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Looking for silver linings: Budgetary certainty for the military in times of economic recession

16 December 2020
Economics
Debt Financing by Nick Youngson CC BY-SA 3.0
Image created by Nick Youngson CC BY-SA 3.0

The economy is going through its most significant economic crisis since the Great Depression, nearly 90 years ago. This crisis has exposed the Australian economy’s structural weaknesses, and consequently, brought the issue of the military’s own long-term financial resilience into focus. From the military’s perspective, the relevant question is ‘what comes next’. Specifically, the military needs to confront two critically important questions:

  • How will this ongoing economic crisis impact the military’s own financial viability over the next decade, even as it confronts 21st century challenges that are emerging and converging in highly unpredictable ways?
  • How can the military justify demands for adequate funding when the government is being forced to take on heavy debt just to stave off a bigger economic collapse?

The importance of these questions – and of budgetary certainty – cannot be overstated. The military’s budget is the primal and direct determinant of its ability to fulfil its mandate to society. Just the way no army can march on an empty stomach, it can also not maintain its lethality with an empty wallet.

Even more importantly, the true significance of the military’s contributions to the national wellbeing appears to be under-appreciated in the public discourse. Not only does it safeguard the nation’s sovereign borders, it is also one of the primary means for national power projection, particularly within the immediate region. In a region characterised by ancient cultures and civilisations, the military helps legitimise the global rules-based order, and reinforces Australia’s credibility as an advocate for this order.

This order has provided the intellectual and institutional framework for Australia’s evolution as one of the world’s most peaceful and prosperous societies. It hardly needs to be stressed that should this order crumble, Australian influence and prosperity would both be seriously undermined, if not entirely destroyed. The latter scenario would obviously be an extreme one, but one that Australia should exert all its efforts to avert.

By contrast, the Australian economy remains a ‘price taker’ in the global economic system. This means that despite its relative prosperity, it has practically no ability to shape the global economic system, rules, or discourse to its advantage. This in turn arises from its long neglect (and indeed the systematic dismantling) of its industrial value-adding capabilities, as well as its increasing dependence on a small number of products and countries for its long-term prosperity.

The key implication of the foregoing discourse is quite simple: now is not the time to let the unfolding economic malaise blunt one of the nation’s most potent means of global power projection.

The most important question therefore becomes, ‘what is to be done in these circumstances?’ How can the government prevent the unfolding recession from actually blunting its military capability? As it turns out, there is a silver lining to the ongoing crisis. The opportunities for helping the military arise from the very conditions of weaknesses that the Australian economy has been experiencing in the recent past. Two related sets of economic stylised facts illustrate this:

The first of these relates to the government’s fiscal response to the pandemic[1]. Governments around the world have taken to borrowing money in the bond markets to shore up their finances. This trend is already well underway globally, and the Australian government is no exception. A recent quote by the Deputy Governor of the Reserve Bank of Australia illustrates the institutional support (and indeed enthusiasm) for increased debt as a strategy for dealing with national economic vulnerability.

The increase in debt is definitely manageable. Moreover, there is not, in my judgement, a trade-off between debt and supporting the Australian economy in the current circumstance. Absent the fiscal stimulus, the economy would be significantly weaker and debt levels even higher. This is particularly so with interest rates at their historically low levels, where the growth benefit from the fiscal stimulus will improve the debt dynamics and help service the debt in the future.

This view is borne out by the recent trends in Australian fiscal policy. Between March 2020 (when the first economic measures in response to the pandemic were announced) and Sept 2020, the Australian government’s gross debt has increased by around $233 billion. This represents an increase of almost 41 percent. By contrast, in the 12-month period between 1 March 2019 and 29 February 2020, the gross debt had increased by only about 5 percent!

This practice of debt-financed fiscal support is expected to continue at least until the next few years. In the 2020 Budget, the Government announced a total support package exceeding $500 billion, all of which will be financed through increased debt. It further forecast that Australia’s Gross Debt would exceed $1.1 trillion by 2023-23. The economic support measures for the current fiscal year also translate into the largest budget deficit in nominal terms in Australian history, and the largest deficit as a proportion of GDP since the Second World War.

Much of this additional debt would have gone towards providing immediate income and employment support benefits to the public, as well as tax benefits to businesses, to prevent them from sliding into insolvency. These policy measures are appropriately classed as short-term stabilisation measures, rather than long-term investments aimed at upgrading the nation’s productive or power projection capabilities.

In essence, this additional spending – over 10 times the entire ADF’s annual budget – is projected to be done over the next 2-3 years only. And yet this will do little to preserve or enhance Australia’s power projection within the Indo-Pacific region. If anything, the economic turmoil over the near term could potentially put considerable pressure on the military’s own budgets, to the point that its ability to maintain/enhance its capabilities, and therefore project power, would be severely compromised.

However, the very strategy currently in use to stabilise the economy – debt-financed spending – is also the most direct and immediate means by which to avert this possibility. If the government can underwrite such a large amount of debt for short-term stabilisation, then a case can surely be made to utilise the same mechanism to support the Australian military as well. All that the government would need to do is raise some additional debt explicitly and exclusively for military development purposes. This could be done through the issuance of some form of ‘National Defence’ bonds that have longer-term maturities, of say 10 years or longer, and would go a long way in providing the budgetary certainty that the military needs over the next decade.

What makes this option particularly attractive is that the government would only need to raise a small fraction per year – for example 3 to 4 percent of what it is already planning to spend on its short-term economic stabilisation measures – to enhance the military’s capabilities, and therefore, its own power projection capabilities. The resulting benefits to the nation in terms of its defence, prosperity, and diplomatic leverage would be both profound and long-lasting.

As logical and self-evident as this reasoning is, it is still incomplete. For any proposal for increased long-term debt to be complete and credible, it must articulate a reasonable pathway for how that debt is to be serviced, and eventually, paid off. In the current context, this pathway becomes clear from expectations about both monetary policy (and its metrics of interest rates and inflation), and economic growth.

A primary justification for the widespread use of debt-financing, including by the Reserve Bank, is the low interest rate regime currently in place. The bond rates are already at historic lows, with rates for 3-year bonds at around 0.18 percent, and 10-year rates at just under 1 percent. For comparative context, the 10-year rates were around 6.5 percent at the start of 2008, shortly before the Global Financial Crisis. Raising money by selling bonds at these historically low rates would lock in these rates, and would consequently ease the debt-servicing burden for the Government over the term of the debt (say, 10 years). While this is highly desirable in and of itself, the real benefit of these low rates becomes evident when one also considers the role of inflation, which is the rate at which money loses value.

For this, it is important to understand the difference between the advertised interest rates (such as those given above), and what we receive or pay in effective terms. The advertised interest rate is called the nominal interest rate. The real or effective interest rate, on the other hand, is determined by the inflation rate. Conceptually, the real interest rate is based on the formula: r = i – π,

where r and i are the real and nominal interest rate, respectively, and π is the inflation rate.

Under normal economic conditions, both rates are positive, with the nominal interest rate being higher than the inflation rate. This allows lenders to receive a net positive return for their investment, and ensures that borrowers pay a net positive amount for the privilege of borrowing money. In the event that the inflation rate exceeds the nominal interest rate, the cost of borrowing becomes negative, and not only do the borrowers not pay anything in real (effective) terms, they are in fact being paid to hold that debt!

This is the broader macroeconomic justification for the heavy debt-financing that we are currently witnessing. With the current inflation rate also less than 1 percent, the real interest rate on most forms of borrowing is close to or less than zero[2]. The next relevant issue relates to expectations about future interest rates, i.e. whether these favourable borrowing conditions can be expected to sustain over the next few years.

For the past few years at least, the biggest economic threats to the world’s developed nations, including Australia, have been low growth and the possibility of deflation. Deflation occurs when prices fall across the economy, and is considered a particularly adverse outcome. This is because deflation can create expectations amongst consumers that prices will fall further, which makes them hold off on making purchases. This in turn reduces demand, slows growth, and reinforces deflationary expectations, thereby creating a sort of vicious cycle.

It is to avert the possibility of deflation that the Reserve Bank – along with most major central banks around the world – has dedicated much of its efforts to over the last few years. Even now, driving inflation up to within the Bank’s target band of 2-3 percent, and keeping it there, remains an explicit and primary objective of the Bank. Given the concerted institutional efforts currently underway to make this happen, it is both a reasonable assumption and expectation that inflation will rise over the foreseeable future.

It is this expectation about inflation that has particular salience for the military’s own budgetary stability. What this means is that if the government now moves to lock in these historically low (real) interest rates (for example, by selling long-term bonds), then its broader macroeconomic objectives will work in the military’s favour. All that would need to happen is that the government/RBA achieves its objective of creating moderate inflationary pressures within the economy. With the current low rates locked in over the next decade, a rising inflation would cause the real interest rate on these bonds to further slide into negative territory. This would means that the hoped-for future inflation would eliminate the government’s (real) debt-servicing burden by default, and the additional debt would not cost it anything extra in real terms.

But the over-subsidised debt-servicing burden is not the only benefit of inflation. It delivers an added benefit – of reducing the real value of the deb

t itself. This is because inflation chips away at the value of money over time. So assuming that the government is able to achieve its goal of moderate inflation – say an average annual inflation rate of 2.5 percent over the next 10 years – even the simplest calculation shows that the real value of the debt will fall by around 25 percent over this timeframe.

In other words, to the extent that the government succeeds in raising inflation, this inflation will help it by paying off about a quarter of its debt on behalf of the military! The longer the debt is held, the greater is the debt-reduction benefit of inflation. It is this same pattern of inflation that underpinned a sharp reduction in Australia’s post-WWII debt, which had increased from 40 percent of GDP in 1939 to around 120 percent by 1945. By 1974, the gross debt as a share of GDP had come down to just 8 percent!

The foregoing discourse makes a credible case for the government to take on long-term debt to finance military capability development. If the nation is truly serious about investing in its future prosperity and security, there would be few investments that would make more economic sense, or that would be more consequential. 

 

[1] Unless otherwise indicated, the data on government debt is derived from official statistics available from the website of the Australian Office of Financial Management, which manages the Commonwealth’s assets and liabilities.

[2] The Reserve Bank has various measures for inflation. The particular measure used here is “CPI excluding volatile items”, available from the most recent RBA Chart Pack.

The views expressed in this article and subsequent comments are those of the author(s) and do not necessarily reflect the official policy or position of the Australian Army, the Department of Defence or the Australian Government.

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