One consequence of the more tumultuous geopolitical environment of the 2020s has been a material rise in global defense spending, and one that looks set to continue.
As the IMF noted in its World Economic Outlook this April:
After decades of declining global defense spending, rising geopolitical risks and more frequent military conflicts are pushing countries toward an inflection point, with several ramping up defense spending. As this reversal is happening at a time of already elevated spending pressures, policymakers face salient trade-offs when spending more on defense.
NATO is a case in point. After a decade and a half of urging its member states to spend 2% of GDP on defense, it has now updated that target to 3.5% (with an additional 1.5% on related resilience measures) of GDP by the mid-2030s. Germany has dropped long-standing fiscal rules, mostly to fund a rearmament drive.
What will be the macroeconomic consequences of this?
Recently, the Clark Center’s US and European Economic Experts Panels were asked about this. Both panels were asked the same three questions and, on two of them at least, registered a broad consensus.
There were no real surprises when the panels were asked whether “The market power of defense suppliers substantially raises procurement costs without adding to military capabilities”? A strong majority of respondents across both panels, weighted by confidence, either strongly agreed or agreed. If there is one thing economists tend to agree on, it is that market power can sometimes be abused.
The answers to whether or not “Increasing public investment in defense R&D would generate substantial technological spillovers and productivity gains in addition to the boost to national military capabilities”? Also showed broad, although slightly weaker, agreement across both panels.
Of course, a similar case can be made about any sort of support for R&D. But, as the IMF noted earlier this year, modern defense spending is becoming ever more focused on capital spending and cutting-edge processes and involves lower labour forces and less basic manufacturing than in the past. This may, and it is still a may, mean it generates wider productivity spillovers.
As the Fund’s researchers noted:
The macroeconomic impact of the current defense buildup could differ from that of past episodes, as defense outlays are increasingly capital and R&D intensive and are occurring in economies that are more integrated and more indebted.
Where the panels disagreed – and rather sharply – was on what is to many the key question – whether “a substantial increase in defense spending largely funded by government borrowing would deliver a measurable boost to economic growth over the next five years”?
Among US experts, weighted again by confidence, none strongly agreed while 29% agreed, uncertainty was high, and a plurality disagreed.
By contrast, 52% of the European experts agreed with the proposition and another 8% strongly agreed.
It is not too hard to see why this divergence arose; most US panel members answered with reference to the American economy whilst most Europeans answered with reference to the European economy. The fiscal dynamics at play on the two sides of the Atlantic are rather different. And, of course, they vary a great deal around Europe too.
Olivier Blanchard of the Peterson Institute, who was uncertain, clarified that ‘probably, but, if indeed debt financed, through the fiscal boost to demand. The supply side effects can go either way, crowding out investment more directly useful to growth’. That is an important clarification and one likely shared by many panel members. The growth impact over five years of a debt-financed increase in defense spending relates more to the ‘debt-financed’ part of the description than the ‘defense spending’ part, i.e. it is the fiscal boost to demand that matters.
Christian Leuz of Chicago Booth, who was also uncertain, further argued that the timeframe under discussion is just as important, alongside a myriad of other factors:
More plausible in the short-run but over 5 years the effect it is uncertain and depends on a variety of factors such as monetary policy, spare capacity, how much is imported or spent domestically, and the composition of defense spending (e.g., how much R&D).
All of which is consistent with the IMF’s own modelling of the impacts of the dent-financed defense spending boosts:
In the baseline scenario, the model predicts moderate output gains… Inflation goes up modestly and temporarily, monetary policy tightens in response, and the current account deteriorates as imports (including those of military equipment) increase… The policy reaction matters. When monetary policy accommodates the shock, the demand effect is stronger and the multiplier is larger. But this comes at the cost of higher inflation and a widening of the current account. When fiscal policy tightens to limit the accumulation of public debt, the effect of the stimulus is weaker and the multiplier is smaller.
The broader takeaway from both panels – and indeed the IMF research – for policymakers for thinking through defense spending and how it is financed is perhaps that there is nothing magical about defense spending vs other types of government procurement.
