Britain's defence spending protects the realm and the economy

The newspapers and screens have been full of conflict and bad news stories from across the globe: Ukraine, Gaza, Syria and Iraq. The human cost and humanitarian toll is high, but what can we say about the economics of such events?

Last week, Governor Mark Carney was the latest to warn of the economic downside from geopolitical risks. Others worry that financial markets are not fully reflecting geopolitical risks and possible consequences. If true, it would not be the first time markets have not priced fully for risk. Ahead of the 2008 crisis, they did not price properly for economic risks, what about geopolitics now?

In my view, this needs to be seen in the context of what is called “hard power”. This is military or defence spending. It has an important influence on the global economic outlook. In my book, The Consolations of Economics, I highlight four key global economic drivers and hard power is one of them.

One is economic and financial power, highlighted by the emergence of China and India and the recovery under way now in the US and UK.

Another is global policy institutions, which are taken for granted but are none the less key. After all, whatever economy one looks at, the outcome depends upon the interactions between economic fundamentals, policy and confidence. Policy plays a big role through interest rates, government spending and taxes but also in terms of global groups such as the International Monetary Fund and G20.

Then there is “soft power”: the power to influence. This is good news for London and the UK. Those who have soft power are copied by others across the world and in economic terms it reflects the importance of global brands and the influence of culture.

The fourth key global driver is hard power. A significant amount of global spending goes on defence, about 2.5pc. Fifteen countries account for four-fifths of global defence spending. The number one spender is the US, which spends more than the next nine added together! The big spenders are the US, followed a long way behind by China, then Russia, Saudi Arabia with the UK in fifth. The rest of the top 10 is made up by France, Japan, Germany, India and Brazil.

Often we overlook the immediate benefits of military spending, in terms of jobs created and scientific and other research that is funded. This is more noticeable in the US than elsewhere.

It is easy to think of defence spending as building tanks, but it is also the optical equipment and computer technology that makes them work and which ends up having a commercial economic benefit. It can also fund innovative, scientific and other research, often at universities, that might not otherwise take place.

That being said, there is no shortage of global economic innovation now, outside of defence, in areas such as stem cells, robotics, 3D printing or green technology. Yet hard power spending plays an additional role, as we see with advances in everyday areas such as trauma care, prosthetics, in the use of data and communications and there is even talk about the commercial viability of using drone technology.

The trouble is, in the West, the economics of military spending, as Sanders Research has pointed out, is that the profits in defence are geared to costs, thus favouring expensive, capital-intensive spending on weapons systems, which often prove not as effective as they should be when put to the test. So the big spenders don’t always win when it comes to the conflicts.

Naturally, if you are in a region impacted by military conflict you see the devastation and economies that are hit by cuts in spending and investment. For the rest of us, it is usually the oil price that is seen as the economic barometer of risk, usually being pushed higher as a risk premium is factored in.

Although the price of oil rose on Friday, it is remarkable that despite recent conflicts it was at a nine-month low earlier in the week, largely on expectation that a weak Europe will dent energy demand. The price of gold, too, often reflects geopolitical risks but that has far less economic impact, so is not a concern.

Despite current economic problems in Europe, I am positive about global growth. But even if the world economy does well, we should be prepared for future geopolitical hot spots.

The area where I think we need to focus our attention in coming years is Asia. In his first six years in office, two of President Obama’s many important words were “and” and “pivot”. Before he came to power, the US had an annual strategic economic dialogue with China. He changed this to a strategic “and” economic dialogue. The importance of this is huge. The good news is that it has allowed China and the US to become increasingly economically linked, with a cat’s cradle of interconnections, despite the politics.

It is a big plus for the world economy that its two biggest economies are tied together in free market values. Of course, the strategic side is different, as the two countries naturally have tensions, cyber security being one example.

That is where the US pivot to Asia is key. The Cold War saw the US versus Russia, with Europe the focus. Notwithstanding Russia’s regional ambitions in Ukraine, the two economic giants to focus on are China and the US. Thankfully, their economic links make a new Cold War a non-starter.

Given this, perhaps the most important event last week was the meeting of foreign ministers from the 10-country Association of South East Asian Nations.

The fact that 17 other countries attended as observers including China, Russia, India and the US shows how important this region has now become. And the major topic: the China Seas, as there are many disputes as to who owns islands and shipping rights within them. The South China Sea accounts for half of world trade.

America wants to retain a high military presence in Asia, but would prefer it if others spent the money.

In this context Japan and India are now strategically important and this is likely to help the success of Abeconomics in Japan and Modi-economics in India, as both increase defence spending. In the future we may talk less of Asia-Pacific and more about Indo-Pacific to reflect this resurgence of Japan and growing importance of India.

Next month Narendra Modi, India’s prime minister, visits Washington. India is a key economic market. One in 12 people in the world is an Indian under 27. In hard power terms it is increasingly important, too.

What does this mean for us? The UK economy is recovering. It has weathered the biggest financial crisis for 80 years. It is weathering the crisis in Europe hitting our exports. Geopolitics is always a risk – both directly through higher oil prices or indirectly by denting confidence.

That is why a strong pound that helps keep import prices down and interest rates low until the economy is more resilient makes sense. It is why retaining the confidence of international investors is vital.

Beyond that, we should keep focusing on positioning ourselves to benefit from the rapidly changing and growing world economy, including the importance of our defence capability. The UK has soft power and needs to retain its hard power, too.

Dr Gerard Lyons is chief economic adviser to Boris Johnson and is the author of The Consolations of Economics (Faber & Faber)