Economic benefits of reducing military expenditure.

Recent changes in the world political situation, particularly with respect to the former Soviet Union, have had profound effects on the global economy. One area where this is particularly true is military expenditure. The World Economic Outlook has recently started to collect data on such expenditure,

which indicate that military spending relative to output has fallen by almost one quarter between 1986 and 1992. Furthermore, this fall has been very generalized, involving almost all regions of the world. After a preliminary note about data on military expenditure, the first part of this annex discusses past trends and staff projections.

The second part of the annex uses MULTIMOD, the IMF's world macroeconometric

model, to illustrate the economic impact of military expenditure, looking at both the short-term impact on activity and the longer-run economic welfare benefits that accrue from lower military spending. Although the primary impact of military expenditure is on national security rather than on the economy, this annex focuses only on the economic impact.(1) A change in the allocation of resources to the military has important indirect economic effects, and identifying the economic consequences provides an important input for overall policy decision making.

There are many factors--such as the impact of changing the composition of government spending--that are not considered in the relatively simple macroeconomic approach adopted here. Nevertheless, the results provide several insights into the economic effects of reductions in military expenditure, as well as an illustration of the potential economic welfare gains. Cutting military spending by 20 percent worldwide could produce a long-run increase in private consumption and in investment of around 1 percent and 2 percent, respectively. These gains, in turn, produce the major share of the rise in economic welfare, which is estimated to have a present value of almost $10 trillion in 1992 dollars (around 45 percent of 1992 world GDP). Those countries that implement the largest cuts have the largest long-term gains in consumption and investment, as well as the largest short-term losses in output. Relative to the size of the spending cuts, net debtor developing countries gain somewhat more than industrial countries, since the benefits from lower world interest rates and increased demand for their exports are larger. Among the developing country regions analyzed below, Africa has the largest economic welfare gains.

An important implication of this analysis is that military expenditure cuts in any one country produce significant positive externalities for the rest of the world, both through lower interest rates and changes in real exchange rates. As a result, the distribution of the economic benefits is considerably more even than the distribution of the cuts. This implies that there are economic, as well as security, reasons for coordinating military expenditure cutbacks.

Trends and Prospects

Since the mid-1980s, the proportion of output that is estimated to have been devoted to military spending has fallen by almost one-fourth, from nearly 4 percent in 1986 to around 3 percent in 1992.(2) As a result, total world military expenditure amounted to $661 billion in 1992, compared with $832 billion if the total had been the same size relative to GDP as it was in 1986. This reduction in military spending has been very general, with almost all regions having significantly decreased their ratio of military expenditure to GDP.(3)

In the industrial countries, part of this fall in the ratio of military expenditure to GDP reflects a reversal of the buildup of military spending in the early half of the 1980s. This trend is particularly true of the United States, which accounts for over half of all industrial country military expenditure, reflecting both its economic size and that it has the highest ratio of military spending to GDP among the major industrial countries. By contrast, the second-largest economy in the world, Japan, has the lowest ratio of military spending to GDP and has shown little change in the ratio of military spending to GDP since 1980. The EC and other industrial country groups, which represent something of a midpoint between these two extremes in terms of percent of output devoted to military spending, had little or no military buildup in the first half of the 1980s but nevertheless show a significant downsizing in the period since 1986.

Developing countries and countries in transition show a pattern similar to that of the EC and other industrial countries: little change in military expenditure as a ratio to output in the early 1980s, followed by a significant fall. The World Economic Outlook estimates imply that military expenditure, which is estimated to have amounted to $110 billion in developing countries in 1992, would have been $144 billion if their share in relation to GDP had remained at its 1986 level. Other estimates indicate higher levels of military expenditure for developing countries, although the general trends are similar.(4) As mentioned earlier, such differences underline the uncertainties inherent in any empirical analysis of military spending.

There are significant differences in the proportion of output devoted to defense among different developing country regions. At 7 1/4 percent of GDP in 1992, the Middle East and Europe region is estimated to have had by far the highest ratio of military spending to output among developing countries, followed by the countries in transition, where military spending amounted to 3 3/4 percent of TABULAR DATA OMITTED GDP.(5) At the opposite end of the spectrum, the Western Hemisphere region had a ratio of military spending to GDP of only 1 percent; Asia and Africa were both below the world average, with ratios of around 2 1/4 percent. The spending of small low-income economies (4 percent of GDP) was significantly higher than the average for developing countries and for the world as a whole.

There are also significant differences in the ratio of military spending to output within these regions. These differences are most pronounced in Africa, where countries such as Ghana, Mauritius, and Nigeria have military spending ratios below 1 percent of GDP, but several other countries are estimated to spend more than 4 percent of GDP on the military. Cross-country differences in military spending are also important in Asia, where several countries have military spending ratios of below 1 1/2 percent of GDP. There is more uniformity in military spending in the Middle East and Europe region, where only a few countries have ratios much below or above the average. The intraregional differences in military spending are least pronounced in the Western Hemisphere.

Despite the diversity in spending, the fall in the ratio of military spending to output has been relatively general across developing countries, with significant declines in Africa, Asia, and the Middle East and Europe. Several factors may have contributed to the cutback in military spending since 1986.(6) Financial factors are found to have a significant impact on military spending, making it likely that the poor growth performance in many developing countries during the 1980s and in industrial countries in the latter part of the decade contributed to the fall in the ratio of military spending to output. The type of government in power was also found to be a major influence on military expenditures, implying that the profound political changes that have occurred in many countries may be another factor in the fall in military spending. Future moves toward more democratic forms of government in developing countries could have a further restraining effect on military spending, since democratic regimes were found to spend the least on the military. Finally, the improved global security environment, and the associated fall in the level of military aid, contributed to the decline in military spending.

The projections indicate that world military expenditure relative to GDP will continue on the downward trend started in the mid-1980s. In the industrial countries, the military spending ratio is projected to fall a further 30 percent between 1992 and 1998. The reduction is particularly large in the United States, where the ratio of military spending to output is expected to fall by 40 percent, but large declines are also projected for the EC and other industrial country groups. The projections for developing countries indicate that the proportion of output devoted to military spending will also fall, although by less than in the industrial countries. As with the decline between 1986 and 1992, it is projected to be very general across geographic regions. The region with the largest decline in military spending relative to GDP is the Middle East and Europe. Small, low-income economies are projected to decrease their military spending ratio by a percentage similar to that of developing countries as a whole.

Economic Impact of Cuts in Military Expenditure

The IMF's multiregional macroeconometric model, MULTIMOD, has been used to simulate the economic impact of worldwide military spending cuts.(7) The main links among the industrial and developing countries in MULTIMOD are through trade, exchange rates, and interest rates.(8) Three features of the model are particularly important for the results. It is a rational expectations model, which means that expectations about future behavior feed back into exchange rates, interest rates, consumption, and investment. It has a well-defined supply side that is based on a production function, so that changes in investment feed through into future potential output. Finally, the trade equations take account of the geographic distribution of trade across different economies.(9)

At the same time, the limitations of the highly aggregated MULTIMOD framework should be recognized. It combines all government spending and thus limits the extent to which the model can deal with issues related to the conversion from military to civilian production. The model assumes that prices are sticky in the short run, which implies that reductions in military spending lead to temporary reductions in output and employment. However, any estimate of these adjustment costs is inherently uncertain and depends on many factors (such as the timing of the military spending cuts, the macroeconomic policy response, and the size of the government fiscal multipliers).(10) In addition, no analysis is made of the distributional consequences of lower military spending for different sectors or regions of a country, an issue of economic as well as political significance. Finally, the aggregate production functions take no account of the fact that some capital currently used in the production of military output may not be convertible to civilian production.(11)

Before discussing the simulation results, it is important to consider the nature of the economic costs and benefits from cutting military spending.(12) Although real GDP is a useful indicator of the short-run impact of military spending cuts on activity and unemployment, it is not a good measure of the economic benefits of military spending cuts. The appropriate measure of the economic benefits from curtailing military spending is the rise in nonmilitary consumption over time. The total cost of a cut in military spending includes any decrease in security induced by lower military spending; however, this security loss is difficult--or impossible--to measure, particularly for the type of coordinated military spending cuts considered in these simulations. For this reason the analysis focuses on the economic benefits from military spending cuts, while acknowledging that these benefits should be weighed against any impact on national security.

All countries are assumed to simultaneously carry out a 20 percent reduction in military expenditures in equal increments over five years, a reduction broadly comparable to the decline already incorporated in the medium-term projections. Each nation is also assumed to lower its military aid, military imports, and military exports by the same amount, so that the cut can be thought of as a phased reduction in all types of military spending. To illustrate the benefits of military downsizing for a given fiscal policy, the cuts in government consumption were assumed to be accompanied by tax cuts of a sufficient magnitude so as to leave the government deficit unchanged. The monetary base was assumed to remain the same as in the baseline in most industrial countries. The results from a basic simulation are discussed in detail below. The impact of alternative assumptions--such as implementing the spending cuts immediately rather than gradually, or assuming that part of the spending cuts represents a fall in investment rather than consumption--is also discussed.

Like any reduction in government spending, the initial impact of the cut in military spending on the industrial countries(13) is to reduce the rate of growth of GDP. The short-term fall in aggregate demand reflects the reduction in government spending, which outweighs the higher demand associated with the tax cuts. Lower government spending, however, leads to lower interest rates and allows governments to decrease taxes. Lower taxes and reduced interest rates raise private sector spending on investment and consumption, which reverses the initial decline in output, and GDP rises significantly above the baseline in the medium term and long run.

First-year military spending cuts of $27 billion reduce GDP by $6 billion in the simulation, reflecting an increase in private consumption and private investment of $4 billion and $17 billion, respectively.(14) The relatively small initial output loss reflects TABULAR DATA OMITTED the gradual nature of the military spending cuts. Given that agents are forward looking, private sector expenditures are stimulated both by current reductions in government spending and by anticipated future reductions, which lower future taxes and interest rates, thereby raising current wealth. Because the cuts are phased in over several years, the short-run stimulus is relatively large in comparison with the initial expenditure cuts, and the short-term losses to GDP are correspondingly smaller.(15)

By the second year of the simulation, the output loss is reversed as private spending continues to grow, and by the sixth year of the simulation, when the decreases in military spending have ceased, the economic performance of the industrial countries is considerably improved. By the end of the eleventh year, GDP, consumption, and investment are $60 billion (0.3 percent), $144 billion (1 percent), and $83 billion (almost 2 percent) above baseline, respectively, and military spending is $170 billion lower. The present value of the gain in economic welfare (using a 4 percent discount rate) is estimated to sum to $8.1 trillion, or 45 percent of 1992 GDP, compared with military spending cuts with a present value of $6.5 trillion, or 36 percent of 1992 GDP.(16)

Results are also shown separately for the United States and Japan. During 1987-89 (the baseline period for the simulations), military spending in the United States represented 6 percent of GDP, the largest ratio in the industrial countries.(17) As might be expected, the short-term impact of this relatively large cut in military spending--1 1/4 percent of GDP after five years--is to reduce GDP below the baseline for several years. These losses in output are, however, relatively small; over the first five years the cumulative loss in real GDP is some $7 billion (less than 0.03 percent of GDP) compared with cumulative expenditure cuts of almost $250 billion. After eleven years, private consumption and private investment rise by 1 1/4 percent and 2 percent respectively--somewhat higher than in the industrial countries as a group.

In Japan, military expenditures represent approximately 1 percent of GDP, the smallest ratio among the major industrial countries. Because of Japan's relatively low military expenditures in proportion to GDP, two very different results occur. First, the initial fall in output is short lived and mild in comparison with that in the United States; by the second year, real GDP is already above the baseline and continues to increase thereafter. Second, the long-run gains relative to GDP are somewhat smaller in Japan than in the United States. By the eleventh year, real consumption and real investment rise by 1/2 of 1 percent and 1 1/4 percent respectively.

Although the gains in Japan are smaller than in the United States, the difference is smaller than might be expected given the difference in military spending. The reason for these relatively favorable effects in Japan is that global cuts in military spending create a positive international economic externality: the economic benefits to all countries are greater in the case of a coordinated reduction in military expenditure than in the case of a unilateral reduction. The externality results from lower world interest rates and from increased volumes of international trade caused by the fact that military spending has a lower trade component than the private sector spending that replaces it. Therefore, cross-country differences in welfare gains are smaller than the differences in the underlying cuts.

The welfare calculations illustrate this point. At $3 1/2 trillion, the present value of the gain in economic welfare in the United States is 54 percent of 1992 GDP, a significantly higher ratio to output than the 31 percent of GDP ($1 1/4 trillion) of Japan. However, these differences are considerably smaller than the differential in military spending cuts. The United States experiences military spending cuts with a present value of 60 percent of 1992 GDP, whereas those in Japan total only 10 percent of 1992 GDP.

The impact of this externality can also be seen in the results for net debtor developing countries (excluding the NIEs). For this group, the simulation indicates that the response of private consumption and investment is strong enough to offset the contraction in government consumption, so that GDP does not fall even in the short run. As with industrial countries, however, the short-run effects on output and spending are mostly small. The effects are more strongly felt in the medium term; government consumption shows a sharp decrease over this period, and private consumption and investment, along with GDP, show a sharp increase. The eventual increase in GDP, eleven years after the cut in military expenditures, is $12 billion (1/4 of 1 percent), whereas private consumption and investment are higher by $23 billion (3/4 of 1 percent) and $18.6 billion (2 percent), respectively.

The present value of the welfare gain is 46 percent of 1992 GDP ($1 1/2 trillion). As a ratio to GDP, these gains are marginally higher than those for the industrial countries, compared with military spending cuts having a present value of 33 percent of 1992 GDP (slightly lower than in the industrial countries). These effects reflect several factors. Lower government spending abroad reduces world interest rates and hence reduces interest payments on foreign debt, whereas the replacement of military spending (which is largely on domestic goods and services) with more import-intensive private consumption and investment boosts world trade and raises commodity prices. These international factors tend to improve the external position of the developing countries, allowing them to invest more.(18)

The results for individual developing country regions illustrate the effect of the size of the relative cuts and the impact of trade patterns on the level and pattern of benefits from decreasing military expenditure. The Western Hemisphere region experiences the smallest cut in military spending. At the same time, its trade relations are predominantly with the United States, which implements the largest cut in military spending among the major industrial countries, and hence has the largest increase in its demand for imports, many of which are from the developing countries in the Western Hemisphere. As a result, the region experiences welfare gains of 40 percent of 1992 GDP--over twice the present TABULAR DATA OMITTED value of the military spending cuts of 19 percent of 1992 GDP. The cuts in military spending in Africa are larger than those in the Western Hemisphere when measured in relation to GDP, although smaller in absolute terms. Because Africa's trade is heavily oriented toward Europe, where military spending in relation to output is lower than in the United States, the boost to exports from cuts in foreign military spending is smaller than for the Western Hemisphere, although Africa does gain significantly from the rise in commodity prices. At 50 percent of 1992 GDP, the welfare gains are the highest of any developing country region and come from military spending cuts of 33 percent of 1992 GDP. The other developing countries, taken as a region, implement the largest cut in military spending. The gains to consumption and investment are, however, relatively modest. This reflects the regional pattern of trade. Unlike Africa and the Western Hemisphere, which export and import to different areas of the world in roughly equal proportions, other developing countries are net importers from Japan and net exporters to the United States. The military spending cuts in the industrial countries lead to a depreciation of the dollar and to an appreciation of the yen. This loss in the terms of trade for the other developing countries leads to a diversion of domestic output into exports. As a result, the welfare gain is only 49 percent of 1992 GDP, compared with military spending cuts of 41 percent.

Military expenditures in net creditor developing countries, primarily oil exporters, are relatively high: 7 percent of GDP. Because a large portion of military expenditure is imported, costs of conversion would be low, since nonmilitary imports can easily be substituted for military ones. As a result, cuts in military spending are immediately replaced by higher private consumption and investment. For these countries, the reduction in military spending of about 1 1/2 percent of GDP is replaced approximately one-for-one by consumption and investment. The present value of this rise in private sector expenditure is 80 percent of 1992 GDP ($569 billion), reflecting the high level of initial military expenditure.

The sensitivity of the simulation results has been examined by running alternative scenarios involving faster implementation of the military spending cuts; failure of the private sector to anticipate spending cuts in the future; less forward-looking consumption and investment; and the assumption that part of the military spending cuts represents a reduction in productive government investment.(19) The first three of these variations, which affect the short-term response of demand, tend to make the short-term reductions in GDP larger than in the base case, but they have little effect on the long-run equilibrium and, hence, on the welfare calculations. In contrast, if part of the cut in military spending is considered to be investment, the welfare gains are reduced appreciably, but the short-run response is essentially unaffected.

1 Economic theory does, however, provide a rationale for government provision of security, since security is a classic example of a public good. The security impact from a general worldwide fall in military spending is, of course, quite different from a unilateral reduction in military spending by one nation. Although a unilateral decrease in expenditure almost certainly reduces national security for that country, a general decrease in military spending has an uncertain impact on security in any given country because the reductions in security caused by domestic military spending cuts are counterbalanced by the greater security provided by lower military spending in rival countries.

2 International trade in military goods is estimated to have fallen even faster. Data on military trade are published by the U.S. Arms Control and Disarmament Agency (ACDA); see U.S. ACDA, World Military Expenditures and Arms Transfers 1990 (Washington, 1991).

3 The share of industrial countries in total world military spending has remained relatively steady at about three-fourths of the total, whereas the share of developing countries increased from 17 percent to 20 percent, with a corresponding decrease in the share of the countries in transition.

4 In particular, see Daniel Hewitt, "Military Expenditures 1972-90: The Reasons Behind the Post-1985 Fall in World Military Spending," IMF Working Paper 93/18 (March 1993). The data reported therein are largely derived from SIPRI, SIPRI Yearbook 1992 (Oxford: Oxford University Press, 1992).

5 The data for countries in transition exclude the countries of the former Soviet Union. Data for these countries are extremely difficult to obtain. For 1992, direct military expenditures and subsidies to military industries in Russia are estimated by the staff to have been about 6 1/4 percent of GDP. However, this total excludes other expenses such as foreign exchange allocations. Data consistent with this estimate are not available for earlier years.

6 For a detailed discussion, see Hewitt, "Military Expenditures 1972-90."

7 See Tamim Bayoumi, Daniel Hewitt, and Jerald Schiff, "Economic Consequences of Lower Military Spending: Some Simulation Results," IMF Working Paper 93/17 (March 1993); and Tamim Bayoumi, Daniel Hewitt, and Steven Symansky, "The Impact of Worldwide Military Spending Cuts on Developing Countries," IMF Working Paper (1993, forthcoming). References to other analyses of this type are cited therein.

8 MULTIMOD does not at present include the countries in transition, including the countries of the former Soviet Union.

9 The results in this section are derived from a version of the MULTIMOD model discussed in Bayoumi, Hewitt, and Symansky, "Impact of Worldwide Military Spending Cuts." Compared with the standard version of MULTIMOD, the main changes are to the developing country part of the model. For a detailed discussion of MULTIMOD, see Paul Masson, Steven Symansky, and Guy Meredith, MULTIMOD Mark II: A Revised and Extended Model, Occasional Paper 71 (IMF, July 1990).

10 No account is taken of the fact that the geographically concentrated nature of military spending could imply higher fiscal multipliers than for other forms of government consumption.

11 This effect is unlikely to be large. The percent of the world capital stock engaged in military production is small and will depreciate over time.

12 See Bayoumi, Hewitt, and Schiff, "Economic Consequences of Lower Military Spending."

13 For the purposes of these simulations, industrial countries include the four newly industrializing Asian economies (NIEs), since in the version of MULTIMOD that was used in these simulations the NIEs were modeled in the same way as the industrial country blocs.

14 All dollar figures are in 1992 real dollars. Unlike the World Economic Outlook, MULTIMOD uses current dollar exchange rates rather than purchasing power parity (PPP) exchange rates to aggregate data across countries, and this is how the data are reported.

15 Other simulations in which the military spending cuts were imposed more rapidly, or in which future spending cuts were not fully anticipated, produced larger short-term output losses but similar long-term results.

16 Any estimate of the economic gains from cutting military spending are extremely uncertain, and the figures presented here should only be regarded as indicative of broad orders of magnitude. In addition, although measuring economic welfare relative to 1992 GDP facilitates comparisons among regions, it does involve comparing the value of all future economic benefits derived from lower military spending against the current level of output. The gain in each year will be only a small fraction of this overall value.

17 Because MULTIMOD is approximately linear, the same simulated exogenous shock will give results that are broadly the same for historically similar baselines.

18 About two-thirds of the welfare gains for net debtor developing countries come from the military spending cuts in the region, and one-third from cuts in industrial countries.

19 Details of these alternative scenarios can be found in the studies of the impact of military spending cuts cited earlier.

Box 10. Military Spending Data

Because military spending is politically sensitive, it is one of the most difficult areas of government expenditure for which to collect reliable data. An important external source, extensively used in several studies, is the Stockholm International Peace Research Institute (SIPRI), although the data do not conform to standard national accounts conventions. SIPRI makes some adjustments to the basic ministry of defense statistics for different countries to take account of factors such as expenditures that are hidden in other ministries' budgets or are off-budget, although the accuracy of these adjustments is unknown.

Recently, the World Economic Outlook data base has been expanded to include data on military expenditure, which are currently available for 84 countries. The estimates may not include all the adjustments in the SIPRI numbers; hence the World Economic Outlook estimates of military spending in developing countries are somewhat lower than other estimates largely based on SIPRI numbers, highlighting the difficulties in obtaining consistent estimates of military spending across countries. However, the SIPRI and World Economic Outlook estimates have very similar trends, which is reassuring given the uncertainties surrounding the absolute values. Data on military spending are also published annually in the IMF's Government Finance Statistics Yearbook. The 1992 issue contains up-to-date data for approximately 70 countries. The World Economic Outlook estimates have two major advantages compared with other sources: they are more current, and they include annual projections of military spending to 1998.