There is a widely held view that political tensions and associated high levels of military spending are likely to detract from a country’s long-run economic growth performance. In an insecure region, so the argument goes, each country must devote a disproportionate share of its endowment of scarce economic resources to “unproductive” military spending. In the absence of international cooperation to reduce political tensions, military spending may be ratcheted up throughout a region as each country tries to outspend its neighbors to ensure its own security, resulting in higher levels of military expenditure but no increase—or even a decrease—in the security of the region. While political tensions themselves can weaken various aspects of economic performance, there are two direct and interrelated avenues by which higher military spending may adversely affect long-run output growth. First, increases in military spending may reduce the total stock of resources that is available for alternative domestic uses such as investment in productive capital, education, and market-oriented technological innovation. Second, high spending on the military may aggravate distortions that reduce the efficiency of resource allocation, thereby lowering total factor productivity.
If these effects turn out to be empirically significant, then a converse proposition is also likely to be valid: the sustained military spending cuts that would become feasible as a result of improved international security should yield a “peace dividend” in the form of higher long-run levels of capacity output. It would then follow that forms of international cooperation that succeeded in reducing tensions, and thus in lowering military spending, would be to the long-run economic benefit of all countries. Interest in the potential size of this peace dividend has risen considerably in recent years with the improvements in international security that have become evident for both industrial and developing countries with the end of the Cold War and the more recent initiatives aimed at achieving a comprehensive peace in the Middle East.
The view that low levels of military spending are associated with strong growth performance is usually argued by recourse to casual empiricism. For example, the post-World War II experiences of the Federal Republic of Germany and Japan lend support to the notion that there are substantial economic benefits from sustaining low rates of military expenditure over long periods of time. The strict postwar limits on defense spending in these countries—combined with the Allies’ effective guarantee of their security— were factors that allowed the Federal Republic of Germany and Japan to devote relatively large proportions of their total factor endowments to productive capital formation, thereby contributing to their impressive economic growth performance during the succeeding five decades. Such general but striking observations have left most economists with a strong presumption that, on average, a country that has a relatively low ratio of military expenditure to GDP is likely to display relatively strong long-run growth performance.
Yet not all military spending is unambiguously counterproductive, or even unproductive, in an economic sense. It is often argued, for example, that expenditure on military training in developing countries may contribute to improving the educational level and discipline of the labor force and may act as a stabilizing influence in the society. Likewise, it has been argued (see, for example, Thompson (1974)) that military expenditure can be economically productive to the extent that it enhances the state of national security and improves the enforcement of property rights, thereby encouraging private investment and growth. Capital expenditure on the military can also have productive uses: many developing countries still benefit from transport and communications networks that were originally constructed for military purposes. These counterexamples suggest that the question of whether, and to what extent, military spending is economically unproductive cannot be resolved by recourse to anecdotal evidence and historical generalizations, but instead requires rigorous theoretical and empirical analysis.
The analysis must also be able to confront formidable estimation problems. Even if cuts in military spending do improve growth performance substantially, these effects are likely to occur with a long lag. Thus, even in cases where military spending cuts are large, the ultimate beneficial effects may be hard to disentangle empirically from other factors that also influence economic growth. Given these considerations, it is not surprising that the existing empirical literature yields ambiguous results, not only on the magnitude of the impact of military expenditure on long-term economic growth, but even on whether the effect is positive or negative. Nevertheless, if national governments are to be convinced that it is to their economic advantage to stockpile fewer guns in order to make room for more investment in productive capital, they need to be presented with robust quantified estimates of the costs that military spending imposes on the economic welfare of their citizens and to have convincing evidence of the improvements in living standards that can result over the long run from military spending cuts.
Such a quantification is attempted in this paper. We address several questions. Is there a peace dividend from military spending cuts? If so, how large might it eventually be? More specifically, how much is productive investment likely to increase in response to military spending cuts, and how strongly will the associated improvements in the efficiency of resource allocation increase long-run capacity output, relative to the level it would have attained if the fraction of GDP absorbed by military spending had remained unchanged?
This paper extends a standard neoclassical growth model to take account of important linkages between military spending, productive investment, and the long-run growth of per capita capacity output. It implements an econometric technique for obtaining empirical estimates of the model from a panel of time-series and cross-sectional data for a large sample of developed and developing countries. We then use the estimated model in simulation experiments designed to gauge the size of the peace dividend—that is, the impact of cuts in military spending on economic growth performance—in a number of major geographic regions. Our estimation and simulation analyses suggest that these peace dividend effects would take some time to emerge, but would eventually be large, especially for countries in regions—such as Eastern Europe, North Africa, and the Middle East— where levels of military spending have traditionally been high.
The paper is organized as follows. Section I summarizes trends in military expenditures since the early 1970s and reviews the empirical literature on the relationship between military spending and economic growth. Section II outlines our extension of a standard neoclassical growth model and the estimation technique used. Section III first presents standard cross-sectional estimates of the effect of military spending on investment and economic growth, and then contrasts them with the results of our panel data estimation. Section IV describes two simulation experiments that help to indicate the rough order of magnitude of the peace dividend from military spending cuts. We first simulate the long-run growth effects of the developments in military spending that have already taken place in various geographic regions during the latter half of the 1980s. We then simulate the potential effects of further declines in military spending that might occur in various regions in the future if a lasting global peace could be secured. Section V concludes.
APPENDIX I Data Sources and Definitions, and Sample of Countries
APPENDIX II Simulation Exercise
There are three elements that determine the gains in GDP over time for a given reduction in the ratio of military spending to GDP (M/GDP = m). First, the effect of m on the ratio of investment to GDP, and the latter’s effect on per capita GDP growth; second, the direct effect of m on per capita GDP growth; and third, the effect of the current per capita GDP on its growth rate (the convergence effect.) From equations (1) and (2), the percentage gain in per capita GDP (Δzt) for a given percentage change in the military spending ratio (Δln m) is given by
The change in the level of the investment ratio produced by a given percentage change in the military spending ratio can be approximated as follows:
Δln m for each group of countries is computed as follows:
Δln m = ln [Average M/GDP( 1986–1990)] – ln [Average M/GDP( 1972–1985)]
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Malcolm Knight, Deputy Director of the IMF’s Middle Eastern Department, holds a Ph.D. from the London School of Economics and Political Science. Norman Loayza is an Economist in the Macroeconomics and Growth Division of the World Bank’s Policy Research Department. He received his doctorate from Harvard University. Delano Villanueva, who holds a doctorate from the University of Wisconsin, was Assistant to the Director of the IMF’s Middle Eastern Department when this article was written. He is currently on a year’s sabbatical leave at the University of Hawaii. The authors are indebted to Paul Cashin, Daniel Hewitt, Mohsin Khan, Anne McGuirk, Peter Montiel, and Michael Sarel for comments. Daniel Hewitt also provided data and advice on interpreting available statistics on military expenditures. Peter Kunzel assisted with the empirical research.
Appendix I provides definitions and sources for all data used in this study. A detailed discussion and analysis of the SIPRI data on military spending, as well as that provided by other sources, is given in Hewitt (1992 and 1993). Based on his detailed analysis, Hewitt concludes that the SIPRI data are to be preferred to other sources for empirical work of the sort we undertake here.
Our paper makes use of the data on military expenditures presented in Hewitt (1992 and 1993), which are based mainly on statistics published by SIPRI. Hewitt’s data cover 124 industrial and developing countries.
It is noteworthy that the weighted average military spending ratio for the whole group of developing countries fell by considerably more than it did in the industrial countries. Whereas the weighted average ratio of developing countries had been nearly 1.6 percentage points higher than that of the industrial countries in Period I, in Period II it fell to a level only 0.6 percentage points higher.
Hewitt (1992) hypothesizes that military expenditures can have a net positive or negative impact on economic growth depending on the alternative use of the funds. He argues that military expenditures on general-use public infrastructure and promotion of research, as well as demobilization of trained personnel, contribute to economic growth; however, military spending is an inefficient way to enhance growth compared with private investment expenditure or government expenditure on social infrastructure and education. In the context of developing countries, Hewitt contends that the justification for military expenditures must be on national security grounds, since the economic benefits are limited.
Hewitt (1992) notes that increases in military spending may be financed through higher external borrowing, lower private consumption, lower private investment, and lower expenditures on other government programs, including productive ones such as education and health services, public infrastructure, and the police and judicial systems. In general, the likely consequences would be lower current consumption and investment levels and lower future growth, the exact mix being dependent on the particular financing channel.
For details of this derivation, see Knight, Loayza, and Villanueva (1993). The growth effects that we discuss in the current paper apply to the transition to the steady state.
The Barro-Lee proxy variable for the incidence of wars is defined for each country as the number of war years as a fraction of total years in the period 1960–85. See Barro and Lee (1993).
There are three differences between the growth equation specified in this paper and the one used in our 1993 paper. First, in this paper we do not include the ratio of government fixed investment to GDP as an explanatory variable, since we found it to be statistically insignificant in our previous study. Second, and more important, we now include as a regressor the ratio of military expenditures to GDP. Finally, to isolate the effect of military expenditures on the allocation of productive resources, we control for the incidence of wars on economic growth by including the above-mentioned Barro-Lee proxy.
The assumption that g + δ = 0.05 follows Mankiw, Romer, and Weil (1992). We find that although changes in this number affect the estimated θn, they do not significantly affect the other estimated coefficients.
The countries excluded from our sample are those in Eastern Europe (including the countries of the former Soviet Union and the former Democratic Republic of Germany), and other countries for which complete data were not available for other variables in the model. The latter include several developing countries in Asia, sub-Saharan Africa, and the Western Hemisphere. Consistent with other empirical studies of long-term economic growth, we also exclude from the estimation sample a few countries—mostly in the Middle East and North Africa—whose main source of GDP comes from the extraction of petroleum resources. The list of countries and the data sources for the variables used to estimate our model are presented in Appendix I.
The exception is sub-Saharan Africa, where the country coverage of our sample is much less comprehensive than Hewitt’s owing to the unavailability of data on the other variables in equations (1) and (2). As a result of these differences in coverage, our data show a small decline in the weighted average military spending ratio for these countries, while Hewitt’s more comprehensive data show a small rise.
In this paper the term investment, used alone, refers to investment in physical capital. When we refer to human capital investment, we say so explicitly.
This follows the technique used by Phillips (1958) to ensure that his estimated relation between the rate of change of nominal wages and the level of the unemployment rate was approximately a phase line.
As expected, the proxy for the incidence of wars exerts a direct negative and significant effect on economic growth. The inclusion of this variable in the panel estimates also alters the magnitude of the estimated coefficients of the other regressors. In fact, all such coefficients decrease in absolute size, reflecting the fact that levels of both physical and human capital are negatively correlated with the incidence of military conflict, whereas the incidence of military conflict is positively correlated with intensification of trade restrictions and with increases in military expenditures.
The positive correlation between military spending and trade restrictions is particularly strong in developing nations. Given that most of these countries import military armaments from industrial countries, they are more exposed to balance of payments difficulties when these purchases are made. This may be one of the reasons why developing countries also tend to operate more restrictive trade regimes.
Specifically, we assume that the natural logarithm of the military spending ratio declines linearly over this period.
To implement the simulation we first substitute equation (2) into equation (1) to obtain the reduced-form relationship between the military spending ratio and the growth path. From this reduced-form equation we obtain the deviation of the simulated growth path for each region owing to the change in the military spending ratio from the path that would have prevailed if this exogenous change had not occurred (for a detailed explanation see Appendix II). Note that since ours is a long-run model the simulations trace the dynamic effects of this change on regional levels of capacity output. We are not interested in the short-run Keynesian multiplier effects of military spending cuts, since these affect actual output relative to capacity output.
Even for the industrial countries and Western Hemisphere developing countries, where initial military spending levels were low and where the cuts during the latter half of the 1980s were modest, per capita output levels would eventually be 2.0 percent and 2.9 percent, respectively, above the baseline paths.