Document created: 31 October 2003
Air University Review,
January-February 1973
There was a time, in the not-too-distant past, when the education of a young man with intentions of following a military career was heavily weighted toward the study of engineering, geopolitics, and military history. Economics was not considered to be a terribly relevant discipline to the military aspirant. Defense budgets were smaller in absolute terms; budget allocations were made on the basis of “need”; economic analysis was not considered to be a vital military function; and scholarly pursuit in the field of economies was generally recommended for the student who planned a university teaching profession. The economist was perceived to be a theoretician, not a practitioner.
In a sense, economists of prior generations tended to agree with the military educators. Although they perceived the study of economic theory to be relevant to the defense establishment, it was seen to be applicable only in the broadest sense. Macroeconomics, the study of economic aggregates, dealt with the problems of allocation of scarce resources among the public and the private sectors. The results of analyses at these lofty, theoretical levels certainly impacted upon the military in the size of its budgets, but most felt this was not an appropriate function to be performed by the military itself.
Microeconomics, a more specialized discipline often called “the theory of the firm,” was relegated to problems of profit maximization. Since the military sold no products, generated no revenues, was not part of a market system, and charged no prices that could cover its costs, profit maximization did not appear to be a consideration for the military planner. Consequently the tools of microeconomics languished in the private sector of the economy with little or no emphasis placed upon them in the not-for-profit arena.
It is clear that we have come a long way since the era I have briefly described. With the introduction of large forces in-being during peacetime, the heavy demands on the nation’s resources by the military arm, and the dramatic growth in demand for the public dollar by “human resources programs, it became more evident that the military is only one of many competitors for public funds. A new emphasis was placed upon the capability to measure, in some meaningful way, the extra contribution to society emanating from additional expenditure on defense. By the same token, periods of austerity produced a very relevant question: Does society lose more total benefit if a dollar is cut from Defense than it does when the dollar is taken from Health, Education and Welfare? For one even sketchily trained in the discipline of economics, these questions strongly imply such terms as “marginal cost,” “marginal revenue,” and “marginal product”—a few of the analytical measures that make microeconomic tools applicable to some macroeconomic problems.
The economist’s skills, whether applied to efficiency in the large or in the small, are generally directed toward the resource allocation dilemma. Although we concern ourselves with budgetary limitations, the stark reality of scarcity applies, of course, to the productive resources at our disposal; the monetary constraints simply denominate those land, labor, capital, and technology limits in terms of dollars—and rather “rubbery” dollars at that during periods of inflation.
With the increasing awareness of scarcity, it would seem that to our “fly and fight” motto we might want to add “efficiently.” Given that we have defined a specific role, mission, or objective, our mandate is clearly to fulfill that role or achieve that objective at minimum cost. Similarly, given the public funds (resources) entrusted to us, we have a vital responsibility to maximize the military returns from those inputs. It is the economics discipline that stresses the resources to be combined in various ways to achieve those elusive optima.
Our current system in the Department of Defense does reflect this relatively new micro-economic approach to resource employment. The Planning, Programming and Budgeting System (PPBS) has imposed a requirement that the marginal costs of and marginal returns from various alternative resource mixes be assessed and that decision-making in Defense emphasize cost and contribution at the margin. This is not to say we have succeeded in neatly quantifying the equivalent of the private sector’s “marginal costs = marginal revenue” equation. Clearly we have not. Nor are any claims made that the quantifications which have been made in any way represent what the numbers should be. We do not yet have the capability in the military to talk meaningfully in terms of normative economics; we are, however, interjecting some rational economic analysis into the decision-making process.
With respect to the level at which economic analysis is to be performed, it would appear that the concept is now being pushed as far down in the organizational framework as possible. Originally stressed by then Deputy Secretary of Defense David Packard, the emphasis is now being placed on decentralized analysis and decision-making, with the responsibility for resource management being passed down to ever lower levels of command. One might expect that explicit guidance of some sort would naturally accompany a metamorphosis such as this. Some guidance does in fact exist. In February 1969, the Assistant Secretary of Defense (Comptroller) issued an instruction establishing the policy that an economic analysis would be performed in support of certain proposed investments in the Department of Defense.1 The publication was steeped in terms familiar to those who had acquainted themselves with PPBS; unfortunately, however, it stresses a concept that may have applicability only under certain conditions. The instruction set out as its purposes and objectives to:
1. identify systematically the benefits and costs associated with resource requirements…;
2. highlight the key variables and the assumptions on which investment decisions are based and allow evaluation of these assumptions;
3. evaluate alternative methods of financing investments; and
4. compare the relative
merits of various alternatives as an aid in selecting the best alternative.2
Clearly, these objectives are sound, rational, and highly worthy of pursuing. They represent an explicit statement of goals which, if attained, will lead to an efficient allocation of scarce resources among competing uses.
The DOD Instruction does not, however, address to any extent the dazzling array of analytical tools available to assist economic analysts in their pursuit of these objectives (nor do I mean to imply that it should). There is simply a listing of quantitative techniques, most of which are typically treated in depth in most statistics, economics, and management science courses.3 The instruction does, however, give particular emphasis to the tool of discounting and establishes rather specific guidelines for applying the method. The guidance includes
—a prescribed discount rate (10%);
—a table of discount factors (at 10%) which reflect an assumption that cost and/or savings flows will occur more or less continuously rather than in a “lumpy,” once-per-period fashion;
—a brief rationale for the use of discounting of future cash flows.
The justification for use of present value factors in DOD-proposed investments is stated as follows:
Interest will be treated as a cost which is related to all Government expenditures, regardless of whether there are revenues or income by way of special taxes for a project to be self-supporting. This position is based on the premise that no public investment should be undertaken without considering the alternative use of the funds which it absorbs or displaces.
1. One way for the DOD to
assure this result is to adopt in public investment evaluations an interest
rate policy which reflects the private sector investment opportunities
foregone. The discount rate reflects the preference for current and future
money sacrifices that the public exhibits in non-government transactions.4
The reader is encouraged to digest this reasoning carefully, for it is sound and eminently rational, so long as all the conditions stated therein are met. Whether those conditions are all in fact being met is, however, subject to question.
The thesis stated above is an opportunity cost concept, which justly
contends that the cost of using resources in one employment must be denominated
in terms of the return sacrificed in diverting those resources from their
next-best employment. It says that the cost of using resources in the public
sector is what they could have returned by being productively applied in the
private sector. This is undeniably true, a valid concept, if there are in
fact productive alternative employments of those resources in the private
sector.
If, however, there is less than full employment of resources in the nongovernment sphere, what is the opportunity cost? If industry is operating at 75 percent of capacity and nearly 6 percent of the labor force is unemployed, would those resources have been employed at all had it not been for the public sector? What is the cost to the private sector of hiring a man who would otherwise have been unemployed? Is there an opportunity cost to the nongovernment sector when the military purchases vehicles from a firm that employs capacity which otherwise would have been idle?
Consider the fiscal 1972 and proposed fiscal 1973 federal budgets. They have been, admittedly, clearly stimulative in nature. The federal budget, as a vehicle for fiscal policy, is the means by which incremental government spending is achieved. In accord with Keynesian economic theory, federal expenditures can and should be used to create supplemental demand, promote spending, and generate greater income, employment, and resource utilization. This additional government expenditure is as much directed toward stimulation of the national economy as it is toward providing specific public goods and services. If this is the case, can it be said that the opportunity cost of resources diverted from the private sector is of the same magnitude as it would be if all resources were fully employed? One could even ask whether there is an opportunity cost at all.
To counter this reasoning, one line of argument might be to point out that idle capacity and unemployed resources exist only in a spotty fashion throughout the economy. While steel industry resources may be underemployed, the construction industry is simultaneously pressed to the limits of its capacity. Consequently, in such an example, an opportunity cost is imposed on the private sector by government construction projects, but the cost is considerably less (or possibly nonexistent) with respect to government demand for steel. To the extent that this is true, it would be difficult to argue for a uniform discount rate to be applied to all government investments. By the same token, a position that insisted on the application of a standard rate for purposes of simplicity (a good reason incidentally) would have to face up to the fact that in the aggregate there are unused resources. Consequently, the credibility of the opportunity cost rationale would be weakened.
One might contend, then, that even though all these disparate resource
utilization rates do exist, the Treasury still faces a positive interest rate
in its long, intermediate, and short term borrowings in the capital market. It
could be asserted that this rate is, in part, indicative of the private sector’s
required rate of return for the forsaken use of funds. True enough, but that
required rate of return for virtually riskless lending is not the basis
put forth in support of discounting government investments. If that were the
rationale, the composite rate would be simple enough to calculate and would
not be 10 percent.
One crucial problem emerges from any discussion of an appropriate social rate of discount. It is the problem of defining that rate and determining its composition. Welfare economics offers some help in this matter by contending that there are actually two measures which require quantification. The first is the marginal social rate of time preference, which reflects society’s rational bias in favor of consumption sooner rather than later. The second is a risk adjusted marginal social rate of return from investment, which reflects the returns that the private sector sacrifices when resources are diverted to public projects. To oversimplify, one measure mirrors society’s preference for a dollar’s worth of consumption now rather than tomorrow; the other reflects the opportunity cost of what that dollar could have returned by productive employment between today and tomorrow. There are elements of both in the theoretically appropriate social rate of discount, but they need not necessarily be the same rate. Only if they do in fact coincide is it possible to aspire to a theoretical maximum or optimum state of welfare in every segment of the economy.
The above may appear to be a tiresome digression into the ethereal and not-so-relevant world of theory, but it is in fact a vital point to be recognized when considering the concept of discounting. It explains why the U.S. Treasury does in fact face a positive (and possibly rising) interest rate in its borrowing activities, while simultaneously there may be a relatively low opportunity cost to the private sector of diverting resources to public projects (such as defense).
The significant point here is that when resources are in excess supply relative to the demand for them (unemployment), the use of an arbitrary discount rate for public investments may well understate the benefits to be derived from those investments in future years while at the same time overstating the costs today. The DOD use of a 10 percent discount rate for proposed investment projects may well be responsible for an unjustified bias against defense expenditures for “out year” benefits because of some simple, mathematically correct but misguided computations.
The situation is, of course, worsened by the requirement that future rates of resource unemployment clearly should be predicted and incorporated in any analysis of long-lived public investment proposals. Unfortunately, this may not be an attractive computational device, since it would require government agencies to make explicit any expectations of future resource unemployment—a disclosure which most likely would not be politically palatable.
Does the foregoing discourse argue against discounting of proposed DOD investments? The answer is “Not necessarily.” Discounting is still a defensible tool for internal analytical purposes (within DOD). Its use would be to assist in recognizing the timing of cost and benefit streams and as a decision-making aid in our arraying of alternatives in some priority fashion. There is no good rationale for giving equal weight to equal dollar outlays, which differ significantly in their timing, so long as a social rate of time preference exists. The discounting thesis, however, should not be justified solely on the grounds of the opportunity cost imposed on the private sector. That cost is clearly variable and one which may differ dramatically between one industry and another, in some cases approaching zero. The opportunity cost thesis does not represent a totally credible single rationale for discounting in DOD. Were discounting defended more as an internal allocative device, its use would be more believable, and a good case could be built for its reduction to something below the current 10 percent rate.
Air University
Institute for
Professional Development
Notes
1. Department of Defense Instruction 7041.3, “Economic Analysis of Proposed Department of Defense Investments,” 26 February 1969.
2. Ibid., I. A.
3. As this article was being written, the Defense Economic Analysis Council issued its definitive Economic Analysis Handbook, which does treat in some detail each of the analytical techniques listed in DODI 7041.3.
4. DODI 7041.3, V, D.
Major Richard Zock (D. B. A., University of Colorado) is Chief, Economics Division, Professional Military Comptroller course, Air University Institute for Professional Development. He has flown F-86F, B-47, and B-57 aircraft, the latter at Phan Rang AB, Republic of Vietnam, 1967-68. He has taught at USAF Academy and Air University; lectured at University of Colorado, Auburn University, and Southern Colorado State College; and now serves as lecturer in economics at Air War College and Air Command and Staff College.
Disclaimer
The conclusions and opinions expressed in this
document are those of the author cultivated in the freedom of expression,
academic environment of Air University. They do not reflect the official
position of the U.S. Government, Department of Defense, the United States Air
Force or the Air University.
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