A robust national defense system has as much to do with the strength of a nation’s finances as it does with the strength of its military. Few people understand this as well as Robert D. Hormats. A leading expert on international finance, a vice chairman of the Goldman Sachs Group Inc.; a veteran of numerous presidential administrations; and author of the recently published book The Price of Liberty: Paying for America’s Wars, Hormats has gone back through American history to track the financial underpinnings of the wars of the United States. His conclusion: Generations of American leaders have understood the critical relationship between financial strength and the ability to protect national interests, but that relationship is currently in danger.

Hormats sat down with strategy+business recently to discuss how the U.S. — or any government — can finance an appropriate level of military readiness in the future without jeopardizing its independence or standing.

S+B: This is a very timely book. One question it raises is, How can past wartime leaders teach us how to prepare for the long war on terror?
HORMATS: The best leaders throughout U.S. history have explained the true cost of national security to the American people. The best results come when leaders are very candid about what the threats are and what the cost of meeting those threats would be.

Wartime financing is not just about raising money. It also involves engaging Americans in the war effort, and capturing their hearts and minds so that when troops are sacrificing abroad, Americans are not immune from that sacrifice. During World War I and World War II, little children bought war stamps with nickels and stuck them in books. The point wasn’t to raise money — the government didn’t need those nickels and dimes — it was to establish this sense of engagement.

Neither Woodrow Wilson during World War I nor Franklin D. Roosevelt during World War II knew how much the wars were going to cost at the outset, but once they concluded the wars were going to be a lot more expensive and last longer than they anticipated, they were willing to make major changes in the U.S. financial system to pay for each war and explain why these changes were necessary. Conversely, when the true cost is hidden from the American public, like it was during Vietnam and the current war in Iraq, leaders lose credibility.

In the current war in Iraq and the broader war against terrorism, except for those who serve in the military and their families, Americans have not been asked to do anything. It could have been an opportunity for the president to introduce a bold policy for energy taxes and energy independence, or to get control over nonessential domestic spending, such as earmarking. Anything that showed there was some measure of sacrifice.

S+B: What difference would that have made?
HORMATS: First of all, remember that the Iraq War was very popular at the beginning. It was popular because Saddam Hussein was such an evil character and because it was initially successful. If the president had used that popularity to, for instance, add to his tax cuts a request that Americans pay a small tax to ensure wounded veterans received adequate medical treatment, this could have given people a sense that they were somehow identified with the troops fighting the war.

The point of this book is not to be critical of George W. Bush or of Congress. Instead, it’s to ask what our future will look like after the Iraq War. Suppose, for example, that we withdraw and then pull back from national security spending, as we did after Vietnam? Then what happens if we aren’t prepared for a future threat? To date, no one has been candid with the American people about why funds will be needed for a long time to meet national security requirements, what the costs are, and what the longer-term implications could be.

S+B: Can’t we maintain our current level of defense spending?
HORMATS: It’s a difficult but manageable challenge. The budget deficit is only US$150 billion, which is small by historical comparisons. The war itself is not difficult to finance. It’s a relatively small portion of GDP. Other parts of the budget, particularly in entitlements, will pose a financial problem. They will become so large that they will put a squeeze on discretionary spending, which includes the military. You have to find a way to ensure that entitlements such as Social Security and Medicare don’t encroach so much on the rest of the budget that they limit national security spending, education spending, and all other aspects of domestic spending.

S+B: Among entitlement reform, taxation reform, dealing with the war, and addressing the deficit, which comes first?
HORMATS: To start, we need to reign in tax subsidies, just like Ronald Reagan did in the 1980s. At that time, the tax code was rife with corporate subsidies, and Reagan pared them out of the system. Unfortunately, many have come back. Cutting corporate subsidies could bring in revenue without having a negative impact on growth.

Another issue that needs to be addressed is the imbalance of funds available for Social Security and Medicare. Without reform, these systems will develop increasing gaps between money coming in and money going out to beneficiaries. You simply can’t allow outlays to rise and inflows to barely increase. It just widens the imbalance.