Posted by: Dirk | November 8, 2011

(Book review) The Price of Liberty

The Price of Liberty by Robert D. Hormats is subtitled Paying for America’s Wars from the Revolution to the War on Terror. The discussion of how the many wars of the US were financed are interesting, but as we approach the modern age the book has deep flaws. Since I am not a specialist in war history but an economist, I cannot judge the strength of the narrative with regard to history, but it seems to be well researched. However, there is one major fact missing: Nixon closed the gold window in 1971 and took the US-dollar off gold during the Vietnam war. It amazes me that this fact is missing, since after the end of the Bretton Woods system financing wars has become much easier for the US government.

In a system with a gold-backed currency government could not create money when it wanted, it somehow had to induce the public to hand over money through either bonds or taxes (or attract gold inflows, which is difficult in big wars because trade is disrupted). This is a simplification, since nevertheless government could resort to printing money, as the South did during the civil war. (It did not help much.) Hormats argues that government spending needs to be financed. He calls this fiscal responsibility, meaning that ‘the current generation is assuming a sufficient share of the responsibility’, and not ‘transferring an inordinate burden to future generations’ (p. 291). Hormats concludes that social security and other welfare state programs will get in the way of financing the (future) war on terror.

Hormats wonders how the wars in Iraq and Afghanistan could be financed while the Bush administration had been cutting taxes at the same time. I would argue that if would understand the implications of the end of a gold-backed dollar he would not be puzzled. As long as international buyers are investing into treasury bonds like they did in the last decade, capital is flowing into the US and is abundant. Strictly, however, the US can print unlimited dollars and/or bonds to finance any war even without relying on foreign borrowers. Since there is no gold backing, the supply of dollars is potentially unlimited.

Of course, inflation would result in case of printing too much money, so that demand is much higher than supply (imports will have risen as well, as the currency depreciated). However, the liquidity of the banking system can be drained by issuing treasury bonds, so that no inflation arises. An alternative route could be the use of taxes to drain the liquid funds out of the system. Oddly enough, Hormats describes this chapter after chapter, but in the end of the book the idea that taxes can pay for wars is lost. Taxation is mentioned in only one sentence on p. 291, but it is not explicitly stated that higher taxes might be part of the solution. Instead, it is public debt that is the key, and the welfare state programs get in the way of spending on defense. This argument is repeated over several pages.

Apart from that, the argument that wars are paid by generations is complete bogus. Government debt means that taxpayers pay taxes, and bond holders are credited, at every point in time. Government bonds redistribute money from taxpayers to bondholders, but they do not allow to shift a financial burden into the future. The future generation will inherit the debt, sure, but just as well they will inherit the portfolio of government bonds, which will generate an off-setting income stream to the tax burden. Since the government debt is financed by issuing government bonds, you can not have one without the other.

Flawed monetary ideas gets in the way of Robert Hormats, and although his historical account is a pretty interesting read, his monetary views follow a pre-1971 mindset. So accusing today’s politicians to be fiscally irresponsible and following a pre-9/11 mindset strikes me as self-defeating. Financing wars by limiting liquidity in the private sector, both through bonds or taxes or combinations of the two, is about distribution of the costs. It seems that Hormats prefers bonds to taxes, but he never says why and on what kind of theory or model his thinking is based. Sadly, this clouds all his policy advice in the conclusion.


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