UK Def 02

Memorandum from Keith Hartley

Introduction: the relevance of economics

1. Economics is about difficult choices involved in allocating limited resources between alternative uses. In this sense, economics focuses on the resource aspect of UK defence. It also has something to contribute on commitments through its analysis of the distinctive features of defence (a public good) and the mechanisms used to express choices, including voting systems, political markets and government behaviour.

2. The question of whether UK defence needs more money is easy to ask but difficult to answer mainly because it raises conceptual and empirical problems, including the lack of data available in the public domain. Any sensible answer to this question needs to be based on analysis and evidence rather than emotion and the assertions of special interest groups (e.g. various lobbies for industry and each of the armed forces). Furthermore, an answer needs detailed research involving a multi-disciplinary team comprising for example, military experts, R&D scientists, political scientists as well as economists. Such a group would be better able to address the challenge of assessing the military production function and the ability to relate various defence expenditure levels to alternative force structures and an assessment of their military capabilities. On this basis, the focus of this Memorandum is on methodology and how the question would be addressed from an economic perspective.

Some Questions

3. What do we know; what is not known; and what do we need to know for sensible and informed debates on UK defence commitments and resources? In answering these questions a distinction needs to be made between what is known in the public domain and what is known within MoD.

4. First, in the public domain, we know the UKs resources devoted to defence spending through annual data on the levels and shares of defence in GDP. We also know how much the annual budget 'buys' in the form of the numbers of military personnel in total and by each of the armed forces and the number of 'front-line' forces (e.g. numbers of warships, infantry regiments and aircraft squadrons). However, in the public domain, we do not know much about the efficiency of UK defence spending and the extent to which the defence budget can 'produce' different military capabilities. We know little about the fighting effectiveness or productivity of our armed forces (apart from media observations and reports of fighting in Afghanistan and Iraq); nor do we know much about the operational effectiveness of UK equipment compared with that of our potential

enemies (e.g. its operational availability and its chances of survival in combat). These are issues which need to be addressed for any informed debate and decisions on appropriate level of UK defence spending. Interestingly, an earlier defence budget system known as programme budgeting (functional costing) provided more useful data on the costs of various force structures than the subsequent management and resource budgeting (RAB) systems.

5. Central to debates about commitments and resources is the key question of the appropriate level of defence spending. Is the UK spending 'too much, too little or about the right amount' on defence? Here, much depends on the UKs defence commitments and society's willingness to pay for them.

The determinants of UK defence spending

6. Economic theory offers two broad approaches to determining a nation's level of defence spending. First, there are textbook conditions for achieving society's preferred level of defence spending; but in reality these conditions are so complex that they cannot be operationalised. For example, voters are unable to express their preferences for different levels of defence spending and commitments and even if they could, it is difficult to aggregate their preferences to produce an ordering for society. Also, as a public good, defence is characterised by 'free riding' so that voters will be reluctant to reveal their true valuations of defence. Defence has a further economic aspect in terms of the contribution of domestic defence R&D in providing socially-beneficial technology spill-overs (e.g. internet).

7. An alternative approach focuses on identifying the determinants of defence spending without providing information on its appropriate level. With this approach, a nation's defence spending is determined by a combination of economic, political and strategic factors. These factors include an nation's income (GDP), the price of military and civil goods, threats (including conflicts), membership of a military alliance, the political composition of the government, technical progress and the strategic environment (e.g. end of the Cold War).

8. Broadly, defence spending can be viewed as being determined by a nation's ability and willingness to pay. We know the UKs ability to pay as reflected in its GDP but less about the UK's willingness to pay for defence compared with such alternatives as education and health. Willingness to pay depends on voter preferences and the ability of government to 'interpret correctly and accurately' these preferences.

Does UK defence need more money: an approach

9. This question is addressed in two stages. First, is there under-funding; second, if so, what is the magnitude of under-funding? These are difficult questions to answer using published data, but the first is relatively easier to answer than the second.

10. There is some published information which can be used to provide indications of any under-funding of UK defence. The available data include levels of UK defence spending over time; trends of defence shares in GDP; international comparisons; defence inflation; the costs of current conflicts; data on recruitment, retention and quits from the Armed Forces; trends in the number of front-line forces; and the costs of the new equipment programme. The data will be based on the period from SDR in 1998. This review will seek to identify any evidence suggesting 'over-stretch' and under-funding. Admittedly, there is anecdotal evidence from various sources suggesting under-funding (e.g. faulty weapons; lack of body armour and helicopters; poor accommodation). Where such anecdotal evidence comes from different sources, including senior military staff and all points in the same direction, it can be regarded as suggestive. In addition, there is the Prime Minister's January 2007 statement of the need to renew the covenant between the Armed Forces, Government and people which means "increased expenditure on equipment, personnel and the conditions of our Armed Forces; not in the short run but for the long run" (Tony Blair, RUSI Journal, 2007, p15).

Military capabilities

11. The 1998 SDR committed the UK to a military capability to respond to a major international crisis similar to the Gulf War or to undertake two small-medium scale overseas operations (e.g. Bosnia). This changed in 2004 with The Future Capabilities White Paper which outlined a commitment to support three simultaneous small to medium scale operations, including at least one as an enduring peace-keeping operation or a one-off large scale operation and a small scale peace operation (all within the same budget). Whilst the move to defining the output of UK defence in terms of military capabilities is welcome, the public does not know what these commitments mean (e.g. the ability to deploy to which parts of the world and for how long?). Nor is it possible to assess how the current involvement in Afghanistan and Iraq relates to the commitment to support 'three simultaneous small to medium scale operations.' If Afghanistan and Iraq constitute medium scale operations, then UK Armed Forces might be 'over-stretched' in relation to the Government's declared military capabilities. Of course, it might be that our Armed Forces can be 'over-stretched' in the short-term (surge capability) but cannot sustain such commitments in the longer-term.

Levels of defence spending and defence inflation

12. Are levels of funding adequate to maintain the UKs declared military capabilities? Table 1 shows UK defence spending in real terms between 1990 and 2006. The change from cash to resource-based accounting in 2001/2 affects the time series comparability of the data. Nonetheless, following SDR in 1998, the defence budget remained broadly constant in real terms to 2003/4 (when RAB stage 2 started). Over the current Spending Review from 2004/5 to 2007/8, defence spending is planned to grow at 1.4% per annum in real terms based on the GDP deflator. However, the 'buying power' of such a real terms increase depends on whether the GDP deflator accurately reflects inflation in defence inputs. Since Smart Acquisition, MoD has 'removed' defence inflation by adjusting all defence input prices, including equipment, on the basis of the GDP deflator (an approach resembling King Canute economics). MoD no longer publishes an index of defence specific prices. Historically, MoD provided the Defence Committee with such a price index. For example, in its 1985 Report on Defence Commitments and Resources, the Defence Committee was informed by MoD of a relative price effect on defence equipment of 1-2% per annum.

13. Currently, there are forecasts of equipment prices rising by about 10% per annum in real terms[1]. Assuming that equipment represents about 40% of the defence budget, suggests that UK defence budgets need to rise by about 4% per annum in real terms for equipment purchases (compared with the current plans for a 1.4% increase in real terms). Certainly, defence inflation exists in other nations such as Canada and the USA. For the UK, the policy-relevant question is whether defence specific inflation exists for equipment and other defence inputs. If so, adjusting the defence budget by the GDP deflator might not be the correct adjustment for identifying appropriate real terms increases in defence spending. A positive defence inflation figure compared with the GDP deflator might indicate the extent of under-funding. The results of any such under-funding will be reflected in reductions in the equipment for front-line forces. Even here, though, further adjustments are needed for improvements in the productivity of defence equipment (e.g. one F-117 with two precision bombs can achieve the same results as a WWII bomber force of over 100 B-17s: RUSI Journal, February 2007, p85). The net result on UK military capability of defence inflation and productivity improvements for new equipment cannot be assessed in the public domain (there is a need for appropriate output indices).

Table 1. UK Defence Spending

Note: RAB stage 1 was introduced over the period 2001-2003 and RAB stage 2 was introduced in 2003/4. Prior to 2001, the defence budgets were on a cash basis.

Sources: MoD/DASA , UK Defence Statistics, 2002 and 2006; HM Treasury,(2007), GDP Deflators

Front-line forces

14. Since SDR, there has been a general reduction in front-line forces. Examples over the period 1997 to 2006 include:

i) Navy: reductions in the number of destroyers from 12 to 8 and in the number of frigates from 23 to 17. The nuclear attack submarine force to be reduced from 12 to 8 vessels by 2008 and the planned purchase of Type 45 destroyers reduced from 12 to 8 vessels.

Ii) Army. Reductions in the number of Regular Army infantry battalions from 40 to 36 and reductions in Challenger 2 squadrons and self- propelled gun batteries (about 84 tanks and 48 AS90 guns announced in 2004 White Paper).

iii) Air Force. Reductions in strike/attack/reconnaissance squadrons from 16 to 14 (including Joint Harrier force); and in air defence from 6 to 3 squadrons.

15. Some of the force reductions will be compensated by the introduction of new equipment (e.g. Astute; Type 45 destroyers; Typhoon; Nimrod MR4). Other force reductions represent the retirement of obsolescent equipment. Nor are such force reductions new: they are part of a long-term trend to smaller but hopefully better equipped forces. Again, the problem with assessing these trends in force numbers is that they do not indicate the impact on the UKs military capability.

International comparisons

16. International comparisons of defence spending are another possible indicator of any under-funding of the UK defence budget. There are extensive data available requiring detailed analysis. This section illustrates the method and its possibilities. Table 2 shows data on defence burdens in 2005 and trends in real equipment spending from 2001 to 2005 (2001 being the start of the 'war on terror'). Any conclusions are sensitive to the choice of comparator. For example, compared with France, the UK's defence burden was lower in 2005, but it was higher than Germany, Italy and NATO Europe. Similarly, using increases in real equipment spending, the UK increase was lower than France and NATO Europe (and the USA). But caution is needed, since the data could reflect different stages of the re-equipment cycle for each nation. More interesting would be a detailed study of international comparisons of defence budgets and force structures (e.g. numbers of warships purchased per unit of expenditure for different nations, etc).

Table 2. International Comparisons

Note: NATO Europe defence share is based on median.

Sources: MoD/DASA UK Defence Statistics, 2006; SIPRI Yearbook, 2006

Costs of conflict

17. The costs of the current conflicts in Iraq and Afghanistan are another possible indicator of under-spending. These costs are being borne by the Treasury's Reserve and not by MoD's budget (i.e. they are net additional costs). For 2005/06, the costs of these operations were some £1.2 billion: hence, this is one estimate of the extent of under-funding.

Personnel: recruitment, retention, quits and pay

18. Trends in inflows and outflows of military personnel are an indicator of 'overstretch' and discontent with service life in general. Evidence from recent years shows an increase in the net outflow of military personnel both officers and other ranks, with outflows particularly affecting the RAF. Data on full-time strength against requirements for all services show a continued deficit for other ranks over the period 2001-2006 with a small increase in the deficit from 2005 to 2006 (there was also a substantial reduction in requirements). Short run movements, though, are not reliable indications of long run trends.

19. A NAO Report on Recruitment and Retention in the Armed Forces (October, 2006) provided further evidence of 'overstretch.' It concluded that "Overall, the Armed Forces were not in manning balance and the figures mask wider shortages of trained personnel within a range of specific trade groups across all three Services." It also found that manning requirements "have not been adjusted to reflect the current levels of deployment ....which have since 2001 exceeded the assumptions made about enduring concurrent operations and which seem likely to do so for some time" (p1). The NAO identified 88 'pinch point' trades which are under strength and in some cases, "...full manning remains a distant prospect" (p1). Further pressure on the Forces is reflected in 'harmony' guidelines being exceeded by significant numbers of personnel, especially in the Army where almost 15% of those on trained strength at January 2006 had exceeded the target at some point in the previous 30 months (p2).

20. Military pay and conditions of employment are means of affecting recruitment and retention. The 2007 Armed Forces Pay Review Body Report (AFPRB) recommended an increase of 3.3% in military salaries and a package which was expected to add a net 3.9% to the Services pay bill. The Service pay bill was 29% of the defence budget (the UK target inflation rate was 2% which suggests a relative pay effect of 1.3 to 1.9% points). In reaching its proposals, the AFPRB identified a doubling in the manning deficit between April and October 2006; a continued upward trend in voluntary outflow; and retention under pressure from operational commitments and current manning levels (AFPRB Report, 2007, pviii). It also quoted MoD as admitting that meeting the 2006-07 recruitment target "remained challenging" (p23).

Funding the new equipment programme

21. There is an ambitious new equipment programme. Projects listed in UK Defence Statistics 2006 totalled some £30 billion excluding Typhoon costs. In addition, the costs of the carriers, JSF, more Astutes and a Trident replacement probably take the grand total to over £70 billion for acquisition costs only. Within this total, there are multiple major spending programmes, any one of which would represent a funding challenge (Trident replacement; carriers including their aircraft). There are also the costs of the new Defence Industrial Strategy and the demands for more defence R&D spending. Faced with such a funding challenge and without a substantial increase in the defence budget, MoD can respond by cancelling some programmes, or reducing numbers purchased or by shifting the new equipment programme 'to the right'.

Conclusion

22. Overall, there is some evidence of under-funding based on defence inflation, especially in equipment costs, as well as problems of recruitment and retention for the Armed Forces, the challenge of funding the new equipment programme and the costs of current conflicts having to be borne by the Treasury Reserve. But during peace-time, under-funding is probably a fact of life for defence. Faced with under-funding, MoD has number of policy options: it can 'fudge it' by resorting to a 'defence review by stealth' (Defence Committee, Defence Commitments and Resources, vol 1, 1985, pxli); or it can seek further efficiency improvements (but it is never clear whether these are achieved at the expense of defence output); or it can undertake a major defence review. As a guesstimate, the extent of current under-funding is at least some £1.2 billion per annum and once the new equipment programme is included, the sum is likely to be much greater.

23. In the absence of a major war, a substantial increase in UK defence spending is unlikely. Level funding in real terms seems most likely. If so, the under-funding problem will become more acute. Difficult defence policy choices cannot be avoided. Possibilities include cancelling a major equipment programme; or withdrawing from the UKs world role; or reducing our commitment to support three simultaneous small to medium scale operations (e.g. a reduction to two); or accepting less capable but considerably cheaper programmes; and more substitution between equipment and personnel (e.g. civilians replacing service personnel; reserve forces replacing regular units - e.g. air force; tanks; infantry).

24. The Armed Forces also face a major challenge, namely, their need and ability to adjust to continual change reflecting new technology and new threats. Such change is occurring continuously in the private sector, but the private sector is subject to incentives and penalties from competition, the profit motive and the disciplines of the capital market. For the Armed Forces, the current challenges might require a re-allocation of Service personnel and budgets from the RAF and Navy to the Army (e.g. an increase in the size of the Army of 10,000 soldiers with corresponding reductions in personnel in the other Services).

7 March 2007

[1] Pugh, P (2007), Retrospect and Prospect: Trends in cost and their implications for UK aerospace, Defence and Peace Economics, 18, 1, 25-37; Kirkpatrick, D (1995), The rising unit cost of defence equipment, Defence and Peace Economics, 6,4, 263-288.