When U.S. Defense Dollars Cost a World of Consumers

Mikhail S. Gorbachev has apparently concluded that the Soviet Union must make a choice between missiles and consumerism. The implicit message of Gramm-Rudman is the same for the United States. The Reagan Administration presumption that it would be possible to expand defense on the back of a surging economy disappeared like a vapor trail as American consumer production migrated instead to other nations. The subplot--the superpowers' new confrontation of economic realities--may be a more important aspect of last week's summit than the dramatized main event.

Since World War II, U.S. policy has been brilliantly successful from a politico-economic standpoint. With American support, industrial nations rebuilt their shattered economies and lesser-developed countries surged upward. Communism, once the apparent wave of the future--even in Western Europe--has been turned back as central planning lost its appeal. From China to Czechoslovakia, communist nations themselves are turning back toward a measure of individual enterprise.

But everything has its price; for the United States, it has been the erosion of capital to help build other nations' economies at the same time America assumed overwhelming responsibility for the West's defenses.

Before the 1950s, the United States produced about 55% of the world's oil, iron and steel and 35% of its coal. It was virtually the only industrial country with a favorable--and massive--balance of trade. It controlled the world's gold supply and international finance. Yet by the 1960s, the beginnings of the current economic problems were manifesting themselves. Those periods when U.S. industry was busiest fulfilling the needs of the federal government were the times when other nations enjoyed the greatest opportunity to move into the American consumer market.

Even before the '60s, the Korean War coincided with the inception of West German and Japanese revival. Then the periods of the "missile gap," the space race and Vietnam brought import-penetration to full flower; Japanese automotive, electronics and appliance manufacturers first made significant inroads. There was a major devaluation of the dollar and, in 1971, the United States ended the convertibility of gold. Finally, Reagan's defense buildup of the 1980s generated a stunningly swift U.S. reversal--from the world's most important creditor nation to world's biggest debtor.

While differentials in labor costs, high interest rates and budget deficits are primarily responsible for the now-chronic American trade and balance-of-payments gaps, the complexities of modern global competition defy simple explanations or generalized solutions. After all, the dollar has been falling now for more than three years without significantly affecting the balance of trade; this year the deficit will be the worst ever, approximately 10% higher than in 1986. There are multiple global cross-currents that in many ways make the workings of international industry more pivotal than those of a national economy. Meanwhile, the U.S. economy has been fragmented along geographic lines; what is bad for one region may be good for another and vice versa.

Conventional wisdom suggests that the 1973 creation of a cartel, the Organization of Petroleum Exporting Countries (OPEC), the driving up of petroleum prices and the inflation that followed was an economic negative. But for U.S. energy, mining, agriculture and ancillary industries--notably in the Southwest, Rocky Mountain states and parts of the Midwest--the oil crunch was a boon. The explosion of oil prices spurred U.S. exploration and production, depressed for years by cheap Middle East oil imports. The U.S. coal-mining industry, the Western world's largest, had been similarly declining but enjoyed a robust revival as coal became an attractive alternate energy source and utilities switched from oil to coal. Coal production increased by more than 50% between 1973 and 1986, and exports more than doubled between 1973 and 1981.

The dollars earned by oil-producing nations also created a development boom participated in by U.S. engineering and construction companies. Projects involving American firms began in oil countries themselves. Excess oil revenues were recycled by international banks into loans for less fortunate Third World nations. Those loans helped create historically high trade surpluses for American agricultural products. In the United States, land prices soared, farm machinery manufacturers prospered and the U.S. fertilizer industry--world dominant--operated at high capacity. The passage of the 1981 tax act, establishing in effect a subsidy for construction, fueled a commercial building boom. All these activities generated a worldwide demand for steel that masked for a time the aging plants, growing inefficiency and high costs of the U.S. steel industry.

Then came the reckoning, starting with the Federal Reserve Board's 1979 decision to raise interest rates as a catchall measure to choke off inflation. Although it took some time for the effect to work its way through the U.S. economy, both domestic and world markets suffered. The worldwide recession and increasing protectionism hit U.S. agriculture, harder than at any time since the 1930s. Falling alongside were the farm-supply industries. Energy conservation, declining industrial demand and safety concerns turned nuclear power plants into white elephants and saddled utilities with billions in losses. The bottom fell out of the steel industry in 1982. With it went iron mining and Great Lakes shipping. The oil glut of the mid-1980s undermined OPEC and, in tandem, the economies of the Southwest and Rocky Mountain states.

Commercial overbuilding encouraged by the 1981 tax act left Houston and Denver with virtually unprecedented 25% to 30% office vacancy rates. Bank failures, as a consequence, are at Depression levels: there were 10 in 1981, 79 in 1984 and 173 during the first 11 months of 1987. Still unresolved are the amounts of losses resulting from the billions of dollars in loans made by many of America's largest banks to Latin American nations.

So while we used to speak of pockets of poverty, we now have entire regions of simultaneous boom and bust. Even as one section of the nation suffered, California and the Northeast prospered as a result of the Reagan defense buildup that created an estimated 1 million additional jobs nationwide. Texas has a budget crisis; California rebates taxes.

But that is only part of the story. If, for example, agricultural exports should rise again, there is no guarantee that they would produce significant benefits for the balance of trade because so much production has moved away. America, the world's leading agricultural nation, the wellspring of farm mechanization, has exported a large part of its farm machinery industry and would now have to import equipment to expand production. Henry Ford produced the first tractors but the United States now turns out fewer than one-fifth of those sold in this country; smaller tractors, accounting for 57% of the total, are made primarily in Japan and medium-size tractors, making up 26%, come from Europe--mostly under the brand names of U.S. multinational companies.

Quite aside from high labor costs, structural factors have been gnawing at the foundations of American industry. Not the least is our litigious nature and the cost of liability insurance. Consider the production of small, general aviation aircraft, once a leading domestic industry. Small-plane production has almost disappeared, having declined more than 90% in the last 10 years as product liability coverage soared from about $2,000 per aircraft in 1972 to $70,000. Other industries adversely affected include construction and trucking, medical supplies and drugs. Massachusetts Institute of Technology economics Prof. Rudiger Dornbusch said he "would not be surprised if the legal system added 20% to the price of exports."

The most dramatic shift in the balance of trade occurred in machinery and transportation equipment: a $30-billion surplus in 1980 turned into a $43-billion deficit in 1986. What has happened in the automotive market dramatizes the futility of attempting to control imports by artificial means, as well as the offsetting effects of countercurrents. When a 2.5-million annual car quota was negotiated by the Reagan Administration with the Japanese, Japanese auto makers compensated by up-scaling their exports, thereby exacerbating the dollar outflow while at the same time producing a bonanza for U.S. automobile manufacturers who benefited from both increased sales and a rise in their own prices. Then the value of the dollar started declining, raising import prices--but interest rates also fell, so that the final cost to consumers was little affected. In fact, with the average length of new-car financing now nearly 4 1/2 years, the monthly cost to purchasers has actually declined. And when cars sell at an average of more than $12,000, an extra $2,000 is not likely to be more of a purchasing factor than emotional appeal or perceptions of quality.

Concurrently, windows of opportunity opened in the lower end of the market for manufacturers in such nations as South Korea and Taiwan, whose currencies have been closely tied to the dollar. The immediate cumulative effect has been a continuing increase in imports--and a bigger deficit in the balance of trade.

Even some conservative economists now recognize that the time has come for reassessment of the U.S. economic condition and America's self-assumed role as the free world's policeman. "Unlike most people who vote Republican," said William A. Niskanen Jr., a former member of President Reagan's Council of Economic Advisers, "I'd cut a lot out of defense. To start with I would cut $50 billion--we are now spending in real terms 20% more than we were spending at the peak of the Vietnam War." It is time, he thinks, for the United States to rededicate itself to the principles of free trade it has lately been preaching more than practicing. "Since 1980 we have in effect established a worldwide steel cartel, we've reinforced the cartelization of the auto industry and created a semiconductor cartel. All by extralegal means. People have gone along with us. But we ought to be using that pressure for things that are of common interest rather than this kind of junk."

The difficulty in the past has been that while American scientists kept pushing at the frontiers of technology, the United States allowed the economic benefits to slip away, partly due to preoccupation with defense. The miniaturization of electronics, for example, stemmed from the U.S. space program in the 1960s, but the Japanese and West Germans have led economic exploitation. After the Challenger disaster, the Reagan Administration decided to concentrate on military applications in space, leaving the French and Chinese to explore new commercial benefits. With the Strategic Defense Initiative and other programs, the Administration expanded the military portion of federal research and development from 50% to more than 70%--and federal funds account for over half of all research money in the nation.

Should the summit turn out to be a watershed in the arms race and more American enterprise and energy is freed for consumer production, U.S. competitiveness will be sharpened and 30 years of erosion in America's position at the world marketplace can be reversed.

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