A key challenge for the defence budget is inflation, which eats into not just the average Aussie family’s buying power, but also the government’s. The higher the rate of inflation, the more the defence budget will be eroded in real terms. Analysts in the US, where inflation is running at around 8%, have expressed concern about its impact on the nation’s defence budget. But Australia’s Department of Defence won’t be immune from inflation’s debilitating effects either.

Over the past two decades, Australia has had relatively low rates of inflation, with 2.25–2.50% being the norm (using the consumer price index). We can assume that the 10-year funding lines included in the 2016 defence white paper and 2020 defence strategic update were developed using that rate of inflation.

But the Covid-19 pandemic has changed that stable picture. First, we had a year of deflation in 2019–20, but since then inflation has increased beyond the norms of recent history. It hit 3.5% in 2020–21.

The government predicted 1.75% for 2021–22 but had to revise that up to 4.25% in the 2022–23 budget. That may need further revision; on 27 April the Australian Bureau of Statistics reported that inflation had risen by 5.1% over the 12 months to March. The governor of the Reserve Bank of Australia said this week that it could hit 6% before it moderates.

Australian government inflation, actual and predicted, 2019–20 to 2025–26 (%)

Source: Budget paper no. 1.

In fairness to the government, accuracy hasn’t been a feature of anybody’s economic predictions in the age of Covid. At the moment, a lot of money (in part generated by various Covid relief measures) has been seeking a reduced amount of goods and services (caused by supply-chain disruptions, lack of workers, sanctions in the energy sector and so on), driving inflation. The government is assuming those disruptions will end and inflation will decrease to 3.0% in 2022–23 and eventually back to a more ‘normal’ 2.5% by the end of the forward estimates. I’m not going to argue for any particular number, but when we’re thinking about risks, it can be helpful to consider scenarios.

Let’s start with the government’s own numbers. Already, the rise in inflation in 2021–22 from the government’s prediction of 1.75% at the start of the financial year to its current estimate of 4.25% has had the effect of eroding more than $700 million from the defence budget in real terms. Using the inflation predictions in the 2022–23 budget papers results in a further loss of $1.4 billion in 2022–23. By the end of the forward estimates in 2025–26, the defence budget will be 3.7% lower in real terms. That might not sound like much, but it represents a cumulative loss of buying power of around $6.8 billion over the forward estimates and $15.2 billion over the decade.

To give a sense of scale, this year the planned spending on naval shipbuilding is $1.6 billion. Nearly that much has already evaporated this year alone even before the shortfalls compound over time.

That’s if we use the government’s official inflation predictions. But we can generate more worrying scenarios. One in which inflation hits 5% but returns to ‘normal’ more slowly, not getting there until late this decade, produces a cumulative reduction in real terms of $16 billion over the forward estimates and $45 billion over the decade (scenario 1 in the figure below). A second scenario in which inflation of 5% becomes the new normal results in a 20% annual reduction in real terms by the end of the decade and a cumulative reduction of $54 billion. A reduction in real buying power of that scale will have a huge impact on Defence.

Effects of inflation on the defence budget (2021–22 real $ million)

Source: ASPI modelling.

We should also bear in mind that around two-thirds of Defence’s equipment acquisition budget goes overseas, largely to the US. So even if inflation moderates here, Defence’s buying power can still be eroded by cost increases overseas.

In sum, if inflation remains above historical levels, it will quickly eat into Defence’s buying power even if whichever government is formed after the election adheres to the funding outlined in the 2020 defence strategic update. To manage that, the government will need to accept reductions in capability or increase the defence budget just to acquire and support Defence’s currently planned capability. That’s before it even considers any increases to meet our worsening strategic circumstances.

ASPI celebrates its 20th anniversary this year. This series looks at ASPI’s work since its creation in August 2001.

‘Strategy without money is not strategy.’

— Arthur Tange, Secretary of the Department of Defence, 1970–1979*

On the cover of ASPI’s first defence budget analysis, The cost of defence 2002–2003, there’s a small picture of a couple of Australian Army vehicles inset into a larger picture of the Department of Defence’s administrative offices at Russell in Canberra.

Below the pictures is a dollar amount, spelled out in words: ‘Thirty-nine million, nine hundred and ninety-one thousand, eight hundred and ninety-eight dollars and sixty-three cents per day’.

That was what Australia budgeted then, every day, to pay for defence. An updated daily dollar figure has since been on the cover of every annual ASPI evaluation of the defence budget.

For 2021–22, the spelled out number was ‘One hundred & twenty-two million, two hundred & forty-two thousand, seven hundred and thirty-nine dollars and seventy-three cents per day’.

Tracking the cash for the kit, then giving the clearest of explanations, has been an enduring feature of the institute’s approach to its examination of Australia’s defence organisation.

The second annual budget brief introduced what became an intermittent feature—a cartoon on the cover. Among the cover greatest hits: a cartoon of a submarine firing two torpedoes rendered as barrels loaded with cash, with the words ‘Pork barrels away!’ issuing from the conning tower; a paper aeroplane labelled ‘White paper’, with one wing on fire and trailing smoke; a bayonet charge by uniformed kangaroos and koalas, all wearing slouch hats; and a senior officer with many medals smiling at a piece of paper labelled ‘Defence budget’, exclaiming ‘Incoming’ as showers of bank notes fall from the sky.

The cartoons are fun with high purpose.

The official presentation of the defence budget had always been notoriously opaque and incomprehensible, Hugh White wrote in 2016, even to people within government and defence: ‘ASPI believed that it would be impossible to foster a more rational and better-informed debate on defence priorities without a clear understanding of how the money was being spent and what things cost.’

For maximum impact, this analysis has to be published only a few weeks after the federal budget is announced in early May, not least to help inform the Senate estimates hearings that begin around the end of May. Recalling the first 2002–03 report, White wrote:

After an astonishing marathon effort, Mark Thomson duly produced the first of what has become an annual series of ASPI defence budget briefs, which was launched in Parliament House in late May. This laid out in clear terms just what the defence budget was being spent on, and how well the numbers added up, as well as including clear recommendations for what could be done better. This immediately established ASPI as the authoritative source of information on and analysis of the hard nuts and bolts of defence policy.

After a decade watching Thomson do his annual May marathon as a frantic sprint, Andrew Davies pronounced: ‘Every year I get to watch Mark Thomson pull off a remarkable feat of “extreme analysis”, as he cranks out 260 pages of the annual Cost of Defence report in the couple of weeks after the federal budget is released. (It’s a bit like extreme ironing, but with fewer shirts and more graphs.)’

Extreme ironing involves taking an iron and ironing board up mountains, on bikes, on the tops of cars, on parachutes, on skis, and in the midst of war zones. For Canberra, Thomson’s feat of extreme analysis was equally as impressive.

Not only did he explain the defence organisation to everybody else in government, politics and bureaucracy, he helped explain Defence to itself.

The sprawling Defence beast was offered a comprehensive yet sharp understanding of its own nature.

Journalists in the parliamentary press gallery quickly embraced Thomson’s deep understanding and clear exposition. He became a unique resource on the day of the federal budget’s release, when reporters spend six hours in the ‘lock-up’, confined in parliamentary committee rooms with embargoed copies of the budget until the treasurer rises to speak at 7.30pm. For defence writers, the most welcome arrival (aside from the coffee and sandwiches) was the smiling, lanky figure of Mark Thomson (also locked up) ready to offer a burst of analysis and explanation. The coffee quality was so-so, but the budget-night journalism on Defence got the Thomson version of intellectual caffeine.

According to the Australian Financial Review, the influence of Thomson’s analysis gave him ‘power’ in the way Canberra dealt with Defence. The paper published an annual list of the most powerful people in Australia—wielding overt, covert or cultural power—and one sector was the five most powerful people in defence. Mark Thomson got the fifth spot in the list in 2004, 2006, 2007, 2010 and 2011. In the first year he appeared, the list ran: prime minister, defence minister, Defence secretary, chief of the Australian Defence Force, and at number 5, Mark Thomson, with this explanation from Geoffrey Barker:

Mark who? A new name on the power list. Dr Thomson is budget and management analyst at the Australian Strategic Policy Institute. He has single-handedly over the past three years made the labyrinthine Defence budget transparent and accessible through his superb post-budget briefs for ASPI. His insights are widely admired and sought in defence, industry and foreign policy circles.

The 2006 list lauded the ‘unprecedented clarity’ Thomson brought to Defence spending, making him ‘a powerful and respected Defence insider’. In 2007, the list called him a ‘star’. In 2010, John Kerin wrote that Thomson ensured ‘the government provides more certainty for the defence industry on weapons’. In 2011, Kerin said that Thomson’s review of the budget was ‘once again compulsory reading. Its release is even more anticipated than the budget itself.’

As well as the annual Cost of Defence work, Thomson ranged widely across the cash–kit–capability nexus. In Pay your money & take your pick, in 2003, he considered what sort of defence force Australia could afford by examining five alternative futures and differing levels of defence spending, ranging from a modest 1.3% of GDP up to a robust 2.5%.

At the cheaper end, Australia would have a force less capable than today’s but still able to undertake a credible range of tasks. The problem was that Australia’s relative military strength would erode as regional countries continued to modernise. With the top option, 2.5% of GDP would provide a power-projection capability built around two aircraft carriers and a much expanded army and more capable air force and navy, significantly boosting Australia’s standing as an ally and its role in the region.

To the question, ‘How much should Australia spend on defence?’, Thomson responded that there was no ‘right’ answer. Canberra made choices and trade-offs. Better a modest policy that worked and lasted than a more ambitious one that failed when the money ran out. Joined to that eternal economic judgement about the opportunity costs of government choices was a statement of the strategist’s creed:

Finally, in all strategic policy making, it is wise to maintain an intelligent pessimism. Lurid and implausible worst-case scenarios should not dominate our thinking, but it is important to bear in mind that strategic policy choices last a long time, and that large and unexpected changes happen surprisingly often. A strategic policy that cannot encompass inherently improbable events is likely to prove inadequate.

Australia’s ability to fund defence was a recurring topic—a discussion ranging from regional power shifts to Australia’s changing demographics. Assuming defence would account for 2% or 3% of Australia’s GDP by mid-century, Thomson’s 2004 calculation was a cash mountain of more than a trillion dollars, just to maintain current capabilities through to 2050:

To many commentators, the question of defence spending is all too simple. You work out what is required so that the Australian Defence Force … can fight and win in any credible circumstance and you simply pay the bill. And you do this irrespective of competing demands for health, education and prudent economic management. In this view, the government (and ultimately the electorate) retains a steady appetite for national security, no matter what the cost. If only defence planning was that simple.

The reality was a constant set of choices about affordability and risk management. The Thomson prediction was that economic needs would batter at Defence’s budget:

If demographics are destiny, our destiny is mixed. While we should be able to maintain a defence force like we have today—or even somewhat larger—out to 2050, our relative economic weight is set to decline in the decades ahead along with, more than likely, our strategic weight. This, by itself, is not an argument for spending more on defence. Just because we can afford to spend more on defence, does not mean we should; and just because other countries can afford to spend more on defence does not mean that they will.

In 2016, Thomson noted that since he wrote his first Cost of Defence in 2002, capital investment to modernise the force had driven the budget: investment had grown by 120%, operating costs by 46% and personnel costs by 39%. The ADF had become ‘a little larger, somewhat better managed, much better equipped, and a lot more expensive’.

Saying goodbye to ASPI in 2018, Thomson worried that multibillion-dollar defence projects were being contorted to ‘buy Australia’ and serve parochial politics:

In normal times, the creation of a boutique defence industrial complex in Australia would simply be wasteful. But these aren’t normal times. The strategic environment is deteriorating much more rapidly than current plans are strengthening the ADF. While the government focuses on the economically dubious goal of ‘creating jobs’ in defence industry, the gap between what the ADF can do and what it might be called upon to do grows by the day.

* Arthur Tange, quoted by Paul Dibb, ‘Defence policymaking’, in Peter J. Dean, Stephan Frühling and Brendan Taylor (eds), Australia’s defence: towards a new era, Melbourne University Press, 2014, p. 166.

It’s difficult to make predictions, especially about the future. This is particularly the case with the trajectory of GDP growth.

That’s one of the problems with tying defence funding to a specific percentage of GDP, whether it’s 2% or some other number. As official predictions for GDP growth change, the Defence Department’s future funding changes. This means that the future force structure is constantly changing as defence planners try to match capability with changing dollars. In the force structure planning that led into the 2009 white paper, entire fleets were created and destroyed on paper in response to adjustments in the Treasury’s predictions for GDP growth. That is, until the government agreed to a firm funding model and Defence matched its capability aspirations to that level of funding.

Unfortunately for Defence, in 2009 the global financial crisis prompted Prime Minister Kevin Rudd to initiate large-scale stimulus spending, and the defence funding model was changed before the ink was dry on that white paper. And a few years later, in an ultimately unsuccessful attempt to pay back the borrowing necessary to fund the stimulus and return to surplus, the government further cut spending. Since funding cuts always hit the capital program hardest, this resulted in large numbers of delayed and scaled-back projects.

One of the good aspects of the 2016 defence white paper was that it contained a fixed funding line for the subsequent decade that Defence could plan to. And, as I’ve noted, the government has delivered that funding.

However, round numbers resonate, so public and media attention has focused on the government’s other funding commitment in that white paper, which was to increase Defence’s budget to 2% of GDP by 2020–21. Based on the 2019–20 portfolio budget statements, that will happen, although we won’t know for sure until Defence’s accounts for 2020–21 are all done and dusted sometime in late 2021 or early 2022.

It’s important to note that the commitment didn’t set Defence’s funding at 2% beyond 2020–21. That funding was to be provided by the fixed funding line. As I explained in ASPI’s 2019–20 budget brief, the fixed funding line exceeds likely projections of a 2% of GDP funding line. How much it exceeds it by depends on the assumptions you make about GDP growth. In the budget brief, I projected out the 2019–20 budget papers’ GDP growth predictions to come up with the gap between the two over the second half of the white paper’s funding decade (Table 1).

That would result in an annual shortfall of around $5 billion by 2023–24 and a cumulative shortfall over the second half of the white paper decade of over $22 billion. That’s more than the entire cost of the F-35 project (remember what I said about entire fleets being created and destroyed based on changing GDP predictions).

That growth rate is pretty consistent with Australia’s historical performance going back to the global financial crisis, which is around 4.7% nominal average annual growth (meaning real growth plus inflation). So, if you’re a glass-half-full kind of person, the assumption’s reasonable.

But in May this year the Reserve Bank of Australia put nominal GDP growth for 2018–19 at 3.5%, so if you’re a glass-half-empty kind of person and think that GDP growth has stalled at that level, then the shortfall gets much bigger—around $35 billion over the second half of the decade (Table 2). That is several fleets’ worth. In that scenario, the government would need to spend 2.4% of GDP just to deliver the white paper funding.That sort of projection is probably a worst-case scenario (hopefully). But short of economic miracles, the white paper’s fixed funding line is going to substantially exceed any 2% of GDP line. For them to align, average annual nominal GDP growth of around 5.5% would be needed, a much better result than Australia has managed over the past decade. In light of the copious analysis that suggests GDP growth is being driven largely by immigration rather than by enhanced productivity, sustained nominal growth of 5.5% seems unlikely.

Should GDP growth stall, government revenue will as well, so there will be more intense competition for funding. In short, it may well become attractive for a future government to provide something closer to 2% and declare its commitment met. To be fair, the government hasn’t hinted at that, although its own statements consistently refer to the 2% commitment, not the larger white paper funding line. But the temptation will be there.

In the next part of this series, I’ll look at whether 2% of GDP is commensurate with Australia’s historical spending on defence in periods of strategic uncertainty.

America’s military-technological advantage, an aspect of its strategic power since the end of the Cold War, is eroding. In response, the Pentagon launched the third offset strategy in 2014—a department-wide effort to find new ways, both technological and institutional, to leap ahead of its competitors. In a new report for the United States Studies Centre, I argue that for the US the third offset is partly an answer to matching its stagnating defence budget with its strategic ambitions.

As Washington concentrated on fighting wars in Iraq and Afghanistan, Beijing (and Moscow) invested in advanced missile technology, satellites, intelligence and reconnaissance assets, and networking capabilities. That has allowed China and Russia to employ anti-access and area denial (A2AD) strategies that have raised the cost and risk to the US if it decides to intervene in a conflict close to those countries’ borders. The decreasing effectiveness of American forces in a high-end conventional conflict may also have an impact on Washington’s credibility with allies in the region.

But A2AD strategies are only one part of a broader set of challenges the US faces to its continuing military superiority. Another is an emerging great-power competition over strategic technologies. Access to technical and scientific innovation is proliferating. China is investing heavily in an effort to create new national industries in artificial intelligence, quantum computing and robotics, and it’s building up an advanced defence industrial base. It is also making significant reforms to the People’s Liberation Army, shrinking its size and strengthening its logistical and support capabilities in an effort to fight and win ‘local wars under informationised conditions’.

Further, technological funding and innovation have shifted from government labs to the private sector, particularly in critical technologies like artificial intelligence. The increasing focus on dual-use technologies, investments in new start-ups and technical talent reflects new areas of geostrategic rivalry. This trend has even been evident in Australia, particularly in the higher education sector.

Finally, the cost to the US of maintaining its lead is growing. This is occurring along two fronts. First, the US’s existing platforms and capabilities are unable to adequately and cost-effectively defend themselves in a ‘salvo competition’. Second, Washington is likely to continue to face budget caps that will hamper its ability to compete with China on a platform-for-platform basis. This is evident from the range of priorities that are competing for limited resources, including nuclear modernisation, army procurement programs and military readiness.

Rather than a single strategy, the third offset is more accurately described as a set of three interrelated efforts. The first involves placing bets on current and future technologies that will, in theory, allow the US military to maintain its ability to project power into contested environments. The second looks to some of the new technologies, like AI, unmanned systems and solid-state lasers, to permit the US to economically compete with great powers and simultaneously maintain its global military posture. The third effort involves reforming and building on the way the Pentagon procures and develops new technologies to take advantage of private-sector developments.

The Pentagon is largely continuing these efforts under Secretary of Defense James Mattis, even if ‘third offset’ has been dropped from the official lexicon. New organisations like the Defense Innovation Board, headed by Alphabet chairman Eric Schmidt, continue to meet, and others, like the Defense Innovation Unit Experimental (DIUx), have increased their presence in Silicon Valley and are starting to see some successes. The Pentagon has continued to increase its research, development, testing and evaluation budget requests; appropriation increased by 11.2% in fiscal year 2018 compared to 2017. Another study has estimated that individual budget lines and projects for a range of third offset technologies increased by 43% between fiscal years 2015 and 2017, representing a ‘serious strategic uplift’.

While these individual budget increases are positive signs, there appears to be little consensus or movement to raise the Budget Control Act caps in an effort to move some third offset capabilities from prototype to production. One recent example is the US Navy’s electromagnetic railgun technology: resources started shifting away from it towards more conventional-powered artillery as it neared the final testing and evaluation stage.

For Australia, the third offset’s success or failure will have profound implications for the US’s future military posture in the Indo-Pacific. The third offset can’t replace Washington’s political will or national interest in maintaining the US alliance system, but it can provide a degree of reassurance for allies that worry about the effectiveness of US forces in a high-end conflict. As the third offset will benefit from an exchange of defence science information and coordination, as well as input from multiple allies on new operational concepts and innovation, Australia is well positioned to contribute in a meaningful way.

Are there any guarantees in life? Of course not.* But it’s possible to improve the odds of success in just about every area of human endeavour, and that includes developing innovation projects in the defence domain.

You’ll note I used the word ‘domain’ and not ‘market’—this post looks at the end user. With a defence industry capability plan and defence export strategy just around the corner, and the new Centre for Defence Industry Capability bedding itself in at the hub of a new business environment, it might be thought strange that this post doesn’t focus on industry and academia. But the innovation process begins with the end user. Service personnel are the customers in a market for defence goods and services, but their primary concern is the operational outcome of the innovation process: what works, what’s actually affordable, and what advantage do I gain from adopting it? That’s where the innovation process begins.

Why the focus on innovation? Because a small country deploying a small defence force won’t derive either an operational advantage or an economic advantage from trying to do the same thing as everybody else, only cheaper. Innovation—in equipment, organisation and process—is the difference between being ordinary, vulnerable and possibly irrelevant, on the one hand, and effective, strong and resilient, on the other.

First, some market-speak. Defence is a monopsony market. That means the defence customer has a significant shaping effect on the market: its size, its behaviour and the barriers to entry. If the ADF is the initial (and possibly sole) customer for a new piece of equipment, or service, then that product’s success depends significantly on how the ADF addresses both the operational need and the opportunity to be innovative in meeting it. It also depends on the partners and suppliers Defence chooses to deliver the new capability—and making a wise choice is a precondition (one of many) for innovation success.

So what are the preconditions for innovation success that the defence customer needs to satisfy? There are a dozen, in my view, and they ought to shape key attributes and behaviours on the part of Defence and the ADF. Technical and professional mastery are essential, of course; situational awareness—understanding the wider world as well as the immediate threat environment—ensures that those skills remain relevant; experimentation and R&D ensure that Defence actually understands its needs properly and can articulate them; Defence and the ADF need to be flexible enough to adopt and exploit what new technology can deliver; they and industry need to understand each other if the innovation process is to work properly; and in a technology-driven monopsony market, Defence can’t allow its industry base to wither into irrelevance. (The full list is here.)

Defence is mobilising itself to satisfy those preconditions, but it still needs to overcome some cultural hangovers that actively stifled opportunities in the past for innovation by industry as well as the ADF.

Defence’s processes have traditionally been risk-averse, almost to the point of being self-defeating: projects have been slow and decision-making has been ponderous. A process designed to protect taxpayers has often, perversely, squandered their money by being too risk-averse and losing sight of both the user’s needs and, on occasion, the opportunity to deliver a wider strategic benefit to the nation.

There haven’t been enough of the essential links between end users, university researchers and industry. All too often those relationships have been strained through the medium of a risk-averse acquisition process and industry policy.

There are many things we can’t and shouldn’t do in this country, and we must be prepared to pay others to do them for us. But by what measure is it considered a wise investment automatically to spend dollars earned by Australian taxpayers to enrich the taxpayers in another country? We can, should and must do more in Australia.

The leverage afforded by defence expenditure is vital. Deliberately opening up more of the defence market and the defence budget to Australian industry has been a shot in the arm to innovators; they’ve been helped by easier access to end users through events such as the recent Army Innovation Day. A stronger presence in the export market will help further.

Defence expenditure is significant enough that it must not be viewed on a narrow, transactional basis, with projects approved and funded in isolation from each other on the basis of the cheapest (aka ‘best value’) vendor. For years that approach worked against wider organisational and operational synergies and resulted in the continual fragmentation of Australia’s industry base, rendering it suboptimal and very fragile. Defence is a strategic activity and the government has at last acknowledged that expenditure on such a scale must be treated as a strategic activity also.

The 2016 Defence White Paper and Defence Industry Policy Statement address these challenges. But to continue satisfying the preconditions for innovation and operational advantage in both industry and Defence, we need to see the emerging cultural changes embedded permanently in the ADF and in Defence’s capability development and acquisition processes. The early signs are very promising, but Defence and industry together need to make those changes future-proof.

* Apart from death and taxes.