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Views and Opinions

Problems Inherent in the International Comparison of Defence Expenditure

by Lieutenant-Colonel E.R. Fetterly

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“War is a matter not so much of arms as of expenditure, through which arms may be made of service.” (Thucydides, History I)

Introduction

National military expenditures are considered a relevant indication of military strength. One consequence is that defence expenditures are commonly used as an international measure of military power. However, in terms of the use of military expenditures as an analytical tool, defence analysts agree that statistical data available on defence spending is not comprehensive, and should therefore be interpreted with caution. The use of comparisons by converting monetary aggregates of defence expenditures to a specific currency has numerous deficiencies. However, it avoids the myriad of problems inherent in comparing force levels across nations. The objective of analyzing defence expenditures between nations is that through such comparisons, the relative amount of resources allocated to defence can be ascertained in order to determine the relevant defence burdens across nations.

National governments strive to achieve multiple goals simultaneously, of which national defence is simply one consideration. Consequently, interest groups, constituents, and others pressure governments to adopt various and sometimes contradictory courses of action. The results are policy choices made by government. The effect of policy decisions is that scarce resources will be allocated to achieve policy objectives. This is reflected in the outcome of the annual budget cycle. Furthermore, the composition of a defence budget is the result of the resolution of political, macroeconomic, and microeconomic concerns that are encountered in the budget process. This is evident in two distinct areas. First, the aggregate level of defence expenditure is a demonstration of national will to other countries. Second, defence budgets are a means to achieve military capabilities through the appropriate allocation of resources.

The objective of this opinion piece is to review the problems inherent in the international comparison of military expenditure. Although operational factors are the determinants of the size, and of the actual distribution of resources within defence budgets, once defence budgets are established, it is economic-based factors that are often used when comparing defence expenditures internationally. The focus of this opinion piece is limited to the comparison of defence expenditures among nations, and, therefore, concentrates upon economic-based factors that are applicable after the establishment of a defence budget.

Impact of the National Economic Structure

The structure of an economy can have an overriding impact upon the composition of the defence budget. In a free-market economy, prices are established through the voluntary exchange of goods and services, and they generally reflect their opportunity cost. Conversely, in a planned or socialist economy, it is the political or state bureaucracy that largely establishes production levels, as well as the prices charged for the output of that production. As a result, the prices for goods and services do not necessarily reflect their real value. Similarly, the wages and benefits of military personnel are derived from this same process. Because the political and bureaucratic process establishes prices, the defence budget in a planned economy is an artificial document that does not necessarily reflect the value of the inputs, or the resulting defence capabilities. However, notwithstanding the economic system in which the nation operates, it is generally the case that the government is the only purchaser of military weapons, and, therefore, their true value is not determined upon an open market. Defence expenditures as a comparison tool are therefore only of value to the extent that the prices used actually reflect either their actual opportunity cost or the military capabilities they produce.

Categories of Defence Expenditures

Defence expenditures can only be compared to the extent that the components that make up those expenditures are consistent. However, nations report defence expenditures in categories that suit national practices, preferences, and circumstances. Consequently, national governments do not report their defence expenditures according to a common international definition. NATO adopted a common definition of defence expenditures in 1950, and regularly publishes official alliance comparisons. Nevertheless, the expenditures reported nationally by NATO countries to their respective legislative bodies differ from that of published official NATO data. This is due to the allocation nationally by NATO governments of defence resources to areas other than those defined by the NATO Secretariat as defence expenditures. This pattern of inconsistent application of a commonly agreed upon definition of defence expenditures by NATO member states to the structure of their national defence budget components is illustrative of the differences all nations apply to the definition of defence expenditure. Consequently, there is a lack of consistency to both the structure and the components within national defence budgets that is not generally addressed when international comparisons of aggregate defence expenditures are analyzed. The result is that aggregate defence expenditures can be overstated if nations include expenditures for elements such as nation-building and search and rescue. Conversely, defence budgets are understated if defence expenditures are reported in the budgets of other government departments.

Exchange Rates

To facilitate the comparison of defence expenditures across nations, national expenditures are generally converted to United States Dollars. The conversion is made with the use of exchange rates. However, the specific exchange rate chosen can have a significant impact upon the resulting converted values. There are numerous problems associated with exchange rates. A number of countries have established official exchange rates on a subjective, or political, basis and, therefore, these exchange rates do not reflect valid market rates. This is primarily, although not exclusively, the case with countries where their economic system is based upon other than market forces. Consequently, these exchange rates are inappropriate for use as a measure to convert currencies. The impact of artificial exchange rates is that they tend to overvalue their currency, and, consequently, defence expenditures are overstated. Therefore, other methods must be used in order to estimate more accurately the relationship between the prices in each country.

In an international market economy, the exchange rates of currencies between nations can vary moderately on a daily basis, with significant variations possible during extended periods, such as a calendar year. As a result, the date at which the exchange rate is selected could have a dramatic impact upon the aggregated data. In addition, the internal purchasing power of a currency is not generally evident in exchange rates. Even for countries such as Canada and the United States, which have a relatively similar economic structure, the internal purchasing power of each respective currency is not necessarily equivalent. Consequently, exchange rates are not always suitable for use as price deflators when comparisons are made between nations.

Exchange rates in a market economy are based upon information produced by the statistical bureau of each nation to a certain extent. The GDP and other relevant aggregate financial data are all released regularly by government statistical agencies. This gives a general description of the economic status of each nation. Decisions by foreigners to buy or sell currencies are made in part through an assessment of national fiscal and monetary policies, economic and political stability, as well as terms of trade. This assessment, to a significant extent, is based upon the use of government statistics. However, the statistical office of each individual nation collects, evaluates and reports economic data in a different manner and at various levels of sophistication and accuracy. Consequently, estimates of aggregated data are difficult to verify independently.

The reliance of nations upon international trade varies greatly. Some nations with a large dynamic internal market might place little emphasis upon international trade. Conversely, other nations, such as Canada, have an economy highly reliant upon international trade. Market forces in countries, such as The Netherlands, with a high level of trade, act to move the exchange rate towards its true value. In the case of a country with limited external trade, conversion based upon an official exchange rate may be a poor tool for use in making international comparisons of defence expenditures, as foreign trade would affect only a small section of that economy.

Finally, purchasing-power-parity (PPP) is a tool that can be used to reduce the effect of fluctuating exchange rates. The objective of PPP is to develop an exchange rate that renders the prices of goods and services in each country to an approximately equivalent amount. In essence, outputs are valued with one pricing. However, this process is not without its difficulties and it has been acknowledged that calculating PPPs is, at times, more art than science.

Price Indexes

The purpose of a price index is to take a specific assortment of identical goods at two separate points in time, and to measure the average change in price of that collection of like goods. The basis of the validity of the price index rests on the premise that the goods used at each point in time are identical. In the event that the goods are different from a technical or qualitative standpoint between periods, the value of the index comes into question. Price indexes in common use are generally civilian in orientation. Consequently, the Consumer Price Index, or a similar general civilian price index, is often used to deflate military expenditures.

The impact is that by using civilian indexes as a surrogate for military indexes, they reflect general price movements in the overall economy, and not specifically that of the military sector. The use of a civilian price index, therefore, includes the implicit assumption that the rate of change in factors is identical. Consequently, civilian price indexes are used not for their accuracy, but as a result of the absence of valid military price indexes.

A limited number of countries have published a military price index. This is done in Canada by the Strategic Finance and Economics section of the Directorate of Budget at the Department of National Defence. The Department produces a Defence Economic Model as a means of measuring the impact of inflation on the purchasing power of Canadian defence spending. There are substantial complications that arise in attempting to establish a distinct and transparent methodology for the calculation of a military price index. This includes the challenge of calculating the rate of change in quality of equipment, productivity growth of military personnel and civil servants, and defining military equipment in sectors where dual use technology is becoming more prevalent. Frequently, military outputs either lack market prices, or the goods used, such as tanks, are unique to the defence sector. Furthermore, a range of military goods can be transferred from one country to another as a gift or as part of a military assistance program, and, therefore, are not reflected in budgets and their subsequently converted indexes. In addition, the vast quantity of products purchased by the military renders the task of pricing all goods and services individually virtually impossible, thus requiring sampling to obtain the required data.

Use of Constant Price Figures

Constant dollars are often used to measure trends in military expenditures over time. In order for a constant price series to be of value, the availability of a detailed, and consistent, classification of military expenditures must be available to enable problems with each category of expenditures to be identified and addressed. However, this detailed classification of expenditures is generally different, in a variety of aspects, for each nation. In addition, the unique combination of price characteristics within the military sector complicates attempts to convert defence expenditures to constant dollars. A notable feature of the market is that the cost structure of military products is constantly evolving, even within individual periods of measurement, such as one year. Consequently, base-year weightings will be outdated in a short period, and, therefore, need to be revised.

Domestic Rates of Inflation

The domestic inflation rate for military related goods and services is not necessarily the same as that of general inflation within an economy. Specifically, military related domestic inflation has tended to be higher than that of general domestic inflation. The result is that if defence budgets are increased to match general inflation only, then defence related purchasing power will decline. This will not be evident in published shifts in levels of defence expenditures. Similarly, domestic rates of inflation from nation to nation will also vary, and unless offset by corresponding changes to exchange rates, they will adversely affect the international comparison of defence expenditure.

Recruitment and Employment of Personnel

Military organizations have recruited personnel through three main methods. These include recruitment by voluntary enrolment, conscription, or a combination of both. Each method has a markedly different impact on the defence budget. To recruit voluntary military personnel, the military must offer attractive wages and benefits that are competitive with the private sector, as both are recruiting from the same pool of young citizens. Conversely, with conscription, young personnel selected for military service by the State are required to fulfil a specific mandatory period of service. Consequently, the military does not have to compete in the job market for new personnel, and, therefore, salaries and benefits can be kept artificially low, and the defence budget will not reflect this fact. The funding level for personnel in the defence budget of that nation, as compared to market rates, will be understated. However, that will be offset to a certain degree by the economic and social burden that conscription brings to a nation. Similarly, the ratio of full-time military personnel to reservists will affect the budget, depending upon the level of each category.

Technological Change and Age of Capital Stock

The emphasis in weapons procurement today is on qualitative, not quantitative, factors. Instead of spending significant sums on the procurement of increasing quantities of weapons, defence departments are now placing their emphasis upon increasing their capabilities. Qualitative improvements in military equipment are achieved through extensive military research and development (R&D). Consequently, current levels of military R&D are prominent indicators of future innovation. R&D expenditures can be a significant element of defence budgets in larger military powers, which is an expression of support for their Defence Industrial Base. Conversely, the R&D effort in smaller nations can be understated, due to technology transfers or the importation of equipment. Compared to R&D in the civilian sector, it can be stated that the military R&D effort to support defence procurement is significantly more intensive. Successful military R&D has two effects. First, it speeds up the pace of armament procurement, and, second, it acts as a stimulant to generate further R&D. The increased level of technology in new weapon systems has a corresponding effect on costs.

The current military capability of a nation is not necessarily reflected in its current defence budget. To a great extent, current capabilities are a reflection of past defence budgets. Weapon systems in defence inventories that were procured in previous years are only reflected in current defence budgets through the ongoing costs of their maintenance and operation. Indeed, the higher the numbers of personnel and weapons systems used by the military forces, the greater the amount of resources that must be allocated to operations and maintenance (O&M) budgets. In essence, there is some positive correlation between O&M budgets and defence capabilities.

The capital acquisition component of current budgets has limited applicability when compared internationally. However, it is an indicator of future changes in capabilities. Advances in weapons technology have been a constant feature of the Western armaments market during the last century. The effect has been that weapons designed for use over several decades are obsolete long before the end of their useful life. A demand is then created for the procurement of newer and more expensive weapons. Consequently, the age of capital stock is an important determinant of its effectiveness upon the battlefield. However, the age of weapons, and their resulting value, is not reflected explicitly in current budgets or in actual expenditures. In addition, due to the unique characteristics of the defence sector, there are no definitions of excess supply in the market. Consequently, there is the potential to produce more weapons than actually required by a society. The opportunity cost of this over-production of weapons is not evident in international comparisons of defence expenditures.

Conclusion

The comparison of defence expenditures between nations is one tool that can be used in attempts to measure the defence burden across nations. This technique is significant because the interpretation made of the levels of defence expenditures in other nations by one country can have an influence on its domestic expenditures for defence. In essence, military expenditures are simply the combined total of capital procurement, operations and maintenance costs, and personnel costs. It would appear therefore to the casual observer to be a simple process to compare defence expenditures among nations. Nevertheless, many practical and theoretical factors hinder the in-depth comparison of defence expenditures across nations. At present, the best that can be accomplished through the comparison of defence expenditures on an international basis is that an analysis of the data can be used to reveal general trends. An appreciation of the problems inherent in the data, as discussed in this opinion piece, will allow the analyst to better understand the limitations of the conclusions obtained from manipulating and comparing international defence expenditure data.

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Ross Fetterly, a PhD candidate in War Studies at the Royal Military College, is the Section Head in Director Strategic Finance and Costing at National Defence Headquarters.

LAV III

DND photo LV2005-A071 by Corporal Serge Gouin

Exercise Phoenix Ram, the largest combined arms brigade-training event in Canada since 1992, took place at the Wainwright Training Area in Alberta in 2005.