A macro-economic approach to understand...

©Decision Analysis Services Ltd 2013

This document is Copyright ©2013 of Decision Analysis Services Ltd. Its contents wholly or in part shall not be communicated or copied by any means whatsoever to any third party, individual or organisation or government without citation of Decision Analysis Services Ltd.

A macro-economic approach to understand the affordability of a nation’s defence budget Dave Exelby (Managing Consultant, Decision Analysis Services Ltd) and Martin Turner (Chief Economist, Manchester Economic Forecasting, Manchester Metropolitan University)

Prepared for ISMOR

30 July 2013

ISMOR July 2013 1


Background

• This is a review of work we have been developing over several years at DAS & MEF

• Insights have been used for a variety of studies for defence primes and supporting parts of UK MoD

ISMOR July 2013 2

• The challenge we set ourselves

– “Could we develop a framework to create scenarios for UK total defence spending beyond CSR (e.g. to 2020 and beyond) reflecting UK’s public spending needs”

• Why would we want to set this challenge?

– SDSRs ought to have an eye on the long term view. Can proposed force structures remain affordable to UK?

– Defence acquisition decisions impact on timeframes well outside the CSR horizon

– Economic growth is uncertain - need to explore alternative scenarios

– Global economics is shifting balances of wealth and power

– Clients need to get an independent view on the defence spending of nations including UK


A high level systems map of our challenge

ISMOR July 2013 3

UK economic output

Defence budget

Other department needs

Geo-political threat (trend)

Geo-political threat (ops)

Defence share of govt. spend

Allies/threat defence spend

UK demographics

Force structure (EP, ESP, Other)

• Defence budgets are impacted by – Economic output

– Demands on other departments

– Threat

• Note we are adopting a top down view – not the traditional bottom up

– How much can UK afford to spend before we get to the capability choices

-

+

+

+

+


UK defence spending has been falling since WW2

• Decline has taken place over the decades

• Periods of stability and decline

• Key questions

– What will happen this time

– Impact of economic performance

– Maintaining current long term trend or are we in a new era?

ISMOR July 2013 4

R² = 0.9238

0

1

2

3

4

5

6

7

8

1960 1970 1980 1990 2000 2010

1960-2011 is -1.3% pa CAGR

UK defence spend (% of UK GDP)

?

0

10

20

30

40

50

60

1960 1970 1980 1990 2000 2010

UK public spending (% of UK GDP)

• Some correlation within the cycles for both public spending and defence

• Little shift in long term trend

• Defence spending often gets squeezed when general spending tight

Source: http://www.ukpublicspending.co.uk/downchart_ukgs.php?chart=F0total&year=1900_2011&units=p&state=UK


UK demographics and macro economics are driving demands on other departments – example ageing population

ISMOR July 2013 5

• The increase in non-working populations will be a major driver of other departmental demands

http://www.parliament.uk/business/publications/research/key-issues-for-the-new-parliament/value-for-money-in-public-services/the-ageing-population/


Our approach – Use a macro economic core model (MGEM) to produce key driver estimates for a defence share model (DEFMOD)

ISMOR July 2013 6

Starting point/ hypothesis

Requirement Approach

Defence spending appears to correlate with the state of public finances in the short term

Represent the short/medium term public finances derived from UK economy

• Deploy a comprehensive macro economic model of the UK

• Reflect official Treasury/OBR forecasts and forecast beyond

• Play out alternative scenarios • Output key metrics used to drive defence spending

Defence within public spending priorities has declined as a long term trend

Represent the drivers for defence spend

• Explore long term trends for public spending • Long term trends in other department spending • Incorporate demographic drivers

Defence is based on maintaining comparative strength with allies/against threats

Understand the relative change in defence spend by allies and threats

• Ensure the macro economic model incorporates other global economies and use this to better understand global defence spending

Geopolitical actions Be able to include/understand political action

• Allow scenarios where political intervention can be incorporated


Our macro economic model – the MGEM model: An overview

• MGEM is an example of a type of model that seeks to represent global economies as a system of systems

– These types of models used by OECD, IMF, European Commission, US Fed as well as economics consulting houses

– MGEM has provided global forecast inputs to a number of scenario projects

– MEF modelling expertise used recently by Economist Intelligence Unit (EIU)

ISMOR July 2013 7

• We only have time to give an overview of the key features of the MGEM model so for the non-economists it may appear that….


Our macro economic model – the MGEM model: Nation coverage

ISMOR July 2013 8

Zone

Major 7 US, Japan, Germany, France, Italy, Canada, UK

Other OECD Spain, Holland, Belgium, Sweden, Switzerland, Australia, Mexico, Korea, Denmark, Finland, Austria, Norway, Ireland, Greece, Portugal, Luxembourg, Slovenia, Slovakia, Iceland, Czech Republic, Poland, Hungary, N Zealand, Estonia, Chile, Israel

BRIC+ Argentina, Brazil, Russia, South Africa, India, China

Dynamic Asia Thailand, Singapore, Malaysia, Taiwan, H.Kong SAR, Indonesia, Philippines

Other trade zones East&Central Europe, Africa & M.East, Latin America, Rest of the World

• MGEM is an example of a structural macroeconomic model

– Explicit economic drivers/structure specified (superior for meaningful shock/policy modelling)

– Contrasts to a pure time series model i.e. “black box” statistical model (no drivers specified)

– MGEM leverages current macro economic modelling knowledge and is developed by Manchester Economic Forecasting (based at Manchester Metropolitan University)

– Models economic disequilibrium; doesn’t assume economy is always “on trend”

– Reflects the model philosophy/approach of the Fair global model (Ray Fair, Yale University)

• It has wide global coverage:


Our macro economic model – the MGEM model: Demand and Supply

• Labour Market

• Sluggish labour market/wage dynamics (as in Fair Model)…

• ..thus threat of inflationary spiral is relatively low (in OECD country models)

• Demand side

– Trade (goods and services) consistent across the 49 countries/zones

– Incorporates cognitive limitations on the economic agents – backward looking expectations (ie no “rational expectations” assumed)

– Components of GDP are explicitly modelled:

• Consumption (public and private)

• Investment (public, private)

• Net trade (goods, services)

ISMOR July 2013 9


Our macro economic model – the MGEM model: Demand and Supply

• Supply side – capacity of the economy

– Uses a calculation of potential GDP based on the full use of factors of production

• Capital, labour and technology

• Incorporates the impact of R&D i.e. quality adjusted Investment

• Comparing Demand & Supply – gives a measure of the “output gap”

• Policy Modelling: – Monetary Policy - Taylor Rule for Interest Rate Setting

• Short-term rates respond to off-target inflation and the output gap

– Exchange Rate • Moves with UK:US interest rate differentials + risk premium

– Fiscal Policy • Next slide

ISMOR July 2013 10


MGEM: National Debt (Fiscal Forecast Overview)

National Debt – is the accumulation of past budget deficits which themselves are the shortfall of public revenue to spending.

National debt is a key driver as a proxy for fiscal capacity

• How MGEM models the broad components of public debt:

– Spending – partly determined by political/budget decisions & partly mandatory eg unemployment (thus dependent on the state of the economy)

– Revenue – depends on the interaction of any (planned) tax rate changes over forecast + state of economy (ie various tax bases)

• UK Budget/OBR Forecasts imposed as the Central Forecast:

– Spending – OBR forecasts of Consumption (Procurement + Wage & Salaries) & Capital Spending imposed over forecast.

– Revenue – any (planned) tax rate changes imposed over forecast.

• UK scenario exercises often examine the fiscal consequences (Budget Deficit National Debt) of any deviation from OBR forecasts for the path of the economy

ISMOR July 2013 11


The macro economic model can be used to develop a forecast aligned to OBR – central forecast

• This provides alignment to official OBR estimates and forecasts beyond 2015

• We can also now step off and undertake a variety of scenarios

ISMOR July 2013 12

1200

1300

1400

1500

1600

1700

1800

1900

2000

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20

UK GDP Central Forecast (Sept 2012) (£Bn FY11 constant)

Forecast GDP Growth (£Bn)

Source: DAS/MEF Global Defence Budget Macro Economic Model, DAS analysis


We can use our structural model to represent a set of alternative scenarios

ISMOR July 2013 13

1300

1350

1400

1450

1500

1550

1600

1650

1700

FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

Cen sf1 sf2 sf3 sf4

Scenario Geo political Global economy UK economy UK govt Fiscal policy/QE

Central forecast

Current OBR/HMT forecast OBR/PESA aligned

sf1 Small Labour majority by 2015 Eurozone crisis remains Weaker than predicted – business and consumer

Keep current policy + Further QE


Keep current policy + Further QE. Manage to build consumer confidence

sf3 Large Labour majority by 2015 Eurozone crisis remains Deep double dip recession Plan B policy – major housing programme, cyclical. Further QE

sf4 Chinese arms race gathers pace US avoids sequestration

Stronger Stronger recovery than expected

Keep current policy

UK GDP Central Forecast (Sept 2012) (Bn FY11 constant)



DEFMOD has been developed to estimate impacts on defence budget

ISMOR July 2013 14

National “Political” Judgement of Defence Share Evolution

DEFMOD Satellite Defence Spending Model

Key Behavioural Equation: Defence Spending Share (% of cash GDP)

MGEM ECONOMIC INPUTS:

Public Debt Ratio Non- Working Age Population

Arms Race Driver Geo Political Input:

Weighted average of “enemy” defence spending shares

Defence Spending Level – Current prices

MGEM

ECONOMIC INPUTS: – Cash GDP

Cost Escalator Judgement

DEFENCE

PRICES MGEM

ECONOMIC INPUTS:

– GDP Inflation

Defence Spending Level – Constant prices

• Defence spending data collated from NATO, CIPRI, national sources and IISS Military Balance

• Key success has been synthesis of data within a structured database


1200

1300

1400

1500

1600

1700

1800

1900

2000

How does the model work? MGEM drives forecast GDP & other drivers DEFMOD estimates defence share of GDP

ISMOR July 2013 15

UK defence budget* Central Forecast (Sept 2012) (% UK GDP and £Bn FY11 constant)

Source: DAS/MEF Global Defence Budget Macro Economic Model


2.7% CAGR (‘12-’20)

Combination of GDP forecast (levels) and the estimated defence share of GDP drives the overall Defence Budget (levels)

26.0

28.0

30.0

32.0

34.0

36.0

38.0

FY0

5

FY0

6

FY0

7

FY0

8

FY0

9

FY1

0

FY1

1

FY1

2

FY1

3

FY1

4

FY1

5

FY1

6

FY1

7

FY1

8

FY1

9

FY2

0

* Based on Defence spending ie Total DEL minus depreciation and impairments

2.41% 2.38% 2.45% 2.51%

2.69% 2.65% 2.59%

2.50%

2.16% 2.01%

1.87% 1.76% 1.71% 1.66% 1.63% 1.61%

1.0%

1.2%

1.4%

1.6%

1.8%

2.0%

2.2%

2.4%

2.6%

2.8%

Forecast % Share GDP to defence*

-2.6% CAGR (NB not pts!)

2005-2021

Note 1960-2011 is -1.3% pa

CAGR


26.0

28.0

30.0

32.0

34.0

36.0

38.0


Central sf1 sf2 sf3 sf4 2% real Central GDP

We can now create a set of alternative defence budget scenarios

ISMOR July 2013 16

UK defence budget* scenarios (prepared Sept 2012) (£Bn FY11 constant)

Scenario Geo political Global economy UK economy UK govt Fiscal policy/QE Cumulative diff.£Bn (‘05-’20)

Central forecast

Current OBR/HMT forecast OBR/PESA aligned


Keep current policy + Further QE


Keep current policy + Further QE. Manage to build consumer confidence

sf3 Large Labour majority by 2015 Eurozone crisis remains Deep double dip recession

Plan B policy – major housing programme, cyclical. Further QE

sf4 Chinese arms race gathers pace US avoids sequestration

Stronger Stronger recovery than expected

Keep current policy


Scenario modelling captures scale of uncertainty - UK defence budget may have up to £9.2Bn additional cumulative pressure over next 10 years

Post 2014 defence spend falls below 2% real GDP – fiscal pressures alone could force reshape of UK defence posture. Fiscal scenarios can be influenced by political choices – but illustrate the challenges

0.0

-8.8

-7.4

-9.2

4.4

* Based on Defence spending ie Total DEL minus depreciation and impairments


20

25

30

35

40


Central Sept 2010 Central July 2011 Central July 2012

The DAS/MEF models have been able to track the deepening challenges for UK economy in general and UK defence in particular

ISMOR July 2013 17

UK GDP and defence budget Central Forecast comparisons (£Bn FY11 constant)

Source: DAS/MEF Global Defence Budget Macro Economic Model

Forecast defence spend (£Bn)


1200

1300

1400

1500

1600

1700

1800

1900

2000


Central Sept 2010 Central July 2011 Central July 2012

Emergence of double dip Note that models do predict growth out of recession

In September, assumed that strong growth – no double dip and government spending could maintain around 2% GDP on defence Progressively worsening position. Defence cuts will be deeper but have been spared early austerity. Can defence rebuild post 2020?

1.6% GDP

2.0% GDP

1.7% GDP

Official OBR/HMT

estimate end


Latest MoD reporting suggests that total defence spend by 2020 planned to be around £42bn cash

• Report stated EP will be 45% of total defence budget by 2021 (para.4)

• This would equate to Defence Spend of around £31-34bn (FY11 constant) (@2%pa inflator, DEL or Defence Spend basis in MoD report)

• We can see that this is considerably more than our forecast

– Political will to maintain the %GDP for defence

– Optimistic GDP forecasts post CSR

ISMOR July 2013 18

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19 FY20 FY21

Contingency Support to New Equipment

Support to In Service Equipment Equipment Procurement (Core) - Uncommitted

Equipment Procurement (Core) - Committed Budget

UK defence EP post Round 12 (Feb 2013) (£M cash)

Source: The Defence Equipment Plan 2012, Feb 2013


We can extend our scenarios further driven by share of GDP for defence

ISMOR July 2013 19

• Long term forecasts shaped by public statements from MoD Centre and Cabinet

• Alternative long term futures reflect

— Maintaining a long term 2%/yr GDP growth

— Defence share of GDP

Scenario Description Budget 2012-2040 CAGR Budget 2020-2040 CAGR

Central Forecast extension Maintain 1.6% of GDP post 2020 0.8% 2.2%

Slow rebuild to 2.6% GDP by 2040 Reach 2.6% of GDP by 2040 2.5% 4.7%

Rapid rebuild to 2.6% GDP by 2028 Reach 2.6% of GDP by 2024 2.5% 4.7%

Maintain min 2% GDP Do not let defence slip below 2% in 2015+ 1.6% 2.2%

Long term UK defence budget scenarios (£Bn FY11 constant)

We can use these (or other) budget scenarios to test affordability of force structures and military policy (in terms of tasking)

SDSR Force transformation

CSR horizon

Long term horizon

0

10

20

30

40

50

60

70

80

FY0

5

FY0

6

FY0

7

FY0

8

FY0

9

FY1

0

FY1

1

FY1

2

FY1

3

FY1

4

FY1

5

FY1

6

FY1

7

FY1

8

FY1

9

FY2

0

FY2

1

FY2

2

FY2

3

FY2

4

FY2

5

FY2

6

FY2

7

FY2

8

FY2

9

FY3

0

FY3

1

FY3

2

FY3

3

FY3

4

FY3

5

FY3

6

FY3

7

FY3

8

FY3

9

FY4

0

Central Forecast extension Slow rebuild to 2.6% GDP by 2040

Rapid rebuild to 2.6% GDP by 2028 Maintain min 2% GDP



These top down forecasts support other modelling work – Force Structures

• DAS has developed its Force structures models that can overlay the costs of transition, operating and maintaining capability for force structure options

ISMOR July 2013 20

Required UK military tasks

Cost of running and support

Cost of maintaining capability

Required UK Force Structure

UK defence budget Top down budget

envelopes from macroeconomic models

Tests the affordability of force structures and tasks

0

20

40

60

80

2012 2017 2022 2027 2032 2037

Capital OtherPersonnel Slow rebuild to 2.6% GDP by 2040Rapid rebuild to 2.6% GDP by 2028 Maintain min 2% GDP

Case example Defence budget (£Bn, FY11 constant)


Conclusions

• Work to date

– Need for the top down model

• Defence stakeholders facing an uncertain future

• Scenario testing as part of planning important

• Fiscal and demographic pressures will continue to bear down – by how much?

• Potential use as within SDSR initial exploration of options

– Debate needs to move to fundamental question on defence role – away from individual project focus

• A research agenda going forward - DEFMOD can be enhanced

– Further data collection

– Revisit geopolitical driver algorithms

– Asymmetric threat drivers

– Enhance usability – create the toolset for collaborative work (workshops, Enhance usability – create the toolset for collaborative work (workshops, on-line DEFMOD scenarios)

ISMOR July 2013 21


Contact details

ISMOR July 2013 22

Dave Exelby Decision Analysis Services Ltd [email protected] +44 7867 801362 www.das-ltd.co.uk

Martin Turner Manchester Economic Forecasting [email protected]

+44 161 247 3480

mailto:[email protected]








A macro-economic approach to understand...

Documents

Transcript of A macro-economic approach to understand...