May 16, 2022

Josh Hendrickson on Economic Growth, National Defense, and US Monetary Policy

Understanding the emergence of modern states through the lens of state capacity can also help us optimize for policies ranging from taxes to national defense spending.
David Beckworth Senior Research Fellow , Joshua Hendrickson Senior Affiliated Scholar

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Josh Hendrickson is Associate Professor of Economics at the University of Mississippi and Chair of the Economics Department. Josh joins David on Macro Musings to discuss US monetary policy and US defense policy. Specifically, Josh and David discuss the coordination of fiscal and monetary policy and what Milton Friedman would think of it today, the Fed’s responsibility for modern inflation trends, state capacity and how it impacts economic growth, the role of national defense in the context of state capacity and economic growth, and much more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Josh, welcome back to the show.

Josh Hendrickson: Thanks for having me.

Beckworth: Well, it's great to have you back on. You are also a co-author of mine. We've done work together. Probably my most cited paper is with you, Josh, so thank you, Josh, for that helping hand there. What's interesting about getting you on today, and maybe some of our listeners already were a little surprised how I introduced you, is that you are someone, probably the only person, I know who's an expert in U.S. monetary policy and U.S. defense policy, at least a part of U.S. defense policy. I don't think I've had any other guests on the show who can speak authoritatively to both issues, so we're going to attempt to do that today. We'll spend about half of our time on U.S. monetary policy and then segue into defense policy, two very different fields.  I'm just curious before we get into this though, Josh, how did you get there? How did you become also a defense specialist?

Hendrickson: I'm really just interested in political economy generally. Part of it was just an interest in learning about institutions and economic growth and that sort of thing, and then noticing that there's these relationships between defense and the development of the state and economic growth and things like that are all... There's all these separate literatures that are all talking about these things that are going on simultaneously, so it got me thinking how are these things all related, and then people who know me, of course, know that I love Earl Thompson's work. He did some work on this area, and I thought that some of the things that he was writing about helped to tie some of these things together, and so it just became an additional research agenda for me.

Beckworth: Very nice, and we'll come to this later in the show. You have a number of articles with some other friends, and we'll come back, a fascinating discussion on public defense and its implications for thinking about economic growth, but I want to begin by looking at monetary policy because you've written a lot in that area. As I mentioned, you're a co-author of mine.

Beckworth: Just recently, the Mercatus Center released a symposium on Milton Friedman and what would he think in this current environment for U.S. monetary policy. As our listeners know, it's a very tumultuous time, to put it mildly. Inflation is really high by historical standards. The Fed is in a bind. It's doing what I call a delicate dance to try to rein in that inflation now, but also try to engineer a soft landing. It may be impossible. Maybe it'll be successful. We'll find out over the next year or two, but we're at a place where no one really thought we would be, a period of high inflation after a decade of really low inflation, and it's been lasting longer than we thought, and so we thought it'd be a good time to talk about what would Milton Friedman think about this.

Beckworth: We have a number of great as essays, one from Peter Ireland. He was a guest on the show just last week. He talks about the growth in the money supply. What would Friedman think about that? We have an essay from Julius Probst on Milton Friedman and the plucking model. Some have argued the new flexible average inflation targeting framework has some elements of the plucking model in it. Pat Horan has an article on the FAIT framework and nominal GDP targeting, and Scott Summer has an essay in there as well on market monetarism, and what would Freeman think about it? Then I have a piece on financial stability and what Milton would Freeman say about that. I want to look at your piece, Josh. You have a fascinating one in there that looks at Milton Friedman's work, that he looks at fiscal policy, monetary policy, how they're connected, and I believe you referenced his early 1948 AER essay, is that right? In this piece?

Hendrickson: Yes.

Beckworth: Walk us through your essay and what it means and how it helps us understand the present situation.

Milton Friedman and Fiscal-Monetary Policy Coordination

Hendrickson: I think one of the interesting things is that, if you go back to Friedman's early career, he's really talking about these proposals for a coordination between monetary and fiscal policy. You could use fiscal policy as this countercyclical tool, but what Friedman argues in that original paper is that you would finance these countercyclical fiscal policies with just money creation. When times are bad, you have countercyclical fiscal policies, spending rises, and then you just increase the money supply to pay for it, and then, when times are really good, you would have contractionary monetary policy and you would pull money out of the system. That doesn't sound very Friedman-like, and so I think a lot of people look at that and they say, "Well, what's going on here?" What happened to Milton Friedman? Where was the moment where he all of a sudden changed his outlook?"

Hendrickson: What I argue in my paper is that I don't think that he actually really changed. I think that what really changed is just how he thought we should go about policy. What Friedman was really trying to do is he was trying to just create more rules-based policy. He even says this in the conclusion of his AER paper where he basically says, "Look, this is a way to create rules-based policy to prevent policymakers from making things worse." Overreacting or under-reacting, that's the main problem that he was concerned with.

Hendrickson: If you look throughout Friedman's career, his primary preoccupation is that policymakers are increasing volatility. They're adding uncertainty in because they tend to overreact or under-react and, in doing so, then they're creating this additional volatility that wouldn't be there otherwise. If you take that as his position, it's not surprising that he moves from this earlier monetary fiscal policy coordination to later just advocating "let's just have a constant money growth rule" because the entire objective of the constant money growth rule was wasn't to say that, hey, this would be optimal policy. It was this would be a way to avoid the Federal Reserve doing, introducing its own harm. Yes, there would still be fluctuations, but they wouldn't be caused by the Federal Reserve.

If you look throughout Friedman's career, his primary preoccupation is that policymakers are increasing volatility. They're adding uncertainty in because they tend to overreact or under-react and, in doing so, then they're creating this additional volatility that wouldn't be there otherwise. If you take that as his position, it's not surprising that he moves from this earlier monetary fiscal policy coordination to later just advocating, 'let's just have a constant money growth rule.'

Share this

Hendrickson: He even mentions this in an interview he did with John Taylor later in life. He basically says, "Look, my views really didn't change. What happened is I just realized that this countercyclical fiscal policy aspect to my plan was just superfluous." It wasn't something that was relevant to his primary concern, which was getting policymakers out of the micromanaging aspects of policy.

Beckworth: Yeah, it's a very interesting piece, his 1948 article in the American Economic Review. If you look at it just from maybe a surface glance, maybe a casual read, you might even say it's Post-Keynesian because, I mean, the prescriptions are very similar to what some MMT or some Post-Keynesian, and that is, in the limit, you get rid of treasuries and the only government liabilities are Federal Reserve liabilities with money. I like the way you salvage this and that you're you saying, "Look, he is really calling for systematic macroeconomic policy." You balance the budget over the business cycle and, in the process, you're also reining in the growth path of the money supply. It is very similar in spirit to his later rule, but his later rules, of course, focused more on monetary policy.

Beckworth: Do you think his views on that linkage, because I had Eric Leeper, for example, recently on the podcast, and he's a big fiscal theory of the price level proponent, and he had a 2010 speech where he actually cited this paper. He goes, "Well, as far back as Friedman, we know there's this tight linkage between the two." He uses that to build a case for the fiscal theory of the price level. What do you think Friedman thought about this linkage later on in his career? I mean, was he worried about fiscal policy creating inflationary pressures, or did he again focus much more on a monetary-dominant view of the process?

Hendrickson: What comes out when you read him, and you have to read him carefully because he actually says some things that are similar to things that people say now, but they say the opposite. To give an example, he viewed monetary policy as the dominant policy, and what he would argue is that, if you ever monetized a deficit to any output effects of monetizing, that deficit were driven by the fact that you had monetary policy reinforcing it. He has a speech late in his career where he goes through examples of times when fiscal policy was expansionary or fiscal policy was contractionary and, basically, what he points out is the only times that these seem to matter is if those effects were reinforced by monetary policy. If monetary policy was working in the opposite direction, then these changes in fiscal policy didn't matter.

Hendrickson: The reason I say you have to be careful about interpreting what he's saying is so, for example, if you hear people talk today about helicopter drops, they call this a fiscal operation. They say, "Well, yeah. Okay, so the fiscal authority is going to have this deficit spending, but then the Fed is going to come in and just buy up all of those bonds that are issued, and so this is just a helicopter drop." This is a fiscal operation, but Friedman didn't call that a fiscal operation. Friedman argued that, no, that's a monetary operation, that the only reason that this policy is working the way that we think it's working is because of the monetary policy. If monetary policy went in reverse, we wouldn't even notice this fiscal expansion at all.

Hendrickson: I think that's the primary reason that he dropped the fiscal aspect of his rule as he went on in his career because the way that he argued it was that, if you look at the empirical evidence, this is like... Basically, what he was doing is he was presenting an early analogous idea to what Scott Sumner calls the monetary offset. If monetary policy is working in the opposite direction of fiscal policy, then the multiplier effect is zero. That was very much Friedman's view, and so he really just thought that if monetary policy really offsets fiscal policy, then fiscal policy was just irrelevant, and anything that we needed to do in terms of expansionary or contractionary policy could just be done with monetary policy. We didn't need the fiscal aspect.

Beckworth: He viewed monetary policy as the final determinant of aggregate demand that could offset what fiscal policy was doing. Maybe you don't know this, but did he ever express concern about, say, budget deficits or the projected path of budget deficits later in his career, 1970s, or maybe the early-'80s with Reagan? Was he not ever concerned about that, or was he always a hundred percent, "It's the Fed. It's the Fed. It's the Fed"?

Hendrickson: As far as I know, he never subscribed to this view of unpleasant monetarist arithmetic. He never, because he always saw fiscal policy as being... I mean, he always saw monetary policy as being dominant, and so whatever monetary policy was doing, that was determining the outcomes. I think that you can find places where he's concerned about fiscal policy just as a general matter, but not in the sense that it's going to take away the ability of central banks to do what they do.

Beckworth: He would not worry so much about fiscal dominance then in most situations, but, I mean, in the limit, I'm assuming he would at some point. I mean, in extreme cases where you have hyperinflation, I mean, fiscal dominance does seem to be a reasonable story, but, in most normal U.S. situations, one can imagine he would subscribe to monetary dominance with the idea being that the Fed sets monetary policy, and fiscal policy is in the background adjusting almost endogenously to what the Fed does versus the other way around.

Hendrickson: I think, too, part of this is semantics. I mean, he did write a review of Thomas Sargent's work, and he talked about this unpleasant monetary arithmetic argument, but in that discussion, Friedman really emphasizes that the Central Bank does have a choice. Now, the Central Bank might end up monetizing the debt, but that monetization is a choice and that the inflation is caused by the choice of the central bank. By monetizing the debt, the central bank is creating the inflation. His fundamental point was, well, the Central Bank wouldn't have to do that. They would have to do that in a sense to avoid default, possibly, or something like that, but his point is that there's nothing that requires the Central Bank to act in that way and that, because the Central Bank has agency in this decision, then we should just think about that as a monetary action rather than a fiscal action.

Beckworth: To be clear, his view is the mainstream view, the monetary-dominant's view. It's the Fed's view. If you look at the Fed's statement on longer-run goals and strategic monetary policy strategy, it says in there that the price level is determined by the Central Bank over the long run. They're saying, "Hey, it's us. We're the ones responsible." Governor Chris Waller recently had a speech where he made that same point, that we are in control. Don't worry about fiscal dominance. It is the point, and this is a nice segue into your piece that you wrote for us. It was a policy brief, and the title of it was “Central Banks are Inflation Creators, Not Inflation Fighters.” I think it dovetails nicely with this notion that the Fed at the end of the day can ultimately be the determiner, the arbitrator of aggregate demand, so speak to what you're arguing in that piece and how it applies to the current situation.

The Fed’s Responsibility for Inflation

Hendrickson: Yeah. This is something I learned from Robert Hetzel, or at least this kind of framing. The idea is that, if you look at how people talk about monetary policy, sometimes people are acting like the Fed is just this actor who's constantly responding to these other things. There are these fires that are popping up, and they just have to put out the fires. That's how they treat inflation, and so inflation just exists and then it's the Fed's job to fight that inflation. Hetzel's point is that, if you look at it from that perspective, you're seeing the central bank as a firefighter. They see fires. They show up. They put them out. What Hetzel's point is, is that the Fed in reality is more of the arsonist. The question is where did this inflation come from in the first place? The answer is that you have an overly expansionary monetary policy. That's what causes inflation. To argue that the Fed needs to fight inflation begs the question of where the inflation comes from in the first place.

This is something I learned from Robert Hetzel, or at least this kind of framing. The idea is that, if you look at how people talk about monetary policy, sometimes people are acting like the Fed is just this actor who's constantly responding to these other things...you're seeing the central bank as a firefighter. They see fires. They show up. They put them out. What Hetzel's point is, is that the Fed in reality is more of the arsonist. The question is where did this inflation come from in the first place? The answer is that you have an overly expansionary monetary policy. That's what causes inflation.

Share this

Hendrickson: This was also the motivation for an early paper that I wrote on the Great Moderation because there were a lot of people who were trying to figure out how did policy change in the switch to Volcker. Actually, a really good example of this is that a lot of New Keynesians said, "Well, what happened is they just got much more serious about fighting inflation." You had all these people estimating Central Bank reaction functions and Taylor rules and things like that and showing that, oh, the response of policy to inflation went up after Volcker took over, and so that's what it was. They just took inflation fighting seriously. The problem is those results were entirely an illusion. They required using ex-post data. Once you use real-time data... So Orphanides has a series of papers on this where he uses real-time data and he shows that, if you estimate these same reaction functions with the information that central bankers had at the time, their decisions actually don't look all that different pre- and post-Volcker.

Hendrickson: The question is, "What happened?" and so I had this paper where I basically argued, falling on this lesson I learned from Hetzel, was that what changed when Volcker took over is that the Fed basically took responsibility for inflation. They said, "The reason that inflation exists is not because of all of these external factors and all of these things that people have been blaming them on. They're because of us. Our policy is too expansionary. We're not going to continue those expansionary policies and, by discontinuing those expansionary policies, we're going to get inflation under control." It was this acceptance of the responsibility as the creator of inflation that ultimately led to inflation coming down to much more reasonable levels.

Beckworth: The application for today would be that, yes, we had a huge fiscal tailwind in 2021. The ARP, the big stimulus package that in hindsight was definitely more than we needed, that definitely created aggregate demand pressures, a lot of spending, but the Fed at the end of the day could have said no. It could have done the fiscal offset. When we question today, "Why is there high inflation?" you're making the point that the Fed needs to take some responsibility. Is that fair?

Hendrickson: Yeah, because I think the Council of Economic Advisers put out this really, well, what I consider a really terrible graphic when inflation first started popping up, and it was this historical view of inflation. Basically, whenever inflation was high on their graph, they had a little arrow pointing to the high inflation with whatever was going on at the time. The reason that I thought this was terrible, but I also used this in my policy brief, was that it really illustrates this view. If you think that the Fed is just an inflation fighter, then sometimes there's just going to be inflation that happens, and there's just nothing that they can do about it. They tried to stop it, but it's just beyond their control or something like that. Whereas, the inflation creator would look at it and say, no, no, no, if you're trying to achieve this particular level of inflation, and inflation is above that level, then your policy is too expansionary. I think this actually ties in really well with Friedman because Friedman was always talking about rules-based policy.

Hendrickson: Lars Svensson has a really good paper. I can't remember the name off the top of my head, but he has a really good paper in the late-'90s where he's talking about why policies like inflation targeting are useful. It's not even so much about inflation targeting. It's just about having an explicit target. What he points out is, if your target is to have 2% inflation every year, then this gives you feedback. This gives you constant feedback as to what's going on with policy. If inflation is too high, is higher than your target, then you know that you're too expansionary, and if inflation is below your target, then you know that you're too contractionary, and so you can adjust policy based on where this variable is relative to its target. Whether that's inflation, whether it's the price level, whether it's nominal GDP, whatever it is, if you have this target, the target is your guide.

Hendrickson: When you look at policy today, there's a lot of complicated things that are going on right there. I mean, we have this pandemic. We shut down the economy and restarted it. There's all these things that are unprecedented. There are all these things that are all happening at once. We've got Russia and Ukraine who are at war. That's disrupting the supply chains after we just had a major supply chain disruption. There's all these things going on.

Hendrickson: Part of the importance of having a target is that that target provides you with a guide as to what contribution your policy is making to this problem. That's also one of the reasons, as we have talked about many times, why nominal GDP is a useful indicator because, if your target is inflation, when inflation is above target, well, that could be because we've got all these supply chain disruptions or it could be because policy is too expansionary or it could be some combination of the two.

Hendrickson: When you have nominal GDP targeting now, supply chain disruptions are going to tend to raise prices, but lower quantities. Those kinds of things aren't going to show up in nominal GDP, and so, if you're looking at nominal GDP over time, that gives you a better indication, but, again, if nominal GDP is higher than where you want it to be like it is now, that's an indication that policy has been too expansionary.

Beckworth: Yep, so it's also important to have the right rule, not just a rule, to have the right rule, I mean, so you want to have that target, but you want to have a target set appropriately. As you just said, you people know where I stand and where you stand on this issue. Okay. Very nice. I encourage the listeners to check out Josh's papers. We just discussed his Friedman symposium paper and then also his policy brief titled Central Banks are Inflation Creators, Not Inflation Fighters. We'll have those linked in the show notes. Also check out the other articles at the Friedman symposium as well.

Beckworth: Okay, Josh, let's move on to National defense, and I'm going to throw in there also tail events that we should be preparing for, a kind of a catchall, because we're going to talk about these. Sometimes they're foreseen, but often unforeseen developments that it's hard for us to often take seriously ahead of time, to plan appropriately for especially if you've lived through a period of relatively peaceful, stable world. I want to begin by just mentioning a couple of pieces I read by Noah Smith on his Subststack, and he responds to a number of progressives who are just beside themselves because of Biden's $815 billion proposal for the Defense budget, and the typical things that progressives will throw out as well, "I wish we had that much money for schools, for healthcare, for all these different things," and Noah goes through and says, among other things, it's a bad look at the very moment we have this, what appears to be a resurgence of a great power conflict, which looks like Russia and China. Of course, Russia may not be quite the great power we thought it would be, but he also goes through and just notes how defense spending as a percent of GDP has declined.

Beckworth: He just put some numbers to this. During the Korean War, defense spending as a percent of GDP was 13%. During the Vietnam War, it was at times 9%, Reagan from six to 7%, and, currently it's about 4% of GDP. It's come down relative to GDP. Also, he notes, if you look at total government spending, it actually has grown as a percent of GDP, which means then that a greater and greater share is going to non-defense spending. These other areas are getting more, bigger shares over time, and so there's this discussion. How much should we be spending? I think the Russian-Ukraine War is highlighting that or really stressed that, and then there's other stories going on even surrounding that.

That's also one of the reasons, as we have talked about many times, why nominal GDP is a useful indicator because, if your target is inflation, when inflation is above target, well, that could be because we've got all these supply chain disruptions or it could be because policy is too expansionary or it could be some combination of the two.When you have nominal GDP targeting now, supply chain disruptions are going to tend to raise prices, but lower quantities. Those kinds of things aren't going to show up in nominal GDP, and so, if you're looking at nominal GDP over time, that gives you a better indication, but, again, if nominal GDP is higher than where you want it to be like it is now, that's an indication that policy has been too expansionary.

Share this

Beckworth: Noah's articles really highlight some of these discussions going on now, and let me throw in another story that I think is related to this. All the Javelin missiles we've been sending to Ukraine, there's been a number of stories about we have a shortage now in the U.S., potentially, if we had to go to war, let's say, in China, so should we care, Josh, about this decline both the relative to GDP? Is it important to think about National defense spending? I want to use that question to motivate you and some papers you've written. I'm going to mention a few. You've written several papers, one titled “Preventing Plunder, Military Technology, Capital Accumulation and Economic Growth,” and you co-authored it with Alex Salter and Brian Albrecht, friends of the show, on the Journal of Macro. You also have a paper out called “Taxation and National defense Revisited.”

Beckworth: Before we get to my question I just asked, "Is this decline important?" let's step back and ask some very basic questions related to this. You've covered these areas in your papers. Let's begin with a question you touched on both of these papers, and that is state capacity. What is state capacity, and what is the link between state capacity and economic growth in the literature? Then, after that, maybe we'll come back and ask what role National defense has. I hear this term a lot, state capacity, and then it seems to be a buzzword for those in the development or the economic growth field, so walk us through that literature and the basic ideas there.

State Capacity, National Defense, and Economic Growth

Hendrickson: Yeah. There are a lot of definitions that people use of state capacity, but, really, what we typically mean is, when we talk about state capacity, we're talking about your ability, the state's ability to adequately provide various public goods and things of that nature. As part of state capacity, there's issues related to the actual provision of public goods, but then there's also questions related to fiscal capacity, so can you afford to provide these kinds of goods and things like that?

Hendrickson: Actually, what really got me thinking about national defense in general is you have all these different literatures that are talking about the development of the modern state. These literatures stretch across history and political science and economics and even historical sociology and things like that. In some cases, it's how did we get from hunter-gatherer societies to modern states? In other cases, it's like how did Europe go from 200 countries to 20 countries over a hundred-year period? I mean, if you look at an old map of Germany, it's all these little tiny states, and now that's just Germany, and so the question is, oh, how did we get to this point? There's this entire literature on that.

Hendrickson: In economics, the state capacity literature is looking at, okay, how did the development of these modern states, these large centralized, bureaucratic states that provide public goods, how did these states emerge? We see the rise of these modern states in what we would call state capacity in conjunction with modern economic growth. In economics, a lot of this is about is state capacity causing growth or is state capacity the product of economic growth or is it some combination of the two? Whereas, in political science and history and historical sociology, a lot of this is more about what caused this consolidation of states and what caused these states to go from these tiny little areas of space on the map to these large bureaucratic states. In history and political science and sociology, there's a lot of focus on war. There's a lot of focus on how do you get from a bunch of little states to one big state? Is somebody just starts conquering all the little states and then they have a big state? That's one way of doing it and things like that, but then, in conjunction with that, there's also this literature on the development of fiscal capacity. How do states figure out how to develop modern tax systems? How do they figure out how to pay for stuff?

What really got me thinking about national defense in general is you have all these different literatures that are talking about the development of the modern state. These literatures stretch across history and political science and economics and even historical sociology... In economics, the state capacity literature is looking at, okay, how did the development of these modern states, these large centralized, bureaucratic states that provide public goods, how did these states emerge?

Share this

Hendrickson: My interest in this was really if war is really the thing that's driving these states, then this can potentially link all of these literatures together. In other words, if war is leading to the consolidation of states, then that means that people have to figure out how to pay for these wars, and if you have to figure out how to pay for wars, then that means you're going to have to develop fiscal capacity. War is not only leading to more centralization of these states, but it's also leading to greater fiscal capacity, and then greater fiscal capacity gives even greater ability to conduct war. So, there's this feedback mechanism, but also war is a selection mechanism. The states that figure out how to pay for this stuff and how to organize their military and do all of these things, they're going to be the ones that win the war and they're going to be the ones that survive. Whereas, the countries that don't develop these policies and institutions, they're going to get overtaken by the states that do, and so there should be this evolutionary selection mechanism. The development of the state is this evolutionary process, and I like this argument.

Hendrickson: Charles Tilly, who's a sociologist, he points this out repeatedly in his work is that nobody set out to design the modern state. The modern state just emerges, and so the question is how does it emerge? In part, drawing on Tilly's work, essentially what I'm arguing is that the modern state emerges as a result of war and the selection mechanism of war, but if you believe that, then we've got to get into even more details. If the states that survive are the ones who are winning wars, then what you would expect to see is you would expect to see policies and institutions specifically designed to get at defense. They're specifically designed to either help in the provision of defense or help in the financing of defense, and so we should look at those policies and look at those institutions and figure out how they're related to this development, and then the last aspect of this is when it comes to economic growth.

Hendrickson: Well, how does this matter? If you think about war as a constant threat, then you've got this issue of the richer you become, the greater target you become for some of these other states to come in and invade and either take your stuff, take you over or just destroy things and, in which case, that's a threat to your prosperity, in which case military technology becomes a constraint on the degree to which you can grow. If you're not providing adequate defense and you're becoming rich, then you become a target, and then potentially your state potentially no longer exists. I don't know. That's a huge overview. There's probably like 10 follow-up questions to that, but that's the big picture of where I'm at.

Beckworth: No, this is a great conversation, Josh. It's an important one, and some of this we teach at our introductory level classes for economics, that national defense is a public good. There's an externality. Who's going to pay for it? That's one reason, but you really are fleshing this out in a much greater detail. You're also providing some linkages. You're providing some causal mechanisms here. You're actually arguing that national defense on its own contributes to economic growth. I mean, there's maybe some circularity, some endogeneity there as well, but you are making a strong argument here that national defense itself, if you can isolate a true causal story, affects economic growth directly.

Hendrickson: I would frame it a little bit differently. I would say we don't have to disregard our ordinary theories of economic growth. I guess the way I would frame it is that adequate defense, and by adequate defense, I mean that in the sense of actually your ability to defend which includes military technology, military tactics, financing, all that stuff, is a limiting factor on economic growth. In other words, if you can't defend your wealth, your wealth is probably going to be fleeting.

Beckworth: Let's take that question of adequate defense. What is adequate defense? I think of the U.S. We think of the homeland, the continental U.S. and its territories, but also the global economy. I mean, we've seen this firsthand in the pandemic. It's important that we have these supply chains working. Now, that was caused by a pandemic. The Russia-Ukraine War, that'd be a case where a war has disrupted our ability to produce, to live the way we normally do. I think of the historian Niall Ferguson. He talks about how England provided a public good to the world with its empire at the time, so, this need for adequate defense, should we think about it just domestically or should we think of it in broader terms? Are we providing a public good to the world that effectively helps us indirectly?

Hendrickson: I mean, it depends on who we're talking about. What's adequate defense is going to be determined by who your allies are, but also who's going to be doing the defending. If there's another country that's going to come to your aid in the event that you go to a war, then some amount of your defense is being externally provided. We would expect that policies and institutions that you have would differ very much from a country that's going to be on its own or that's maybe a place like the United States, which is the current greatest military power in the world. You would expect the United States to have much different policies than countries that are going to be supported by the United States, for example.

Hendrickson: When you think about adequate defense, I think this actually helps to frame the question or helps to frame a lot of questions. If you get back to Noah's point, and he's talking about how much should we spend and what should we spend this money on and that sort of thing, the funny thing about adequate defense is, in my models of defense, I generally have some constraint. The constraint is all about providing adequate defense, and so here's the conditions for providing adequate defense, but the idea is that in the event that you provide adequate defense, you don't actually spend time in war, in the model, so the thing is that you're adequately financed and prepared for the war, but you wouldn't be fighting the war because nobody has an incentive to come fight you because you've invested in the policies and institutions and infrastructure necessary to fight the war.

Hendrickson: Arguments where you're like, “well, look at all this money we're spending, but we're not ever fighting anybody,” it's possible that we're just wasting a ton of money on defense and we could spend substantially less, but it's also possible that the reason that we're not fighting people is because you're spending this amount, and so it creates a very difficult identification problem. That's one issue. Then the other thing is that, once you frame this in terms of providing adequate defense, you can get ideas about exactly what sorts of policies and institutions would pop out of this. There's two ways to look at your wealth. Wealthier places might become greater targets for attacks, which is certainly true historically, but also wealthier places have much more to lose from an attack because, even if the wealth is just destroyed, then they're substantially less wealthy than they were before, and so, if you think about adequate defense, what this basically says is that the amount that you're going to have to spend is going to be some function of how wealthy you are.

Hendrickson: In terms of things like tax policy, what that tells you is that, if you're going to design a tax policy to finance defense, then the optimal tax rate that you're going to charge people is going to be proportional to the marginal cost of defense that they're creating in their actions, but then that opens a whole can of worms because certain things that people do are going to have different contributions to this externality. Just wealth accumulation in general is going to tend to increase the cost of providing adequate defense, but certain types of wealth creation might actually not add as much of a cost or might reduce the cost, so if the form of wealth creation that I'm engaged in is creating something that could actually help in a war, then maybe that should be taxed less or maybe that should actually just be subsidized, and so this opens a whole can of worms of thinking about how you would design policies and institutions to deal with all of these sorts of problems.

There's two ways to look at your wealth. Wealthier places might become greater targets for attacks, which is certainly true historically, but also wealthier places have much more to lose from an attack because, even if the wealth is just destroyed, then they're substantially less wealthy than they were before, and so, if you think about adequate defense, what this basically says is that the amount that you're going to have to spend is going to be some function of how wealthy you are.

Share this

Beckworth: The big point is that we want to have a tax policy, and the way you framed it precisely, you want to have an optimal tax policy that internalizes the defense externality, and that would be a tax on capital being equal to the marginal defense cost. Another implication that falls out of this is you could potentially have too much wealth because, once you start to tax the wealth to provide the defense, it's going to cause some adjustments. It's, in theory, possible to have too much wealth.

Beckworth: Let's pull away there from the precision here and get back to, I think, the big point, and that is, in order to maintain and preserve some level of wealth, you got to have this defense spending take place. It's hard to know for sure how big it is because of identification problems, at least empirically. But it also means, I think, that our friends who own the free market libertarian side who want to vastly reduce the size of the budget, this point should give them pause. It should have some added humility to their story. The ability to freely live, operate, function in a society you might define as classically liberal requires a significant investment in defense expenditures.

Hendrickson: Yeah. I think one of the biggest challenges I have is that I find that the people who are most interested in this work are people who have very strong ideological views about defense. One of the things that I am trying to push back on is I write a bunch of papers where I'm like, hey, we can understand this particular policy or this particular institution as a way to finance defense, and what I'm trying to do is I'm trying to make that argument in a positive sense. I'm doing positive economics. If this is a relevant constraint, then we would expect to see this, and do we actually see it, that kind of thing, and so one of the things I'm careful about or that I've become more careful about is, when I'm writing these papers, what I have to emphasize is, okay, if I'm saying that defense contributes to state capacity and state capacity contributes to growth, this is not saying that war makes us rich or something like that.

Hendrickson: I find oftentimes the people who most want to talk to me about this are people who are somewhat anti-war both on the left and on the libertarian side, whether they're left-libertarian or right-libertarian, and the reason is that they just think that we spend too much on defense. The more left-leaning people are like, "If we spent less on defense, we could spend more on these other social programs," and then you have the libertarians who are like, "If we spent less on defense, then we could just have less government and so we can keep more of our money for ourselves," and things like that.

Hendrickson: In both camps, they think that this would make things better off, but I think that the crucial thing that I'm saying is that they're looking at this entirely in terms of a guns-and-butter comparison. The more guns we have, the less butter that we have. What I'm saying in my research is that that's only part of the story. I mean, there is a guns-and-butter element to this, but you run into these constraints. You're trying to balance this trade-off, but you're not just choosing a point on a production possibilities frontier like economists would think about this problem. To some extent, you're affecting where the production possibilities frontier is because, if you don't have enough defense, your production possibilities frontier might be lower, at least in equilibrium, because you're not going to be able to develop enough wealth without being attacked and having it taken or destroyed.

Hendrickson: On the other hand, if you have too much defense spending, first of all, then it is superfluous. You do have more than what's adequate to defend yourself, in which case you could be spending it in a wiser fashion. The basic idea is we can't just think about moving along the production possibilities frontier. What's actually happening here is that that choice is determining not only where you are on that frontier, but where that frontier is located, which makes the question a lot harder.

Beckworth: That's great. I like that. The production possibility frontier itself, the capacity of the economy itself, is endogenous to where you pick that point on the initial production possibility frontier. It affects, in a dynamic sense, where you end up. Let's move on here as our time is running down. Just to summarize, there's an optimal level of defense spending. You have capital. You have wealth. You want to protect it, and it's possible, as you mentioned, to go, "Oh, it's possible to spend too much," and there's lots of examples one go throughout. F-35 seem to have a lot of problems with spending and breakdowns and stuff. It's easy to point a finger at one program here or there, but you're making a bigger point, I think.

Beckworth: Let me step back from this and go back to the state capacity point you're making. One of the tragic things that has happened, but it's also interesting, is the Russia-Ukraine War, and one thing that we've seen is that the Russian army is far less effective than we thought it would be. People attribute it to corruption. The state is so corrupt. I think you could argue or frame this in terms of state capacity, that there wasn't the state capacity there to support a strong military. How would you look at this revelation about this state of the Russian military in terms of your research about state capacity and economic growth?

Hendrickson: I think one of the things that we have to think about that's important is we don't want to focus solely on external issues. We also have to think about internal issues, and this is a thing you hear libertarians talk about a lot is that if you have a state that's powerful enough to defend you, then you also have a state that's powerful enough to attack you. If you have a really strong state that can defend you against other people, what happens when the state turns its power on you? There's all these issues.

Hendrickson: To me, the thing that is most fascinating about getting into defense is, once you start thinking about it in this framework, what you start to realize is that this is tied to a bunch of different literatures throughout economics and then that you can say something unique about defense because if you have this defense constraint, you want to have a state that's capable of providing adequate defense, but that only protects you from external predation, so then you have to protect yourself from internal predation. You have to design policies and institutions that prevent the state from using that power against you.

Hendrickson: Also, you have to deal with this issue that if defense is this primary goal, then things like status within the society might be determined by whether or not you're providing these kinds of services and things like that also because feedback mechanisms are sometimes weak. It's hard to know where you are, because the argument that I make is that this is like an evolutionary process. I mean, you never really know if you're providing adequate defense. I mean, the way that you find out if you're providing adequate defense is really by going to war. But even by going to war, even if you win, it's possible that you are still spending too much or that you are over-invested in defense. It's only really when you lose that you find out that you didn't have the policies and institutions and infrastructure to provide adequate defense.

Hendrickson: The key thing is I focus on this in a sort of evolutionary sense. What states are really doing is they're just trying to make their best guess of what's going on and what they need to do given the threats and the constraints that they see and that it's only through this process of conflict that it's revealed who's doing this well. You just have this experimentation and imitation of successful states that goes through here, but then you also have to worry about... You brought up sometimes we spend money on things that don't work and things like that. Some of this is due to corruption or some of it's due to rent-seeking or something like that. That's part of the problem. Part of the problem is how do we design these policies, institutions and infrastructure to make sure that we have adequate defense while at the same time designing policies, institutions and infrastructure that prevent people from coming in and just using the fact that constrain exists to create profit for themselves at the expense of everybody else? I think that's actually just what makes this whole topic fascinating and interesting is how do states deal with this especially when nobody's really setting out to design the perfect system. Everybody's just doing their best and imitating what other people in war.

Beckworth: Groping in the dark for a better outcome.

Hendrickson: Right.

Beckworth: I guess a fascinating way then to paint a picture for this is, if you look at Russia, Putin, President Putin clearly did not know where he was in terms of wherever they were on the frontier, and the war has revealed a lot. I think, Josh, this, this paper I'm going to mention is a culmination of some of this work. You have another paper with Alex Salter and Brian Albrecht, and it's titled “Evolution, Uncertainty, and the Asymptotic Efficiency of Policy.” It's coming out in Public Choice. This is like a summary of that argument, is that right?

Hendrickson: Yeah. That paper came about from thinking about feedback I was getting on some of these defense papers, so some of these defense papers I'm arguing. I'm like the only economist who has tried to explain why we have the Jones Act, for example. The argument that I make in that paper is that the merchant marine is providing a form of capital that's complementary to defense, and so we would expect that it would be subsidized. In my paper, I'm not going to go through the whole thing, but the United States has had this consistent, evolving policy of subsidizing the merchant marine and subsidizing shipbuilding and these sorts of things. What my argument is, is that if you believe in this adequate defense constraint, then it's not hard to understand why we have something like the Jones Act.

Hendrickson: Lots of people like to yell at me and say, "Well, but it's a terrible thing." I'm not saying that it's the optimal policy. What I'm saying is we can understand it if we understand this defense constraint. In response to papers like that, I also get a response where it's like, "You're just assuming that voters and politicians are just super smart and they know exactly what the optimal thing to do is." And so how do we end up with these good policies that nobody understands? If you're the only economist who can explain the Jones Act, then how do you explain why the general public, who for the most part gets basic economic concepts wrong, can understand and support it?

Hendrickson: This paper that we wrote was really about... I view it as very complementary to my other work. My co-authors might just view it as an independent project, but I view it as complementary because what got me thinking about these issues is, how do policies emerge and how do we get rid of bad policies and what survives in the long run? If you think about this from an evolutionary perspective, what we basically argue is that, yeah, there are always interest groups that are out there rent-seeking, but because those interest groups create costs for other people, eventually, if those costs get substantial enough, then people organize interest groups to oppose the other interest group.

Hendrickson: What we argue is that, over the very long run, bad policies or inefficient policies tend to be pushed out by this endogenous entry of new interest groups and things like that. It was very much a way just to think about policy when people are saying like, "Oh, you're giving too much credit to these, to voters and politicians to understand these issues," and what I'm saying is, no, they don't actually have to understand these things on a deep level, that essentially the policies that are serving some important or effective function are just going to survive, and the ones that aren't serving this essential function or that aren't very effective, then they're going to tend to be pushed out either just through repeal or just by being replaced by some other better policy. That just ties in with the same evolutionary arguments I was making about defense. Although it's not as clear, the voting booth is not as an effective selection mechanism as being destroyed by war or something like that, but it's a similar sort of feedback mechanism.

How do policies emerge and how do we get rid of bad policies and what survives in the long run? If you think about this from an evolutionary perspective, what we basically argue is that, yeah, there are always interest groups that are out there rent-seeking, but because those interest groups create costs for other people, eventually, if those costs get substantial enough, then people organize interest groups to oppose the other interest group...What we argue is that, over the very long run, bad policies or inefficient policies tend to be pushed out by this endogenous entry of new interest groups.

Share this

Beckworth: Yes. No, this is very good, and I'll just mention I had one of those people that you alluded to, Colin Grabow, on the show a few weeks ago. Interestingly, at the end of the show, he suggested that the Jones Act not be completely abolished. I mean, part of him wants to have it abolished, but to change it so that we have more direct subsidies as opposed to maybe having restrictions on port entrances and stuff, but directly subsidizes the fleet even more. I think you and him actually have a common path forward.

Beckworth: I want to end though on this. I know we're running low on time here, but your work in this area also carries over into, I think, general thoughts about preparing for tail events. You had a policy brief, 2020, part of a Mercatus series, and it was titled “The Coronavirus and Lessons for Preparedness.” Just in general, we don't plan well for these events we're not familiar with. We don't plan well for a potential asteroid hitting Earth, a solar flare knocking out electric grid, the next big pandemic. It's just hard. Even this budget that the president has been proposing for the next pandemic in the future is disappointing to many people because it's not taking seriously the possibility of things that could happen. My question to you is do we have a hard time as humans, and can you describe this evolutionary process we're trying to grope away in the dark trying to figure it out? Is it just incredibly hard to prepare and think about tail events?

Hendrickson: I think it is, but I also think that, as economists, we need to do a much better job explaining what can be done. I mean, we can think about this in a variety of ways. I mean, one way to think about it is that if you look at the pandemic, for example, you had essentially President Trump and President Biden using things like the Defense Production Act to divert resources towards certain things. If you think about that just in a vacuum, the fact that the Defense Production Act exists should lead people to invest less in the of things that might be diverted for use under the Defense Production Act, but knowing that that Act exists and knowing that these resources can be diverted and knowing that that means that people are going to tend to under-invest in these resources that would be diverted, then the way to correct that in a basic intertemporal problem would just be to subsidize the industries whose resources are going to be diverted during some kind of national emergency or something like that.

Hendrickson: The other way to think about it is, I mean, we can think about this in finance terms. I'm a big fan of Steve Ross' work in finance that tries to evaluate fiscal policies and things like that using the tools of modern finance and asset pricing. I think that we can do the same things for other events like pandemics and national emergencies where we can just think about what we're willing to pay. If you think about a pandemic, your ability to shorten a pandemic or prevent a pandemic or something like that, we could think about the value in terms of the value of statistical life saved. If that's the case, the value of statistical life is just a function of wages, and so we can use time series data on wages to price out contingent claims contracts that pay out an amount equal to the value of statistical life that having these policies would produce. It can be complicated, but these problems can give us an indication about how much we should be spending on these things even if they're very low-risk events.

Beckworth: We need to do a better job as economists pushing this point forward, and you did that in your policy brief that we will provide a link to. All right, with that, our time is up. Our guest today has been Josh Hendrickson. Josh, thank you so much for coming back on the show.

Hendrickson: Thank you very much for having me.

Take the Macro Musings listener survey here.

Photo by Anna Moneymaker via Getty Images

Support Mercatus

Your support allows us to continue bridging the gap between academic ideas and real-world policy solutions.Donate