Defense Economics: An Institutional Perspective [1st ed. 2021] 3030738140, 9783030738143

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Marcus Matthias Keupp

Defense Economics An Institutional Perspective

Defense Economics

Marcus Matthias Keupp

Defense Economics An Institutional Perspective

Marcus Matthias Keupp Swiss Federal Institute of Technology Military Academy Birmensdorf ZH, Switzerland

ISBN 978-3-030-73814-3 ISBN 978-3-030-73815-0 https://doi.org/10.1007/978-3-030-73815-0

(eBook)

Translation from the language edition: Militärökonomie by Marcus Matthias Keupp, © Springer Fachmedien Wiesbaden, ein Teil von Springer Nature 2019. Published by Springer Fachmedien Wiesbaden GmbH, ein Teil von Springer Nature. All Rights Reserved. © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG. The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

In contriving any system of government, and fixing the several checks and controuls of the constitution, every man ought to be supposed a knave, and to have no other end, in all his actions, than private interest. By this interest we must govern him, and, by means of it, make him, notwithstanding his insatiable avarice and ambition, co-operate to public good. ––David Hume

Preface

A new scientific truth does not generally triumph by persuading its opponents and getting them to admit their errors, but rather by its opponents gradually dying out and giving way to a new generation that is raised on it. ––Max Planck

This book is the international edition of a volume that first appeared in 2019, in German and French.1 The idea behind it is to offer an alternative view on defense economics by grounding the subject in institutional theory and the Austrian school. This book features the central idea that all economic problems in a military organization have institutional causes. There is a dearth of such perspectives in contemporary defense economics research. Few perspectives put a hard truth at the center of their analysis: Contemporary armed forces are not-for-profit organizations controlled by state bureaucracies. These exert their control by operating a planned economy system that allocates a fiscal commons (the defense budget) to the different branches of the armed forces. In order to finance operations and fund investments, a complex interaction between political decision-makers, the private industry, state bureaucracy, and the military staff determines how armed forces may partition and spend these funds. What could possibly go wrong? The author holds the chair of defense economics at the Military Academy at the Swiss Federal Institute of Technology Zurich. However, this book is not about the Swiss Armed Forces. The economic analysis treats defense economics in a generalizable way, without delving into the organizational depths of any specific armed force. It emphasizes that the economic problems described here exist in any armed force in which a state bureaucracy exercises economic control. Consequently, all statements in this book represent solely the author's opinions and analyses; in

1 For the original works, see Keupp MM (2019) Militärökonomie and Économie militaire, both published by SpringerGabler, Wiesbaden.

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Preface

particular, they do not constitute an official communication from the Swiss Armed Forces or the Federal Department of Defense, Civil Protection, and Sport. I have completely reviewed and revised for an international audience. I thank Holly Cogliati and Kilian Cuche for their help with editing and proofreading. All the comments received from Renaud Bellais, Fabian Muhly, Dimitri Percia David, Mauro Mantovani, and Daniel Lätsch helped to improve prior versions of this manuscript. Many thanks also go to Christian Rauscher and Nikos Chtouris, from Springer Nature, for making this edition possible. Finally, I must thank the many staff officers and career officer candidates I met and taught at the Military Academy, all of whom offered their views of and insights into actual military organizations. Their comments and discussions greatly helped me shape this book. Finally, I thank the commander of the Military Academy, Brigadier General Peter C. Stocker, for all his support during the writing of this work. Birmensdorf ZH, Switzerland June 2021

Marcus Matthias Keupp

Contents

1

Introduction: The Fundamental Economic Problem of the Military . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1 16

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Institutions and Armed Forces . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Contemporary Armed Forces as Planned Economy Systems . . . . 2.2 Consequences for Human Behavior . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Politicians . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.2 Planners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.3 Residents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.4 Interest Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.5 Combatants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . .

23 23 31 31 33 40 45 58 61

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Effectiveness of Military Performance . . . . . . . . . . . . . . . . . . . . . . . 3.1 Military Conflicts as Objective Selection Environments . . . . . . . . 3.2 Consequences of the Planned Economy System . . . . . . . . . . . . . 3.2.1 Delayed Correction of Forecasting Errors . . . . . . . . . . . . 3.2.2 Reduced Dynamic Adaptability . . . . . . . . . . . . . . . . . . . 3.2.3 Limited Factor Substitution . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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67 67 69 69 79 82 89

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Efficiency of Military Performance . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Opportunities and Limitations for Efficiency Gains . . . . . . . . . . . 4.2 Consequences of the Planned Economy System . . . . . . . . . . . . . 4.2.1 Structural Inefficiency . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.2 Crowding Out of Investments by Operating Expenses . . . 4.2.3 Undermining of Formal by Informal Institutions . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . .

93 93 103 103 106 110 113

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Contents

Opportunities for Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 Limited Reform Capacity of a Planned Economy . . . . . . . . . . . . . 5.2 System Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2.1 Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2.2 Decentralization of Property Rights . . . . . . . . . . . . . . . . . . 5.2.3 Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

115 115 120 120 125 129 132

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

List of Figures

Fig. 3.1 Fig. 3.2 Fig. 3.3 Fig. 3.4 Fig. 3.5 Fig. 3.6 Fig. 3.7 Fig. 3.8 Fig. 3.9 Fig. 3.10 Fig. 3.11 Fig. 3.12 Fig. 3.13 Fig. 4.1 Fig. 4.2

Continuum of possible transfers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Forecasting error of politicians . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Continuum of possible resource requirements . . . . . . . . . . . . . . . . . . . . . . 72 Forecasting error of planners . . . . . .. . . . .. . . . . .. . . . .. . . . .. . . . . .. . . . .. . . 73 Incorrect prediction of supply curve by politicians . . . . . . . . . . . . . . . . 75 Incorrect prediction of supply curve by planners . . .. . . .. . .. . . .. . .. . 76 Consequences of sudden escalation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Consequences of sudden de-escalation . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . 78 Path dependency of defense spending . .. . .. . . .. . .. . . .. . .. . . .. . .. . .. . 81 Different factor combinations for the same output level . . . . . . . . . . . 83 Limited factor substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 Capability degradation due to imperfect substitutability . . . . . . . . . . . 86 Capability degradation due to missing property rights .. . . .. . .. . . .. 88 Reduction of inefficient factor input . . .. . . .. . . .. . . .. . . .. . . .. . . .. . . .. . 98 Reduction of real purchasing power of the nominal defense budget . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . .. . . . . . . 107

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List of Tables

Table 1.1 Table 1.2 Table 2.1 Table 3.1

Classification of goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Financial contributions of NATO members to national defense . . . 9 Hierarchy of institutions . . . .. . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . . . . . .. . . . . . . 26 Dynamic change among armed forces because of ineffectiveness . . .. . . .. . . .. . .. . . .. . . .. . .. . . .. . . .. . .. . . .. . . .. . . .. . .. . . .. . . 69

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Chapter 1

Introduction: The Fundamental Economic Problem of the Military

Contemporary military organizations are anything but private companies. Both military and civilian bureaucracies who do not function according to free-market principles administer them. Quite the contrary: As these bureaucracies control all economic activity in the armed forces, a planned economy system is established. Any economic analysis that ignores this fundamental problem not only leads to false conclusions, but also to irrelevant policy recommendations.1 From the early Middle Ages to the age of absolutism, armed forces were not an element of the nation state; rather, they were organized and financed in a decentral and private manner (Potter 2008; Mallett 2009). In the feudal system, a feudal lord distributed, among his vassals, land that they could exploit. In return, the vassals provided military strength for their lord in times of war. Although the returns from their possessions were for the vassals to keep, they had to finance their personal military equipment (sword, horse, armor) and recruit combatants from their local labor force. Private military contractors, such as the Italian condottieri, provided military performance beyond the feudal system. They recruited mercenaries all over Europe and offered military services to all those who could afford it. The high point of this ‘business model’ was the Italian Renaissance, when local rulers and city-states not only fought for supremacy in northern Italy. They also competed for highly mobile human resources (scientists, traders, artists) by offering them patronage that protected them against prosecution, expropriation, and censorship (Jones 2003; Kempers and Jackson 1992; Martines 1988). This competition led to a continuous demand for short-term and localized military action, to which both feudal lords and contractors responded. The market for security therefore organized itself; in particular, it did not require significant bureaucratic planning or coordination.

Quia parvus error in principio magnus est in fine 1

An initial small mistake is a big one in the end (Thomas Aquinas 2001).

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. M. Keupp, Defense Economics, https://doi.org/10.1007/978-3-030-73815-0_1

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Before the emergence of the modern nation states, military power was distributed and financed in a decentralized manner. Sovereigns did exist by title and rank, but the extent of their actual power was limited. In particular, the relatively small magnitude of their possessions did not enable them to deploy military force to an extent that would have overpowered regional princes and vassals. For example, the German prince-electors of the late fifteenth century refused to provide their emperor Frederick III with any military support against the Hungarian king Matthias I, who was exerting pressure on the Hapsburg ancestral lands in the east. Before the reign of Louis XI, the power of the kings of France was limited to the Île-de-France, i.e., the ancestral property of the Crown, whereas powerful regional princes maintained their own private armies. This case was similar in medieval England, where such princes controlled proprietary military forces, despite the existence of a central sovereign. Lords and sovereigns fought in the Wars of the Roses in England, as well as the French Civil Wars of the fifteenth and sixteenth centuries, with such private armies, on greenfields far away from cities and commercial centers. In all of these conflicts, the cost of financing war operations disciplined the princes, because they had to finance the maintenance and projection of their military power from the income their estates provided. The cost of warfare often ruined a prince, and that subjects rebelled or refused to pay when taxed to finance war action. Princes had to face the hard truth that the potential productivity and tax base of their lands and cities were limited and tied to agricultural production cycles and working trade relationships. Consequently, these economic factors limited the size of any armed force; medieval armies had barely more than 10,000 men. As the seasonal pattern of war actions followed agricultural production cycles, pillaging and burning fields and stables to annihilate enemy resources was commonplace. The sacking of cities and the extortion of ransom from the families of captured nobles raised funds that helped finance wars. The prevailing contemporary view that a centrally organized state should be the sole provider of military performance would appear absurd to the princes and military contractors of these times. In particular, they would not see why a centralized state bureaucracy should organize the production of a public good ‘security’ whose value cannot be measured economically. There certainly was a consensus that a sovereign lord sometimes had to use military force to assert his interests (Macchiavelli 2008). However, neither regional princes nor sovereigns would make this force an integral element of their court or state. Instead, they raised their own forces and demanded additional troops from their vassals, whereas they disbanded these forces again during peacetime. They hired and fired their military contractors based on their performance in the field. Their interest in generating funds to finance troops kept their ambition in check and made them consider resource efficiency (Papke 1975; Oestreich 1957; Oman 1991; Roberts 1995). As a result, private military companies are not a contemporary phenomenon. Their ‘business model’ is essentially unchanged since antiquity (Axelrod 2014). This decentralized organization of security began to change as Justus Lipsius proposed significant reforms to armed forces organizations. Novel tactics introduced by the Spanish infantry had considerably reduced the effectiveness of conventional

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mercenary armies. Quoting the military writers of antiquity, Lipsius proposed to maintain a standing army of continuously drilled and well-paid soldiers. William I, Prince of Orange, put these proposals into practice. In the 80 years of the Dutch Wars of Independence, his reforms proved to be effective. Sovereigns and princes, surprised by the resilience of the Dutch against the Spanish forces, would soon emulate this model. Lipsius had focused on increasing combat strength: armed forces should deploy their force more efficiently, and good pay should prevent destructive looting. However, even he could not yet imagine that such a military force would be anything else than an instrument by which sovereigns would project their power. The emergence of the modern territorial states led to a gradual centralization of government. In France, this development already began during the reign of Philip the Fair (Sumption 1990). It reached a turning point when both Charles VII and Louis XI managed to limit the power of the regional princes and significantly strengthened role of the central sovereign. Similarly, Henry VII Tudor ended the Wars of the Roses and consolidated the British monarchy into a centralized power. At the same time, European philosophers began to rethink the intellectual conception of the state. Philosophers such as Hobbes and Bodin proposed that the state was no longer a loose confederation of feudal lords and vassals connected by a system of oaths and obligations. Rather, it was a mechanical instrument by which an absolute sovereign who, graced by God and above the law, protects and governs his or her territory and all subjects living therein (Hobbes 2006; Franklin 1973). Louis XIV, who equated his royal person with this idea of a centralized and mechanized rule, represents the extreme form of this doctrine. The major military powers of the seventeenth century—France and Sweden—began to integrate their armed forces into the organizational structure of the absolutist state. In 1634, Gustavus Adolphus of Sweden created a college of noblemen whose task it was to coordinate national military planning and to recruit soldiers. In France, royal minister Mazarin appointed intendant Michel Le Tellier in 1643 as Secretary of State for War. Under the protection of Louis XIV, he created a standing, centrally led French armed force that the Chancellery administered. The military power and success of France in the late seventeenth and early eighteenth century soon persuaded other absolutist monarchs to adapt this model. War offices and colleges—precursors of the contemporary ministries of defense—became the hallmark of absolutist power structures, e.g., in England (1684), Russia (1711), Spain (1714), and Prussia (1787). The ideas of the French Revolution reinforced this centralization tendency. This view no longer sees the individual as a subject, but rather as a defender of the nation, and therefore state administration must conscript citizens and organize their military service. In particular, it must register and force citizens to participate. Hence, the production of military force is no longer subject to private initiative, but continuously organized and managed by state bureaucracies. During the nineteenth century, other European powers adopt both the French conscription-based model and its bureaucratic organization. When the ‘delayed nation states’ of Italy and Germany are founded in 1861 and 1871, they retain significant federalist elements in their respective organizations. Nevertheless, both create national armed forces that are decentrally staffed, but centrally managed by state bureaucracies. Even Switzerland,

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the model state of a decentralized confederation, has managed its armed forces by a centralized bureaucracy—the Federal Military Department and its successor organizations—since 1852. The ideological influence of the French Revolution, the Napoleonic Wars, and the colonial expansion of the European powers spread this model throughout the world. As a result, all the armed forces around the globe share the same economic problems, regardless of their demographic, cultural and doctrinal contexts. This ability to be generalized points to systematic causes. If these problems were simply the result of a lack of economic expertise or historical coincidence, efficiency would differ significantly across military organizations. Instead, the cause is systematic and inherent to this organizational model. Whether for a monarchy, a dictatorship, or a democracy, if a nation state organizes armed forces as an instrument of national power, and if a centralized state bureaucracy controls their economic affairs, a planned economy system is the result. This system allows for, enables, and even promotes unproductive human behavior. It does not matter whether ideologists consciously opt for a planned economy system, if it emerges unintentionally, or if it is the result of an historical development process. The political system of the state and the economic system by which the bureaucracy manages armed forces may differ. Dictatorships can introduce a free market economy, and democracies can prefer a planned economy. For example, the Pinochet dictatorship in Chile reversed the socialist reforms of the Allende government, whereas the French Republic has been experimenting with a system of statesponsored economic planning since 1946 (planification, integrated into France Stratégie since 2013). Even if a nation’s private sector enjoys economic liberty, the state administration can still introduce a planned economy system in the public sector. Once this institutional perspective screens the literature on defense economics, much past research in defense economics appears to be irrelevant. Whenever the literature fails to account for the fundamental institutional problems a planned economy system entails, it ignores the very source of the economic problems that contemporary armed forces face. The contributions that explain how armed forces could instate private-sector efficiency are mostly pragmatic and atheoretical. These studies interpret defense economics from a new public management perspective that strives to increase the efficiency of operations in public organizations. Such studies analyze how bureaucrats could manage the defense system more efficiently. They also discuss how management methods used in the private sector could be adapted to a military environment (Richter 2007; Kern and Richter 2014; Lipow and Plessner 2008; Pyman et al. 2009; Navarro-Galera et al. 2011; Davis 2011; Dorobek 2013; Rohlfs and Sullivan 2013; Solomon and Stone 2013; Arkes and Cunha 2015; Blanken and Lepore 2015; Billyard and Donohue 2016). As they attempt to infuse state-managed planned economies with private sector efficiency, these writings succumb to the same errors of judgment that the communist leaders of the late twentieth century made. They believed they might resolve the

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inherent deficiencies of a planned economy system by initiating reforms or revising state planning. However, the economic problem is not an inefficient process design. The planned economy system is, in and of itself, the problem because it fundamentally fails to create incentives that motivate humans to act efficiently (Hayek 1944). On the contrary, a planned economy system must even suppress any such incentive, as the restriction of economic choice it entails is logically incompatible with individual liberty and action (Röpke 1963). Consequently, attempts to address defense economics problems with applied management techniques have disappointing results. It is questionable whether spending associated with such attempted reform yields any productive results. Agents might pay lip service to such reforms, but at the end of the day, there is little, if any, improvement (Kern and Richter 2014).2 So far, the defense economics literature has done little to address this fundamental problem. Most English- and French-speaking contributions focus on research settings that explore micro- and macroeconomic problems in the context of military organizations. Various overviews of this literature are available in French (Bellais et al. 2014; Chardigny 2013; Malizard 2014, 2015) and in English (Hartley and Sandler 1995; Sandler and Hartley 2007; McGuire 2007; Poast 2006; Coyne and Mathers 2011; Alptekin and Levine 2012; Chen et al. 2014; Coyne 2015). This body of literature is problematic for two reasons. First, few contributions consider actual military organizations. Instead, they analyze aggregate settings (e.g., economics of war and peace, coordination problems in arms markets, analysis of the arms industry and its interaction with state decision makers, game-theoretic modeling of arms races, economic analysis of terrorism, advantages and disadvantages of various conscription models, prioritization of state investment, and the influence of defense spending on gross domestic product and economic growth). Although these studies rigidly apply neoclassical theory, they are of little use when it comes to the actual economic problems of military organizations. For instance, it is not enough to reduce such problems to the fundamental ‘guns versus butter’ model, which is supposed to calculate optimal investments in defense (Caruso 2010; Dikici 2015; Panagariya and Shibata 2000). The allocation of financial resources does not equate military performance. Without a clear definition of what military performance actually is, decision makers can judge neither its effectiveness nor its efficiency. There has been a longstanding consensus in the literature that military performance—to which authors generally refer to as ‘protection’, ‘security’ or ‘defense’— should be interpreted as a public good (Head and Shoup 1969; Thompson 1974; Hummel 1990; Blagden 2009; Ritchie 2011). This concept is problematic for several reasons. Public goods are defined by non-excludability and non-rivalry. The former implies that no individuals can be excluded from consumption, even if they refuse to co-finance the production of this good. The latter implies that the utility of any

2

Ironically, this situation is quite advantageous for defense economists. If state bureaucrats could manage any armed force just like a private business, the field of defense economics would not exist; a primer on strategic management and cost accounting would suffice.

6 Table 1.1 Classification of goods

1 Introduction: The Fundamental Economic Problem of the Military

Rivalry Non-rivalry

Excludability Private goods Club goods

Non-excludability Common goods Public goods

particular individual realizes is not compromised as another individual consumes the good. Table 1.1 differentiates between public and other types of goods. Actual military performance might differ from this ideal definition (Coyne 2015). Residents3 can in fact compete for the consumption of scarce military performance, as the armed forces might not be able to protect all residents equally. Financial or logistical deficits can restrict their capability to deploy force. Both the intensity and the structure of any such force deployment are unknown until information about the tactical or operational situation is available. If strength deployed is insufficient or unsustainable, commanders must decide to whose favor the scarce military performance should be rationed (Cowen 1985; Hummel and Lavoie 1990). There will thus be local rivalry among residents for the consumption of limited military performance as armed forces ration the regional deployment of their power. Even if they operate at full capacity, the armed forces can consciously refrain—for tactical or operational reasons—from evenly applying force in all regions or from defending specific areas. Therefore, particular residents might never (or not all of the time) be provided protection, although they had to co-finance the organization of the armed forces in the past. In times of war, a city can be declared an open city, i.e., it is not defended and it can be freely occupied by enemy forces. In this case, residents receive no compensation for their financial contributions to the armed forces. They must also bear the costs of the occupation. For example, although American troops declared Manila an open city in 1941 and removed all military installations, a Japanese invasion force entered the city and installed a hard occupation regime.4 Whenever authors or politicians model military performance as a public good, they can justify the idea that the state should organize armed forces by bureaucratic planning and taxing residents to fund both the military and its planners. In particular, they can cite the free-rider problem, where residents are willing to consume a public good but are less willing to pay for its production. This ‘market failure’ would require a state production of public goods (Samuelson 1954, 1955; Bator 1958; Tiebout 1956; Musgrave 1959; Buchanan 1968; Harrison 1975). However, liberal economists have shown that private producers can generate military performance even under ‘anarchic’ conditions in a free market economy (Friedman 1973; Rothbard 1973; Hummel and Lavoie 1990). The private and non-monopolistic production of military force is efficient (Powell and Coyne 2003). This alternative production is also feasible on a larger scale, and there is no coercing

3 Here and in the following, the term ‘residents’ denotes all inhabitants of a state, irrespective of their citizenship or political rights, whose taxes, duties and levies fund the armed forces. In contrast, ‘citizens’ here and in the following refers to the subpopulation of residents that have political rights. 4 The extent to which the international law of war can protect residents in this case is very much a question of how the occupation force behaves.

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argument that would justify production by state monopolies (Sechrest 2004, 2007; Powell and Stringham 2009). On the contrary, government failure is just as likely as market failure. There is a significant risk that a state bureaucracy produces inferior public goods and squanders resources while doing so (Forte 2010). This is particularly the case when the public goods and services in question are technologically complex (Rothkopf 2007). The notion ‘public good’ is fraught with significant conceptual and semantic problems. It is not readily clear what the public good is, or how analysts should measure it. Using vague keywords, such as ‘protection’ or ‘security’, does not solve this problem. These terms do not describe military performance as such; rather, they describe the subjective perceptions of individual residents (Baldwin 1997; Malešič and Kümmel 2011) or outcomes generated by military performance (Engerer 2011). It is true that a good is defined as an item that creates utility, i.e., something that satisfies human needs or desires (Milgate 2008). However, unlike state-funded street lighting, for example, military performance has no product characteristics. It resembles a service contract, as armed forces are not an end in themselves. The duty of the military to the residents is not limited to their mere existence; rather, they owe actual performance, i.e., mission success. Otherwise, armed forces generate nothing but costs that are never offset by any benefits. The conceptualization of military performance as a public good therefore erroneously equates production cost with performance. Whenever armed forces fail to accomplish their mission, this equality no longer holds. In fact, the state-run production of military performance can generate public bads, such that residents would be better off with no armed force at all. Finally, whenever military performance is termed ‘defense’, analysts reduce its conception to defensive aspects. Although this view is might be appropriate in continental Europe, military performance also includes offensive action. For example, it is somewhat problematic to view the 2003 Iraq invasion as an act of defense given that, by the time the invasion began, Iraq no longer possessed weapons of mass destruction (Koblentz 2018; Duelfer 2016). Although open wars of aggression have become rare since 1945 when the UN Charter banned them, military interventions for political or economic reasons are still commonplace in many regions of the world. Such power projections are not acts of defense, although state propaganda declares that they are (Nordhaus et al. 2012; Hummel and Lavoie 1990; Coyne and Hall 2014). It is hard to see how analysts could capture this offensive deployment of military force by the notion of a public good. This conceptual problem is not one of morality, but of incompleteness. Military performance has also been conceptualized as a club good, particularly so in the context of military alliances (Engerer 2011; Sandler and Tschirhart 1997). Indeed, residents can voluntarily pool their resources as they attempt to generate a joint military performance that exceeds the sum of all individual efforts. History abounds with examples of such voluntary alliances by which merchants, cities and city-states joined their forces to defend their rights and freedom against regional princes and sovereigns, e.g., in the Hanseatic or the Swabian League (Harreld 2015; Pavlac and Lott 2019). Nation states can conclude bi- or multilateral treaties that establish supranational alliances. In economic terms, such alliances can be

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interpreted as ‘club goods’, i.e., the good produced by club members is available for consumption by these members only. Therefore, all members must jointly organize and fund the production of the club good. Furthermore, they have the authority to decide about the admission of new members and the dismissal of extant club members. In theory, club members do not compete for the jointly produced good, because it is equally available to all. Thus, this type of good removes the non-excludability but maintains the non-rivalry condition (see Table 1.1). This conception of military performance, however, is also questionable. First, club members compete for the club good whenever it is scarce. For example, equipment deficiencies can impede a defensive alliance from providing equal protection for all members when an opponent threatens several members at the same time. This problem exists whenever club members acquire or combine military equipment for joint use (‘pooling and sharing’). If the demand for such shared resources exceeds available supply, club members will compete for consumption, so that the jointly owned resources must be rationed. In principle, the joint organization of defense generates positive externalities that should benefit all members. This effect is mitigated, however, once individual club members begin to behave as free riders. Unfortunately, every member has an incentive to do so. Club members face a complex principal-agent problem in which each member is both principal and agent. Each individual club member must survey whether the other members contribute their share to the joint financing and to the organization of the club good. At the same time, each member has an incentive to shirk this funding and to enjoy the club good for free. Consequently, in the absence of a centralized coordination mechanism, the joint spending of all alliance members is too low. For this reason, alliances are more stable if a hegemonic power leads and coordinates the members. Whereas, if this power forces non-compliant members to pay, the problem persists. For example, to date, only nine of the 28 NATO member states spend the agreed share of at least two percent of their GDP for national defense (NATO 2019, see Table 1.2). Any individual club member can therefore rationally act against the collective interest of the club (Klingen 2011). Furthermore, the cost of bureaucratic coordination grows exponentially with the number of club members, such that an everincreasing proportion of club resources goes into bureaucratic administration rather than into the production of military performance. As a result, the global inefficiency of a jointly organized production can exceed the combined inefficiencies of all individual efforts (Olson 1965; Hardin 1982). Therefore, each club has a saturation point, beyond which the coordination cost of integrating a novel member exceeds the marginal performance improvement that any such member can contribute. The problems of conceptualizing the production of joint military performance as a club good is not limited to the non-rivalry condition. The club members’ power to expel non-compliant members from the club can also be limited. The threat of removing a free-riding club member is only credible as long as that member’s contribution to joint production is substitutable. In contrast, whenever a particular club member makes an indispensable contribution, the threat of expulsion is implausible. Therefore, military performance strongly depends on the engagement of such

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Table 1.2 Financial contributions of NATO members to national defense NATO member states Albania Belgium Bulgaria Canada Croatia Czech Republic Denmark Estonia France Germany Greece Hungary Italy Latvia Lithuania Luxembourg Montenegro Netherlands Norway Poland Portugal Romania Slovak Republic Slovenia Spain Turkey United Kingdom United States Average NATO Europe & Canada Average NATO Total

Military expenditure (%real GDP, 2019e) 1.26 0.93 3.25 1.31 1.68 1.19 1.32 2.14 1.84 1.38 2.28 1.21 1.22 2.01 2.03 0.56 1.66 1.36 1.80 2.00 1.52 2.04 1.74 1.04 0.92 1.89 2.14 3.42 1.57 2.52

central members and results from a system of satellites organized around a hegemon rather than from a democratic club of equals. For example, the individual contribution of the United States strongly influences NATO’s collective military performance. Such hegemonic leadership makes alliances stable, but it is incompatible with the economic notion of a club good. Finally, there are similar semantic problems with the notion of public goods. Terms such as ‘protection’, ‘defense’ and ‘security’ do not describe actual military performance, but rather subjective perceptions generated by this performance, even if alliance members produce it collectively. A quite exotic perspective interprets the national defense budget as an ‘insurance premium’ that is paid to avoid war-related economic damage (Hartley 2010). In this

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perspective, analysts assume that residents want to buy ‘security insurance’ just as they would buy house or car insurance. For example, under the assumption that the Swiss capital stock of about 1728 billion Swiss Francs (Federal Statistical Office 2020) would suffer a mere 5% loss as a consequence of war action, the annual Swiss defense budget of 5 billion francs per year appears to be a relatively small premium in comparison to the expected loss of about 86 billion.5 However, this argument is inadequate. Analysts can neither estimate the incidence rate of non-probabilistic risk events—such as intentional attacks—, nor can they estimate the related damage as long as they use value-at-risk methods (Gillard and Anderhalden 2020). Therefore, there is no insurance market by which merchants could negotiate premiums for war-related damage. Precisely because the correct premium is inestimable, private firms refuse to underwrite coverage for war- or terror-related damage, particularly so when high-value assets are at risk (Keupp and Schöb 2015). The calculation of insurance premiums for hypothetical war-related damage is highly speculative. It implicitly assumes that military performance will be equally available, effective, and provided to all residents. These assumptions might not hold. The incentive to buy insurance is rooted in the belief that the insurance company will pay the insured value if there is any damage. This belief is already questionable, as far as private insurance companies are concerned. For any individual that buys insurance, the payment of the premiums is a certain event (otherwise, the insurance company would deny any payout). However, even if a client has reliably paid all premiums paid in the past, the actual payout in case of damage is uncertain. The insurance firm can contest and deny claims, reduce payouts on grounds of contributory negligence, and can make them subject to terms and conditions. Consequently, individuals cannot know the extent to which (if any) the firm will settle their claims. Analogously, they cannot know the extent to which the armed forces will be able to protect the capital stock until real force deployment begins. They can hope, but not predict with any certainty, that their property will benefit from this protection. As discussed above, residents compete for military performance if armed forces decide to ration it. This implies that some residents might never receive any compensation for the ‘insurance premium’ of the defense budget they co-financed with their taxes. The propensity to buy insurance would therefore significantly differ across individual locations. Civilians who live in densely populated urban areas would be much worse off if they were to experience the deployment of military force—both friendly and hostile—in these areas because the collateral damage and loss of civilian human life in urban warfare is significant. Rational residents in these areas are unlikely to buy insurance, yet they could minimize the risk of damage by moving

5 Although the capital stock can remain unharmed during wartime, it might still be reduced after defeat. For example, between 1945 and 1952, the Soviet Union expropriated and deconstructed industrial assets in the East German occupation zone in order to add these assets to its own capital stock.

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themselves, their property and labor supply away from hostilities. Finally, even if the defense budget is interpreted as an ‘insurance premium’, it is still unclear what terms such as ‘defense’ or ‘protection’ are supposed to mean, and how the effectiveness of their deployment and the efficiency of their production should be measured. A more rigorous stream in the literature models military performance as the result of a neoclassical ‘production function’ (e.g. Hildebrandt 1999; Rohlfs 2006). In this view, the state spends the defense budget to acquire capital (arms) and labor (combatants), both of which are then—somewhat mysteriously—‘transformed’ into military ‘performance’ or ‘output’. Proxy measures such as numbers of troop deployed, or technical performance rates of weapons systems, are to capture this output (e.g., Beeres and Bogers 2012). Although such models are formally correct and rigorous, they remain irrelevant, both because they ignore the fact that armed forces are an organization, not an abstract function, and because they do not consider the implications of the institutional situation of contemporary armed forces. Furthermore, the productivity of combatants significantly differs from that of bureaucrats, although both consume resources in the defense sector and both must organize military performance. Hence, at the very least, analysts should consider the ‘toothto-tail’ ratio of fighting versus administrative personnel when they assess the performance of an armed force (Gebicke and Magid 2010). When these restrictions are taken into account, the major assumptions of such neoclassical models no longer hold. The planned economy system generates no incentives to maximize the efficiency of operations. Hence, the assumption that all inputs are entered at minimum cost is unrealistic. In such a system, there are no market prices, or they are unknown to the bureaucratic planner, such that economic decisions based on artificial prices and asymmetric information. Simply put, these models assert that an effective defense output is produced, despite the fact that military performance is not ‘made available’ in real organizations. On the contrary, the generation of military performance is a production process in itself. It combines capital (financial means, systems) and labor (civilian employees, combatants)—that much is true—but it does so by orchestration complex bureaucratic routines. In theory, war action could be interpreted as a negative production function, by which capital and labor inputs are used to destroy enemy resources (the annihilation of which could be measured), rather than to produce any original output. However, this conceptualization would be inapplicable to any peacetime situation. Despite its formal rigor, the neoclassical literature on defense economics is essentially self-referential. It can neither consider nor solve the actual economic and organizational problems of contemporary armed forces. Indeed, if defense economics were merely a question of neoclassical optimization under the assumption of rationality and perfect information, there would be no need to sadly conclude that after 40 years of research, defense policy still ‘abounds with mischief’ (Hartley 1997). Given this unsatisfactory state of the literature, researcher should clarify the notion of military performance first. Each resident possesses individual and inalienable rights that natural law requires to protect: life, physical integrity, liberty and private property (McConnell 1984; Rothbard 2002). All of them may suffer because

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of war action, and so may the constitutive characteristics of the state (Rubin 2007; Spadafora 2015): people (population is reduced as combatants and civilians die), territory (reduced by occupation or annexation), and authority (reduced by loss of control). Finally, the economy also suffers. GDP grows and shrinks with greater or lesser capital, labor, and total factor productivity (Solow 1956). Capital productivity falls as opponents destroy or expropriate the national capital stock.6 Labor supply and skill is reduced as residents are injured, die, or flee.7 Total factor productivity—the share of productivity growth due to knowledge and technological progress—decays with this labor force reduction; moreover, intellectual property can be expropriated.8 Responding to such threats, citizens, rulers, and monarchs create armed forces. Any such force constitutes an organization by definition, as it is a purposeful structure whose members pursue the same goal (Firth 2013; Watson 2017).9 The extent to which this organization can prevent or minimize these damages depends on the military capabilities it has. Ockham’s razor advises researchers to prefer parsimonious explanations. Rather than to obfuscate the debate by framing military performance in unclear terms such as ‘security’ or ‘defense’, analysts should observe what armed forces actually do. The analysis of this empirically observable action does not depend on the concepts by which researchers might label this action. In particular, unless they can observe and measure this activity, an analysis of the effectiveness and efficiency of military performance is impossible. Therefore, observation of what military organizations do and for what purpose is the first step of the analysis. In order to generate capabilities, both military and private organizations purposefully combine material, knowledge and human resources (Amit and Schoemaker 1993; Grant 1996; Teece 2019). Capabilities are generated in social routines that continuously condition and shape human behavior and competencies (Felin et al. 2012). Thus, capabilities are not grounded in particular organizational resources or members, but rather in the systematic interaction of all members and resources (Barney 1992). In particular, a military organization combines human resources (civilian employees, combatants), material resources (weapons, infrastructure) and knowledge resources (weapon systems operation, infantry tactics, etc.) to generate both offensive and defensive capabilities. It deploys these capabilities in combat, or

6 The net capital stock is the sum of all replacement values for all capital goods used for production in the economy. These assets include civilian buildings, machinery, equipment, livestock, crops, research and development and computer programs. Both physical and cyber warfare may damage and destroy all of them. 7 The statistical value of a life is estimated at not less than two million US$ (Viscusi and Aldy 2003; Doucouliagos et al. 2012), so a violent end of life or permanent disability significantly reduces the productivity that human beings can realize over the course of their working life. This reduction also diminishes the tax base of the nation state (Holcombe 2008). 8 For example, between 1945 and 1947, the United States expropriated all German patents and deported German scientists to the USA (Gimbel 1986, 1990). 9 From hereon, the terms ‘armed forces’ and ‘military organization’ will be used interchangeably.

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it uses them accomplish non-combat missions, such as intelligence or exfiltration (Hartley 1995; Kinnaird et al. 2003; Kerr et al. 2008). Unless researchers study the social interaction in these routines across multiple levels, there is little hope for any deeper understanding of the microfoundations of military capabilities (Harmon et al. 2019). In a private firm, capabilities are a prerequisite for the production of competitive goods and services (Ravichandran and Lertwongsatien 2005; Hall 1993; Yeoh and Roth 1999; Wright et al. 2001). Survival in a market environment requires profitable sales of competitive goods and services. Therefore, firms thrive as long as they have the capability to produce these goods and services, and they vanish when they lose the capability to do so. In a private firm, capabilities are therefore an intermediate construct by which performance can be determined. However, among armed forces, military capabilities are the direct and observable production outcome. Unlike in a private firm, capabilities are not a prerequisite for the production of some other output, but they constitute the output as such. A capability-based approach to military performance is therefore generalizable. Neither does the analysis depend on the personnel, budget, doctrine, culture or resources of the particular organization in question, nor does it depend on the political system of the state. In particular, resource endowment does not equal mission success. History provides numerous examples where materially inferior parties were victorious.10 The availability of material, knowledge, and human resources is a necessary, but not a sufficient condition for the generation of organizational capabilities (Kusunoki et al. 1998). Therefore, both the military budget and counts of weapons systems are insufficient proxy measures for military performance. Neither the number of systems and combatants, as documented in the Military Balance (2021), nor the financial size of the military budget can measure the extent to which armed forces possess actual military capabilities. For example, although Ukraine possessed thousands of battle tanks in 2014, it was unable to resist the Russian annexation of the Crimean Peninsula. Military performance is not determined by counting system units. It rather depends on the successful deployment of key capabilities, such as the capability to engage (Beeres and Bogers 2012), to fight (Moore et al. 1991), to operate autonomously (Kinnaird et al. 2003; Kruys 2001; Tellis et al. 2000), and to structure (Isely and Crowl 1951; Moran 2006; Millett et al. 1986). Hence, a capability-based approach protects analysts from the erroneous conclusion that resource endowments and military capabilities are identical. Finally, a capability-based approach enables the analyst to measure the effectiveness and efficiency of military performance. Effective defense requires more than the mere creation of a military organization—even if this organization possesses military capabilities. Quite simply, it requires an effective mission outcome in a particular environment of operations (Hinge 2000). Otherwise, all investments in the

10 For example, in the battles of Salamis (480 BC), Agincourt (1415), Galveston (1863) and Longewala (1971).

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organization are lost, and the residents would be better off if they had never invested any resources in the first place. The comparison between the resources invested and the capabilities generated provides residents with information about the efficiency with which the military organization transforms their taxes into military performance (Henderson and Cockburn 1994). Defense economics, therefore, is a problem of economic organization: How should the state design institutions that govern the efficient transformation of scarce resources into effective military performance? As the nation state and its bureaucracy create and shape these rules, analysts must study both. Indeed, economic action does not take place in a vacuum, but in social contexts that are structured by rules (Boettke and Storr 2002). These rules—institutions—govern human behavior by rewarding desired actions and punishing those undesirable (North 1990, 2005).11 Formal institutions, such as legal norms and private contracts, establish and structure such rules. However, rules can also emerge as inter-subjective conventions between individuals (informal institutions). Any positive analysis must begin in the present (Buchanan 2004). Researchers should first ask which rules structure the creation of military capabilities, how these rules influence human behavior, and how this behavior influences economic results. On this basis, analysts may elaborate recommendations for economic reform. Institutional differences lead to different political, social, and economic outcomes (Boettke and Fink 2011). Institutional settings are responsible for differences in prosperity and wealth across human societies and nations (Rodrik et al. 2004; Hodgson 1988, 1993; Ostrom 2005; Acemoglu et al. 2001; Acemoglu and Robinson 2012). A nation’s ability to develop economically depends primarily on its institutional configuration (Scully 1992; Kasper and Streit 1999; Platteau 2000). Both state and self-created institutions significantly influence the economic performance of organizations (Powell and DiMaggio 1991; Zucker 1987). The performance of any economic system is hence not only associated with but also determined by the institutions that define this system (Boettke et al. 2013; Matthews 1986). A same human being will behave differently under different institutional configurations. Therefore, an institutional analysis strives to reveal which institutions influence human behavior and in what way. This book attempts to contribute to the fields of new institutional economics and public choice; both are explained in detail in Furubotn and Richter (2005). Although the consequences of institutions for the sociological and psychological behavior of combatants have been widely explored (Paparone 2013; Moore and Barnett 2014), their consequences for the economic situation of state-managed armed forces have been studied very little. Ten years ago, Klingen (2011) lamented the dearth of institutional perspectives in defense economics, although researchers have pointed out their usefulness early on (Reppy 1991). To date, few such

The use of the term ‘institution’ among economics differs from its colloquial usage as ‘important organization’ or ‘authority’. In the remainder of this book, the term is used exclusively in the economic sense explained here. 11

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perspectives are available (e.g., Driessnack and King 2004; Pahlavi and Ouellet 2009; Herrera 2013; McGuire 2007). These contributions, however, barely study military organizations, let alone the economic problems implied by bureaucratic management. Although there are excellent institutional analyses of military and security policy contexts (Mintz 1992; Klingen 2011), these studies provide aggregate analyses that focus on the national and supranational level. An analysis on the organizational level is fundamentally missing. This book provides such an analysis. It uses a narrative approach, since this method is more suitable for the analysis of complex institutional contexts than formal methods (Bates et al. 1998; Greif 2006; Djankov et al. 2003). This recommendation applies, in particular, to the comparative analysis of alternative institutional configurations (Rodrik 2007). First, an Austrian analysis assesses the institutional context of state-run armed forces (Chap. 2). It explains why a planned economy system is defined whenever a state bureaucracy economically controls armed forces. It further details how this system influences the behavior of different key groups of human beings inside and outside military organizations. Then, it explores the implications of the planned economy system for the effectiveness (Chap. 3) and the efficiency of military performance (Chap. 4). The book concludes with some proposals for reforms (Chap. 5) based on the introduction of property rights and economic liberty in military organizations. These proposals deliberately ignore any speculation about their political feasibility. Efficient economic solutions do not require any particular political ideology or need to consider party tactics (Friedman 1953). Economists should not judge such issues. While politicians can deliberate how, if at all, they may win majorities for implementation, scientists must restrict themselves to providing accurate advice to decision makers. However, they may consider how they might position their proposals in the process of political persuasion (Hutt 1971). Even if the (defense) economist presents himself as a king’s jester and is not taken seriously by the proponents in his time (Vaubel 2007), both the errors in theoretical reasoning and the practical failures of any planned economy system will be evident. Whoever desires to possess efficient and effective armed forces will have no other choice than to forego a planned economy system. Military leaders, in particular, should be aware that the institutions and methods by which state bureaucracies control military organizations are simply the result of historical developments. However, if a particular institutional situation is merely the result of historical processes, then there is no reason to cling to them, except for convention. This convention can be costly and, when military performance is ineffective, it can implicate the loss of human life and wealth. The duty of generals to obey their political leaders does not liberate them from the duty of conscientious reflection in the interest of those they are sworn to protect. Whenever dysfunctional institutions endanger this mission, they should be abandoned, or, in Nietzsche’s words Man muss mit dem Hammer philosophieren (one must philosophize with the hammer).

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Mallett M (2009) Mercenaries and the masters. Warfare in Renaissance Italy. Pen & Sword Military, Barnsley Martines L (1988) Power and imagination. John Hopkins University Press, Baltimore Matthews R (1986) The economics of institutions and the sources of growth. Economic Journal 96: 903–918 McConnell T (1984) The nature and basis of inalienable rights. Law and Philosophy 3: 25-59 McGuire MC (2007) Economics of defense in a globalized world. In Sandler T, Hartley K (Eds.), Handbook of Defense Economics, Vol. 2, 623-648 Milgate M (2008) Goods and commodities. In Eatwell J, Milgate M, Newman P (Eds.) The new Palgrave dictionary of economics. Macmillan, London, 546-548 Millett AR, Murray W, Watman KH (1986) The effectiveness of military organisations. International Security 11:37-71 Mintz A (Ed.) (1992) The political economy of military spending in the United States. Routledge, London, New York Moore BA, Barnett JE (Eds.) (2014) Military psychologists' desk reference. Oxford University Press, New York Moore SC, Stockfisch JA, Goldberg MS, Holroyd SM, Hildebrandt GG (1991) Measuring military readiness and sustainability. RAND Corporation, Santa Monica Moran M (2006) Modern military force structures. Council on Foreign Relations, London Musgrave RA (1959) The theory of public finance. McGraw-Hill, New York NATO (2019) Defence expenditure of NATO countries (2013–2019). Communique PR/CP(2019) 123. North Atlantic Treaty Organisation, Bruxelles Navarro-Galera A, Ortúzar-Maturana RI, Muñoz-Leiva F (2011) The application of life cycle costing in evaluating military investments: An empirical study at an international scale. Defence and Peace Economics 22:509-543 Nordhaus WR, Oneal JR, Russett, B (2012) The effects of the international security environment on national military expenditures: a multicountry study. International Organisation 66: 491-513 North DC (1990) Institutions, institutional change and economic performance. Cambridge University Press, Cambridge North DC (2005) Understanding the process of economic change. Cambridge University Press, Cambridge Oestreich G (1957) Soldatenbild, Heeresreform und Heeresgestaltung im Zeitalter des Absolutismus (Schicksalsfragen der Gegenwart, Band 1). Max Niemeyer Verlag, Tübingen Olson M (1965) The logic of collective action. Harvard University Press, Cambridge MA Oman C (1991) A history of the art of war in the sixteenth century. Greenhill Books, London Ostrom E (2005) Understanding institutional diversity. Princeton University Press, Princeton Pahlavi P, Ouellet É (2009) Guerre irrégulière et analyse institutionnelle : le cas de la guerre révolutionnaire de l'armée française en Algérie. Guerres mondiales et conflits contemporains 3:131-144 Panagariya A, Shibata H (2000) Defense and welfare under rivalry. International Economic Review 41:951-969 Paparone C (2013) The sociology of military science. Continuum, New York Papke G (1975) Von der Miliz zum Stehenden Heer 1648-1789. In Militärgeschichtliches Forschungsamt (Hrsg) Handbuch zur Deutschen Militärgeschichte 1648-1939. Bernard & Graefe Verlag für Wehrwesen, München Pavlac, B.A., Lott, E.S. 2019. The Holy Roman Empire: A historical encyclopedia. Santa Barbara: ABC-CLIO Platteau JP (2000) Institutions, social norms, and economic development. Routledge, New York Poast P (2006) The economics of war. McGraw-Hill, Irwin Potter D (2008) Renaissance France at war: Armies, culture and society. Woodbridge, The Boydell Press Powell B, Coyne C (2003) Do pessimistic assumptions about human behavior justify government? Journal of Libertarian Studies 17:17-38

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Powell W, DiMaggio P (Eds.) (1991) The new institutionalism in organisational analysis. University of Chicago Press, Chicago Powell B, Stringham E (2009) Public choice and the economic analysis of anarchy: A survey. Public Choice 140: 503-38 Pyman M, Wilson R, Scott D (2009) The extent of single sourcing in defence procurement and its relevance as a corruption risk: A first look. Defence and Peace Economics 20:215-232 Ravichandran T, Lertwongsatien C (2005) Effect of information systems resources and capabilities on firm performance: A resource-based perspective. Journal of Management Information Systems 21:237-276 Reppy J (1991) On the nature and scope of Defence and Peace Economics: A comment. Defense Economics 2:269-271 Richter G (Hrsg) (2007) Die ökonomische Modernisierung der Bundeswehr: Sachstand, Konzeptionen und Perspektiven. Springer, Wiesbaden Ritchie N (2011) Rethinking security: a critical analysis of the Strategic Defence and Security Review. International Affairs 87:355-376 Roberts M (1995) The military revolution, 1560–1660. In: Clifford J. Rogers (Eds) The military revolution debate. Westview Press, Boulder, 13–35 Rodrik D (2007) One economics, many recipes: Globalization, institutions, and economic growth. Princeton University Press, Princeton NJ Rodrik D, Subramanian A, Trebbi F (2004) Institutions rule: The primacy of institutions over geography and co-integration in economic development. Journal of Economic Growth, 9:131165 Rohlfs C, Sullivan R (2013) The cost-effectiveness of armored tactical wheeled vehicles for overseas US Armed forces operations. Defence and Peace Economics 24:293-316 Rohlfs C (2006) The government’s valuation of military life-saving in war: A cost-minimization approach. American Economic Review 96:39-44 Röpke W (1963) Economics of the free society. Henry Regnery, Chicago Rothbard MN (1973) For a new liberty: Libertarian Manifesto. Macmillan, New York Rothbard MN (2002) The ethics of liberty. New York University Press, New York Rothkopf MH (2007) Thirteen reasons why the Vickrey-Clarke-Groves process is not practical. Operations Research 55: 191-197 Rubin EL (2007) Beyond Camelot: Rethinking politics and law for the modern state. Princeton University Press Samuelson PA (1954) The pure theory of public expenditure. The Review of Economics and Statistics 36:387-389 Samuelson PA (1955) Diagrammatic exposition of a theory of public expenditure. The Review of Economics and Statistics 37:350-356 Sandler T, Hartley S (Eds) (2007) Handbook of defense economics: Defense in a globalized world. Elsevier, Amsterdam Sandler T, Tschirhart J (1997) Club theory: Thirty years later. Public Choice 93:335-355 Scully GW (1992) Constitutional environments and economic growth. Princeton University Press, Princeton NJ Sechrest LJ (2007) Privately funded and built US warships in the quasi-war of 1797–1801. The Independent Review 12:101-113 Sechrest LJ (2004) Public goods and private solutions in maritime history. The Quarterly Journal of Austrian Economics 7:3–27 Solomon B, Stone C (2013) Accrual budgeting and defence funding: Theory and simulations. Defence and Peace Economics 24:211-227 Solow RM (1956) A contribution to the theory of economic growth. Quarterly Journal of Economics 70:65–94 Spadafora A (2015) Georg Jellinek on values and objectivity in the legal and political sciences. Modern Intellectual History 14: 747-776 Sumption J (1990) Trial by battle: The Hundred Years War I. Faber and Faber, London

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Teece D (2019) A capability theory of the firm: An economics and (strategic) management perspective. New Zealand Economic Papers 53: 1–43 Tellis AJ, Bially J, Layne C, McPherson M (2000) Measuring national power in the postindustrial age. RAND Corporation, Santa Monica The Military Balance (2021). London: Institute of Strategic Studies Thomas d’Aquin (2001) Prooemium. In Alarcón E (Ed) Corpus Thomisticum, De ente et essentia. Ad Universitatis Studiorum Navarrensis, Pamplona Thompson EA (1974) Taxation and national defense. Journal of Political Economy 82:755-782 Tiebout CM (1956) A pure theory of local expenditures. Journal of Political Economy 64:416-424 Vaubel R (2007) Realistische Politikberatung. Schweizer Monatshefte 87:30-31 Viscusi K, Aldy JE (2003). The value of a statistical life: A critical review of market estimates throughout the world. Journal of Risk and Uncertainty 27: 5-76 Watson T (2017) Sociology, work and organisation. Taylor & Francis Wright PM, Dunford BB, Snell SA (2001) Human resources and the resource based view of the firm. Journal of Management 27:701-721 Yeoh PL, Roth K (1999) An empirical analysis of sustained advantage in the US pharmaceutical industry: Impact of firm resources and capabilities. Strategic Management Journal 20:637-653 Zucker L (1987) Institutional theories of organisation. American Review of Sociology 13:443-464

Chapter 2

Institutions and Armed Forces

2.1

Contemporary Armed Forces as Planned Economy Systems

In the age of nation states, the creation of any armed force is a political act. Prior to this age, private initiative spontaneously created armed forces to satisfy a short-term demand for military force and disbanded them once they had accomplished their mission. Today, those who have political power in the state create a (or maintain an existing) armed forces organization that exists as such. Without this institutional legitimization, armed forces could not emerge or continue to exist. Once the state creates a permanent military organization, this organization exists independently of both its actual military performance and of any individual opinion regarding the extent to which military performance is actually required. Specifically, it also exists in peacetime, for as long as a political consensus exists to maintain the institution that establishes the organization as such. Whenever the armed forces lose this consensus, they cease to exist, either because politicians reduce their budget to zero because they formally disband the organization.1 Contemporary nation states use institutions to create, legitimize and fund their armed forces. In democratic states, where a rule of law exists, they can be found in the constitution or national laws of the state; elsewhere, the institution is the result of a decision made by a monarch, prince, or authoritarian ruler. Examples are Art. 58 of

Corruptissima re publica plurimae leges (The more corrupt the state is, the more laws it has (Tacitus, Annales III, 27)) 1 For example, in Liechtenstein (1868), Costa Rica (1990) and Panama (1990), military organizations were dissolved following political decisions taken by the sovereign or the citizens. In Switzerland, since 1989, the Group for Switzerland without an Army has been campaigning for Article 58 of the Federal Constitution—which defines that a military organization exists as such—to be deleted. In 1999 they also campaigned that an article, which expressly forbids the creation of any armed force, should be added to the Constitution.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. M. Keupp, Defense Economics, https://doi.org/10.1007/978-3-030-73815-0_2

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the Federal Constitution (Switzerland), Art. 87a of the Basic Law (Germany), Art. 15 of the Constitution of the Fifth Republic (France), Art. 1 sct. 8 clause 12 of the U.S. Constitution (USA), Art. 36 of the Belgian Constitution, Art. 91 pt. 7 of the Constitution Act (Canada), Art. 97 of the Dutch Constitution or Art. 117d of the Italian Constitution.2 All of these constitutional articles legitimize the existence of armed forces as such, even if politicians do not expect any deployment of military force in the near future. This institutional legitimization concentrates military power in the hands of the nation state alone. It is true that the nation state is not the only public body that demands military performance; both international allies and regional politicians can be interested in the performance a national military organization has to offer. However, every nation state has only one military organization that supplies this performance. In stark contrast to both the private sector and earlier phases of military history, there is no competition between different providers of military performance. Once the first phrase in article 58 of Switzerland’s Federal Constitution (‘Switzerland has an armed force’) is read with emphasis, it is quite clear that Switzerland does not only have an armed force, but it also has only one (national) armed force. This formal institution reflects the historical tendency towards the centralization of government and military power. As of today, with the exception of (relatively small) private military companies, there is no longer any competition between decentralized providers of military power. Instead, there are only total state monopolies in which the generation and deployment of all military capabilities is concentrated. From the viewpoint of the nation state, the question of whether the same (or a more effective or efficient) military performance could be decentrally organized is irrelevant. Consumers shy away from any private firm that fails to satisfy their demand or to meet their quality expectations, which implies such firms soon exit the consumer market, whereas a state-run military organization exists irrespective of the quality or cost of the military capabilities it generates. Even if the residents do not require any of these capabilities, they are still obliged to finance this generation by the taxes they pay to the national budget. In conscription-based armed forces, citizens can be obliged to contribute their labor supply to the generation of military capabilities for a limited time. In states with a rule of law, citizens can refuse military service, but they cannot avoid paying taxes, unless they emigrate to a nation state that does not have a military organization. Hence, there is a certain irony in contemporary military organization. The nation

2

If those with political power prefer to not establish a national military organization but still require military performance, they can commission another state to provide it. For example, Papua New Guinea and the Solomon Islands—territories that were formerly governed by Australia but are now independent states—have concluded accords by which Australia provides military material and training of local forces. Similar arrangements have been made by the Cook Islands (defended by New Zealand), Monaco (defended by France) and San Marino (defended by Italy). In these cases, the institution that legitimizes the presence of foreign armed forces is an international treaty. As most contemporary nation states have founded military organizations, the problems generated by this international principal-agent relationship are not considered.

2.1 Contemporary Armed Forces as Planned Economy Systems

25

states forces all residents—including pacifists who would abolish any military organization and refuse any military service—to co-finance the military organization by the taxes they pay on income, consumption, and trade. As long as an institutional legitimization of the armed forces exists, shirking the funding of the generation of military capabilities entails prohibitively high transaction costs for the average resident. As a result, contemporary armed forces no longer face situations that generations of monarchs and princes had to deal with, namely, the challenge of raising money for every campaign, often against resistance from feudal lords, parliaments, and the clergy. The institutional legitimization of contemporary armed forces not only guarantees the mere existence of a military organization, but also its budget. Over the course of the existence of military organizations, the number of weapons systems, as well as of the combatants and civilian employees, has varied. Yet they continue to exist, as long as institutions pave the way to transfer financial means (even if fluctuating) from the state budget to the organization. There are limits to this de facto guarantee of both existence and funding, because each annual transfer of financial means requires political legitimization: In every budget period, those who hold political power must decide what share of the national budget should be allocated to the armed forces. As a result, the annual defense budget is subject to vacillating political contexts and the ebb and flow of subjective threat scenarios whose probability of occurrence is unknown. If politicians interpret the state of their environment as peaceful, they will be inclined to reduce transfers to the armed forces and favor alternative spending (‘peace dividend’). If they suspect that conflict is imminent, they will prefer to increase financial contributions. Whenever imbalances between these (hypothetical) scenarios and (actual) financial transfers emerge, military performance is either inefficient (the defense budget allocated is too large) or ineffective (the quality of capability generation degrades). The accounting principles according to which the government transfers funds to the armed forces do not matter. The point is that state-controlled armed forces cannot generate any financial means beyond the defense budget, unless the state grants them economic liberty. In the absence of such liberty, the armed forces are completely dependent on transfers from the state budget, and they must live with the risk that these transfers can increase or decrease at any time, particularly as a consequence of unforeseen events. The armed forces can therefore only expect to receive some funds, whereas the amount of these funds is unknown. The institutional foundation of a military organization guarantees its existence only as such, whereas its size and resource endowment are fundamentally uncertain. This institutional foundation locks armed forces in a state of continuous existence, even if their performance is below expectations. Unlike private firms, statecontrolled armed forces can neither establish nor dissolve themselves, nor can they merge with other armed forces, nor can they alter the general economic framework that controls them. Politicians can significantly their head count or equipment. Nevertheless, except for radical institutional reforms or a total defeat in war, armed forces cannot cease to exist.

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Table 2.1 Hierarchy of institutions Institutional level International norms Constitutional law Public law State bureaucracy Military bureaucracy Human interaction

Institution Alliances, international treaties Constitutional articles Laws, doctrine, documents Ordinances Regulations, manuals, orders Informal institutions

Author Politicians Politicians Politicians Civil planners Military planners Combatants

Consequently, state-run armed forces do not have any entrepreneurial freedom to not generate capabilities, even if their financial means are insufficient. Whereas a company can alter its production quantitatively and qualitatively at will, bureaucrats define the requirements armed forces must fulfill. Hence, the spectrum of entrepreneurial possibilities is limited to the continued operation of the organization. In all aspects that concern their existence, armed forces are subject to politically motivated regulation; they can implement but not alter this regulation. Decisions about bureaucratic management, budgetary transfer procedures, doctrinal mission definitions, and the choice for a conscription-based or professional system are all made at the political and bureaucratic level. Finally, every institution that legitimizes armed forces must remain materially vague. Institutions at the constitutional or national-law levels can only prescribe that a military organization must exist. However, they cannot not define, in detail, its organization, management, missions, and capabilities. As a result, the institutional justification of the armed forces goes hand in hand with the obligation to provide detailed planning, as state control implies that centralized bureaucratic planning replaces the decentralized coordination of free-market participants (Kambrod 2007). A political consensus is required to define the annual defense budget and the missions of the armed forces, but politicians, taxpayers and combatants can still disagree on the purchases and personnel financed with this budget. Hence, lowerlevel institutions are required to organize the generation of military capabilities. In order to understand the implications of this problem, Table 2.1 provides a generalized hierarchy of institutions (Williamson 2000). All levels are interconnected; institutions on lower levels detail and substantiate those on the higher levels. Institutions on the two topmost levels legitimize the very existence of the military organization. If so desired by the polity, these institutions integrate this organization into international alliances and treaties. On the next level, politically negotiated doctrinal documents define the mission of the armed forces.3 Particular laws define the general economic framework regarding budget, organization, and conscription (if any). These laws are further detailed by ordinances authored by the executive, i.e.,

3

Examples include the White Paper on Defense (Germany), the Security Policy Report (Switzerland), the White Paper on Defense and National Security (France), the National Security Strategy (USA) and the National Security Consultation (Canada).

2.1 Contemporary Armed Forces as Planned Economy Systems

27

by state and military bureaucracies.4 The influence this executive has on the content of any ordinance is significant but limited. The judiciary can control the extent to which any ordinance conforms to the law, but it will do so only if a complaint is filed. However, the number of ordinances far exceeds the number of laws because no political consensus is required to author an ordinance and enforce it. As these ordinances are further detailed in the bureaucratic day-to-day management of the armed forces, the number of institutions rises exponentially, as civilian and military planners create an ever-increasing number of detailed institutions in the form of service instructions and orders (for combatants) and directives (for civilian personnel). Both military and civilian bureaucracies are highly differentiated. They are staffed by planners, i.e., active and demobilized combatants with desk jobs, and by civilian experts. Both organize the generation of military capabilities, i.e., they acquire material, knowledge, and human resources, and they create and adapt the social routines in which these are combined. They organize the payment of salaries, benefits, and compensations, evaluate the technology of candidate weapons systems that the arms industry offers, plan investment needs, organize daily operations, etc. Private firms can informally implement such planning, whereas military planners must use formal and legalistic instruments in order to make bureaucratic management compliant with the laws and ordinances on higher levels. Entrepreneurs can directly enforce significant and even existential decisions by their property rights and economic liberty. For example, private firms can informally terminate their business, buy or sell business units, change the business model, and hire or fire staff, thus creating no formalized institutions other than business contracts in the process. In contrast, bureaucracies must create institutions to organize a particular issue and must adapt all of them on all levels, as changes to the organization or planning of the issue occur. Although the executive and legislative branches control the defense budget and mission of the armed forces, they are less interested in the day-to-day resource allocation and capability generation. The judiciary can evaluate the extent to which ordinances comply with the law, but it cannot judge the extent to which these ordinances make sense from an economic point of view. The enforcement of this control on lower levels is associated with much higher transaction costs, because it is harder to prove that any specific order or service instruction fails to comply with any specific ordinance. The judiciary, in particular, cannot assess whether or not any order or instruction that civilian or military bureaucrats create, on lower institutional levels, makes any sense from an economic perspective. Hence, the institutional situation of any military organization can fully comply with the letter of the law but still generate ineffective capabilities or squander resources.

4 In the Swiss context, article 58 of the Federal Constitution is substantiated by seven national laws (Armed Forces Act, Military Criminal Code, Military Installations Protection Act, Act on Military Information Systems, Act on War Material, Act on Weapons, Act on the Support for Disarmament and Non-Proliferation of Chemical Weapons). These are implemented by more than 80 ordinances.

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The development and administration of institutions on lower levels is highly labor intensive, hence the number of both military and civilian bureaucrats grows with the number and detail of such institutions. In a planned economy, the state can reduce this bureaucratic apparatus, but never abolish it completely, because in such a system the generation of capabilities requires formal top-down planning. Consequently, if any change in planning is required, the transaction cost of this change is proportional to the institutional level. Planners may revise service instructions, manuals and orders without much effort, whereas the reform of an ordinance already requires them to influence or to convince higher-level members of the executive who author and approve the content of these ordinances. To change any laws, politicians must win majorities and debates. For this reason, armed forces reforms, i.e., fundamental re-planning of all institutions from higher levels (laws) to detailed bureaucratic changes (orders) often take years or decades. Any institutional change on higher levels creates the need for subsequent adaptations on lower levels, as ‘a stroke of the legislator‘s pen turns entire libraries into waste paper’. The amendment of a single law requires the adaptation of all ordinances and subsequent bureaucratic regulations that are associated with it. Armed forces require three types of material resources to generate military capabilities: real estate and military infrastructure (military bases, buildings, barracks, training grounds, airfields, bunkers, military fences, etc.), privately produced goods that are also consumed in the military sector (e.g., food, office supplies, vehicles), and armaments (weapon systems, ammunition).5 However, the institutional situation of state-controlled armed forces entails a total lack of property rights regarding all of these resources, which means that the roles of purchaser, proprietor, and user of any material resource diverge. Individual entrepreneurs, as well as corporations, can freely purchase any resource (or refuse to do so if the quality or price of the offer is unsatisfactory). Through this purchase, they acquire property rights, so that they can freely use the resource for the purposes of their production. Hence, the existence of economic liberty and property rights in free markets makes identical the roles of purchaser, proprietor, and user of a resource. Both individual entrepreneurs and firms are free to purchase and use any resource, but they cannot pass on their responsibility for inefficient procurement. Furthermore, they must defend their property rights against acts of expropriation, and they must manage the risk of any ineffectiveness. Therefore, private initiative for entrepreneurs and corporations, under the conditions of economic liberty and property rights, entails a simultaneous optimization of efficiency and effectiveness, and no bureaucratic enforcement is necessary to instill the motivation to do so. No such motivation exists, however, among the members of state-controlled military organizations. Civilian and military planning bureaucracies organize the procurement of any material resource. When it comes to procurement, they can only

The boundary between the two latter categories can be fluid because dual use goods, such as training aircraft, can sponsor both civilian and military purposes.

5

2.1 Contemporary Armed Forces as Planned Economy Systems

29

act freely in economic terms to the extent that laws and ordinances allow them to do so. These bureaucracies do not bear the cost of inefficient procurement; the taxpayer, whose taxes finance both their salaries and their budget, does. Furthermore, neither the taxpayer nor the bureaucracy acquires any property rights, instead, the state hold all property in his name. Finally, neither bureaucrats nor taxpayers actually use these resources—the combatants do. However, combatants can neither control nor manage the inefficiency of any procurement, nor do they have any property rights. Probably, for the first time ever in human history, contemporary combatants are no longer the proprietors of their infrastructure, vehicles, weapons systems, or uniforms. They are merely borrowed state monopoly goods for temporary use. The printed and sewn emblems and marks on any movable property, as well as the entries in the land register, bear witness to this fact.6 In the absence of property rights, annual transfers from the state budget are the only source of funding for state-controlled armed forces. These transfers do not distribute cash. Rather, they are institutionally framed as an approval to incur costs that the state (i.e., tax money) pays for, but only during a particular time or budget period. Whenever armed forces fail to spend such budgets completely, any remaining authorization to spend is nullified as the budget period ends. This problem exists irrespective of the length of the budget period, even if this period spans several years. As a result, contemporary armed forces cannot realize any intertemporal savings or create extra funding by taking out loans or offering bonds. As a result, they cannot produce any reliable multi-period investment plans or accumulate a capital stock that would finance future investments or expansion or that would flow to sales proceeds. Ironically, the armed forces are permitted to lose and destroy materiel at will during military engagements, but they cannot procure novel materiel unless by prior political and bureaucratic approval. The lack of economic liberty means that armed forces do not have the entrepreneurial freedom to reconfigure their resource base if the demand for military capabilities changes. Although combatants can use state monopoly goods while they are on loan to them, the combatants cannot liquidate the goods or acquire any new resources without prior political and bureaucratic approval. This is applicable even if the situation requires an immediate adaptation of their military capabilities (hence of the material resources by which these are created). Finally, unlike in the private sector, wages and prices for goods and services are not determined by liberal negotiation. State funds pay the salaries of both civilian employees and combatants, hence the structures and scales of these salaries are institutionally fixed, even if they contain performance-bound components and benefits. A monetary compensation of exceptional individual performance by bonuses, stock options, or extra pay is not possible outside these boundaries, implying that

6 Either the state holds this property in its own name, or state agencies and organizations monopolize all property rights.

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civilian employees and combatants can increase their salaries only by rising hierarchically, and not by individual performance. In contrast with the private sector, employees charged with bureaucratic tasks face only a low risk of losing their jobs when they perform inadequately because compliance with norms and risk avoidance is central, whereas value creation is difficult to measure (Lipsky 2010; Balla and Gormley 2018). The prices a military organization pays for private or military goods and services need not correspond to actual market prices. The interaction among the armed forces, private firms, and the arms industry, which all provide goods and services, is also regulated on multiple institutional levels.7 Public procurement rules and procedures govern the use of state funds for the purchasing of resources. In the absence of political rents, negotiations led by politicians and bureaucrats emphasize compliance with formal rules rather than use of business acumen (Cowen and Lee 1992). These decision makers often tolerate economic inefficiency if they see opportunities to manipulate political budget decisions in their favor (Rogerson 1994). As a result, the prices that armed forces pay can significantly diverge from the prices private firm charges from private consumers in the marketplace. This argument also holds for any compensation the armed forces charge if they provide auxiliary support to regional public bodies or civilian organizations. In this case, the price that private providers would charge for similar services is irrelevant; armed forces can charge only for their support what institutions permit them to charge.8 Together, these limitations constitute a planned economy. This type of economic organization can be recognized by the institutional characteristics discussed here, all of which apply to contemporary armed forces: total monopolization of supply in the hands of the state, centralized planning of both production and demand, state ownership of the means of production, and state control of wages and prices. This institutional situation influences human behavior to a significant extent, so much so that human agents who interact in a planned economy exhibit a fundamentally different economic behavior compared to those who are part of a free market economy.

As state interests and co-ownership strongly influence the business policy of firms in the arms industry, any direct comparison with private-sector industries is difficult. 8 For example, in the Swiss armed forces the Ordinance on the Support of Civilian Activities and Off-Duty Activities with Military Means (SR 513.74) significantly limits the possibilities of the armed forces to request full compensation or the transfer of any profit the civilian party makes when it uses armed forces labor and materiel. 7

2.2 Consequences for Human Behavior

2.2 2.2.1

31

Consequences for Human Behavior Politicians

Since have no other source of income but transfers from the state budget, those with political power in the state exercise economic control over the armed forces. This problem is independent of the political system of the state and exists irrespective of whether politicians are actually competent to estimate correctly the required budget. Politicians can influence both the magnitude and the structure of the defense budget by voting (or deciding) in favor of a particular sum or a particular one-off transaction. As any budget change requires political consent or approval, this behavior is the primary source of variation in any defense budget. Politicians maximize individual political interest, in particular, power and influence (Aranson and Ordeshook 1981; Mayer 1992). Therefore, their behavior needs not consider actual voter preferences (Lemieux 2004). Politicians are by no means the neutral and altruistic civil servants that Max Weber imagined. Their primary interest is to stay in power (through re-election or reappointment) and to earn a lucrative income after the end of their political career (Klingen 2011). However, except for totalitarian dictatorships, politicians cannot simply cling to power. They must succeed at organizing political majorities by which their views and beliefs become law. To achieve this, they will take positions that appeal to the median voter (Black 1948; Downs 1957; Congleton 2004), serve the interests of their clientele and political affiliations, and vote in favor of lobbyists who can provide them with influence and opportunities to generate revenue in the future (Olson 1965; Tool 1979; Livingston and Thompson 1966; Tullock 1967; Krueger 1974). This political mechanism and its reliance on building consensus and majorities, however, is beyond economic rationality. Although entrepreneurs do not require political majorities to be successful with their business, such majorities are a prerequisite for success in politics. In this sphere, it is not the expertise of individual experts that counts, but the fact that any majority favors an (if economically dysfunctional) opinion (Boettke et al. 2007). Whenever residents’ taxes and mandatory contributions are redistributed by centralized political decisions, politicians will favor any redistribution that maximizes their chance of re-election or reappointment, even if this politically motivated spending causes significant inefficiency, misspending, and deadweight loss at the expense of consumers and taxpayers (Powell and Coyne 2003; Glaeser and Shleifer 2002). Politicians express their spending preferences according to the maximum principle, i.e., they formulate a maximum amount of state funds that should pay for all costs associated with the generation of military capabilities. This sum can range from zero (political position: armed forces should be abolished) to the complete national budget resources (political position: all state resources should go to national defense). Once a particular maximum budget is fixed, the armed forces can authorize the procurement of resources and the hiring of civilian and military personnel, as

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long as this spending is compatible with the financial and organizational restrictions the defense budget sets. In the absence of property rights, the defense budget fluctuates with the everchanging views and opinions of the politicians whose interactions determine both the size and the structure of the budget. Hence, from the politician’s point of view, not doctrine or military planning, but political power of the defense budget controls the armed forces, especially so if the armed forces disagree on the budget cuts. Both the maintenance of current operations and any future investments in state-controlled armed forces are subject to political rationing. The upper limit of the defense budget is given by the sum of all government revenues, but there is no lower limit as it can be reduced to zero.9 If the defense budget is reduced for political reasons, previous investment plans are rendered irrelevant and current operations face budgetary pressures. If, in retrospect, the defense budget proves to be too high, opportunities for a more productive spending of taxpayers’ money are lost. Politicians face no economic liability for such consequences, whereas the law holds individual entrepreneurs and stockholders of corporations liable, via their equity stakes, for all the losses a private firm makes. Hence, they must also forego their equity to satisfy third-party claims in case of bankruptcy. Entrepreneurs and executives are liable, under criminal law, for their business decisions and the correctness of their bookkeeping, and they cannot delegate this liability. The possible consequences of their actions discipline their behavior, provide them with incentives to learn from their mistakes, and motivates them to improve their forecasting and management capabilities. A similar responsibility for faulty policy does also not exist for politicians. In democratic systems, politicians of national parliaments and executive bodies enjoy immunity, as long as they hold their mandate or public office. In authoritarian systems, the rulers can protect themselves from prosecution. If any change to the defense budget proves to be erroneous in retrospect, due to either ineffective or inefficient armed forces, the politicians who agreed on this budget cannot be held liable. A major scandal might force prominent members of the executive, e.g., the Secretary of Defense, to resign, but the legislature will not be held personally responsible for bad economic policy. Politicians therefore have no incentive to learn from past mistakes or to develop their economic and military knowledge in order to produce better estimates of the required defense budget.

9

However, the armed forces are already incapacitated before they reach this point, whenever the budget no longer allows them to finance the cost of replacing weapons systems or to pay wages and benefits for the current number of combatants.

2.2 Consequences for Human Behavior

2.2.2

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Planners

Constitutional articles, doctrinal documents, laws, and a budget alone do not produce military performance. Armed forces can hardly generate military capabilities unless they detail these high-level institutions to the level of day-to-day operations. Planners, i.e., civilian and military bureaucrats inside military organizations, are charged with this task. They must procure privately produced goods and weapon systems, build infrastructure, recruit civilian employees and combatants, and organize military training. Planners have a different view on capability generation and do not necessarily plan their activities under the restriction of the actual or expected defense budget set by politicians. Instead, they conceive their first plans by using a portfolio of desired military capabilities. Planners elaborate this portfolio by aggregating intelligence into threat scenarios of future conflicts that may require the deployment of military force. By elaborating on the requirements of such deployment, planners list the needed military capabilities and their intensities in space and time.10 From this list, planners derive the corresponding demands for human and material resources. Kaufman (2009) and Kambrod (2007) illustrate this planning process with an example of the United States Armed Forces. Politicians determine the defense budget according to the maximum principle (i.e., they aim for a budget cap), whereas planners determine financial demands by the minimum principle. Procuring all the resources required for their planning at minimum cost is the objective of the planners. A budget cap is therefore undesirable since it restricts the extent to which the generation of military capabilities is feasible or even possible. Hence, the planners lobby for a maximum defense budget, but they still face the risk of planning revisions if the actual defense budget diverges from their forecast. Mechanistic and reactive planning processes, the documents of which are continuously revised as defense budgets and missions change, characterize statecontrolled armed forces. Still, planners assume a relatively stable and predictable world, whenever they produce planning documents that stretch over multiple budget periods. In these documents, they attempt to predict all resource requirements for the near future and to partition these requirements such that they can fully use the allocated defense budget. For example in the annually revised Bundeswehrplan, the German Armed Forces define all future requirements in terms of personnel, equipment, armaments, and infrastructure. In the Swiss Armed Forces, there are several multi-year plans for arms procurement (Masterplan, revised annually), investment in infrastructure and service organization. Similar planning instruments exist in the armed forces of the United States (Strategic Planning Guidance), France ( force employment concept), Canada (defense strategy), and Belgium (strategic vision for defense). 10 The intensity of military capabilities can be quantified by calculating the size of the operations environment, standard combat days, or the sustainability of troop deployment.

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This bureaucratic planning is inherent to a planned economy system, but it is nonetheless inefficient. First, this system offers very little incentive for entrepreneurial action. Planners can detail and execute, but not modify or adapt, high-level institutions. The mission, doctrine, conscription (if any), and defense budget of a state-controlled military organization all confront planners with insurmountable restrictions to which all planning must conform. As a result, this fixed framework is difficult to change or adapt, whenever unforeseen situations, novel threats, or disruptive technologies emerge. The economic problem of military planning is thus more complex than in Niskanen's (1971) model, where bureaucrats always attempt to maximize their budget. Planners can lobby for a large defense budget, but they cannot change or circumvent the above restrictions since the polity sets these. Moreover, the defense budget represents a fiscal commons, i.e., a global, non-specific allocation of funds that the armed forces’ branches must subdivide between them. A consequence of the lack of property rights is that the armed forces can neither raise third-party funds in equity or in fixed-income markets nor realize savings. However, this effect also applies to each of their branches, such that—in the absence of institutions that define property rights—the branches compete with each other for a maximum share of the defense budget (Coyne and Duncan 2018). In a planned economy system where transfers from the state budget are the only source of income, the allocation of one monetary unit to a specific branch (say, the navy) implies that this monetary unit is no longer available to any other branch (say, the air force or the army). As a result, planners in the respective branches compete with each other; their primary interest is to redistribute a maximum share of the defense budget to the branch that employs them (Higgs 2001; Domke 1992). Hence, though the totality of all planning appears rational and coordinated, in fact it constitutes an ongoing political competition for scarce resources. However, precisely because such planning emerges because of competitive distribution struggles, it reflects the relative strength and assertiveness of the involved bureaucracies rather than the professional competence of the involved planners. The centralized planning of military capabilities is subject to a number of information problems. Any initial endowment with material, knowledge, and human resources enables the armed forces to choose from a wide variety of potential military capabilities, but the scarcity of these resources forces planners to decide which subset of all possible capabilities to prefer. Within the fixed general framework of the defense budget and national doctrine, planners can freely determine the military capabilities that the armed forces should generate, maintain, and abandon. The selection of this subset is not subject to any outside control or second opinion. In the absence of real engagements that test the effectiveness of military performance, no timely information exists by which planners could assess the congruence of the planning with reality. This impossibility to rapidly assess and act on emerging situations is highly problematic. Private firms and entrepreneurs can obtain timely or even real-time information from factor markets (e.g., commodity prices) and consumer markets (e.g., turnover at a particular point of sale). Access to this these data enables them to

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quickly adapt their investment and production planning to changing technologies, customer demands, and supply and demand shocks. Any planning is therefore subject to a continuous and incorruptible feedback from supplies and customers. If private firms choose to ignore this information, or if they fail to respond adequately, they risk the going concern of their business. There are no such rigid reviews of military planning. Years or decades can pass before a conflict occurs; hence, planners can only evaluate the accuracy of their planning with much delay (if at all). From an institutional point of view, the planning of any capability generation occurs on lower institutional levels. As long as planners comply with the letter of the laws and ordinances, there is no review of the economic consequences of their planning—any judiciary control or audit review focuses on compliance, but not on the consequences of bureaucratic planning for the efficiency or effectiveness of the armed forces. The law can hold individual planners criminally liable for corruption and failure to comply with regulation, but not for poor planning or a lack of economic expertise. This information problem is systemic; it therefore persists even if the armed forces dismiss incompetent planners, Planners can predict the organization’s salary expenditure in a relatively reliably way. After all, they defined salary levels and work force requirements in the first place. They do face, however, a major information problem whenever they must procure civilian and military goods and any associated services (Markowski et al. 2008). As a military organization does not produce these goods, but buys them from private sector firms and arms producers, planners cannot know the true production costs of these goods (Mitchell and Simmons 1994). In particular, they cannot determine whether a price increase is the result of actual technological or quality improvements, is due to inflation, or is an attempt of the supplier to realize greater margins. This problem is harder to resolve whenever planners interact with arms producers, because pricing and calculation in the arms industry are notoriously opaque, and this information asymmetry significantly weakens the negotiation position of the planners. In a planned economy system, planners have no intrinsic incentive to obtain such information about the production technology or pricing of the goods that they plan to purchase. Before they could objectively assess what is ‘good value for money’ or ‘expensive’, they would have to compare—preferably internationally—a large number of price quotes and contracts, estimate marginal and average cost functions for the civilian goods and weapons systems whose acquisition is planned, and use completed procurement projects as a reference for comparison. They would also have to analyze moral hazards, adverse selections, and incentives for unproductive entrepreneurship among suppliers, all of which could lead to sales prices above true and fair market values. The acquisition and interpretation of this information involves significant transaction costs for planners. Planners are unlikely to accept such transaction costs unless they expect at least an equivalent information benefit, such as significant cost savings, or a sustainable improvement of the effectiveness of military performance. This benefit, however, cannot be realized in a planned economy system. Without property rights, planners cannot realize savings. They never receive any compensation for the valuable time

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and human resources they spend when they explore opportunities for more efficient procurement. As government employees, planners cannot personally benefit from improvements by bonuses, premiums, or stock options. Neither can the armed forces, as such savings involve a less-than-full utilization of the authorization to spend that which the defense budget grants. If planners show how to organize a materially and qualitatively identical procurement at a lower cost or with fewer staff, there is also a risk that they may find themselves out of a job or with reduced budgets. Hence, the information benefit for planners is not zero, but negative. As a result, planners in a planned economy system have no incentive to negotiate the most favorable purchase prices possible. Instead, they will endeavor to use their authorizations to spend to the maximum extent possible—even and especially if suppliers charge prices above market prices. Well-meant proposals for a better contract design in public procurement (e.g., Girth and Lopez 2019; Bergman and Lundberg 2013) thus cannot recognize the fundamental (and unsolvable) information and incentive problems that a planned economy system entails. In this respect, it is interesting to note how different institutional configurations influence human behavior as one same individual migrates between different systems of economic organization. As private individuals, planners have access to price and product information in consumer and financial markets, and they consider this information when they make decisions about their private consumption and investments. For example, as they consider using their private property to buy a car or invest in the stock market, they would cautiously analyze all available information, as they have to bear the financial consequences of inefficient investment or an ineffective car. Two basic institutions generate the immediate self-interest that leads to a quest for efficiency: economic liberty and property rights. As neither exists in a planned economy system, there is no incentive to collect and analyze information, and indifference replaces efficiency seeking. Hence, the attempt to leverage private interest in efficiency and utility maximization for investment planning in the public sector is futile. Although these investments are funded by scarce taxpayer money (including taxes paid by the planners themselves), the institutional configuration of a planned economy system makes planners indifferent to efficiency improvements, even if information that could realize such improvements is known or available at low transaction costs. State bureaucracies attempt to resolve this problem by creating organizations that are to evaluate technologies and goods before procurement. The Swiss Federal Office armasuisse employs 750 people to evaluate, both technically and economically, the procurement of any military equipment whose cost exceeds a low threshold. Although this number of employees seems large, the German Federal Office of Equipment, Information Technology and Use of the Armed Forces (BAAINBw) employs about 6500, and the British Defence Equipment and Support about 11,000. The Material Command of the United States Armed Forces has an active strength of 70,000 combatants and civilian employees whose exclusive task is to handle all material development, procurements, and demand planning. For a second step, planners in these organizations must consider opportunities for efficiency improvements. As a result, they create institutions on lower levels that

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detail information collection and evaluation procedures. For example, they can force suppliers to submit competitive bids before they make an investment decision, and they can threaten both suppliers and evaluators with civilian and criminal sanctions if they fail to comply. However, this threat is only credible if the state hires additional planners whose only task it is to review and audit any decisions the actual planners make. In extreme cases, this leads to the creation of a price-control bureaucracy whose only raison d’être it is to evaluate the adequacy of any prices that civilian suppliers and arms producers charge. In the German Armed Forces, for example, the ‘price checkers’ are a group of planners whose perform such evaluations. This internalization of transaction costs makes the running of state-controlled armed forces particularly expensive, because the state must the salaries of both the planners and their auditors. The extent to which these costs for bureaucratic monitoring and auditing are actually offset by corresponding efficiency improvements is therefore unknown; in the worst case, these control costs exceed the losses of inefficient primary planning. This institutional situation shapes planners’ behavior. First, they are under pressure to plan something at all. They must detail and apply high-level institutions in order to define resource acquisition, management and training procedures. Hence, planners are obliged to produce at least some plan. Whereas entrepreneurs can freely decide to forego any formal planning and run their firms informally, planners cannot do so as the production of such planning is the very justification for their salary, post, and existence. Planners also find themselves under considerable time pressure because, in the absence of property rights, they must use to the fullest the spending authorizations they possess. Whenever the end of the budget period approaches, if the budget has not yet been spent in full, it is rational for planners to spend the remaining means in any—if inefficient or ineffective—way. This ‘December fever’ is not only wasteful (Liebman and Mahoney 2017) but also commonplace in public bureaucracies (Hurley et al. 2014; Baumann 2019). In the absence of any property rights, planners spend funds like private individuals would if they were confronted with an inheritance tax of one hundred percent. The end of the budget period strips planners of the authorization to spend. As a result, in their point of view, this end is equivalent to a foreseeable act of expropriation. Planners, therefore, rationally decide that the procurement of any item—even if it is sold at an outrageous price or has questionable quality—is preferable to losing the authority to spend at all. For example, the United States Armed Forces spent $4.5 billion on the very last day of the 1983 fiscal year. A 30-year time-series analysis of the expenditure distribution of these armed forces shows that spending intensity increases significantly towards the end of the fiscal year. In the last month of the fiscal year, the average volume of expenditures is 2.3 times higher than in other month (Mayer 1992). Finally, unlike entrepreneurs, planners cannot simply wait until profitable opportunities emerge. Private property rights and economic liberty enable entrepreneurs to downsize or pause business activity in times of adverse market conditions or meager demand. They can go back in business once a new demand or an attractive supply reappears in the marketplace. In a planned economy system, however, planning

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cannot be paused, and planners cannot deviate from their planning to exploit unforeseen opportunities. Due to the lack of property rights, planners cannot ‘save up’ for the defense budget if there are no attractive investment opportunities in the present budget period. For this same reason, investing separately in only a few units of a goods or weapons system, in order to control the risk of technological failure and inferior performance, appears unattractive to them. Therefore, planners are under constant pressure to produce some action, even and especially so if they have no knowledge about future threat scenarios, market conditions, or investment opportunities. All of these problems already are the cause of a high probability of inefficient investments and errors of judgment, both of which cannot be corrected until the next planning cycle begins. Still, planners must assume that their planning can generate the correct military capabilities (i.e., those whose deployment neutralizes the predicted threats), and that their planning generates these correct capabilities better than any alternative coordination mechanism. Without these two assumptions, planners would question the reason for their very existence. Both assumptions, however, are rebuttable. Planners do not and cannot have objective information about the future, in particular, about future defense budgets. They can merely predict, but not know, the development of existing and the emergence of novel technologies. The true production function and associated cost of capability generation is unknown to them, as is the true willingness of the population to allow the armed forces to consume the resources they finance with their taxes (Higgs 2006). Nevertheless, the planned economy system requires longterm, forward-looking decisions that must specify particular threat scenarios, technologies, and investments. Planners are therefore forced to plan as if they had such foresight (Anderson 1997). Planners can therefore only determine the structure and intensity of military capabilities in the present, in ignorance of future developments, but they must assume their planning perfectly anticipates these. In contrast to this innate superiority belief of planned economy systems, the market mechanism offers only an experimental process of discovery. Specifically, it does not attempt to predict or prescribe any future states (Duncan and Coyne 2013). As future technological developments are unknown, if the technology proves to be ineffective or inefficient, entrepreneurs can experiment with new technologies and terminate these experiments. In the same vein, producers and suppliers can erroneously forecast sales figures, but point-of-sales data quickly inform them about the reality of these forecasts. As a result, if business proves to be unprofitable, they can revise their forecasts, reconfigure production, and divest a particular line. Markets efficiently correct planning errors so that in the long term, only effective and efficient solutions survive the experimental process (Kirzner 1979). In a planned economy system, planners do not have the liberty or the incentive to conduct such experiments. Hence, recommendations to imitate investment and cost control methods used in private firms (e.g., Baker 1992; Tysseland 2008; Apte et al. 2011; Markel et al. 2014) are bound to fail. In a planned economy system without property rights, planners cannot balance short-term liquidity constraints by taking out loans or raising equity. They also

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cannot indicate reliable depreciation periods for civilian goods and military equipment, because the use of goods and the operation of equipment hinges on the availability of funds in future (unknown) defense budgets. Hence, the useful life of any equipment is known technologically, but not economically. If politicians reduce the defense budget, planners must reverse any plans to discontinue the use of particular systems because funds for replacement are no longer available. Finally, planners have little or no flexibility to adapt their planning at short notice, as unforeseen events occur. Consequently, they can only hope to minimize forecasting errors from an early stage. As state-run armed forces have no insolvency risk, there is no rigorous correction for such forecasting errors. The costs resulting from such errors are higher than in the private sector since there are no competitive mechanisms that could correct poor planning quickly. In the marketplace, competition implies that the customer base of firms that forecast poorly or fail to adapt to changing demand patterns gradually erodes. Sales decline, and firms soon reach a point where they no longer make profits that could finance novel investments. Once sales figures further decline, firms cannot cover their fixed and variable costs, hence they eventually become insolvent. Finally, liquidators auction off any remaining assets the firm controls. Therefore, in a competitive market environment, assets eventually flow into the hands of those entrepreneurs and firms who understand to use them productively. In the absence of such corrective mechanisms, the costs of erroneous predictions are either socialized or passed on to a scapegoat. Although audit reports around the world abound with examples of spectacular incompetence (e.g., National Audit Office 2008), planners never learn from their mistakes, and planning accuracy does not improve. Given that the correction of any planning in a planned economy system is cumbersome and time consuming, planners must assume that threat scenarios, conscription (if any), defense budget and doctrines will remain stable in the near future. Only by this assumption can planners author multi-period plans without the fear of imminent and continuous revision. Else, continuous and dynamic change would have to be met with nonstop improvisation. Given that Marxist theorists consider the planned economy system to be superior to an ‘anarchic’ market organization, there is a certain irony in the fact that planned economies perform the worse the more ‘anarchic’ their environment is. Any change on high-level institutions, such as the abolition of conscription, significant armed forces reforms, or doctrinal revisions is relatively manageable because such institutional changes requires political majorities and long discussions. In contrast, the defense budget can vary at short notice, as unforeseen developments occur. For example, recessions strain the national budget and require defense budget cuts, whereas novel threats can require unforeseen additional investment in weapons systems and logistics. In the absence of property rights, a timely response to such shocks is difficult as the political cycle of a budget year is much shorter than the multi-annual planning cycles. Short-term changes made to the defense budget can make years of detailed planning a mere waste of time. This is particularly true in the case of expensive and technologically complex procurement projects, where the planning of which

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takes years of analysis and evaluation. Planners can therefore only hope, but not expect, that the plans they elaborate will prove to be economically viable in the near and distant future. In the absence of property rights, they cannot guarantee that replacement funds will be available whenever a system reaches the end of its life cycle; and vice versa, whenever politicians authorize unforeseen additional spending, planners must improvise to generate investment projects at short notice before the end of the budget period nullifies this authorization again. Nevertheless, the freedom from judiciary control, which planners in the executive enjoy, is ambiguous. Although they are relatively free to devise any plans as long as they comply with higher-level institutions, these can become futile once circumstances or political majorities change. The immediate consequence of this problem is a low labor productivity among planners, as the time and costs spent in planning represent sunk costs, i.e., any expenses and hours worked cannot be recovered. Whenever unforeseen events require revisions, planners must write off these sunk costs without any compensation and reinitiate planning from scratch. This lack of adaptive capacity makes the planned economy system especially vulnerable to exogenous shocks. In the absence of a stable environment and a longterm predictable development, seemingly rational and formal planning procedures are replaced by haphazard measures by which planners attempt to correct long-term errors in judgment by short-term improvisation. The armed forces can then no longer rely on any stable planning; instead, they find themselves in a situation of continuous and chaotic change.

2.2.3

Residents

Irrespective of their citizenship, the residents of a state are subject to direct and indirect taxation. The institutional legitimization of the military organization obligates residents to fund it, even if they are ideologically opposed to the existence of any armed forces. For example, they might have to pay a poll tax that directly funds the armed forces, or their taxes on income and consumption are redistributed on the national level to fund the defense budget. As the state enforces the payment of taxes, a resident cannot shirk this financing, except by emigrating. If the armed forces are based on conscription, citizens, i.e., residents with political rights, must also contribute their labor supply for a limited time. However, since conscientious objection is possible in all but authoritarian states and dictatorships, the state cannot enforce participation in conscription-based military service. For all residents, whether they have a right to vote or not, compulsory contributions and taxes represent sunk costs. Once taxes have been paid, they cannot be recovered unless through tax credits. The obligation to pay is independent of both their political rights and their assessment of the extent to which the armed forces are effective. Still, superior military effectiveness is the only reason residents should jointly finance professional armed forces at all. Residents cannot simply wait until a conflict occurs to test the effectiveness of their armed forces, as such conflicts could

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put their lives, health, freedom, and property at risk. They likely predict the effectiveness of the military organization already in peacetime, not only because they want to safeguard their individual rights, but also because the state loses its moral legitimacy hence its right to exist if it is unable to protect them (Hobbes 2006; Locke 2014). Besides this interest in the effectiveness of armed forces, residents are also interested in the efficiency with which the armed forces use the resources they finance by their taxes. Poor planning, waste, and negligence in the generation of military capabilities all result in residents not receiving adequate value for the money they contribute, and the correction of this inefficiency can even require additional resources. Only effective and efficient armed forces provide an adequate equivalent to the financial means the residents provide. Effective, yet inefficient, armed forces have high opportunity costs, since they could produce the same military performance with fewer resources. Efficient, yet ineffective, armed forces are inexpensive but unable to accomplish their missions. If they are neither efficient nor effective, residents have no equivalent at all for their financial contributions. They therefore face a significant principal-agent problem. In order to ensure that planners put the resources they finance to efficient and effective use, they must monitor the generation and deployment of military capabilities. This control, however, is difficult to exercise, as it is associated with significant transaction costs. Although the residents supply the financial means, planners decide how these means are used in military capability generation, i.e., they decide which systems are bought, which personnel recruited, which infrastructure built, etc. As there is no mandatory external review of this spending, the residents cannot exercise any effective control. Essentially, the armed forces themselves determine whether or not they will be able to accomplish a particular mission, and whether they use resources efficiently. As long as they do not suffer defeat in battle, they have no incentive to review the effectiveness and efficiency of their capability generation. For this reason, planning errors in military organizations can persist for a long time, as the effectiveness of any military capabilities is unknown until armed forces actually deploy them in the field. Residents must therefore exercise the control, but this requires a commitment of significant time and resources. For example, in order to forecast the effectiveness of their armed forces, they can to attempt to review simulations and maneuvers. However, they probably lack the professional qualification to evaluate military performance; hence, external expertise must be hired. Finally, key information could be missing or flawed, as military maneuvers are often classified and are hard to observe, or because information about failed maneuvers is oppressed. Even citizens who experience the military organization as combatants during conscription can only assess specific capabilities, but not the effectiveness of the organization as a whole. Unlike the stockholders of a private company, residents cannot expect that an entrepreneurial interest in profit maximization will favor competitive production methods. Furthermore, an efficient use of resources is not necessarily a criterion for success in battle; hence, the armed forces could disregard residents’ interest in

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resource efficiency.11 Any squandering of resources could go unnoticed because, as set out above, planners do not have an incentive to inform themselves about market prices. Residents must acquire this information if they want to judge the efficiency with which the armed forces procure resources. All of these transaction costs are significant, as obtaining relevant information in a military context is significantly more difficult than in other policy areas (Klingen 2011). Any individual resident who invests time and money to evaluate armed forces’ efficiency and effectiveness to the benefit of all residents would provide a public information good for all residents, yet no individual resident has any incentive to do so. Due to this coordination failure (Weingast 1995, 1997), residents take no collective action and exercise no control; instead, they rationally opt to be uninformed. However, they may reduce this transaction cost when they exercise control indirectly. To this end, the residents can delegate all information gathering and analysis to specialized control groups (parliamentary oversight, audit offices, supervisory bodies, etc.). These groups internalize the related transaction costs and provide the results of their analyses to the public at very little or no expense, either because they are required by law to conduct such a review or because they expect their findings to be politically or commercially useful.12 They can also confront politicians with the results of their investigations. Furthermore, in order to create public transparency about the utilization of the resources they funded with their taxes, residents can use the media to launch inquiries into the actions of officials (Coyne and Leeson 2009). The media can collect, in particular, information from whistleblowers who fear reprisals if they disclose knowledge about inefficiency or ineffectiveness to audit offices. From an economic point of view, both control groups and the media solve the coordination failure among residents. They bear the transaction costs of collecting information and make the result of their inquiries available to all residents at little or no expense (e.g., by informing them for the price of a newspaper, or by letting residents download study results and documents for free).13 As long as there is an open and democratically controlled access to this information, these groups can

11

Even enemy intelligence services are interested in the combat power and capability development of the armed forces, i.e., its effectiveness, more than in the efficient use of resources. In a military sense, efficiency is only relevant when it comes to the question of what losses of equipment and personnel are acceptable for the accomplishment of a particular mission, or the maximum time that any particular task takes. 12 For example, public bodies required by law to conduct such audits exist in Switzerland (Swiss Federal Audit Office), Germany (Bundesrechnungshof), France (Inspection Générale des Finances), Canada (Treasury Board of Canada Secretariat), the USA (Government Accountability Office) and the UK (National Audit Office). 13 In an economic sense, both the media and public bodies concentrate expenses and spread benefits widely among the population. They thus represent the opposite of classic political lobbying that concentrates benefits with a small group of well-informed rent seekers and spreads the costs of these rents widely among the population (Olson 1965).

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efficiently inform the residents. They thus simulate competitive market pressure by political means (Becker 1983) if the disseminated information is factually correct. Meanwhile, any such control can only discover, but not prevent, the inefficient use of resources or the ineffectiveness of military performance. As extant problems are resolved, residents can prevent future damage, but they still have to pay for any inefficiency and ineffectiveness that has occurred to date. For example, in the case of failed procurement of large and expensive weapons systems, these costs are substantial, and planners must write off any associated investments. Whenever residents discover inefficiency or ineffectiveness among their armed forces, they can exit the military sector. Residents can refuse to work as civilian employees for the armed forces, or devise ways to avoid tax payments. An even more radical form of exiting the military sector is emigration. Residents can completely withdraw from the state’s tax base, so that they no longer contribute to funding the armed forces. For example, in authoritarian states that coerce their residents to serve in their armed forces for a long time, the cost of political persecution exceeds the transaction costs of wandering off, and therefore citizens migrate to other jurisdictions (Banzhaf and Walsh 2008; Werner 2000). Citizens can refuse to participate in conscription and opt to serve alternatively (e.g., in the civilian service, in civil engineering, or civil defense). Furthermore, they can lobby political support in an effort to abolish the armed forces altogether. Citizens can also voice their concerns politically by voting and lobbying in favor of institutional changes. Both exit and voice are efficient corrective mechanisms for dysfunctional institutional configurations, particularly whenever governments attempt to impose the cost and welfare loss of oppressive regulation onto the citizens (Hirschmann 1970; Vaubel 1989). Residents ‘vote with their feet’ whenever they exit the military sector, no matter the method of leaving (Tiebout 1956). This vote is a factual rejection of the institutions that organize state-run armed forces. Unlike combatants and planners, residents must not necessarily comply with these institutions. Instead, they subject it to a quasi-market test by comparing it to alternative institutional arrangements—in particular, those outside the military sector—and then decide which set of institutions they prefer. Such alternatives thus provide a market for institutions (Pejovich 1994, 2012) in which armed forces must prove themselves. Hence, as long as the institutions responsible for military ineffectiveness or the squandering of resources are not adapted (at any level), residents with a competitive labor supply have no incentive to work in or return to the military sector. In this case, professional armed forces cannot fill positions although they offer good pay. Conscription-based armed forces can theoretically neutralize competing institutions by alternative services less attractive or by banning them altogether. However, such ‘raising rivals’ costs’ strategies (Goldberg 1982; Oster 1982; Salop and Scheffman 1983) are very costly in terms of transaction costs, as all service alternatives have to be made equally unattractive and political consensus is needed to change the corresponding institutions outside the military sector. Citizens can anticipate future repression and bring forward their exit decision to the present. If the state still forces

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them to serve, they are likely to minimize their involvement in the military organization, thus causing decline in morale. Whenever citizens voice their political rights to initiate institutional reform, they face the problem of rarely being able to vote directly on defense policies, even in states governed by the rule of law. Their choice is restricted to electing representatives or political parties that support or resist certain defense policy programs (Lee 1990).14 Defense policy issues are typically not decisive for electoral outcomes, at least in times of peace (Klingen 2011). This means that, in the short term, citizens can exert relatively little political influence, but in the long term, they can apply budgetary pressure on their armed forces by supporting representatives who advocate reducing the defense budget. Citizens can then threaten to maintain this pressure until institutional reform has begun. Between elections, citizens can support political programs that propose a fundamental reorganization of the armed forces, e.g., to abolish conscription. As any particular military organization can monopolize the generation of the military capabilities that it provides, but not generation as such, citizens can also lobby for institutional change at the international level, e.g., by proposing to replace extant national armed forces with protection provided by an international alliance. Although such significant change is subject to high transaction costs, it could constitute the only alternative to defenselessness if the ineffectiveness of the extant armed forces is obvious. Finally, citizens can punish the executive for particularly serious cases of ineffectiveness (e.g., defeat in war) and inefficiency (e.g., procurement scandals) by demanding the dismissal or resignation of the responsible planners or ministers. Whenever residents threaten to exit the military sector or to voice their concerns, they cast a vote of no confidence in their armed forces. Therefore, the military organization faces pressure to adapt and to convince residents of the opposite, and this pressure substitutes for the missing economic incentives among planners and politicians. In particular, the political pressure that the media can raise among citizens can motivate people to create initiatives (or referendums) that propose to strengthen economic oversight over the armed forces, or to implement reforms that require armed forces to more efficiently and effectively use resources. Although this political selection process is slower and more inefficient than market-based coordination, it nevertheless leads to an efficient allocation of public resources, if there is democratic competition between political opinions (Boettke et al. 2007). Moreover, institutional change is time-consuming, as all orders, regulations, instructions, contracts, etc. generated by former (inefficient or ineffective) operations and production must be reviewed and, if necessary, adjusted or abolished. Hence, residents must

14

However, large-scale arms procurement in Switzerland can be subject to an optional referendum, so that citizens can deny approval. They did so for the first time ever on May 18, 2014, when they rejected the Gripen Fund Act that was to legitimize and finance the acquisition of the Swedish Saab JAS-39 E/F fighter jet (‘Gripen’). This possibility to directly vote on arms procurement is probably unique in the world.

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also finance the costs of this institutional reform until it resolves the issues in question.

2.2.4

Interest Groups

An institutional perspective should not only analyze the relationship between residents and their armed forces, but it must also consider any interest groups that attempt to exploit the generation of military capabilities for their own economic interests. The related behavior has been termed rent seeking (Krueger 1974), and it appears whenever a small, well-organized interest group can improve their economic position at the expense of the remaining residents, the military organization, or both. They concentrate economic benefits (‘rents’) among themselves and spread the costs of these rents widely among all residents (Olson 1965, 1982; Weingast et al. 1981). Planned economies create particularly strong incentives for rent seeking as they offer opportunities for unproductive or even destructive entrepreneurship (DiLorenzo 1988). Unlike productive entrepreneurs, rent seekers do not want to create additional growth. Instead, they merely want to redistribute existing resources to their benefit; and they even destroy existing value added in the process (Baumol 1990; Sobel 2008; Coyne and Leeson 2004; Congleton and Hillman 2015). As a result, scarce resources are not used for the productive creation of military capabilities, but for the rent seekers’ personal benefit. Whenever armed forces are organized as planned economies, rent seekers can profitably exploit the situation where purchasers, proprietors, and users of the material resources consumed in the generation of military capabilities are not identical. Rent seekers attempt to influence both the planners who prepare the procurement of goods and services and the politicians who must organize political majorities for and sign off on large-scale procurement decisions and the defense budget. Rent seekers are less interested in the competitiveness of their products than in convincing planners or politicians to procure these. Political competition thus replaces competition in the marketplace (Aligica and Tarko 2014). If this destructive entrepreneurship continues for a long time, politically or bureaucratically authorized deals supplant efficient market transactions. As these still require the approval of individual planners and politicians, rent seekers strive to institutionalize their relationships with public bodies, both to protect themselves against judiciary investigations and to make their income from rent seeking independent of any particular planner or politician (Higgs 2006). In extreme cases, rent seekers cease to offer their goods and services in the marketplace and exclusively push for institutionalized (hence riskless) sales in the public sector. Ironically, the public learns of rent seeking among public administrations only when the residents question particular resource allocations. Using exit and voice mechanisms discussed in the preceding section, they can exert pressure on planners and politicians to force them to justify the economic viability of the projects in

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question. As these activities entail high transaction costs or require insider information, the media only reports particularly spectacular examples of rent seeking. Rent seeking is a global phenomenon since the planned economy system makes armed forces vulnerable to rent seeking (Jones 1999; Hartley 2008). In the marketplace, firms receive direct and timely information about actual sales and turnover. In contrast, rent seekers artificially generate both demand and turnover by persuading planners and politicians to buy a particular quantity of goods and services at a particular price. They attempt to convince both parties that the goods and services on offer are required for military capability generation, even if competitive products are available in the marketplace. Whenever these attempts succeed, the armed forces procure products that are either overpriced (implying inefficiency) or technologically inferior (implying ineffectiveness). Military capabilities then degrade, or politicians must increase the defense budget to finance both rent seekers’ surcharges and the replacement of any faulty products and services they deliver. It is important to note that rent seeking is not synonymous to corruption. Therefore, the suggestion that planners should obtain several comparative offers before they make procurement decisions does not eliminate the problem. If all firms that submit such offers seek rents, then all bids will exceed the competitive market price. Well-organized rent seekers can also collude to submit bids that do not significantly differ, but each of which still exceeds the competitive market price. Consequently, planners cannot prevent but only reduce rent seeking, and they cannot decide whom it favors. In the context of a military organization, there are four groups of rent seekers. On the supply side, the armed forces must procure goods and services from civilian suppliers and the arms industry. On the demand side, regional politicians, as well as private firms and individuals, want to exploit military capabilities for their own benefit. As they organize the generation of military capabilities, the armed forces require civilian goods and services that the private sector produces (e.g., food, fuel, construction materials, civilian vehicles, training, software, logistics services). The armed forces must therefore rely on civilian suppliers who can provide these goods. These purveyors anticipate both the fundamental information problem that planners must face (they do not or cannot know market prices and technologies of the required goods) and the fact that they have no incentive to invest transaction costs and efforts to realize savings. The information advantage that private producers have over government, in terms of understanding the technologies they use, is an important source of policy failure in government-financed research and development (Keck 1988). Civilian suppliers benefit both from this information asymmetry and from the fact that planners are under constant pressure to spend their budgets before their authority to do so expires at the end of the budget period. Hence, suppliers attempt to abuse this situation by adding a maximum surcharge on production costs (‘cost plus’ pricing), by maximizing sales volumes, and by negotiating preferential conditions that restrict competition. To justify the prices they charge, suppliers will point to high production costs, superior quality, or purchasing power differences. Whereas, in fact, prices are high

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because they factor in the rents they hope to earn. Suppliers will also be interested in billing any services on a time and quantity basis (e.g., per hour, or per delivery process) rather than on a flat rate basis, as this billing structures encourages suppliers to maximize the number of hours worked (if unproductively). If suppliers cater to only a particular unit or branch of the armed forces, they will be interested in extending their activities to the entire organization—regardless of whether or not other branches actually require the goods and services they offer. Planners are hardly in a position to defend themselves against this behavior, even if they are aware that it occurs. Information asymmetry and complexity grow with every supplier and contract added, so that the cost of discovering and preventing rent seeking grows accordingly, hence the act of fighting rent seeking becomes increasingly unattractive to planners. For example, the United States Armed Forces purchase goods and services from more than 24,000 civilian suppliers, but they no longer appear to be able to monitor their contractual relationships, to collect receivables, to match actual delivery volumes with ordered quantities, and to detect fraudulent behavior by suppliers (Guttman 2004; Minow 2005). Civilian suppliers also face transaction costs as they maximize rents. First, institutions that govern the procurement of goods and the awarding of contracts by public bodies generally require a public call for tenders. For example, all WTO member states that have ratified the Agreement on Government Procurement must issue public and international tenders for any procurement whose value exceeds a certain threshold, with the exception of military equipment (World Trade Organization 1994).15 Civilian suppliers must, at least formally, comply with such procedures and submit tender offers. They must invest time and resources to elaborate technical information and cost calculations. Suppliers are interested in circumventing the related regulation as far as possible, so that planners can directly award them the contract. To achieve this goal, suppliers will exploit loopholes and exemption clauses as far as possible. For example, they could argue no alternative supplier exists who could master the technical challenges associated with the product or service, or that significant time pressure makes lengthy evaluations infeasible.16 Finally, civilian suppliers strive to perpetuate their business relationship with the armed forces, for as long as possible, by proposing multi-year contracts. In this case, they must spend only once the transaction costs associated with winning the contract, whereas they can realize risk-free rents as long as the contract is in force. As they seek to perpetuate their business relationship, suppliers attempt to persuade planners to institutionalize long-term collaborations by public-private partnerships or joint ventures. By such institutionalized collaboration, suppliers optimize revenues hence rents for a long time, because it is easier to create such structures than to 15

In Switzerland, this threshold is set at 230,000 Swiss Francs for goods and services and at 8.7 m Swiss Francs for buildings (Ordinance on the Adjustment of Threshold Values for Public Procurement for the Years 2020 and 2021, SR 172.056.12). 16 In Switzerland, articles 13 and 14 of the Public Procurement Ordinance (SR 172.056.11) define twelve special cases that legalize the direct awarding of contracts. In these cases, suppliers are exempt from handing in tender offers, and no competitive bidding takes place.

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dissolve them and because alternative suppliers can no longer threaten to substitute the goods or services in question by competitive bidding. The longer such institutionalized collaborations last, the more the quality of goods and services declines; this is because suppliers no longer face any competition to innovate or to improve efficiency. They save money on these investments but continue to charge high prices to the armed forces in order to maximize rents (Hart et al. 1997). Civilian suppliers are particularly interested in taking over any maintenance work the armed forces normally run by themselves. When such activities are delegated (government outsourcing), strategic dependencies are created. Civilian suppliers justify these arrangements with purported cost savings or ‘synergy effects’. They also point to efficient production methods, which they (supposedly) master, in the private sector. Government outsourcing has substantially increased since the end of the twentieth century, particularly in the United States and the United Kingdom (Perlo-Freeman and Sköns 2008). While continental Europe has experimented for some time with government outsourcing, many states have disbanded or re-nationalized former joint ventures.17 For example, in 2016 the German Armed Forces nationalized the joint venture BWI Informationstechnik GmbH, which they had founded as a public-private partnership with Siemens and IBM, in order to regain sovereignty over IT processes and applications. The company LH Bundeswehr Bekleidungsgesellschaft mbH (LHBw), a former joint venture between the German Armed Forces and textile manufacturer LionHellmann, was nationalized in 2015, shortly before it became insolvent. It is questionable whether such joint ventures will ever achieve their objectives. From the viewpoint of the armed forces, the costs for such outsourced services initially increase, because civil suppliers also factor in their ordinary profit margin, any rents earned on top of that margin, and value-added tax (VAT). If, for the context of Switzerland, a VAT rate of 7.7% and a profit margin of 10% is assumed, the armed forces would not benefit from outsourcing services unless an annual cost reduction of more than 17.7% is realized on a continual basis. The promised ‘synergy effects’ often remain promises as the transaction costs of organizing and maintaining a public-private partnership often exceed any (alleged) efficiency gain, even if the military organization inefficiently produces the goods and services in question (Franck and Mélèse 2008). Furthermore, the extent to which the military organization is willing and able to evaluate the economic performance of government outsourcing projects is questionable. Planners can lack the necessary economic competence and motivation to carry out severe audits. And even if they are able to do so, reliable data for a before/after comparison might not available, such that the efficiency improvement (if any) is unmeasurable (Domberger et al. 2002; Kulmala et al. 2006; Uttley 2005).

17

A contemporary exception exists in Norway, where the partially state-owned arms producer Kongsberg has jointly founded with ThyssenKrupp the firm kta naval systems to produce submarines.

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The problems of government outsourcing are not limited, however, to inefficiency issues. The balance of power between the military organization and the supplier has a significant influence on the course and profitability of the cooperation (Sanderson 2009). Continued collaborations with particular suppliers creates path dependencies, i.e., the consolidation and self-reinforcement of past decisions that limit the scope of future decisions (Vergne and Durand 2010). It is likely that cooperation with existing suppliers will be preferred to new relationships with other suppliers. Such lock-in effects (Arthur 1989) are associated with the risk that, whenever a particular contract expires, novel competitive or technologically advanced suppliers will not be awarded the new contract, rather those suppliers with whom the armed forces have collaborated in the past (Tripsas and Gavetti 2000). Whenever suppliers take over the maintenance or servicing of military systems, they control key steps or systems required in the generation of military capabilities. Hence, any failure to execute these steps or to operate these systems becomes a strategic risk to the armed forces. Quality problems, supply chain interruptions, and negligence among civilian suppliers then compromise the effectiveness of the military capabilities in question. As the suppliers become increasingly irreplaceable, the longer their co-integration lasts, the more the armed forces find it impossible to retake control because they lack the technological knowledge or work force, or both, to do so. The only option available to the armed forces is to phase out the suppliers by dissolving or nationalizing any institutionalized structures. In this case, dissolution cost offsets any efficiency improvements realized during the collaboration, and therefore the military organization could sustain a net loss. At least in continental Europe, the joint-venture model seems to be out of fashion. Whenever politicians or planners approve arms procurement deals, civilian suppliers are interested in offset transactions that often come with such deals. In principle, the WTO Agreement on Government Procurement prohibits such transactions (World Trade Organization 1994: XVI), but it does not apply to the procurement of defense equipment. By offset transactions, the arms manufacturer commits to commissioning manufacturing and support tasks to the firms of the buyer country. These firms might finish the production of non-critical components, or the original manufacturer may employ them as subcontractors.18 Unlike in the private sector, competitiveness is not required to win these contracts. Instead, civilian suppliers in the buyer country organize themselves in interest groups that lobby planners and politicians who decide which firm is awarded which contract. As the arms manufacturer factors in a surcharge on the purchasing price as compensation for providing the commissions, thus these offset transactions increase the price of arms procurement. As the purchase is financed by the defense budget (i.e.,

18

These commissions need not even relate to the arms deal or technology itself (‚indirect offset deals‘). As civilian suppliers attempt to maximize their income from rent seeking, the volume of all offset transactions may even exceed the purchase price.

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residents’ taxes), offset transactions are an indirect subsidy by which arms deals are used to shepherd state funds to rent seekers. Civilian suppliers are also interested in the offset transactions that involve the subsequent adjustment and modification of any weapons system, irrespective of the military effectiveness of such adaptations. They propose such work especially when the military equipment in question is a commercial off-the-shelf (COTS) product that by definition does not require any adaptation. In extreme cases, politicians try to legitimize the acquisition of a particular military equipment by highlighting the positive business and employment impact the related offset transactions will have for suppliers in their constituencies. By such arguments, rent seekers abuse the armed forces as a vehicle for protectionist policies. If a particular military equipment is acquired solely because it is associated with offset transactions that are attractive to civilian suppliers in domestic markets, residents should remind politicians that they should serve the national interest (by focusing on the military effectiveness of the arms acquired) rather than that of local rent seekers. After all, the less competitive the domestic industrial base is, the more negative the long-term macroeconomic effects of any offset transaction will be. As long as private firms can win contracts and commissions by outcompeting others in the marketplace, they do not require subsidies. However, if suppliers must rely on offset transactions to fill their order books, then these transactions merely preserve uncompetitive industrial structures that would not survive under free competition. The armed forces have to bear the risk of keeping such suppliers alive, as any quality problems induced by these suppliers reduce the performance of the procured systems hence compromise the effectiveness of the military capabilities that depend on them. It is therefore not surprising that auditors examine both the economic and the technological fallout of offset transactions. Offset transactions do not contribute to the accomplishment of military missions, increase purchasing cost by at least five to ten percent and slow down the dynamics of industrial development in the private sector (Federal Audit Office 2007). As a result, this business practice is increasingly being challenged, even in the United States, where offset transactions have become a standard element in arms procurement since 1975 (Martin 1994; Nackman 2011; Brauer and Dunne 2004; Markowski and Hall 2014). Just like civilian suppliers, the arms industry (see Hartley 2007, for a detailed overview) has strong incentives to maximize rents. Arms producers are also interested in maximizing sales prices and volumes and in institutionalizing long-term relationships with the armed forces. They also attempt to exploit planners’ problems: information asymmetry, missing incentives for efficiency improvements, and time pressure. These fundamental economic problems exist irrespective of the fact that some states prefer an autonomous production of weapons systems and that others prefer to import them from foreign suppliers or to jointly develop them with foreign nations (DeVore and Weiss 2013). Due to the particular structure and organization of the arms industry, arms producers pursue a different type of rent seeking than civilian suppliers. Typically, nation states institutionally protect or even co-own their arms producers. Since high fixed costs and technological intensity confront new entrants with high barriers,

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there is no effective competition in the arms industry. The WTO Agreement on Government Procurement does not apply to arms procurement (World Trade Organization 1994: XXIII). It is difficult to obtain objective information on military equipment prices because there is no transparent market, and because producers have an incentive to hide the true costs of production in order to impose maximum selling prices on the armed forces (Hartley 2007). Excluding China, the international arms industry is essentially an oligopoly. Therefore, its firms have an incentive to form cartels. Together, fifty U.S. firms control about 58% of global arms sales. Firms from the UK, France, Russia, Italy, Japan, and Germany almost completely control the remainder (SIPRI 2018). These firms share significant international crossholdings and business interests; hence, they often collude when they set prices for their products (Hartley 2018). The technology used in military equipment is classified and known only to producers, thus only they know the true cost functions, quality risks, and performance parameters (Scherer 1964; Rogerson 1994). The arms industry has a decisive information advantage over any military organization, and neither planners nor politicians can neutralize this advantage by acquiring information in the marketplace (Mantin and Tishler 2004). For civilian goods, quotes and prices at least exist and can be known to market participants; in the case of arms, objective prices cannot be known unless by total deconstruction and an understanding of the technology. Even if states collaborate to maximize interoperability and economies of scale (to keep arms producers in check), they can hardly manage the entanglements of principal-agent and collective action problems involved in such collaboration (DeVore 2011). Finally, military equipment is usually very expensive, which means that absolute price deviations are less conspicuous or noticeable. If, for example, a fighter aircraft costs US$ 140 m per unit, a price increase to US$ 145 m seems like a relatively small price increase of 3.5%. Whereas, the absolute difference is five million dollars per unit, which could be used to buy large quantities of lower-value goods, such as fuel, food, or personal equipment. In addition to this, the price of military equipment has a limited informative function, as product selection is not made by tender offers but by political decisions. As a result, arms producers can impose arbitrary prices for both weapons systems and all related maintenance, as long as politicians are willing to buy the system. Hence, they adopt a price-differentiating behavior in order to maximize each country’s willingness to pay, irrespective of any actual production cost. For this reason, arms manufacturers sell technologically identical weapons systems to different nation states at different prices. These prices reflect the respective country’s purchasing power and willingness to pay. Arms producers also attempt to maximize rents by negotiating for the highest possible profit margin (Hartley 2007, 2012). If procurement contracts must be renegotiated due to unforeseen changes, arms producers try to pass on in full any cost increases to the armed forces, even if the producers are responsible for these costs (Rogerson 1994). Just like civilian suppliers, arms producers strive to sell a maximum number of units per system or equipment, but they are interested in a different structure of these sales. Civilian suppliers maximize rents if they repeatedly supply the armed forces over a long time. Hence, they are interested in spacing out any sales and in preferring

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multiple small deliveries or services to few but large sales. In contrast, arms producers supply expensive and technology-intensive goods. In order to develop these goods, they must invest in research and development over several years, since technological leadership drives competition in the arms industry (Hartley 2007). To make a sale, arms producers must present themselves to planners and politicians as technically competent and reliable, regardless of the actual quality of their technology (Higgs 2007; Melman 1985). As a result, arms producers must bear significant fixed costs as they pre-finance technological innovation and marketing. The usually long life cycle of highly valuable and technology-intensive arms systems, such as fighter aircraft or battleships, limits the absolute number of all transactions involving investment-intensive military equipment. A successful sale of military equipment to any particular nation satisfies the demand of that nation’s armed forces for a long time, and arms producers earn risk-free income from service and maintenance during the system’s life cycle. Once armed forces become habituated to using particular systems, they are more likely to procure the next generation of systems from the original producer because these path dependencies influence the replacement decision (Pejovich 1993; Pierson 2000; Buchanan and Yoon 1994). Arms producers therefore maximize rents whenever they can sell systems with as many effectors and as long a life cycle as possible, and vice versa, they lose decades of revenue if they fail to close a deal. As nation states and their armed forces are the sole purchasers of technologyintensive military equipment, there is no alternative market, and the number of nations with the necessary defense budgets and purchasing power is limited. Arms producers therefore have fewer opportunities to amortize their investments than civilian suppliers do. As a result, they are typically not interested in arrangements whereby armed forces attempt to partition large sales volumes into smaller packages by spreading out the procurements over multiple defense budgets; and for this same reason, they resist any long-term evaluations of prototypes. They can only amortize their investments by obtaining a supply monopoly over several years, or by selling large numbers of systems units at a time. In contrast to the civilian supplier, the arms industry is interested in maintaining long-term customer relationships less than in persuading — at all costs — planners and politicians, once an opportunity to close a deal emerges. As soon as nation states announce their intention for large-scale arms procurement, arms manufacturers begin to invest in this persuasion. Politicians and planners decide how large the defense budget is and how it is spent. Typically, planners evaluate the technical and economic aspects of candidate systems, and politicians sign off on the procurement contract. Arms producers attempt to persuade both to obtain favorable evaluations and decisions (lobbying). Due to the oligopolistic structure of the arms industry, any particular arms producer supplies a larger share of the global market, such that the incentive to invest in lobbying for arms producers are much stronger than for civilian suppliers (Olson 1965). As evaluations can take years until planners or politicians make a procurement decision, lobbying both groups continually is costly, and the related expenditure is amortized only when the deal is closed.

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The arms industry is notorious for lobbying planners and politicians. As the procurement decision is the result of planners’ evaluations and subsequent political decisions, sales volumes depend on the extent to which producers can persuade these two groups. Not surprisingly, therefore, in order to circumvent compliance and competitive bidding, arms producers often attempt to corrupt planners and politicians (Pyman et al. 2009). Any attempt to exert influence is more effective if the decision-making process is centralized, concentrated in the hands of a few politicians, and exempt from democratic control by citizens. As politicians and planners fear negative repercussions if any persuasion attempts are uncovered, arms producers can offer them lucrative positions in their firms in the event of dismissal or resignation (Fisman and Gatti 2002; McCormick and Tollison 1981; Crain and McCormick 1984; Hartung 2011; Duncan and Coyne 2015; Coyne et al. 2016). While much media attention accompanies arms procurement deals and the related lobbying, it is often disproportionate to the relatively small size of these (if multibillion) deals. In 2018, on a global scale, arms sales of the SIPRI top 100 armsproducing and military services companies in the world (excluding China) totaled 420 billion US$ (SIPRI 2018). Even if the 2017 nominal world GDP is estimated conservatively at 80,000 billion US$, these sales represent a mere 0.52% share. In 2010, the arms industry in Germany—then among the top ten of weapon-exporting nations—contributed less than 0.5% to German GDP. In 2019, Switzerland exported arms of about 728 million US$, or 0.1% of Swiss GDP (Deutscher Bundestag 2011; Seco 2019). Although the economic impact of arms deals is limited, the military consequences are severe. The armed forces have to bear the technological and military risk if lobbying makes politicians buy flawed or ineffective systems. In a planned economy system, the armed forces are the users, not the evaluators or purchasers of their arms. Consequently, flawed systems reduce the effectiveness of their military capabilities. Due to the long life cycle of arms systems, long after politicians have resigned and the arms industry has poached planners, the armed forces still have to cope with inferior technologies and reduced effectiveness, until systems are refitted or replacements bought. Armed forces can do little to pressure producers to manage such problems from the outset. Although price negotiations occur between arms producers and politicians, the negotiating power of the latter is limited because the intention to buy arms is publicly known. Politicians can therefore hardly threaten to not procure a particular system or to renegotiate prices, particularly so if there are few or no technological substitutes. It is the norm, rather than the exception, when delivery deadlines are met with delays, budgets are constantly exceeded, and arms performance is less than expected (Hartley 2007; Eckerd and Snider 2017; Jones 1999; Kovacic 1991). Whenever armed forces are not delivered merely a prototype, but a whole system with many units at one point in time, they have to bear technological and performance risks. If the system performs below expectations or requires costly refitting, the armed forces can press charges against the manufacturer. However, litigation entails high transaction costs, and the outcome of any trial is uncertain. For example, in 2017 Austria filed a claim for damages of 1.1 billion euros against the aircraft manufacturer Airbus because operating costs and fuel consumption per flight hour

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proved to be significantly higher than promised. The case is still pending (Knolle and Schwarz-Goerlich 2017). In 2016, Germany lost a compensation case against arms producer Heckler & Koch. The manufacturer was sued after the discovery of quality defects in its G-36 assault rifles (Reuters Staff 2016). Within the general framework of a planned economy, the fundamental incentive and information problem of arms procurement cannot be resolved. As a result, these episodes repeat themselves, regardless of the particular military organization, technology, or historical period (Riposo et al. 2014). Even if planners jointly develop arms with manufacturers, attempts to objectively evaluate which investments in R&D they should finance (and why) are often unfeasible or politically undesirable (Keck 1988). The only effective measure by which planners might reduce future risks for effectiveness is the procurement of commercial off-the-shelf (COTS) products that are already in use among other armed forces. In this case, planners can reliably estimate system costs performance by learning about the practical experience other armed forces had with this system. While civilian suppliers and arms producers seek rents on the supply side, regional politicians act on the demand side. First, they seek rents by proposing that planners move that the generation of military capabilities to their county or constituency. Whenever the creation of military capabilities located to a particular region, the armed forces require land, buildings, food, fuel, transport, goods for daily needs, and a wide variety of services. The local labor market benefits from this demand, and the local private responds by beginning or expanding production. Regional politicians seek to establish military bases, airfields and training grounds within their region, expecting that these infrastructures will bring employment and economic prosperity to their constituency (Arnold 1979; Mehay and Solnick 1990). In this way, they use the generation of military capabilities to subsidize their local economy (Dyckman 1964; Atkinson 1993). Whether these capabilities are effective or produced efficiently is irrelevant to them, they focus on the creation of local jobs and business that this generation entails. As both regional income and tax bases grow, politicians increase their chances of re-election or reappointment. Hence, they attempt to convince planners that extant military sites should remain in their region, or that their constituency is particularly suitable to the installation of novel military sites. In times of defense spending cuts, they will lobby state politicians and committees for military sites in their region to continue to operate (Braddon 1995). Regional politicians oppose the closure of local military sites, even if there are no negative or even positive consequences for the region (Poppert and Herzog 2003). As regional politicians are familiar with the economic conditions in their local communities more than state politicians are, they have an incentive to lobby for regional policy decisions in their favor (Vaubel 1986; Lee 1985; Aranson 1990). They can also offer political support, for example, by encouraging their local constituents to vote in favor of arms procurement deals or a larger defense budget. Such collusion between different political levels helps regional politicians earn political rents, and the cost of such ‘structural policy’ is spread among all residents (Brennan and Buchanan 1980; Shadbegian 1999).

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The more structurally weak a region is, i.e., the less able it is to generate growth and employment from its own initiative and resources, the stronger the incentive is for regional politicians to lobby state politicians. As a result, structurally weak regions compete for political favors that central governments grant (Coyne and Moberg 2015). Given that the defense budget is a fiscal commons, citizens’ votes can indirectly influence the total size of the defense budget, but not its regional distribution. Instead, a complex collusion between planners, regional politicians, and oversight committees determines the regional allocation of military sites. Therefore, the spatial configuration of any military capability generation reflects the rent seeking performance of regional politicians. However, these politicians are not interested only in attracting or maintaining any generation of military capabilities. They can also use these capabilities to substitute labor and capital expenditures, such that the local constituency can afford a higher resource consumption. The spectrum of military capabilities is not limited to the use of force alone. All armed forces have logistics, transport, construction, and communication capabilities, and there is civilian demand for all of these. Armed forces can also provide material and trained personnel that can support or substitute civil engineering, law enforcement, security patrols, medical supply, civil defense and disaster relief. Whenever regional politicians consume these capabilities at less than production cost or even free of charge, regional politicians abuse the armed forces as a vehicle to shepherd indirect subsidies to their constituencies. Private firms will not produce goods and services unless customers come up with actual demand. In contrast, a military mission cannot assigned unless capabilities relevant for that mission are available immediately. Armed forces therefore generate military capabilities ‘on reserve’, such that they are ready to deploy at short notice. From the perspective of regional politicians, armed forces have a considerable portfolio of ready-to-use capabilities. Whenever there is not an imminent military mission, armed forces are under pressure to demonstrate the usefulness of these capabilities and the resource consumption used for their generation. In this situation, regional politicians can trigger demand by proposing that military capabilities could help create local infrastructure or services. Examples of such exploitation are preventive disaster relief (e.g., the construction of dikes or drainage), technical support, and the construction of temporary infrastructure for public events. In so doing, the armed forces supplant goods and services that otherwise would have to be provided by the private sector or organized by regional public bodies. Local residents enjoy the created infrastructure and services for free, such that there is no need to increase the local tax base, which, in the absence of military capabilities, would have to finance these investments. The economic problem is not that armed forces allow the local population to utilize their capabilities. The issue is that the infrastructure built and services rendered are provided below production cost, sometimes free of charge, i.e., as a local subsidy. If the armed forces would bill their capabilities at the prices that private contractors would charge, regional politicians would have no incentive to prefer them to any private supplier or service provider. Further, logrolling with

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regional politicians by providing subsidized services can secure political support in times of defense budget cuts. From the perspective of planners, if local communities are billed their capability consumption at cost, unforeseen extra revenue is created which cannot be saved or invested at short notice. Moreover, once the politicians opposed to the military learn of these extra sources of revenue, they could propose to cut the defense budget. Although local communities profit from such subsidies in the short term, they reduce both their competitiveness and the health of their public infrastructure in the long term, as they become dependent on the armed forces’ presence and capabilities. The longer the local communities substitute proprietary investments by services that the armed forces provide, the less they invest in the maintenance of their local infrastructure and public services. Once the armed forces cease to provide these services or relocate sites to other areas, the local tax base can no longer sustain the extant infrastructure or finance replacements. Just like regional politicians, private firms, clubs, associations, and individuals are interested in the consumption of military capabilities, if only for other motives. These groups do not seek re-election, but cost savings and additional revenues. Niskanen's (1971) model is also incomplete in this respect, as the consumption of military capabilities is not limited to political or state actors. Whenever armed forces are organized as planned economies, private actors can also earn rents. The nation state is thus the sole generator, but not the sole consumer of military capabilities. The armed forces can provide skilled labor and capital-intensive equipment that can substitute for private wage and capital expenditure, especially if a large labor force and a hierarchical structuring of job tasks is required. They also possess heavy machinery that is not readily available in the private sector, or only from specialized providers, at a significant cost (e.g., heavy construction machinery, heavy clearance equipment, special conveyors, and movable bridge systems). Again, the economic problem is whether the armed forces provide labor and machinery at or below cost. Unless they bill at market rates the hours worked and capital equipment provided, their labor and material constitutes a subsidy to private actors. These can save costs thus increase profits. If they can consume military capabilities for free, gross profit equals net profit. The economic question then is what share (if any) of these profits should be transferred to the armed forces, especially when private groups not only save expenditures, but also generate continuous profits whenever the armed forces provide them with permanent structures (e.g., jetties, cable cars, roads, buildings). Moreover, considering that free or low-priced armed forces labor crowds out employment in the private sector, local firms can request compensation payments. In principle, the armed forces can require the transfer of any such profits.19 In contrast to planners, private groups do not lack incentives for bookkeeping and

19

In Switzerland, private groups that use military capabilities can be required to transfer at least some profit to state social security (art. 9 sct. 5 of the Ordinance on the Support of Civilian Activities and Off-Duty Activities with Military Means, SR 513.74).

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calculation of individual profits. Therefore, provided the bookkeeping provides a true and fair view, armed forces can know if private firms made a profit. As military capabilities substituted private-sector labor and machinery, they can price any services rendered and structures built at market rates. This transparency gives private actors an incentive to suppress, during contract negotiation, any terms that require profit transfers or compensation. They could lobby planners and politicians, persuading them to consume military capabilities at low or no cost. Both could favorably consider such proposals whenever they expect that this approval will earn them political rents (prestige, increased chances of re-election, or retention of power).20 Rent seeking by private firms and individuals is not neutral, but equivalent to an indirect subsidy. Rent seekers typically argue that military capabilities are generated irrespective of actual demand; any related spending would therefore represent sunk costs, and especially so in peacetime, since this spending cannot be recuperated or reversed. Hence they argue that any such capabilities should be provided free of charge because they have already been paid for. This argument meets the interest of armed forces to deploy any capabilities they have (if only for sake of appearances), but it comes at the expense of the residents. They do not finance the defense budget to subsidize private and regional political interest, but rather to obtain professional protection for their life, health, freedom, and property. From the residents’ point of view, any alternative use of these capabilities should either be illegal or at least billed at cost, according to the ‘user pays’ principle. Without rent seeking, the generation of military capabilities would not only be more efficient but also more effective, as well-organized rent seekers can influence planners to prioritize those capabilities that are most useful for their own (but not necessarily the national) interest. Finally, private groups cannot earn rents only by saving costs, but also by using the armed forces’ intellectual property (logos, lettering, utility models, industrial designs, etc.) to generate additional revenue. The use of this intellectual property could suggest to customers that the products in question have a particular robustness or quality. Again, the problem is not whether private firms exploit intellectual property rights in this way, but whether they pay competitive royalties to the armed forces. Since they cannot claim such payments unless a contract or legal norm exists, the armed forces must create institutions that protect their intellectual property against abuse and free riders. Unless they register their designs, logos, symbols and lettering with a patent office and protect their copyrights, trademarks, and utility model, they will fail to claim any royalties. Even if this protection exists, planners must still be made aware of any infringements, and they must organize enforcement of the respective institutions. Again, due to the lack of property rights in planned economies, any 20

For example, the Federal Council in Switzerland authorizes every year a federal decree that legitimizes the deployment of the Swiss Armed Forces to the benefit of the World Economic Forum (WEF). Although the foundation that runs it is a private for-profit organization, the WEF is declared an extraordinary event in the direct interest of the nation, such that any services the armed forces provide are paid for by the defense budget.

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proceeds from royalties and compensations for infringements are attributable to the nation state, but not to the armed forces, as the intellectual property rights of the armed forces are also a state monopoly good.

2.2.5

Combatants

Whenever a military organization is state-run, combatants are state employees. Professional soldiers, NCOs and officers have permanent employment; both their salary and benefits (if any) are paid from the defense budget. So are conscripted combatants; in addition, these also receive payments that (partially) compensate the loss of private-sector income during military service. These payments are independent of organizational performance or individual productivity. Civilian employees merely administer the military organization. This administration, as such, does not produce any value added; combatants, not bureaucrats, create military capabilities. It is therefore insufficient to consider bureaucrats as monopoly producers of defense (Niskanen 1971) or to include combatants under the ‘military bureaucracy‘(Klingen 2011). Combatants, not bureaucrats, deliver military performance in the field. However, in a planned economy, planners require combatants for administration tasks, in order to legitimize their existence and employment. The opposite does not apply, as combatants do require political, but not bureaucratic oversight as they generate military capabilities. Hence, planners are interested to legitimize their interference by organizing combatants’ daily routines, exercises and training as comprehensively as possible via formal institutions (checklists, formalized process presentations, manuals, operating instructions, regulations, mandatory courses, etc.). Whenever armed forces are organized as planned economies, combatants do not purchase, own or maintain any goods or military equipment, despite the fact that they use them on a daily basis. The state holds all property rights, and its bureaucracy organizes all acquisition and maintenance. The military institutions hold the individual combatant responsible for negligent or deliberate loss of personal equipment, just as they threaten to replace commanders if they accept excessive loss of troops or allow decisive enemy action. However, combatants are responsible only for military mismanagement, but not for any economic mismanagement of the armed forces as such. Hence, they have no incentive to question inefficient procurement (Hartley 1995). By using equipment during daily routines and training, combatants create logistics, maintenance, and replacement costs that the defense budget pays for, even if these routines are inefficient and their resource consumption excessive.21

21

From an accountant’s point of view, combatants are cost generators since their actions trigger resource consumption. However, the cost bearers are planners in the state bureaucracy since they allocate state funds to pay for this consumption. Therefore, no cost allocation according to the

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59

Combatants are also citizens hence taxpayers. However, as their salary and benefits are completely financed by taxes, in the balance they receive much more tax money from the state than they pay to it. Therefore, the personal net-tax balance is always positive for any combatant, hence they have no incentive to question any inefficient use of taxpayer money. Any search for economic optimization confronts combatants with transaction costs for which they receive no compensation. If they direct planners’ attention to any inefficiency, these may respond with restructuring or downsizing. Military culture evaluates combatants by their military, and not their economic, performance (Hartley 1995). In peacetime, their career advancement depends on the successful planning and execution of maneuvers. When deployed, their performance in battle and troop leadership determines their future career and life expectancy. Therefore, visibility and leadership, but not necessarily economic competence, determines career advancement (Moore and Trout 1978). As soon as planners have procured goods and awarded contracts to as private firms, combatants can no longer influence any of the associated fixed costs. They can reduce variable costs by reducing the intensity with which the equipment and services are used. By doing so, however, they degrade the very military capabilities they are supposed to generate. Therefore, combatants are interested in efficiency in military terms, e.g., operational loss of troops or waste of time. Within a planned economy, this interest in military efficiency does not translate into a likewise interest in economic efficiency. On the contrary, any parsimonious planning of exercises or deployments can be counterproductive in purely military terms, as such planning can restrict combatants’ freedom to act or not permit them to withhold reserves for a later deployment. Both planners and combatants are interested in the acquisition of any goods— even if objectively unnecessary, and irrespective of cost—as both groups can strengthen their political and economic position by procuring more equipment. Planners need procurement projects to execute the bureaucratic tasks they were hired for, and combatants require both private sector and military goods and services to generate military capabilities, irrespective of the extent to which these capabilities will ever be deployed in the field. Therefore, planners and combatants have an incentive to collude whenever any large-scale procurement looms. Whenever planners procure inferior goods, their careers can suffer, but their life expectancy does not change. The same does not apply to combatants who must use faulty goods during military operations; hence, their survival depends on the quality of their equipment. Combatants are interested in military effectiveness much more than in the economic efficiency of any equipment. They prefer a maximum of functionality and performance, whereas they are indifferent to the implied economic cost. This maximization of functionality allows combatants to maximize their chance

principle of accountability is possible as long as the armed forces operate under a planned economy regime.

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of survival and planners to use their authorizations to the fullest. Consequently, the cost of inefficient procurement and excess functionality is passed on to the residents. To mitigate the risk that planners procure ineffective equipment, combatants can resort to the same mechanisms that residents can use to discipline planners and politicians—exit and voice. As members of the military organization, combatants have better information about its performance and problems than any civilian resident does. They could leave the organization before significant problems manifest themselves, or they could use their insider information to voice their concerns. Such options, however, are associated with significant risks for combatants’ careers and lifetime income. First, conscripted combatants are obliged to serve; hence, they cannot exit the military sector. However, the transaction cost of exit is high, even if the state allows combatants to leave. Conscripted combatants must bear the transaction costs of migrating to an alternative service (e.g., civil service, civil protection, etc.). Professional soldiers face the problem that only the national military organization requires the capabilities the generation of which they dedicate their career to. As they attempt to migrate to the private sector, they can find that leadership and management methods differ significantly (Popper 1996). The transaction costs associated with migrating to blue-light organizations such as the police, the fire brigade, or disaster relief organizations are probably lower. Even in this case, professional soldiers must terminate their military career and any prestige, salary and benefits that come with it. As the risk of unemployment increases with age (Kyyrä and Wilke 2007), leaving the military sector at an advanced age is particularly risky. As a result, professional combatants only leave the military sector only if they face significant mortality risk due to poor equipment, if the private sector offers them attractive employment, or if they bureaucratic management has demoralized them to the extent that exit seems more attractive continued employment. Combatants have only limited means to voice any concerns associated with the ineffectiveness or inefficiency of military capability generation. The judiciary can oversee laws and ordinances, but planners in a military organization can freely author and revise institutions below the level of ordinances. Unless they formally question the compliance of such institutions with the law, there is little that combatants can do if they want to resist increasing bureaucratization. Instead, they may consider transferring to a desk job, or they may become planners themselves if they are no longer fit for military duty or deployment, so that they have an incentive to collude with extant planners to secure their future careers. Such migration is rather unlikely in the opposite direction. Finally, military culture rewards assimilation and subordination, but it punishes contradiction and dissent. As their careers progress, combatants’ objective performance evaluations are increasingly replaced by socially constructed networks and subjective assessments (Moore and Trout 1978). Public statements that question the effectiveness of any equipment or services can have negative repercussions for a combatant’s future career. At the most, combatants can resort to whistleblowing or express their dissatisfaction by indiscretions, such as the disclosure of confidential documents to the media. Such actions, however, might not constitute only a criminal

Bibliography

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offense but also incur punishment by dismissal and civil claims if discovered. As combatants rationally assess these risks for their lifetime income, voicing concerns is perceived as unattractive, unless for irrational motives such as disgruntlement or a desire for revenge.

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Chapter 3

Effectiveness of Military Performance

3.1

Military Conflicts as Objective Selection Environments

Before an actual conflict begins, it is unknown whether and to what extent the military capabilities generated in peacetime can actually provide effective military performance. Only real conflicts allow the armed forces to test the effectiveness of any military capabilities they have generated in the past. Just like a private firm does not know actual turnover until shops report sales figures, information about the effectiveness of military conflicts is not created until an actual conflict begins. When the theory of evolution (Hannan and Freeman 1984; Burgelman 1991) is applied to military organizations, they populate a selection environment in which they compete with each other for the realization of their missions or objectives. In this competition, they use their military capabilities to impose their own will on that of the opponent, if by force (Clausewitz 1989). Hence, any military conflict can be interpreted as a selection event, the outcome of which makes it possible to determine objectively whether the armed forces have accomplished their mission. Military conflicts objectively inform the residents about the effectiveness of the any military capabilities. Residents can compare and contrast this objective information against subjective opinions and communication. Even those who were uninformed, unwilling or incompetent to assess military performance can now learn about the effectiveness of their armed forces, as the media quickly and inexpensively disseminate information about the conflict. Governments can be controlled by regulatory competition better than by elections (Vaubel 1999). By way of analogy, government policy on armed forces is controlled by the outcome of conflicts more effectively than by political mechanisms. In this sense, a military conflict puts armed forces under the same selection and adaptation pressure that private firms experience under market competition (Alchian 1950; Fortune and Mitchell 2012). Omnis arbor quae non facit fructum bonum exciditur et in ignem mittitur (Matthew 7:19) © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. M. Keupp, Defense Economics, https://doi.org/10.1007/978-3-030-73815-0_3

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Predicted military conflicts can take place only in the distant future or not at all, and novel conflicts that planners failed to predict can suddenly emerge. As military capabilities are generated in the present, the extent to which (if any) they will be deployed in the future is unknown. Years or decades can pass until this deployment occurs, so that the military organization is not, or not always, under direct pressure to prove its effectiveness. The design of maneuvers and simulations can only partially resolve this problem as they are subject to the same information problem. Exercises are always an incomplete and modeled reproduction of possible conflicts; hence, they can only imperfectly forecast any future military performance during an actual engagement. Until actual troop deployment begins, there is no information by which planners and combatants could evaluate the accuracy of any past planning. Without this information, there is no way to learn how and why (if at all) this planning should be adapted. This is why those military organizations that must prove themselves continuously in the field, not only receive information about their effectiveness better than those forces deployed less frequently. With each deployment, they also receive information about which capabilities are not or not fully effective, so that they can adapt planning in a timely manner. This correlation, however, is subject to boundary conditions. For example, if a conflict only requires the deployment of a subset of all capabilities, any evaluation is necessarily incomplete as it is limited to this subset. For example, the success of foreign interventions says nothing about the capability to defend the homeland, and armed forces that effectively fight conventional wars can suffer defeat in hybrid conflicts and in cyber warfare. Unless capability generation is continuously adapted to changing threat landscapes, disparities develop between the supposed and actual effectiveness of the armed forces. Still, the armed forces will assure residents of their (supposed) effectiveness by political communication and by organizing maneuvers. Whenever residents face high transaction costs as they attempt to evaluate the veracity of this information, such disparities go unnoticed. However, the defeats of the future are already born in the present if the generation of military capabilities does not evolve and merely perpetuates existing structures. Furthermore, whenever capabilities generated in the past prove to be ineffective in contemporary conflict, defeat is not just a punishment for neglect or inaccuracy. It also provides detailed information about mission failure. After-action reviews then allow the armed forces to analyze which capabilities were ineffective in which selection environments. This is why defeat often triggers transformation (Solomon et al. 2008). The path dependencies of the past suddenly turn out to be burdens. However, subsequent adaptation is still slow because historical processes and models of capability generation must be adapted against the resistance of incumbent planners and military leaders (Tripsas and Gavetti 2000). Such changes must be the more radical the more the effectiveness of the armed forces has been compromised. During this transformation process, capabilities that proved ineffective are abandoned and novel ones are learned. This pattern is observable on a regular basis throughout history (see Table 3.1). Yet, a fundamental information problem remains.

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Table 3.1 Dynamic change among armed forces because of ineffectiveness Selection event Battle of Jena and Auerstädt, 1806 Crimean War, 1853–1856

Outcome Heavy defeat of the Prussian armed forces

Adaptation Complete reorganization of the Prussian armed forces and state bureaucracy (‘Prussian reforms’)

Defeat of the Russian armed forces

Trigger for the reforms of the Russian armed forces in the 1870s; development of railroad-based transport infrastructure and logistics Total reorganization of the Ottoman armed forces under the command of the German General Liman von Sanders, from 1913 onward Restructuring of the U.S. Armed Forces by the General Abrams Plan (inter alia, abolition of conscription, development of special forces, technological improvements of weapon systems) Co-trigger for the 2008 Russian military reform; significant downsizing, abandonment of mass mobilization, brigadebased structure, focus on small mobile forces with permanent alertness

First Balkan War, 1911 Italian-Turkish War, 1912 Vietnam War, 1965–1973

Heavy and repetitive defeats of the Ottoman Armed forces

Russo-Georgian War, 2008

Russian victory, but poor reconnaissance, communications and control during operation

USA defeated in asymmetrical conflict with North Vietnam

Until the next conflict begins, it is unclear whether and to what extent these reforms are effective (Nielsen 2010). These fundamental considerations are independent of the economic system by which the armed forces are managed. However, under a planned economy system, the behavior of planners and politicians leads to significant problems that reduce the effectiveness of any military capability.

3.2 3.2.1

Consequences of the Planned Economy System Delayed Correction of Forecasting Errors

Combatants must generate military capabilities before actual deployment is required. The effectiveness of any armed force therefore depends on the extent to which planners can realize congruence between the (contemporary, planned) generation of military capabilities and the (future, actual) demand for these capabilities. This extent is subject to the minimization of forecasting errors that planners and politicians make. Such errors are highly likely to occur with any economic organization. However, under a planned economy regime, the consequences of forecasting errors are much harder to resolve.

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Δp1

0

ppol

Δp2

p*

ppol

pmax

Fig. 3.1 Continuum of possible transfers

First, politicians can both overestimate and underestimate the size of the defense budget. Regardless of their party affiliation, politicians are interested in redistributing a maximum share of the national budget to the favor of their political clientele. The political debate about the defense budget focuses on opportunity cost considerations. As each unit of taxpayer money can be allocated only once, each monetary unit in favor of the armed forces implies one monetary less unit for alternative use (e.g., foreign policy, infrastructure, or social welfare). ‘Left wing’ politicians prefer to spend the unavoidable minimum and propose alternative uses, whereas ‘right-wing’ politicians are more inclined to expand the defense budget. As a result, the annual defense budget is essentially a random result. Its size reflects the different strengths of and negotiations between political camps. Specifically, it is contingent on the incessant change of political majorities, climates, zeitgeist, and subjective threat perceptions, each of which influences citizens’ short-term voting behavior. This politically determined defense budget can be too high or too low, in relation to the objectively required budget, i.e., to the financial means required for the generation of effective capabilities that future conflicts require. Politicians must accurately forecast future threat scenarios, the military capabilities of likely opponents, the likely course and escalation of conflicts, etc., although they usually do not have better information about future military conflicts than the residents do, nor do they have better forecasting abilities.1 As a result, politicians can miscalculate both the objectively required defense budget as a whole and the requirements for specific military capabilities. Indeed, p*, which describes the objectively required transfer for the generation of a specific military capability, falls within a continuum defined by the extreme points of zero and pmax (see Fig. 3.1). At zero, no resources are transferred to fund this generation, whereas at pmax, all available resources are transferred. An allocation of zero represents the view that a specific military capability is not required at all; as an aggregate over all capabilities, it represents the pacifist optimum.2

1

Politicians and lobbyists could produce better forecasts if they could access classified information, join professional committees, or benefit from personal qualifications. Unfortunately, they are not immune to mistakes. It is also questionable whether they can assert their views, even if they are correct, in political discourse with uninformed peers. 2 A transfer of zero means that the capability is terminated since funds required for its generation are cut off. Hence, a transfer of zero over all capabilities is economically equivalent to the abolition of the armed forces. In economic terms, this extreme point is an admissible solution.

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p

A ppol p* ppol p0

Δq1 qpol

Δq2 q*

qpol

q

Fig. 3.2 Forecasting error of politicians

As politicians provide their estimate of ppol, they can both underestimate (Δp1 < 0) and overestimate (Δp2 > 0) the objectively required transfer p*. As a result, the transfers that politicians approve are either insufficient to generate the military capabilities in question, or they are oversized. The generation of a military capability requires material resources (e.g., civilian goods, military equipment, and infrastructure) that are designated by q in all the following diagrams.3 These material resources are offered by the arms industry or the private sector, according to supply curve A whose structure politicians can hardly influence. The minimum asking price p0 reflects the production cost of the material resources, as producers have no incentive to sell their goods below cost. Assuming that politicians have correctly estimated the shape and slope of the supply curve, the politically approved transfer of ppol enables the armed forces to procure material resources up to a maximum of qpol. However, this politically approved transfer can differ considerably from the objectively required transfer p*.

3

To simplify the presentation, all following diagrams refer to the acquisition of material resources. However, they can also inform the analysis of human resource requirements by interpreting q as the quantity of labor required and A as the labor supply curve.

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Δq1

0

qplan

Δq2

q*

qplan

qmax

Fig. 3.3 Continuum of possible resource requirements

Figure 3.2 shows the effects of this forecasting error. If politicians underestimate the required transfer, once the predicted conflict begins, the resulting military capabilities are insufficient. In this case, the quality or intensity of military performance decreases, because the available capabilities must be rationed spatially or temporally. As the objective need for material resources is q* (which could have been procured if the objectively required transfer of p* had been forecast and approved), there is a capability gap (Δq1 < 0) that reduces the effectiveness of military performance. If politicians overestimate the need for transfers, the armed forces can procure more material resources than are required for capability generation. The armed forces will then be effective, but not efficient, since they could realize the same capability generation with less resource input. Hence, there is an excess endowment of Δq2 > 0. This endowment comes at high opportunity costs because the excess transfers are no longer available for alternative use, and because they generate permanently high operating costs as the number of system units purchased and operated exceeds the objective requirement. Even a real military conflict only partially solves this forecasting problem. The outcome of a conflict informs residents about the effectiveness of the capabilities generated in the past. However, the extent to which (if any) the armed forces could have realized at lower cost remains unknown. Not only politicians but also planners can be mistaken when they make forecasts. Politicians consider the generation of military capabilities from a budgetary perspective. They therefore allocate funds according to the maximum principle by negotiating a maximum share of the national budget that should be allocated to generate military capabilities. In contrast, planners plan according to the minimum principle, grounding their planning in the (subjective) threat scenarios they identify. They determine a minimum resource requirement that is necessary to generate a particular military capability with a particular intensity in time and space. Then they determine the financial resources this requirement entails. However, they cannot know if their predictions about a future conflict scenario and the related resource requirements are correct until the conflict actually occurs (Goodwin and Wright 2010). Planners do not know with certainty which military capabilities will be needed and to what extent. Therefore, the objective resource requirement for a given military capability (q*) is also located on a continuum. It can take any value between zero and qmax or be identical to these extreme points (see Fig. 3.3). Here, the zero point reflects planners’ belief that a particular capability is irrelevant. The point qmax indicates that a capability is so crucial that all available

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p

A pplan Δp2 p* pplan

Δp1

p0

qplan

q*

qplan

q

Fig. 3.4 Forecasting error of planners

resources should be used to generate it. Within this continuum, planners select under uncertainty a requirement of qplan that either underestimates (Δq1 < 0) or overestimates (Δq2 > 0) the objectively needed endowment. Although it is theoretically possible that qplan and q* are identical, either by chance or as a result of perfect planning, this probability is low because there is only one correct resource requirement, and there are many possibilities by which it can be misjudged. For example, planners can predict conflicts that never occur; they can correctly predict the onset of a conflict but misjudge how it develops, or they can be surprised by a conflict that they failed to predict. In all three cases, they have misjudged resource requirements; hence, there is a gap between planned and actual resourceendowments. Therefore, just like politicians’ budget forecasts, the portfolio of planned military capabilities is also a random result. It is shaped by planners’ subjective views about future conflicts and technological developments (Mowery 2012; Dombrowski and Gholz 2006). Notwithstanding the illusion of reliable planning portrayed by official documents, charts, and presentations, this fundamental uncertainty is a typical feature of modern military organizations (Moulton 1971). Figure 3.4 shows the financial consequences of the forecasting errors planners make. If they underestimate the resource requirements, there is a funding shortfall of Δp1 because the politically approved transfer is insufficient to procure the resources

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needed for capability generation. If they overestimate the requirements, a budget surplus of Δp2 results, so that excess funds are available that are not allocated to any capability generation. The consequences of this forecasting error are especially severe when planners believe that a specific capability is irrelevant, but it proves to be significant in a future conflict. In this case, military performance is reduced in a decisive way as no material resources are procured at all. Hence, the correction of the forecasting error requires a fundamental revision of long-term investment planning. Such errors keep occurring through history, as decision-makers are unable to recognize the military potential of emerging technologies, as well as the novel military capabilities these technologies enable. For example, although the Austro-Daimler Panzerautomobil (‘automobile tank’) was presented to Austrian officers and state executives during the Imperial maneuvers in 1906, they did not plan for the acquisition of any armored vehicles (Jobse 2019). In 1911, Marshal Ferdinand Foch, then Commander-in-Chief of the French Armed Forces, thought that airplanes were an interesting toy, but had no military value whatsoever. He did not prioritize the acquisition of aircraft (Pickover 1998). As early as 1916, the military value of tanks became obvious during the Battle of Cambrai and, as early as 1940, air superiority proved to be a decisive factor in both land and sea battles. Remote-controlled, unmanned air vehicles (drones), whose use until 1995 hardly exceeded experimental flights, have been deployed in Afghanistan and other regions since 2001, and they are expected to replace or merge with combat aircraft technology soon (Reinhardt et al. 1999; Coffey and Montgomery 2002; Sullivan 2005; Stulberg 2007). Before 1993, only a circle of experts knew what the Internet was; today, there are complaints about the shortage of personnel in electronic warfare (General Accounting Office 2019). Planners and politicians can misjudge both resource requirements and their prices. There is no guarantee that they can correctly forecast the shape and slope of the supply curve. Regardless of the historical, military and organizational context, procurement is often (much) more expensive than expected. Arms manufacturers regularly exceed promised delivery dates, and decision makers ignore or oppose institutional reforms that intend to alleviate these problems (Fitzgerald 1989; General Accounting Office 2017; Hartley 2007; Smirnoff and Hicks 2008; Kim and Brown 2012). The defense acquisition and budgeting process is fraught with a multitude of agents who have conflicting goals. Although these agents can be mapped and analyzed, the amalgam they form can hardly be disentangled (Schwenn et al. 2015). Consequently, pricing errors are commonplace with arms procurements. Figure 3.5 illustrates the case where politicians incorrectly forecast the supply curve. They approve a budget of ppol to acquire a resource endowment of qpol. However, if supply is less expensive than expected, the arms manufacturer does not offer this supply according to supply curve A, but rather according to A’. The armed forces could then use the remainder of the approved transfer ppol to purchase additional resources to the extent of Δq3. However, there is no corresponding planning for such procurement; hence, planners must produce short-term improvisations by which they can spend the unexpected windfall before their authority to do

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p

A‘‘

A p‘‘ Δp4

A‘

ppol Δp3 p‘ p0

Δq4 q‘‘

Δq3 qpol

q‘

q

Fig. 3.5 Incorrect prediction of supply curve by politicians

so expires. If no such improvisation can be made, politicians reduce the approved transfer from ppol to p’, so that the surplus of Δp3 is transferred back to the national budget. If politicians underestimate the prices suppliers charge, they assume a supply curve of A, whereas the actual supply curve is A“. As a result, their originally approved transfer of ppol can buy only the resource endowment q“, and the armed forces face a shortage of material resources to the extent of Δq4. This lack of resources reduces military performance, as not all planned capabilities can be generated or only on a lower quality or performance level. If politicians still want the armed forces to procure the originally planned endowment, they have to authorize additional spending to the extent of the financing shortfall of Δp4. Similar results are obtained if planners incorrectly forecast the supply curve (see Fig. 3.6). If, on one hand, the actual supply is less expensive than planned, the planned quantity of material resources qplan can be procured, but there is a funding surplus of Δp5. Planners lose the authorization to spend this approved transfer at the end of the budget period, unless they come up with improvised procurements. If, on the other hand, supply is more expensive than expected, the planned resource endowment cannot be procured until politicians approve extra funding that covers

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A‘‘

A p‘‘ Δp6

A‘

pplan Δp5 p‘ p0

Δq6 q‘‘

qplan

q

Fig. 3.6 Incorrect prediction of supply curve by planners

the shortfall of Δp6. If they refuse to do so, the originally planned procurement must be reduced by Δq6 to q“. Both politicians and planners regularly misjudge actual supply curves. This misjudgment reflects the fundamental information problem that all politicians and planners face. They can only imperfectly know future prices, technologies, and manufacturers’ business strategies. For example, at US$800,000 per unit, missiles for the US Navy’s Zumwalt Class destroyers were much more expensive. Meanwhile, there was no political support for a budget increase, so most of the funds planned for vessel acquisition had to be reallocated. The remaining amount barely enabled the armed forces to purchase three destroyers, whereas planners had initially foreseen buying 28 (Defense News 2016). Austria publicly announced that it ponders selling off its 15 Eurofighter Typhoon fighter aircraft to Indonesia. Already in 2017, the government decided to retire the system from service, following severe misjudgments and disinformation about its true operating costs (Defense News 2020). Finally, different types of forecasting errors can occur simultaneously and interact with each other. On the one hand, they can cancel each other out. For example, planners can underestimate resource requirements, but they can still purchase additional units because prices are lower than expected. However, such effects are

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p

A‘

p*

A

Δp8

pplan

Δp7

Δq7 qplan

q*

q

Fig. 3.7 Consequences of sudden escalation

random outcomes and not the result of risk management or contingency planning. On the other hand, forecasting errors can exponentiate. For example, suppose a sudden and unpredictable escalation of the threat scenario increases the demand for resources, while the arms industry reacts to this novel demand with price increases.4 Figure 3.7 illustrates this case from the planner’s perspective, assuming that planners originally forecast an endowment of qplan. As the required resource endowment grows to q*, it exceeds the originally planned endowment by Δq7. At the same time, supply is more expensive than expected because it no longer follows curve A but A’ instead. The financial shortfall thus amounts to Δp8 (and not just to Δp7). Figure 3.8 illustrates the opposite case of an unexpected easing of the threat scenario. Suppose that planners had expected the known threat scenario to continue and therefore had planned for a resource requirement of qplan. De-escalation would then cause the demand for military capabilities to shrink, such that the optimal resource endowment is reduced to q*. As a result, the material endowment of the armed forces is oversized by Δq8. Meanwhile, the de-escalation reduces the global demand for arms, so that the supply curve shifts 4 There is no guarantee that arms producers will meet this demand at all, as they might also internationally ration their production volume, or auction it to the highest bidder.

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3 Effectiveness of Military Performance p

A

pplan

A‘ Δp9

p*

p0

Δq8 q*

qplan

q

Fig. 3.8 Consequences of sudden de-escalation

from A to A’. The combined result of the effects is a ‘peace dividend’ of Δp9, i.e., significant authorizations to spend that had been approved in the past. Politicians now have an incentive curb and revoke these authorizations as they reallocate funds in the national budget. Furthermore, they likely reduce the defense budget in all subsequent budget periods until the threat scenario escalates again. For example, after the Eastern Bloc collapsed in 1989 and the Soviet Union dissolved in 1991, a phase of global de-escalation began and lasted until 2014. This development caught by surprise both intelligence analysts and planners; therefore, it affected armed forces in Western Europe in an unexpected way. The budget cuts that followed over the two subsequent decades significantly reduced both the material endowment and the number of combatants in those armed forces. It was not until Russia’s annexation of the Crimea in spring 2014 and the subsequent Ukrainian crisis that analysts and planners were caught off guard again, and a new cycle of spending and generation of military capabilities began. Both examples demonstrate that contemporary history can obsolesce military planning at any time, and neither planners nor politicians can predict such exogenous shocks with any certainty.

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3.2.2

79

Reduced Dynamic Adaptability

In principle, the armed forces seem to be subject to the same strategic problems as private firms and entrepreneurs. Just as the institutional legitimization of an armed force does not create military performance, entering a company in the commercial register is not equivalent to profitability. Planners cannot know the future effectiveness of military capabilities, and entrepreneurs cannot know the extent to which goods and products will sell profitably (if at all). Both groups can over- and underestimate the material and human resources required for production, as well as the sales prices of any goods and services these produced. Both public and private sector organizations are subject to the same basic information problem, and both cannot prevent that forecasting errors occur. They differ, however, regarding their ability to correct forecasting errors and misjudgments. In a market economy, forecasting errors can be corrected much quicker than in a planned economy system. In the latter, the correction of such errors is slow, subject to high transaction costs, and in the absence of a selection environment, it can even not happen. As a result, the extent to which military organizations can dynamically adapt to unforeseen developments, technological change, and exogenous supply and demand shocks is much lower than among private-sector firms. This difference can be expressed in terms of the dynamic capabilities an organization possesses. When a private firm has dynamic capabilities, it can flexibly reconfigure existing routines and resources, thus adapt production to unforeseen changes in factor and goods markets (Grant 1996; Pisano 1994; Eisenhardt and Martin 2000). Only firms that manage to adapt to ever-changing markets and environments are likely to survive in the long term (Henderson and Cockburn 1994; Teece et al. 1997; Nelson and Winter 1982). They must therefore continuously create novel capabilities and unlearn those that have become irrelevant to their current line of business (Teece et al. 1997; Eisenhardt and Martin 2000; Helfat and Peteraf 2003). Armed forces must also adapt their capabilities as they respond to changing threat landscapes. In particular, technological change requires that armed forces continually adapt their equipment and training routines (McNeill 2013). As the effectiveness of any military capabilities depends on such continuous adaptation, sustained military performance is very much a question of the ability to adapt and change. This goal, however, is difficult to achieve, as the information required to orchestrate change is only generated with much delay. In the private sector, firms receive continuous and real-time information from points of sale about the performance of their goods and services, and they have timely information about costs and expenses. They can quickly assess the extent to which their business planning is in line with market realities. If they fail to reach their objectives, they can define measures to increase revenues or cut costs. Among armed forces, such objective information is generated only during of military conflicts or if evidence of significant ineffectiveness or inefficiency is made public. Therefore, feedback on the efficiency with which the armed forces efficiently generate and effectively deploy military capabilities is not frequently available. Even if the armed

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forces are willing to change, they cannot define the direction of this change unless they identify the causes of any ineffectiveness or inefficiency. In the absence of timely information, views about the origins of and solutions for these causes differ and are subject to political discussion. Due to the lack of property rights in a planned economy system, there is no direct incentive for change, even if planners or combatants discover disparities between planned and actual capabilities. Private firms and entrepreneurs, who compete in markets, suffer business losses if they fail to adapt to changing market environments. For them, erroneous sales forecasts are equivalent to lost profits or business loss. As customers buy from competitors, sales decline, whereas operating costs remain stable hence profit declines. Firms that fail to adapt first struggle to cover their fixed costs. Opportunities to fund investments decline with profit, and the firm gradually loses its competitiveness. In the end, it can no longer generate enough working capital to maintain daily operations. As cash reserves in private firms typically do not cover more than a few weeks of operations, the threat of this downward spiral strongly disciplines private firms and entrepreneurs to constantly survey markets for changing consumer preferences and demand. As property rights are private, firms cannot impose any losses implied by failing to do so onto taxpayers. In contrast, armed forces under a planned economy setup do not have property rights, and the economic consequences of both inefficient and ineffective military performance are socialized, i.e., imposed on taxpayers. Therefore, neither planners nor politicians have an incentive to press for immediate adaptation to changing environments. Private firms do not enjoy any institutionally guaranteed existence; on the contrary, superior competitors can force them to exit the market at any time. Therefore, as environments change, individual entrepreneurs and firms have strong incentives to exploit any opportunities to make profits. There is no such profitmaximization calculation under a planned economy system, and information about inadequate efficiency does not directly entail any adjustments (Boettke et al. 2007). Even if the armed forces recognize the need for change and are willing to adapt, the bureaucratic administration of all the economic processes involved in the process makes any adaptation slow and subject to significant transaction costs. Under a planned economy system, the normal budgetary process is already fraught with long delays between initial planning and political budget approval (Mayer 1992). Many lower-level institutions have to be adapted to implement the desired change. Institutional change, however, is not free of charge. Existing institutions create path dependencies that must be overcome before any change is effective (Boettke et al. 2008). If laws, doctrines, or constitutional articles need to be adapted, the change is subject to prior political approval. Moreover, significant institutional change is unlikely unless during favorable windows of opportunity, specifically when a phase of political change and subsequent institutional reform replaces the inertia of ‘politics as usual’ (Buchanan 1990). Individuals inside the military organization also might want to preserve the current inventory of institutions. They therefore resist any change related to their own post, job, or domain, even if they accept the need for change at the

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7%

6%

5%

4%

3%

2%

1%

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

0%

FRA

GER

USA

UK

Fig. 3.9 Path dependency of defense spending

organizational level. Private firms have little tolerance for such resistance. The entrepreneurial interest in profit maximization quickly cuts off resource supply for unprofitable activities (Wagner 1989). However, in a planned economy, power struggles among planners shape the decision about which routines to maintain, change, or abandon. As prestige, personal power, and dominant positions are much more important than material rewards in all sorts of organizations (Barnard 1938); especially in bureaucracies, struggles for power and prestige in times of change can come at the expense of future military effectiveness. All of these problems make military organizations change slowly, hence they are constantly ‘out of phase’ with contemporary threats. Decades can pass between the recognition of a need for change and the completion of the change process. In the meantime, the initial threat scenario will already have evolved again. As a result, the change that was just completed is already obsolete, and novel change is required. Military organizations under a planned economy system therefore only ever prepare for ‘yesterday’s war’ (Echevarria 2016). Change among armed forces is subject to long-term cycles of growth and contraction. Figure 3.9 illustrates this problem. It shows the ratio of defense spending to GDP for France (FRA), Germany (GER), the United States (USA), and the United Kingdom (UK). After the end of the Cold War, these countries all reduced military spending significantly. Similar trends began in Asia, the Middle East and Oceania (SIPRI 2017). Once the threat situation changes again, politicians approve

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novel budget growth only with much delay. Budget growth is politically more difficult to justify than budget cuts, because it takes a 100% budget increase to reverse a 50% budget cut. Assuming an index value of 100 for any given defense budget, a reduction of this budget to an index value of 70 over the course of ten years would require an absolute reduction of 30% and an annualized reduction of 3.5%. Starting from an index value of 70, a return to the original nominal value of 100 takes an absolute growth of 42.86% or an annualized growth of 3.6%, without considering compounded inflation. As the armed forces have no property rights in a planned economy system, the ‘peace dividend’ earned during such reduction phases cannot fund future investments once the threat scenario escalates again. On the contrary, during such phases politicians lobby for majorities that advocate alternative spending of these funds. As a result, they are no longer available if an increase of the defense spending increase is required again. Therefore, it is extremely costly to reverse the effects of long-term dependencies, and the related change and adaptation armed forces have to undergo takes a long time. As a result, under a planned economy regime, it takes much longer to expand armed forces than to reduce them (Gupta et al. 2002).

3.2.3

Limited Factor Substitution

Armed forces can generate the same military capability with different combinations of capital (i.e., material resources such as military equipment, civilian goods, real estate, and infrastructure) and labor (i.e., combatants, civilian workforce). Figure 3.10 illustrates this basic relationship; the isoquant represents a constant output level, i.e., a particular strength or intensity of the military capability in question. All points that lie on the isoquant represent the same level of production output. Whenever capability generation becomes more capital intensive, machinery and equipment replace human labor, and the opposite substitution occurs when capability generation becomes more labor intensive. The combination (K1, L1) illustrates the case where technological systems that require few human operators generate a particular capability. The combination (K2, L2) shows an alternative way to produce it with a numerous workforce that has little or low-tech equipment. Although the foundation of a military organization defines initial labor and capital intensities, neither is permanent. First, doctrinal reform involves adjusting labor and capital intensities. For example, as threat scenarios change, armed forces may prioritize interventions abroad by Special Forces. This decision is linked both to a reduction in the number of combatants (labor intensity) and to an increase of transportation equipment (capital intensity). Second, any particular combination of capital and labor is subject to technological change regularly creates novel and obsolesces extant capabilities. As they respond to this change, armed forces might have to adapt the capital or labor intensity of their capability generation. For example, the massive use of archers equipped with a novel

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83

K

K1

K2

L1

L2

L

Fig. 3.10 Different factor combinations for the same output level

technology—the longbow—enabled English troops to realize decisive victories in the battles of Crécy (1346) and Agincourt (1415), despite the fact that the military capabilities of the French (heavy armored cavalry) were significantly more capital intensive. Similarly, the development of tanks and fighter aircraft during the twentieth century emphasized capital-intensive capabilities, whereas the Napoleonic wars were fought with mass armies that were relatively lightly equipped. Third, enemy capabilities can force the military organization to implement specific factor substitutions. For example, if an opponent’s capabilities become more technology intensive, the armed forces must either adapt their own capability generation to a higher technology level (substitution of labor by capital), or resort to asymmetrical tactics (substitution of capital by labor). While the first option requires significant upfront investment, the second can begin spontaneously. This effect explains the emergence of clandestine and partisan armies whenever an opponent operates on a superior technology level, such as the Minute Men of the American Revolution, the Polish underground force Armija Krajowa during World War II, the Vietcong in the Vietnam War, and the Mudjaheddin during the Soviet invasion of Afghanistan.

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3 Effectiveness of Military Performance K

A

K*

B

Kmax

C

Kmin

L*

Lmin

Lmax

L

Fig. 3.11 Limited factor substitution

In both cases, the question is not so much whether labor replaces capital or vice versa, but whether this substitution is at all possible within an acceptable period. Military performance does not require that the ratio of capital to labor input remains constant over time, but this ratio must be adaptable to changing threat environments, doctrinal reform, and technological evolution. The ease with which the organizations can acquire, recombine and divest human and material resources is crucial for this adaptability. Under a planned-economic system, the ability of armed forces to implement such change is severely limited. Labor cannot be arbitrarily replaced by capital, as planners must determine a minimum number of combatants. In a private firm, the number of employees is not limited or subject to bureaucratic planning, rather it fluctuates with the firm’s economic situation. Entrepreneurs can freely determine the labor intensity of their firm and substitute labor by capital at will, provided they can fund investments required for this substitution. In contrast, planners can reduce labor only to the extent that the minimum number of combatants required by law or strategic planning is not undercut. Figure 3.11 illustrates this effect. Under a planned economy system, the substitution of labor by capital is limited by the lower limit Lmin. Unless institutional reform downsizes the number of combatants, capital intensity cannot grow beyond Kmax, hence factor combinations to the left of point B, such as the one given by (K*,

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85

L*) cannot be realized. Planners not only face a lower but also an upper limit of labor intensity, hence there are further limits to the substitutability of capital by labor. The total number of those citizens who are fit for military service and have not left the military sector or the country defines the maximum labor supply.5 Hence, there is an upper limit Lmax that makes factor substitutions to the right of point C infeasible, and capital intensity cannot fall below Kmin. If the structure of the military organization is based on the number of combatants, these upper and lower boundaries restrict all feasible capital intensities to the interval between Kmin and Kmax. This problem exists independently of whether combatants are conscripts or professionals. However, whenever combatants are conscripts, the substitutability of labor by capital is limited even further by two additional factors. The relative price of conscripted labor is heavily biased. Since conscripted combatants receive negligible pay in comparison to hours worked, only a fraction of their civilian wage is reimbursed (if any). As a result, any work they do is not compensated at competitive wages; instead, this work subsidizes the armed forces as marginal productivity exceeds marginal wages by far. As a result, downsizing the number of conscripted combatants generates only modest cost savings. These could be insufficient to finance any corresponding investments that are supposed to substitute conscripted labor for technology-intensive systems. Capital-intensive production is technologically more complex than laborintensive production. For example, the operation of capital-intensive weapon systems, such as combat aircraft, requires intensive education, technological expertise, and continual training. Conscripted combatants might not be numerous or qualified enough to generate the required capabilities, so that temporary or professional personnel must substitute for conscripts. As the professionals earn significantly higher salaries, this substitution is costly hence possible only to a limited extent. There are then three options for solving this problem: abandon substitution in favor of capital-intensive goods, reduce the technological intensity of capability generation to a level that conscripts can still operate, or abandon conscription. The lack of property rights in a planned economy aggravates these problems. The reduction of any labor input does not imply that funds can be reallocated to acquire capital-intensive goods; on the contrary, the authorizations to spend (in this case, to pay wages and benefits) simply expire. Whenever the dismissal of personnel is not or cannot be compensated by a corresponding increase in capital intensity, it is not factor substitution that follows, but capability degradation. Figure 3.12 illustrates this problem. Figure 3.12 illustrates a case where an institutional reform of the armed forces reduces the number of combatants from L1 to L2. If the output defined by point A 5 Until the middle of the nineteenth century, combatants in Europe regularly served in foreign armies. For example, German commanders Clausewitz, Gneisenau, Scharnhorst and Yorck temporarily served in the Russian Armed Forces. Today, however, the idea of the French Revolution that only citizens can join the national armed forces has prevailed. Contemporary exceptions to this rule are, for example, the armed forces of Luxembourg or the French Foreign Legion, which also or exclusively accept foreigners as combatants.

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3 Effectiveness of Military Performance K

B

A

L2

L1

K1= K2

L

Fig. 3.12 Capability degradation due to imperfect substitutability

were to remain constant, an increase of K1 would be required so that point A can move upwards along the isoquant. However, there is no such increase, as the authorization to pay wages and benefits simply expires and there is no novel authorization to invest. As a result, the capital intensity after the reform (K2) still corresponds to that of before the reform (K1). This new factor combination of (K2, L2) makes the isoquant shift to a lower output level defined by Point B. As the isoquant runs closer to zero, capability generation degrades.6 Finally, combatants might also want to maintain their number to preserve their interests, irrespective of whether or not any factor substitution towards a higher capital intensity would be advantageous from an economic or military perspective (Owen 1994). From the perspective of military commanders, any reduction of the combatants they command, let alone a dissolution of any troops, causes a loss of prestige and calls into question both the existence of such commanders and the usefulness of any military capabilities they generated (Hartley 1995).

6

Arithmetically speaking, this effect increases the equipment ratio, because fewer combatants now share the same number of systems. However, capability generation still degrades since there is no compensation for the decrease in labor input.

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The substitution of capital by labor is also problematic, especially under a planned economy. As the armed forces have only authorizations to spend, but no cash, buildings and systems lock up all capital. Any substitution of capital by labor therefore first requires the liquidation of weapons systems, infrastructures, and real estate in order to free up funds. This liquidation is complicated as military equipment has a high asset specificity. Whereas the private sector will buy civilian goods such as vehicles, construction or office equipment, armaments, military real estate (e.g., barracks, airfields) and infrastructure (e.g., dams, NBC shelters, bunkers, etc.) are much more difficult to liquidate.7 In particular, real estate is often located outside of residential areas; consequently, conversion into civilian real estate is costly. Unless specialized firms can convert military installations to bunkers or production sites, civil demand for such objects is low. The arms industry has no interest in buying back weapons systems. Legal secondary markets for arms exist only to a very limited extent, and they are subject to international non-proliferation control. The opportunities to sell off used weapons systems to generate free funds are therefore very limited. As only nation states consume capital-intensive assets, such as fighter aircraft or tanks, the number of buyers is small and any bargaining power is minute. The liquidation of capitalintensive goods is also difficult for technical reasons. For example, whenever arms manufacturers customize weapons systems for specific usages or terrains, other states might find it difficult to put such systems to good use in their particular contexts. When military equipment is demilitarized, liquidation costs often exceed the residual value of usable components or scrap metal. Finally, institutional barriers must be overcome before liquidation can take place. For example, in Switzerland, any divestment of military real estate is subject to prior inspection and authorization in accordance with the Ordinance on the Planning Approval Procedure for Military Buildings and Installations (SR 510.51). Even in the event of a successful liquidation, due to the lack of property rights under a planned economy system, such freed-up funds cannot readily fund novel investments. For example, when a company sells machinery in order to buy commercial real estate from the proceeds, there is no balance-sheet contraction, simply an asset swap. In a planned economy, this liberal reallocation of capital is impossible. As the nation state holds the property rights for all military assets, any proceeds from the liquidation of such assets go to the national budget (not the defense budget). At the time of sale, the extent to which the armed forces are reallocated these proceeds in future defense budgets is unknown because politicians will lobby for alternative investments. This uncertainty annihilates the very basis of any factor substitution, namely, the possibility to reconfigure the resource base (Helfat 1997). Figure 3.13 illustrates this effect. It illustrates a repeated reduction of capital intensity from K1 to K4. After each reduction, liquidation proceeds flow back to the national budget while the defense budget remains constant. Given a constant

7 Provided that these assets have not yet been fully depreciated, such that a residual value still exists that may generate positive liquidation proceeds.

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K1

A

K2

B

K3

C

K4

D

Lkonst

L

Fig. 3.13 Capability degradation due to missing property rights

combatant number of Lkonst, capability generation continuously degrades as the isoquant moves closer to zero through points B, C and D. Combatants typically resist the liquidation of assets and the closing of military sites (Hartley 1995). Traditionalists can lobby political support for such resistance by arguing that any operational material should be maintained and deployed, even if it is ineffective against superior enemy technology. As long as such irrational resistance exists, any attempt to liquidate assets comes at high transaction costs that further reduce the expected proceeds. Even if it is possible to use liquidation proceeds to hire additional combatants, there is no guarantee that a qualified labor force will be available. The substitution of capital by labor can fail if the national labor supply that is willing to migrate into the military sector is insufficient in terms of quality or quantity, or both. Skilled members of the civilian labor force could be unwilling to leave the private sector. As state pay scales define all salaries and benefits in the military sector, the armed forces cannot freely negotiate competitive wages that might poach employees from the private sector. As a result, the supply of highly skilled labor can be zero whenever specialists refuse to leave the private sector. Planners might also misjudge their willingness to do so, as private sector employees not only consider real wages

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but also the opportunity costs of leisure and lost civilian lifetime income (Percia David et al. 2019). Unless they can offer competitive advantages not available in the private sector, the armed forces must pay much higher wages or offer superior job or social security to offset this calculation. Planners also tend to underestimate the speed with which individuals, in order to develop their professional qualification, change vocational engagements. It is therefore particularly difficult to make experts in technology- and knowledge-intensive professions commit to state-run armed forces whose bureaucratic procedures decelerate innovation and adaptation. Once they face this adverse selection, the armed forces can attempt to use institutional innovations to improve their attractiveness, as military and private sector institutions compete for labor supply (Pejovich 2003). For example, the United States Armed Forces introduced the GI Bill to provide combatants with free tertiary education at the end of their commission. If they fail to implement such innovations, the armed forces can only reduce job requirements thus accept capability degradation. From a purely technical perspective, factor substitution is unlimited. Any combination of labor and capital is feasible, even a combination of a minimum of labor with a maximum of capital, or vice versa. The problem is that a planned economy organization creates significant rigidities that hinder or completely impede factor substitution. The delays in dynamic adaptation that go with these rigidities considerably reduce the effectiveness of any military capabilities. The assumption that the production factors labor and capital are divisible at will, perfectly mobile, and substitutable with constant elasticity (Varian 2014) is therefore inappropriate, at least for state-run armed forces.

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Echevarria AJ (2016) Rediscovering US military strategy: A role for doctrine. Journal of Strategic Studies 39:231-245 Eisenhardt KM, Martin JA (2000) Dynamic capabilities: What are they? Strategic Management Journal 21:1105-1121 Fitzgerald AE (1989) The Pentagonists: An insider’s view of waste, mismanagement, and fraud in defense spending. Houghton Mifflin, Boston Fortune A, Mitchell W (2012) Unpacking firm exit at the firm and industry levels: The adaptation and selection of firm capabilities. Strategic Management Journal 33:794-819 General Accounting Office (2019) Report GAO-19-570 (Future warfare). Office of Public Affairs, Washington DC General Accounting Office (2017) Report GAO-17-317 (High risk series). Office of Public Affairs, Washington DC Goodwin P, Wright G (2010) The limits of forecasting methods in anticipating rare events. Technological Forecasting & Social Change 77:355-368 Grant RM (1996) Toward a knowledge-based theory of the firm. Strategic Management Journal Summer Special Issue 17:109-122 Gupta S, Clements B, Bhattacharya R, Chakravarti S (2002) The elusive peace dividend. Finance and Development 39:49-51 Hannan M, Freeman J (1984) Structural inertia and organisational change. American Sociological Review 49:149-164 Hartley K (1995) Industrial policies in the defense sector. In Hartley K, Sandler T (Eds) (1995) Handbook of defense economics. Elsevier, Amsterdam et al., 459-489 Hartley K (2007) The arms industry, procurement and industrial policies. In Sandler T, Hartley K (Eds) Handbook of defense economics. Elsevier, Amsterdam et al., 1139-1176 Helfat C, Peteraf M (2003) The dynamic resource-based view: Capability lifecycles. Strategic Management Journal, October Special Issue 24:997-1010 Helfat CE (1997) Know-how and asset complementarity and dynamic capability accumulation. Strategic Management Journal 18:339-360 Henderson RM, Cockburn I (1994) Measuring competence: Exploring firm effects in pharmaceutical research. Strategic Management Journal, Winter Special Issue 15: 63-84 Jobse L (2019) Austro-Daimler Panzerautomobil. Online from www.tanks-encyclopedia.com Kim YW, Brown T (2012) The importance of contract design. Public Administration Review 72:687-696 Mayer KR (1992) Elections, business cycles, and the timing of defense contract awards in the United States. In Mintz A (Ed) (1992) The political economy of military spending in the United States. Routledge, New York, 15-32 McNeill WH (2013) The pursuit of power: Technology, armed force, and society since AD 1000. University of Chicago Press, Chicago Moulton JL (1971) Defence planning: The uncertainty factor. Long Range Planning 3:50-53 Mowery D (2012) Defense-related R&D as a model for ‘grand challenges’ technology policies. Research Policy 41: 1703-1715 Nelson RR, Winter SG (1982) An evolutionary theory of economic change. Belknap Press, Cambridge Nielsen SC (2010) An armed forces transformed: The U.S. Armed forces’s post-Vietnam recovery and the dynamics of change in military organisations. U.S Armed forces War College, Carlisle Owen N (1994) How many men do armed forces need? An international comparison. Defence and Peace Economics 5:269–288 Pejovich S (2003) Understanding the transaction costs of transition: It’s the culture, stupid. Review of Austrian Economics 16:347–361 Percia David D, Keupp MM, Marino R, Hofstetter P (2019) The persistent deficit of militia officers in the Swiss Armed Forces: An opportunity cost explanation. Defence and Peace Economics 30: 111-127 Pickover CA (1998) Time: A traveler's guide. Oxford University Press, New York

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Pisano GP (1994) Knowledge, co-integration, and the locus of learning: An empirical analysis of process development. Strategic Management Journal, Winter Special Issue 15:85-100 Reinhardt JR, James JE, Flanagan EM (1999) Future employment of UAVS: Issues of jointness. National Defence University, Washington DC Schwenn, K., Colombi, J., Wu, T., Oyama, K., Johnson, A. 2015. Toward agent-based modeling of the U.S. Department of Defense acquisition system. Procedia Computer Science 44: 383-392 SIPRI (2017) Military expenditure by country as a percentage of gross domestic product, 19492016. Electronic data from www.sipri.org Smirnoff JP, Hicks MJ (2008) The impact of economic factors and acquisition reforms on the cost of defense weapon systems. Review of Financial Economics 17:3–13 Solomon B, Chouinard P, Kerzner L (2008) The Department of National Defence strategic cost model, volume II – theory and empirics. Defence R&D Canada-CORA, Ottawa Stulberg AN (2007) Managing the unmanned revolution in the US Air Force. Orbis 51:251-265 Teece DJ, Pisano G, Shuen A (1997) Dynamic capabilities and strategic management. Strategic Management Journal 18:509-533 Tripsas M, Gavetti G (2000) Capabilities, cognition, and inertia: Evidence from digital imaging. Strategic Management Journal 21:1147–1161 Varian H (2014) Intermediate microeconomics: A modern approach. W.W. Norton & Co, New York Vaubel R (1999) Enforcing competition among governments: Theory and application to the European Union. Constitutional Political Economy 10:327–338 Wagner R (1989) To promote the general welfare. Pacific Research Institute, San Francisco

Chapter 4

Efficiency of Military Performance

4.1

Opportunities and Limitations for Efficiency Gains

Effectiveness is a necessary but not sufficient condition by which analysts must judge military capabilities. Their assessment must also consider the efficiency with which combatants generate them, i.e., the relationship between capabilities created and the resources consumed during this creation. Efficiency is therefore a measure of the extent to which time, material, and human resources are transformed into productive outcomes. Low efficiency is always a sign that the economic principle was violated (squandering of inputs, unproductive use of working time, wastefulness, inferior technology used, etc.). The less material and human resources are used to generate any given intensity and quality of military capabilities, the more efficient this creation is. An efficiency assessment analyzes only the production side and makes no conclusions about the effectiveness of the capabilities. As a result, a full assessment of military performance must consider both its effectiveness and its efficiency.1 An efficiency analysis requires that performance outcomes and resource inputs are set in relation to each other. Both variables must be objectively measurable, but they can have different units of measurement, including non-monetary ones. For example, investors can measure the efficiency of their strategy in monetary terms by comparing real returns to capital employed. In this case, the efficiency measure is a percentage, namely, yield. For example, a car manufacturer can measure production

Caveat emptor! (Purchaser, be vigilant! (Precept of the Roman right of purchase: the purchaser has the responsibility to complain to the seller about any defects of the goods or services purchased)) 1

The (presumed) saying of Pyrrhus after the Battle of Ausculum (‘another such victory, and we are lost’) illustrates this consideration. The battles of the Somme (1916) and Verdun (1916) are also examples of extreme disparities between resource input and operational success.

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. M. Keupp, Defense Economics, https://doi.org/10.1007/978-3-030-73815-0_4

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efficiency by measuring vehicles produced per hour, thus the use of monetary variables is not required.2 In principle, such comparisons are also possible in military organizations by recording the time and personnel required to produce a fixed and measurable performance outcome. In organizational practice, the repeated measurement of these outcomes creates performance standards for acceptable time and resource inputs required to complete a particular task (Taylor 1914, 2004). Armed forces are notorious for applying such Taylorist measurement because they strive to make the performance evaluation independent of the individual who executes the task in question. As a result, they measure both mundane (e.g., time to make a bed or polish boots) and complex tasks (e.g., time and personnel required for an aircraft sortie) according to this principle. Military organizations can also compare monetary and non-monetary variables as they assess the efficiency of their capability generation. There is no need to speculate about the extent to which (if any) this production can be valued in monetary terms. Indeed, an efficiency analysis does not necessarily require information about what the output produced is worth, but provides only information about the resources consumed during production. Military organizations are alike to all organizations whose resource consumption is measurable in monetary terms while their production output is immaterial (e.g., police, firefighters, non-profit organizations, schools, universities). In the private sector, the research and development departments of firms whose business models rely on innovation generate measurable personnel and operating costs, but there is considerable leeway when it comes to valuing the intellectual property they produce. Nevertheless, managers can measure the efficiency of this production (e.g., by calculating total cost per patent). Military organizations can only partially assess the efficiency with which they generate capabilities. Although they are relatively successful at judging the efficiency with which time is used, they find it difficult to assess cost. The textbook approach of cost accounting is to distribute the costs of all material and human resources used to generate a specific capability over the total production volume, such that relative prices are obtained (e.g., cost per flight hour). If the costs of any resource consumption can be determined objectively and comprehensively and distributed correctly over the production volume, an organization can accurately price production cost. However, in military organizations, combatants find it hard to objectively assess and distribute total cost. The cost structure of military organizations is mainly in the form of overhead costs, i.e., total costs are incurred by many different cost units, which makes a clear allocation difficult. For example, service providers within the armed forces globally provide IT services, command support, logistics, and administration to the armed forces, but a particular military exercise of unit only consumes a fraction of these services. Therefore, controllers must create distribution keys that allocate the respective costs to individual consumers. They face the challenge of calculating hourly

2

Assuming a homogeneous and consistent product structure and quality.

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usage rates for armaments, real estate and infrastructures, as well as imputed costs per hour worked. The analytical quality of these calculations depends on a complete census and a reasonable allocation of all overhead cost. These calculations are significant when it comes to evaluating the resource consumption for a complex military performance that involves the deployment of many capabilities. For example, judging the efficiency of a seaborne maneuver that involves dozens of vessels over several days is far from trivial. First, this assessment requires the full identification of all capabilities deployed during the maneuver. Then, controllers must measure and distribute the specific consumption of all human and material resources consumed during the deployment of these capabilities. They must evaluate any overhead costs incurred by consuming support and administration services and factor them in by calculating hourly or daily rates. Finally, they should factor in the impairment and loss of any civilian and military materiel. These calculations can entail significant measurement errors and delineation problems, thus the costs for a specific military performance cannot be calculated but by arbitrary assumptions, even though the total sum of all overhead costs is known at the organizational level. However, the calculation of these figures merely generates knowledge about costs. This knowledge does not yet enable the armed forces to judge the efficiency of capability generation since cost center accounting assigns cost types to cost units. Although this distribution provides transparency about the causality of costs, it cannot determine whether any costs attributed to the generation of a specific capability are adequate, too high or unnecessary. Even under the assumption that the calculated cost figures are reliable and objective, the allocation of overhead costs is not equivalent an efficiency assessment. Once they have calculated cost figures, combatants must decide if these are competitive, appropriate, or too high. Only this relative comparison reveals any inadequate use of scarce resources. An assessment of what is ‘too high’ therefore requires reference values. If no such values exist, combatants can still make intertemporal comparisons by comparing cost figures of the current budget period to those of prior periods. However, such comparisons require consistent measurement of both output levels and production times. Still, even such repeated observation cannot identify a continuously inefficient production. Benchmark values are therefore required. However, an assessment based on such benchmarks is problematic in a military organization when monetary, rather than temporal units, are to be compared. A firm can, at least within its industry, make direct comparisons with its competitors and draw conclusions about the efficiency of its production. For example, it can determine whether competitors manufacture similar goods with fewer human or material resources. This direct comparison is not easily possible for military organizations. Combatants cannot easily compare capability generation across armed forces worldwide, because both capital and labor intensities as well as doctrines and threat scenarios differ. Finally, international comparisons involve significant transaction costs, and required data may be classified.

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Comparisons with the private sector are only possible to a limited extent. On the one hand, for many military capabilities, there are no related goods or services— such as the use of force—hence no market prices for these services exist.3 On the other hand, a military organization also produces outputs that hardly differs from those used in civilian production (e.g., construction work, property maintenance, logistics and mobility services). These two extremes define a continuum that indicates the extent to which military production is similar or not to production in the private sector. The more this is the case the more likely it is that market prices for comparable goods and services exist. Once controllers reduce these by the profit margin earned in the respective industry and VAT, they can estimate production cost relatively well. If this estimate differentiates between labor and capital inputs, they can also compare production efficiency. For example, they can divide the yearly salary and benefits paid to a specific combatant or civilian employee by the number of hours worked. Thus, they can compare hourly labor-cost rates to competitive wages in the private sector. They can also assess the amount of hours required to produce a specific output at a particular quality level. If firms in the private sector can produce a similar output faster, with fewer resources, or at a higher quality level, there is leeway to improve the efficiency of the military organization. Although it is unlikely that armed forces under a planned economy regime will ever achieve the efficiency of a private firm, the comparison with the private sector enables the armed forces to, at least, roughly evaluate the extent to which their capability generation is efficient. Empirical studies suggest there is much room for improvement. The quality of the output military organizations produce is not only inferior to private-sector production, but they also consume much more resource input while producing it (Lurie 2016; Government Accountability Office 2010). Even obvious inefficiency does not force military organizations to adapt because institutions guarantee their existence. Within their nation state, there is no other producer of military capabilities with whom they would have to compete. Any savings made by of efficiency improvements simply generate unused authorizations to spend that expire by the end of the budget period. Hence, neither combatants nor planners have any intrinsic motivation to improve efficiency, even if costs are known and attributable. Well-meant proposals for adapting optimization methods that are widely used in the private sector, such as life-cycle costing (e.g., Navarro-Galera and Ortúzar Maturana 2011) or strategic sourcing (e.g., Apte et al. 2011) are bound to fail under a planned economy regime, and the intended efficiency improvement is unlikely to ever materialize. An efficiency analysis makes sense only if leaders use it to enforce adaptation and change. Indeed, the calculation of any cost figures is costly in itself, as it requires the

3

Contemporary private military companies cover only a fraction of the services provided by a military organization. In particular, they rarely offer a massive use of force or heavy weapon systems.

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acquisition of IT systems and the employment of controllers who perform these calculations. These investments represent sunk costs, as the armed forces cannot recuperate any funds spent on controllers’ salaries and IT systems. Therefore, a private firm will not hire controllers, until it is sure that they can spot opportunities for cost savings that exceed this expenditure. A firm invests in cost accounting because it hopes to optimize its production processes and resource inputs. In order that production can be adapted, efficiency analyses identify unproductive resource inputs or excessive resource consumption. Private firms will downsize, restructure, or close any business units whose production fails to meet efficiency targets. The savings realized by these measures amortize prior investments in cost-accounting systems. Therefore, it is not the calculation of figures that improves efficiency, but the entrepreneurial action that these figures inform and enable. Leaders must make hard decisions if they want to realize efficiency improvements. They must consider reducing the number of combatants and civilian staff, closing sites, or discontinuing the use of infrastructures. Unless leaders are ready to enforce efficiency improvements, even against resistance to change, efficiency analyses are useless. Nevertheless, armed forces have been experimenting with cost accounting methods for decades. For example, the U.S. Department of Defense has done so since at least 1975 (Ansari and Euske 1987), and the German Armed Forces began doing so in 1993 (Richter 2007; Kern and Richter 2014). The extent to which these efficiency analyses have ever generated any economic benefit remains questionable. Even in 2015, i.e., after forty years of experience, The U.S. Department of Defense was incapable of doing proper cost accounting (Government Accountability Office 2017). Production efficiency can be improved only if the same output can be produced with fewer resources, or if the same resource input can generate better or more production output. In principle, bureaucratic organizations should have much leeway for both types of efficiency improvements as their production is typically far off an (if imperfect) x-efficient production point (Peacock 1983).4 Beyond this point, each additional unit of human or material resources contributes nothing to the production outcome, so that such excess input could be reduced without negative repercussions. Figure 4.1 illustrates the possibilities to do so. The output designated by isoquant I1 can be efficiently generated at point A by the factor combination (K*, L*). If the military organization produces this same output with a capital input of K1 or a labor input of L1, production is inefficient (points B and C). Excess human (ΔL1) and material resources (ΔK1) can be reduced without any loss of production volume or quality until the optimum factor inputs of K* and L* are attained. Under the context of a planned economy, institutional reform and 4

The x-efficient point is the point of maximum resource efficiency under imperfect competition. Although imperfect competition causes actual efficiency to be lower than the theoretical optimum, the specific organization cannot increase its efficiency beyond this point unless it reorganizes or market conditions change. As armed forces typically have no competitors within the nation state, they should prefer x-efficiency to neoclassical efficiency.

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K1

C ΔK1

K*

D

A

ΔK2

B

E

K2

I1 I2 ΔL1

ΔL2 L2

L*

L1

L

Fig. 4.1 Reduction of inefficient factor input

overcoming resistance to change are required to enforce this reduction (Greenwood and Hinings 1996; Pentland et al. 2012). Combatants and civilian employees are state employees, so any reduction of their number is subject to the labor law institutions of the public administration. These can define significant barriers for layoffs and transfers, thus a long transition period and high restructuring costs (Smith et al. 1987). Even if excess staff is clearly unproductive, state employees receive their salary irrespective of their individual productivity. Due to the difficulties associated with the liquidation of arms and military infrastructure discussed in Chap. 3, the capital intensity of any armed forces only changes gradually. They might reduce the intensity with which they operate arms and systems in an attempt to reduce operating expenses. However, savings resulting from such reductions are limited, and they come at the price of capability degradation such as reduced readiness or sustainability. Fixed costs comprise more than 50% of the operating costs of many arms systems. Even if operations cease completely, the armed forces must continue to maintain decommissioned systems if they want to avoid capability degradation. Finally, whenever armed forces attempt to increase the efficiency of their capability generation by cutting factor inputs, they can involuntarily compromise effectiveness. The challenge of realizing efficiency improvements is to reduce excessive,

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but to maintain required factor inputs while keeping output levels and quality constant. If the armed forces fail to meet this constraint, they can involuntarily reduce factor inputs too much and hence find themselves on a lower output level. The problem is that the military organization does not know exactly where the x-efficient point is located because it lacks objective data to locate it. Figure 4.1 illustrates a case where the armed forces start out from point B and attempt to cut excessive labor input while keeping capital input stable at K*. As they reduce labor input not only by ΔL1 but also by ΔL2, they move beyond the x-efficient point A to a new factor combination designated by point D. However, with this new factor combination (K*, L2) only a lower output can be realized, hence the isoquant shifts to I2 that is closer to zero. An analogous solution is obtained if the armed forces start out from point C, attempt to curb excessive capital input, reduce this input not only by ΔK1 but also by ΔK2, move beyond the x-efficient point A, and find themselves at a lower output level in point E. In both cases, any return to the previous output level requires the armed forces to reverse this reduction by the difference between ΔL2 and ΔL1, or between ΔK2 and ΔK1. In organizational practice, this means rehiring the employees or combatants who were laid off but were of crucial importance for systems operation, and reacquiring or reactivating decommissioned systems and assets. Such reversals are associated with high transaction costs, as planners must provide additional incentives to win back disgruntled ex-employees, to make decommissioned systems operational again or to buy back any assets. If the factor input reductions have also nullified the respective authorizations to spend, planners cannot finance this reversal unless politicians create novel authorizations to spend. Until then, the reduced output level is permanent. A failed attempt to increase efficiency generates capability degradation and therefore reduces the effectiveness of military performance. Planners must therefore correctly estimate the productivity of both materiel and personnel, and they must clearly distinguish between unproductive and productive factor inputs. For example, if top performers are laid off, but unproductive combatants and administrative staff continue to be employed, the organization is bereft of valuable knowledge and skills that are hard to replace. Highly qualified specialists have a great deal of implicit knowledge that is difficult to document in writing and can only be transferred to new employees through prolonged social interaction (Nonaka and Takeuchi 1995). If the armed forces dismiss these specialists (if unintentionally), they can still hire replacements, but the implicit knowledge is lost. In times of recession, private firms reduce factor inputs or production volume, e.g., by layoffs, supply reductions, divestment of unprofitable business units or withdrawal from particular markets. In these cases, however, the reduction is conscious and intended. It follows that any production must be profitable in the end if the firm is to survive. In particular, the variation of factor inputs over time is a consequence of economic liberty. Managers and entrepreneurs decide if production should be increased or downsized, and they adjust factor inputs accordingly. Under a planned economy system, the armed forces cannot freely decide whether the organization should expand or downsize. However, at any time, political majorities can

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cut the defense budget, which implies involuntary downsizing, even if the associated reduction of factor inputs leads to capability degradation. The attempt to improve the efficiency of military organizations is problematic for fundamental reasons because there are conflicts between the effectiveness of military capabilities and the efficiency with which combatants generate them. Such conflicts exist with, but are not limited to, the creation of capacity reserves, armed forces logistics, location choice, and the design of military exercises. To keep stocks and maintain a constant storage of materials is expensive as stock locks up capital. A private firm must therefore accept high opportunity costs if it wants to be ready to deliver at all times. For this reason, a firm will finance only the minimum stock necessary to bridge the time between demand and delivery. In contrast, the military organization plans its capability requirements by specifying hypothetical conflict scenarios that require the immediate deployment of military capabilities. Irrespective of the extent to which these scenarios correctly predict future conflicts (if at all); they require the generation of military capabilities in the present. Since planners and military leaders take significant time to plan arms procurement and organize training procedures, armed forces operate with significant excess capacity in peacetime. As only a fraction of these capabilities is required in this present, this excess production is clearly inefficient but necessary to preserve the future effectiveness of military performance. As long as the true probability with which any particular threat will materialize is unknown, and as subjective political and doctrinal views differ regarding this probability, objective efficiency assessments are hard to make. This problem could be mitigated if military capabilities available in peacetime were offered in the market at competitive rates above production cost. This opportunity applies to military capabilities that, in particular, can also be used in the civilian sector (e.g., security services, logistics, pioneering, engineering, medical services and disaster relief). However, this deployment can be politically undesirable, as the military organization would compete with or even crowd out private sector production. Furthermore, many military capabilities, especially those that are expensive to generate, have a high asset specificity. Whenever capability generation in peacetime requires an excess capacity of heavy or complex weapons systems (e.g., combat aircraft, battle tanks), it is virtually impossible to amortize the related production cost as there is no demand for such assets in the private sector. The conflict between the effectiveness and the efficiency with which a military organization creates can only be resolved in theory. In order to optimize the efficiency of this creation, forecasting errors by planners and politicians would have to be minimized, so that planned scenarios would correspond perfectly to future threats. Only in this case would any contemporary output match future demand, hence there would be no excess factor inputs in the present. Neither planners nor politicians have objective knowledge about the future, so both find it hard to evaluate which military capabilities will be truly required in future conflicts. The more planners and politicians argue that any theoretically possible threat scenario could become reality, the more spending they would have to authorize for a comprehensive capability generation. Such an ‘all hazards’

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approach increases the likelihood that future military performance will be effective because capabilities for all possible scenarios will be generated, no matter how unlikely these scenarios are. This approach, however, is extremely inefficient, as excessive factor inputs are required in the present and only a fraction of the capabilities would actually be required in the future. A private firm that wants to be ready to deliver at any time, regardless of the customer’s location and the quantity ordered, must bear high logistics costs, as much stock reserves and regional warehouse and distribution structures are required for high delivery readiness. As a result, the efficiency of logistics operations is low; there is no way to increase it unless delivery readiness is reduced. Other conflicting objectives exist between the capacity utilization and the throughput time of a stock management system and between the adherence to delivery dates and optimal warehouse stock levels (Shen and Daskin 2005). Entrepreneurs have economic liberty and can therefore align business policy with customer preferences. If customers tolerate long waiting times or pay high rates for fast delivery, entrepreneurs emphasize the efficiency of operations. However, if customers prefer firms which offer rapid delivery, those firms with the highest readiness to deliver will outcompete all others, so that entrepreneurs must tolerate higher logistics costs. These conflicting objectives also exist in military organizations. Among both private firms and military organizations, demand for products and services triggers demand for logistics. In consumer markets, private consumption triggers logistics; in military selection environments, the deployment of capabilities requires the movement of material and personnel to the theater of operations. Despite this seemingly similar situation, military organizations cannot freely choose whether to prefer low logistics costs or high delivery readiness. Military logistics are considerably more expensive than civilian logistics. The armed forces require logistics outside civilian traffic and industry infrastructure. They often operate in rough terrain, where logistics must rely on specialized hence costly equipment. Civilian logistics do not operate in such terrains, either because there is no civilian demand, or due to security concerns. Military logistics are essentially closed-loop logistics. The focus of civilian logistics is on delivering goods and services, whereas returns are costly to handle hence undesirable. In contrast, military logistics are almost entirely a matter of returns. Combatants continuously require the maintenance and replacement of arms and civilian goods deployed during a mission. In a combat zone, complex logistics must transport them to the place of engagement, monitor and replace them and evacuate the wounded. Consequently, there are narrow limits to the trade-off between efficiency and effectiveness in military logistics (Rutner et al. 2012). The generally higher cost level, compared to civil logistics, cannot be reduced without reducing capability effectiveness. As a result, cost-cutting programs based on any benchmarks obtained from civilian logistics providers may endanger mission success. Decentralized warehouses enable a logistics firm to maintain stock close to customer locations, so that delivery is fast and transport costs are low. However, this regionalization entails high fixed-costs because firms must build or lease each

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local warehouse. They incur this fixed cost regardless of capacity utilization. A regional logistics structure implies the duplication of stock across all warehouses. When such regional structures are centralized, fixed costs are reduced, but delivery times and transport costs increase. Private firms therefore calculate an optimum number of warehouses from these conflicting cost functions. They optimize the geographic location of each warehouse in relation to customer locations. In contrast, military organizations cannot necessarily base their location choice on economic geography alone. For doctrinal and tactical reasons, it can be necessary to locate sites in areas that are unattractive to civilian logistics firms due to missing infrastructure or long transport routes. Sites at which much military equipment is concentrated represent high-value targets. Therefore, there are limits to the minimum number of sites or location that any armed force can operate. A private business can work efficiently with a single central warehouse, whereas a military organization would be highly vulnerable to any attack on this centralized structure. Whenever regional politicians seek rents by attracting military infrastructure to their constituency, these problems are exacerbated. In this case, politicians, not military requirements, determine the spatial distribution of military sites. As a result, logistics costs grow as politicians trade efficiency considerations for favors.5 The speed with which logistics infrastructure can be created and dissolved is much lower than in the private sector. Consequently, a given portfolio of military sites still generates fixed costs even when these sites are no longer required for logistics or capability generation. Regional politicians will oppose the closure of extant sites to preserve their rents, and the opening of new sites conflicts with civil demand for housing (in urban areas) or environmental protection (in rural areas). Finally, there is an indissoluble tension between the effectiveness and the efficiency of military exercises and maneuvers. If military capabilities are to be generated under combat conditions, i.e., in routines and with factor inputs required in actual conflict, significant expenses for planning, logistics, command support, ammunition, fuel and repairs are required. Therefore, a high effectiveness of military exercises goes hand in hand with low efficiency. Simulators can deliver costeffective training; they reduce both operating expenses for troop deployment and the probability of accidents and damage (Federal Audit Office 2013). However, the extent to which (if any) virtual simulations are an effective substitute for training in the field is debatable. Since they can only imperfectly mimic real combat, attempts to save costs by using simulators excessively may compromise military effectiveness. This simple substitution is only permissible for basic capabilities such as vehicle operation. The training of complex military capabilities on a simulator, such as the deployment of tactics in the field, requires additional

For this reason, politicians must spend subsidies as they attempt to attract private firms to structurally weak constituencies, because the economic-geographic optimization these firms require would dissuade them from investing in sites that are remote or lack infrastructure or local labor supply.

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investments for the preparation, involvement and after-action review of all involved staff officers, system operators, and commandants. These additional expenses must be added to reflect the true full cost of simulator operations.

4.2 4.2.1

Consequences of the Planned Economy System Structural Inefficiency

The economic theory of bureaucracy has described and empirically confirmed four types of bureaucratic inefficiency: a production volume that is too high or too low in relation to real demand (Niskanen 1971; Migué and Bélanger 1974; Peacock 1983), a too excessive or too expensive consumption of factor inputs, the consumption of inputs that do not meet quality expectations (Migué and Bélanger 1974), and inefficient, labor-intensive production methods (Orzechowski 1977). Contemporary studies have also shown that bureaucracies produce goods and services much more expensively than the private sector, and production quality is often inferior despite the additional resource consumption (Lemieux 2004, 2013). However, few studies explain that the planned economy system according to which bureaucracies function is the very source of this inefficiency. The mere existence of a bureaucratic organization as such does not imply that this organization produces its output inefficiently. After all, bureaucratic organizational structures can also be found in large firms in the private sector, but these organizations can still produce their output efficiently. Bureaucratic inefficiency in itself is not the problem; managers can eliminate it by layoffs, contract design, or competition. The problem is that human action determines the efficiency with which resources are transformed into production output. Under a planned economy system, humans do not have any incentives to take action that can increase the efficiency with which the organization produces its output. For a private firm, inefficiency equals loss of profits: Each unit that is consumed unproductively contributes to operating cost, but not to revenue. For a novel entrant, inefficiency among incumbent firms is an opportunity to gain market share by offering the same product quality at a lower price. In free markets and under perfect competition, inefficiency is quickly eliminated through entrepreneurship. Both the competitive pressure of the market and the entrepreneur’s interest in profit maximization guarantee that only indispensable resources are used in the production process. Hence, there is no resource consumption beyond immediate production requirements. As a result, firms that tolerate inefficiency gradually lose market share and are eventually forced to leave the market. In a planned economy system, humans have no incentive to act entrepreneurially. Both combatants and civilian employees do not have any incentive to push for efficiency improvements, as the associated savings would only imply that politicians nullify authorizations to spend in subsequent budget periods. Planned economy systems are therefore structurally inefficient, as only by using their full authorization

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to spend—even if inefficiently—can organizational members optimize their economic position. The institutions of planned economy system shift individual incentives away from efficiency optimization and towards budget maximization. Therefore, organizational members can be considered to be acting rationally when they use all available authorizations to spend to the fullest, especially as the end of the budget period approaches (‘December fever’). In this respect, resources are not consumed for productivity, but for budgetary reasons. Hence, planners have no interest in distinguishing between purchases that are actually needed and those that are not, or in checking whether the resources one unit requires could be transferred from other units who have excess endowments. Instead, planners will continue to buy from the private sector, until their authorizations to spend expire. As the planned economy system separates those who cause costs from those who must pay for them, such excess consumption goes unnoticed and unpunished. Structural inefficiency in a planned economy system is not limited to the excessive consumption of resources, but planners also procure goods and services at excessive prices. Suppliers and arms manufacturers are constantly seeking rents in both the private and the public sector, but in the latter, there is no corrective mechanism for reducing or eliminating such rent seeking. When a private firm pays more than the market price for its factor inputs, production cost increases, and eventually it loses its business to other firms who had kept production cost low from the outset. In a planned economy system, the planner’s fundamental information problem prevents an exhaustive comparison of prices, and due to the lack of property rights, there is no incentive to realize savings. Although contracts for recurring purchases goods and services might be renegotiated if excessive prices are discovered, excessive prices paid for arm’s length transactions and custom manufacturing or modification cannot be renegotiated. Planners in a planned economy system not only procure overpriced, but also inferior goods and services. Excessive prices caused by suppliers’ rent seeking are economically equivalent to a sales tax. Residents could tolerate this surplus as long the quality of products and services procured by planners meets expectations. As long as military effectiveness is not compromised, structural inefficiency is limited to the rents that suppliers realize. However, rent seeking by suppliers not only leads to excessive prices but also to poor production quality. The centrally organized planning of military capability generation rests on the assumption that product quality increases with the intensity of planning, i.e. with both the number and the detail of documents that define requirements. Planners attempt to minimize forecasting errors in order to maximize the quality of both private goods and armaments that armed forces will use in the future. However, neither do planners know the true operating costs and technologies of the goods and services that they plan to purchase, nor can they verify the quality claims of any vendor. Within the context of a planned economy, this fundamental information problem cannot be resolved. Given that their authorizations to spend expire at the end of each budget period, opportunities for extensive testing and verification are limited. Hence, there is a considerable and uncontrollable risk that

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suppliers deliver inferior products and services and claim they simply followed the requirements that planners defined. At worst, the purchased goods and services are expensive and useless, and capability degradation follows. The U.S. Government Accountability Office (2010, 2017) regularly documents various examples of such quality problems, but they can be found in all military organizations. This contextual independence indicates that the inefficiency of modern military organizations has structural causes. As the roles of users and purchasers in the planned economy system are not congruent and procurement projects follow political preferences, quality problems only become apparent after procurement. This effect is particularly problematic when the acquisition takes place once rather than through a series of smaller purchases over time. Phasing any procurement of goods and services over time at least enables planners to identify quality problems at an early stage, whereas in the case of a one-off transaction, the armed forces must cope with any quality problems for the rest of the system’s life cycle. Finally, state-run armed forces produce goods and services with an overly high labor level, i.e., a given production objective is met by using too many employees or working hours. Every bureaucratic system strives to maximize its workforce (Meltzer and Richard 1983). Rigid institutions inside public administrations facilitate the recruitment of employees but impede their dismissal. As the growth of an organization depends on its size, this effect intensifies with the size of the organization (Parkinson 1957; Vaubel 1994; Vaubel et al. 2007). The resulting surplus of administrative staff is costly but does not contribute to military effectiveness. The administrative bureaucracy of a military organization has no interest in verifying whether combatants truly need the products and services it makes. On the contrary, it produces institutions that combatants must implement, even if they believe these practices do not contribute to military effectiveness (checklists, formalized descriptions of processes, manuals, regulations, training courses, etc.). The extent to which such institutions contribute to military effectiveness is debatable. In the private sector, entrepreneurs would regularly review the contribution of such institutions to organizational effectiveness. Unproductive institutions cannot exist there because administrative costs reduce profit. As long as private firms cannot pass on the costs of such bureaucratic products and services to their clients, they have a strong incentive to curb self-created institutions by reviewing how (if at all) bureaucrats contribute to profit. A private firm terminates the employment of any staff that does not contribute to the generation of competitive products and services, as in this case marginal wage exceeds marginal productivity. Under a planned economy system, administrative staff are not interested in such audits because they question the usefulness of their activities and their very existence. Bureaucrats are therefore not interested in knowing whether the private sector can produce any good or service more efficiently, or whether their production meets any actual demand. Therefore, bureaucracies inside military organizations tend to employ an excessive labor input to reproduce goods and services that already exist in the private sector.

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Crowding Out of Investments by Operating Expenses

In a planned economy system, the politically approved defense budget is the only source of funding for the armed forces. From this fixed budget, they must finance day-to-day operations (operating expenses) and the acquisition of arms and privatesector goods (investment expenses). Operating expenses comprise both personnel costs, i.e., the salaries of combatants and civilian employees, and maintenance costs, i.e., the costs of operating, maintaining and repairing civilian and military equipment used by the military organization. The operating expense of a military organization continually increases over time for three reasons. Both salaries and factor-input prices are subject to domestic and foreign monetary inflation.6 If the nominal defense budget is not indexed to the annual domestic inflation rate, it continuously loses purchasing power; hence, an increasing proportion of the budget is dedicated to finance the monetary inflation of operating expenses. Furthermore, technological innovation in the arms industry makes operations expensive. The manufacturer’s research and development cost is factored into sales prices, and technological progress and increasing system complexity implies high servicing and maintenance costs (Kirkpatrick 1995; Drew et al. 2013). The operating expense for heavy weapon systems is particularly vulnerable to such cost increases (Arena et al. 2008; Hove and Lillekvelland 2015). The defense budget thus loses additional purchasing power by such technology-induced inflation. The planned economy system handles poorly this effect because the state can control the wages of its employees hence neutralize increases in personnel costs. As a result, planners cannot influence the prices that the arms industry or private sector suppliers charge for service and maintenance. Figure 4.2 illustrates the loss, over 20 years, of the purchasing power of a nominal defense budget P(n), assuming an annual monetary inflation rate of 1% and an annual increase in technology-induced costs of 3%. Monetary inflation alone leads to an annually increasing loss of purchasing power of ΔP1. Together, monetary and technology-induced inflation generate an annually increasing loss of purchasing power of ΔP2. If the nominal defense budget cannot compensate for this inflation, its real purchasing power is gradually reduced. Even if planners correctly predict the cost increase induced by inflation and technology, i.e., the shape of the P(i, t) curve, they cannot generate additional funds that could offset this increase. After 20 years, the initial nominal budget has lost about 62% of its purchasing power, so that the remaining budget only allows for a purchase of goods and services on a lower technology level, or the number of effectors or systems must be reduced. Finally, as any bureaucratic organization is interested in maximizing its workforce, progressively more administrators create increasingly more institutions. There

6 Foreign manufacturers and service providers may bill products and services rendered in foreign currency. Therefore, the armed forces must consider not only the domestic, but also the respective national inflation rates of all international arms manufacturers and private firms from whom they buy goods and services.

4.2 Consequences of the Planned Economy System

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100

P(n)

90

ΔP1

80 70

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P(i)

50 40

P(i,t)

30 20 10 0

1

2

3

4

5

6

7

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9

10 11 12 13 14 15 16 17 18 19 20 21

Fig. 4.2 Reduction of real purchasing power of the nominal defense budget

is no regular review and deselection of such institutions because it is easier to create new institutions than to abolish existing ones. The transaction costs of legitimizing a written document are low, as long it is created inside the organization and not subject to judicial review. In contrast, the transaction costs of scaling back or abandoning such an institution are high. Once the bureaucracy legitimizes an institution, it creates and administers routines that implement it and hence create employment. The abolition of institutions is therefore resisted by those in the bureaucracy who apply and enforce them, even if combatants argue that a particular institution does not contribute to (or even impedes) the effectiveness of the military capabilities they must generate. Moreover, the structural inefficiency of planned economy systems impedes any penalization of the continual growth of institutions. In the absence of such penalties, extant institutions are not reviewed or revised even if their contribution to productivity is nil (Boettke and Coyne 2009). The continuous growth of institutions also results in a related growth of operating expenses, as an ever-increasing share of the defense budget is required to pay the salaries of those who create and administer the institutions. Furthermore, combatants face a reduction of their labor productivity whenever they must devote hours worked to comply with and execute these institutions. As a result, temporary military or civilian personnel must compensate for this loss of productive working hours, hence operating expenses further increase.7

7

The opportunity cost of institutional growth can be calculated by dividing a combatant‘s salary and benefits by hours worked. The resulting hourly rate is an estimate of the monetary loss due to the fact that this working hour is spent administering institutions rather than generating military capabilities. Unless the institution in question contributes to this generation, the cost of any working hours spent complying with it is sunk and hence lost.

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This increase of operating expenses is independent of the number of combatants. In particular, operating expenses do not decrease as planners downsize the military organizations, because the inventory of institutions remains constant. On the contrary, operating expenses increase after significant armed forces reforms, as the implementation of the reform entails to plan it and then to reconfigure the resource base. As a result, such downsizing reduces the number of combatants much more than the headcount of bureaucrats. For example, between 1914 and 1928, the British Admiralty reduced its fleet by two thirds and dismissed one third of its combatants, but at the same time administrative staff increased by 80% (Parkinson 1957). Between 1990 and 2014, the Swiss Armed Forces reduced the number of combatants by 77.5%, whereas during the same period the number of employees in the Defense Division of the Department of Defense, Civil Protection and Sport (including its predecessor organizations) fell by only 21.5% (Federal Office of Personnel 2015; Swiss Armed Forces 2015). As of March 2018, the Defense Division still had 8803 full-time equivalent posts, of which only 2910 employed to professional officers and NCOs, whereas 5893 dedicated to civilian administrators (Swiss Armed Forces 2018). Whenever armed forces are organized under a planned economy regime, these three effects—monetary inflation, technological progress and growth of institutions—are the source of continuous growth of operating expenses. Unless politicians index the nominal defense budget to their growth, only investment budget cuts can finance it. Hence, operating expense gradually crowds out investment. If efficiency improvements cannot compensate for the growth in operating expenses, this trend continues until investment expenses are nil. At this point, the entire defense budget is used to finance day-to-day operations and salaries. Assets, infrastructures and systems that have reached the end of their physical life can no longer be replaced, and no novel investments can be made. This situation leaves armed forces with no other choice than to accept capability degradation, as outdated systems and infrastructures reach lose their physically integrity. Planned economy systems are unable to generate investments for the replacement of outdated and the purchase of novel assets. This inability to augment, let alone maintain, the capital stock is a significant reason that every planned economy eventually fails. Under a free-market regime, private firms with economic liberty and property rights can always negotiate access to capital, as long as they have a good credit rating. For example, they can take out bank loans, or they can raise equity by issuing new shares or bonds. Therefore, the inability to raise capital among other market participants is a sign of a troubled or dying firm. If the participants doubt the firm’s credit rating or business model, they can refuse to invest in the firm. As a result, the firm must consume the remaining working capital until it can no longer replace machinery or fund innovation, so that eventually it exits the market. Among private firms, cutting investments to finance operating expenses constitutes a desperate measure that would refuse unless they are completely cut off from credit supply. In contrast, for armed forces under a planned economy system, this substitution constitutes the path of least resistance. Although it leads to significant degradation of capabilities in the long term, it preserves their ability to operate in the short term.

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Under a planned economy regime, the only option to offset the continuous growth of operating expenses and to finance investments at the same time is to index the defense budget. Its necessary annual growth is determined by the combined rate of monetary inflation, technology-induced cost growth, institution-induced cost growth, and the annualized demand for future replacement investments. Unless this indexation is anchored at the institutional level (e.g., by a special law), there is no guarantee that the calculated index values can be financed, as short-term pressures on the national budget can induce politicians to cut the defense budget. In the absence of such institutionally enforced indexation, there are only three second-best options, none of which solves the problem of decreasing investment expense. First, the armed forces can accept this decline and consciously degrade their capabilities. If the remaining investment expenditures can no longer finance replacement investments, the armed forces can decide not to replace buildings, infrastructure and systems at all, or not to the same extent, or replace them with assets that have a lower technology or performance level. In each of these cases, the available investment expenditure constitutes a price cap that exists independently of any doctrinal requirements. If this amount is too low to finance adequate replacements, the effectiveness of military capabilities degrades until the remaining investment expense can finance replacements.8 Else, the armed forces must envision doctrinal or organizational change. They may consider reducing the number of combatants until it is proportional to the reduced number of equipment and systems that can still be financed by the remaining investment expense.9 For example, the German Armed Forces abandoned conscription in 2011 when they faced an increasing gap between replacement investments and available funds. Armed forces can also envision joining an alliance, as financially stronger allies can provide them with equipment and infrastructure. For example, none of the Baltic States has an air force, instead they rely on other NATO members who monitor and, if necessary, defend their airspace. Only two other solutions remain if the armed forces refuse these options. First, they can ration the available equipment; second, they can postpone investments into future budget periods. If the available investment expenditure is insufficient, planners may ration the use of systems, infrastructure, and services among combatants. In organizational practice, this means that either all combatants receive only some equipment, or they have to share equipment or wait their turn until planners provide them with the required systems. Alternatively, some troops might be fully equipped, while others receive nothing, or some may receive preferential treatment and receive equipment first while others must wait. Combatants who are disfavored by such methods have an incentive to shirk rationing and to secure supplies for themselves at the expense of others. Whenever they build up private stocks and withhold materiel,

8

This effect is comparable to the substance degradation of real estate managed under an institutionally defined rental-price control regime (Jenkins 2009; Block 2002). 9 However, the transition to a system of professional combatants often requires a specialization of military capabilities and therefore generates novel yet differently structured demand.

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fewer equipment is available for other combatants, so that the intensity of rationing increases. Rationing is also possible by doctrinal change. For example, if there is not enough materiel to protect all objects or areas simultaneously, the armed forces can concentrate certain forces to protect certain targets and forego the protection of others. In any case, rationing results in combatants competing for scarce resources. Furthermore, once planners ration materiel among units and troops, there is a high rate of circulation hence a more rapid depreciation of the resources. As a result, rationing increases operating expenses (even if for controlling systems that monitor the status and location of each rationed unit of materiel). Although this increase of the utilization rate seems advantageous, it requires high investment. When armed forces postpone investment into future budget periods, they forego the timely replacement of buildings, infrastructures, and systems that have reached the end of their life cycle. As a result, capability generation degrades as infrastructure degenerates, service levels decline, and technologically outdated weapons systems are deployed in the field. Further, operating expenses for systems beyond their useful life augment exponentially. As the number of physical failures increases, if a total capability loss is to be avoided, increasingly more repair costs are incurred. This effect, known by the adage ‘the poor man lives dearly’, is more severe the longer replacement investment is delayed. At the same time, planners can postpone investments only to the extent that the incumbent system continues to operate. As soon as mechanical or software failure renders the system inoperative, the military capability enabled by this this system is lost. Since the continuous operation of the incumbent system has consumed all investment expenditure that should have financed a replacement, there is no way to reverse this situation. Consequently, economic inefficiency eventually implies military ineffectiveness.

4.2.3

Undermining of Formal by Informal Institutions

The continuous creation of institutions inside the military organization not only causes an increase in operating expenditures but also additional efficiency losses. In principle, combatants could the growth of low-level institutions as long as this growth does not impede capability generation. In daily organizational practice, combatants evaluate the extent to which this is the case. While bureaucrats attempt to enforce compliance with institutions in day-to-day operations, combatants have no incentive to comply with every institution. On the contrary, they will examine the extent to which any novel formal institution is compatible with the body of informal institutions they have established by social convention (Boettke et al. 2008). In contrast with administrative staff who mostly operate from headquarters, combatants are stationed decentrally, i.e., at the very locations where military capabilities are generated or deployed. They can therefore better assess the extent to which certain institutions are required for such generation or deployment (if at all). This decision is based on informal institutions, i.e., on the socially constructed and

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commonly accepted beliefs of what is useful or permissible. Combatants create informal institutions by social interactions that emphasize trust and reciprocity, so that non-compliant members are punished by social exclusion. These institutions can effectively shape human behavior and activity, although they are never formally codified (Keefer and Knack 2005; Hume 2000). Therefore, the acceptance of a formal institution depends heavily on the extent to which individuals believe it is compatible with their informal institutions (Weingast 1995, 1997). A novel formal institution can only develop its intended effect if it is compatible with the inventory of extant informal institutions (Aoki 2001; Platteau 2000; De Soto 1989). As a result, irrespective of how many institutions the bureaucracy produces, only a subset will be accepted and applied in organizational practice. Whenever combatants refuse to comply with a novel formal institution, they cast a vote of no confidence in the planners that authored it. Therefore, whenever a centralized bureaucracy disregards the significance of informal institutional legitimization, organizational resistance follows (Benson 1989; Djankov et al. 2003; Leeson 2009; Williamson 2009). Indeed, the inventory of all formal institutions needs not necessarily constitute a logical, conclusive and coherent set. On the contrary, it more often resembles a conglomerate of historically evolved institutions that can well contradict each other. Institutions can also emerge as a by-product of unrelated decisions that planners and politicians have made in the past. As a result, the bureaucracy produces institutions in ignorance of the informal institutions that combatants apply among themselves, or it is aware of this situation but chooses to ignore it. Planners have no incentives to analyze the extent to which any combatants would likely accept a novel institution that is drafted, as this inquiry is not only fraught with transaction costs but it can also provoke negative feedback that threatens the legitimacy of the novel institution and hence challenges the planner’s work. At the same time, combatants have no incentive to oppose planners publicly when they announce a novel formal institution, since open resistance also implies transaction cost. Combatants cannot simply refuse to comply with formal institutions because both the military hierarchy and the civilian judiciary sanction disobedience. Open resistance can even endanger careers, as superiors may refuse to promote those who openly voice concern and disapproval. If employees in a private firm believe the inventory of formal institutions is incompatible with their informal institutions, they can leave the firm at any time. In contrast, conscripted combatants cannot leave the military sector, and professionals can only do so if they sacrifice their future military career. Combatants must therefore at least pay lip service to the novel the formal institution, but they can evade it informally. Such ‘evasive entrepreneurship’ (Coyne and Leeson 2004) manifests itself in the following behaviors. When combatants believe a formal institution is incompatible with their informal institutions, they can implement it only with much delay, interpret and execute it literally, or choose to ‘overlook’ the noncompliance. In many military organizations, procurement procedures involve dealing with a complex web of formal institutions that prescribe terms and conditions, and that regulate compliance once a particular value threshold is passed. Combatants can choose to simplify this regulation by

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splitting larger procurements into smaller modules, or by constructing scenarios to justify exceptions. Combatants can also agree among themselves to relativize formal institutions by social interaction. They thus create informal institutions that complement, modify, or completely replace the formal institution in question (usually referred to in organizational practice as the ‘unofficial channel’ or ‘the sideline’). These alternative procedures are not only accepted because they are often more effective than the formal institution but also because they enjoy informal legitimization. Therefore, in every organization there are evolutionary processes in which formal institutions compete with informal alternatives (Greif and Kingston 2011). However, combatants cannot deselect institutions they disapprove of; instead, both formal institutions and their informal alternatives coexist. As combatants are unwilling to bear the transaction costs associated with persuading planners to change formal institutions, they comply with formal and simultaneously create informal alternatives. In organizational practice, parallel processes then develop, as planners enforced formal institutions while combatants simultaneously enact informal alternatives. This behavior is neither unusual nor is it limited to military organizations. Indeed, it exists whenever dysfunctional formal institutions impede efficient economic action. Entrepreneurial activity, all value creation, then shifts to the informal sector. Entrepreneurs replace formal institutions they perceive as dysfunctional by informal interactions (De Soto 1989). However, this avoidance increases operating costs beyond the production cost of the formal institution. These are sunk costs, i.e. irreversibly lost costs, because planners cannot recover the salaries and material spent while they authored formal institution in question. As combatants discuss dysfunctional formal institutions and potential alternatives, they must dedicate a fraction of their productive work hours to neutralize bureaucratic initiatives rather than to the generation of military capabilities. Whenever they deselect such institutions in organizational practice and create informal processes that run in parallel, the transaction cost of organizing social interaction that legitimizes such alternative processes comes on top of the cost the bureaucracy caused when it creased the formal institution. Once bureaucrats are aware that informal alternatives have emerged, they will attempt to enforce the formal institutions in question even further. Then, a multiperiod game emerges, characterized by the creation of ever-new formal institutions, followed by ever-new evasive entrepreneurship. Since the number of possible communication relationships between individuals increases exponentially with the number of communicating individuals, operating expenses increase with the number of institutions and the salary of the involved participants. As these devote more and more work hours to discuss institutions and enforce compliance, the military organization becomes more concerned with itself than with the generation of capabilities.

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Lurie PM (2016) Comparing the costs of military treatment facilities with private sector care. Institute for Defense Analyses, Alexandria Meltzer AH, Richard S (1983) Tests of a rational theory of the size of government. Public Choice 41: 403-418 Migué JL, Bélanger G (1974) Toward a general theory of managerial discretion. Public Choice 17:27–43 Navarro-Galera, A., Ortúzar Maturana, R.I. 2011. Innovating in defence policy through spending efficiency: The life cycle costing model. Journal of Policy Modeling 33: 407-425 Niskanen WA (1971) Bureaucracy and representative government. University of Chicago Press, Chicago Nonaka I, Takeuchi H (1995) The knowledge-creating company: How Japanese companies create the dynamics of innovation. Oxford University Press, New York Orzechowski W (1977) Economic models of bureaucracy: Survey, extensions and evidence. In Borcherding T (Hrsg) Budgets and bureaucrats. Duke University Press, Durham, 229-259 Parkinson CN (1957) Parkinson’s law and other studies in administration. Buccaneer Books, Cutchogue Peacock A (1983) Public X-inefficiency: Informational and institutional constraints. In Hanusch H (Ed) Anatomy of government deficiencies. Springer, Heidelberg, 125-138 Pentland BT, Feldman MS, Becker MC, Liu P (2012) Dynamics of organisational routines: A generative model. Journal of Management Studies 49:1484-1508 Platteau JP (2000) Institutions, social norms, and economic development. Harwood Academic Publishers, Amsterdam Richter G (Hrsg) (2007) Die ökonomische Modernisierung der Bundeswehr: Sachstand, Konzeptionen und Perspektiven. Springer, Wiesbaden Rutner SM, Aviles M, Cox S (2012) Logistics evolution: A comparison of military and commercial logistics thought. The International Journal of Logistics Management 23:96-118 Shen ZJ, Daskin M (2005) Trade-offs between customer service and cost in integrated supply chain design. Manufacturing & Service Operations Management 7: 188-207 Smith R, Humm A, Fontanel J (1987) Capital-labour substitution in defence provision. In Deger S, West R. (Eds.) Defence, security and development, Saint Martin’s Press, New York, 69-80 Swiss Armed Forces (2015) Armeeauszählung 2015. General staff of the Swiss Armed Forces, Berne Swiss Armed Forces (2018) Führungsinformation Verteidigung Personal. General staff of the Swiss Armed Forces, Berne Taylor FW (1914) The principles of scientific management. Harper, New York Taylor FW (2004) Scientific management. Routledge, New York Vaubel R (1994) The political economy of centralization and the European Community. Public Choice 81: 151-190 Vaubel R, Dreher A, Soylu U (2007) Staff growth in international organisations: A principal-agent problem? An empirical analysis. Public Choice 133:275–295 Weingast BR (1995) The economic role of political institutions: Market-preserving federalism and economic development. Journal of Law, Economics, and Organisation 11:1–31 Weingast BR (1997) The political foundations of democracy and the rule of the law. American Political Science Review 91: 245-263 Williamson CR (2009) Informal institutions rule: Institutional arrangements and economic performance. Public Choice 139: 371-387

Chapter 5

Opportunities for Reform

5.1

Limited Reform Capacity of a Planned Economy

In principle, any economic system can be reformed in two ways: by changing the existing inventory of institutions or by replacing this inventory with an alternative one (Buchanan and Tullock 1962; Buchanan 1990). A military organization can try to implement reforms within the planned economy system, or it can abandon this system and adopt an alternative instead. However, reforms within a planned economy system are possible only to a limited extent. The central issue in any planned economy system is that the property rights for all production factors are not held by the individuals who organize or consume this production but by the nation state. In any contemporary military organization, combatants are simply users; they are not proprietors of the factor input they require to generate military capabilities. The same applies to the defense budget: the armed forces do not receive any cash, only authorizations to spend taxpayer money. This institutional configuration does not enable them to realize savings that could fund future investments because, in the absence of property rights, the intertemporal accumulation of capital is impossible. Therefore, planners have an incentive to use in full all available authorizations to spend, even if this spending involves purchasing overpriced or inferior goods and services. Hence, the military organization suffers from structural inefficiency that planners can try to minimize but never eradicate. Formal contracts cannot specify or control the personal effort with which individuals tackle their job tasks (Greif and Kingston 2011). Neither planners nor combatants have an incentive to invest the transaction cost that comes with defining and executing efficiency-increasing measures. These fundamental problems cannot be resolved unless property rights are introduced.

Nihil commune habet proprietas cum possessione (Property and possession have nothing in common (Dig. 41.2.12.1, Ulpianus 70 ad ed.)) © The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. M. Keupp, Defense Economics, https://doi.org/10.1007/978-3-030-73815-0_5

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Instead of encouraging efficiency-increasing measures, the planned economy system relies on threatening planners and combatants with punishment if they tolerate or create structural inefficiency. There are two ways to introduce this threat; the effectiveness of both is limited and fraught with high transaction costs. On the one hand, the military organization can create institutions that subject each procurement to scrutiny and evaluation procedures that investigate the adequacy of prices paid and quality delivered (e.g., anti-corruption and compliance guidelines, procurement regulations, audit procedures, etc.). Such regulations can also make those who plan and procure goods and services criminally liable if they tolerate or promote inefficiency. In the event of any inefficient use of resources, planners can face prosecution and lawsuits that reduce their lifetime income and net worth. To create compliance institutions implies to employ bureaucracy who administer and enforce them. The additional expenses paid for the salaries and resource consumption of this bureaucracy are known, whereas the extent to which it can prevent or reduced structural inefficiency (if at all) is unknown. As a result, total regulatory costs can exceed any efficiency gains. As they attempt to increase efficiency by using bureaucratic instruments, the armed forces operate even more inefficiently than before. The threat of civil and penal sanctions also changes the behavior of both planners and combatants. As they attempt to anticipate and minimize the risk of punishment, they have an incentive to invest a portion of their authorizations to spend in obtaining external legal advice, to work even more hours when scrutinizing procurement projects, to initiate lengthy reviews even for small purchases, and to excessively document all details of the procurement process in writing. The resulting costs, especially the opportunity cost of time, can well exceed those of the original inefficiency. Even if culpable planners and combatants are truly sanctioned, they cannot easily reverse the economic damage they caused to the armed forces. It is true that planners face the ruin of their personal finances once they confronted with significant claims for restitution. However, these claims can far exceed their remaining life income and assets, so that any compensation they can pay at all is disproportionate to the damage caused. Even if planners and combatants must forego their future careers as they become subject to penal prosecution, the economic damage they have caused to the military organization is irreversible and permanent. As a result, the threat of restitution claims is effective only for relatively small losses. Any compliance regulation that emphasizes civil action and restitution is therefore a symbolic act more than an effective compensation of inefficiency. Military organizations can also make procurements above a certain threshold subject to external audit or political approval. After all, direct democratic voting is the best protection against the influence of well-organized interest groups. To persuade a majority of the population (rather than just planners or politicians) is prohibitively expensive for rent seekers (Frey 1992; Frey and Bohnet 1993). Moreover, outsourcing control only shifts, but does not solve, the problem. External auditors and voters must also invest significant transaction costs when they evaluate planned procurements. Political voting is an inefficient disciplinary mechanism

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(Ferejohn 1986), as it incurs transaction costs associated with organizing the elections and evaluating their outcomes. The extent to which (if any) these expenses improve the efficiency of capability generation is unknown. Moreover, voters can vote only on specific procurement projects, not on the general economic organization of the armed forces. Hence, even if residents or auditors scrutinize every procurement project, the structural inefficiency of the planned economy system continues to exist. The planned economy system is not able to generate incentives by which planners can seek efficiency improvements, and such incentives cannot be generated at reasonable cost or by threats of punishment. Without property rights, none of the actors in a bureaucratic system has such incentives. It is perhaps futile to use appeals based on morality to convince civilian suppliers and arms manufacturers to cease seeking rents; or to convince bureaucrats to act like entrepreneurs. Political entrepreneurs are required as they can engineer institutional reforms that terminate the destructive entrepreneurship rent seekers pursue (Wagner 1966). Unless such fundamental institutional reform is initiated, the armed forces have no other choice but to accept and co-finance ever-increasing operating expenses. Unless the nominal defense budget is indexed to offset the associated crowding out of investment expenses, this acceptance comes at the price of capability degradation. The economic problems that result from a planned economy system are never solved, but merely shifted to the future. Structural inefficiency eventually causes military ineffectiveness as capability generation degrades and eventually halts. However, as long as there is no imminent conflict, neither politicians nor planners have any incentive to address these long-term consequences for military performance. Another defining characteristic of planned economy systems is the subordination of all economic activity to centralized bureaucratic planning. This setup has negative consequences for the dynamic adaptability of any armed force. As planning is labor intensive, failed and superfluous planning incurs high operating expenses. Planners in the armed forces must predict, years or decades in advance, future threat scenarios yet still adapt or abandon the plans if circumstances change. Planners do not have better information about the future than other human agents do; more specifically, they cannot know all the necessary decision parameters (Hayek 1944). Planners are also unaware of other relevant information, such as market prices in the private sector, since they must incur transaction cost to access this information. Moreover, planners can only imperfectly predict the cost functions of complex arms systems, even if they understand the technology these systems use, because producers refuse to disclose the parameters of such systems. Finally, planners are unaware of the future development of both military doctrine and future technologies whose emergence could render their original planning irrelevant. Although planners closely interact with politicians, the information they receive does not necessarily improve their forecasts. Whenever politicians can earn rents or improve their chance of reelection, they are indifferent to the implied economic costs since they can pass them on to taxpayers. As politicians negotiate, no information about the economic efficiency of politically feasible solution is generated (Boettke

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and Coyne 2007; Kirzner 1985). Instead, the true costs are only revealed long after the decision has been made. Therefore, politicians have no incentive to examine the economic consequences of their policies or to adapt them accordingly. Political decision-makers prefer the status quo, even if change is required from an economic perspective (Fernandez and Rodrik 1991). Planners can probably never completely predict or forecast the evaluation of a complex economic system. Although planners might have the best of intentions and can honestly attempt to minimize forecasting errors, future developments are fundamentally uncertain, hence even seemingly simple adjustments can prove to be complex (Hayek 1967). Only a competitive environment generates timely and relevant information that can reliably guide any adaptation. Planners and entrepreneurs share essentially the same information problem. Neither knows whether the production they organize today will meet any future demand. Planners do not know the future effectiveness of military capabilities generated today, and entrepreneurs do not know whether goods and services produced today will sell tomorrow. However, factor and goods markets continuously supply entrepreneurs with information about sales prices and turnover. Points of sale quickly inform them about the accuracy of their forecasts; hence, they can adjust production accordingly. By their property rights, they can reconfigure production processes and factor inputs. If they have underestimated actual demand, they can expand production; if they overestimated future sales, they can downsize production and reduce factor inputs. Such entrepreneurial action does not require political approval or the assent of any planning bodies. On the contrary, the economic liberty that entrepreneurs enjoy is the very basis for this dynamic adaptation. Entrepreneurs can quickly correct forecasting errors, just as they must bear the economic consequences of failing to implement such corrections (Leeson et al. 2006). Planners neither enjoy this economic liberty nor are they held responsible for failed adaptation. Any change they propose requires compliance with hierarchical chains of command and organizational procedures. Whenever planners receive information that suggests a need for adaptation, they must frame this information in an initiative, which then must ascend through the hierarchy of planners until it reaches a decision maker. This process is not only time-consuming and fraught with transaction costs, but there is also no guarantee that such initiatives will survive political discussion. Senior planners can doubt or oppose the information, and politicians can refuse to act on it. As neither planners nor politicians face to competitive pressure, they are not sanctioned if they ignore relevant information, or only with much delay when the ineffectiveness of their decisions becomes obvious to the public. Economically viable production is the result of an experimentation process that discards inefficient resource allocations (Hayek 1978; Sowell 1980; Thomsen 1992; Boettke 1998; Horwitz 1998). Through this experimentation, market participants can identify opportunities themselves, and whenever they are outcompeted, they are informed that such opportunities exist (Leeson et al. 2006). However, in a planned economy system, no such experimental process is available to planners or politicians; hence, they cannot improve their forecasts and decisions over time.

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Even if senior planners and politicians at the top of the hierarchy initiate reforms of the armed forces, effective change is slow. Even if the information that induced the change is correct, the specific institutional adaptation can prove to be erroneous. In this case, military performance does not only not improve; in addition, all investments made in organizational restructuring and adaptation are sunk hence irreversibly lost. If entrepreneurs face such problems, they can reverse the initiated changes or experiment with different adaptations until change is successful. As planners attempt to imitate them, the delays implied by centrally administered planning procedures makes dynamic and repeated adaptation particularly cumbersome. As they must revise the inventory of formal institutions upon every (if failed) change, the armed forces are in a state of permanent reform where change is continually initiated and reversed, while capability generation suffers. Consequently, the trial-and-error change that private firms can initiate often proves to be dysfunctional in military organizations. Radical change requires radical freedom. Therefore, armed forces can only gradually change and adapt to new situations unless they abandon centralized planning. Armed forces, under a planned economy regime, cannot achieve the efficiency or the effectiveness of a private firm. The institutions of a free market and a planned economy are fundamentally incompatible, hence a ‘transfer’ of ‘successful’ management methods is bound to fail, just like transfers of ‘successful’ institutions across countries and cultures fail (Greif and Kingston 2011; Boettke et al. 2013). As long as armed forces are state-run and controlled by a bureaucracy that administers a planned economy system, defense economics will always be fraught with institutional problems that cannot be resolved within this system. This fundamental problem is independent of an armed forces’ nation-state, doctrine, culture, structure, tradition, or leadership. If problems of defense economics are institutional problems, then they are the result of inappropriate or undesirable human behavior. The mere existence of a bureaucracy that administers armed forces is not the problem, hence the general reference to bureaucratic inefficiency is too simplified (Tullock 2002). Institutions are at the root of dysfunctional economic behavior among humans. Even bureaucrats would act economically responsible if institutions would provide them with incentives to do so. Humans do not always behave rationally, but they always act according to their own (if non-monetary) interests and objectives (Smith 2016; Becker 1993; Miller 1999). Entrepreneurial initiative does not emerge under any institutional regime; instead, entrepreneurs leave dysfunctional institutional contexts and migrate their firms to jurisdictions that are more conducive to economic liberty. Just like entrepreneurs, combatants and citizens leave the military sector and seek alternative ways to organize national defense if they are no longer convinced that the armed forces are effective. These problems will persist unless fundamental institutional reforms provide planners and politicians with incentives to act economically. For example, the collapse of the communist dictatorships in Eastern Europe after 1989 set off a wave of private micro-entrepreneurship that fundamentally and positively

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transformed the economies in these countries. Such productive entrepreneurship will begin only when reforms create institutions that reward it (Boettke and Coyne 2009). Isolated reforms of specific institutions within the planned economy system are not enough; instead, the institutions that cause dysfunctional human behavior must be changed (Coyne et al. 2016). Only when novel institutions can harness individual human interest and deploy it to the benefit of the military organization can the organization become efficient and effective.

5.2 5.2.1

System Reform Property Rights

Private property is the irreplaceable and non-negotiable foundation of any economic activity and, in particular, of economic liberty. If a nation state does not guarantee private property rights, humans have no incentive to seek efficiency improvements or innovate, as profits and assets that result from such entrepreneurship can be confiscated at any time. It is not surprising that the design of property and disposition rights (or the lack thereof) strongly influences the behavior of individuals and the economic performance of the state (Demsetz 2002; Ostrom 2008). In a universe of scarce resources and increasing entropy, individuals must give up some of their resources if they want to acquire a physical or virtual object with which they hope to create value. Once property rights are transferred to individuals with this purchase, they can use the object as they please, but they must also pay for any maintenance and repair. Once they have these rights, they are interested in obtaining as much utility or income from the object as possible, and in preserving the object’s capacity to generate both. Furthermore, they are interested in reducing any waste and inefficiency associated with the maintenance of the object, as any squandering of resources makes the economic exploitation of the object more expensive, reduces its value in use and shortens its usefulness. Whenever the proprietors of an object can realize savings by cutting the costs required to purchase or maintain it, their wealth increases, hence they have a positive and self-reinforcing impetus to minimize both the investment for and the operating expense of any object. Therefore, humans who have property rights need not fear sanctions to act economically. They now have an intrinsic motivation to do so. The unrestricted power of disposition that proprietors have over their property makes them fundamentally free (Stirner 1972). This idea, which is deeply rooted in the Roman legal tradition, provides proprietors with extensive negative freedom. No other individual can force them to buy or sell an object at all or at a particular time or price. Only those who enjoy this negative freedom can disregard the opinion or approval of others as they independently realize their individual economic plans. However, this freedom also gives proprietors the obligation to carefully use and sustain their property, as they cannot impose the economic responsibility for any loss or impairment onto others.

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Property rights are the essential precondition for the intertemporal optimization of consumption and investment. Their unrestricted power of disposition enables proprietors to decide to not consume some of their resources, to preserve them for an intended future use or purchase, and to invest them profitably while they wait. They will only take such decisions, however, if they can safely assume that any resources they do not consume today will still exist in the future, i.e., if their property rights can be enforced against any individual or state that tries to confiscate or restrict the use of any saved resources. Without such a guarantee, proprietors have no incentive to accumulate savings, stocks or reserves, as they would constantly fear expropriation or administration that interferes with their property, even if by pseudo-legal measures. Not surprisingly, property rights are the most important institutional basis for a nation’s economic prosperity (Acemoglu and Robinson 2012). The more secure and enforceable property rights are, the fewer individual freedoms the government can restrict (Locke 2014). Institutional guarantees that prevent expropriation by the state are more important for economic development than those that punish theft among fellow citizens (Acemoglu and Johnson 2005). The history of socialist experiments in economic policy shows that any collective-ownership regime that expropriates or forbids individual property leads to extreme inefficiency in the use of resources. In such regimes, residents have no incentive to innovate, to explore more efficient production methods, or to let the ‘collective’ exploit their labor and initiative (Jerven 2014; Swinnen and Mathijs 1997). More specifically, the significant squandering and misallocation of resources that occurs among armed forces worldwide can be due to ill-defined or missing property rights (Coyne and Duncan 2018). Only two institutional changes are required to introduce property rights. First, capital must replace authorizations to spend, and armed forces must have the right to save all capital not spent in the current budget period. Second, politicians must legitimize declarations of earmarking that allow the armed forces to keep the proceeds from any services rendered, goods delivered, and structures built in favor of third parties. The same applies to any liquidation proceeds from the sale of equipment, buildings, or infrastructure, to saved wage expenses after downsizing, to saved operating costs when combatants realize efficiency improvements, and to any royalties the armed forces have the rights to when others use their intellectual property rights. All these inflows contribute to accumulating capital since they remain in the military organization.1 Under a planned economy system, planners have no incentive to collect information about market prices, technologies, and cost functions, and they prefer to use authorizations to spend in full to any evaluation of terms and prices. Therefore, auditors must enforce compliance by bureaucratic procedures. Property rights solve this problem. If planners accept that suppliers inflate procurement prices to earn rents for themselves, they reduce the capital of the military organization, and they can no

1 This accumulated capital might even serve as collateral, such that the armed forces could borrow from banks or investors, or raise equity in capital markets.

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longer impose the economic consequences of this neglect onto taxpayers. Whereas, whenever they scrutinize prices, curb rent seeking and renegotiate existing contracts, they can realize savings and thus contribute to increasing capital. The military organization can reward planners and combatants for their vigilance by bonus systems. For example, planners and combatants could receive 1% of any savings they realize by accurate price control or efficient evaluation methods. Likewise, armed forces can thwart the tolerance of rent seeking and waste by ending the careers of all planners and combatants who are indifferent to such neglect. This simple institutional setup reduces investment expenses for three reasons. First, although both civilian suppliers and arms manufacturers are still interested in earning rents, they will no longer succeed in doing so because on the side of the armed forces, property rights unite the roles of proprietor, purchaser and user. Planners will have an incentive to curb rent seeking and any direct awarding of contracts that circumvents competitive bidding. As a result, planners will no longer collude with suppliers and aggressively negotiate procurement prices. Future purchase prices will be reduced by the extent to which suppliers earned rents in the past. Second, under a regime of property rights, planners will no longer approve offset transactions in the context of arms procurement, as this constitutes indirect subsidies for domestic suppliers and manufacturers in addition to the procurement price. As the cost for these subsidies can no longer be imposed onto taxpayers, arms prices decrease by the extra amounts that manufacturers charged for their willingness to offer deals for the domestic industry. Planners and combatants will have an incentive to oppose these deals and will no longer accept any proposals that suggest customizing or adapting complex systems after purchase. Instead, they will opt for commercially available off-the-shelf products whenever possible. Third, the introduction of property rights enables the armed forces to optimize intertemporal investments. Under a regime of property rights, the armed forces could save hence accumulate capital over time, since there is no longer any need to spend funds out of fear the authorization to do so may expire. Combatants and planners should not be under pressure to invest, rather they can wait until opportunities present themselves or reliable technologies are developed. In particular, suppliers will no longer abuse the ‘December fever’ context. Planners will be able to take all the time they need to inform themselves about cost functions and technologies (Bowman and Hurry 1993; McGrath 1997). They will be able to hedge investment risk by not buying all units of a system or good at once, rather to stretch out procurement over several periods and re-evaluate prices and quality after each purchase. Quality risks associated with rushed investments or with the acquisition of a large number of system units at a time are reduced, and suppliers will no longer be able to put pressure on planners to procure a complete system at short notice. In particular, planners will be able to take advantage of real options models (Trigeorgis 1996; Borison 2005; Miller and Waller 2003) by which the decision to purchase an asset is structured by call options. As there is no obligation to exercise an option, planners can end procurement projects if vendors fail to deliver the required quality level or if novel threats emerge.

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The structuring of investments by real options is advantageous whenever future requirements are unknown or subject to unforeseeable economic developments, such as in aircraft development and acquisition (Gibson and Morell 2004; Miller and Clarke 2008), information technology (Balasubramanian et al. 2000), shipbuilding (Bendall and Stent 2007), and the management of high-risk projects (Mathews 2009). For example, a real options model would merely procure a few prototypes, while further investment is deferred until their evaluation is completed. Depending on the outcome of this evaluation, planners can decide either to procure additional system units or to terminate further investment. Such a procurement model is certainly not in the interest of the arms industry, but as planners will have property rights and will no longer face any time pressure, they can simply threaten to defer procurement indefinitely or to buy from another competitor willing to accept their real options model. The introduction of property rights would also reduce operating expenses. Whenever the armed forces generate capabilities with inefficient factor endowments, the excess expense this inefficiency causes corresponds to a loss of capital, as the armed forces must pay for any extra salary and maintenance cost related to this inefficiency. Dysfunctional processes, excessive costs for spare parts, or overpriced contracts for service providers all incur unnecessary operating expenses hence a reduction in capital. Controllers can therefore review and audit current organizational practice with a view to maintaining only productive staff and only those resources whose operations and maintenance are truly required for the generation of military capabilities. For this same reason, armed forces also have an incentive to rescind or renegotiate all service contracts with third parties. No coercion, compliance institution, or bureaucracy would be required to generate this incentive to review or to guarantee that individuals act upon audit results. Therefore, the salary of any staff that, to date, had enforced compliance by authoring institutions and performing ex-post price control can be saved. Planners will no longer face a requirement to forecast specific numbers of employees or factor endowments. Instead, they can now experiment with different factor endowments and combinations of capital and labor input in order to identify optimal combinations; and they can quickly reverse decisions if any combination negatively affects capability generation. The introduction of property rights also replaces destructive by productive entrepreneurship. Under a planned economy system, productive entrepreneurship that focuses on efficiency and value creation cannot thrive. Instead, system members veer to redistribute resources to themselves as they attempt to increase their power and influence (DiLorenzo 1988). Any such redistribution is fraught with significant transaction costs, since all working hours spent for destructive entrepreneurship, such as internal struggles for funding, prestige, and power, are no longer available for capability generation. This unproductive use of time will not end unless a regime of property rights ends the fact that the defense budget is fiscal commons. This regime replaces the redistributive character of planned economy systems by a focus on improving efficiency.

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As a result, planners and combatants will attempt to identify and exploit such opportunities. Property rights imply that the armed forces no longer have any incentive to make their services available free of charge. Public and private organizations will still attempt to consume military capabilities below production cost or for free, but the armed forces will refuse to provide them in this way. Instead, they will can bill any services rendered at or above cost. Moreover, the armed forces can earn interest or dividends when free working capital is saved up, earn rent and lease payments from letting third parties use military infrastructures, and receive royalties from commercializing intellectual property rights.2 This additional income can offset at least some of the increase in operating expenses that is due to monetary inflation and technological progress. Furthermore, whenever the armed forces let go any staff whose job task was to author and enforce institutions that did not contribute to the generation of military capabilities, they reduce both operating expenses and any dysfunctional growth of low-level institutions. As combatants replace dysfunctional formal with informal institutions, they can both free up work hours and curb operating expense even further. These effects should significantly reduce the extent to which the growth of operating expense can crowd out investment. Both private goods and weapons systems have a maximum life span beyond which their usefulness declines to the point of physical breakdown. Under a planned economy context, planners cannot know the extent to which funds will be available in the future to replace these systems (if at all). Without property rights, investment planning is based on nothing but hope and haphazard improvisation. It then rests solely on the rebuttable assumption that some funds will be available at some time to finance at least some replacements. Hence, all documents that planners produce to ‘plan’ or ‘foresee’ investment needs are in fact pseudo-rationalizations that simply mask this fundamental uncertainty. In contrast, under a regime of property rights, planners can optimize intertemporal investment. They can predict future income and savings rates, and they can cushion this planning against the risk of defense budget cuts. As long as defense budgets are relatively large, they can create strategic reserves that offset future budget cuts. In short, professionalism replaces haphazard improvisation. Property rights enable planners to produce long-term intertemporal simulations of cash flow and investments. Thus, planners become aware of the significance of inflation, interest rates, and exponential growth, as they plan large investments for goods and systems whose usefulness spans years or decades. Planners will also begin to understand that reliable investment planning requires assets to be depreciated and savings rates to be calculated, so that future requirements for funding replacements can be spread over several periods. Ideally, planners will begin to calculate net present values that discount future expenses to the present time, taking into account inflation and weighted average cost of capital. They will be

2 For example, the Thai land forces own three television channels (Thai TV 5, Thai Global Network, BBTV Channel 7).

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required to produce balance sheets and profit-and-loss statements that reflect the actual economic situation of the armed forces. Property rights thus transform bureaucrats into professionals, as they apply methods of investment planning that have long been standards of good practice in the private sector (Mittra et al. 2016). Consequently, planners who miss the leeway a planned economy context offers can either leave or adapt.

5.2.2

Decentralization of Property Rights

If two institutions are co-integrated, changes in one institution will only be permanent if the other institution changes simultaneously. Otherwise, both revert to their prior status quo. Political and economic institutions tend to move together, and reforms in one without simultaneous reforms in related institutions are unsustainable (Sobel and Coyne 2011). This especially applies to the nexus between property rights and economic centralization. Without property rights, neither the introduction of centralized property rights nor a decentralization of economic activity can eliminate the economic problems a planned economy system entails. Property rights are a necessary but not a sufficient condition for a transition to a better economic system. As a result, property rights must also be decentralized. If centralized property rights are introduced, then all mobile and immobile assets (civilian goods, arms, real estate, structures) can be held by a centrally managed sovereign fund, and the users of these assets—combatants and civilian personnel— would be distributed decentrally across military sites. For all of these assets, the sovereign fund holds the property rights in the name of the armed forces, but only at the level of the organization as a whole. Therefore, the defense budget, as well as any revenue and savings that the decentralized users generate by their entrepreneurial activity, would flow into this fund. This structure has a number of negative incentive effects. First, this situation is economically equivalent to a profit transfer agreement. Individuals have no incentive to invest time and resources into identifying and exploiting profitable opportunities if they have to transfer to others the economic benefits that this entrepreneurship generates. For combatants and staff at decentralized sites, centralized property rights barely make a difference vis-a-vis a planned economy system, because they have to return any savings and income they generate. Such transfers also create a system of indirect internal subsidies by which combatants, among troops who continuously search for efficiency improvements, would subsidize those who do not. Under a system of centralized property rights, those who generate costs are not the same as those who have to pay for them. If property rights are centralized, individuals in decentralized units are merely users, but not proprietors of their system, because the sovereign fund holds all property rights. Hence, combatants would have an incentive to pass on any cost associated with the systems they use to the fund managers.

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There is no guarantee that combatants who have continuously contributed funds in the past will receive help when they require additional transfers. It is precisely because the fund is centrally managed that it still constitutes a fiscal commons whose funds are rationed among combatants and the systems they operate. The centralized state bureaucracy that manages the fund determines both the amount and the timing of any cash flows. Centrally held property rights thus create the same type of compulsory savings that social security systems exhibit. Individuals are forced by law to pay a certain share of their gross income to a state-held or state-sponsored public insurance organization. Whereas this compulsory payment is certain, any future payoff is a promise, but not an obligation since the laws that regulate such payoffs are subject to political change. Finally, the concentration of all property rights in a centrally managed fund does not eliminate incentives for rent seeking and lobbying. Since the funds holds and administers all property, both civilian suppliers and the arms industry still need to convince only a small number of fund managers and politicians to buy their goods and services. Therefore, the transaction costs of both rent seeking and political lobbying remain low, hence rent seeking likely continues. A centrally managed state fund also requires political oversight and control; hence, politicians can abuse this oversight and use the fund to co-finance other policy areas. For example, they can attempt to access cash reserves to fill short-term financial bottlenecks in the national budget, or they can attempt to distribute rents and subsidies to their political clientele. It is therefore unlikely that a centralized organization of property rights would lead to a long-term increase of both the efficiency and effectiveness of capability generation. Although efficiency can increase in the short term after the creation of centralized property rights, the above effects will create similar economic problems as in a planned economy system. The co-integration between property rights and economic decentralization is mutual. The introduction of property rights without economic decentralization will not solve the problems of a planned-economy context, nor will an economic decentralization of the military organization that does not define property rights. Even if an armed forces reform dissolves all centralized organizational structures and distribute all materiel and personnel among decentralized troops, neither combatants nor civilian employees could act entrepreneurially. Although the troops would be free to organize their local operations and investment, they would still be funded by the national defense budget. In the absence of property rights, decentrally generated income or savings would be transferred back to this budget. As a result, troop receive no rewards for their initiative. For this same reason, the negative economic consequences of inefficiency and waste in decentralized units are transferred to the national level, as the costs of excess resource consumption must be still be paid for by the defense budget. Decentralization alone is therefore insufficient unless it comes with a decentralization of property rights across branches and units. Therefore, organizational reform should distribute all assets the military organization has among all units. These take possession of the resources and hold all property rights in their name. Each unit draws up an opening balance sheet that

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records the initial endowment with all assets and their residual value. This information allows them to devise depreciation plans and corresponding savings rates for asset replacement in the future. Each unit is also assigned the civilian staff and combatants who, under the prior planned economy context, organized the generation of military capabilities in this unit. For each of these capabilities, the unit defines a readiness level to which the generated capabilities must conform. Each unit can draw up a profit and loss statement. As for revenue, each unit receives a fraction of the national defense budget. This initial income must be politically negotiated, but only once. Furthermore, the unit can freely add to this fixed income by billing any services rendered. As for costs, all salaries and expenses paid to administer personnel, as well as all costs to operate, maintain and repair the systems required for capability generation must be recorded. There now is congruence between those who cause costs and those who pay for them. Each unit is free to hire additional staff or lay off existing personnel, but it must pay for all salaries and social security of the staff it hires. The unit is free to generate military capabilities with whatever factor endowment it believes is efficient, but it must finance all investment and operating expenses. Both planners and combatants are therefore aware that any waste and neglect directly and negatively affect the efficiency and effectiveness of their capability generation. Hence, they have a strong incentive to perform audits and enforce cost control. Productive entrepreneurship then emerges, thus reducing costs and increasing income. As each unit can choose the capital and labor intensity of its capability generation, the decentralization of property rights enables them to tailor their resource needs and investment planning to their capability requirements. For example, units that generate capital-intensive capabilities can plan for larger savings rates, as they must replace expensive technological systems, whereas labor-intensive units can emphasize spending required to hire and train large numbers of combatants. Decentral management of operations makes centralist planners superfluous. Each decentralized unit has an incentive to review the inventory of institutions the centralized organization has created in the past. Upon this review, it only should adopt those institutions it believes are relevant to the generation of military capabilities. Each unit can conduct this review by analyzing the robustness and the efficiency of the institutions in question. An institution is robust if, despite human imperfections such as opportunism, reduced knowledge and limited goodwill, it encourages individuals to create the desired economic outcomes (Hume 2000; Pennington 2013). It is efficient when there is social consensus about its relevance and usefulness, hence its desirability (Platteau 2000). Unless an institution conforms to both criteria, there is no reason to maintain it (or to keep paying any staff that administers it). The introduction of decentralized property rights therefore not only cleans up the institutional inventory but also prevents the crowding out of investment expenses. As only robust and efficient institutions are kept, there is no longer a need to undermine dysfunctional formal institutions by informal procedures, and the related working hours spent can be reallocated to the generation of military capabilities.

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Under a regime of decentralized property rights, private firms and arms manufacturers face significant transaction costs, as they attempt to earn rents and lobby decision-makers. Instead of a few centralized politicians and administrators, they must now persuade personnel in all decentralized sites, thus the transaction cost of persuasion increases with the number of units. Each unit has an incentive to scrutinize such persuasion attempts, as it cannot impose the negative economic consequences caused by excessive prices or inferior quality on any other unit. Consequently, procurement prices fall, quality risks are reduced, and suppliers can no longer win contracts by political lobbying alone. As the results of their individual economic actions unfold, different units can also learn from each other. A unit that regularly realizes significant cost savings or efficiency improvements will attract the attention of other units. They will want to learn about the methods that achieved this success, and they will want to explore how these methods might be transferable. Only the methodologies that are both efficient and universally applicable will propagate throughout the organization. All others remain context-specific to the focal unit. The distribution among the methods used throughout the organization and those used in a specific unit is therefore optimal. There will be no more need for centralist coordinators who prescribe general economic or management methods. On the contrary, units can productively exploit their information advantage for these requirements because they understand their day-to-day operations and capability generation better than any centralized coordinator. They are therefore more competent to assess which institutions are truly required and why. Finally, different units can trade resources with each other, for example, by exchanging staff, swapping capacities to use infrastructures, borrowing equipment from each other, or pooling resources for joint procurement projects. Such exchanges are not a zero-sum game because, as long as both units cooperate voluntarily, they will improve their economic positions. In summary, the introduction of decentralized property rights should significantly increase organizational efficiency (Bernholz and Vaubel 2007). These efficiency gains then have a positive effect on military effectiveness. Resources that the planned economy squandered or used unproductively now facilitate the production of useful capabilities. Under a regime of decentralized property rights, the savings realized by such efficiency improvements can sponsor the recruitment of specialists from the private sector, or these savings can fund future system replacements. Finally, decentralized property rights increase the capacity of a unit to adapt to changing environments and threat landscapes. Decentral unit can now flexibly reconfigure their resource base, so that they can respond to change without having to interact with a centralized bureaucracy of planners.

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5.2.3

129

Implementation

In a planned economy system, any attempt to reform the armed forces requires a finality, i.e., a future stable state that planners define as appropriate, given the defense budget and their threat scenario forecasts. Although planners cannot receive objective data about the future, they must define what the goal of their planning is. Armed forces reforms under a planned economy regime therefore define target values of key planning variables, such as the number of combatants or the size of future defense budgets. Although planners do not know whether the finality they define will establish armed forces whose capabilities are effective, they must propose a particular organizational structure that is built on the target values the finality defines. Once politicians approve of these targets, the contemporary organization must be adapted until it meets the planned requirements. To this end, planners must revise all extant institutions and author new ones required to realize this change. Consequently, the planning and implementation of armed forces reforms under a planned economy regime is complex, time-consuming, and associated with high transaction costs. However, there is no guarantee that the defined finality is appropriate in view of future technology developments and the evolution of the threat landscape. Despite their best intentions, planners can misjudge or ignore future developments, so that the finality they defined is inappropriate by the time the armed forces reform is completed. There is no guarantee that the novel set of institutions that were developed or rewritten as a consequence of the finality will prove to be effective (Greif and Kingston 2011). Even if political and military decision makers are not satisfied with the contemporary situation of the armed forces, there is no guarantee that any reform will improve the status quo. On the contrary, external interventions in an economic system can make its performance worse. This effect is particularly well known in development economics where attempts to ‘improve’ economic performance by institutional reform rarely succeed (Easterly et al. 2006). The reason for this low success rate of planning by finalities is trivial but significant. Whenever planners specify a desired future state of the organization, they can be incorrect in many ways, even if their analysis of the contemporary situation and institutional inventory is correct. However, the recognition of contemporary problems does not prejudice the emergence of future solutions. Some of the knowledge required to identify such solutions is distributed throughout the present economy, whereas other knowledge elements are only generated in the future. Therefore, no planner can know the resource configuration that maximizes welfare (Hayek 1945). As a result, planners do not (and cannot) have all necessary information that is required to predict which organizational structures and capabilities will prove be effective in the future and which will not (Lavoie 2015). In contrast, decentralized economic organization—under a regime of property rights—does not require the specification of finalities. This regime enables experimentation, as decentral units can flexibly adapt their resource base and the factor combinations used to generate military capabilities. They can therefore experiment

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with a wide variety of organizational designs and select those they believe are appropriate given the contemporary situation. As this experimentation evolves, so does the organization. Today, it is unknown how long any adaptation to novel situations will take, or what the future capability requirements will be. However, this knowledge is not required since it is not generated unless this adaptation takes effect. As different organizational units continuously alter their structure and resource endowment, an experimental process emerges which identifies many alternative ways to produce and adapt military capabilities. Many of these will be inefficient from the beginning, and some will require further adaptation before the generated capabilities are effective. However, at the end of this experimental process of variation and selection, only the efficient and effective configurations will continue to exist, and all inferior solutions are abandoned. Experimentation thus replaces the finalities of central planners with a more humble approach. No belief in the accuracy any forecasts or judgments is required. Instead, the willingness to admit and immediately correct errors is sufficient. It is not necessary or desirable to predict and bureaucratically define any future organizational state, capability portfolio, or structure. On the contrary, such an approach only reduces opportunities to discover efficient resource configurations. This entrepreneurial search should not be confused with disorderly chaos. Indeed, the very essence of entrepreneurial activity is to control and shape the future without seeking to predict it (Sarasvathy 2008). As a result, all institutions that define and implement solutions identified by such experimentation are efficient and robust because they result from actions that organizational members take and evaluate. Such solutions are not planned or calculated, but discovered (Smith 2003; Leeson 2008). Therefore, institutions on high levels should guarantee that this decentralized discovery process unfolds with a maximum degree of freedom. Empirical studies in the field of development economics show that to remove institutional bottlenecks and to facilitate discovery processes is more effective than to plan deterministic reforms that rely on the definition of finalities (Easterly et al. 2006). Only a few yet indispensable institutions are required to facilitate this discovery: property rights, economic liberty, competition, and the rule of law. Once the armed forces can make the transition from a planned economy regime to an economic order that embraces these fundamental institutions, there is no reason to expect they could not improve the efficiency and effectiveness of their capability generation. Although such an economic reform is radical, it does not require any idealism. Quite the contrary, it harnesses a much more fundamental human trait, namely, individualism. Therefore, no utopian image of man or political weltanschauung is necessary to implement it (Hayek 1948). All that is required is a change agent who is willing to enforce such a reform, against significant organizational resistance. Transformation will not begin spontaneously. Armed forces with a decentralized economic regime will no longer require centralized planners that distribute resources or prescribe where and how to generate capabilities. Therefore, all planners, rent

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seekers, and politicians who benefit from the status quo the planned economy system allows will lose power and income. They will therefore resist any transition towards alternative economic organization. To overcome this resistance might require waiting until a favorable opportunity emerges. Human belief and human action adopt and abandon institutions, because rules ultimately arise from ever-changing moral and ethical human convictions. Institutional change requires a belief that a proposed change is both required and favorable. Before this belief exists, political majorities required for fundamental institutional change will be difficult to organize. Institutions change gradually and slowly, and their existing inventory is adapted only marginally, if at all, because there are strong path dependencies and mental models that make reflections about alternatives unattractive and undesirable (North 2005). Not surprisingly, therefore, armed forces tend to become rigid and inflexible during peacetime, and radical reform proposals lack the necessary political support. However, whenever armed forces suffer defeat or experience radical political change, their traditional is questioned, and inertia is replaced by organizational dynamics (Solomon et al. 2008). As missions are not accomplished, residents question the effectiveness of the armed forces, voice opinions against defense spending and migrate from the military to the private sector. Prior mental models collapse and radical change becomes possible in the short term (Denzau and North 1994). The replacement of a planned economy system by a regime of decentralized property rights certainly requires radical change. Consequently, military organizations under a planned economy system rarely ever change from the inside, even if this change would be advantageous in an economic sense. Indeed, at lower institutional levels, organizations lack a reflective consciousness that critically questions the sense of their daily operations. In order to break these rigid path dependencies, change must begin at the top of the organizational or institutional hierarchy (Schreyögg and Kliesch-Eberl 2007). Political entrepreneurs are required who challenge the institutional inventory (Battilana et al. 2009; Garud et al. 2007). These entrepreneurs should be close to the end of their political or military careers so they need not fear reprisals as they initiate radical reforms. They should not personally benefit from any change they induce. Ideally, they should not occupy any position that their reform creates, so that personal conflicts of interest are avoided (Vaubel 1996). A reform of the economic system by which armed forces are organized is anything but trivial. The only alternative is the persistence of the planned economy system with its structural inefficiency and its negative repercussions for military effectiveness. The problem is not that the planned economy system is administered inefficiently—the system is the problem. Only those who philosophize with the hammer will be able to replace it with something better, and this replacement requires a hero who is willing and able to swing the hammer.

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Index

A Absolutism, 1 Adaptation, 29, 79 Agreement on Government Procurement, 47 Armed force, 2 Armed forces reform, 126 Arms industry, 77 Arms manufacturer, 74 Arms procurements, 74 Asset specificity, 87 Awarding of contracts, 47

B Borrowing, 128 Budget period, 95 Bureaucracy, 103 Bureaucratic management, 26

C Call for tenders, 47 Capacity, 100 Capital, 108 Capital intensity, 82 Capital stock, 10, 108 Cartels, 51 Citizen, 85 Civilian suppliers, 47 Club good, 7 Co-integrated, 125 Combat strength, 3 Combatant, 125

Commercial off-the-shelf (COTS), 50 Competition, 24 Compliance, 30 Condottieri, 1 Conflict, 2 Conscription, 3 Constitutional articles, 80 Contract design, 36 Controlling, 110 Coordination failure, 42 Corporations, 28 Cost bearer, 58 Cost calculation, 47 Cost center accounting, 95 Cost function, 51 Cost generator, 58 Cost plus pricing, 46 Cost unit, 94

D Deadweight loss, 31 December fever, 104 Decentralization, 125 Defense budget, 38 Defense economics, 119 Defense spending, 5 Demilitarized, 87 Distribution keys, 94 Doctrine, 3 Dynamic capabilities, 79 Dynamic change, 69

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021 M. M. Keupp, Defense Economics, https://doi.org/10.1007/978-3-030-73815-0

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136

Index

E Economic liberty, 25, 99 Effector, 106 Efficiency, 108 Endowment, 72 Entrepreneurial freedom, 26 Equity, 108 Executive, 26 Exit, 43 Expropriation, 121

Institutions, 26, 57 Insurance, 126 Intellectual property, 57 Interest groups, 116 International norms, 26 Intertemporal savings, 29 Inventory of institutions, 80 Investment expenses, 117 Investment planning, 124 Isoquant, 82

F Factor input, 97 Factor substitution, 85 Feudal system, 1 Finality, 129 Fiscal commons, vii Fixed cost, 50 Forecast, 38 Forecasting errors, 69, 118 Formal institution, 58 Free-market regime, 108 Free-rider problem, 6 Full cost, 103 Funding, 8

J Joint ventures, 47

K Knowledge resources, 12

H Human behavior, 36 Human resources, 12

L Labor force, 1 Labor input, 84 Labor intensity, 82 Labor supply, 11 Laws, 126 Legislator, 28 Legitimization, 23 Life cycle, 52 Liquidation, 87 Liquidation proceeds, 121 Litigation, 53 Loan, 29 Lobbying, 126 Local communities, 56 Logistics, 39

I Incentive, 71 Individual liberty, 5 Individual rights, 41 Ineffectiveness, 80 Inflation, 35 Informal institution, 14 Information asymmetry, 50 Infrastructure, 28 Innovation, 52 Institutional configurations, 15 Institutional legitimization, 25 Institutional reform, 44

M Maintenance, 52, 120 Maneuvers, 68 Market prices, 11 Material resources, 12 Materiel, 95 Maximum principle, 31 Median voter, 31 Military alliances, 7 Military capabilities, 44 Military organization, 40 Military performance, 6, 23 Military power, 2

G Government outsourcing, 48 Guns versus butter model, 5

Index Military services, 1 Minimum principle, 33 Mission, 26

N National budget, 70 Nation-state, 119 NATO, 8 Natural law, 12 Negotiation, 57 New public management, 4

O Offset transactions, 49 Operating expense, 102 Opportunity cost, 41 Optimization, 59 Orders, 28 Ordinance, 60 Ordinances, 26 Organizational practice, 94 Overhead costs, 94

P Path dependencies, 131 Peace dividend, 25 Performance level, 75 Personnel, 99 Planned economy system, 11 Planners, 6 Planning, 6 Politician, 24 Polity, 26 Pooling and sharing, 8 Principal-agent problem, 8 Private military companies, 2 Private military contractors, 1 Private property, 12 Private sector, 29 Procurement, 43 Procurement contracts, 51 Procurement price, 121 Production factor, 89 Production function, 11 Productivity, 98 Professional armed forces, 40 Profit maximization, 81

137 Property rights, 115 Protection, 44 Public good, 2, 5 Public-private partnerships, 47 Public procurement, 30, 36 Purchasing power, 46

R Readiness, 98 Real options, 122 Reduction, 99 Re-election, 54 Regional, 2 Rent seeker, 45 Rent seeking, 45 Research and development, 46 Resident, 70 Resource base, 29 Resource requirement, 72 Resources, 47 Routines, 58

S Savings, 122 Security, 1 Selection environment, 67 Service level, 110 Services, 126 Simulator, 102 Social routines, 27 Specialists, 99 State administration, 3 State monopolies, 24 Subsidy, 57 Sunk costs, 57, 112 Supply curve, 71, 77 Synergy effects, 48

T Tax base, 43 Taxes, 36 Technology, 27 Tenders, 47 Threat scenario, 25 Transaction costs, 27, 128 Transfer, 31

138 U User pays, 57

V Voice, 43 Voter, 116

Index W Wage, 56 Waste, 39 Whistleblowers, 42 WTO, 47