There was an article today in USA Today that has an interesting point about the relationship of war to the American economy which is important to think about as the "Fiscal Cliff" grows close, especially in the context of a more assertive Russia and a Rising China and frankly because of the fiscal implications of Obamacare being uncertain as to the Medicaid extension.

As to the article, the Congressional Budget Office and the Bureau of Economic Analysis, both the gold standard as such things go, estimate that U.S. economic growth was trimmed this year to date by about a quarter to a half a percentage point by a "peace dividend" from ending combat operations in Iraq and a significantly reduced tempo of operations in Afghanistan.

As what to make of this, especially in the context of the impending "Fiscal Cliff,"of potentially very large cuts in future defens spending, when I teach macroeconomics at an elementary level one properly always points out four variables that are always at the center of consideration: the determination of "Output" defined in terms of GDP or GNP, the rate of growth of output, the determination of the level of employment, and the determination of the price level and changes in the price level/inflation.

The distribution of income is a variable of some import, although generally speaking treated somewhat separately, partly due to methodological considerations of the implications of accepting "equilibrium analysis," and partly because most of economics assumes that the distribution of income makes some sense in terms of "marginal factor productivity," the latter meaning that if it makes sense in terms of revenue at the margin to pay a factor of production like labor, one pays.

Some don't accept those premises in the economics profession, although that cannot be said to be the majority professional opinion, if its certainly an important minority opinion, and of course majority professional opinions aren't always correct either.

But as to those first four variables, that is what macroeconomics is about as to subject matter; output, growth of output, employment, and inflation/price determination: no matter how complicated one wants to make that analysis, from a simple AD=AS Classical model with vertical supply curve to the 1,400 variable FRB/US/Global macroeconometric model of the Federal Reserve System.

As to the measure of economic output normally used, GDP, which stands for Gross Domestic Product, in order to understand the structure of a capitalist economy, for improved student understanding, one should then go into greater detail as to the composition of output, in which the decomposition sometimes conceals as much as it reveals, in particular the governmental part of output.

Output is normally defined as C + I +G +NX=GDP, in which C stands for consumption, I stands for business purchases of capital goods and inventories plus new construction, and NX stands for Net Exports.

G stands for government purchases of goods and services, not transfer payments like Social Security and welfare etc, since that would be double counting, at least in the long run, in which however there remains a serious conceptual issue in that use of dollars in dollars out with governmental output.

The conceptual difficulty is that if it is a reasonable approximation to say that consumption, investment, and especially goods and services in tradables are priced competitively, where marginal cost is not too different than price, necessary for equilibrium to hold and be efficient with respect to the underlying distribution of wealth in the sense of Pareto that in equilbrium no one can be made better off without someone being made worse off, the same cannot often be said with government output, especially in the military field, since it is often the case that government output is constructed under conditions of bilateral monopoly.

In particular, governmental output, especially in the military-industrial-intelligence complex, especially the latter, often has only one buyer and one seller, bilateral monopoly, the opposite of the model of a competitive market.

Thus, the efficiency conditions it is reasonable as a first approximation to say hold in the other categories of GDP, which means that one dollar spent in fact has that valuation in terms of marginal utilities provided by other goods, cannot be said to likely be the case in the military-industrial-intelligence complex.

That doesn't mean what that complex does is bad, just that it isn't so simple to treat analytically in the usual framework of GDP accounting, which can be seen to a point in the relationship of peace to "declining economic output."

 Common sense tells us that since war is almost always zero sum in character, it would be somewhat misleading to say that it was all bad that the defense spending decline caused a GDP decline, especially since to continue that logic to its conclusion would be to argue for a real war state, instead of what we have now, in which even broadly considered, military-industrial-intelligence activites do not consume more than eight per cent of GDP.

That is lower than the level that Eisenhower noted when coining the term "military-industrial complex," if its not small either, especially of course in the free spending environment after 9/11.

On the flip side of that, defense spending has a "killing two birds with one stone property" somewhat, as it achieves security goals, as opposed to building holes and then filling them a la Keynes semi-serious suggestion as to infrastructure spending as economic stabilizer, if of course to the extent that infrastructure spending generates externalities in economic growth, that kills two birds with one stone too.

One takeaway point is that because of the conditions of non-market pricing in defense spending, it's too simple to say that reductions in output due to a decline in defense spending because of more peaceful conditions in Iraq and Afghanistan is actually a loss, save for the other peculiarity of defense spending: imperfect flexibility of inputs.

The inputs to defense spending are labor and capital as usual, which because of the professionalization of the Armed Forces are rather imperfectly applicable to the civilian sector.

Thus, in terms of the "Fiscal Cliff," one might want to proceed cautiously as to cutting defense spending for having in fact negative economic consequences of a long-lasting character, as the absorption problem might in fact not be small for either capital or labor.

That would argue for going a little more slowly with defense spending cuts when in doubt, and also not just whacking the Army and Marines in a time of relatively high unemployment, even as it would also suggest that as much as possible, the defense-industrial-intelligence complex needs to be managed with an eye to externalities in the civilian sector as much as possible too, especially the strategic implications of what it is we use that complex to achieve in the international system.

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