The threat of terrorism has lost the US its 'peace dividend' and will make it harder for the country to grow and innovate, says Amity Shlaes.

Both the increase in defence spending and the looming budget deficit will be themes in President George W. Bush's State of the Union address on Tuesday night. The first will likely be laid out explicitly, the second will be more implicit. Still, there is a connection between these two new facts of post-September 11 life.

Defence spending, so necessary to fulfil America's wartime obligation, helped to create the deficit. Given a choice between budgeting for victory and budgeting for bookkeepers, Mr Bush is choosing the former. And who cannot understand that choice? Still, coming around the bend of history as we have done since September 11, we can now see a whole series of larger truths about budgets, the US economy, war and peace.

The biggest of these is that the federal surplus of the 1990s and the "peace dividend" from the end of the cold war amounted to the same thing - the surplus was the financial mirror of peace. That means the new threat of terror will make it harder for America to innovate, grow and generate surpluses in future.

Consider, first of all, the record in terms of budget numbers and nominal dollars. In spring 1989, a point when Erich Honecker was still presiding over the May Day parade in East Berlin, total US defence outlays peaked at $304bn. By the following year, the world had changed. From that point onwards, US defence spending began to drop and drop - hitting a low of $266bn by 1996.

It is important to emphasise that we are talking here not about smaller increases but of something normally unheard of in the world of budgets: real dollar decreases in the amount spent. Although defence spending did rise again at the end of 1990s, it remained below the 1989 high throughout the decade.

This net reduction enabled the US, in 1998, to achieve its first surplus in three decades. To put the story another way, had defence spending continued its 1980s growth trend through the 1990s, there would have been no surplus.

Another way to look at this is the proportion of the budget taken up by defence. During the 1990s, defence spending decreased from what today seems an astoundingly high 30 per cent of the federal tax take to something like 15 per cent in 2000. Relative to gross domestic product, US defence spending dropped to 3.8 per cent of the economy in 2000 from 6.7 per cent at the end in 1990.*

In other words, the US economy in the 1990s became free of a burden - war, or the threat of it - that it had shouldered since the early 1940s. It could at last unknit its figurative brow, cast off irrationalities, distortions and inefficiencies and do what economies do when they are happy: innovate. Quantifying the dollar value of this period of liberty is hard but we can point to obvious factors.

The country did not have to worry about heavy security; visitors could walk the halls of Congress or universities without identity badges. Former defence- related projects such as the internet could migrate to the private sector, where they helped to fuel growth. Technology that had been confined to museums was suddenly accessible to every 12-year-old. Life became all butter and no guns.

It is important to recall what a contrast this was with the cold war years, when economic innovation and growth were monitored by a heavy-handed Washington. Think of Big Steel and Big Labour meeting President John F. Kennedy to establish market prices and wage rates. It was no accident that this command-and-control philosophy of economic management was in place in 1960, when spending on national defence represented half of all federal outlays. Even as late as the 1980s, simple private sector tasks such as export licences were national security nightmares.

September 11 has forced us back in the direction of those days. The trend is visible in budget numbers. The surplus of $313bn forecast for 2002 disappeared in the haze of the World Trade Center; the Congressional Budget Office says there will be a deficit of $21bn. Increases in defence spending account for some of that but the greater part of the loss - three-quarters of it - is owed to a recession that has been accentuated by September 11.*

Yet more costs will come if Congress approves - as it probably will - increases in the annual defence budget for which Mr Bush is now asking, along with hefty increases for spending on homeland security.

But what about the as-yet- unquantified damage that war will inflict on the economy in future? One of the more obviously vulnerable areas of the economy is insurance. What premiums will companies end up paying to insure against the threat of terror?

Another is the travel industry. Even a federal bail-out has not been sufficient to spare the airlines. Yet another problem is the new burden of regulation. All companies are likely to suffer under the sort of onerous prescripts we can expect from Tom Ridge's new Office of Homeland Security.

Less discussed, but potentially very damaging, is the prospect that America will now shut the door to immigrants. These - both the legal and illegal variety - contributed to the increases in productivity the US saw in the 1990s. It is too early to know precisely how much of a drag the new circumstances will impose. What is clear is that the outlook for strong growth in this new decade is less certain than it was in the 1990s and less certain than before the September 11 attacks.

Americans always knew that the ending of the cold war was a great good. What a pity that it took the start of a new war - this war on terror - to reveal exactly how great.

* Economic Report of the President (2001), Haver Analytics

** Where did the 2002 surplus go? www.taxfoundation.org

© Copyright 2002 Financial Times