Valuing defense.

Author:Smith, Ron
 
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Abstract

This paper examines three questions in the valuation of defense in the UK. First, how to calculate the value of defense to society in order to determine the appropriate budge? Second, how to ensure value of money in defense procurement? Third, how to value defense assets as required under the new Resource Accounting and Budgeting system for controlling public finance? A central theme of this paper is that while budgets and forces can be measured and military capabilities can be estimated, the final security outputs are inherently intangible. It is this intangibility that makes the valuation of defense so difficult in all three areas.

Introduction

In summer 2004, as in every Public Spending Round, the UK Ministry of Defense, MOD, was locked in combat with Her Majesty's Treasury, HMT, over the size of the proposed defense budget. Traditionally two factors have driven these fraught negotiations: overstretch and overspend. The overstretch arises because the military commitments the UK government have incurred around the world greatly exceed the capabilities that HMT are willing to finance. This prompts the question, how should one determine the value of defense, the right size for the defense budget? Section 2 addresses that question. The overspend arises because the weapons procured are usually late and over budget. This prompts the question, how should one determine Value for Money in defense procurement? Section 3 addresses that question. To these two traditional factors that drive the negotiations there has been added a third factor, a new system of budgeting, Resource Accounting and Budgeting, RAB, which has made the MOD's life a lot harder. A central feature of RAB is that assets are valued and depreciation and a cost of capital are charged to the operating budget. This prompts the question how should one value military assets? Section 4 addresses that question and examines the impact of RAB. Section 5 contains some concluding comments.

In examining these three aspects of valuing defense it will be useful to keep a simple flow-chart in mind. At one end, the budget pours in. In 2003/4 defense spending, on national accounts definitions was roughly 28 billion [pounds sterling], 2.5% of GDP, the total income of the country. This is a rough figure because the change to RAB discussed below, means that there are a number of different ways to measure the defense budget. The figures used in this paper are largely taken from DASA (2004). This budget is used to buy forces: military personnel, equipment, infrastructure and logistics. How the budget translates into forces will depend on such factors as wage rates for personnel, construction costs for new equipment and the depreciation of old equipment. These forces provide military capability, the ability to do particular things, including to win in combat. In the MOD objectives, military capability is defined as the ability "to deliver appropriately motivated, manned, trained and equipped force packages, at the required level of readiness and with the necessary support, sustainability and deployability, to achieve the full range of agreed military tasks". There are 27 agreed military tasks. These capabilities are then used by UK government to obtain the desired security outputs. The extent to which military capability delivers security outputs will depend on the nature of the threat, the strategies adopted by governments, the support of allies, and the relative effectiveness of military responses to the threat.

A central theme of this paper is that while budgets and forces can be measured, albeit with difficulty in some cases, and military capabilities can perhaps be estimated, the final security outputs are inherently intangible. It is this intangibility that makes the valuation of defense so difficult.

The Value of Defense

Economists, like cynics, are accused of knowing the price of everything and the value of nothing. This is not quite true. Economists tend to treat price and value as being the same: something is worth what people, at the margin, are willing to pay. On that basis, the value of defense is the two and a half percent of GDP that collectively the UK is willing to pay for the security the defense budget provides. The structure of the calculation of the appropriate level of military spending--how much is enough-is straightforward in principle, if not in practice. There is a potential threat, military expenditure increases security in the face of that threat but it also has opportunity costs in terms of foregone consumption. The optimal choice is to increase military expenditure to the point where the marginal security benefits of the military expenditure equal the marginal utility costs in terms of foregone consumption. The optimal defense budget will be higher the greater the threat and will be higher the greater the effectiveness of military expenditure in countering the threat. Thus when the Soviet threat was removed at the end of the Cold War, defense spending was reduced. More detail on using this approach to explain the demand for military spending can be found in Smith (1995).

This marginal analysis will not work if there are discontinuities, such as fixed costs, where you get no benefit until you have spent a large amount. In that case it may be that the military expenditure that you can afford is ineffective, since it does not get you over the threshold. Then there is no point in spending on defense and you are in the position of Costa Rica, abolishing the armed forces, or the Danish no-tax party, whose defense policy was an answer machine that said 'we surrender' in Russian. What we observe is that countries steadily drop capabilities as the fixed costs become too large for them to play in the game. Once many countries had aircraft carriers, but now that they are so expensive, few countries can afford them.

In conducting the analysis one might try to calculate the total value of defense as the total utility of the defense budget, the sum of the value of all the units less their cost. Such total utility is often estimated through cost-benefit analysis, to determine whether a proposed investment, such as a new road or railway, should proceed. Such calculations involve combining monetary costs and benefits with imputed monetary values (shadow prices) for non-monetary consequences. In the case of new roads the non-monetary consequences include pollution generated, time-saved in traveling and lives saved, since new roads are through safer. It is a complicated and controversial process and requires a counterfactual analysis of hypothetical situations: what would happen if the project proceeds against what would happen if it did not. One might ask, what would be the consequences, should the UK, like Costa Rica, choose to spend nothing on defense. But the calculation requires measuring the outputs of the defense budgets. The inputs, the forces (soldiers weapons, etc) and to a...

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