The Multipliers and the Military

New OBR research shows Defence investment can boost growth

BLUF: A discussion paper from the OBR shows how Defence spending hike, and indeed all other investment-focused spending increases, can boost growth and reduce debt.

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The submissions deadline for input to the Strategic Defence Review just passed - presumably Lord Robertson’s team are busy sorting through the input on the 23 questions they put to defence contractors, think tanks, trade unions and other interested parties.

However, the missing issue in the SDR questionnaire was money.

At one level this is a good thing. Because if you’re doing a “root-and branch” review of Britain’s defence capabilities, you need to match the capabilities to the threats, not to some arbitrary budget figure.

But the idea that Britain can sustain its national security while spending 2.3% of GDP is ludicrous. Likewise the promised 2.5% figure, agreed by both Labour and the Conservatives before the last election.

So the SDR is going to have to make a statement about affordability.

If Lord Robertson’s team concludes that the UK needs to rearm rapidly – going to 3, 4 or 5% of GDP, the experience of the 1930s suggests this can only be financed sustainably through debt.

Keir Starmer, in a round of post-conference interviews, seemed to open the door to this, saying:

“There’s a difference between day-to-day spend and borrowing to invest, and I’ve always thought we should borrow to invest.

There’s been speculation that Rachel Reeves will rewrite the fiscal rules, or extending their time-horizons, to give herself permission to borrow more. But a recent OBR discussion gives her plenty of ammunition to hike borrowing, especially for defence equipment, infrastructure and intellectual property, even without a rule change.

This edition of Conflict & Democracy presents a model – based on the OBR’s own figures - for assessing the multiplier effects of increased defence spending. It’s nerdy, and requires you to read numbers, but bear with me because it’s worth it.

The OBR’s blind eye to growth

In all previous Economic and Fiscal Outlook reports, the OBR has used "fiscal multipliers" to predict the impact of changes to government spending on investment, services and welfare, and of changes to the tax take.

For Defence spending, only the investment and services categories are relevant. The latest version of the multiplier model, published in November 2023, is as follows:

Source: OBR

The short summary of this is that investment has a bigger short term impact on demand than day-to-day spending:

• £1bn extra spent on Defence equipment, infrastructure and intellectual property would add £1bn to GDP in the year it is spent, falling to zero in Year 5;

• £1bn extra spent on Defence salaries, operations and maintenance etc would add £0.45bn to demand, again falling to zero in Year 5.

Many neo- and post-Keynesian economists would dispute the small size of these numbers. Capping the impact of investment at 1:1 ignores spillover effects. But that’s not the biggest problem.

Until this year the OBR offered no modelling of how public investment affects the UK's long term output potential – that is, how investment stimulates the economy’s ability to grow. That is important, because “investment led growth” strategies are not primarily about short-term bang-for-buck, but long-term impact.

The OBR’s tortuous rationale, in its 2019 Forecast Evaluation Report was that: (a) there hadn’t been much public investment under the Tories (b) “considerable uncertainty surrounds our forecast”; and (c)…

“The impact of higher public investment on supply is frequently uncertain. Some public investment – for instance, in key transport infrastructure – can be expected to raise potential output but often only beyond our usual forecast horizon. Some projects, though serving a valuable social purpose, will have negligible impact on potential GDP – for instance, investments in national defence.”

In addition:

“Most empirical studies find a relatively weak relationship between public investment and potential growth, perhaps because while some investments have boosted supply, others have had little or no effect. Furthermore, recent work suggests that the impact of public investment is lower for more developed countries.”

That is a lot of reasons to avoid modelling the most basic assumption of capitalism: that investment in capital boosts long term growth.

But hey, now there’s a Labour government and they have changed their minds.

Enter the 2.5 percenters…

In Public Investment and Potential Output, a discussion document issued by the OBR in August, Suresh et alshow that while public investment boosts demand temporarily (as in the multiplier model above), it can also boost supply - that is the output potential of the economy - permanently. They find that:

"A sustained 1% of GDP increase in public investment could plausibly increase the level of potential output by just under 0.5 percent after five years and around 2.5% per cent in the long run (50 years)."

This is because increased public investment can grow the economy through three channels:

• Increased labour supply

• Increased capital stocks, including:

  • Intellectual property

  • Machinery and (NB) weapons systems

  • Dwellings

  • Other structures

• Increased total factor productivity.

Now, to the uninitiated, those figures – 0.5% after five years – may look small. Indeed, to this neo-Keynesian they look like an under-estimate. But even a 0.5% uplift in the size of the UK economy massively improves the chances of reducing the debt pile over time.

Because while a week is a long time in politics, 50 years but the blink of an eye when it comes to debt management. If the economy is 1% bigger in 10 years time, the affordability of the debt pile increases over the long term.

In their modelling, Suresh et al consider numerous technical factors that  might alter the prediction: the time taken for depreciation, for example.

However, unlike the 2019 FER, which was down on defence investment, the OBR team is explicit that weapons systems add to the capital stock. Obviously, the MOD also invests in all the other capital stock categories (for example satellites, R&D, bases, energy generation plant and accommodation).

From the OBR research, I derive following model of the long-term impact of investment on growth, over 10 years and in Year 50. This applies to all investment, not just Defence.

It should be noted that, because the OBR team has modelled a time lag to full effectiveness, the most substantial growth effects take place after 10 years. But at Year 10 a billion pounds extra spent today is producing close to a billion in extra GDP, before we’ve even factored in the short-term effects.