Feature – British Defence Needs Europe

A Soldier Riding a Small Bicycle, British Army.

Fears of perpetual inefficiency of the British defence industry, have driven some to claim that “Britain’s just a third-class power.” With the Brexit debate continuing to echo across dinner tables up and down this country, and with no signs of that ending any time soon, Brexit sometimes becomes a rather abstract and intangible thing: A boogie monster of cataclysmic proportions. Brexit raises a number of questions about Britain’s new place in the world but also reignites the embers of some old debates anew.

In this vein, Britain’s impending exit from the European Union has intensified the cacophony of debate on whether or not Britain should abandon the inefficient domestic defence industry and shift towards more off-the-shelf purchasing in defence procurement. Not only would abandoning the domestic defence industry be short-sighted, but such moves would cause long term economic damage to a significant sector of the domestic economy. This would result in thousands of job losses across the country and unacceptably hamper the ‘freedom of action’ of the British Armed Forces. Both of these consequences would be politically unpalatable.

However, this is not to advocate for complete self-sufficiency across all defence procurement. Autarky would be both unnecessary and extremely costly. This is about tilting the needle on the spectrum slightly further towards greater self-sufficiency in an effort to boost domestic defence exports to economic benefit. This will reduce the domestic unit costs of procurement at a time when off-the-shelf purchasing has become relatively more expensive, while British exports have become cheaper for other nations. Before conducting this analysis, there are a few considerations to note by way of scope.

Firstly, ‘self-sufficiency’ will be focussed on the procurement of ‘complex product systems’ as opposed to ‘simple product systems’. This is because simple product systems “have the characteristics of consumer markets – high-volume and relatively short-life cycles.” The procurement of these types of product systems within the EU, while crucial to the future of British defence, is clouded with uncertainty while the future relationship between Britain and the EU is negotiated. This renders most arguments surrounding such procurement types highly speculative. Moreover, these product systems are increasingly replaceable in a globalised market place and do not suffer from the same high barriers to entry as complex product systems do. These market dynamics result in greater competition which drives down prices due to easily accessible substitutability. As such, self-sufficiency in these contexts provides extremely limited benefits at a high cost.

The focus here will be on ‘complex product systems’. These tend to have a narrow range of customers, low-volume production and long lifecycles. Additionally, obsolescence of technology and components, and upgrading is an integral part of the individual product lifecycle, as are the supply chains that facilitate the continuous operation of these systems. When these supply chains become vulnerable they can often hamper the military’s freedom of action. Therefore, ‘self-sufficiency’ will be defined as the relative independence of the British Armed Forces’ freedom of action.

Europe, The Daily Express.

Secondly, the reality is that British grand strategy “depends not just on our own efforts, but on working hand in glove with our allies to deal with the common threats that face us all.” Whether it acts as part of NATO, in coalition with the United States or potentially even on EU operations after Brexit, it is highly unlikely that Britain will act alone. In order to meet the qualitative threshold for self-sufficiency being ‘worth it’ the following must be true: greater freedom of action must not exceedingly hamper the Armed Forces’ current capacity to integrate with allies or severely deplete the limited defence budget. Any boost to the domestic defence industry must be done with this wider grand strategic picture in mind in order to avoid committing Britain to unacceptable trade-offs.

Thirdly, ‘costs’ will be defined comparatively. This is both in terms of numerical ‘financial costs’ of defence procurement programmes, but also in terms of ‘opportunity costs’ incurred through, for example, the impact of a post-Brexit transfer of capital abroad and consequent loss of domestic revenue. This discussion of opportunity cost further ties in with the definition of ‘trade-offs’ which also looks at opportunity cost writ large and the impacts a larger domestic defence industry would have.

Fourthly, the definition of ‘risks’ will focus on the challenges posed by vulnerable supply chains. The conflicts for which British defence procurement is designed around are highly unlikely to be short in duration: whether it is a conflict with a recognised international competitor like Russia or another humanitarian intervention such as Syria, British conflicts are likely to be protracted in nature. The scope of ‘risks’ will, therefore, be limited to concerns posed by protracted conflicts. This limiting is based on the fact that complex product systems reliant on vulnerable supply chains pose obvious risks, but such risks only become a material challenge to the military’s freedom of action when conflicts are protracted and maintenance of equipment is required in order to continue to sustain operations.

Off-the-Shelf Procurement is Not as Appealing as it Once Was

Off-the-shelf defence procurement does have two notable benefits that ought to be taken into account: Firstly, it reduces costs. Secondly, it reduces the time lag between deciding to purchase a complex product system and having the system delivered and available to use by the Armed Forces. Both of these benefits, however, can be mitigated. The former through the depreciation in the value of the pound, and the latter by a stronger and more self-sufficient on-shore defence industry.

At the very least, in the short and medium term, the depreciation of the pound undermines the basic logic on which off-the-shelf purchasing is based. In general, off-the-shelf purchasing is relatively cheaper and it tends to be favoured by military commanders as it often allows “more hardware for a given budget.” In contrast, “executive elites favour multinational collaborative projects to balance efficiency concerns with a desire to ensure domestic economic benefits.” In 2017 Britain increased its defence budget by 2.3%. However, due to the “fall in exchange rates in 2017, in current US dollars, this meant a fall of 3.5% in dollar purchasing power.”  A similar effect can also be seen in the Euro-Pound exchange rates. Furthermore, there is a persistent fear that Brexit-induced capital flight could restrict current anaemic economic growth which would further weaken the pound and exacerbate this trend of declining purchasing power.

Procuring equipment off-the-shelf which is necessarily conducted in foreign currencies is ill-advised when the currency is weak and likely to get weaker. This is especially true given the Ministry of Defence’s recent track record of insufficiently hedging against depreciation in the pound.

Falling Pound, George Banco.

Off-the-shelf purchasing with a defence budget that is shrinking in relative terms makes off-the-shelf procurement tangibly more expensive. As a result, the difference between the costs of domestic and off-the-shelf purchases is reduced, but the domestic economic benefits accrued through domestic production continue to remain equally high. This kind of shift significantly changes the cost-benefit calculus for British defence procurement.

The most obvious example of where procurement programmes have been left vulnerable by the decline in purchasing power was the recent Brexit referendum. In this case, the Ministry of Defence inadequately hedged against Brexit as it was expected that the Brexit referendum would be won by the ‘Remain’ campaign. In 2017 the National Audit Office warned that this decline in purchasing power meant that the MoD ‘Equipment Plan 2016 to 2026’ may no longer be economically viable.  Conclusions that were reinforced by the House of Commons Defence Select Committee report in December 2017 which highlighted “serious doubts” about the viability of the same programme.

The financial situation for defence is unlikely to improve in the near future. There is an understandable fear that potential further cuts continue to loom large as “any economic shock resulting from Brexit would put public spending, and therefore the defence budget, under further pressure.” As the public purse becomes more and more strained the desire for cost-saving grows ever stronger.

The benefits of competition in defence procurement in driving down the costs of procurement programmes are well documented. However, due to the relative fall in the pound, off-the-shelf defence procurement has quite simply become too expensive because of the current wider economic conditions. It is domestic defence spending that in the long-run will be able to decrease the costs of British defence procurement. It is maximising the economic flipside of a weaker currency to British benefit that will best be able to take advantage of these conditions.

Knock-On Effects of a Larger Indigenous Defence Industry

One of the important reasons why having an indigenous defence industry is so crucial is that it promotes “a strong and healthy skills base…[which itself] helps the productivity and competitiveness of the economy.” By increasing the size of the domestic defence industry and gearing it towards maximising exports it will be able to take advantage of greater economies of scale which can drive down overall costs. This is because high one-off costs incurred through research and development of the products can be spread across an increased volume of production, which reduces the individual unit cost.

This benefits the British Ministry of Defence as it can get the same product at a lower cost. This also helps to “smooth out the impact of fluctuating or limited domestic demand,” through using export demand to fill the gap created between what industry can supply and what the British government demands. A steadier stream of demand can help the defence industry to plan accordingly, and mitigate the time lag that results from the Ministry of Defence generating urgent operational requirements for which industry is unprepared for.

As part of this, the onus is on the MOD to continuously communicate with industry and to plan the future required capabilities effectively. At the same time, the onus is on industry to remain agile and be prepared to shift production to cater to government needs. In this way, government and industry have a symbiotic relationship, as reflected in the current government strategies. When coupled with the relative fall in the value of the pound, this makes products less costly and thus more competitive in the global marketplace.

The Royal United Services Institute London, Art UK.

Furthermore, when defence procurement spending occurs domestically there are obvious beneficial positive second and third order effects to be taken into account. Domestic defence spending accrues significant tax revenues that can be recycled through the treasury back into defence. This means that, as was proved by a 2012 study conducted by the Royal United Services Institute:

If the UK government spends money on a UK contractor with a largely British supply chain, the great majority of that tax paid will flow back to the British Government, whereas money spent with an overseas supplier becomes a source of revenue for another government.

Using this method of keeping the economic benefits accrued through defence procurement on-shore “close to 36 per cent of the government spend of £1 million… [can be] returned to the Exchequer via tax and National Insurance contributions.” Retaining a third of the total cost of a procurement programme in this way decreases the overall cost of a procurement programme through de facto regained revenue. This can alleviate some of the pressure on the defence budget.

Taking such considerations into account also further increases the relative cost of already expensive off-the-shelf systems due to the fall in the purchasing power of the pound. The same study from the Royal United Services Institute concluded that should Britain reduce current levels “to even a third of its capital spending on off-the-shelf foreign systems, that would represent about £1 billion less revenue for the Treasury than might have been the case.” This significant loss of funding is representative of a wider detriment to the British economy and is indicative of why off-the-shelf procurement is no longer as attractive as it once was.

‘National Security Objective 3’ of the 2015 Strategic Defence and Security Review was to “promote our prosperity.” This highlighted a causal link between economic stability and the sustainability of Britain’s Armed Forces contributing to their effectiveness. According to the latest estimates the British defence industry “employs 215,000 predominantly highly skilled personnel and supports a further 150,000 jobs in supply chains.” In 2013 this resulted in a return of approximately “£8.2 billion in gross value added to the UK economy.”

These statistics evidence what is a significant industry for the British economy. An industry that could be used to create further employment, and one where cutting support in pursuit of off-the-shelf solutions would inevitably create unemployment. This makes it highly unlikely that politicians driven by re-election will want to jeopardise their prospects but cutting domestic industry and creating despondent and unemployed constituents. It is such concerns that drive the desire for a strong domestic industry.

Domestic Defence Spending is Not a Panacea but Neither is Partnering

Having a weaker pound in relative terms can be extremely beneficial to the British defence industrial base by making exports cheaper. Exports can then raise domestic fiscal revenue which can be further circulated into defence spending to further extrapolate these advantages caused by currency depreciation. That being said, it is important not to cast such advantages as a panacea for all of the problems relating to British defence procurement. The British defence industry is notoriously and often lamentably inefficient. The current framework incentivises this and that cannot be overlooked.

BAE Systems Branding, FeWeek.

In 2015/16 93% of BAE Systems contracts with the Ministry of Defence were conducted on a non-competitive basis. Firms like BAE that operate within the oligopolistic market of domestic defence procurement for complex product systems have incentives to overcharge the government on non-competitive contracts. This stems from the fact that auditing practices are “relatively poor at determining whether any expenditure that actually occurred was necessary.”

In order to exploit this, firms aim to maximise profits “by shifting one dollar of overhead away from a competitively priced defence program…selling at a competitively determined price and onto a sole source defence product where price is set equal to accounting cost.” This means that firms can increase costs on non-competitive programmes and artificially restrict costs on competitive programmes. These methods can be used to extort the MOD and as a result, earn unfair profit levels. These incentives are powerful and represent one reason to be wary of placing the domestic defence industry on a pedestal.

Another is evidenced by the 2010 Strategic Defence and Security Review. In this review, it was announced that the Nimrod MRA4 programme would be scrapped and that Britain would “depend on other maritime assets to contribute to the tasks previously planned for them.” This made strategic sense as at the time as the programme was roughly £789 million over budget and 114 months late. However, when it was reported that in 2015 that “the MoD has been regularly forced to call in NATO aircraft to track suspected submarines” off the British coast there was a public outcry. The subsequent 2015 Strategic Defence and Security Review responded by purchasing “nine new Boeing P8 Maritime Patrol Aircraft,” that were tasked with carrying out the functions that the Nimrod was originally going to be tasked to.

The British defence industry has run projects to an unacceptable standard before. The Nimrod project proves that. There are therefore risks in suggesting that Britain should aim to be more self-sufficient and consequently rely to a greater extent on said domestic defence industry. This is especially true given some of the incentives for firms to choose inefficient production methods. While it is true that the domestic defence industry can be inefficient, this is an insufficient basis on which to conclude that the pursuit of greater self-sufficiency should be abandoned.

Partnering Has the Same Challenges and Fewer Benefits

The same issues that often plague domestic defence procurement are also visible in partnering programmes. The key difference between the two, however, is that the former produces positive externalities of production that are beneficially recycled through the British domestic economy, whereas the latter takes the capital used for the procurement programme offshore to the benefit of foreign governments.

To date, the British approach to procurement has relied to a great extent on international procurement projects, particularly trans-Atlantic and pan-European projects. Within the EU, collaborative equipment procurement as a percentage of total equipment procurement for Britain stood at 23.8% in 2013 and 28.4% in 2014. If EU collaborative procurement represents roughly a quarter of total British procurement then it makes sense to establish how that can be rationalised with the proposed supporting of the British defence industrial base post-Brexit.

Soldiers March in Brussels, Global Risk Insights.

The logic behind these sorts of partnerships is that they offer potentially greater economies of scale…and can also increase interoperability. Moreover, pooling defence resources in a partnering procurement strategy has the added benefit of reducing waste. For example, according to EU data, the bloc has 19 types of armoured infantry fighting vehicle, compared with one in the United States. This kind of variety in equipment could have a serious negative impact on the interoperability of the militaries which has consequent effects on operational effectiveness.

That being said, there is an important fact that should make many hesitant to rely on such procurement strategies which often are chosen at the expense of supporting the domestic defence industrial base. Ultimately defence procurement is a means to an end, with the end being the effective use of the equipment in combat. The equipment that has been manufactured by Britain to date through partnering programmes has tended to be extremely inefficient.

The Tornado jets which were produced as a joint venture between Germany, Britain and Italy have been shown to have “a readiness rate of just 44 per cent.” The Eurofighter jets which followed and were produced by pooling resources between the same three states “were ready for use 52 per cent of the time, [both of which are] well under the goal of an average 70 per cent readiness”.

What good is having cutting-edge technology if you can only use it less than half of the time? In this case, not only has freedom of action been sacrificed in the partnering program itself, but the lack of quality of the equipment will further restrict British Armed Forces’ freedom of action. All this has been achieved without significant domestic economic benefit being accrued through production occurring exclusively in Britain.

There is no doubt that partnering programmes produce positive externalities in the wider economy. The same Eurofighter that was highlighted for being extremely inefficient created 100,000 high skilled jobs, and exports of €13.4 bn – €17.9bn. In terms of wider defence procurement, the European Defence Agency reports that “each €100m cut from EU defence expenditure implies: €150m fall in EU GDP; €40m fall in EU tax revenues; 2870 jobs lost; and 760 skilled jobs lost.” This is not to question the fact that these large scale procurement programmes have a significant positive effect on the economy. The above statistics prove that they do. This is to question where these positive externalities are being felt.

Once Britain leaves the EU the reality is that the overall benefit of the community is of much less relevance to the British polity, let alone the British people, than the individual success of the United Kingdom. In this way, boosting the domestic defence industry so that it can itself produce such externalities within Britain, and in particular, aiming to produce high volumes of exports would be of significant economic benefit. Ideally, Britain should have good equipment and economic benefit, but in the rare cases when equipment fails to meet the high standards Britain sets it makes sense to at least receive some domestic economic benefits.

The Flawed Conceptions of ‘Open Procurement’ and Competition

Britain’s National Security Through Technology defence white paper published in 2012, which was reaffirmed by the Strategic Defence and Security Review in 2015 delineates a national strategy for defence procurement. This strategy emphasises the merits of “open procurement” as a starting point in pursuit of value-for-money and in order to allow “the defence and security sectors to be efficient and competitive.” However, the strategy also aptly explains that value-for-money in and of itself is insufficient as a basis for a procurement strategy. There are some occasions where it is of vital importance to national security “to protect…operational advantages and freedom of action,” at the expense of the pure financially driven value-for-money considerations.

One of the flaws in this characterisation of ‘open procurement’ is that ‘operational advantages’ is conflated to equate to ‘technological operational advantages’. In this way, it avoids the fact that technological operational advantages can be superceded by quantitative ones. This is particularly true when British Armed Forces are involved in campaigns such as those recently in Libya and Syria where the risk to personnel in the air is extremely low. In operations like these, an increase in quantity often offers a greater operational advantage than an increase in the quality of the technology.

Langkawi Aerospace Exhibition, Getty Images.

Fighter jets generally are the perfect example of this trade-off between volume and quantity. One fighter jet can carry only a limited payload. While increasing the quality of the jet has little impact on operational effectiveness under these circumstances, the quantity of jets increases the quantity of potential payload that can be delivered. As such, it is possible through the definition provided on “operational advantages” in the white paper, that what may have been a technological advantage can be lost as an actual “operational advantage” due to lack of critical mass. This echoes a rather old debate that has previously observed that the same expenditures would produce a more effective defence if larger numbers of less elaborate and less technically sophisticated weapons were purchased.

Moreover, authors often overstate the benefits of competition as even within a global marketplace these benefits tend to be extremely difficult to accrue. There are a variety of reasons why it is difficult to generate competition even in a global marketplace, for example: the barriers to entry for the production of complex product systems are extremely high, governments are often the only legitimate customers of product systems with exclusive military use, and some capabilities are extremely niche which disincentivises firms from investing in researching and developing these capabilities. In this sense choosing between ‘self-sufficiency’ on the one hand, and ‘competition’ on the other, is somewhat of a false dichotomy.

This is not to say autarky should be pursued, but merely that the self-sufficiency of the British defence industry should be increased. Competition has thus far delivered significant benefits to the Ministry of Defence by driving down costs, and competition can continue to achieve this within certain limitations. States tend to be extremely reluctant to sacrifice protecting their domestic defence industries for largely political reasons which limits the number of firms that can capably compete.

Even the European Union, which is one of the most liberalised trading blocs in the world, operates a system whereby defence procurement remains predominantly of national concern. Unlike so much of the economic relations between Britain and the EU, defence procurement has been largely insulated from European integration. This is predominantly due to the application Article 346 of the Treaty on the Functioning of the European Union. This article allows EU member states to protect their “essential interests of…security which are connected with the production or trade in arms, munitions and war material.” The result of the application of this article is that EU member states effectively set their own rules for defence procurement, and in the case of Britain, the EU has little impact on UK defence policy. The lion share of British defence markets are outside the EU and Britain will thus be relatively unaffected in this respect by Brexit. In 2012, only 4% of total British turnover in defence exports were in EU sales compared with 38% in exports outside the EU and 58% domestic sales.

The use of the exemption provided by Article 346 has ensured that EU member states spend the majority of any investment in defence domestically to protect the industry from any competition and to sustain what has long been seen as a manufacturing sector of strategic significance nationally. This existing and predominantly protectionist stance means that there is less risk post-Brexit in aiming to boost the domestic defence industry to facilitate exports, for the reasons outlined above.

Conclusion

The UK cannot afford to maintain a complete ‘cradle-to-grave’ defence industrial base in all areas, [but] there are specific military capabilities and technologies which are critical…to retain the ability to use its military forces as and when it desires

There will inevitably be occasions where it makes sense for the government to pursue off-the-shelf purchases. My goal here has not been to undermine that fact. The point I am trying to make is that Britain ought to tilt the needle on the spectrum further towards self-sufficiency in an effort to boost domestic defence exports to economic benefit.

Off-the-shelf procurement has become relatively more expensive, and domestic exports have become relatively cheaper. The domestic defence industry does have its inefficiencies but so too do other methods of defence procurement, in particular, procurement through ‘partnering’. The domestic defence industry supports a large number of workers throughout Britain. These workers have specialist skills that can be leveraged to the benefit of the British defence export market.

As economic uncertainty continues to surround the British government and causes the pound to depreciate, Britain is faced with a choice: either it takes a short-sighted and short-term view and purchases items off-the-shelf to the broader detriment of the domestic economy, or it embraces the hand it has been dealt. To do this Britain would take advantage of its now relatively cheaper exports and the current state of its domestic defence industry to pursue greater self-sufficiency. Ultimately, whether Britain likes it or not the time has come to ‘feed the beast’. This is the only way to equip our armed forces so that they may protect us.

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