The Economics of Arms

Keith Hartley

• Publisher: Agenda Publishing
• Year: 2017
• Print ISBN: 9781911116240
• eBook ISBN: 9781788210935
• Topic: Business
• Subtopic: Business General
• Index: Business

It is estimated that today some 2.7% of world GDP ($1.5 trillion) is spent on arms. In 2014 Lockheed Martin, the US defence contractor, had revenues of $45 billion – the equivalent of the GDP of Tunisia. This book explores the business behind these breathtaking figures and explains how the arms industry makes its money.

The book begins by defining the industry, explaining why the sector is important, outlining its prime contractors and key supply chains. Its cost categories (from R&D to maintenance), the role of technical innovation, and the sector's dependence on the monopsony buying power of Government, are all examined. The structure-conduct and performance model is used to show the workings of the arms market and its various entry and exit conditions, and the sector's performance is analysed through various indicators including exports, development time scales, cost overruns and profitability. The complex choice problems of domestic procurement are considered alongside sales to foreign governments and the opportunities that may present for bribery and corruption.

The Military-Industrial-Political-Complex (MIPC) is unpacked and the behaviour of its major agents – national defence agencies, the armed forces, producer groups, political agents (voters, political parties and budget-maximising bureaucracies) – is scrutinised, both in times of conflict (expansion) and peace (contraction). The book concludes by considering future trends, such as whether arms industries are better under state or private ownership, and how they can meet the challenge of new threats in different forms. The discussion throughout is anchored to case studies from all parts of the world, including Brazil, Korea, Japan, Russia as well as UK, US and Europe.

As an authoritative non-technical introduction to the economics of arms industries, it is suitable for students of business studies, politics, international relations, political economy, strategic and defence studies as well as for courses on microeconomics and industrial economics. As a masterly summation from one of the world's leading defence economists, it will also be required reading for staff in defence ministries, procurement agencies, the armed forces and strategic studies think-tanks throughout the world.

1

THE IMPORTANCE OF ARMS INDUSTRIES

Introduction: the policy issues

Arms producers and arms industries are controversial: they are often criticized and condemned. But such criticisms need to be addressed and carefully considered. Arms firms and whole arms industries cannot be dismissed and proscribed without more detailed and careful analysis and evaluation of their apparent “wrongdoings”.

This chapter sets the scene and outlines the policy issues to be explored in the book. Are arms industries important: if so, why, and which other industries are viewed as important? Do they provide “good value for money”, or are they inefficient, corrupt and immoral; should they be condemned as “merchants of death”; and do they exploit their market power at the expense of taxpayers? What can and should governments do about them: should privately owned arms firms be subject to tighter government regulation or should they be taken into state ownership, and will state ownership solve the “problem”? These and other questions will be addressed in this book, at the end of which the reader will be able to reach a more informed judgement about the economic aspects of the arms industry. In this chapter, the arguments surrounding the arms industry will be presented and assessed. A legal approach would ask what is the case for the prosecution and what are the arguments for the defence? A starting point requires an explanation of why economists disagree about arms industries and other policy issues, followed by a definition of the arms industry.

Why economists disagree

The typical view of economists is that where there are ten economists there will be ten views and only one will be correct, but no one knows who will be correct!

Economists have good reason to disagree.¹ Their disagreements might focus on differences of view about the relevance of a specific theory (e.g., Keynesians versus monetarists), on whether theories should be accepted or rejected on the basis of their explanatory power and predictive accuracy, or on the realism of their assumptions. Disagreements continue over the accuracy and reliability of evidence and on the appropriateness of particular policy solutions in relation to each economist’s value judgements and their views about the best solutions. Here, a distinction arises between positive and normative economics. Positive economics is concerned with what is whereas normative economics is about what ought to be.

Economists disagree about arms industries for all these reasons. They will disagree about the best economic model for explaining and understanding the behaviour of arms producers, industries and markets. For example, cost overruns and delays on major arms projects are viewed either as the result of firms tackling high-technology problems and uncertainty or as private monopolies exploiting taxpayers. There will also be disagreements about the facts to be explained and the reliability, relevance and acceptability of the evidence. Finally, they will disagree about the best policy solutions, with some preferring market-type solutions (e.g., privatization, or more competition) and others opting for state-type solutions such as state-owned and not-for-profit enterprises. Even definitions of the industry are a source of controversy.

What’s in a name? Matters of definition

Arms firms and industries are known by various names. They have been called arms, weapons, military, defence or security industries. Differences of definition often reflect whether the analyst is a peace or defence economist: peace economists prefer the term arms industry whereas defence economists prefer the description defence industry. Care is needed in distinguishing between arms industries and the military, comprising a nation’s armed forces in the form of armies, navies and air forces. Armed forces buy arms as inputs into their “production” of defence outputs in the form of peace, protection and security.

Arms industries supply weapons to armed forces both nationally and internationally via exports. They are involved in the design and development (research and development, or R & D), production, servicing and modification of military equipment. They are also involved in training military personnel as well as the management and maintenance of military facilities (e.g., docks, airfields and ranges) together with the disposal of equipment, some of which might involve substantial environmental and “clean-up” costs. For example, disposing of nuclear weapons is costly and time intensive (the process can take up to 50 years). In the case of nuclear-powered submarines, the options include docking at a military shipyard, dumping at sea and temporary safe storage prior to permanent disposal. Russia dumps its nuclear waste at sea (the Kara Sea, north of Siberia); the US uses a nuclear waste repository at Hanford in Washington state; and the UK stores its redundant submarines at Devonport and Rosyth prior to storing its nuclear waste at Capenhurst, Cheshire. Similar disposal and clean-up costs arise for nuclear research and production plants and for storage sites for nuclear weapons.

There are, however, various definitions of arms industries. A narrow definition focuses on lethal equipment, comprising lethal air, land and sea equipment. Examples include combat aircraft and helicopters, missiles, tanks and artillery, submarines, aircraft carriers, warships and space systems.² Lethal equipment also embraces conventional and nuclear equipment, as well as major projects and small arms (e.g., rifles, ammunition). Indeed, a distinction can be made between the relatively controlled trade in major conventional weapons and the relatively uncontrolled trade in small arms and light weapons. A further dimension embraces the defence electronics industry, which provides the navigation, guidance and communications systems for modern weapons. The emergence of cyber warfare and the companies involved in such activities adds to the challenges of defining arms industries.³

There is a broader definition of arms industries that includes all firms supplying goods and services to national defence departments or ministries. Such a definition embraces non-lethal goods and services such as the supply of accommodation, the construction of military bases, the supply of fuel, food and financial services and the supply of motor vehicles, computers and IT systems. The increasing emphasis on the outsourcing of military activities to private contractors has expanded arms markets, allowing new firms to enter markets for activities that were traditionally undertaken “in-house” by the armed forces. Examples include catering, cleaning, transport, training and air tanker operations (e.g., in the UK, RAF air tankers are provided by a private contractor).

There is a further sub-group of weapons: namely, arms firms involved in the supply of weapons of mass destruction (WMD), comprising nuclear, biological and chemical weapons. Biological and chemical weapons are subject to international conventions that outlaw their development, production and stockpiling; but not all nations are signatories to these international conventions and those that are signatories might not abide by the rules. There are also similar international conventions on certain conventional weapons and cluster munitions.

Arms producers are subject to national and international laws that affect their ability to trade, so arms sales that violate such laws form illegal trades. Most large conventional equipment is readily identifiable and is supplied by a small number of large firms, meaning that trade in such equipment is easily regulated and policed by national governments. For example, export sales of aircraft carriers and combat aircraft are difficult to hide and conceal; but export sales of small arms and light weapons (e.g., rifles, ammunition, machine guns, some missiles) are much more easily hidden and can be traded illegally. There are a large number of small firms supplying small arms and this makes their policing more difficult and costly. There is also a demand for illegal arms, with demand coming from non-state groups such as terrorists, rebel groups (freedom fighters) and criminal gangs (e.g., the Mafia). Such demands, often for small arms, can be satisfied by illegal trading, by theft or by acquisition in conflict. Given a demand for illegal trading, arms dealers will emerge to satisfy such demands by bringing together willing sellers and willing buyers. For the purposes of this chapter it is sufficient to recognize that some arms producers supplying small arms and light weapons might be involved in illegal trading (some producers might not be aware of their role in illegal trading: see Chapter 2). Nor are national governments the only buyers of arms; other buyers include private groups and individuals.

New technology affects how we define arms producers and arms industries. For example, manned aircraft only emerged after 1903, leading eventually to today’s major aerospace industry, supplying combat aircraft, helicopters, missiles and space systems (including rocket propulsion and moon landings). Aerospace is a completely new industry that did not exist in 1900, and it has resulted in air forces as a new branch of the armed forces. Entry into space has added space to the traditional dimensions of warfare, which now include space weapons and assets (e.g., military satellites). Other examples of technical advance that led to new arms firms include radar, electronics, tanks, nuclear-powered submarines, drones and unmanned air vehicles. More recently, cyber has emerged as a new market, reflecting new threats to national security. Cyber involves markets for software and surveillance technologies that meet an objective that otherwise requires espionage or the use of force. Cyber is an interesting example where the product is not directly lethal but where security is included in one of the definitions of arms industries.

Arms producers and industries are not static: they are changing continuously to meet new threats and new technologies. Some arms firms respond to change by adopting new technologies or by acquiring other firms with relevant technologies and existing markets. Firms that adjust to change successfully will survive; those that fail to adjust will exit the arms industry. For example, BAE Systems has sold many of its civil holdings and acquired a cyber business (BAE 2015). Firms that have exited the aerospace industry include famous aircraft firms (e.g., de Havilland, Hawker, Supermarine and Vickers (all UK); North American and Curtiss–Wright (both US)) and such firms as Swan Hunter (UK) have exited the shipbuilding industry, while other arms firms have exited the industry and entered new civil markets.

Defining and classifying arms producers needs to allow for their defence-dependence (see Table 2.1). Some arms firms supply dual-use products: for example, track can be used for tanks or tractors; steel can be used for warships and bridges; and jet engines are used on both military and civil aircraft. Also, some producers of arms have a high dependence on their arms sales, with such sales accounting for 80 per cent or more of total sales. Questions then arise as to whether firms supplying dual-use products and those with a low defence-dependence are part of the arms industry? One answer is that they qualify as part of the arms industry if they supply their products to a national or foreign defence department or to a national or foreign arms producer.⁴ In this case products include goods and services, both lethal and non-lethal, where the supply-side comprises R & D, production, repair, maintenance, modifications and upgrading of equipment. Disposal of arms, especially of WMD, can also be added to the definition of arms industries.

The arms trade is big business and the size of the business varies with war and peace and with international tension (e.g., arms races). The business increases during war, conflict and periods of international tension (e.g., threats, including terrorist threats), all of which lead to increased defence spending. Similarly, business and spending declines with peace and disarmament (e.g., at the end of the First World War, the Second World War and the Cold War), with declining business leading to job losses, plant closures and exits from arms industries. But change is not instantaneous and costless: it takes time and involves adjustment costs (e.g., unemployment, and under-employment of labour and capital resources: see Chapter 9). A further clarification is needed between total defence spending and arms spending. Defence budgets are allocated to acquiring military personnel, arms and other equipment, as well as military facilities (e.g., military bases including airfields, barracks and dockyards). As a result, arms spending forms only part of a nation’s total defence budget (e.g., equipment spending might vary from 10 per cent to 30 per cent of a nation’s defence budget, where the remaining items of expenditure include personnel, infrastructure and other components).

Arms or defence equipment provides an input into the production of final or overall defence output. The armed forces combine arms with personnel, military facilities (capital such as military bases and communications systems) and other equipment and services to produce overall defence output. However, there is no recognized method of valuing defence output. Traditionally, in many economies, the convention was to assume that inputs equalled outputs (a convention that applied throughout the public sector); but this provided no single valuation of overall defence output. Instead, defence output has been variously described as the provision of peace, protection, deterrence, insurance against future threats and, ultimately, security, but with no single monetary valuation on these outputs. In some economies, defence output is expressed as defence capabilities: for example, the capability to deploy, say, 5,000 combat troops and supporting air and sea forces to the Middle East indefinitely. While this is an improvement over the convention that inputs equal outputs, it lacks a money value for these capabilities: hence, it is not possible to determine whether overall defence spending is a worthwhile investment.

Arms industries are different from the final output of overall defence. For arms, there are market prices comprising input costs and profit margins that reflect the government’s and other buyer’s willingness to pay. But there are no money valuations that can be placed on the final output of overall defence to provide a single indicator of its value or benefit. In contrast, many civilian goods and services, such as motor cars, televisions and mobile phones, are traded in private competitive markets with large numbers of buyers and sellers determining market prices, showing society’s valuation of these products. Defence, however, differs in several key ways from private competitive markets and this explains the challenge in measuring and valuing overall defence output. Nevertheless, all is not lost and economics offers some policy guidelines in this area. The costs of defence and of specific capabilities can be identified and policy-makers can then ask whether defence provides at least a comparable level of benefits. For example, if overall defence spending costs £N billion, does it provide overall benefits of a similar value? The same question can be asked for specific force capabilities, such as nuclear strategic forces, an aircraft carrier capability and a specific combat aircraft capability (e.g., the capability provided by an F-35 combat aircraft).

Different definitions of arms producers and industries affect the size of the industry. A narrow definition based on lethal equipment only would result in a smaller industry than one based on a wider definition that included all sales to national and foreign governments and to national and foreign arms producers. Critics of arms industries need to be clearer about their definitions. Whichever definition is used, the importance of the industry needs to be assessed.

The importance of the industry

Economists assess the economic importance of an industry in terms of its contribution to national output (GDP) compared with the contribution if the resources were used in alternative industries. For example, what is the contribution to GDP of arms industries compared with such alternatives as agriculture, banks and financial services, chemicals, construction, creative industries, electronics, motor vehicles and pharmaceuticals? All industries and services contribute to national output so the key question is which industries maximize national output. In competitive market economies, competition resolves this issue by allocating society’s scarce resources between alternative uses so as to maximize national output: hence, an industry in a competitive economy will produce a greater output than its alternatives in other sectors. But real-world economies are not perfectly competitive and private markets often fail to work properly. They might “fail” to work properly because of imperfections such as monopoly power and entry barriers as well as beneficial and harmful externalities (harmful externalities include traffic congestion, noise and pollution: see Tisdell & Hartley (2008)).

Assessing the economic importance of arms industries immediately encounters two major data deficiencies. First, official government statistics on national output do not identify arms industries as a separate and identifiable industrial grouping in any census of production statistics (see Chapter 2).⁵ Second, there are no money valuations for the defence final output of the arms industry: instead, there are only money values for the input costs of arms purchases. Nonetheless, the contribution of arms industries to peace, protection and security for a nation’s citizens cannot be ignored: these aspects of defence output have some positive money valuation and society has to reach a judgement on whether the value of these benefits exceeds the cost of supplying arms. One approach is to consider the “Hitler question”: namely, what would the UK have been willing to pay to protect itself from invasion by Hitler in 1940? In this context, the UK arms industry supplied the aircraft, tanks and warships that eventually contributed to the defeat of Hitler in 1945 (e.g., Hurricanes, Spitfires, Lancaster, Halif...

Table of contents

• Front Cover
• Half-title Page
• Title Page
• Dedication
• Copyright Page
• Contents
• Preface
• 1. The importance of arms industries
• 2. The facts
• 3. The economics
• 4. The importance of government
• 5. Arms industries: structure and conduct
• 6. Arms industries: performance
• 7. Buying arms
• 8. The military–industrial–political complex
• 9. Disarmament, conversion and peace
• 10. The future of arms industries
• References