Funding defence at 2% of GDP presents two technical challenges; planning under economic uncertainty and managing foreign exchange risk.
Economic growth and planning
The basic problem is simple; efficient defence planning requires medium- to long-term funding surety to avoid wasteful investments that then prove unaffordable, and to ensure that resources are available for required ADF capabilities when required.
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A handful of years of sub-par economic growth can make a big difference to GDP-based funding due to the compounding of growth. For example, the 2010 Intergenerational Report (IGR) predicted 4% real growth from 2011-12 to 2014-15, which was not realised in practice.
Table 3.6 is comparing the predicted to actual growth in the economy results in a 5%
difference over the four years. All other things being equal, the result is that the economy will be 5.3% smaller than predicted, with means that 2% of GDP will be smaller in real dollar terms by the same margin. One might hope that accelerated growth following the slowdown would make up the difference. However, as shown in Chapter 1.3, the global economy has not bounced back to fill the output gap this time around. A funding regime based on GDP share is at the mercy of economic performance; in extremis, funding could be cut in a recession.
Table 3.6: The tyranny of compounding interest
2011-12 2012-13 2013-14 2014-15 Compounded
2010 IGR 4% 4% 4% 4% 17.0%
Actual 3.70% 2.50% 2.50% 2.50% 11.7%
Shortfall 5.3%
Source: 2010 IGR and RBA statistics for actual
Of course, it’s possible to arrange a funding regime based on GDP share that avoids
disruptive near-term fluctuations (more on how to do that later). But defence is a long-term enterprise, so shifting medium- to long-term economic expectations can make a substantial difference. Consider the evolving outlook as given in Treasury’s four Intergenerational Reports this century, see Table 3.7. Although the first two IGR gave average growth rates per decade while the latter two offered only snapshots on selected years, it’s clear that our economic outlook has changed substantially as projections of population, productivity and workforce participation have evolved.
Table 3.7: IGR growth projections 2003 to 2015
2000s 2010s 2020s 2030s 2040s
2002 IGR 3.10% 2.30% 2.00% 1.90%
2007 IGR 3.00% 2.60% 2.30% 2.20% 2.00%
2009-10 2014-15 2019-20 2024-25 2029-30 2034-35 2039-40 2044-45 2049-50 2054-55
2010 IGR 1.60% 4.00% 2.70% 2.60% 2.50% 2.30%
2015 IGR 2.50% 2.80% 2.80% 2.60% 2.30%
Source: IGR 2003, 2007, 2010 and 2015.
Interpolating the projected growth and applying it to the extant estimate of GDP allows the size of the economy to be projected forward. This is done in Figure 3.8, which shows substantially divergent projections from 2003 to 2015. Note that the principle driver of the differences is the assumed rates of growth rather than the value of GDP at the starting points. The authors of the IGR are well aware of the sensitivity of their projections, and they appropriately highlight the uncertainties. But they cannot be wished away. Productivity growth, in particular, is poorly understood and difficult to anticipate. For a defence planner
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trying to put together a plan for development of the ADF, the inherent uncertainty in medium- to long-term economic growth makes a GDP-based funding model problematic.
Consider the substantial differences in the aggregate funding available for the decade commencing 2023-24 (when the government has promised 2% of GDP), see Figure 3.9.
Figure 3.8: IGR long-term projections for GDP
Figure 3.9: 2% of GDP as projected by successive IGR
With a substantial boost to defence funding delivered by each IGR, perhaps Defence is happy to take its chances with a GDP-based funding model. If so, they are brave souls. Not only is the Australian economy undergoing a structural change to a new regime where higher productivity jobs may be hard to find, but there is a body of economic opinion arguing that the waves of productivity-boosting technological development of the 20th century are unlikely to be repeated in the medium term at least.
0 1 2 3 4 5 6
GDP 2014-15 $ (trillion)
2015 IGR 2010 IGR 2007 IGR 2002 IGR
0.0 0.1 0.2 0.3 0.4 0.5 0.6
IGR 2003 IGR 2007 IGR 2010 IGR 2015
2014-15 $ (trillion)
$98 billion (-20%)
2% GDP 2%GDP 2% GDP 2% GDP
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With a White Paper nearing completion, it’s natural to ask how large the uncertainties are for nominal GDP out into the next decade. In this year’s Budget Papers, the Treasury provided confidence intervals around its nominal GDP forecasts out to 2016-17 using 2013-14 as the most recent measured base-year; see Table 3.8 where the 70% confidence intervals are given. Note that the confidence intervals come from historical forecasting performance rather than economic modelling. In any case, the uncertainties are appreciable.
Table 3.8: Treasury forecasts for nominal GDP growth
Lower 70% Central Upper 70%
Average annualised growth 2013-14 to 2014-15 0.65% 1.55% 2.35%
Average annualised growth 2013-14 to 2015-16 1.05% 2.29% 3.64%
Average annualised growth 2013-14 to 2016-17 1.64% 3.24% 4.93%
Source: 2015-16 Budget Paper 1, Chart 4 page 7-7.
Nominal verses real GDP
Even if real GDP growth matches central projections, it does not guarantee that Defence will not be disadvantaged by economic externalities. Under a GDP-based funding regime, Defence funding will rise and fall in tandem with nominal rather than real GDP. In general, the prices faced by Defence from its domestic suppliers and labour force (reasonably approximated by the Consumer Price Index) move at a different rate from the prices of the goods and services that make up Australia’s GDP (as measured by the Implicit GDP Chain Price Index)—especially the prices received for commodity exports. Over the past decade, the two indices have rarely moved in step, Figure 3.10.
Figure 3.10: Prices and product
Source: ABS 5204.0 and ABS 6401.0
As a result, for a given share of GDP, Defence can either be advantaged or disadvantaged by the relative movements of the two indices. Note that during the 2000s, Defence funding was indexed relative to the non-farm GDP deflator which delivered a $1 billion plus windfall gain to defence on one occasion.
0%
1%
2%
3%
4%
5%
6%
7%
Implict GDP Chain Price Index Consumer Price Index
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Even if the vagaries of economic growth and price indices can be managed, it remains to be seen how a GDP based funding regime will accommodate the substantial exposure of defence expenditure to foreign exchange movements.
Foreign exchange
Since 2000, the exchange rate between the Australian and US dollar has ranged from 1 A$ = 0.5 US$ (2001) to 1 A$ = 1.10 US$ (2011). This can have a substantial impact on the buying power of any fixed level of defence expenditure. For example, in 2013-14, more than 70% of defence acquisitions by cost came from foreign sources, along with 41.6% of materiel sustainment spending. Assuming these proportions apply to the defence budget in 2023-24 as indicatively structured in Figure 3.6, the effective buying power of 2% of GDP can be estimated assuming that all foreign spending goes to the United States (unrealistic in practice but adequate for demonstrating the sensitivity). Figure 3.11 shows the result.
Figure 3.11: Effective buying power of 2% of GDP in 2023-24 at various exchange rates
This is not a hypothetical issue. When the now Prime Minister promised 2% of GDP for defence on August 25 2013, the Australian dollar was worth 0.90 US$. At the time of writing, it was worth 0.80 US$ (and RBA would like to push it down further). The difference in buying power using the model described above is a fall of 5%. Thus, without any decision being taken by the government, promised defence funding has fallen substantially.
What happens if we maintain defence spending at 2% of GDP?
If it was decided to fix defence funding at 2% of GDP for a period of time, additional problems will arise. Defence costs tend to exceed inflation. Specifically, the unit cost of maintaining and crewing an up-to-date military capability exceeds inflation by 2% to 3% each year. Thus, for a static defence force to be sustainable on a fixed share of GDP, nominal GDP growth needs to exceed inflation plus 2% to 3%. As Table 3.7 shows, real GDP growth is projected to fall below the upper end of the range in the coming decades. To complicate matters further, as Figure 3.10 makes clear, there is no guarantee that the GDP-deflator and CPI will move in tandem, which could either exacerbate the problem or compensate for it.
0 10 20 30 40 50 60
0.50 0.55 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00 1.05 1.10
Effective buying power 2015-16 $ billion
US$ - A$ exchange rate
$12.9 billion (-27%)
Base: A$1 = 0.80 US$
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If the 2015 White Paper sets out a significant expansion of the ADF—which appears likely—a fixed share of GDP may not be adequate for more than a short period of time. In that sense, a commitment to 2% of GDP in 2023-24 may mean having to exceed 2% of GDP
subsequently. The possible exception would be if there was a temporary boost to capital spending which declined at the same rate as the additional personnel and operating costs grew. Such a strategy might be workable for a decade or so, but we would have to be fortuitously lucky.
Notwithstanding these serious problems, Treasury’s 2015 IGR observes that the 2% GDP target for defence spending ‘enables defence expenditure to reflect changes in national income without representing a significant change in policy.’ Setting aside the technical point that GDP is not the same thing as income (that’s why the ABS tracks Gross National Income), fluctuations in defence spending on the scales examined here most definitely have the same impact as significant changes in policy.
Making 2% of GDP workable
If we must have a GDP-based funding regime, a funding model needs to be formulated to support coherent long-term defence planning and prevent disruptive near-term fluctuations.
Clearly, any model that explicitly ties defence funding to a share of GDP year-after-year will be problematic—it would be neither robust against the impact of foreign exchange nor immune to buffeting by the business cycle. Moreover, it may not be adequate to sustain an expanding or expanded defence force in the medium to long term.
A workable GDP-based funding regime could be constructed as follows:
• Defence funding should be based on a rolling 10-year funding envelope:
o anticipating wage and domestic price inflation
o updated completely every 4-5 years via a White Paper
o extended by anticipated GDP growth in the final year between White Papers.
• The 2% of GDP figure should employed as a benchmark during the White Paper process rather than a mechanical driver of year-on-year defence expenditure.
• Each year, the 10-year funding envelope should be adjusted to maintain its buying power against price and exchange movements as follows:
o foreign exchange movements for foreign spending
o Consumer Price Index (CPI) for non-fuel domestic spending.
A more complex basket of deflators could be employed for indexation, but because the annual adjustments are just that, adjustments, CPI is a workable surrogate for near-term domestic price and wage movements. Naturally, Defence should continue to receive full supplementation for the next additional cost of deployments.
Of course, this is a second best option compared with jettisoning the 2% promise in favour of a regime that balances the strategic risks Australia faces against the opportunity costs that defence spending imposes on society.
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