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Federal
on financing the military buildup. This argument involves two links. The first link maintains that the administration
will not be able
to achieve simultaneously
large increases in
military spending
and reductions
in taxes
and the deficit. Although the administration
anticipates
a $45-billion deficit in FY 1982
and a balanced budget by FY 1984, most
private forecasters anticipate a larger deficit
in FY 1982-possibly
as high as $70 billion.
A large deficit in FY 1982 would reduce the
chances for a balanced budget in FY 1984.
The second link in the inflation argument
is that deficits are routinely
accompanied
by increases in the money stock. When the
government
borrows
from
private credit
markets
to finance
its deficits,
it places
upward pressure on interest rates. It often is
alleged that the Federal Reserve, because of
its concern over high interest rates, accommodates some or all of the federal government's credit demands by purchasing
government
debt through
open-market
operations and increasing the money stock. Causality tests suggest that a positive, weakly
significant, correlation
exists between Treasury borrowing
from the public and the
Federal Reserve System's holdings of government debt; however, no causal relationship
was found
between
Treasury
borrowing
from the public and the money
supply
(M-1B).3
These
results
suggest that
although
the Federal
Reserve makes some
open-market
purchases in response to Treasury borrowing,
this amount
is not large
enough to dominate movements in the money
supply, which is influenced by other factors.
These causality
tests can measure only
persistent correlations
between deficits and
money that cause inflation. They may not
detect periodic short-run
relationships,
pro3. The causal ity tests were conducted
by fi rst
converting
quarterly
time-series
data to "white
noise"
following
Box-Jenkins
techniques
and
then investigating
the correlations
between
the
appropriate
"whitened"
series. The time period
was usually 1959 to 1980. These are preliminary
results of a forthcoming
study on deficits and inflation
by Michael L. Bagshaw and Owen F.
Humpage;
details are available on request.
See
L.D. Haugh,
"Checking
the Independence
of
Two Covariance
Stationary
Time Series: A Univariate
Residual
Cross-Correlation
Approach,"
Journal

of

the American

Statistical

vol. 71 (June 1976), PP. 378-85.

Association,

ducing temporary
or one-shot
overall price levels.

increases

in

Deficits also may cause increases in the
absolute level of prices if they are accompanied by increases in the velocity of money
(evidence of a decline in money demand
relative to output).
Such velocity changes
may occur if the public perceives government debt as net wealth, or if the debt is
issued in short maturities
and increases the
liquidity of the average wealth holder. The
perceived
increase
in wealth
or greater
liquidity of wealth could enable individuals
to economize on their money balances, i.e.,
to support a greater volume of expenditures
with a smaller stock of money balances. Causality tests show a positive correlation
between Treasury borrowing
and the velocity
of money (M-1B); however, the relationship
is not strong.
Another
argument
relating
recent defense-spending
proposals and inflation concerns the real-resource
requirements
of the
program. A military buildup, this argument
contends,
transfers
resources
to the less
productive
defense
sector
while
simultaneously
maintaining
aggregate
employment and income. The supply of aggregate
real output
slows, while demand
remains
unchanged; prices ratchet upward as long as
the resource transfer continues.
There are, however,
many extenuating
circumstances.
The argument,
for example,
assumes that all resources are fully employed
so that increased production
of private and
defense goods cannot be achieved simultaneously. The economy often operates at less
than its potential, as is currently the case. In
addition, the full-employment
level of output is not unchanging in a dynamic economy.
It depends on the structure
of prices and
wages, taxes, government
regulations,
and
many other institutional
arrangements.
An
increase in aggregate supply is conceivable,
particularly
if the government
increases
incentives
for
investment
and
productivity growth.
The extenuating
circumstances,
however,
need not rely on supply-side economic arguments.
Most importantly,
if the military
buildup is accompanied
by a reduction
in
nondefense
federal spending or a lower rate
of monetary
growth, aggregate price pressures associated
with the resource transfer

would be mitigated.
Despite the defensespending increases, the Reagan administration
intends to reduce the relative size of total
federal spending to 21.2 percent in FY 1986
from 22.6 percent
in FY 1980, and the
Federal Reserve System expects to lower
gradually
the rate of money growth over
the same period. Such policies, to the extent
that they lower the growth in real privatesector demand,
will reduce the aggregate
price pressures associated with the transfer
of resources to the defense sector.
In summary,
the relationsh ip between
military spending and inflation is not direct.
The results depend on the conduct of monetary policy and the ability of the fiscal authorities to lower nondefense
federal spending and encourage private-sector productivity.

Will Bottlenecks Result
in Price Pressures?
In a free-market
economy, relative prices
rise and fall to adjust quantities of goods and
services demanded to the amounts being supplied. When demand for a specific product
increases, the relative price of that good also
will increase, forcing conservation
in its use
and encouraging
expansion
of its production. The choice to increase military
ex-

Federal

penditures enjoys no reprieve from the laws
of the marketplace.
At the present time, there appears to be
enough excess capacity among the major defense industries to support an expansion of
production.
Bottlenecks,
however, are developing among some defense subcontractors,
particularly
in low-technology
industries
such as large-scale castings and forgings. As
military spending slowed during the 1970s,
defense-related
production
became less profitable, causing an exodus of defense subcontractors
into civilian manufacturing.
For
many
of these
defense
subcontractors,
the federal government was their only buyer.
Given time and a constant government
demand, the subcontracting
network will be
reactivated,
but in the meantime
bottlenecks in the subcontracting
network
will
raise prices of defense resources and lengthen
lead times for delivery of defense goods.
There may also be shortages of individuals
with specific defense-related
skills, forcing
specific wage rates up. Shortages and bottlenecks that cause relative price shifts, however, will not cause inflation if the Federal
Reserve does not accommodate
them. They
will, however, reduce the real value of defense spending
and private spending
on
defense-related
resources.

Reserve Bank of Cleveland

BULK RATE

Research Department
P.O. Box 6387
Cleveland,OH
44101

U.S. Postage Paid
Cleveland,OH
Permit No. 385

Address correction requested
as shown
from mailing list

Reserve Bank of Cleveland,

Military Spending and the Economic Outlook
by Michael F. Bryan and Owen F. Humpage
The United States is embarking on an unprecedented
increase. in peacetime
military
spending. The program has prompted heated
discussions about the implications of defense
spending for real output, employment,
and
prices. Many economists expect the defense
buildup to have a relatively small, yet significant, impact on real aggregate economic activity and price levels over the next few years.
Nevertheless,
the direct impact of increased
military spending on some sectors, such as
durable goods, and specific prices should be
of much greater significance.
Following the Vietnam War, U.S. defense
spending declined in real terms, as a percentage of the total federal budget and relative
to GNP. In FY 1978 real defense expenditures constituted
24 percent of total federal
expenditures,
having fallen from their last
peak level of 44 percent in FY 1968. Real defense spending equaled 5 percent of GNP in
1978, down from 10 percent a decade earlier.
Military spending started to rise sharply
again beginning in FY 1979. In response to
its NATO commitments
and developments
in the Middle East, the Carter administration
increased real military expenditures
3.9 percent in FY 1979 and 3.4 percent in FY 1980
and proposed to raise real military spending
at a 5.0 percent average annual rate through
FY
1985.
The
Reagan
administration
greatly augmented the Carter administration's
defense-spending
proposals.
Real military
spending now officially is expected
to increase at an average annual rate of 8.6 percent through
FY 1986, equaling approximately 7 percent of total GNP by then. AI-

Humpage

Bryan

is an economic

is an economist.

both

analyst
with

and Owen
the Federal

Reserve Bank of Cleveland.
The views stated herein are those of the authors

Please send mailing label to the Research
Federal

July 27,1981

~£Q2Qomic ommentary
C

Michael

o Correct
o Remove

Reserve Bank of Cleveland

and

Department,

P.O. Box 6387,

Bank

Cleveland,

OH 44101.

not

necessarily

of Cleveland

those of the Federal
or of the Board

of the Federal Reserve System.

Reserve

of Governors

though the military-spending
increases will
cover a broad range of budget categories,
over one-half will be used for procurement.
Most of the procurement
funds will be spent
on aircraft, ships, missiles, and other combat vehicles.

The Military Spending Process
Long and variable lags often exist between
a presidential
request to increase military
spending and an observed change in defense
purchases as recorded by the GNP accounts.
They depend on many factors, including the
nature of the goods being bought, the capacity of the defense industry, and the urgency of the need. One can identify three lags
in the military-spending
chain. Production
and employment
can occur at any point
along this chain.
The first two lags involve the budget process. There is a time lapse between the date
when the president proposes an increase in
military outlays and the date when Congress
actually appropriates
funds for the coming
fiscal year. Measured from the January budget, this lag could be as short as four months
or as long as nine months. Between 1975 and
1980, however, the average lag was seven and
one-half months. There also may be a time
lag between the date when the Department
of Defense receives its appropriation
and the
time when it awards contracts. The lags associated with the budget process and with
the issuance of prime-contract
awards currently do not appear to represent
major
delays
because
of the widespread
support
throughout
Congress
for increased
military spending.
The final lag in the military-spending
process occurs between the awarding of prime
contracts
and the delivering
of military
goods. On average between 1960 and 1979,
changes in military
prime-contract
awards
resulted in significant changes in deliveries in

the current
quarter
and subsequent
five
quarters (see chart 1). The strongest correlation occurred in the second and third quarters following
a change in prime-contract
awards. Small weapons, clothing, cars, and
trucks can be delivered almost immediately.
More sophisticated equipment requires longer
lead times; some equipment
surely takes
much longer than five quarters.
Deliveries, however, are a poor indicator
of the economic activity caused by military
spending. Investment in plant and equipment
and inventory accumulation
of supplies may
precede contract awards if firms are certain
of future government orders. Production may
immediately
follow contract
awards,
and
may quicken to a full pace if not hampered
by production
bottlenecks
or resource
shortages.
As production
proceeds,
items
Chart 1 Correlations of Select Defense
Indicators against Current and Lagged
Prime-Contract
Awards
Correlation

Recent Developments

coefficient

0.50
0.40

0.20
0.10

o
Quarters

o

(lagged)
2

3

4

5

t:::{:}:) employment
in defense industries
against
prime-contract
awards
_
defense
deliveries
against
prime-contract
awards
a. Insignificant
at the 95 percent
level;
lags
beyond
five
quarters
insignificant at the 95 percent confidence

appear in the GNP accounts as inventories.
Employment
typically
follows
contract
awards with a one-quarter
lag, as shown
in chart 1. Employers prefer to utilize their
existing work force more intensively before
incurring the additional expense of newemployees. When deliveries finally are made,
they appear in the GNP accounts as increases
in defense purchases but are matched by offsetting declines in inventories.
Given the concentration
of large procurement items in the recent military-spending
proposals and given the likelihood of production bottlenecks
and shortages, the production
processes may extend longer than
past experience
suggests. The same factors
responsible for longer lead times may induce
additional
plant and equipment
spending,
since the U.S. commitment
to increase defense spending appears firm.

confidence
abo
are
level.

Contracts:
Quarterly
average of monthly
primecontract awards deflated by the GNP deflator for
government purchases.
Deliveries:
Government
purchases
less compensation
(N IPA basis) deflated
by the GNP deflator for government purchases.
Employment:
Quarterly average of monthly employment in defense industries.
Method:
Described in footnote 3 of the text.
Interval:
1960:IQ to 1979:IVQ.

The increase in military
spending thus
far has been small relative to what is anticipated. Between 1978: IV Q and 1981: II Q, for
example, real defense spending only increased
from 4.5 percent to 4.8 percent of total
GNP. In addition, the increases seem to reflect Department
of Defense employment
and purchases
of standardized
goods and
services rather than major procurement
items.
A review of various "defense indicators"
shows that economic activity has picked up
somewhat
in response
to higher military
spending,
but the increases in orders, production,
and
private-sector
employment
have been small and inconsistent (see table 1).
Military prime-contract
awards and manufacturers'
new orders for defense products
have demonstrated
large percentage increases
(greater than one standard deviation above
the mean) somewhat more often since January 1979 than over the previous three years.
These large increases, however, have not occurred with any regularity,
and they often
have been followed
by declines in primecontract
awards and new orders. Likewise,
manufacturers'
unfilled orders for defense
products
have not risen in a manner suggesting a strong, persistent
increase in military spending.
The frequency
of large increases in industrial
production
of defense
goods has not increased since early 1979,
but there was a fairly consistent
string of

Table 1

Frequency

of Large Increases
Primecontract
awards

1975:12 to 1978:12
1979:1 to latest available data pointa

New
orders

0.10

0.14

0.24

0.24

in Defense

Industrial production

Table 2

Indicators
Unfilled
orders

Shipments

0.20

0.08

0.17

0.10

0.14

0.07

1.00

0.28

0.33

(1981:1 ) (1981 :5) (1981 :5) (1981 :4)

0.14
(1981 :4)

DOD employment

(1981 :5) (1980:12)

Employment
0.16
0.18
(1981 :3)

a.

Dates in parentheses designate the latest month for which data are available.
Methodology:
Because the defense-indicator
series are erratic from month to month or quarter to
quarter, trends in the series are difficult to discern. Consequently,
a six-month moving average of monthly
percentage changes was calculated
for various defense indicators.
The mean and standard deviation of
the moving-average
time series for each defense indicator were calculated over the 1975:12 to 1978:12
period. Next, a count was made of the number of times the percentage increase in a given defense indicator exceeded one standard deviation above the mean (as calculated
over 1975: 12 to 1978: 12). The
table shows this count for two subperiods;
in each case the count was divided by the number of months
in the subperiod. The data pertain only to defense industries unless otherwise indicated.

Regional Impacts
The defense-production
sector
of the
economy
is highly
concentrated
among
relatively
few firms within
specific
geographic areas. The initial production
and
employment
triggered
from increased
defense spending are, however, only the first

of Military

Industry
Inventories

modest
increases
(greater
than
average,
but less than one standard deviation above
average) in late 1980 and early 1981.
In contrast to production
and orders, inventories suggest that firms are preparing for
anticipated
future
military-production
increases. Inventories of defense products have
shown larger percentage
increases in every
month since January
1979. Inventories
include materials, goods in process, and final
products, but the lack of significant increases
in defense-goods
production
suggests that
much of the increase in defense-related
inventories reflects the accumulation
of basic
materials
or components
rather than final
defense products.
The increased frequency
of large gains in shipments
of defense products also may mirror the rise in inventories,
since shipments include inter-plant transfers
within multi-plant firms.
Employment
by the Department
of Defense (military and civilian) has shown persistently large increases since early 1980, but
employment
in private-sector
defense
industries gives only a slight indication
of a
significant
rise. Typically,
however,
employment gains lag a rise in production.

Concentration

links in a long chain of economic activity.
Investment
induced
by defense
spending
creates demand in states that produce durable goods, and the income earned by defense workers eventually
will be spent on
nondefense products. These effects distribute
the economic stimulus associated with additional defense spending more evenly throughout the nation.
Between 1978 and 1980, over one-half
of the total value of all military
primecontract
awards involved aircraft,
missiles,
and ships (see table 2). These industries
are characterized
by highly technical, largescale production
facilities and a high degree
of industrial
and regional concentration.
Nine aircraft firms, eleven missile producers,
and eight shipbuilders
received virtually all
of their respective industries' military primecontract
awards between
1978 and 1980.
More than 20 percent of the total value of
Department
of Defense contracts
during
the last three years was awarded to five corporations;
47 percent
was received
by
25 firms.
Between
1978 and 1980, firms in six
states received over one-half of the military
prime-contract
awards. Firms in California
were the overwhelming
leaders, receiving approximately
20 percent. Two-thirds
of all
aircraft-contract
awards went to firms in
California,
Texas,
and Missouri; one-half
of the shipbuilding
contracts
were awarded
to firms in Virginia, Connecticut,
and California, and three-fifths
of the missile and

23.3

a.

Data

averaged

prime-contract
SOURCE:

California
New York
Texas
Connecticut
Missouri
Massach usetts
Subtotal
Pennsylvania
Ohio
Kentucky
West Virginia
District total

13.7
10.7
4.0
20.6
72.3
27.7
100.0

annually,

1978

through

1980;

U.S. Department

p.116.

Percent

20.2
8.5
8.2
6.3
5.4

General Dynamics
McDonnell Douglas
United Technologies
Lockheed
General Electric
Subtotal

5.7
4.7
4.0
3.1
3.0
20.5

6-10
11-25
26-50
51-100
Total

11.2
14.8
11.2

5.3
53.9
3.2
2.4
0.3
0.1
6.0
100 corporations

receiving

9.0
66.7
largest

dollar

volume

of

of Defense.

1. Apparently
Ohio's industries
are an increasingly smaller source of Department
of Defense
procurement.
Between
1958 and 1962, Ohio's
industries
received 4.5 percent of the total military prime contracts and 7.7 percent of total aircraft awards. In 1980 defense contracts
in Ohio
equaled 2.4 percent of the total, a historical low,
and its aircraft awards fell to 3.4 percent. Ohio's
industries,
however,
are more important
in defense subcontracting
than in primary contracting.
2. See

Corporation

awards.

space-systems
contracts
went to firms in
Cal ifornia and Massachusetts.
In contrast,
firms located in states of the Fourth Federal
Reserve District (Kentucky,
Ohio, Pennsylvania, and West Virginia) received only 6
percent of the total prime-contract
awards.l
Recipients
of military
prime-contract
awards typically do not perform all of the
work entailed in the contract; they subcontract much of the work to other firms. Although subcontracting
slightly diffuses the
initial impact of defense spending, the subcontracting
network seems nearly as regionally concentrated
as the primary-contract
network.
In 1966, for example, 75 percent
of all military subcontracting
occurred in ten
states, with California
and New York accounting for 40 percent.2 The subcontracting
network, however, is not immutable.
Given
the size and the technical nature of projected
defense spending and the likelihood of pro-

Murray

Peacetime

Awards"
Percent

State

Percent

Aircraft
Missiles and other
space systems
Ships
Vehicles
Others
Total hard goods
Other supplies
Total

Prime-Contract

Weidenbaum,
(Praeger

Defense

The Economics

Publishing,

of

1974),

duction
bottlenecks,
additional
firms may
seek defense-related
orders and reduce the
regional
concentration
in the
subcontracting network.
The stimulative
effects of the military
prime-contract
awards and subcontracting
eventually
will affect incomes throughout
the country.
The military
spending
increases, however, will be financed in part by
cuts in federal nondefense
spending categories. Both the defense and the offsetting
nondefense
budget developments
must be
weighed in assessing regional impacts of the
budget. On balance, the military
buildup
may result in large relocations
of employment, investment,
and income, and not all
regions may benefit.

Military Spending and Inflation
Many economists
caution that the administration's
defense-spending
program will result in higher rates of inflation. Inflation, or
a persistent rise in the overall price levels,
cannot exist without
an equally persistent
rise in the supply of money or a decl ine in
the demand for money that outpaces
the
growth of goods and services. Factors that
reduce the demand
for money,
such as
readily available
credit,
and factors
that
reduce the aggregate growth of real output, such as slowdowns
in long-term
productivity growth, result in inflation only if
they are not offset by monetary policy.
One argument
relating
recent defensespending proposals to inflation concentrates

the current
quarter
and subsequent
five
quarters (see chart 1). The strongest correlation occurred in the second and third quarters following
a change in prime-contract
awards. Small weapons, clothing, cars, and
trucks can be delivered almost immediately.
More sophisticated equipment requires longer
lead times; some equipment
surely takes
much longer than five quarters.
Deliveries, however, are a poor indicator
of the economic activity caused by military
spending. Investment in plant and equipment
and inventory accumulation
of supplies may
precede contract awards if firms are certain
of future government orders. Production may
immediately
follow contract
awards,
and
may quicken to a full pace if not hampered
by production
bottlenecks
or resource
shortages.
As production
proceeds,
items
Chart 1 Correlations of Select Defense
Indicators against Current and Lagged
Prime-Contract
Awards
Correlation

Recent Developments

coefficient

0.50
0.40

0.20
0.10

o
Quarters

o

(lagged)
2

3

4

5

t:::{:}:) employment
in defense industries
against
prime-contract
awards
_
defense
deliveries
against
prime-contract
awards
a. Insignificant
at the 95 percent
level;
lags
beyond
five
quarters
insignificant at the 95 percent confidence

appear in the GNP accounts as inventories.
Employment
typically
follows
contract
awards with a one-quarter
lag, as shown
in chart 1. Employers prefer to utilize their
existing work force more intensively before
incurring the additional expense of newemployees. When deliveries finally are made,
they appear in the GNP accounts as increases
in defense purchases but are matched by offsetting declines in inventories.
Given the concentration
of large procurement items in the recent military-spending
proposals and given the likelihood of production bottlenecks
and shortages, the production
processes may extend longer than
past experience
suggests. The same factors
responsible for longer lead times may induce
additional
plant and equipment
spending,
since the U.S. commitment
to increase defense spending appears firm.

confidence
abo
are
level.

Contracts:
Quarterly
average of monthly
primecontract awards deflated by the GNP deflator for
government purchases.
Deliveries:
Government
purchases
less compensation
(N IPA basis) deflated
by the GNP deflator for government purchases.
Employment:
Quarterly average of monthly employment in defense industries.
Method:
Described in footnote 3 of the text.
Interval:
1960:IQ to 1979:IVQ.

The increase in military
spending thus
far has been small relative to what is anticipated. Between 1978: IV Q and 1981: II Q, for
example, real defense spending only increased
from 4.5 percent to 4.8 percent of total
GNP. In addition, the increases seem to reflect Department
of Defense employment
and purchases
of standardized
goods and
services rather than major procurement
items.
A review of various "defense indicators"
shows that economic activity has picked up
somewhat
in response
to higher military
spending,
but the increases in orders, production,
and
private-sector
employment
have been small and inconsistent (see table 1).
Military prime-contract
awards and manufacturers'
new orders for defense products
have demonstrated
large percentage increases
(greater than one standard deviation above
the mean) somewhat more often since January 1979 than over the previous three years.
These large increases, however, have not occurred with any regularity,
and they often
have been followed
by declines in primecontract
awards and new orders. Likewise,
manufacturers'
unfilled orders for defense
products
have not risen in a manner suggesting a strong, persistent
increase in military spending.
The frequency
of large increases in industrial
production
of defense
goods has not increased since early 1979,
but there was a fairly consistent
string of

Table 1

Frequency

of Large Increases
Primecontract
awards

1975:12 to 1978:12
1979:1 to latest available data pointa

New
orders

0.10

0.14

0.24

0.24

in Defense

Industrial production

Table 2

Indicators
Unfilled
orders

Shipments

0.20

0.08

0.17

0.10

0.14

0.07

1.00

0.28

0.33

(1981:1 ) (1981 :5) (1981 :5) (1981 :4)

0.14
(1981 :4)

DOD employment

(1981 :5) (1980:12)

Employment
0.16
0.18
(1981 :3)

a.

Dates in parentheses designate the latest month for which data are available.
Methodology:
Because the defense-indicator
series are erratic from month to month or quarter to
quarter, trends in the series are difficult to discern. Consequently,
a six-month moving average of monthly
percentage changes was calculated
for various defense indicators.
The mean and standard deviation of
the moving-average
time series for each defense indicator were calculated over the 1975:12 to 1978:12
period. Next, a count was made of the number of times the percentage increase in a given defense indicator exceeded one standard deviation above the mean (as calculated
over 1975: 12 to 1978: 12). The
table shows this count for two subperiods;
in each case the count was divided by the number of months
in the subperiod. The data pertain only to defense industries unless otherwise indicated.

Regional Impacts
The defense-production
sector
of the
economy
is highly
concentrated
among
relatively
few firms within
specific
geographic areas. The initial production
and
employment
triggered
from increased
defense spending are, however, only the first

of Military

Industry
Inventories

modest
increases
(greater
than
average,
but less than one standard deviation above
average) in late 1980 and early 1981.
In contrast to production
and orders, inventories suggest that firms are preparing for
anticipated
future
military-production
increases. Inventories of defense products have
shown larger percentage
increases in every
month since January
1979. Inventories
include materials, goods in process, and final
products, but the lack of significant increases
in defense-goods
production
suggests that
much of the increase in defense-related
inventories reflects the accumulation
of basic
materials
or components
rather than final
defense products.
The increased frequency
of large gains in shipments
of defense products also may mirror the rise in inventories,
since shipments include inter-plant transfers
within multi-plant firms.
Employment
by the Department
of Defense (military and civilian) has shown persistently large increases since early 1980, but
employment
in private-sector
defense
industries gives only a slight indication
of a
significant
rise. Typically,
however,
employment gains lag a rise in production.

Concentration

links in a long chain of economic activity.
Investment
induced
by defense
spending
creates demand in states that produce durable goods, and the income earned by defense workers eventually
will be spent on
nondefense products. These effects distribute
the economic stimulus associated with additional defense spending more evenly throughout the nation.
Between 1978 and 1980, over one-half
of the total value of all military
primecontract
awards involved aircraft,
missiles,
and ships (see table 2). These industries
are characterized
by highly technical, largescale production
facilities and a high degree
of industrial
and regional concentration.
Nine aircraft firms, eleven missile producers,
and eight shipbuilders
received virtually all
of their respective industries' military primecontract
awards between
1978 and 1980.
More than 20 percent of the total value of
Department
of Defense contracts
during
the last three years was awarded to five corporations;
47 percent
was received
by
25 firms.
Between
1978 and 1980, firms in six
states received over one-half of the military
prime-contract
awards. Firms in California
were the overwhelming
leaders, receiving approximately
20 percent. Two-thirds
of all
aircraft-contract
awards went to firms in
California,
Texas,
and Missouri; one-half
of the shipbuilding
contracts
were awarded
to firms in Virginia, Connecticut,
and California, and three-fifths
of the missile and

23.3

a.

Data

averaged

prime-contract
SOURCE:

California
New York
Texas
Connecticut
Missouri
Massach usetts
Subtotal
Pennsylvania
Ohio
Kentucky
West Virginia
District total

13.7
10.7
4.0
20.6
72.3
27.7
100.0

annually,

1978

through

1980;

U.S. Department

p.116.

Percent

20.2
8.5
8.2
6.3
5.4

General Dynamics
McDonnell Douglas
United Technologies
Lockheed
General Electric
Subtotal

5.7
4.7
4.0
3.1
3.0
20.5

6-10
11-25
26-50
51-100
Total

11.2
14.8
11.2

5.3
53.9
3.2
2.4
0.3
0.1
6.0
100 corporations

receiving

9.0
66.7
largest

dollar

volume

of

of Defense.

1. Apparently
Ohio's industries
are an increasingly smaller source of Department
of Defense
procurement.
Between
1958 and 1962, Ohio's
industries
received 4.5 percent of the total military prime contracts and 7.7 percent of total aircraft awards. In 1980 defense contracts
in Ohio
equaled 2.4 percent of the total, a historical low,
and its aircraft awards fell to 3.4 percent. Ohio's
industries,
however,
are more important
in defense subcontracting
than in primary contracting.
2. See

Corporation

awards.

space-systems
contracts
went to firms in
Cal ifornia and Massachusetts.
In contrast,
firms located in states of the Fourth Federal
Reserve District (Kentucky,
Ohio, Pennsylvania, and West Virginia) received only 6
percent of the total prime-contract
awards.l
Recipients
of military
prime-contract
awards typically do not perform all of the
work entailed in the contract; they subcontract much of the work to other firms. Although subcontracting
slightly diffuses the
initial impact of defense spending, the subcontracting
network seems nearly as regionally concentrated
as the primary-contract
network.
In 1966, for example, 75 percent
of all military subcontracting
occurred in ten
states, with California
and New York accounting for 40 percent.2 The subcontracting
network, however, is not immutable.
Given
the size and the technical nature of projected
defense spending and the likelihood of pro-

Murray

Peacetime

Awards"
Percent

State

Percent

Aircraft
Missiles and other
space systems
Ships
Vehicles
Others
Total hard goods
Other supplies
Total

Prime-Contract

Weidenbaum,
(Praeger

Defense

The Economics

Publishing,

of

1974),

duction
bottlenecks,
additional
firms may
seek defense-related
orders and reduce the
regional
concentration
in the
subcontracting network.
The stimulative
effects of the military
prime-contract
awards and subcontracting
eventually
will affect incomes throughout
the country.
The military
spending
increases, however, will be financed in part by
cuts in federal nondefense
spending categories. Both the defense and the offsetting
nondefense
budget developments
must be
weighed in assessing regional impacts of the
budget. On balance, the military
buildup
may result in large relocations
of employment, investment,
and income, and not all
regions may benefit.

Military Spending and Inflation
Many economists
caution that the administration's
defense-spending
program will result in higher rates of inflation. Inflation, or
a persistent rise in the overall price levels,
cannot exist without
an equally persistent
rise in the supply of money or a decl ine in
the demand for money that outpaces
the
growth of goods and services. Factors that
reduce the demand
for money,
such as
readily available
credit,
and factors
that
reduce the aggregate growth of real output, such as slowdowns
in long-term
productivity growth, result in inflation only if
they are not offset by monetary policy.
One argument
relating
recent defensespending proposals to inflation concentrates

the current
quarter
and subsequent
five
quarters (see chart 1). The strongest correlation occurred in the second and third quarters following
a change in prime-contract
awards. Small weapons, clothing, cars, and
trucks can be delivered almost immediately.
More sophisticated equipment requires longer
lead times; some equipment
surely takes
much longer than five quarters.
Deliveries, however, are a poor indicator
of the economic activity caused by military
spending. Investment in plant and equipment
and inventory accumulation
of supplies may
precede contract awards if firms are certain
of future government orders. Production may
immediately
follow contract
awards,
and
may quicken to a full pace if not hampered
by production
bottlenecks
or resource
shortages.
As production
proceeds,
items
Chart 1 Correlations of Select Defense
Indicators against Current and Lagged
Prime-Contract
Awards
Correlation

Recent Developments

coefficient

0.50
0.40

0.20
0.10

o
Quarters

o

(lagged)
2

3

4

5

t:::{:}:) employment
in defense industries
against
prime-contract
awards
_
defense
deliveries
against
prime-contract
awards
a. Insignificant
at the 95 percent
level;
lags
beyond
five
quarters
insignificant at the 95 percent confidence

appear in the GNP accounts as inventories.
Employment
typically
follows
contract
awards with a one-quarter
lag, as shown
in chart 1. Employers prefer to utilize their
existing work force more intensively before
incurring the additional expense of newemployees. When deliveries finally are made,
they appear in the GNP accounts as increases
in defense purchases but are matched by offsetting declines in inventories.
Given the concentration
of large procurement items in the recent military-spending
proposals and given the likelihood of production bottlenecks
and shortages, the production
processes may extend longer than
past experience
suggests. The same factors
responsible for longer lead times may induce
additional
plant and equipment
spending,
since the U.S. commitment
to increase defense spending appears firm.

confidence
abo
are
level.

Contracts:
Quarterly
average of monthly
primecontract awards deflated by the GNP deflator for
government purchases.
Deliveries:
Government
purchases
less compensation
(N IPA basis) deflated
by the GNP deflator for government purchases.
Employment:
Quarterly average of monthly employment in defense industries.
Method:
Described in footnote 3 of the text.
Interval:
1960:IQ to 1979:IVQ.

The increase in military
spending thus
far has been small relative to what is anticipated. Between 1978: IV Q and 1981: II Q, for
example, real defense spending only increased
from 4.5 percent to 4.8 percent of total
GNP. In addition, the increases seem to reflect Department
of Defense employment
and purchases
of standardized
goods and
services rather than major procurement
items.
A review of various "defense indicators"
shows that economic activity has picked up
somewhat
in response
to higher military
spending,
but the increases in orders, production,
and
private-sector
employment
have been small and inconsistent (see table 1).
Military prime-contract
awards and manufacturers'
new orders for defense products
have demonstrated
large percentage increases
(greater than one standard deviation above
the mean) somewhat more often since January 1979 than over the previous three years.
These large increases, however, have not occurred with any regularity,
and they often
have been followed
by declines in primecontract
awards and new orders. Likewise,
manufacturers'
unfilled orders for defense
products
have not risen in a manner suggesting a strong, persistent
increase in military spending.
The frequency
of large increases in industrial
production
of defense
goods has not increased since early 1979,
but there was a fairly consistent
string of

Table 1

Frequency

of Large Increases
Primecontract
awards

1975:12 to 1978:12
1979:1 to latest available data pointa

New
orders

0.10

0.14

0.24

0.24

in Defense

Industrial production

Table 2

Indicators
Unfilled
orders

Shipments

0.20

0.08

0.17

0.10

0.14

0.07

1.00

0.28

0.33

(1981:1 ) (1981 :5) (1981 :5) (1981 :4)

0.14
(1981 :4)

DOD employment

(1981 :5) (1980:12)

Employment
0.16
0.18
(1981 :3)

a.

Dates in parentheses designate the latest month for which data are available.
Methodology:
Because the defense-indicator
series are erratic from month to month or quarter to
quarter, trends in the series are difficult to discern. Consequently,
a six-month moving average of monthly
percentage changes was calculated
for various defense indicators.
The mean and standard deviation of
the moving-average
time series for each defense indicator were calculated over the 1975:12 to 1978:12
period. Next, a count was made of the number of times the percentage increase in a given defense indicator exceeded one standard deviation above the mean (as calculated
over 1975: 12 to 1978: 12). The
table shows this count for two subperiods;
in each case the count was divided by the number of months
in the subperiod. The data pertain only to defense industries unless otherwise indicated.

Regional Impacts
The defense-production
sector
of the
economy
is highly
concentrated
among
relatively
few firms within
specific
geographic areas. The initial production
and
employment
triggered
from increased
defense spending are, however, only the first

of Military

Industry
Inventories

modest
increases
(greater
than
average,
but less than one standard deviation above
average) in late 1980 and early 1981.
In contrast to production
and orders, inventories suggest that firms are preparing for
anticipated
future
military-production
increases. Inventories of defense products have
shown larger percentage
increases in every
month since January
1979. Inventories
include materials, goods in process, and final
products, but the lack of significant increases
in defense-goods
production
suggests that
much of the increase in defense-related
inventories reflects the accumulation
of basic
materials
or components
rather than final
defense products.
The increased frequency
of large gains in shipments
of defense products also may mirror the rise in inventories,
since shipments include inter-plant transfers
within multi-plant firms.
Employment
by the Department
of Defense (military and civilian) has shown persistently large increases since early 1980, but
employment
in private-sector
defense
industries gives only a slight indication
of a
significant
rise. Typically,
however,
employment gains lag a rise in production.

Concentration

links in a long chain of economic activity.
Investment
induced
by defense
spending
creates demand in states that produce durable goods, and the income earned by defense workers eventually
will be spent on
nondefense products. These effects distribute
the economic stimulus associated with additional defense spending more evenly throughout the nation.
Between 1978 and 1980, over one-half
of the total value of all military
primecontract
awards involved aircraft,
missiles,
and ships (see table 2). These industries
are characterized
by highly technical, largescale production
facilities and a high degree
of industrial
and regional concentration.
Nine aircraft firms, eleven missile producers,
and eight shipbuilders
received virtually all
of their respective industries' military primecontract
awards between
1978 and 1980.
More than 20 percent of the total value of
Department
of Defense contracts
during
the last three years was awarded to five corporations;
47 percent
was received
by
25 firms.
Between
1978 and 1980, firms in six
states received over one-half of the military
prime-contract
awards. Firms in California
were the overwhelming
leaders, receiving approximately
20 percent. Two-thirds
of all
aircraft-contract
awards went to firms in
California,
Texas,
and Missouri; one-half
of the shipbuilding
contracts
were awarded
to firms in Virginia, Connecticut,
and California, and three-fifths
of the missile and

23.3

a.

Data

averaged

prime-contract
SOURCE:

California
New York
Texas
Connecticut
Missouri
Massach usetts
Subtotal
Pennsylvania
Ohio
Kentucky
West Virginia
District total

13.7
10.7
4.0
20.6
72.3
27.7
100.0

annually,

1978

through

1980;

U.S. Department

p.116.

Percent

20.2
8.5
8.2
6.3
5.4

General Dynamics
McDonnell Douglas
United Technologies
Lockheed
General Electric
Subtotal

5.7
4.7
4.0
3.1
3.0
20.5

6-10
11-25
26-50
51-100
Total

11.2
14.8
11.2

5.3
53.9
3.2
2.4
0.3
0.1
6.0
100 corporations

receiving

9.0
66.7
largest

dollar

volume

of

of Defense.

1. Apparently
Ohio's industries
are an increasingly smaller source of Department
of Defense
procurement.
Between
1958 and 1962, Ohio's
industries
received 4.5 percent of the total military prime contracts and 7.7 percent of total aircraft awards. In 1980 defense contracts
in Ohio
equaled 2.4 percent of the total, a historical low,
and its aircraft awards fell to 3.4 percent. Ohio's
industries,
however,
are more important
in defense subcontracting
than in primary contracting.
2. See

Corporation

awards.

space-systems
contracts
went to firms in
Cal ifornia and Massachusetts.
In contrast,
firms located in states of the Fourth Federal
Reserve District (Kentucky,
Ohio, Pennsylvania, and West Virginia) received only 6
percent of the total prime-contract
awards.l
Recipients
of military
prime-contract
awards typically do not perform all of the
work entailed in the contract; they subcontract much of the work to other firms. Although subcontracting
slightly diffuses the
initial impact of defense spending, the subcontracting
network seems nearly as regionally concentrated
as the primary-contract
network.
In 1966, for example, 75 percent
of all military subcontracting
occurred in ten
states, with California
and New York accounting for 40 percent.2 The subcontracting
network, however, is not immutable.
Given
the size and the technical nature of projected
defense spending and the likelihood of pro-

Murray

Peacetime

Awards"
Percent

State

Percent

Aircraft
Missiles and other
space systems
Ships
Vehicles
Others
Total hard goods
Other supplies
Total

Prime-Contract

Weidenbaum,
(Praeger

Defense

The Economics

Publishing,

of

1974),

duction
bottlenecks,
additional
firms may
seek defense-related
orders and reduce the
regional
concentration
in the
subcontracting network.
The stimulative
effects of the military
prime-contract
awards and subcontracting
eventually
will affect incomes throughout
the country.
The military
spending
increases, however, will be financed in part by
cuts in federal nondefense
spending categories. Both the defense and the offsetting
nondefense
budget developments
must be
weighed in assessing regional impacts of the
budget. On balance, the military
buildup
may result in large relocations
of employment, investment,
and income, and not all
regions may benefit.

Military Spending and Inflation
Many economists
caution that the administration's
defense-spending
program will result in higher rates of inflation. Inflation, or
a persistent rise in the overall price levels,
cannot exist without
an equally persistent
rise in the supply of money or a decl ine in
the demand for money that outpaces
the
growth of goods and services. Factors that
reduce the demand
for money,
such as
readily available
credit,
and factors
that
reduce the aggregate growth of real output, such as slowdowns
in long-term
productivity growth, result in inflation only if
they are not offset by monetary policy.
One argument
relating
recent defensespending proposals to inflation concentrates

Federal
on financing the military buildup. This argument involves two links. The first link maintains that the administration
will not be able
to achieve simultaneously
large increases in
military spending
and reductions
in taxes
and the deficit. Although the administration
anticipates
a $45-billion deficit in FY 1982
and a balanced budget by FY 1984, most
private forecasters anticipate a larger deficit
in FY 1982-possibly
as high as $70 billion.
A large deficit in FY 1982 would reduce the
chances for a balanced budget in FY 1984.
The second link in the inflation argument
is that deficits are routinely
accompanied
by increases in the money stock. When the
government
borrows
from
private credit
markets
to finance
its deficits,
it places
upward pressure on interest rates. It often is
alleged that the Federal Reserve, because of
its concern over high interest rates, accommodates some or all of the federal government's credit demands by purchasing
government
debt through
open-market
operations and increasing the money stock. Causality tests suggest that a positive, weakly
significant, correlation
exists between Treasury borrowing
from the public and the
Federal Reserve System's holdings of government debt; however, no causal relationship
was found
between
Treasury
borrowing
from the public and the money
supply
(M-1B).3
These
results
suggest that
although
the Federal
Reserve makes some
open-market
purchases in response to Treasury borrowing,
this amount
is not large
enough to dominate movements in the money
supply, which is influenced by other factors.
These causality
tests can measure only
persistent correlations
between deficits and
money that cause inflation. They may not
detect periodic short-run
relationships,
pro3. The causal ity tests were conducted
by fi rst
converting
quarterly
time-series
data to "white
noise"
following
Box-Jenkins
techniques
and
then investigating
the correlations
between
the
appropriate
"whitened"
series. The time period
was usually 1959 to 1980. These are preliminary
results of a forthcoming
study on deficits and inflation
by Michael L. Bagshaw and Owen F.
Humpage;
details are available on request.
See
L.D. Haugh,
"Checking
the Independence
of
Two Covariance
Stationary
Time Series: A Univariate
Residual
Cross-Correlation
Approach,"
Journal

of

the American

Statistical

vol. 71 (June 1976), PP. 378-85.

Association,

ducing temporary
or one-shot
overall price levels.

increases

in

Deficits also may cause increases in the
absolute level of prices if they are accompanied by increases in the velocity of money
(evidence of a decline in money demand
relative to output).
Such velocity changes
may occur if the public perceives government debt as net wealth, or if the debt is
issued in short maturities
and increases the
liquidity of the average wealth holder. The
perceived
increase
in wealth
or greater
liquidity of wealth could enable individuals
to economize on their money balances, i.e.,
to support a greater volume of expenditures
with a smaller stock of money balances. Causality tests show a positive correlation
between Treasury borrowing
and the velocity
of money (M-1B); however, the relationship
is not strong.
Another
argument
relating
recent defense-spending
proposals and inflation concerns the real-resource
requirements
of the
program. A military buildup, this argument
contends,
transfers
resources
to the less
productive
defense
sector
while
simultaneously
maintaining
aggregate
employment and income. The supply of aggregate
real output
slows, while demand
remains
unchanged; prices ratchet upward as long as
the resource transfer continues.
There are, however,
many extenuating
circumstances.
The argument,
for example,
assumes that all resources are fully employed
so that increased production
of private and
defense goods cannot be achieved simultaneously. The economy often operates at less
than its potential, as is currently the case. In
addition, the full-employment
level of output is not unchanging in a dynamic economy.
It depends on the structure
of prices and
wages, taxes, government
regulations,
and
many other institutional
arrangements.
An
increase in aggregate supply is conceivable,
particularly
if the government
increases
incentives
for
investment
and
productivity growth.
The extenuating
circumstances,
however,
need not rely on supply-side economic arguments.
Most importantly,
if the military
buildup is accompanied
by a reduction
in
nondefense
federal spending or a lower rate
of monetary
growth, aggregate price pressures associated
with the resource transfer

would be mitigated.
Despite the defensespending increases, the Reagan administration
intends to reduce the relative size of total
federal spending to 21.2 percent in FY 1986
from 22.6 percent
in FY 1980, and the
Federal Reserve System expects to lower
gradually
the rate of money growth over
the same period. Such policies, to the extent
that they lower the growth in real privatesector demand,
will reduce the aggregate
price pressures associated with the transfer
of resources to the defense sector.
In summary,
the relationsh ip between
military spending and inflation is not direct.
The results depend on the conduct of monetary policy and the ability of the fiscal authorities to lower nondefense
federal spending and encourage private-sector productivity.

Will Bottlenecks Result
in Price Pressures?
In a free-market
economy, relative prices
rise and fall to adjust quantities of goods and
services demanded to the amounts being supplied. When demand for a specific product
increases, the relative price of that good also
will increase, forcing conservation
in its use
and encouraging
expansion
of its production. The choice to increase military
ex-

Federal

penditures enjoys no reprieve from the laws
of the marketplace.
At the present time, there appears to be
enough excess capacity among the major defense industries to support an expansion of
production.
Bottlenecks,
however, are developing among some defense subcontractors,
particularly
in low-technology
industries
such as large-scale castings and forgings. As
military spending slowed during the 1970s,
defense-related
production
became less profitable, causing an exodus of defense subcontractors
into civilian manufacturing.
For
many
of these
defense
subcontractors,
the federal government was their only buyer.
Given time and a constant government
demand, the subcontracting
network will be
reactivated,
but in the meantime
bottlenecks in the subcontracting
network
will
raise prices of defense resources and lengthen
lead times for delivery of defense goods.
There may also be shortages of individuals
with specific defense-related
skills, forcing
specific wage rates up. Shortages and bottlenecks that cause relative price shifts, however, will not cause inflation if the Federal
Reserve does not accommodate
them. They
will, however, reduce the real value of defense spending
and private spending
on
defense-related
resources.

Reserve Bank of Cleveland

BULK RATE

Research Department
P.O. Box 6387
Cleveland,OH
44101

U.S. Postage Paid
Cleveland,OH
Permit No. 385

Address correction requested
as shown
from mailing list

Reserve Bank of Cleveland,

Military Spending and the Economic Outlook
by Michael F. Bryan and Owen F. Humpage
The United States is embarking on an unprecedented
increase. in peacetime
military
spending. The program has prompted heated
discussions about the implications of defense
spending for real output, employment,
and
prices. Many economists expect the defense
buildup to have a relatively small, yet significant, impact on real aggregate economic activity and price levels over the next few years.
Nevertheless,
the direct impact of increased
military spending on some sectors, such as
durable goods, and specific prices should be
of much greater significance.
Following the Vietnam War, U.S. defense
spending declined in real terms, as a percentage of the total federal budget and relative
to GNP. In FY 1978 real defense expenditures constituted
24 percent of total federal
expenditures,
having fallen from their last
peak level of 44 percent in FY 1968. Real defense spending equaled 5 percent of GNP in
1978, down from 10 percent a decade earlier.
Military spending started to rise sharply
again beginning in FY 1979. In response to
its NATO commitments
and developments
in the Middle East, the Carter administration
increased real military expenditures
3.9 percent in FY 1979 and 3.4 percent in FY 1980
and proposed to raise real military spending
at a 5.0 percent average annual rate through
FY
1985.
The
Reagan
administration
greatly augmented the Carter administration's
defense-spending
proposals.
Real military
spending now officially is expected
to increase at an average annual rate of 8.6 percent through
FY 1986, equaling approximately 7 percent of total GNP by then. AI-

Humpage

Bryan

is an economic

is an economist.

both

analyst
with

and Owen
the Federal

Reserve Bank of Cleveland.
The views stated herein are those of the authors

Please send mailing label to the Research
Federal

July 27,1981

~£Q2Qomic ommentary
C

Michael

o Correct
o Remove

Reserve Bank of Cleveland

and

Department,

P.O. Box 6387,

Bank

Cleveland,

OH 44101.

not

necessarily

of Cleveland

those of the Federal
or of the Board

of the Federal Reserve System.

Reserve

of Governors

though the military-spending
increases will
cover a broad range of budget categories,
over one-half will be used for procurement.
Most of the procurement
funds will be spent
on aircraft, ships, missiles, and other combat vehicles.

The Military Spending Process
Long and variable lags often exist between
a presidential
request to increase military
spending and an observed change in defense
purchases as recorded by the GNP accounts.
They depend on many factors, including the
nature of the goods being bought, the capacity of the defense industry, and the urgency of the need. One can identify three lags
in the military-spending
chain. Production
and employment
can occur at any point
along this chain.
The first two lags involve the budget process. There is a time lapse between the date
when the president proposes an increase in
military outlays and the date when Congress
actually appropriates
funds for the coming
fiscal year. Measured from the January budget, this lag could be as short as four months
or as long as nine months. Between 1975 and
1980, however, the average lag was seven and
one-half months. There also may be a time
lag between the date when the Department
of Defense receives its appropriation
and the
time when it awards contracts. The lags associated with the budget process and with
the issuance of prime-contract
awards currently do not appear to represent
major
delays
because
of the widespread
support
throughout
Congress
for increased
military spending.
The final lag in the military-spending
process occurs between the awarding of prime
contracts
and the delivering
of military
goods. On average between 1960 and 1979,
changes in military
prime-contract
awards
resulted in significant changes in deliveries in

Federal
on financing the military buildup. This argument involves two links. The first link maintains that the administration
will not be able
to achieve simultaneously
large increases in
military spending
and reductions
in taxes
and the deficit. Although the administration
anticipates
a $45-billion deficit in FY 1982
and a balanced budget by FY 1984, most
private forecasters anticipate a larger deficit
in FY 1982-possibly
as high as $70 billion.
A large deficit in FY 1982 would reduce the
chances for a balanced budget in FY 1984.
The second link in the inflation argument
is that deficits are routinely
accompanied
by increases in the money stock. When the
government
borrows
from
private credit
markets
to finance
its deficits,
it places
upward pressure on interest rates. It often is
alleged that the Federal Reserve, because of
its concern over high interest rates, accommodates some or all of the federal government's credit demands by purchasing
government
debt through
open-market
operations and increasing the money stock. Causality tests suggest that a positive, weakly
significant, correlation
exists between Treasury borrowing
from the public and the
Federal Reserve System's holdings of government debt; however, no causal relationship
was found
between
Treasury
borrowing
from the public and the money
supply
(M-1B).3
These
results
suggest that
although
the Federal
Reserve makes some
open-market
purchases in response to Treasury borrowing,
this amount
is not large
enough to dominate movements in the money
supply, which is influenced by other factors.
These causality
tests can measure only
persistent correlations
between deficits and
money that cause inflation. They may not
detect periodic short-run
relationships,
pro3. The causal ity tests were conducted
by fi rst
converting
quarterly
time-series
data to "white
noise"
following
Box-Jenkins
techniques
and
then investigating
the correlations
between
the
appropriate
"whitened"
series. The time period
was usually 1959 to 1980. These are preliminary
results of a forthcoming
study on deficits and inflation
by Michael L. Bagshaw and Owen F.
Humpage;
details are available on request.
See
L.D. Haugh,
"Checking
the Independence
of
Two Covariance
Stationary
Time Series: A Univariate
Residual
Cross-Correlation
Approach,"
Journal

of

the American

Statistical

vol. 71 (June 1976), PP. 378-85.

Association,

ducing temporary
or one-shot
overall price levels.

increases

in

Deficits also may cause increases in the
absolute level of prices if they are accompanied by increases in the velocity of money
(evidence of a decline in money demand
relative to output).
Such velocity changes
may occur if the public perceives government debt as net wealth, or if the debt is
issued in short maturities
and increases the
liquidity of the average wealth holder. The
perceived
increase
in wealth
or greater
liquidity of wealth could enable individuals
to economize on their money balances, i.e.,
to support a greater volume of expenditures
with a smaller stock of money balances. Causality tests show a positive correlation
between Treasury borrowing
and the velocity
of money (M-1B); however, the relationship
is not strong.
Another
argument
relating
recent defense-spending
proposals and inflation concerns the real-resource
requirements
of the
program. A military buildup, this argument
contends,
transfers
resources
to the less
productive
defense
sector
while
simultaneously
maintaining
aggregate
employment and income. The supply of aggregate
real output
slows, while demand
remains
unchanged; prices ratchet upward as long as
the resource transfer continues.
There are, however,
many extenuating
circumstances.
The argument,
for example,
assumes that all resources are fully employed
so that increased production
of private and
defense goods cannot be achieved simultaneously. The economy often operates at less
than its potential, as is currently the case. In
addition, the full-employment
level of output is not unchanging in a dynamic economy.
It depends on the structure
of prices and
wages, taxes, government
regulations,
and
many other institutional
arrangements.
An
increase in aggregate supply is conceivable,
particularly
if the government
increases
incentives
for
investment
and
productivity growth.
The extenuating
circumstances,
however,
need not rely on supply-side economic arguments.
Most importantly,
if the military
buildup is accompanied
by a reduction
in
nondefense
federal spending or a lower rate
of monetary
growth, aggregate price pressures associated
with the resource transfer

would be mitigated.
Despite the defensespending increases, the Reagan administration
intends to reduce the relative size of total
federal spending to 21.2 percent in FY 1986
from 22.6 percent
in FY 1980, and the
Federal Reserve System expects to lower
gradually
the rate of money growth over
the same period. Such policies, to the extent
that they lower the growth in real privatesector demand,
will reduce the aggregate
price pressures associated with the transfer
of resources to the defense sector.
In summary,
the relationsh ip between
military spending and inflation is not direct.
The results depend on the conduct of monetary policy and the ability of the fiscal authorities to lower nondefense
federal spending and encourage private-sector productivity.

Will Bottlenecks Result
in Price Pressures?
In a free-market
economy, relative prices
rise and fall to adjust quantities of goods and
services demanded to the amounts being supplied. When demand for a specific product
increases, the relative price of that good also
will increase, forcing conservation
in its use
and encouraging
expansion
of its production. The choice to increase military
ex-

Federal

penditures enjoys no reprieve from the laws
of the marketplace.
At the present time, there appears to be
enough excess capacity among the major defense industries to support an expansion of
production.
Bottlenecks,
however, are developing among some defense subcontractors,
particularly
in low-technology
industries
such as large-scale castings and forgings. As
military spending slowed during the 1970s,
defense-related
production
became less profitable, causing an exodus of defense subcontractors
into civilian manufacturing.
For
many
of these
defense
subcontractors,
the federal government was their only buyer.
Given time and a constant government
demand, the subcontracting
network will be
reactivated,
but in the meantime
bottlenecks in the subcontracting
network
will
raise prices of defense resources and lengthen
lead times for delivery of defense goods.
There may also be shortages of individuals
with specific defense-related
skills, forcing
specific wage rates up. Shortages and bottlenecks that cause relative price shifts, however, will not cause inflation if the Federal
Reserve does not accommodate
them. They
will, however, reduce the real value of defense spending
and private spending
on
defense-related
resources.

Reserve Bank of Cleveland

BULK RATE

Research Department
P.O. Box 6387
Cleveland,OH
44101

U.S. Postage Paid
Cleveland,OH
Permit No. 385

Address correction requested
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Reserve Bank of Cleveland,

Military Spending and the Economic Outlook
by Michael F. Bryan and Owen F. Humpage
The United States is embarking on an unprecedented
increase. in peacetime
military
spending. The program has prompted heated
discussions about the implications of defense
spending for real output, employment,
and
prices. Many economists expect the defense
buildup to have a relatively small, yet significant, impact on real aggregate economic activity and price levels over the next few years.
Nevertheless,
the direct impact of increased
military spending on some sectors, such as
durable goods, and specific prices should be
of much greater significance.
Following the Vietnam War, U.S. defense
spending declined in real terms, as a percentage of the total federal budget and relative
to GNP. In FY 1978 real defense expenditures constituted
24 percent of total federal
expenditures,
having fallen from their last
peak level of 44 percent in FY 1968. Real defense spending equaled 5 percent of GNP in
1978, down from 10 percent a decade earlier.
Military spending started to rise sharply
again beginning in FY 1979. In response to
its NATO commitments
and developments
in the Middle East, the Carter administration
increased real military expenditures
3.9 percent in FY 1979 and 3.4 percent in FY 1980
and proposed to raise real military spending
at a 5.0 percent average annual rate through
FY
1985.
The
Reagan
administration
greatly augmented the Carter administration's
defense-spending
proposals.
Real military
spending now officially is expected
to increase at an average annual rate of 8.6 percent through
FY 1986, equaling approximately 7 percent of total GNP by then. AI-

Humpage

Bryan

is an economic

is an economist.

both

analyst
with

and Owen
the Federal

Reserve Bank of Cleveland.
The views stated herein are those of the authors

Please send mailing label to the Research
Federal

July 27,1981

~£Q2Qomic ommentary
C

Michael

o Correct
o Remove

Reserve Bank of Cleveland

and

Department,

P.O. Box 6387,

Bank

Cleveland,

OH 44101.

not

necessarily

of Cleveland

those of the Federal
or of the Board

of the Federal Reserve System.

Reserve

of Governors

though the military-spending
increases will
cover a broad range of budget categories,
over one-half will be used for procurement.
Most of the procurement
funds will be spent
on aircraft, ships, missiles, and other combat vehicles.

The Military Spending Process
Long and variable lags often exist between
a presidential
request to increase military
spending and an observed change in defense
purchases as recorded by the GNP accounts.
They depend on many factors, including the
nature of the goods being bought, the capacity of the defense industry, and the urgency of the need. One can identify three lags
in the military-spending
chain. Production
and employment
can occur at any point
along this chain.
The first two lags involve the budget process. There is a time lapse between the date
when the president proposes an increase in
military outlays and the date when Congress
actually appropriates
funds for the coming
fiscal year. Measured from the January budget, this lag could be as short as four months
or as long as nine months. Between 1975 and
1980, however, the average lag was seven and
one-half months. There also may be a time
lag between the date when the Department
of Defense receives its appropriation
and the
time when it awards contracts. The lags associated with the budget process and with
the issuance of prime-contract
awards currently do not appear to represent
major
delays
because
of the widespread
support
throughout
Congress
for increased
military spending.
The final lag in the military-spending
process occurs between the awarding of prime
contracts
and the delivering
of military
goods. On average between 1960 and 1979,
changes in military
prime-contract
awards
resulted in significant changes in deliveries in