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Mr. Chairman and members of the subcommittee:
It is something of a novelty and a relief to appear before a
committee of Congress in my individual and not in an official capacity.
Your chairman, in his letter to me of January 7, addressed me not ±n my
official role but, I gathered, as one who has been interested in economic
studies for a good many years—though of course I do not profess to be an
expert in these vast fields that you are exploring.
Your chairman's very interesting letter said that "in order to
obtain some understanding of possible effects of a reduction in armaments,
I would like to pose a few questions on the assumption that the defense
budget was reduced by an across-the-board cut of fifty per cent."
As you are aware, that is a hypothetical proposition that would
be affected by many unforeseeable possibilities—the timing of such a cut,
whether it was brought about gradually or abruptly, the state of the
economy at the time, the needs of the country for all manner of goods and
services, housing, roads, schools, and so on. The labor force available
would be a very important factor.
Despite these imponderables, it seems to me very worth while
to make certain assumptions, as you have done, and then to explore the
possibilities—if not the probabilities. One's view of the future depends
largely on his own state of mind, his confidence in the vitality and
adaptability of our economic system and institutions. I am an optimist.


Experience of the not distant past has, I think demonstrated the extra¬
ordinary capacity of this country to adjust to radically different
environments—from slack times, to preparedness, to all-out war, to a
period of postwar transition that did not bring about the heavy tide of
unemployment that was almost universally feared and predicted.
Being an optimist about our future, I do not accept the belief
that prosperity rests upon indefinite continuance of vast government
expenditures for arms. The diversion to private consumption or other
public uses of the great resources of manpower and materials at our
disposal could, I believe, add immeasurably to our standard of living
without grave economic dislocation. We could, of course, so mismanage
our affairs that transitions would be wasteful, painful, and needlessly

I have a high degree of confidence that we will not bungle that

I wanted to make these few prefatory remarks in presenting two
memoranda prepared by our staff people at the Board of Governors as
informal studies, based on your hypothesis and not in any sense as Board

Both were prompted by suggestions emanating from your sub¬

committee . One discusses "Control of Armament Reduction Through Budgetary

The other is entitled "Comments on the Economic Significance

of a Fifty Per Cent Cut in Security Expenditures."

March 7, 1957.
Control of Armament Reduction Through Budgetary Inspection*

Proposals to ensure international compliance with scheduled
armament reductions through periodic inspection of governmental budgets
assume that budgetary appropriations can be brought—by relatively simple
regulations—to reflect accurately actual levels of military expenditure.
Numerous difficulties, both technical and in respect to enforcement,
raise serious doubts whether this can be done.
At the technical level, the difficulties of identifying and
measuring provisions for military expenditure under a variety of dissimilar
budgetary procedures should not be minimized.

The experience of domestic

agencies in establishing and enforcing uniform accounting methods for
regulated industries may give some idea of the complexity of the problems

Price level fluctuations, moreover, raise a basic difficulty.

It seems unlikely that any simple coefficient applied to the monetary
unit from year to year, as suggested in the proposal, would compensate
for the impact of price changes on the real rate of military outlay.
Military expenditures do not represent an unchanging "package" of component
goods and services, and movements in individual prices are likely to
diverge widely—especially where these may be subjected to various measures
of selective control.
Fundamental differences in methods of capital accumulation between
socialist and capitalist economies further complicate the problem of
defining military expenditure. Any defense program is concerned not merely
with maintaining armed forces in being but with expanding productive capacity
in defense related industries, transportation, and power facilities. Under
a capitalist system, the government may encourage private investment along
these lines through tax relief, military contracts, stockpiling commitments,
* Prepared by the Division of Research and Statistics, Board of
Governors, Federal Reserve System.

- 2 or direct subsidy; any or all of these might be classified as military
expenditures by an international authority. In a socialist economy,
on the other hand, provision for all types of economic expansion may be
made through the government's budget and, where alternative civilian
applications exist, could hardly be questioned.
Aside from technical questions of classification and measurement—
which despite their complexity might, in theory, be determined equitably
by international experts--it seems unlikely that deliberate falsification
could be detected from a study confined to the official budgets themselves.
It would, accordingly, probably be necessary to police a system of control
over budgetary appropriations by the same physical inspection of productive
and stockpiling activity that would be required by a system based directly
on such controls.

March 7, 1957

National security expenditures have increased to a rate of
about $44 billion since last summer, following a two year period of
stability at a rate of about $41 billion.

The current level represents

10 per cent of the market value of our total annual prodtiction--the
same as in 1956. It is the lowest percentage absorbed by defense
requirements since early in the period of expansion in security outlays
stimulated by the outbreak of hostilities in Korea. Over $9 billion is
for pay to the Armed Forces. Roughly $25 billion of security expendi¬
tures is for purchases of goods (including construction) which compares
with private business expenditures for producers' durable equipment of
about $32 billion, total new business and residential construction of
$33 billion, and consumers' expenditures on durable goods of $35 billion.
While defense spending has been large, it has not contributed directly
to the expansion in economic activity since early 1954. In this period,
Gross National Product has increased one-fifth, while national security
expenditures have changed relatively little.
The impact of a 50 per cent cut in defense spending, which would
amount to about $22 billion at current expenditure rates, is difficult
to assess since defense outlays have had pervasive effects throughout
the economy.

The nature and extent of adjustments which undoubtedly

would be necessitated in a period of transition would depend largely on
the economic climate of the time, the length of the period during which
the reduction is effected, the specific expenditures affected by the cut,
the relative importance of the defense program at that time, and the types

* Prepared by the Division of Research and Statistics, Board of Governors,
Federal Reserve System.


of action undertaken by the Government to ease the transition. These
circumstances, indeed, are of such over-riding importance that past
experiences with demobilization are of limited value in anticipating
the effect of a cutback at the present time.
This was illustrated by the situation at the end of World War II,
when military expenditures reached a peak annual rate of about $90 billion
and accounted for two-fifths of the Gross National Product. During four
years of war, a backlog of demands and financial liquidity had accumulated,
and when security outlays were sharply reduced, total output of goods
and services declined only briefly, and the large scale unemployment that
many observers predicted did not develop.
More closely comparable to the currently proposed cutback in
military outlays is that which occurred after the Korean War.

From mid-

1953 through the third quarter of 1954 the annual rate of defense expendi¬
tures fell by $11 billion from a level of $53 billion; this reduction in
the national security component amounted to 3 per cent of the Gross
National Product. A $22 billion reduction in defense spending would
amount to 5 per cent of the current level of the Gross National Product.
In the post-Korean experience, the initial defense cutback-during the second half of 1953—reduced the annual rate of national
security outlays by $4 billion; over the same period, total output of
goods and services declined about $10 billion. A shift from business
inventory accumulation at a rate of $3.1 billion to liquidation at a rate
exceeding $5 billion largely accounted for this decline. At the same time,
disposable personal income did not decline but only leveled off, in part
reflecting a significant increase in unemployment payments both to veterans

-3and to non-veterans, and consumer purchases declined only slightly;
State and local government expenditures increased.
Despite an additional decline of $7 billion in the annual rate
of national security outlays and some reduction in purchases of producers
durable equipment during the first three quarters of 1954 other expendi¬
tures, particularly residential construction, State and local expenditures
and consumer outlays, all rose. These increases were reflected in a
reduction in the rate of inventory liquidation and formed the "basis for
economic expansion in 1955. Vigorous use of fiscal and monetary policies,
including the reduction in personal income tax rates in 1954 and a policy
of active monetary ease, contributed to the recovery.
From the second quarter of 1953 to the third quarter of 1954
the Armed Forces were reduced by 300,000 and nonfarm employment fell by
almost 2 million. Unemployment increased from about 1.5 million persons,
or 2.5 per cent of the labor force, to about 3.5 million, or 5.5 percent
of the labor force. Most of the decline in employment was concentrated
in durable goods manufacturing industries, but work forces were also
reduced in nondurable goods manufacturing, in the Federal Government and
in the railroad and mining industries. In the same period, however,
almost 500,000 were added to the payrolls of the finance and service
industries and State and local governments. Part of the downward adjust¬
ment was reflected in a reduction in hours of work.
By mid-1955, however, an expanding labor market had largely
absorbed earlier declines. Employment was at record levels and unemploy¬
ment was again low.

In 1956 unemployment averaged less than 4 per cent

of a labor force of 70 million persons, 3.5 million more than in 1953.

It is evident from this review that both the initial impact of
the post-Korean cutback and the rate of readjustment depended on under¬
lying economic conditions at that time, and on the governmental policies
adopted during the transition.

Similarly, the impact of defense cutbacks

in the near future can only be gauged in terms of the underlying economic
conditions likely to prevail when it occurs. The current situation is
one of general economic strength.

Some areas of the economy are less

bouyant than others, but in general demands for goods, services and credit
remain high. Defense expenditures, while an important component of total
activity, have contributed little to the rise in activity since mid-1954.
Some aspects of the defense program, such as stockpiling and defense
plant expansion, have been exerting a diminishing pressure on resources.
In the latter part of 1956, there were about 2.8 million men in
the Armed Forces compared with about 3.5 million in mid-1953. It is
estimated that national security expenditures for supplies, equipment and
construction had declined to about 10 per cent of the physical volume of
industrial production, as measured by the Board's index. This compares
with 20 per cent in early 1953, before the 1953-54 reduction in defense
production, and 13 per cent in late 1954. Perhaps 17 or 18 per cent of
total industrial activity in late 1956 in durable goods industries was
directed to the defense effort in the form of output of ordnacee, military
aircraft and ships, radar, trucks and locomotives, and other end-products
and in the form of aircraft parts, electric motors, steel, aluminum, etc.,
as compared with 5 percent or less for nondurable goods.
Expenditures for stockpiling of strategic materials have also
been of declining over-all economic significance.

In the first half of

1956 deliveries to the stockpile amounted to $145 million, half the value

-5of deliveries in the first half of 1955 and one-third the rate in 1952 and
early 1953•

Through loans and long-term purchase agreements, the stock¬

piling program stimulated expansion in capacity for several basic materials.
In the past few years of high level economic activity the additional supplies
thus made available have been largely absorbed by industrial demands. In
the event of a

one-half curtailment in defense expenditures, the quantities

of these supplies the Federal Government would be obligated to acquired under
the terms of these contracts would depend on the strength of civilian
Another facet of the defense effort has been encouragement of
increases in productive capacity of defense related industries through an
accelerated amortization program. As in the case of stockpiling, the
peak impact of this program has long since passed.

Since 1950. certificates

of necessity have been granted for the purpose of expanding productive
facilities in 225 strategic industry groups to meet specified capacity
goals. To date, projects constructed under this program have amounted to
$37 billion, on which accelerated amortization has been

applied to about

$22 billion. The total outlay on these projects represents about onefifth of all business expenditures for new plant and equipment during
the seven year period from 1950 through 1956. The degree to which the
stimulus to investment has been concentrated on certain industry groups
is indicated by the fact that public utility, rail and primary metal
expansion accounted for half the value of all projects certified.
The accelerated amortization program probably had only slight
influence on business capital expenditures in 195&. Measured by project

-6costs, two-thirds of all outstanding certificates of necessity had been
issued "by the end of 1952, with the bulk of expenditures presumably
taking place in the years immediately thereafter.

The proposed outlay

on projects covered by certificates of necessity issued during 1956 was
less than $3 billion, little more than eight per cent of the current
annual rate of corporate spending on plant and equipment. Even if the
defense program were to be sustained at its present level, future
increases in capacity will probably be geared primarily to the needs
of the civilian economy.
Although defense expenditures are no longer providing much,
if any, stimulus to economic expansion, they are absorbing large amounts
of human, material and financial resources•

Consequently, a fifty per

cent reduction in defense outlays would confront specific industries
and geographical areas--and through these, the economy as a whole—with
serious immediate problems. In the longer run, however, it would free
manpower and industrial resources to meet a broad range of human needs
both here and abroad•

The defense program itself has generated several

forces which may be expected to ease the transition.
Military outlays for scientific research

and development in

recent years have been large, totaling about $l-l/2 billion last year.
Many of the military research developments made or in process have major,
but as yet unexploited, civilian applications.

If these developments, and

the scientific and technical skills concentrated in defense activities
could be released for peacetime applications, significant progress in
raising living standards might be achieved.

Technological development

would open new investment outlets and could stimulate demand, thereby
providing a major impetus toward sustained economic expansion. An easing

-7of market pressures would also permit more rapid progress in meeting the
"backlog of demand for schools, water and sanitary facilities, hospitals, and
other community services by State and local governments• Reduced military
requirements would likewise facilitate progress in meeting major goals for
highway construction.
Just as a reduction in military outlays presents problems and
challenges to our own economy, it would present similar problems and opportuni¬
ties in many other countries• U. S. defense expenditures abroad, including
also expenditures of the U. S. Armed Forces stationed in foreign countries,
amounted to $3.2 billion in fiscal 1956. This sum was equal to about 14 per
cent of all foreign payments made by the United States. For some countries,
however, receipts of U. S. defense expenditures represented a relatively
more important source of dollars. Less highly industrialized countries
mainly in the Near East and Far East, who received about one-seventh of our
defense expenditures abroad in fiscal 1956, would probably be most seriously
affected by a reduction in U. S. outlays. On the other hand, there are a
number of countries--such as Belgium, Germany, the Netherlands, and Canada-whose balance of payments situation is so strong that they may be expected
to weather a reduction of one-half in U. S. defense expenditures without
serious drain on their gold and dollar reserves. These countries receive
about one-fifth of our total defense outlays abroad.
The bulk of our foreign defense spending went to countries whose
gold and dollar reserves might be seriously affected, but who should be able
to adjust successfully if the reduction in spending was not made too rapidly.
This group includes countries such as France, Denmark, Italy, Norway, the
United Kingdom, and Japan.
Although these countries might face complex problems of adjustment,
it should be noted that a cut in our defense expenditures abroad would
not automatically mean a corresponding decrease in their

-8dollar receipts. In contrast to outright financial aid, our defense
expenditures abroad are not free gifts: the recipient countries are
required to use the equivalent of these funds for purchasing or pro¬
ducing goods and services for their own defense, for our mutual Allies,
and for our Armed Forces. The recipient countries therefore must
utilize productive resources for defense purposes, resources which would
be set free to the extent that our defense expenditures would be curtailed.
Given enough time to effect the necessary readjustments, it should
generally be possible to re-employ the productive resources of those
countries in such a way as to make good the loss of dollar revenue: say,
by increasing the production of goods and services for export. Some
problems, particularly in retraining labor and securing capital for
expanding production of export goods, and in finding export markets, may
have to be solved in the period of transition.
A major contribution to the solution of the problem which may
be faced by foreign countries would be the maintenance of a strong
domestic economy in the United States. Toward this end, governmental
policies would need to be directed to the easing of the impact of dis¬
armament on specific industries or areas and to the preservation of
confidence in over-all economic prospects. Existing Government programs
that would promote a smooth transition, such as veteran benefits and
unemployment compensation, might be re-examined in order to insure their
maximum contribution. Reductions in Federal taxation made possible
through savings affected by disarmament would permit and encourage
expansion of private spending now limited by the defense program's drain
on financial and physical resources. Industry would be encouraged to

-9exploit more promptly the technological developments of recent years.
Well-timed reductions in personal income taxes would help to make effective
underlying consumer demands for goods and services, which in turn would
promote further expansion of productive capacity.
If a smooth transition could be provided between a cold war
economy and a peacetime economy, there would be little doubt that poten¬
tial civilian demands exist here and abroad which would be ample to
utilize and even to strain our productive facilities and expanding labor
force. During the transition itself, however, uncertainty throughout the
econony could lead to cumulative repercussions beyond the industries
directly affected by military cutbacks. If broader dislocations and a
significant rise in unemployment are to be avoided, public confidence in
over-all economic prospects must be preserved, It is of the utmost
importance that the Government be prepared to act quickly to meet any
developments and that this determination be generally understood.