Global Determinants of Defense Reform: Economic Liberalization Robert Looney Professor, National Security Affairs Naval Postgraduate School Conference on Global Determinants of Defense Reform at the Naval Postgraduate School Monterey, California, September 9-10, 2005

Outline Main Issues – Economic Liberalization, and Defense Expenditures. Policies of International Financial Institutions -- Neoliberalism in the period. Operational Measures of Economic Liberalization. Economic Liberalization and Defense Expenditures – General Patterns. Contrasting Environments of Economic Liberalization, Institutions, and Defense Expenditures – Resulting Patterns of Defense Expenditures and Economic Growth. Implications for Defense Reform.

Main Issues: Effectiveness of Security Expenditures Every society must choose between direct productive allocation of its resources and reservation of some of those resources to protection of that production. From this perspective, resources allocated to defense or to security are themselves no less potentially productive than resources allocated to direct economic activities. Defending persons and property, however, has its dark side. Powers of enforcement, coercion and punishment are vested in individuals and institutions. Will these be effective in their task, contributing to growth and development, or will they be corrupt, inefficient and thus detrimental to economic activity?

Main Issues (contd.) A complicating factor has been the post-cold war ascendancy of neo-liberal free market economic policies and associated expansion in globalization. In theory, both should be conducive to improved growth and development. However, each has tended to place pressure on “unproductive” expenditures. In many instances this has been translated into declining security budgets, especially in situations where macroeconomic instability exists. In many cases the resulting reduction in security expenditures has created a vicious circle of increased violence, instability and further macroeconomic instability. It is becoming increasingly clear that more knowledge is needed to assess the broader impact of security expenditures. Specifically, in which situations are productive aspects of security expenditures likely to prevail over the unproductive? Does economic liberalization tend to increase or decrease the effectiveness of security expenditures?

Trilemmas, Economic Integration, Liberalization and Defense Expenditures

IMF, The World Bank and the “Washington Consensus” Adoption of the “Washington Consensus” in the Late 1980s. Shift from Failed State-Led Development Strategies of the 1960s and 1970s to Market Led Development. Fiscal Discipline – Limit Budget Deficits. Macroeconomic Stability Key Objective of Policy Public Expenditure Priorities – Redirect Expenditure Toward Human Capital and Infrastructure. Tax Reform – Broaden Tax Base and Cut Marginal Tax Rates.

Washington Consensus (contd.). Financial Liberalization – Abolish Interest Rate Controls. Exchange Rates – Introduce Unified and Competitive Exchange Rate. Trade Liberalization – Replace Quantitative Restrictions by Tariffs then Reduce Tariffs Over Time. IMF and World Bank Empirical Studies Suggested Defense Expenditures Have Negative Impact on Macroeconomic Stability and Economic Growth. In this framework defense expenditures viewed as unproductive and a threat to macroeconomic stability. Concern over “excessive” defense expenditures.

Measures of Economic Liberalization – Fraser Institute Equates Economic Liberalization With Economic Freedom: Personal Choice, Voluntary Exchange, Freedom to Compete and Protection of Person and Property: Size of Government: Expenditures Taxes and Enterprises. Legal Structure and Security of Property Rights. Access to Sound Money. Freedom to Exchange With Foreigners Regulation of Credit, Labor and Business.

Measures of Economic Liberalization: Wall Street Journal, Heritage Foundation Focus on the Relative Progress Made by Countries in Moving to a Deregulated, Limited Government Free Market Environment: Trade Policy. Fiscal Burden of Government. Government Intervention in the Economy. Monetary Policy. Banking and Finance.

Economic Liberalization: Wall Street Journal/Heritage Foundation (contd.) Measures of Economic Freedom (contd.): Capital Flows and Foreign Investment. Wages and Prices. Property Rights. Regulation. Informal Markets.

World Bank Governance Indicators Key Dimensions of Governance: Voice and Accountability – Extent to Which Citizens Able to Participate in the Selection of Governments. Political Stability and Absence of Violence. Government Effectiveness – Competence of Civil Servants – Credibility of Government’s Commitment to Policies. Rule of Law. Control of Corruption.

Economic Liberalization, Governance and Defense Expenditures Environments and The Economic Effectiveness of Defense Expenditures – Main Issues: Previous Studies Have Found Positive Links Between Defense and the Economy in Resource Unconstrained Environments and Negative Links in Resource Constrained Countries – Do Similar Patterns Apply to the Relative level of Economic Liberalization/Governance Reform? To What Extent Do Economic Environments Control the Level of Defense Expenditures? How Do These Environments Influence the Economic Effectiveness of Defense Expenditures? What types of Economic Liberalization/Governance are Most Significant in This Regard.

Differences: High/Low Defense Expenditure Countries Key Differences Countries Above/Below Mean for Defense as a Share of GDP: Foreign Direct Investment – Much Higher in Low Defense Countries. Low Defense Countries Better Macroeconomic Aggregates – Lower Government Consumption – Higher Savings Rates, but Similar Investment Rates. Low Defense Countries Had Higher Rates of Growth – Late 1990s and Early 2000s.

Differences: High/Low Defense Expenditure Countries (contd.) Wall Street Journal/Heritage Economic Freedom Index – Low Defense Countries Score Consistently Higher. Only Area High Defense Countries Higher is in Fiscal Burden. Frasier Index – Low Defense Countries Superior Progresses Except in Access to Sound Money. Main Areas of Difference are in Governance – Low Defense Countries Score Much Higher in All Categories, Especially in Voice and Accountability – Gap Widened from 1990s. Regression of Defense Burden on Economic Liberalization – Statistically Significant Variables: Voice and Accountability, Fraser Summary Economic Freedom Index, Fraser Legal Structure Index and World Bank Rule of Law Index – Explain 43% Variance in Defense Burden.

Economic Impact: High/Low Defense Countries -- Model Model: GDPYPG = F(GFCY, AIDPER, GFDIY, GCNPY, MILXY) ? GDPYPG = Growth Per Capita Income. GFCY = Gross Capital Formation Share of GDP MILXY = Defense Expenditures Share GDP GFDIY = Gross Foreign Direct Investment Share of GDP GCNPY = General Government Consumption Share of GDP.

Economic Impact: High/Low Defense Countries -- Results Main Results (Statistically Significant): Total Sample GDPYG = (+)GFCY (–) MILXY (consistent with IMF/World Bank View) High Military Expenditure Countries GDPYG = (-) MILXY Low Military Expenditure Countries GDPYG = (+)GFCY

Interpretation of Results Previous Research Has Shown That Defense Expenditures: Have Both Positive and Negative Effects on The Economy. The Environment in Which They Occur Dictates Which Will Predominate. High Defense Countries Lagged the Low Defense Countries More in Economic Liberalization and Governance Than in Basic Macroeconomic Aggregates. For the High Defense Countries Positive Linkages Associated With Defense Expenditures May be Suppressed by the Their Relatively Low Levels of Governance and Economic Liberalization.

Economic Liberalization and Defense Expenditures--Linkages With High and Low Defense Countries Now Defined With Regard to their Position Above and Below A Regression Equation of Defense on Economic Liberalization and Governance Indices -- Hypothesis: Countries Where Key Economic Liberalization and Governance Indicators Are High Relative to Defense Expenditures Should Have Positive Economic Effects from Increased Military Expenditures. Those Countries Who Have High Defense Expenditures Relative to Economic and Governance Reforms Should Have Negative or Neutral Linkages Between Military Expenditures and the Economy.

Country Groupings: Main Differences Defense Burden (Defense Share of GDP): Old %(H) vs. 1.49%(L) New – 3.19%(H) vs. 1.67%(L) Growth in Per Capita GDP Old –2.32%(L) vs. 1.88%(H) New 1.94%(H) vs. 1.76%(L). Economic Liberalization/Governance Old -- Low Consistently Better New – Nearly Balanced With Each Group Superior in Some Areas.

New Country Groupings Trends in Defense Burdens

New Country Groupings: Patterns of Growth

New Country Groupings: Comparisons of Capital Formation

Economic Impact: New Groupings High/Low Defense Countries -- Results Main Results (Statistically Significant): Relatively High Military Expenditure Countries GDPYG = (+) GCFY Relatively Low Military Expenditure Countries GDPYG = (+)GFCY (+) MILXY

Summary: Economic Liberalization, Governance and Defense Impact

Implications For Defense Reform World Bank, IMF View Of Defense Expenditures Implicitly Assumes Negative Links With Economy--Biased Towards Arbitrary Budgetary Cuts in Defense Often Neglecting Security Considerations. The Trilemma Between Institutions, Nation State and Globalization May Not be As Binding as Commonly Believed. There May Be a Variety of Alternative Approaches to Economic Growth and Globalization Consistent with Good Economic Performance and Productive Defense Expenditures. Results Here Suggest A Constructive Approach is Possible -- Letting Countries Define Their Security Needs While The IMF/World Bank Can Push for Complementary Economic/Governance Reforms.

Implications For Defense Reform (contd.) Specifically: Rather Than Considering Defense Expenditures as Excessive or Not Based on Their Absolute Amounts or Share of GDP, Defense Expenditures Should be Assessed in their Economic and Institutional Settings. Within this Context Economic Strategies Should be Designed in Conjunction Improvements in Key Areas of Governance and Economic Reform To Reinforce the Positive Linkages of Defense Expenditures With the Economy. Selective Economic Liberalization and Improved Governance in Key Areas Rather Than Across the Board Efforts May Be Sufficient for This Purpose. The Key is to Coordinate Economic Liberalization and Governance Reforms in the Civilian Sector With the Requirements of Improved Security in the Defense Sector.