Riding for a Fall

COSTS OF BEING A SUPERPOWER

President George W. Bush has called terrorism the United States' greatest national security threat since World War II and has declared that the war on terrorism must be waged "for years and decades, not weeks or months." Most Americans agree with this assessment and with the need to pay whatever price is necessary to wage this war. But what is the price? And how will the United States pay for it?

It now seems nearly certain that the aging of America's population--which would pose a massive fiscal challenge over the next few decades itself--will unfold in an era of large additional commitments to our national security agenda. Two other issues, in addition to security costs, require attention because of their profound connections both to U.S. national security and to U.S. fiscal and economic performance: the United States' growing financial dependence on foreigners, and the extreme aging overtaking the rest of the developed world.

To paraphrase the poet John Donne, no nation is an island, least of all a superpower with such manifest responsibilities as the United States has in a newly dangerous world. But to commit America to a broader role while remaining blindly ignorant of the ultimate cost of doing so is sheer folly. Clearly, there are long-term tradeoffs to be faced: between economic security and national security, between retirement security and national security, and between today's taxpayers and tomorrow's taxpayers. As yet, however, the leaders of the two major political parties have hardly mentioned these tradeoffs, much less discussed them seriously. When it comes to the long-term fiscal and economic future, U.S. leaders are mute not only on domestic challenges but on global challenges too.

FIRST GLOBAL CHALLENGE: THE WAR ON TERRORISM

In September 2003, with bombs still raining down on Baghdad, President Bush made an emergency war-spending request for $87 billion. It was the largest such request since the opening months of World War II. The cost details arriving from the battlefield were riveting. For patrolling the "Sunni Triangle" in Iraq, the Army wanted 595 extra Humvees, at a price tag of $250,000 each. Another 60,000 troops needed three-piece body-armor suits: $5,000 each. Every day, the logistical needs of the forces in Iraq required dozens of 30-truck convoys from Kuwait and Turkey, carrying everything from half a million bottles of spring water to countless electronic modules, all provided by 6,000 civilian contractors. Sun and sand, meanwhile, did more damage to the equipment than did ambushes by insurgents. Every Bradley fighting vehicle in Iraq needed new tracks every 60 days, at $22,576 each. Apache attack helicopters, in perpetual need of maintenance, single-handedly devoured an amazing $1.3 billion in spare parts in fiscal year 2003. Engineering and construction costs were (and still are) billions of dollars over their original estimates.

In short, the stunning effectiveness of the U.S. armed forces has come with an equally stunning price tag. For most of U.S. history, going to war was like organizing a large federal jobs program, with most of the work done by inexpensive, quickly trained recruits. Today, it is more like a NASA moon launch, entailing a massive logistical tail supporting a professionally managed and swiftly depreciating body of high-tech physical capital. Just keeping two divisions engaged in "stability operations" in Iraq for one week costs $1 billion; keeping them engaged for a full year would cost the entire GDP of New Zealand.

Since September 11, moreover, the U.S. military has been planning to invest even more in its war machine to overcome some of the remaining weaknesses: slow reaction time to crises in remote regions and inexperience in dealing with unconventional, so-called "asymmetrical," threats, such as terrorism, guerrilla war, and weapons of mass destruction (WMD). Even after scrapping certain old weapons plans (such as the Crusader artillery system) and scaling back some other purchases, the total net cost of this military transformation will be large.

Weapons procurement, which fell to a post-Cold War low of about $50 billion a year in the mid-1990s, is scheduled to rise to over $100 billion a year by 2010--more than its previous (real dollar) peak in the mid-Reagan years. On the drawing board are lightweight Stryker brigades, state-of-the-art stealth warships, super-fast low-profile watercraft for coastline combat, and all the science-fiction paraphernalia of the Army's next-generation "Objective Force." These weapons will include non-line-of-sight cannons, electromagnetic "rail guns," robotic mules and assault vehicles, long-endurance unmanned tactical aircraft, loitering attack missiles, and total digital integration of fire and sensor systems.

Although the Bush administration incorporates an estimate of these new costs into its projections for defense outlays, most budget experts believe that it seriously underestimates the total future cost of the war on terrorism. To begin with, the administration refuses to make any projections for future military operations; it plans to procure all such funds through emergency appropriations. Also, much of the new technology is still under development and thus sure to experience cost overruns.

The Congressional Budget Office recently recalculated the administration's projections assuming, first, ongoing but diminishing operations in Iraq, Afghanistan, and elsewhere; and second, a historical rate of cost overruns for all new procurement. The results are eye-opening: total defense outlays over the next decade may cost 18 percent more than the administration's official projection. Including interest costs, this excess amounts to $1.1 trillion in new spending, a budgetary surcharge higher than the cost of the first decade of the new Medicare drug benefit.

Even this number does not reflect the cost of any new military operations abroad, which three of every four Americans believe are "very likely" in "the next few years," according to a Gallup poll. Nor does it reflect any permanent increase in active-force troop strength, which Congress may insist on even over administration resistance. With ongoing peacekeeping missions around the world, not even help from worn-out reserve and National Guard units can prevent the armed forces from being stretched dangerously thin should a new threat emerge. In December 2003, only two of the Army's ten divisions were both uncommitted and in a high state of readiness. That same month, 54 of the 61 members of the House Armed Services Committee, joined by the top Republican and Democrat on the House Intelligence Committee, signed a letter to President Bush urging him to enlist more troops.

Whatever they may feel about Iraq, most Americans seem to agree with the president's premise that in the war on terrorism, the best defenses are a good offense and forward deployment. Along with augmenting the capabilities of its armed forces, the United States is sharing intelligence with friendly governments around the world and training and equipping their antiterrorist forces as needed. Sea-and land-based ballistic missile defenses, long under development, are now being deployed at a growing cost ($10.3 billion in the fiscal year 2005 budget).

But sometimes the best defense is a good defense. No matter how effective the United States is at global preemption and deterrence, it must also take effective measures to prevent terrorism within U.S. borders. Here, too, there is an especially large gap between the resources needed and those allocated in official projections.

Most CIA analysts predict that there is a high probability of a serious terrorist attack with WMD on U.S. soil over the next several years. Granted, there is no conceivable price at which the United States could make itself totally secure against such an attack. Yet it is possible, at reasonable cost, to take extra steps that would make the country significantly less vulnerable to future attacks, which could cause catastrophic human or economic losses. Thus far, the government has not taken many of these steps, nor does it plan to. It is only a matter of time before American voters will, or at least should, insist that more be done. Indeed, this insistence may crystallize overnight come the next serious terrorist scare.

Yet doing more to bolster homeland defense will, of course, cost more money. What follows are just a few of the areas that need action.

More dollars need to be spent on equipping first responders: the fire, police, and other emergency personnel who are first to act after a terrorist strike. Only one-tenth of all fire departments currently have the capacity to respond to a building collapse, only a third of firefighters on any particular shift are equipped with breathing apparatuses, and only half possess radios (a deficiency that directly contributed to the high fatality rate among New York City firefighters on September 11). Moreover, biochemical and radiation sensors are lacking; urban search and rescue is spotty; the 911 emergency phone system is still not available nationwide; and emergency communications are not interoperable. The estimated cost to rectify these deficiencies and prepare first responders for a non-nuclear attack is $62 billion over five years.

America's health-care system is also under-resourced. During last winter's flu season, health clinics had to turn away patients when vaccines ran out--not a good sign that the United States is ready to handle a major biological terrorist attack. Acute-care hospitals have few quarantine or decontamination facilities and very little "surge capacity" in beds. Vaccines for major biological threats (most notably, smallpox) remain understocked. National Guard and reserve personnel and even many professionals in the public-health network have little or no training in responding to a nuclear or biological emergency. The minimum estimated cost to improve health-care capabilities over the next five years is $36 billion.

Reducing the threat posed by cargo containers will require another large injection of government funds. Only two percent of the roughly 20,000 cargo containers arriving each working day at 300 U.S. commercial ports are ever inspected by federal authorities. One recent study concludes that the current odds of detecting a shielded nuclear weapon inside a container are only about 10 percent. Closing all U.S. ports for more than a month in response to the mere threat of smuggled WMD would throw the U.S. economy into recession. The minimum estimated cost to remedy these security flaws--including the introduction of measures such as globally monitored packing, tamper-proof seals, and satellite tracking-would be $20 billion upfront, with an unknown yearly investment needed after that.

The fact that six of the September 11 terrorists possessed expired or fraudulent visas points to the manifest failure of federal agencies to prevent illegal immigration, to locate illegal immigrants within the United States, or to monitor noncitizens who enter legally. There are currently 8 million to 12 million illegal aliens in the country, including nearly 300,000 who are fleeing official orders of deportation. The FBI cannot possibly handle this caseload, and local authorities have historically been excluded from any data on illegal immigrants. Few terrorism experts believe that an adequate level of safety can be attained without a total overhaul of the U.S. immigration system, a reform that may ultimately introduce biometric national identity cards. The costs of such measures are unknown but likely to be very large.

Finally, the U.S. government must spend more on safeguarding critical infrastructure, which, if disabled, could trigger widespread public terror and serious economic loss. For example, few water reservoirs or grain silos are any better guarded now than before September 11; a large share of consumable energy flows through a relatively small number of pipelines and refineries in remote, unguarded locations; and a well-placed attack aimed at electronic communications could bring financial trading to a stop. Transportation lines have bottlenecks: for example, five bridges and one tunnel entering New York State account for 70 percent of all trade with Canada, the United States' main trading partner. Again, the minimum cost to rectify these deficiencies is unknown, but it is likely to be very large.

Any effort to assess the cost of needed homeland security improvements must, of course, be hedged with the language of probability. Most of the wild-card surprises (say, another major terrorist strike) clearly lie on the side of higher costs. Yet even absent dreadful news, it seems very probable that the United States will be spending progressively more on homeland security over the next decade or two. No one can foretell exactly which areas of spending will rise fastest; much will depend on what threats emerge as the war on terrorism wears on. Much will also depend on whether homeland security becomes ravaged by pork-barrel politics. Regrettably, Congress is allocating much of the early spending on a politics-as-usual formula (each state receives according to its population) rather than on an objective assessment of need.

For the first time in the post-World War II era, the United States faces a future in which every major category of federal spending is projected to grow at least as fast as, or faster than, the economy for many years to come. That means not just pension and health-care benefits for retiring "baby boomers," or increasing interest payments as deficits and interest rates rise, but also appropriated or "discretionary" spending for national defense, for foreign aid, and for domestic homeland security programs.

The Bush administration has adjusted long-term discretionary spending projections upward from where they were in the Clinton era--but it has not done so sufficiently. In the post-September 11 world, Americans should not be banking on significant reductions in the level of discretionary spending, at least not without assurance that the danger has passed. They certainly should not imagine that any such reductions would pay for further tax cuts or allow the U.S. government to postpone reform of unsustainable retirement benefit programs.

SECOND GLOBAL CHALLENGE: A HARD LANDING

The United States is now borrowing about $540 billion per year from the rest of the world to pay for the overall deficit funding Americans' consumption of goods and services and U.S. foreign aid transfers. This unprecedented current account deficit is paid for through direct lending and the net sales of U.S. assets to foreign businesses or persons: everything from stocks and bonds to corporations and real estate. The United States imports roughly $4 billion of foreign capital each day, half of that to cover the current-account deficit and the other half to finance investments abroad. At 5.4 percent of GDP in the first quarter of 2004, this deficit is substantially higher than its previous record (3.5 percent of GDP) in 1987, when the dollar fell by a third and the stock market took its "Black Monday" plunge. And experts at the New York Federal Reserve Bank and the Institute for International Economics predict that this deficit will grow even larger.

The rise in the current account deficit over the past 30 years is linked to a long-term decline in U.S. national savings, which is in part driven by widening U.S. federal budget deficits. Over time, chronic borrowing has accumulated into large debts owed to other countries. U.S. citizens must pay for these increasing liabilities with a growing annual debt-service charge, consisting mainly of interest and dividend payments. This charge is very sensitive to interest rates--going up when interest rates go up--and its growth over time will itself widen the current account deficit.

If nothing else were to change, borrowing would continue until foreigners accumulated all the U.S. assets they cared to own, at which point a rise in interest rates (choking off investment) and a decline in the dollar (choking off imports and stimulating exports) would gradually close the current-account deficit. It would not entirely disappear, but it would close sufficiently to stabilize foreign holdings as a share of the U.S. economy. Afterward, Americans would cease to borrow as much from the rest of the world. In the absence of an increase in the national savings rate, people would just have to get by with less investment in their own economy and debt-service payments would no longer rise. Instead, Americans would simply make do with less capital, slower growth in GDP, and, of course, a slower rate of increase in their living standards.

Dreary as this scenario is, this sort of "soft landing" is the very best outcome we could expect so long as the United States' future fiscal path and national savings rate remain unchanged. But according to many economists, it is quite possible that the dynamic of gradual adjustment will at some point be trumped by a sudden loss of confidence, leading to a run on the dollar. If the dollar were to overshoot in a large and sudden plunge, inflation and interest rates could well jump substantially and financial markets could ratchet downward. The United States has already experienced some sort of dollar run four times over the last 30 years--in 1971-73, 1978-79, 1985-87, and 1994-95--with far less daunting projections than those of today. They typically began after the dollar had already been declining gently for some time. None was as serious as the hard landing the United States may yet face.

The next dollar run, should it happen, would likely lead to serious reverberations in the "real" economy, including a loss of consumer and investor confidence, a severe contraction, and ultimately a global recession. Soaring interest rates would cause the federal deficit to jump, as U.S. Treasury bond buyers demanded much higher returns. If short-term Treasury rates were to jump back to the four to five percent range, federal interest outlays would climb by $30 billion in the first year and by as much as $50 billion in the second year. Rather than improve the prospect of fiscal reform, gloomy economic conditions could delay it further.

Virtually none of the policy leaders, financial traders, and economists interviewed by this author believes the U.S. current account deficit is sustainable at current levels for much longer than five more years. Many see a real risk of a crisis. Former Federal Reserve Chairman Paul Volcker says the odds of this happening are around 75 percent within the next five years; former Treasury Secretary Robert Rubin talks of "a day of serious reckoning." What might trigger such a crisis? Almost anything: an act of terrorism, a bad day on Wall Street, a disappointing employment report, or even a testy remark by a central banker.

Skeptics say not to worry because governments around the world would never allow a crisis to happen. They would intervene massively to support the American currency by buying dollars. Indeed, they might try. But foreign governments might lose their nerve sooner than place vast sums of their own taxpayers' money into declining dollar-denominated assets. And once the mood of private investors worldwide changed decisively, there would be little that governments could do, even if they had nerves of steel. The magnitude of tradable assets around the world (global stock markets alone are now capitalized at over $30 trillion) would overwhelm the efforts of even the most dedicated band of central bankers or treasurers.

The skeptics are right about one thing: most governments have no great desire to correct the current imbalance of global trade and finance. Foreign leaders are as eager to stimulate their economies with a bustling export sector as U.S. political leaders are to keep running budget deficits at low interest rates. Fred Bergsten, director of the Institute for International Economics, observes, "We finally understand the true meaning of supply-side economics. Foreigners supply most of the goods and all of the money." It is an ugly but politically convenient arrangement. But it cannot be sustained indefinitely.

Most economists assume some sort of readjustment is inevitable. For the United States to export more and import less, however, it follows by arithmetic that the rest of the world must do the reverse. What if the rest of the world refuses? In a deflationary era of slack demand, some world leaders may feel compelled to maintain their trade surpluses by whatever means available: buying dollars, cutting interest rates, subsidizing exports, or resorting to outright protectionism and capital controls. Such policies may succeed for a time in delaying the readjustment, but only at the cost of throwing the global economy further out of kilter and worsening Rubin's "day of serious reckoning" when it arrives.

The question is not just hypothetical. With the substantial fall in the exchange value of the dollar since the beginning of 2002, global investors may be telling markets that a partial readjustment of the U.S. current account deficit is overdue. Although this fall has largely been accepted by some countries--members of the eurozone and Canada, for example--it has been largely rejected by others, most notably Japan, Taiwan, South Korea, and China (the currency of which is pegged to the dollar). The resulting regional asymmetry means that those who follow the "euro path" get hammered, whereas those who follow the "Asian path" get off easier by resisting the readjustment. In time, without better global cooperation, those following the euro path may give up and resort to a variety of surplus-preservation measures, such as subtle import restrictions and other de facto protectionist moves.

Although no one can predict how the current imbalance in the global economy will play out, trade economists marvel at just how many ways this lopsided flywheel can spin off the axle. One thing that economists agree on is that for the world to readjust to a path of balanced growth, the United States must export more and save more while the rest of the world must import more and consume more. This will require major shifts of labor and capital, not to mention profound cultural changes within all these economies.

Yet if moving to equilibrium too fast (the plunging dollar scenario) is full of peril, so is moving there too slowly by keeping adjustments on hold. And so too, for that matter, would be the situation in which different regions work at cross-purposes. All of these risks will have to be borne, moreover, during an era in which a major act of terrorism or war could send shock waves through global financial markets at any moment. Of course, the United States will try to exercise its global leadership and get every region to cooperate. But what happens to the dollar and the global economy depends as much on what foreign political leaders and investors do as on any unilateral U.S. policy.

That is so because America's economic leverage is diminished. A quarter of a century ago, the United States was still the largest net lender on earth; 20 years ago, its global assets still exceeded its liabilities. Today, however, its net investment position is sinking below negative $3 trillion. Americans may hope that the rest of the world will go on lending unlimited funds forever. That wish, however, is unrealistic.

THIRD GLOBAL CHALLENGE: A GRAYING FIRST WORLD

For generations, the United States has relied on the material assistance of other developed countries in pursuing global projects of common interest--from defending democracy to managing the economy to helping the poor and oppressed. Washington continues to rely on this assistance today, not least for helping the United States meet the global challenges discussed above: the war on terrorism and the financing of fiscal deficits.

In the future, however, this reliance will decline--not out of pique or unwillingness, but from sheer incapacity, caused by the explosive fiscal costs of aging and (ultimately) the accelerating population decline projected to occur in nearly all developed societies over the next several decades. This is the third global challenge facing the United States' long-term fiscal strategy. It will burden Americans by increasing the cost of the first two challenges and by forcing the country to assume global leadership on problems once relegated to others.

The primary cause of the coming demographic revolution is falling fertility. Since the 1960s, birth rates have declined steadily throughout the developed world (and in most of the developing world as well). But whereas in the United States fertility has stabilized at just under 2.1 births per woman, which roughly assures a stationary population, it has fallen much further in other countries: to 1.5 in western Europe overall, 1.4 in Japan, and 1.2 in certain southern European nations such as Spain and Italy. In most of these countries, people live at least as long as in the United States and immigration is much lower. Together, these trends produce very rapid aging.

Superimposing these dramatic demographics on extravagant pay-as-you-go retirement systems creates the fiscal equivalent of a perfect storm. Monthly public pension benefits and tax levels in most of the countries in question are considerably higher (relative to worker wages) than in the United States, and their retirement ages have been dropping even faster. It is common for European workers to retire in their late fifties, often on special disability or unemployment arrangements. In France, only 39 percent of men aged 55 to 64 remain employed, versus 65 percent as recently as 1980. These super-aging societies will also consume more health care. According to the Center for Strategic and International Studies, total public benefit spending on the elderly in Japan, France, Germany, and Italy is projected, on average, to climb from 15 to 28 percent of GDP over the next 40 years. That figure is greater than the total revenues collected at all levels of government in the United States today.

To pay for such costs, these countries may try raising taxes. But many of them already have tax burdens of over 45 percent of GDP and payroll tax rates of over 35 percent of wages. At these lofty rates, many mainstream economists warn that further tax hikes may slow the economy more than they will raise new revenue.

Of course, political leaders can propose trimming benefits, but here they will encounter stiff resistance, because the elderly in these countries are so dependent on public benefits, which in turn are vigorously defended by powerful trade unions and their political allies. In continental Europe, employers do little pension saving on behalf of workers. According to a Merrill Lynch study, only seven percent of Europe's workers are covered by corporate pensions and only one percent by 401(k)-type savings plans. Household savings rates are higher in Europe than in the United States, but the savings are heavily skewed by income. Most median-earning households have little to count on except the promise of a government check. Thus, whether in Paris, Berlin, or Rome, the political leader who suggests even minor benefit reductions is typically greeted by general strikes and mass demonstrations. Washington's foreign friends, in other words, will face the wrenching dilemma of whether to fund weapons or walkers even more than the United States will.

In the end, governments in the developed world will patch together some fiscal expedient to tide them over. But one thing seems certain: they will be subjected to intense pressure to slash other spending and run larger budget deficits. The cuts will probably include defense, security, and international aid. And leaders will grow even more reluctant than they are already to commit public resources to U.S.-led military actions or nation-building operations. Meanwhile, private-sector savings rates are almost certain to fall as the number of retired households rises and the number of working-age households declines. Larger budget deficits combined with declining private savings will end, and perhaps even reverse, the large current account surpluses that these countries have historically generated over the postwar era.

Haruhiko Kuroda, special adviser to Japanese Prime Minister Junichiro Koizumi and former vice finance minister for international affairs, is a world-class financial expert. My recent conversation with him on the issue of aging in the developed world was illuminating. He confirmed that the combination of an aging society and low birth rates in Japan remains a big problem and that, with a 25 percent drop in the number of workers under the age of 30 forecast in the next decade, Japan will face unprecedented deficits in the future. How, I asked, will Japan fund these deficits? "As you know, we have a big savings rate and a big capital account surplus. For some period, we can use those resources," he responded. "But Mr. Kuroda, you are now financing about a quarter of America's current account deficit. Can you really spend the same money twice?" I asked. "Yes. It is a very difficult problem."

If nothing else forces a rebalancing of the global economy, demography will be the clincher, its impact slow but inexorable. In the longer term, low fertility will mean not just a vicious fiscal squeeze but also an accelerating population decline. This too will have profound consequences in developed countries. The rate of GDP growth can decelerate and even shift into reverse in those countries in which the rate of workforce decline exceeds productivity growth. Population decline will also surely reshape the politics of migration and protectionism, reorient geopolitical strategy, and recast the cultural mood. Outside the United States, the population of the developed world is peaking now. By the early 2010s, assuming no change in fertility, it will decline by about one million people per year; by the late 2020s, by about three million per year; and in the 2040s, by over five million per year.

The United Nations periodically publishes a list of the 12 most populous nations. Back in 1950, this list included six nations from the "first world" (the United States, Japan, Germany, the United Kingdom, Italy, and France) and one from the "second world" (the Soviet Union). By 2000, only four of these nations remained on the list. In the UN projection for 2050, only one "first world" country remains--the United States, still in third place. According to political scientist Samuel Huntington, "the juxtaposition of a rapidly growing people of one culture and a slowly growing or stagnant people of another culture generates pressure for economic and/or political adjustments in both societies." Over the next few decades, Americans will be asking just how these adjustments may reshape the geopolitical contours of tomorrow's global order.

MORE WILL THAN WALLET?

One demographic reality is already clear: no one can substitute for the United States' global role. Yet the United States cannot fulfill this role without facing up realistically to its full cost. Leading nations cannot indefinitely borrow massively from those they intend to lead. As the economist Benjamin Friedman puts it, "World power and influence have historically accrued to creditor countries." Equally, leading nations cannot subscribe to a foreign policy that has been aptly characterized by historian Niall Ferguson as based on "the Wal-Mart motto: Always low prices." Global security has never been guaranteed on the cheap--and that is unlikely to change in an age of fanatical passions and hand-held WMD.

A leader must be willing to assume burdens. A global leader must be ready to undertake continent-wide projects requiring great patience, larger resource commitments, a public sector unburdened by excessive political promises, and an economy whose long-term prospects are unquestioned either at home or abroad. To date, unfortunately, America's elected officials leave the impression that vaunted superpower status comes with few long-term costs or responsibilities. They imply that wars can be waged without a war budget and that great debtors can set great examples.

President George H.W. Bush once opined that "America has more will than wallet, but what we need is will." His point was that good intentions count for more in international affairs than mere material resources. This may be true some of the time, and for a short while, perhaps. But ultimately good intentions need resources to be effective; "will" must prove itself by persuading citizens to open their wallets and, if necessary, to forgo other outlays.

The United States would greatly benefit from a serious and realistic discussion of the total cost of its long-term security agenda. It is a discussion that would lend welcome urgency to efforts to control the federal deficit, and, in particular, to reform ballooning entitlement programs. It is a discussion that would reconnect the domestic and foreign policy communities by requiring every policymaker to make a tradeoff: "How much am I willing to pay in tax hikes or benefit cuts in order to fund my security priorities?" Most of all, it is a discussion that ordinary Americans would welcome. People know in their personal and family lives that they cannot call for new sacrifices or promise new benefits without carefully considering the consequences. Why, they wonder, should things be any different in national life?