Mostly Economics

I have been reading and seeing a lot of discussion and debate on Mumbai terror attack.  I have no clue on how the entire defence and security system works. However, I would like to give this an economic perspective.

The attacks take me back to basics of economics. In the first few pages of any introductory text-books is a concept called Production Possibility Frontier:

In economics, a production-possibility frontier (PPF) or “transformation curve” is a graph that shows the different rates of production of two goods that an economy (or agent) could efficiently produce with limited productive resources. Points along the curve describe the trade-off between the two goods, that is, the opportunity cost. Opportunity cost here measures how much an additional unit of one good costs in units forgone of the other good. The curve illustrates that increasing production of one good reduces maximum production of the other good as resources are transferred away from the other good.

Wikipedia link puts food and computers on y and x axis. In most text-books one finds guns and butter instead. Guns can be taken as the defence and security system of the country. There used to be always this debate earlier- whether a country should spend on guns or butter given its limited resources. India also has limited resource that needs to be spent across spectrum of public goods. There are 2 broad scenarios:

• India is spending adequately on defence but it is not done very efficiently. Hence, in terms of PPF we are inside the curve and should try and reach the curve. The policy prescription would be to make the expenditure process more accountable and ensure money goes where it belongs.
• India is not spending enough on defence. In terms of PPF we are at point C (or even farther to right) in graph 1 as shown in wikipedia (replace computers by guns/defence). Here, the policy prescription would be to devote more resources to guns/security and move towards point B (not at B, towards B).

So, where are we? In reality PPF is an abstract concept as there are multiple goods that are produced and one can’t analyse it via PPF as it allows only 2 goods. So, we can’t say which point on PPF are we on. However, what we can look at is how much we spend on defence vis-a-vis all other goods.

Here is a table which shows the govt expenditure on defence:

• The first 2 columns show how we spend on defence i.e. whether on salaries (revenue) or towards purchase of new arms, machines etc (capital). So, this answers part of the first scenario. In this we can see till 2003-04, 70% of defence expenditure was towards revenue items which is very high. This pattern changes in 2004-05 and now higher expenditure is beginning to show towards capital items. However, we don’t know how much is the ideal distribution but 70% towards revenues clearly looks excessive. This is changing but revenue still forms bulk of defence expenditure. The terror attacks points to the need to have better equipment and this would mean more expenditure is needed on capital goods. What could also be done is to cut revenue expenditure on subsidies and interest payments which comprise 40% of revenue expenditure.
• The next three columns show how much we spend on defence with respect to other goods. This answers to second scenario. Beginning 1990s the ratio as a % of GDP declines from 2.7% in 1990-91 to 2.1% in 1996.97. This again increases and touches 2.4% in 2001-02 (perhaps in response to 1999 Kargil war) and then again declines to 2.0% in 2007-08 which is the lowest ratio in the time-series. 
• The terrorist attack points to both- the need to increase capital expenditure and overall amount towards defence/security. How much should be enough? This would involve some international comparison to understand what is appropriate
• As per this wikipedia list, India is 11th highest ranked in terms of military expenditure and spends about 2% of the world defence expenditure with US topping the list at 45%. The same link also shows the list of 16 top countries with highest defence expenditure as a % of their respective GDP. It shows North Korea at top with 23% of GDP and Maldives at bottom of the list at 5.50%. Israel whose security system is lauded spends about 7.30% of its GDP on defence.

I am no expert on how much is sufficient and the nitty-gritties of defence industry, but we need to think about economics while suggesting policies. If we spend more on defence, the resources would be spent less on others. Which others? Moreover, in recent Union Budget discussions, the focus has been on off-balance sheet items etc. But previously theer was focus on defence and people didn’t like if more was spent on defence. So, it is not as if it is an entirely new issue.

India is already facing severe pressures to devote its limited reources on nearly everything under the sun-  education, infrastructure (both hard and soft, each comprising 7-8 sub-sectors), agriculture development etc etc. And now on defence and security which can not be ignored anymore. In times of already high fiscal deficit (PM’s EAC says it could be above 7%), how do we finance so many activities? How do we allocate resources in best possible manner? These are crucial questions and unfortunately there are no easy answers.

Update:

1. Niranjan Rajadhyaksha has an excellent post on these issues – Understanding India’s Defence Spending Dilemmas