Special issue: defence inflation

Introduction

Defence inflation is a recurring factor in determining defence spending. It is widely reported in official government publications and in the trade press, but remains relatively neglected by defence and peace economists. There is a need for more in-depth economic analysis and critical evaluation.

Consider the theoretical and empirical issues associated with defence inflation. What is defence inflation; does it affect all countries; how large is it compared with general economy-wide measures of inflation; what are its effects; why does it occur; how, if at all, can it be controlled; and what are the costs of regulation? These questions are explored in this special issue.

Defence inflation affects the prices of all factor inputs into money defence spending. These include military and civilian personnel; equipment including spares; buildings; land; and all other inputs purchased by national Defence Ministries. Aggregate defence spending is measured initially in money terms but these money values need to be corrected for price changes to determine the real level of defence spending which is a more reliable indicator of the buying power of money defence expenditure. Such adjustment requires that defence spending in current prices needs to be adjusted to a constant price basis which provides a more reliable indicator of time trends in a nation’s real levels of defence spending. But adjusting money defence spending to real levels requires an appropriate price deflator. Typically, in making such adjustments, nations use some widely accepted macroeconomic indicator such as the GDP deflator or consumer price index. However, where such adjustments are based on a price deflator which fails to reflect actual rates of defence inflation there can be effects on the real buying power of a defence budget reflected in the size and effectiveness of a nation’s military forces (e.g. a smaller army, navy and/or air force using older equipment). This raises a fundamental problem for measuring defence inflation, namely, the absence of an accurate measure of defence output and the associated productivity changes: what is defence output and how is it valued? Typically, defence inflation measures inflation in defence inputs purchased by the national Defence Ministry without allowing for improvements in productivity and efficiency (e.g. the performance of combat aircraft in 2015 compared with 1940).

Defence inflation contributes to the rising costs of equipment (capital) and personnel (labour) inputs into the defence production process. Any resulting changes in relative factor prices will lead to substitution effects encouraging the substitution of relatively cheaper for more expensive inputs some of which might lead to changes in the relative size of each of the armed forces. Cost increases affecting equipment projects will also lead to further trade-offs in the form of slippages in delivery dates and reduced numbers purchased.

Definitions, Aim and Scope

A distinction is needed between defence inflation and cost escalation, which reflects rising real unit cost between successive generations of new equipment (e.g. US F-16 to F-22 aircraft). Cost escalation usually reflects new technology and new equipment features between generations of new equipment. For example, a 2016 jet combat aircraft flies faster, further, higher and carries more accurate weapons than its 1914 propeller-driven equivalent. Nonetheless, defence inflation contributes to cost escalation in money terms and can affect real terms cost escalation where price adjustments based on the national price deflator do not reflect the actual measure of defence inflation.

The term ‘intergenerational cost growth/escalation (ICE)’ is also used often to describe cost escalation. ICE measures the change in cost between one platform and the next generation of a similar platform of military equipment. A certain amount of performance or capability improvements are expected in the next generation, but the impact on the unit cost is not explicitly measured.

Recent articles on ICE point to the notion of tournament goods (Chalmers 2009; Kirkpatrick 2003, 2008) in order to contextualize the rising unit costs in military goods in relative terms to that of an adversary. Here, it has been argued that one should not adjust for quality changes from one generation to the other since the new generation equipment provides ‘the same military capability against an enhanced threat’ (Kirkpatrick 2008). Such quality adjustments in defence specific indices are cogently discussed in Horowitz, Harmon, and Levine (2015) and Hove and Lillekvelland (2015) in this issue.

The causes of defence inflation need to be identified and evaluated as well. A starting point might be any distinctive features of defence markets. These include the importance of government as a monopsony or major buyer and the ability of government to determine the ownership, structure, conduct and performance of its national defence industry. Government also procures complex high-technology defence equipment from an industry which is often dominated by monopoly or oligopoly. Such procurements require costly inputs of highly skilled labour and associated physical capital inputs and are usually based on non-competitive and cost-based contracts which provide the financial framework for defence inflation and cost escalation.

Arena et al. (2008) classify the causes defence inflation as either economy or customer driven. Since most defence suppliers procure inputs from the wider economy, inflation in the wider economy significantly affects sector (defence) specific inflation. The other main driver is the customer or specifically defence ministries. Defence ministries have been asking for and receiving complex military equipment to satisfy both external (perceived) threats and multiple national objectives such as industrial development policies.

Organization

This special issue aims to provide a more current and multi-country assessment of defence inflation. It covers contributions from diverse nations in both size and scope including Norway, Sweden, the United Kingdom (UK) and the United States (US). Key aspects of the inflation debate are covered in this special issue ranging from country specific experiences (Hartley 2015; Keating and Arena 2015; Nordlund 2015) to technical issues such as quality adjustment and price indexing (Horowitz, Harmon, and Levine 2015; Hove and Lillekvelland 2015).

The special issue begins with Hartley’s (2015) article which provides an institutional and public choice assessment of defence inflation. The causes of defence inflation and cost escalation are addressed with a focus on the distinctive features of defence markets and the role of contracts in financing inflation and escalation. Comparisons are made with US experience with cost escalation. The UK paper concludes by outlining and evaluating possible solutions to both defence inflation and cost escalation. These include efforts to restrict defence inflation to the general level of inflation in the UK economy (GDP deflator) and to remove ‘optimism bias’ and gaming behaviour leading to cost escalation. Despite these policy reforms, both defence inflation and cost escalation remain features of UK defence procurement.

The article by Keating and Arena (2015) is a cogent survey of the US experience with special emphasis on the customer-driven inflation and its consequences. The authors review the evidence for cost growth above economy-wide inflation for both acquisition and maintenance phases of the life cycle of military equipment. Significantly, the findings for the maintenance stage of military equipment indicate an absence of correlation between its age and maintenance cost (average annual real rate of growth) after adjusting for usage. Various explanations are provided including resource-induced inflation: increased funding leading to choices requiring more complex, better maintained systems.

Significant ICE is observed for Sweden in Nordlund’s (2015) article especially when compared to recent international studies. The paper provides a detailed description of the Swedish defence inflation index and the associated economic and political consequences. The article also tackles a number of theoretical and practical challenges associated with the measurement of military personnel productivity. Like the Hartley article, Nordlund also discusses the impact of process improvements and contracting on defence cost reductions.

While the Swedish article briefly presents the concept of tournament goods to describe the rising unit cost in military equipment, the article by Hove and Lillekvelland (2015) devotes a section to discuss relative effects and how the need to counter new investment by adversaries can lead to a technology race with significant impacts on ICE. Hove and Lillekvelland also provide a more nuanced discussion on ICE by articulating the difference between inter- and intra-generational cost escalation. Based primarily on publicly available Norwegian data, Hove and Lillekvelland also provide a means to adjust for observable quality and production parameters.

The last paper in this special issue, by Horowitz, Harmon, and Levine (2015), extends the discussion on quality adjustment by demonstrating an alternative hedonic approach for calculating price indexes. Specifically, the article uses regression analysis to relate aircraft investment cost to the aircraft’s specific physical and operational design features, such as weight and speed. This article, based on US experience and aircraft procurement in particular, makes contribution to the literature by examining the source of the wide differences in aircraft cost growth rates calculated by the Gross Domestic Product deflator, the Producer Price Index for civilian aircraft and the National Defense Index.

Concluding Remarks

While most industry and trade press devote considerable ink and space to the discussion of defence inflation and its consequential impact on the purchasing dollars of the armed forces, economists have been relatively silent. This special issue aims to rectify this oversight through a multi-national survey and analysis of the topic. The five papers presented include both theoretical and empirical methods and point to potential country-specific factors and challenges.

The articles share a number of noteworthy commonalities. First, each article provides a consistent definition of defence inflation and cost escalation. The consistent taxonomy should prove a catalyst for motivating more theoretical and empirical examination of this important topic. Second, data on select military platforms are used to conduct an assessment of inter-generational cost escalation. Given the paucity of data on diverse military equipment costs, the data presented in the special issue are a welcome and needed addition. Finally, the diversity of the nations included in the study point to the validity and relevance of defence inflation irrespective of military or economic size. The rigorous analyses included in these articles should inform important resource allocation decisions in this fiscally and geo strategically uncertain environment.

Disclosure statement

No potential conflict of interest was reported by the authors.