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Essays, Opinion, & Commentary |
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A Government's Gotta Do What a Government's Gotta Do by Diane Coyle, Ph.D.
Ever since September 11, 2001, defense has been one of the highest priorities in public policy. The defense of the nation is the classic example of a public good provided by the government. Even the most ardent free-market conservative -- actually, especially an ardent free-market conservative -- believes the government has to raise enough tax to pay for the military. Yet the apparently simple aim of making adequate provision for the security of the nation raises some difficult questions. For defense is where foreign policy and economic analysis collide. The users of weapons need not only a military strategy but also a commercial strategy for procuring all that expensive hardware. Wherever strategy is important, either in defense or in less lethal areas of business, game theory is a natural way to think about what the outcome will be. Game theory is less fun than it sounds, but it's nevertheless a fascinating and powerful technique for understanding behavior in situations where the "players" are not operating in the perfectly competitive and static markets of basic economic theory. One of the simplest examples is the famous prisoners' dilemma, in which two partners in crime are interrogated separately and offered a reduced sentence if they sell out their colleague. If neither tells on the other, they will each get five-year sentences. If one confesses the details, he will get just one year but his partner ten years, but if both spill the beans, both will go away for ten years. The outcome if they compete, by each implicating the other, is the worst. Games in real life are much more complicated. And game theory has played a vital role in analyzing strategic problems of all descriptions, including defense. There is no more powerful way of trying to inside your enemies' minds and predict what they will do. As the opening line of the movie A Beautiful Mind puts it, "Mathematics won the war." Let's start, though, with the most basic questions in national defense. For example, should you make all your own weapons or import them? A national arms industry has the advantage of security of supply and control over the technology, not to mention all the potential commercial spin-offs. However, complicated weapons systems are very expensive to produce, involving a vast amount of research and development. So much of the cost is the initial fixed cost of development and testing prototypes that there are huge economies of scale in weapons manufacture. To give an idea of the figures, the development of a new air-to-air missile runs at about $1.5 to 2 billion. America, the world's lone superpower for the fore- seeable future, does develop its own weapons, but for European countries it looks a lot more sensible to work jointly or simply import. If a country does opt to make rather than import weapons, the next question is whether it should allow the export of the arms to third world countries to try and recoup some of the costs, because it is, after all, more efficient and profitable to manufacture the weapons on a very large scale. Governments and their commercial partners who have developed an expensive weapons system are in a position of monopoly power and could make a tidy profit -- as long as they are happy for other countries to have access to the weaponry and the technology. These judgments are becoming all the more difficult as more and more military technologies have lucrative commercial applications, such as the Global Positioning System. This technology uses satellite information to pinpoint exact locations on the earth's surface, and has been pounced on by auto manufacturers, for example. Even email software was once at risk of a U.S. government export restriction because the National Security Agency objected to foreigners being able to encrypt their messages using the (then) spyproof methods developed by American companies. The balance of judgment is rather different for different types of weapon. In the case of weapons of mass destruction or those classified as inhumane (as if there were humane ones) like land mines, considerations of security and morality tend to outweigh the economic arguments, for obvious reasons. For example, the nuclear powers are cautious about helping any other country develop the same capability, and few governments with the capacity to make biological weapons see this as a burgeoning export industry. There is a real fear that chemical and biological weapons could fall into the hands of terrorists, too. So ultra-strict export bans tend to apply. (It can still be difficult determining exactly what to ban, as a notorious British trial of three businessmen who had sold a big pipe to Iraq demonstrated. The government alleged it was part of a supergun. The businessmen eventually won their legal battle to prove it was in fact a pipe.) At the other end of the scale, trade in light weapons such as rifles and machine guns, which are the main cause of death in conflict, is extremely hard to monitor. There is a substantial legal and illegal market, and many countries make their own small arms anyway because the technology is relatively simple and such arms are not costly to manufacture. In fact, some conflicts involve even more basic means of death, generally not imported, like the machetes that were the preferred method in the Rwandan massacres. So the economically interesting part of the arms trade concerns the major weapons systems in between these two categories, items such as aircraft and warships, missiles, tanks, heavy artillery, and so on. Often they are packaged with services such as training and maintenance, which can be the most profitable part of a contract. Secrecy means there is no reliable source of statistics on this trade. However, estimates indicate that the five permanent members of the U.N. Security Council -- the U.S., China, Russia, France, and the U.K. -- account for about 85 percent of the world supply of arms. The United States exports about 15 percent of its production, the U.K. and France 25 percent and 20 percent respectively. About 80 percent of sales go to smaller and poorer countries, mainly in particularly troubled regions of the developing world. This suggests that whether a country is an arms exporter or importer dearly has a geopolitical aspect. But there is an economic aspect, too. Even very poor countries produce light weapons and munitions for their own armies. Very rich or very big countries are self-sufficient in arms, and some are substantial exporters of bigger weapons systems. The main demand for imported weapons therefore comes from countries with middling levels of GDP, not big enough to produce all their own but still big enough (or badly governed enough) to have ambitions that require weapons that pack a bigger punch than machine guns. However, the available figures suggest demand for arms imports has fallen substantially since the end of the Cold War, and is indeed negligible outside a few areas like East Asia and the Middle East. Failing prices and fierce competition for contracts suggests there is massive overcapacity. Given the size of government subsidies to some arms manufacturers, which must be offset against manufacturers' profits to assess the national economic benefit, it is doubted whether there is a positive net return in the arms business. It looks a lot like a declining Rust Belt industry such as steel or shipbuilding, but one with a lot of strategic and political baggage. Certainly, there have been numerous mergers in the U.S. and European industries, in an effort to shrink the amount of excess supply. Making a profit is complicated by the fact that government policy prohibits the sale of major weapons systems to some potential paying customers. For the manufacturers, the problem is relatively straightforward: how to make a profit in the teeth of stiff competition, subject to all kinds of government restrictions, but also with a captive market in the form of your own government and with a good chance of getting generous taxpayer subsidies through cheap export credit, funds for research and development, and so on. For governments, its a different matter. They want to achieve several potentially conflicting objectives through the arms trade. One such objective is to enhance national security. This points to spending a lot on arms. But if one country spends a lot, this can create military instability by making neighbors and enemies feel insecure -- there is an externality, in other words. If every country spends a lot on arms, in an arms race, this can be much more stable militarily but involves an inefficiently high amount of spending on arms rather than on hospitals or schools. This is why politicians sometimes conclude it's worth putting a lot of effort into arms control regimes. Not just because it might save lives but also because a regime that involves less spending on defense is economically more efficient. If a group of neighboring countries are allies, like the Western European nations since 1945 (but not before), then the ones with big defense budgets are providing a public good to the others sheltering under their defense umbrella. But that might tempt some countries to free-ride by underspending on their own defense and exporting what arms they do produce (although it will come to seem less like free-riding the closer the political integration of the European countries becomes). Another government objective coincides with that of arms suppliers. It is to have a profitable arms export business, in order to reduce the amount of subsidy that needs to be paid and to create or save jobs, often in particular regions of the country. The arms industry is dominated by a few large companies, and also experiences big economies of scale, as described earlier. That means it is an oligopoly, or even monopoly in some categories of weaponry. There just aren't all that many companies that make tanks, nuclear submarines, or fighter planes. In such an industry restricting output and raising prices will maximize profits. The output of arms will in fact be smaller than if perfect competition prevailed. Unfortunately, history indicates that it is difficult to make arms control regimes stick. Countries are all too willing to kill each other's citizens or their own. Oligopolies in general are not very stable. OPEC, the cartel of oil producers, is one example. For about a decade from the early 1970s it sustained huge oil price increases by restricting production. In 2000 this wildly successful policy had a brief renaissance. However, despite knowing how well it works in terms of increasing their revenues, most of the time OPEC is unable to limit how much oil its members pump out. There is an overwhelming incentive to free-ride by letting all the other members restrict their output while increasing your own in order to take advantage of the high market price. But once the free riders start to increase supply, the price will fall and the discipline breaks down. Arms manufacturers have the same incentive to undercut their rivals, especially in a shrinking market, and one in which deals are generally kept secret. (After all, the oil price is flashed on screens all around the world all the time. It's difficult to hide any change in supply and demand conditions.) So even at the purely commercial level, both arms buyers and arms suppliers have tricky strategic considerations. The relevance of game theory becomes still more apparent when we turn to military considerations. Game theory involves difficult mathematics. In general, though, all parties involved will benefit if they cooperate rather than compete (sometimes requiring that one compensates another); but there are clearly incentives not to cooperate, especially in the arms business. Even a noncooperative game can result in a stable equilibrium outcome. However, the arms market equilibrium often appears to be unstable, too, instability in an arms race implying war. The antiballistic missile treaty that kept the Cold War cold was stable, thanks to its foundation on mutually assured destruction. If one side launched nuclear weapons at the other, it was guaranteed it would be attacked in return. The cost -- atomization of major cities and much of the population and the economy -- was sufficiently high to deter both the U.S.S.R. and the U.S. from starting a nuclear war. However, to keep up a credible threat of destruction required both to spend huge sums on nuclear weapons. The equilibrium was, like other arms races, stable but inefficient. Much of the intense concern outside the United States about President George W. Bush's proposed National Missile Defense (NMD) system is not a worry about a return to inefficiently high defense spending, however, so much as a fear that the new equilibrium might be unstable. This discussion has so far assumed nation states are the relevant political units in analyzing warfare. But most of today's conflicts are civil wars -- twenty-five out of twenty -- seven big conflicts recorded by the Stockholm Peace Research Institute in 1999. Most of these occur in developing countries, which is just what you might expect looking at the pattern of which countries export and which import arms. In a civil war, the analysis of the game might involve different ethnic or religious groups. On the face of it, it is both tragic and puzzling that the world's poorest countries are the ones squandering resources on warfare. Why is there more instability in these regions? Perhaps the absence of the credible threat of triggering a global nuclear winter helps account for it. That seems to be a real disincentive to starting a war, where it applies. It is certainly a threat nobody would much like to see someone like Iraq's Saddam Hussein wielding. In some developing countries, there are natural resources to fight over, whether diamonds or oil or water. Plentiful natural loot of this sort tends to lead to a high level of conflict. However, so does extreme poverty, because this reduces the direct costs of warfare. If there is no abundant physical infrastructure or farmland to destroy, if soldiers have very low earnings potential in other occupations, then the opportunity cost of death and destruction is low. Opportunity cost is a way of comparing the actual outcome with what might have been, and in such cases the economic potential of peace is not all that much better than what happens to the economy during the conflict. A lack of hope for the future therefore means higher levels of conflict than in countries where there is a lot more to lose. Some recent research at the World Bank suggests economic conditions such as poverty or slow growth or economic decline or dependence on primary commodities are better predictors of war than any political or ethnic variables. Conversely, growth and prosperity tend to be correlated with peace and respect for human rights and political liberties. The tools of game theory can be applied just as well to interethnic or other intergroup rivalries, however. In a divided country, there are two strategies that lead to peace, or a stable equilibrium. One is when the government spends a lot on weapons, so potential rebels would have to spend a lot themselves to win a war. So military regimes can be stable even when they expropriate to themselves large amounts of national resources, making it tempting for rivals to try and replace them. However, this is unlikely to be the most efficient outcome. Alternatively the government, perhaps faced with rivals likely to be good at fighting it, might decide not to spend that much on defense but instead promise to redistribute a share of the national pie to the insurgents. If they can make this promise credible, civil war can be avoided. However, the number of civil wars both large and small suggests this kind of credibility is in practice nonexistent in a divided society. The number of civil wars has increased sharply since the end of the Cold War in 1989. It is as if the removal of the overwhelming threat of nuclear catastrophe has reduced the potential cost of going to war at a smaller scale. So while arms spending worldwide has fallen, suggesting the war game has been heading toward a more efficient level of defense spending, the stability of the low-spending outcome is not obvious. The American NMD plan is hugely unpopular among other NATO countries, but perhaps President Bush is right to worry about what all the foreigners are doing to each other. Or perhaps not. Economics cannot answer these difficult questions of geopolitical strategy. But it does offer tools, such as game theory or the analysis of industrial structure when there are economies of scale, that can illuminate important aspects of the behavior of governments and arms manufacturers. Common sense says we should all live in peace and harmony, but as we clearly don't, any insight into why vast sums of money are spent on weapons and by whom must be welcome.
Copyright © 2002 Diane Coyle. Reprinted with permission. Diane Coyle writes and speaks on business, technology, and the global economy. She is a regular columnist for The Independent, a presenter of BBC Radio's Analysis program and directs Enlightenment Economics, a consulting firm. She is also a Visiting Research Fellow at the London School of Economics' Centre for Economic Performance. Diane was the Economics Editor of The Independent for eight years, and in 2000 she won the prestigious Wincott Award for Senior Financial journalists After getting her Ph.D. from Harvard, she spent a year working at the U.K. Treasury. Diane is also the author of Paradoxes of Prosperity, The Weightless World, and Governing the World Economy. She lives in London.
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