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Defence budget watch

Posted By on May 2, 2016 @ 15:00

It’s all but certain that the government will make good on its white paper funding commitment in tomorrow’s Budget. With the fanfare of the submarine and frigate announcements still echoing, it would be political suicide to not come up with the money.

Yet one aspect of the Budget will still be critical for defence—whether the government manages to deal with the vexed question of debt. As I argued earlier this year, there’s an intrinsic tension between debt and defence because each dollar can only be spent once. Unless the government gets debt under control, the pressure to limit growth in defence spending will mount in the years ahead.

Just as worryingly, a failure to reduce debt will increase our economic vulnerability. Among the many responsibilities of government, one of the most important is to manage the risk of economic shocks, including by backstopping bank deposits and, when necessary, providing fiscal stimulus. The ability to fulfil this critical role demands access to borrowing, which in turn requires that government debt be kept at a manageable level. While the share of GDP spent on defence is a questionable proxy for the adequacy of our defence firepower, government debt as a share of GDP is a good proxy for our vulnerability to economic shocks.

There’s plenty to worry about on the economic front. A little over seven years after the Global Financial Crisis (GFC), the world economy is yet to properly recover. For five years in a row, the International Monetary Fund has overestimated global and regional growth. National officials and private sector economists have done no better. It’s not that policy makers have sat idle. After the initial wave of Keynesian fiscal expansion ebbed, and with interest rates at historical lows across most advanced economies, officials have resorted to ‘unconventional’ monetary policy, or quantitative easing. In the US, United Kingdom, Japan and Europe, central banks have injected the equivalent of hundreds of billions of dollars into the banking system. Yet, apart from some encouraging but as yet inconclusive signs in the US, growth remains below expectations.

There’s nothing approaching a consensus for why the GFC marked the transition from steady to faltering growth. Our economic models have proven insufficient to the task. The sobering conclusion is that we live in a global economic system that is both poorly understood and beyond the power of policy makers to control with any certainty.

Notwithstanding what we don’t know, there are clear risks in the global economy as it stands—all of which have potential implications for Australia’s security and prosperity. Most obvious are the consequences of continued slow global growth, or worse still, a decline to an even slower rate of growth. Setting aside the direct impact on the price and volume of our commodity exports, continued slow or slowing global growth would exacerbate several non-economic problems we face already. Not unexpectedly, there’s a strong interplay between the economic and strategic risks we face.

Take the US. Saddled with high debt following the financial crisis and with an alarmingly dysfunctional polity grappling with mounting fiscal pressures, our great and powerful ally is already finding it hard to maintain the scale and sophistication of its armed forces. Quite apart from the inexorable rise in the unit cost of advanced military equipment making the task harder, the nation that spent upwards of 9% of GDP on defence in the 1960s is only able to muster around 3.5% today. It’s hardly surprising that the post-Cold War planning benchmark of being prepared to simultaneously fight ‘two major regional conflicts’ is rapidly receding into memory. Every year that the US endures slower growth, accelerates the absolute and relative decline of its military power.

If the arithmetic of western military power is not worrying enough, the domestic political implications of the post-GFC malaise are no more encouraging. In Europe, reactionary politics are making a something of comeback in a haunting echo of what happened in the economic turmoil of the 1920s and 30s. In the US, the insurgent candidacies of Sanders and Trump are undermining the apparent consensus of the US role in the world and threatening a return of isolationism.

Of course, all of the risks and problems outlined so far would be far graver if the global economy were to suffer a repeat of the GFC. The difference a second time around would be that governments shackled with high debt would struggle to refinance banks and deliver fiscal stimulus by conventional means. The likelihood of a second financial crisis is presumably low given recent reforms to the financial sector. Yet, as always, we don’t know what we don’t know.

Finally, there’s China. The good news is that China’s policy makers have launched a new round of stimulus that’s boosting growth and buoying up commodity prices. The bad news is that the new round of stimulus will exacerbate already high levels of internal debt. It’s likely that an increasing number of the investments will be unprofitable and therefore translate into underperforming loans. China is already awash with manufacturing overcapacity, vacant real estate and public works projects whose costs outweigh the benefits. The risk is that the banking sector will eventually fall into crisis, much as occurred in the advanced economies in 2008. Given Australia’s strong linkage with the Chinese economy, we’d be in trouble.

With an election around the corner, tomorrow’s Budget will be critical as a political document. But at the same time, the Budget will have to address the strategic and economic risks Australia faces. There is no choice to be had. We cannot have strong defence without a strong economy, and in an increasingly uncertain world we need strong defences to underwrite our prosperity. The challenge for the government will be to find a balance.

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[1] argued earlier this year: http://www.aspistrategist.org.au/funding-defence-and-squaring-the-circle/