Military Economics

Ron Smith Professor of Applied Economics, Birkbeck

ICEA 16 January 2019

Outline

• Introduction • Defence Budgeting • Economic Effects • Procurement Issues • Conclusions

Defence

• In the overlap between the spheres of power and money; interact because application of power needs to be financed

Economic Environment

Strategic Environment

Defence

Issues in the overlap 1 • Separate tracking of economic and security

issues, both nationally and internationally (different people go to World Trade Organisation and Wassenaar meetings on conventional weapons trade)

• Different languages and preconceptions in the two spheres

• Unintended consequences of actions in one sphere on the other (e.g. Versailles)

• Resource constraints produce strained relations between MoD and Treasury

• Very few defence economists.

Issues in the overlap 2 • Speed of change in economic and strategic

spheres differ. The longstanding economic failings of the Soviet Union had the political consequence of an abrupt change.

• Role of oil and volatile oil price. • Efficient illicit markets in weapons, drugs, people

and money • Post-conflict stabilisation and reconstruction

requires getting both economics and security right.

Outline

• Introduction • Defence Budgeting • Economic Effects • Procurement Issues • Conclusions

Military Value Chain

Budget

Forces

Military Capability (Ability to do things)

Military Objectives (probability of Winning)

Security

• Threat perception

• Ability to pay

• Recruit, • Procure

• Lead, • Train • Morale • Logistics

Tactics Strategy

– Goals?

Economy

Strategic

Environment Civil

Society Bureaucratic

Culture Science/

Technology

Very tenuous links between them

• Budgets to Forces: wages/conscripts; efficiency of procurement and arms industry

• Forces to Capability (ability to do things/probability of winning): training, leadership, logistics

• Capability to Security: Grand strategy. • Ultimate goals of the military? Since they are a

potential threat to the government this prompts “Coup-proofing” in many countries.

Measuring Defence Budgets • What to include? Intelligence, paramilitaries, veterans

pensions/healthcare. • Defence Budget: cash? RAB? Treatment of assets?

UORs? • Current prices or constant prices: how to measure

defence inflation? Between generations of weapon; over lifetime of project; or total input costs.

• Has recently benefited from low oil price and controls on public sector pay.

• Defence Budget as a share of GDP (military burden) • In UK share has been over 50% during WWs and now

fixed at 2%, close to long-run peace-time average. 2% achieved by some redefinition of items.

UK Share of Military Expenditure in GDP, 1830-2013, (cut off at 15%). Where next?

0

2

4

6

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14

16

1850 1875 1900 1925 1950 1975 2000

SM

The Soviet Estimate • In 1976 the CIA revised estimated share of Soviet military expenditure in GNP from

less than 8% to 11-13%. • It was interpreted as meaning the Soviets were more threatening than had been

previously thought in fact it meant the Soviets were less efficient. • The CIA first estimated Soviet forces: troops, tanks, missiles etc, from technical

intelligence sources such as satellite photographs. • It then estimated what those forces would have cost the USA, to give a dollar figure. • This was then multiplied by an estimated rouble-dollar exchange rate, to get a rouble

figure, which could then be expressed as a share of CIA estimates of Soviet GNP. • In 1975, the CIA got "an unusually large body of new information" that suggested the

Soviet military industry was much less efficient than it had previously thought. It altered the exchange rate to reflect this raising the estimated share of milex in GNP

• The revision did not affect CIA's view of the capability of Soviet military forces or the estimated dollar cost of reproducing Soviet defence programs. The revision reflected the fact that the CIA thought that it was costing the Soviets far more resources to produce those forces.

Types of Defence Inflation

• Changes in the price of defence inputs: what about productivity?

• Changes in the price of defence output: un-measurable?

• Cost over-runs on individual projects: budgeting issue?

• Changes in costs between generations of equipment: Towards Starship Enterprise?

In Principle: Think forward and reason back

• Threats to security? • Capabilities (military or other) needed to

meet them? • Forces needed to provide capability? • Budgets needed to provide forces? • Valuation of possible security gains of the

expenditure against benefits of its alternative uses (opportunity cost of defence)?

Thus the questions for a Defence Review are:

• What will be the UK role in the world and its associated vital interests?

• What are the most likely threats to those interests?

• What are the most effective military responses to those threats?

Answer

• We have no idea. • Every previous defence review was

overtaken by unpredicted events, including the 2015 SDSR: Brexit.

• In practice we have to muddle through. • This is nothing new. Shaped by political

economy rather than optimisation

Defence budgeting in practice • Outcome of bargaining between multiple

stakeholders with different interests • Industry lobbying • Inter-service rivalry • Political concerns and pressures • Heritage Commitments • Contractual commitments • Media attention • Attitudes of Allies • Financial Constraints are always there; most

binding at times of crisis.

UK Growth and defence reviews

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-4

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55 60 65 70 75 80 85 90 95 00 05 10 15

G

S

H1

H2 N

OFC

SDR

SDSR10

SDSR15

Controversial Issues • Security threats? • Effectiveness of a military response to those

threats? • Balancing Resources, Commitments and

Capabilities? • Efficiency with which the military budget would

be used? • Overstretch versus black holes? • All shrouded in uncertainty. • Insurance premium?

Outline

• Introduction • The Economic Environment • Defence Budgeting • Economic Effects • Procurement Issues • Conclusions

Macro-Economic Effects of Military Spending

• Keynesian Demand Side Effects of the spending, reduced unemployment?

• Supply Side Effects on labour force; displacing labour/ providing training?

• Supply Side Effects on investment through crowding out and interest rates?

• Effects on technical progress and productivity? • Arms Trade on the balance of payments?

Benefits/Costs of arms exports. • Labour: Volunteer forces / conscripts

/reserves/PMCs; links to civil society.

More Macro effects

• Wars can be financed by: printing money, issuing debt, raising taxes, cutting other government expenditure.

• Conversion of military resources/Peace dividend at end of conflict

• Apart from the importance of War financing the large macro literature does not come to any clear conclusion.

Nor does the Bible

• Isaiah 2:4. He will judge between the nations and will settle disputes for many peoples. They will beat their swords into plowshares and their spears into pruning hooks. Nation will not take up sword against nation, nor will they train for war anymore.

• Joel 3:10. Beat your plowshares into swords and your pruning hooks into spears. Let the weakling say, “I am strong”.

Outline

• Introduction • The Economic Environment • Defence Budgeting • Economic Effects • Procurement Issues • Conclusions

Procurement Organisations

• Responsibility of DES, Defence Equipment & Support

• Single Source Regulation Office, oversees part of the programme, can arbitrate. Still quite new. SS about 40% of equipment budget £8b.

• NAO used to review major projects now reviews equipment plan.

Procurement Issues • Long time horizon: 1955 design B52 still in operation,

C130 Hercules has been in production for over 60 years • Average procurement time about 7 years, can be much

longer; • Can be done quickly in combat, Urgent Operational

Requirements, UORs • Electronics often obsolete by in service date, ISD • Large uncertainty about: requirement, threat, technology,

so lots of changes as programme matures • Conflicts between different stakeholders • Usually late, over budget, underperforms specifications

Constant Reviews • Report by Bernard Gray, 2009 subsequently Chief of Defence Materiel,

head of Defence Equipment and Support • Liam Fox: Budget shortfall of £38bn between planned purchases and

available budget, 2010 • Strategic Defence & Security Review 2010 • Report by Lord Levene 2011 on defence reform • Report by Lord Currie 2011 on single source procurement • White paper on National Security Through Technology 2012 • Strategic Defence & Security Review 2015 • Gavin Williamson: Mobilising Modernising and Transforming Defence 2018

Process • CADMID (Concept, Assessment, Demonstration,

Manufacture, In-Service, and Disposal) cycle. • Since Zuckerman report in the 1960s it has been

repeatedly recommended that one spend 10-15% of development budget up front on initial research to demonstrate technology; rarely done

• UORs, acquired rapidly but not inter-operable. Battles over who pay for them.

Defence Lines of Development • Training • Equipment • Personnel • Information • Doctrine and Concepts • Organisation • Infrastructure • Logistics • +'interoperability'

Sources; in order of expense

• Commercial off the shelf, limited range. • Imports; not customised; security of future

supply/cost of components? Offsets • Licensed production; 25% premium,

transfers technology, some independence • Collaboration; juste-retour? • Domestic development; Local monopoly

problem.

Contract forms: Partnering with cost-plus

• Very flexible, can easily adjust if requirement changes • Builds up relationships and trust; but may be exploited • Creates monopoly: may inhibit innovation and the entry

of new firms • Moral hazard problem: no incentive to minimise costs. • MoD can pool risks over many projects providing

insurance to risk averse contractors • What profit formula? • Can distort make or buy decision

Contract forms: Competitive

• Competition with fixed/firm price for specified contract. Indexing?

• Incomplete contracts: Inflexible/expensive if requirement changes;

• Adverse selection (winners curse), worsened by need to bail out.

• Risk aversion means large risk premium built into price.

Industrial Structure

• Demand determined by the state: only domestic customer, regulates/promotes exports, finances R&D.

• Forms of firm: nationalised/state arsenal; GoCo; private national; private multinational.

• Can state commit to a Defence industrial strategy?

• Economic forces for globalisation versus political forces for national self-sufficiency

World concentration

• Not a concentrated industry; 2 manufacturers of large civil aircraft (Boeing & Airbus) 11 manufacturers of fast military jets.

• Top 5 firms had global market share of 22% in 1990 rose to a peak of 45% in 2002 declining to 33% in 2014, then rising to 36% in 2015 and 2016, falling slightly to 35% in 2017.

Technology

• Spin-off or diversion of R&D from civilian uses;

• Spin-in/COTS (Commercial off the Shelf) and match between military and civilian technologies;

• technology strategy: • Internet DARPA; World Wide Web CERN.

Finance

• PFI (RIP?), PPP etc. • Gives supplier more incentive to build in

reliability • Supplier has to borrow at a higher interest

rate than the government • Long term contracts inflexible when

requirements change

Outline

• Introduction • The Economic Environment • Defence Budgeting • Economic Effects • Conclusions

Long term trends • Systems costs (e.g. platforms between generation) grow

at 6-8%p.a. in real terms • Defence budgets grow more slowly • For a while push it into the “bow-wave” of postponed

expenditure. • Story of UK defence policy since WWII: • Growing imbalance between resources, capabilities and

commitments, intermittently resolved by defence reviews, where capabilities and commitments have to be sacrificed

• Currently £20bn “black hole”. NAO says Equipment Plan “unaffordable”.

Palgrave 2009 Shortlisted for the 2010 Duke of

Westminster Medal for Military Literature

Birkbeck, University of London