On economics and submarines
29 Oct 2014| and
A lesson for submarines

According to the South Australian government, the Australian economy will be better off by $21 bn if our next generation of submarines is built in-country rather than purchased from overseas. With the Abbott government likely to make a decision about the submarines soon, the claim deserves close examination.

The underlying analysis is set out in a paper from the SA Economic Development Board  based upon commissioned work done by the official-sounding National Institute of Economic and Industry Research. It’s a short paper, running to only nine pages, and sparse in detail.

The paper compares two options:

  • purchasing 12 submarines from overseas and performing only light maintenance on the boats in Australia;
  • building 12 submarines in Australia and performing both light and heavy maintenance in Australia.

The options posited immediately skew the analysis by assuming that with the foreign build option, heavy maintenance would be done offshore. It fact it would be feasible and advantageous to perform heavy maintenance in-country. In case there’s any doubt, we successfully executed an extensive mid-life upgrade of the British-built Oberon class boats.

As a starting point, the paper assumes that it would cost $20 bn to acquire 12 boats irrespective of where they are built at the baseline exchange rate of 92c to the US dollar. Thus, at today’s exchange rate of 88c, we already face a $900 million premium for a foreign build.

But recent experience demonstrates that there’s a substantial premium associated with building ships in-country (albeit one that depends on the prevailing exchange rate). As Andrew Davies put it, in the case of the $8.1 bn Air Warfare Destroyer (AWD) project, we’re getting three ships for the price of four, not counting recent cost blowouts and the lost value of increasingly delayed delivery. Estimates of the effective rate of assistance for the Landing Helicopter Dock and AWD programs come in at 70% and 33% respectively.

Not only is the higher up-front cost of local construction ignored, but the analysis unreasonably privileges future spending by omitting a net-present-value calculation of costs—which matters a lot given the unrealistic assumption about off-shore heavy maintenance and the 40-year time-horizon of the model.

The SA paper also ignores the ‘agency’ problems of local build. First, it can be desperately hard to get acceptable productivity from a domestic monopoly—as our sorry experience with submarine maintenance shows. Second, and as we’ve seen, an incumbent local supplier will form a natural alliance with unions and the state government to shift risk and cost increases back to taxpayers.

The SA paper then makes matters worse by modelling the economic impact via an input–output model. One of us has already blogged about the shortcomings, but the essential features are easy to recount.

The problem’s best explained by thinking of a ship built in Australia. The workers and local subcontractors will receive income, which they will largely spend on other locally-produced goods. By using data on the inputs and outputs of Australian producers of those goods, it’s possible to trace the direct and ‘multiplier’ effects of the spending on GDP and tax revenue.

That’s fine, but such an analysis ignores the alternative use of the labour and other inputs—it assumes they’ll sit idle if our hypothetical ship isn’t built. In reality, market forces will redeploy them elsewhere in the economy where they will contribute to GDP and pay taxes. That’s especially true in any long-run scenario—and this modelling stretches over 40 years.

The unreality of input–output modelling is well understood, so more sophisticated general equilibrium modelling is the standard approach for addressing long-run ‘what if’ questions about policy. The SA paper rejects general equilibrium modelling on the grounds that ‘no capacity constraints are anticipated in the labour market’. That is, it assumes that there will be a pool of unemployed in Australia for the next 40 years who, but for the opportunity, have the aptitude to become highly skilled engineers and trades persons. Indeed, as there are no ‘ramp up’ costs in the model, it assumes all these skills and resources already exist—in obvious contrast to the findings of the RAND study.

If the economy really was as static and unresponsive as assumed in input–output modelling, we could never have absorbed the resource boom. Nor would we ever have recovered from the removal of tariffs on cars, footwear and clothing. But we did, and the economy responded with new jobs in new areas. More importantly, consumers came to enjoy cheaper prices. There’s a lesson here about buying submarines. The economic argument for mandating local construction is ultimately no different to the neo-mercantilist arguments which sought to hold back productivity-boosting reforms of the 1980s and 90s. Then as now, the focus should be on the overall benefits rather than those concentrated in the hands of a few.

Henry Ergas is a senior economic adviser, Deloitte Access Economics, and professor of Infrastructure Economics, University of Wollongong. Mark Thomson is senior analyst for defence economics at ASPI. Image courtesy of Flickr user sea turtle.