Defence budget set to take a big inflationary hit
15 Jun 2023|

The size of the cuts that Australia’s Defence Department must make to existing programs to create room for the recommendations of the defence strategic review will be dictated in part by the persistence of inflation.

The breakout of inflation was barely recognised at the time of the March 2022 budget. The Reserve Bank’s cash rate still stood at a rock-bottom 0.1% and both the bank and Treasury believed a rise in international prices reflected short-term factors that would soon pass.

These included disruptions to supply chains caused by the pandemic, interruptions to energy supplies caused by Russia’s invasion of the Ukraine and the disruption to food supplies caused by extensive flooding in late 2021.

Treasury expected that the consumer price index would reach a peak of 4.25% in the three months to June 2022 and then drop back to 3% by the current June quarter. The RBA was even more confident, tipping ahead of last year’s budget that inflation wouldn’t surpass 3.75% and would be back to 2.75% by now.

Instead, inflation accelerated to 6.1% by June 2022 and touched 7.8% by March this year, the latest complete CPI survey. Last month’s budget stayed with optimism: Treasury predicted that inflation would be back to 6% by the current quarter and would be down to 3.25% by June next year.

Inflation hits the budgets of every government department (and every business and household), but Defence is unusually exposed because of its large capital acquisition program, which involves multi-year commitments that are often exposed to cost increases. Defence has capital purchases this year of $15.1 billion, much higher than the next-ranked Department of Social Security’s capital purchases of $866 million.

Defence inflation is difficult to untangle. There is intergenerational cost inflation, with each successive generation of defence equipment involving greater complexity, capability and expense than the one before. The development costs of equipment involving new technology are inherently uncertain, while new technology frequently involves rare or hard to fabricate materials, with high costs.

Major acquisition programs are subject to cost blowouts, only part of which are due to ‘inflation’; changes in specifications, delays and poor planning contribute to the rest. Then there’s the lack of competition in defence procurement, which, in the US, is behind the stories of US$1,400 toilet seat lids, US$1,260 coffee cups and US$436 hammers.

Defence equipment is typically manufactured without the economies of scale that would be required in the private sector. One US study found that over a 70-year period, defence costs rose 30% faster than prices across the economy.

While Defence deals with inflationary pressures across the full spread of its operations, simple construction materials have contributed to the difficulty of its budget management. The price of concrete has risen by 18% over the past two years, and steel is up 40%.

Treasury’s updated forecasts for inflation in the 2023–24 budget translate to a reduction in Defence’s purchasing power of between 5% and 6% a year, relative to the forecasts made in the budget delivered in March 2022.

The latest forecasts assume that inflation returns to ‘normal’ levels rapidly; however, the loss of purchasing power, incurred as prices rose 6% over the last year and a similar amount the year before, is permanent.

There have been some encouraging signs—for example, excluding ‘volatile’ prices like energy and food, the CPI had come back from a peak of 7.5% in October to 5.5% by April. Oil and shipping prices have fallen sharply and are back to pre-pandemic levels.

On the other hand, the cost of market services has risen by 6.7%, while electricity prices are up 15.2% and housing 8.9%. The trend of continued inflation in services is evident in other advanced nations, and reflects the continued ‘overheating’ of economies after years of ultra-low interest rates and excessive government stimulus.

The share of the population with a job is close to a record high, the number unemployed is close to a record low, and there are almost as many unfilled job vacancies as there are people without a job and looking for one. Business is operating with less spare capacity than at any time in the last 40 years. It would be surprising to see inflation fall far while these factors prevail.

It appears likely, therefore, that inflation will take longer to bring under control than either the RBA or Treasury is predicting. If inflation is still at 5.5% by the middle of next year, and still at 4.75% by June 2025, the erosion in the value of the defence dollar would rise to almost 11% over 2024–25. The impact of inflation is cumulative—the lost value of a deflated currency is never regained.

As ASPI’s 2023 defence budget brief demonstrated, the core provision of defence funding is lower in this year’s budget than in the budget of March 2022, once compensation for adverse foreign exchange movements is taken into account. Excluding that compensation, defence funding totals $152.5 billion between 2023–24 and 2025–26, down from $154 billion over the same period in the March 2022 budget.

Defence has to squeeze between $7.3 billion and $7.8 billion of new and otherwise unfunded spending into that reduced budget allowance, covering items recommended in the defence review, such as the hardening of northern bases, the nuclear-powered submarines and a long-range strike capability.

Before looking at inflation, this suggests Defence is having to make new purchases equivalent to around 4% of its total budget with total resources that are about 1% less, implying that savings equivalent to 5% of its budget will have to be found.

The breakout of inflation means that, on the current forecasts from Treasury, the defence dollar buys 5% less than it expected in March last year. This would require savings equivalent to roughly 10% of the defence budget to be found to finance the new priorities under the defence review.

If inflation lingers at around 5%, the savings required would rise to roughly 15%. There is doubtless fat in the defence budget, as there is in all departmental budgets, but trying to achieve a massive reorientation in defence priorities consistent with the recommendations of the review while at the same time seeking huge savings is unlikely to generate an outcome satisfactory to anyone.