure enough, over the next 20 years they had 20 years of surpluses and paid down about 60 percent of this debt. Remarkable! And they paid it off in gold. If it was originally incurred in gold, it was paid off in gold on the original terms. This did remarkable things for preserving America's creditworthiness, and also gave politicians—Ulysses Grant got up before the Congress and said, "We should have the strongest credit in the world. If we don't pay this debt off properly, we won't, and our whole country will suffer in the eyes of the world as lacking creditworthiness."

So the Civil War illustrates two things. One, it illustrates the importance of equity. It also illustrates, again, the importance of paying down the debt.

A third element that comes through the process throughout this period is to engage Americans in war financing, to give them a sense of participation in the war. This, to me, is perhaps one of the most critical elements of the process, and perhaps the area where we have least learned from the experience of the past. That is, war financing is not just about money. Obviously, to a degree, it is about money.

During the Second World War, Roosevelt argued before the Congress. He said: Look, we need not just a slight superiority in weaponry. We need what he called "a crushing superiority," and that means taxes and bonds, and bonds and taxes. It means giving up the luxuries we've been used to. It means giving up a lot of the ordinary things that we've been used to.

His goal was not just to raise the money, although he had to do that, but it was to engage Americans, to make it clear to Americans that while their husbands and sons were fighting in Asia and in Europe Americans were making sacrifices on the home front. That was a critical element.

That was a critical element even in the Civil War. Lincoln went around saying that everyone of modest means should buy war bonds. He went to various cities and towns, and a lot of politicians did this, to very small towns. The objective was to engage people in support of the Union Army, to make them understand that this was their cause; and, if it was their cause, they had to make some sacrifices for this cause.

During World War I, there was a very interesting Treasury Secretary, William Gibbs McAdoo, quite an interesting guy, and very much a part of New York history. His company was the company that built the PATH [subway train] tunnels, and they were called McAdoo's Tunnels. His company started the PATH. No one thought it could be done. There had been no rail transportation under the Hudson. His company did it. He was very entrepreneurial. He was from Tennessee.

Woodrow Wilson, of course, was from Virginia. We had not had Southern leadership in this country since the Civil War, since Polk was president. After the war, there were no Southerners. This was the first group of southerners who were now back in Washington.

They were very populist. They supported a lot of these populist progressive movements. Their goal was essentially to demonstrate again that populism meant not just doing things to help lower-income people, but engaging people in the war effort. So they went around and did something that was very interesting and at the time very controversial.

Lincoln had established these war bonds. During World War I, they had these huge bond drives. They were called Liberty Bond drives. Every little town had bonfires at night, and you'd have your congressman or some local celebrity come around, and you would have thousands and thousands of people turning out in the town square to pledge money for Liberty Bonds. There were seven war bond drives during the course of the war.

Again, it was to raise money, but it was also get people involved in the war. Initially, it was not a particularly popular war. They went around saying: "Look, your troops are out there, your husbands are out there, your sons are out there, they're in the trenches of Europe. You've got to do something, and you've got to do it by buying these war bonds."

McAdoo called it "capitalizing patriotism." He said that the people who cannot fight in the trenches of France should fight in the financial trenches of the United States by buying these bonds.

It had a terrific response in a country that was very doubtful about whether we should be in the war. The massive purchases of these bonds in a way gave the war a lift, because people felt engaged in this war.

The Second World War, very much the same thing. You had huge increases in taxes, so everyone was making a tax sacrifice by paying, all people. The First World War taxes were considered a class tax; only relatively high-income people paid them. In World War II, almost everyone paid a tax. If you made more than $600 you paid a tax, and it became what was called the "mass tax." So people were engaged in the war by paying more taxes.

But they also were engaged in the war with these bond drives that Secretary of Treasury Morgenthau sponsored. Morgenthau said he was doing this, in part, because people came up and asked him, "What can I do? What can I do to help?" He said, short of working in a munitions factory or actually fighting, there was a frustration, that people felt they wanted to do more but couldn't, and these war bond drives were part of the way that people felt that they could make some commitment to the war effort, that they could feel engaged. There were other things, like rationing and price controls, but these bond drives were very much a process of, not only raising money, but engaging people in this war process. It was, I think, a remarkable event.

The thing about it was that politicians were very candid about the fact that wars cost a lot of money. There was no attempt to soft sell. Obviously, it was a war, and most Americans intuitively understood this.

But we shouldn't forget Americans were very isolationist before World War I. Many Americans didn't want to get involved. Before World War II, the draft only passed by one vote. Imagine if it had failed. We were a country that did not want to go to war. There is a strong historical argument that, but for Pearl Harbor, Americans would have tried to stay out of the war longer than they did. The war had been going on for two years before we got involved.

So the effort here was to tell Americans: "Look, this is an expensive war." Roosevelt doesn't mince words. He said: "War costs money. That means taxes and bonds, and bonds and taxes." That's a key element, and it appears throughout the whole book itself, but primarily in the World War II section, that it was a very, very direct response to the war, and people had to pay for it, and there was no attempt to sort of downplay this at all.

Now you fast-forward—and I'll skip the Cold War, because we can go back to that. There were a number of elements of participation in the war, but it was a very different war. Prior to the Cold War, we had had periods of war and mobilization, periods of peace and demobilization. The Cold War was a period of constant mobilization, constant readiness, and that imposed a number of particularly important financial risks and differences from the way past wars were financed.

But let me just skip to the current war. I think the current problem is this. It's not so much that this is an expensive war, relatively speaking. At its peak, World War II cost 40 percent of GDP annually; 40 percent of the GDP was involved in the war. That was unprecedented. We had never had anything like that. We didn't keep GDP records during the Civil War, but in the modern era nothing has come close to 40 percent. Korea was 15 percent. Vietnam was 10 percent.

This war is 1 percent of GDP. The entire defense budget and homeland security budget is below 5 percent of GDP. So it is manageable from a fiscal point of view, if you look at it only in the context of the portion of the economy tied up in the war.

But there are a number of other issues. As I said before, wartime financing is not just about raising money; it's about engaging Americans to feel that they have some sense of participation in the war, that while the troops are making sacrifices they are also making sacrifices. That part, that component of war financing, simply hasn't been there this time.

If you go back to 9/11, after 9/11 the President said, "Act like you normally act, go shopping, do the kinds of things you were normally doing." And there was some reason to say this—you don't want the terrorists who are living in caves in Afghanistan to force Americans to retreat from their normal daily lives.

On the other hand, he was making the point that these are people who are out to kill us. We are at war with terrorism, or terrorists, of various kinds, al-Qaeda and many others. So there was no sense on that part of the equation of getting Americans to do anything differently.

Now, that would have been a very good opportunity for leadership to go to the American people and say, "This is a moment when we should pull together and, not just go shop or act normally, but we should have a much bolder energy policy to reduce dependence on imported oil"—none of that happened—or to say, "Look, we're going to have to spend more money on terrorism today. We should reduce spending on nonessential domestic programs."

Instead what happened? There was really no effective energy policy proposed, and we went about increasing our dependence on imported oil.

The second thing is domestic non-security, nonessential spending—bridges to nowhere and many other things of that ilk—continued to go up. In fact, non-security domestic spending in the first four years of this administration increased at a more rapid rate than the first four years of the Clinton Administration.

So it was Congress and the President simply saying, "We're going to continue our normal spending operations." The argument was: "Well, 9/11 changed everything." It didn't change fiscal policy one bit. We spent more money on homeland security, but there was no change in the allocation of resources elsewhere in the budget.

And there was nothing on the tax side. In fact, taxes were cut again in 2003. Now, even if you make the argument that that tax cut was valid—and some do, because the economy was weak, and you can make a reasonable economic argument that you needed the stimulus—you can't make the argument at the same time that all this wasteful domestic homeland spending was needed. That is where the cuts should have been, and that is where in every other war in the past we have looked for money to provide support for our national security, cutting nonessential programs, and shifting resources in the budget to national security programs.

Most Americans have accepted that. You go to them and say, "These are the sacrifices that the country requires. We should reallocate resources from less essential to more essential programs, from parochial domestic requirements for your constituency to broader national security requirements that are important to the long-term survival and the security of the United States."

That kind of debate never occurred. That reallocation never occurred.

Then you get to the more specific element of the Iraq war. It is very much the same thing. Again, as I say, it is a relatively cheap war, but the fact is there has been no sense of sacrifice.

The troops are sacrificing. Their families in many cases are sacrificing—many of them have to go on welfare or get food stamps because the breadwinner is off fighting in Iraq.

Had in early 2003, or even after the war had begun, the President gone and said: "Look, I don't want a big tax increase, I don't like tax increases, I'm against them, but I want to have a little check-off and give people the opportunity to check off a few dollars to make sure that the troops have proper body armor, to make sure that the troops have their Humvees properly armored, to make sure that families are well looked after when these people go away, to make sure that there is proper health care for wounded veterans"—something to give people a sense of engagement. That never occurred either.

And again, domestic spending on non-security issues continued to go up.

Now, this is not so much a fiscal issue—because this war is very affordable, the budget deficit is going down—but it is a question of wartime financing, of involvement, of shared sacrifice and shared engagement. That just has not been there.

Where it become more dangerous is in the future, in financing the war against terrorism over the long run, because long after we are out of Iraq—whether one agrees with the war in Iraq or disagrees—there is going to be a war against terrorism for a much longer period of time than the Iraq war.

We know there are people looking to get weapons of mass destruction. We know that there are people who if they got them they would try to use them in this country or against our allies. These are very horrible weapons that they are trying to get—nuclear weapons, dirty bombs, biological weapons, chemical weapons. If they can get their hands on them and get them in and detonate them, the implications would be enormous.

It is going to cost the United States a lot of money to address these issues, to prevent this kind of thing from occurring, and to respond if, heaven forbid, it were to occur. This is not cheap either.

I think one of the problems we have had in not explaining to Americans that wars cost money, and in not explaining to Americans that they should make some contribution to this, is that down the road it is going to be a lot harder to raise the sums of money required to make sure that we do the kinds of things that the 9/11 Commission recommended.

If you look at the 9/11 Commission follow-up reports, they indicate stingingly that a lot of the things that they had wanted to be done have not been done. A lot of the spending on homeland security that they recommended has not taken place.

Then, it is going to take two years just to get the military back to where it was in 2003. A lot of weaponry has been destroyed. A lot of it has been incapacitated. Much of it was really made to oppose the Russians in Fulda Gap, not to fight a war in the Middle East. So fixing all this weaponry up is going to take time and money.

Lots of new weapons are required. I'm not saying the military should get it all it wants, but it is going to need at least some new generations of weaponry.

And then, you have to pay for a lot of these injured veterans who are going to need help all their lives.

These are going to be very expensive long-term costs for our country, which means that the peace dividend that people expect is probably not going to be as great as many have anticipated. We are still going to have national security requirements.

And what makes funding this more complicated than in the past is this. If you look at the period of Vietnam, there was a lot of flexibility in the budget. In other words, when Lyndon Johnson wanted to spend more money on the war in Vietnam, it was possible. He didn't want to do it. The Congress actually in the end took money away from the non-security budget and put it into the Vietnam War budget. There was enough flexibility in the budget to do that. A lot of these were discretionary programs in the Great Society.

The difficulty now is that the amount of discretionary spending in the budget is squeezed down and the amount of mandatory or entitlement spending is growing at a very rapid rate. That is based on predetermined formulas.

Over a period of time, if you look at the numbers that are presented by the trustees of the Social Security system, the Medicare system, the Medicaid system—when you add them all together, plus interest on a rising federal debt, the amounts there will take all the money in the entire budget by the year 2020. Which is to say if the current trend continues, if you pay all those obligations in these entitlement systems, there would be no discretionary money left over for anything, not for the military, not for education, not for roads, not for agriculture—for nothing.

Now, this is not a scenario that is likely to happen because you can't simply cut all these programs out of the budget. But the basic point is that it is going to be a lot harder in an environment where people already after the Iraq war will be soured on security spending, where people will say, "Well, we haven't been attacked, so we really don't need as much homeland security spending." It is going to be a much more difficult challenge to raise the sums of money needed for national security in the future because all of it is going to be crowded out by these entitlement programs.

Now, somewhere along the line something has to change so that we can finance the needed entitlement programs. Because a lot of older people depend on them, a lot of people depend on these programs for their health, we have to fund these programs properly. I'm not arguing we should not. Obviously, in many cases they are not sustainable, simply because from a fiscal point of view you can't continue to have the costs mushroom year after year after year. So whether there was a big defense budget or we spent zero on defense, those programs still have to be reformed. But they have to be reformed in a humane way so that people who need the money are going to get the money.

At the same time, we have to find enough money in the budget to make sure we are adequately protected against terrorism and have enough in our military budget to go after terrorists and prevent these kinds of things from occurring.

How we work these things out is going to be a very critical element of national policy over the next decade or decade-and-a-half, and it is going to require a lot of things.

It is going to require, as I say, genuine reform of the entitlement programs. You'd need that anyway. Even if you put the whole national security issue aside, that is going to be needed. It is very difficult, particularly Medicare, which is rising at a very rapid rate. So the country has to confront that, no matter what.

Second, I do think politicians have to go before the American people and explain that we still have a national security requirement in this country, we have a national security requirement abroad, we have one at home, a lot of unmet homeland security needs, and that those have to be paid for.

And don't try to downplay it. Don't try to finance it through supplementals and these budgetary gimmicks which we've used in this war. Even during Vietnam we did not use supplementals to the same degree that we've used them in this war. But it gives people the sense you can finance these things through gimmicks, you can finance them in ways that evade the budgetary process. That is not the way wartime leaders have done it in the past. They have been very direct about what the costs are and very direct about how they should be funded. That kind of dialogue, that very candid dialogue, is also needed.

Third, I talk a little in the book about energy patriotism, which essentially goes back to McAdoo's point about capitalizing patriotism through bond issues. You don't need to do that today. But one way of engaging patriotism today is to explain to people that we're very dependent on foreign energy, we're very dependent on the Middle East and many other very unstable parts of the world, and we need to do something internally to reduce that dependence from a financial point of view and from a national security point of view.

Those are several of the elements that are going to be needed in a very candid dialogue. There are no soft answers here. They are all tough answers. Anyone who tries to say, "Well, this can be done with a little gimmick here" or "we can pay for this all through growth," that simply is not going to happen. And it just evades the question. It enables people to avoid making these hard choices.

The last point that I'll make, and the last point that changes the equation, in addition to the fact that all these entitlements will squeeze the military budget if they're not dealt with, is the element of dependence on foreign capital. I think this is where the book comes all the way back to Hamilton. That is, Hamilton understood the dependence the United States had on foreign capital were there to be another war. That's why he wanted us to be seen as creditworthy, because we would have to borrow from some other countries to raise money if there were to be another war.

The same thing is true today. The United States has never in its history during a wartime period been more dependent on foreign capital than it is today. If you look at the budget deficit today, foreigners finance roughly 60 percent of that deficit. A large portion of that is China and a lot of countries in the Middle East that have accumulated these petrodollars. So we are heavily dependent on this foreign capital.

That means that were anything to go wrong and this foreign capital would shrink, we would have a very difficult time. As opposed to the 1790s, the country wouldn't go bankrupt; we'd still have a very strong economy and we could still raise a lot of money.

But picture it this way. We import net between $700-$800 billion worth of capital from the rest of the world every year, and a portion of that goes to finance the federal deficit. Let's suppose there were a terrorist attack.

Compare a terrorist attack today—or, say, a few years down the road—with 9/11. During that period, 2001, we had a budget surplus and we were only half as dependent on foreign capital as we are today. Now, because of entitlements and interest payments, we are going to have a very big deficit in the next decade. We will be even more dependent, considerably more dependent, on foreign capital than we are today.

And let's assume that a terrorist attack comes, disrupts the economy, disrupts American infrastructure, and the economy weakens very dramatically because revenues would decline in a slower economy.

The cost of rebuilding, the cost of the response, would be considerably greater, if it's an attack on infrastructure. The last one really wasn't; it was an attack on a few buildings. Let's suppose there's a dirty bomb in the middle of New York or the middle of Washington or Los Angeles. Consider the repair costs. Consider the cleaning-up costs. Much, much greater. And then, the cost of going after the perpetrators would be very high also.

But you'd be doing that from a large budget deficit perspective and the country would also be more dependent on foreign capital.

So the potential for disruption if foreigners say, "Wait a minute. We're not going to supply you with as much money. We're not going to buy as we have in the past because your economy may be weaker. If we lend you money, we may still lend, but we're going to demand a higher risk premium," because the demand for capital will go up as the federal government borrows more money to pay for all these after-attack expenses.

So this dependence on foreign capital is an enormous vulnerability, and it takes us right back to what Hamilton said. That is, sound finances are critical to national security. If we cannot ensure that our finances are sound over the next decade or two, dealing with entitlements programs, dealing with funding the military in a responsible way, dealing with cutting back on a whole range of these earmarkings which are a big waste of money—they're not huge in budgetary terms, but they are corrosive because they show that insiders get what they want and normal people don't—but it does cost; there are billions and billions of dollars tied up in these earmarkings.

Unless we are able to make responsible fiscal decisions, we are going to end up in a position in the next decade—not so much now; things are looking pretty good now, but in the next decade—where we are fiscally very vulnerable, where we simply don't have the resources we need to keep faith with older people, to keep faith with our Medicare and Medicaid recipients, to make sure we have funds for national security—and our vulnerability to some disruption in the flows of foreign capital becomes much greater than it is today.

That, as I say, goes back to the basic theme, which is unless we are able to ensure sound finances, our national security is at risk. We so far don't see—at least I don't see—any politicians who are making these cases in a clear enough way to mobilize the kind of constituencies that they need to get the mandates that they need to make these tough changes.

I will stop there and open it up to questions.

JOANNE MYERS: I thank you very much for the history lesson, which certainly will inform our future. I'd like to open the floor to questions.

Questions and Answers

QUESTION: First of all, thank you very much. I thought it was a tremendous presentation.

I gather you feel that fiscal policy has been very bad in the last eight years, and not only all the other mistakes related to the war. I wonder if you could relate this to this rather strange argument that's going on between the President and the Congress right now about funding the troops. As you just put it, this all costs 1 percent of GDP, or some such, and yet the public debate here is that supposedly there's not going to be any money for the troops after July 15 or something, according to remarks by Secretary Gates yesterday evening. Is this just a political issue here, or is there a genuine financing problem?

ROBERT HORMATS: This is a very interesting point. I actually looked into this.

The broad point on fiscal policy is I think fiscal policy today—the criticism I have is not so much the magnitude. It's not like Lyndon Johnson, where you had completely irresponsible fiscal policy. Today's fiscal policy, in part, is based on the fact that they did cut taxes in 2001 and 2003. Economists can argue plausibly that we needed the stimulus. So I don't really fault them for those tax cuts per se. One could quibble with they benefit a certain group and don't benefit others.

But what I quibble about is if they needed stimulus in 2003, they should have kept the stimulus to 2003, 2004, 2005. They extended it to the end of the decade, and then they want to make it permanent. So it seems to me we're giving up a lot of revenues during a period of time when we don't know what our expenses for the war on terrorism and other things are going to be.

One person who said this was McCain. He said: I'm all for tax increases, but I don't want to vote for a tax increase yet until I know the cost of the war and the cost of the peace.

It does seem to me that was one of the mistakes that they made. It was not so much that they cut taxes, but the length, the duration, of these tax cuts. They wanted to make them permanent.

But the second is even if you concede, you stipulate, that the tax cuts in their entirety were a good thing, those people who were most zealous about the tax cuts should have been equally zealous in cutting nonessential spending, and they weren't. That's the bigger fault, I think, particularly when you're engaged in war and you could make an heroic argument and say, "Look, we need to make sure we have enough money for the war in Iraq or the war on terrorism or the war in Afghanistan, which means some programs that we now have we should be cutting to make room in the budget for that." I think that is a problem and is a mistake.

The bigger mistake is not preparing people for the next decade, when we know fiscal policy is going to spin out of control, because we know what the costs of these programs are going to be and we know we simply don't have the revenues to pay for them. There is really very little of that debate, that candid debate about the future, going on from the point of view of keeping faith with people who do need the money and keeping faith with the broader question of national security.

The actual numbers that relate to this particular current funding debate are very interesting. I actually asked the Pentagon about this. It is true—and even if you ask the military services, the nonpolitical people: If there is not a certain amount—it doesn't need to be all of it—a certain amount voted by, I think it's July 1 or the end of June, what happens?

It's not so much that they don't have the money for the troops—they'll have the money for the troops; it's that other programs have to, in effect, be defunded or cut back or postponed. That creates certain deficiencies in the way the military is run.

So there are real costs to it. It's not so much the troops not getting their money, but they have to draw that money from other parts of the Pentagon budget, and that means other arms programs that they need or procurement that they were trying to undertake will simply have to be postponed. And that involves costs—if you cut a contract, cut it back, you have to pay penalties. So there are implications to this that are real.

Gates is right. Gates is a pretty candid guy. When I was on Kissinger's staff, we worked together. What a breath of fresh air compared to his predecessor! [Donald Rumsfeld]

But it also comes from the uniformed services, who have no political axe to grind at all, and they say the same thing. So I take the uniformed services. It's mostly cuts from other programs.

It doesn't mean that a guy who is out in Iraq won't get the guns or the ammunition, or a woman who is driving a helicopter is not going to get her helicopter refueled. They will get that. But other parts of the military will suffer.

It is actually better to have this clarified one way or another very, very quickly. In the end, they are going to support the money for the troops.

I was telling the table before this very interesting thing about the War of 1812, which is sort of esoteric and deep in American history, but it illustrates a very interesting point. The War of 1812 was wildly unpopular. It was far more unpopular than the current war, if you can imagine that. Almost all of New England not only didn't like the war, there were people who wanted to secede from the Union because of the war, because it interrupted their trade with Britain and a number of other things.

The Federalists, who had been the stalwart party in the 1790s, decided that their response to this was to block the ability of the Madison Administration to borrow money. So they went to all these banks and threatened the banks with canceling their business if they lent the government money—a whole lot of things that are in the book. A very sordid period.

Even though most Americans wanted to end the war, even though most Americans thought the war was highly unpopular, didn't like Madison, didn't like the war, within twenty years the Federalist Party ceased to exist because it was considered unpatriotic, even though the war was disliked.

So there is a history. When you start fooling with the funding of the troops, it tends to rebound to your disadvantage. And they know this. Nancy Pelosi knows this, Reid knows this. The troops will get their money.

But there are a lot of other things that were in the bill, like all these extraneous things, that shouldn't have been put in the bill in my judgment. If you have a military bill, you have a military bill. Many of those other things are perfectly valid. I'm not even arguing that they're not valid—some are, some aren't—the peanut and the spinach stuff I think we could have done without. But it would have been better to have it in a separate bill and have it be voted up or down on the merits.

QUESTION: You mentioned at the very end of your talk, Bob, that this idea of having supplemental bills to finance a war was a new thing now. That was going to be my question before you said it. But let me ask it this way now. You also said that there are no quick fixes, no gimmicks, by which we can correct the situation. Isn't that one that's correctable? Couldn't we going forward insist that the budget process be one that includes war costs in the overall central budget rather than a supplemental one?

ROBERT HORMATS:
Absolutely. There are a number of things that could be done. I was more talking about the issue of reforming Social Security and Medicare. It is a very easy thing to deal with supplementals.

People have said, "Well, Vietnam was financed with supplements." Not true. In the beginning, the first two years, it was financed with supplementals. Then the Democrats in the Congress went to Lyndon Johnson. This was Senator Stennis, Senator Russell, and Senator Eastland, the old guard in the Democratic Party.

First, McNamara goes up there and says, "I don't really know the numbers, so I really can't tell you what the number is next year, so we're going to have to do this in supplementals." They didn't believe a word of it, because they said, "McNamara is a number cruncher, he knows everything, he knows all those numbers, he just doesn't want to tell us." Which was partially true.

So these guys go up to the President and they said, "Mr. President, you know you've got to stop doing this. We have to defend your budget in the Congress. You're not telling us what your numbers are."

So after 1968 the supplementals essentially stopped. Once in a while there were extra costs, and maybe there would be a couple billion dollars in supplementals, but over 70 percent of the Vietnam War was paid for by regular budget appropriations.

What does this do? Supplementals are a very good thing. They are called emergency supplementals. They come in at the last minute. They are not integrated with the overall budget process.

Therefore, there are no tradeoffs, because they come in too late. If you finance these things through the regular budget process, then you make tradeoffs—you make tradeoffs within the Pentagon budget; maybe the war should get priority over a certain domestic program. And then, within the broader budget, in order to keep within the budget caps, the budget resolution, you may have to give up other programs. But if you come at these things through this sort of backdoor supplemental process, there are no tradeoffs, there is no prioritization.

And the military doesn't like it either. That's the interesting thing. You talk to the uniformed services, they hate this, because they want to know what their budget is. They want to know what their budget is in advance. They don't want to have this thing come in at the last minute. It's very disturbing to them.

This is purely for political reasons. And the notion that, after four years into a war, you don't know what the war cost is going to be next year, no one really believes that. And if you don't know exactly, at least you have a pretty darn good idea. You could say, "Maybe it will cost $100 billion and maybe it will cost $90 billion," so you go up with a regular appropriation of $90 billion, and then if you need ten more, then that's what supplementals are for, that marginal emergency difference.

The President has promised this for the next fiscal year. That's what he said he was going to do. But it's still not clear that that's—we haven't seen it yet, in other words.

QUESTION: Bob, that was so extraordinary and enlightening. The question is how to have your words get to the White House and the Congress so that they'll act more prudently. Perhaps some of your New York Times friends will help the process.

ROBERT HORMATS: I've tried. You know, it's a very hard message at this point to get through. I've sent copies of the book to all the candidates, or all the ones who I think read, which is the majority. Let it be said that the majority of them read. I'm hoping that they will read it. And then, I wrote a two-page letter to explain basically this.

I've gotten some very good responses already. I'm going to try to spend some more time in Washington to try to explain some of these issues.

It's interesting. When you explain this fairly candidly and you go through the history, then you do get people who are more receptive to the process.

But unless you engage—and this is the optimum time to do it, because there is this political debate underway—unless you go out there and say, "It's important to be clear about what these priorities are, what these risks are, and if we don't do what we need to do and you don't get a mandate to do them during the campaign, it is very hard once you're elected to just surprise people and say, 'Oh, by the way, I didn't talk about this, but now I want to institute these changes.' Very hard to do."

So this is exactly the time, I'm hoping. The people at Times Books are very good. They said, "You've got to get this done by May." The average author wants to have a little bit more time. I owe a lot to the publishers that it was out now so that it really does get an opportunity to get filtered into this debate.

But I think candidates are just—Americans are too used to easy answers to these things. The answer to energy is not an easy answer. The answer to entitlements is not an easy answer. The answer to military spending, paying for national security spending—there are no easy answers here for these fundamental issues.

Warren's point is very good. There are things you can do. You can stop using supplementals.

You can have much, much, much tougher restrictions on earmarking, which is really a travesty. It's a travesty on the domestic side because there is so much money being spent on it. But when you are in a war and you have people saying—the military decides it needs so much, then you put in the budget—or you put in your little earmark saying, "We want to keep this base open," or "We want you to fund this particular airplane because it's in our district," or "We want this road to a base even though the military doesn't think it's needed"—when you start doing that sort of multiplicity of individual funding bills that come in through the earmarking process, which, again, are not considered in the normal budget process—they come in at the very end; they're not even in the budget resolution. It's a very chaotic process.

There are at least some things you can do to make this a more fiscally responsible process.

QUESTIONER: Thank you. Now for my question. Would you reconsider what you are saying in terms of America's place in the world? At the beginning, obviously, we were a very tiny country, but then in the 20th century we became a superpower. Now there's a question for the future, where our current president thought we were the only superpower, but along comes China. You raised this whole issue of the fiscal situation and borrowing. So what is this going to do to America's place in the world?

ROBERT HORMATS: Well, if we continue to borrow heavily, we are more and more dependent on foreign suppliers of capital.

I'm not of the view that the Chinese are going to just wantonly pull the rug out from under us. They don't have an interest in doing that because they want to sell goods here. So I don't think anyone is going to deliberately seek to undermine the dollar precipitously. Even now we see them diversifying their asset holdings to euros and Swiss francs and Australian dollars and other things, so the dollar is going down, in part, for that reason.

But, as I say, for this great superpower to be so much in hock to the rest of the world, it does create this notion of dependence. Even if the countries don't exercise that leverage that they've got, there's this feeling that they could and they might.

I'm not of the view that they will do it just willy-nilly, as part of some act of pique. But I do think if some disruptive event occurs, like a terrorist attack or a long-term capital kind of crisis or some other crisis, I do think some of that money is vulnerable. You don't need much of a shrinkage in that flow to cause a lot of disruption here.

In the end, it does make us look like a more dependent power. When you consider we're more dependent on capital and more dependent on imported energy, it means that our vulnerabilities to those two interruptions are much greater.

QUESTION: Thank you especially for your historical perspective, which is fascinating.

My question has to do with tax policy going forward and its role in the mix of things that need to be applied to the, as you say, enormous fiscal challenges in the future.

It seems to have become politically incorrect to call for higher taxes. This whole sort of Laffer concept, that taxes hurt the economy, seems to have been assumed to be correct. And yet, we have had over the past few years an enormous tax increase through the increased price of oil, which I think everybody accepts has the same fiscal impact as a tax increase. And yet, despite the huge, enormous, and never-spoken-of tax increase through the price of oil, the economy has thrived.

ROBERT HORMATS: Correct.

QUESTIONER: So I would like to you to address this concept that taxes are a bad deal, especially in light of the enormous reduction in the tax on capital.

ROBERT HORMATS: It's an interesting question. I think politically it is going to be very difficult to get a consensus to raise taxes even back to the Clinton levels. But the irony is that with the Clinton tax levels, which is to say the levels before 2001, we had a booming economy, as you know, in the latter part of the 1990s with the old tax rate, and we've had it again with the higher oil prices. The economy has just churned forward at a very rapid rate. Oil prices are still high. They're not as high in real terms as they were in the early 1980s, but nonetheless they are high.

It's hard to make the argument that these lower taxes have been the determinative factor in the robust growth that we've had. And it really hasn't been that robust, but it has been a reasonable rate of growth, and it has helped to reduce the budget deficit. So raising taxes can help.

Now, how you do it is very important. There are a lot of ways. You can raise the marginal tax rate back to the Clinton level. You can raise the dividend tax rate or the cap gains tax rate. I think it is going to be very hard to do that. You can make the argument that that tends to be a tax on productive investment and you shouldn't do it. It's a debatable point on both sides.
But what's not debatable is that we are going to have to deal with some of these costs with added revenues, and the added revenues cannot only come, or will not only come, from higher growth. Some will. In fact, we are doing very well and our growth is producing a lot of revenues.

But if you look at the needs of Social Security, Medicare, Medicaid, et cetera, and you look at the military needs, and you look at other things like education, and you look at people who want to—and the argument is you should change the Alternative Minimum Tax, which has to be done at some point when it's hitting too many people—somewhere you've got to find some additional revenue.

Now, there are many permutations. During the Reagan Administration, it was done in the following way. He had this visceral dislike for taxes in general, but particularly for raising the marginal tax rate. So what did he do? He allowed—in fact, the Congress, after the 1981 Reagan tax cut—big increases in revenues as a result of changes in corporate tax benefits. In other words, corporate tax subsidies, of which there are a great many in the budget, were reduced under the Reagan Administration. If you look at the tax subsidies in the last energy bill, a lot of those were really not needed for large corporations.

You can do this in a variety of ways that don't necessarily raise the dividend tax rate or don't necessarily raise the cap gains tax rate. There are a lot of ways of doing it.

I think we have to have some kind of debate as to what kind of government we want, what programs we want to pay for, and how we're going to pay for it. A very candid debate will mean some kind of tax increase somewhere down the road, unless you assume growth will provide all the money for everything, and even the White House Council of Economic Advisors has written a report saying that's not going to happen.

JOANNE MYERS:
Unfortunately, we have run out of time. We have so many questions you'll have to come back. Thank you.
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