Talking with Eric Torenberg, Noah Smith says “The Fed will not stick to any rules that it officially adopts.” (minute 32) “The Fed will always exercise discretion.”
That was a comment from Arnold Kling. The Fed has a dual mandate for keeping price stability and keeping unemployment near the natural rate. It interprets the former as 2% inflation, and the latter as perhaps around 3-5%. But these mandates often conflict with one another and the Fed has discretion to adjust its policy.
When I listened to the podcast I immediately thought about juxtaposing the discretion of the Fed with DoD. The Fed’s independence is there to assure that politicians don’t pull economic levers that benefit them personally in the short run but have bad long term effects, like “helicopter drops” of money or easing interest rates in a hot market. The US has this arrangement despite the fast that Congress has the power to borrow money, coin money, and regulate its value.
Similarly, politicians have incentives to drive up defense spending that has short term “Keynesian” benefits but potentially long term problems. Moreover, their ability to select defense programs is compromised by the self-interest of protecting jobs in their districts, and horse trading with other members to get there.
Indeed, the US Congress used to provide the Army and Navy quite a bit of discretion in the 1950s and before as to funds allocation. Yes, Congress has the power of the purse, but like in monetary policy, it should perhaps exert some restraint. There is a long heritage to “lump sum” budgets and presidential discretion that is perfectly consistent with the constitution and firm congressional oversight.
Monopsony
Here’s Arnold Kling commenting some more on the Noah Smith episode:
He claims that we don’t restrict supply in health care, and instead the problem is that prices are too high. If the government took over health insurance and drove down prices, all would be well. This is wrong, for reasons I won’t get into here.
The point I’ll make here is that the US Government is a monopsonist (single buyer) in the world of national security. That has NOT led to lower prices and improved outcomes, as I document the cost disease problem in defense acquisition here.
The major problem in my mind is the lack of competitive alternatives creates too little diversity and too little error correction. A single buyer of an entire sector has a self-reference problem, it can’t define value buy looking at what other people are doing.
Inflation
And while we’re on the economics topic, former USD Comptroller Bob Hale mentioned that if inflation does start picking up, it will erode the buying power further of DoD’s FY 22 request. While FY22 request is 1.6% greater than the previous year ($703.7 vs. $715 billion), inflation was at an annualized rate of 5% in Q1 of 2021 compared to 1.4% and 2.3% in the previous years. Consumer and producer prices, particularly those faced by defense contractors and their employees, typically outpace inflation. (This price escalation should be used to estimate realistic future costs, not economy-wide inflation.)
This problem is worse than it sounds. Most of DoD’s budget for FY22 won’t actually be spent for a few years. Procurement appropriations don’t actually leave the US Treasury for seven to ten years depending on the account. For example, Navy shipbuilding doesn’t expend 90% of its appropriation until the seventh year due to long lead times.
Interestingly, DoD’s FY22 budget did not release the green book where they publish inflation expectations and outlay rates. However, if inflation were expected to be 2% per year, then cost estimators would have to include an additional 5.8% for Navy shipbuilding to account for inflation over future years. If inflation turned out to be 5%, then the cost estimator should have increased the program cost by 14.5%. In other words, sustained inflation 3 percentage points above expectations reduces buying power for Navy shipbuilding by nearly 9%! The Navy could afford nearly one-tenth as much shipbuilding in FY22 as it anticipated under this scenario.
(Again, Navy estimators would use the SCN index which is a composite of labor and material price escalation used in shipbuilding rather than economy-wide inflation rates. But the same general conclusion holds is SCN expectations were 2% vs. 5%. The inflation rates are used to adjusting to a common base year figure across appropriation and programs. See CAPE’s inflation and escalation handbook.)
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