National Defence Budgets: The Importance of External Threats by Karl Skogstad A thesis submitted to the Department of Economics in conformity with the requirements for the degree of Doctor of Philosophy Queen's University Kingston, Ontario, Canada September 2014 Copyright c Karl Skogstad, 2014 Abstract In this thesis I study and provide insight into how national defence budgets are de- termined. This is accomplished through the use of both theoretical modeling and empirical analysis. A main theme running through the thesis is that a primary deter- minant of domestic levels of defence spending is the defence spending level of other nations. By conditioning on these global interactions in a structured way, I am able to provide meaningful estimates of the impact of various factors on national defence spending. In Chapter 2, I examine the costs and benefits of maintaining domestic arms manufacturers during peace time. A model is developed that examines under which circumstances a country would wish to maintain domestic arms industries. The pre- dictions of this model are tested using the historical example of Canada's lack of advanced shipbuilding facilities during World War II. By comparing the performance of corvettes and destroyers during convoy escort, I quantify the superiority of the latter over the former. A counterfactual scenario then examines the savings in terms of ships and lives that could have resulted from having invested in domestic arms industries in peace time. Chapter 3 examines more generally how national defence budgets interact with each other in a spatial econometric framework. By creating a series of weighting matrices that qualitatively represent how countries are likely to interact militarily, I quantify the extent to which a country's relative location impacts its level of defence spending. I find that relative location is a significant determinant of defence spending, and furthermore, I am able to identify regions of both high and low defence spending spillovers. Some countries have large domestic arms industries, whereas others largely im- port their military hardward. In Chapter 4, I examine, both theoretically and empir- ically, how this distinction and the resulting arms trade influences defence spending behaviour. I also examine the impact that a base level of security, measured by ge- ographic and socioeconomic factors has on the choice of defence budget. Consistent with the theory, I find that there are significant differences between arms producers and importers in the way they respond to exogenous factors. i Dedication To my family for allowing me to follow my dream. ii Acknowledgments This work would not have been possible without the support of a great number of people. First and foremost I would like to thank my wife Shanna for all the support she provided. Her hard work provided me with the opportunity to focus on my research. I am grateful to Professor Huw Lloyd-Ellis, Professor Ugurhan Berkok, and Pro- fessor Beverly Lapham for all of their guidance, advice, and encouragement over the course of my PhD. This work has benefited from the discussions I have had with a great number of my fellow students. I am especially grateful to Andrea Craig, Lee Morin, and Matthew Webb for their assistance. I am thankful for all of the feedback I received from my presentations at the Cana- dian Economic Association conferences (Calgary and Vancouver) and the Fall 2013 Defence and Security Economic Workshop. I sincerely thank the Ontario Graduate Scholarship program,the John Deutsch Institute, and Queen's University for financial assistance. Finally, thank you to my parents for their support and encouragements through- out my education. All errors remain my own. iii Table of Contents Abstract i Dedication ii Acknowledgments iii Table of Contents iv List of Tables vi List of Figures viii Chapter 1: Introduction . 1 Chapter 2: Canada's WWII Navy . 8 2.1 Introduction . 8 2.2 Historical Setting . 13 2.3 Model . 27 2.4 Data . 40 2.5 Analysis . 48 2.6 Counterfactual . 55 2.7 Conclusion . 68 2.8 Figures . 72 2.9 Tables . 79 Chapter 3: Defence Budgets . 89 3.1 Introduction . 89 3.2 Spatial Econometrics Overview . 95 3.3 Data . 98 iv 3.4 Weighting Matrices . 100 3.5 Preliminary Spatial Analysis . 107 3.6 Results . 110 3.7 Geographic Analysis . 116 3.8 Conclusions . 121 3.9 Figures . 124 3.10 Tables . 129 Chapter 4: Arms Producers . 144 4.1 Introduction . 144 4.2 Data . 149 4.3 Model . 153 4.4 Results . 166 4.5 Conclusions . 172 4.6 Tables . 175 Chapter 5: Conclusion . 184 Bibliography . 188 Appendix A: Chapter 4 Model . 195 v List of Tables 2.1 Composition of the RCN . 79 2.2 Naval construction in Canada during the war . 80 2.3 Corvettes, Destroyers, and Frigates Compared . 80 2.4 Convoys of Focus . 81 2.5 Merchant Marine Losses by Convoy . 81 2.6 U-boat-Convoy Engagement Statistics . 81 2.7 Convoy-days with given number of U-boats within range . 82 2.8 Escort Statistics . 82 2.9 Escort Statistics for Convoys which Suffered a Loss . 83 2.10 Probit Regression Results . 84 2.11 Negative Binomial Regression Results . 85 2.12 OLS and Panel Regression Results . 86 2.13 Counterfactual Commissioned Ship Schedule . 86 2.14 Average Number of Escorts by Type . 87 2.15 Costs and Benefits of Counterfactual Building Program . 87 2.16 Costs and Benefits Range of Counterfactual Building Program . 88 3.1 Summary Statistics . 129 3.2 Candidates for Type P Countries . 130 3.3 Type P Countries . 131 3.4 Alliances . 132 3.5 Summary of Weighting Matrices . 133 3.6 Global I Statistics . 134 3.7 Local I Statistics (1999 Contiguous Matrix) . 136 3.8 Baseline Case . 139 3.9 Baseline Case: Effects Breakdown . 139 3.10 Internal Factors Included . 140 3.11 Internal Factors Included: Effects Breakdown . 141 3.12 Yearly Rhos . 142 3.13 Regional Analysis . 143 3.14 Defence Spending per Capita . 143 vi 4.1 Countries with a Significant Domestic Arms Industries . 175 4.2 Average Yearly Arms Exports by Arms Producing Countries . 176 4.3 Top 20 Arms Importers . 177 4.4 Largest Arms Producing and Military Services Companies . 178 4.5 Summary Statistics . 179 4.6 Summary of Weighting Matrices . 180 4.7 Baseline Results . 181 4.8 Baseline Results: Effects Breakdown . 182 4.9 Physical Geography Variables . 183 vii List of Figures 2.1 Number of Commissioned Ships in the RCN . 72 2.2 Commissioning of RCN Ships by Month . 73 2.3 Number of Commissioned U-boats . 74 2.4 Number of U-boats Launched and Lost . 75 2.5 Game Tree . 76 2.6 German Naval Grid . 78 3.1 Residuals and Weighted Residuals (Contiguous) . 124 3.2 Residuals and Weighted Residuals (Two Groups) . 125 3.3 Residuals and Weighted Residuals (World Police) . 126 3.4 War in Syria (Inverse Distance Matrix) . 127 3.5 Authoritarian Eastern Europe (Two Groups Matrix) . 128 viii Chapter 1 Introduction National defence budgets comprise a large share of most government expenditure, averaging around 2.5% of total GDP per year between 1993 and 2008. Despite its importance, a clear understanding of what factors influence this level of spending still remains unclear. More specifically, economists lack a precise understanding of how foreign defence expenditures impact a government's defence spending decision. Additionally, a better understanding of why some countries opt to construct their own military equipment domestically, often at a premium, while others are willing to import their arms is needed. This thesis seeks to fill some of these gaps in our knowledge in order to better understand how the events that occur and decisions that are made in one country can ultimately impact the military spending of another country. By the end, the framework I develop will allow me to comment on how current events, such as the recent civil war in Ukraine, for example, will likely impact the defence spending of that country and its neighbours. Additionally, I will be able to comment on why the Canadian government has recently decided to purchase naval vessels from Canadian 1 CHAPTER 1. INTRODUCTION 2 shipyards, when cost savings could be achieved if they were procured from foreign suppliers.1 Much of the defence expenditure literature is influenced by the models of Richard- son (1960) and Smith (1980). The models developed by these two authors postulated that the defence spending chosen by a given country is primarily a function of the defence spending or threat posed by foreign countries. For a time during the 1970s and 1980s, the literature moved away from this theory, instead claiming that the primary determinants of defence spending were factors internal to a country, such as the nature of the government, the size of its bureaucracy, and political considera- tions.2 Recent papers have strived to combine these two literatures.3 There has also been a strongly related literature that studies defence spending behaviour within an alliance.4 This thesis takes the stance, with supporting evidence, that a primary determinant of defence spending must be the threat posed by foreign entities.5 While political economy factors must also have some influence over spending levels | for instance in the choice of where a new military installation may be located | it is ultimately the threat posed by foreign countries which provides the justification for any significant change in defence spending. The second chapter in this thesis concerns itself with understanding when a coun- try would adopt a policy to produce weapons domestically, as opposed to simply 1Known as the National Shipbuilding Procurement Strategy. See Jenkins, Castelli, Clanfarani, Fraser, and Nicholson (2013) regarding cost savings. 2See, amongst others, Nincic and Cusack (1979), Griffin, Wallace, and Devine (1982), and Cusack and Ward (1981).