Maxed Out: NATO and the Growing Debt Crisis

NATO is the most powerful military alliance the world has ever known. But that power, at its core, is a reflection of the economic might of the nations in the Alliance. In times of dire economic circumstances, the capacity and the motivation to maintain strong armed forces and project military might around the world is diminished. In this age of austerity and soaring debt levels, it is difficult to envision a world where NATO remains as relevant as it has been, as governments’ debt catches up with them, unless drastic change are made by state governments.

Maxed Out: NATO and the Growing Debt Crisis

Since 2008, the world has witnessed collapsing banks, ballooning deficits, bouts of deflation and inflation, as well as unprecedented shifts in monetary policy. At the centre of it all is debt, which has been spurred on for years by low interest rates and shared delusion that the economic roller coaster ride would never have to come back down.

The immediate collapse of the banking sector in most countries may have been averted in 2008 with the help of unprecedented infusions of liquidity from governments trying to save their banking sectors. However, the problem still plagues the western world today. Depressed asset prices, slow growth and banks that are reluctant to take on risk have meant that the recovery is moving along more slowly than anyone would have liked. Governments are not seeing the revenues that they need, but they do not want to burden the fragile economy with higher taxes. As a result they are continuing to borrow vast sums of money. This is growing increasingly problematic.

The American Federal Reserve recently announced another round of quantitative easing; a plan to jumpstart the economy by buying $600 billion worth of bonds that would again inject massive amounts of liquidity into the markets. The European Central Bank (ECB) had established a €750 billion emergency fund in May 2010 to mitigate the problems of the debt crisis. It has already been used to bail out the Irish government to the tune of €85 billion and was also used, along with help from the International Monetary Fund (IMF), to loan €110 billion to rescue Greece from default. While these actions are expected to avert the outright default of state governments in the short term, there remain fundamental problems with many NATO countries’ economies.

In 2009, the world spent close to (US) $1.5 trillion on defence, with NATO countries accounting for around 70% of that expenditure. The United States accounted for roughly 43% of world spending. Other major spenders include the United Kingdom, France, Germany, Italy, Spain and Canada.

However, 2009 was a very different atmosphere politically speaking, with many still willing to accept more spending and increases in the deficit. Just a year later, much has changed. Most countries have now witnessed far too many bailouts and have sought to push themselves further from the edge of financial Armageddon. Defence cuts, as part of a broader strategy of austerity, are on the books and in some places have already been put into place.

Of course all NATO countries want to maintain a strong military. But most are finding themselves between an economic rock and a hard place. This can be said of all the allies, alarming the person in charge of keeping NATO strong.

“There is a point where you are no longer cutting fat; you’re cutting into muscle, and then into bone,” said Anders Fogh Rasmussen, Secretary General of NATO. “I understand full well why Allies are cutting into their defence budgets. Given the financial crisis, they have no choice. But I also have to say: cuts can go too far. We have to avoid cutting so deep that we won’t, in future, be able to defend the security on which our economic prosperity rests.”

Whether the planned cuts actually hit the muscle, as the Secretary General put it, is the subject for future discussion. However, the reductions in military spending certainly are telling of the future economic realities of the world.

Five little PIIGgies

Portugal, Italy, Ireland, Greece and Spain (The PIIGS) are the European Union countries that have been in the weakest fiscal positions in the wake of the financial crisis of 2008. These governments all have severe debt problems and are running perpetual deficits that are exacerbating the problem. They do not have the option of unilaterally increasing their money supply, as is the case of the United States, because the Euro is a shared currency and none of these countries have their own central bank. This means that they will need to rely on help from the ECB to save them.

Greece was the first country to require a bailout package since the initial financial crisis of 2008. Despite receiving a massive infusion of cash from the ECB and the IMF to prevent sovereign default and internal banking collapse, which amounted to the equivalent of almost half the Greek GDP, the outlook remains quite bleak. Unemployment is expected to rise from about 10% this year to almost 15% in 2011. Moreover, the Greek economy contracted by an estimated 4.2% this year, marking the largest recession in Greece in the last 40 years. This casts doubt on the Greek government’s ability to pay back the IMF and the ECB, despite a rather generous interest rate. This is because the loans expire in 2-3 years, at a time when Greek debt to GDP is projected to be 150%, up from about 115% in 2009. The expectation is that when the loans mature, the Greek government will simply refinance with loans from the private sector. If the economy continues to contract, and the debt burden grows, few expect that the Greek government will be able to find loans as cheaply as they have right now, greatly increasing the cost of servicing the debt.

Greece has instituted very drastic reforms as a condition of receiving these loans; the cuts in spending have been met with very serious opposition. As part of a broader strategy of reforms, the Greek government is planning to reduce spending on the military, including pensions for servicemen. The Greek defense budget for 2010 is expected to come in at roughly €6.24 billion and the country has already predicted a 2011 budget decrease of almost €600 million. With 145 troops committed to the mission in Afghanistan, one must expect that further cuts could impact the Greek contribution to future efforts.

After being touted as the “Celtic Tiger” for years, the Irish Economy came to a grinding halt in 2010 as the government struggled to save the overly leveraged banks. Many are predicting a 12%-14% contraction in the Irish economy in 2010. Unemployment has jumped 11.4%. The EU approved a €85 billion loan to the Irish government in an effort to maintain its solvency. To put the degree of the crisis in perspective, that loan amounts to more than half of the Irish GDP.

Even though the Irish and the Greeks are the first to receive a bailout so far, this international financial problem is only beginning. Portugal will likely require a bailout soon as well. Not only is Portugal the EU country with the lowest GDP per capita, the Portuguese debt to GDP ratio has increased from 76% in 2009 to 86% in 2010 to an expected 91% in 2011. The government has run deficits of almost 10% of GDP for the last few years. Moreover, Portugal suffers from unemployment of around 10% of the population, which shows no signs of abating. For the past 10 years the GDP, wage growth and productivity have remained largely unchanged. Since 2007, the yield on Portuguese 10-year government bonds has fluctuated between 3.80% at the best of times, and 4.96% at the height of the financial crisis. It remained this way until 2010 when it began a rapid climb to close to 7% as of November. Since higher bond yields reflect investor concern about the ability of a government to pay back its debt, this suggests that the markets are already starting to account for the added risk and are expecting the ECB to have to bail out the Portuguese government.

The dire situation in Portugal is impacting the country’s defence budget. Massive cuts, including around 11% of the previous budget, are expected. Just prior to the NATO Summit in Lisbon in mid-November, the head of Portugal’s Strategic Defence Intelligence Service resigned over objections to his agency’s budget reduction.

Spain is also in serious economic trouble. Its federal deficit was 11.2% of GDP in 2009 and is expected to increase in 2010. The ratio of total sovereign debt to GDP is still below the EU average; however, the ratio has doubled in the last 12 months and is continuing to climb upwards. As the world’s 9th largest economy, some argue that a bailout for Spain that is large enough to have a significant impact in combating the problem might be impossible to fund. To make matters worse, the construction industry was a chief employer in the years leading up to the collapse of the Spanish housing market in 2008. With construction remaining at recession lows, unemployment is steady at about 20%. Spain faces a systematic problem of restarting its housing market, or retraining the construction workforce to join more competitive industries. There is no quick fix for the Spanish economy.

As mentioned above, Spain’s deficit is only projected to rise in the coming years. As with the Greeks, the Spanish are also using the defence budget to trim away at those seemingly insurmountable budget deficits. The country is planning on cutting €500 million in 2011, with further cuts expected, along with postponement of past military commitments. The Spanish Secretary of State for Defence explained that two-thirds of the planned cuts were to administrative areas of the budget, with the remaining third hitting the Army, Navy, and Air Force.

Although the Italian economy has relatively strong fundamentals, like a high domestic savings rate and reasonable fiscal policies that have been pursued for the last few years, the Italian debt to GDP ratio is the second highest in Europe, next only to Greece. Analysts are concerned that higher interest rates, which currently hover at 4.7%, would have a devastating effect on the Italian capacity to service its debt. Moreover, the Italian economy has a very slow, albeit positive, growth rate averaging about 1%, which is not expected to change. This means that Italy is not expected to grow its way out of the problem.

Silvio Berlusconi and his ministers have also targeted the defence budget as an area of savings. It was reported in the Italian media that the department would likely lose 10% of its budget in the upcoming year, with cuts of hundreds of millions of Euros more planned for the fiscal years of 2012 and 2013. The Italian military is expected to shed 10,000 jobs as well as delay, or in some cases cancel, already scheduled equipments upgrades and purchases.

This past summer, Italy announced that it was saving $2.6 billion by reducing the number of Eurofighter Typhoons it was purchasing to 96, from its original plan of 121.

These countries have been receiving a large amount of media coverage in recent months given the challenges they face. However, their military budgets represent a relatively small fraction of the NATO total. A reduction in military spending in these countries would certainly affect NATO’s capacities, but on their own do not represent a serious threat to the Alliance’s military supremacy.

The Rest of the Farm

Outside of the so-called PIIGS, the picture still looks bleak.

France is not at the same risk of default as many other countries, however, they are implementing austerity measures. Since French President Nicolas Sarkozy was elected, he has been working to reduce the spending of the government. In 2010, France ran a deficit that was 7.7% of GDP, contributing to a debt that is approximately 90% of GDP. The government wants to bring that deficit to within 3% of GDP by 2013 by slashing spending. However, the French people are resisting these measures. Strikes and protests shocked Paris when the French government voted to increase the retirement age from 60 to 62.

To help meet the French governments desire to see a deficit that is within 3% of GDP, the defence ministry is going to slash spending by 3.5% from 2011 to 2013. In addition, it plans on downsizing 54,000 military jobs by 2014. Such a move will probably be met with a great deal of opposition.

The United Kingdom has also acknowledged its seriously weak financial position and taken very serious steps to correct it. Between now and 2015, it is on track to cut 4.5% of GDP from its annual budget. Britain is currently running a deficit of about 10% of GDP and is projected to have a public debt of 88% of GDP by 2011.

“Tackling the budget deficit is unavoidable,” said George Osborne, Chancellor of the Exchequer, in an address to Parliament. “To back down now and abandon our plans would be the road to economic ruin.”

The new coalition government has plans to reduce spending in all areas, including cutting £7 billion from the welfare budget, raising the retirement age by one year and removing almost 500,000 public sector jobs. These austerity measures, while politically difficult, are necessary to reign in the deficit.

Of all the NATO members, the United Kingdom is perhaps the one whose defence department will witness the greatest level of cutbacks. It is schedule to lose close to (US) $3 billion in 2011 from the previous years estimates, with Prime Minister David Cameron pledging that defence spending will be reduced by 8% over the next four years.

Those reductions have targeted several areas. First, the Ministry of Defence is scheduled to reduce its staff by 42,000, which includes each branch of the military as well as civilian employees.

The government has also decided to decommission the Navy’s flagship carrier, the Ark Royal, right away instead of 2014, which was originally planned. The good news for the Navy is that both new aircraft carriers, the HMS Queen Elizabeth and the HMS Prince of Wales, will still be built.

However, for the next 9 years, no planes will be taking off from a UK carrier. In order to save the F-35 Joint Strike Fighter project, which will be used by the new carriers, the government was forced to retire the Harrier from service. It also sacrificed its reconnaissance jet in order to help pay for the F-35 as well as the Eurofighter.

The Navy will also be generating savings by reducing its Trident nuclear missile levels. Now, each ship will carry about 40 warheads instead of the previous 48. The government has also pledged to cut its nuclear stockpile to around 120. It hopes that these reductions will save about $1.2 billion (US).

The Army was not spared in the cost-cutting. It will be losing 40% of its tanks, 35% of heavy artillery and will lose some brigades.

With all the planned cuts, the UK has pledged to maintain 2% of GDP spending on defence, as is mandated by NATO. Currently, it is one of the few countries that actually stick to that promise.

Even the United States, which has served as the economic powerhouse of the world for almost a century, is on a dangerous economic path. Peter Orszag, Director of the Office of the Management of the Budget (OMB), commented on the Congressional Budget Office’s long range projections in June: “the (CBO) today released its long-term budget outlook. Just like the long-term outlook for our Budget, the CBO report concludes that we are on an unsustainable fiscal course. About this, there is no ambiguity.”

In an article written for the IMF, renowned economist Laurence Kotlikoff outlines the American fiscal position in dire terms. Kotlikoff examined the problem in terms of a fiscal gap, which is the average annual budget surplus over the long term that would have to be maintained in order to prevent the debt from growing any larger, while still funding promised obligations. He estimates that in the case of the United States, that gap is about 8% to 14% per year, expressed as a percentage of GDP. That means that to “achieve present value fiscal balance would require a change in the … government’s net cash flow equivalent to at least an immediate and permanent doubling of income taxes.”

An 8% annual growth rate, let alone 14%, in a developed country like the United States would be unheard of, especially on a sustainable long term basis. Since 1960, the US Government has run only six surplus budgets. The federal government budgets in 2009 and 2010 were both in deficit to the tune of about 10% of GDP. The CBO, in its long term predictions, sees no end to US Government budget deficits. With no curtailing of government spending and an ever increasing portion of the tax base going toward debt servicing, the capacity of the US government to raise new funds by borrowing will be increasingly diminished.

Pressure is being put on the US Department of Defense (DoD), whose budget stands at (US) $637 billion. Military spending in the United States accounts for about $1 of every $5 spent by the federal government.

Despite the United States’ precarious long term financial position, The White House sees a growth of 1.8% in 2011 and 1.1% in 2012 for the DoD budget.

US Secretary of Defense, Robert Gates, announced in the summer that he would be finding $100 billion (US) of savings over the next five years. He plans on reducing the military’s reliance on contractors, reform procurement and eliminating unnecessary items. Indeed, he looked to be doing just that when he announced that the DoD no longer needed nor wanted the additional F-22 Raptors. He also cancelled new shipbuilding and the development of new missiles. Yet, the savings associated with most of these cuts will be funneled directly back into the DoD coffers, with new spending on unmanned aerial vehicles (UAV) such as Predator drones, and other counter-insurgency projects.

The National Commission on Fiscal Responsibility and Reform, created by President Barack Obama, just released its report in November and targeted the Department of Defense.

It recommended the F-35 Joint Strike Fighter, the largest military procurement, be cut in half, with certain versions of the jet being eliminated all together. The commission also suggested cancelling the V-22 Osprey, a vertical take-off capable tiltrotor airplane, along with other planned combat vehicles. The Commission estimated that these could save the government $100 billion (US) by 2015.

Of the Commissions recommendations, Secretary Gates said “math, not strategy.”

The Commissions recommendations are non-binding and Congress is still the body that must pass any reform. With each congressional district employing DoD members or companies that rely on DoD procurement, such drastic cuts seem improbable.

What is clear is that the United States can not sustain its current fiscal path. But there seems to be no political will to address this very serious problem. What will happen to the NATO alliance as the country that spends more than $600 billion on its military every year grows increasingly insolvent?

2009 Deficit: $56 billion… Being Nowhere Near Default: Priceless

Even those NATO countries who remain in a comparatively strong financial position, like Germany, the Netherlands and Canada will sustain economic damage arising out of the weak financial position of other nations.

Germany, in one of the best fiscal positions, has decided to reduce the amount it spends on defence by €8.3 billion by 2014. To do this, it plans on reducing the number of soldiers from 250,000 to around 165,000. The country recently announced that it was suspending conscription there, which it hopes will produce a more efficient force, as a measure to contribute to the cost-cutting target.

Canada is in a relatively strong financial position when compared to other NATO countries. With a government that, until recently, had been running budget surpluses, a financial system that emerged from the economic crisis relatively unscathed and with vibrant and growing economy, Canada is in one of the best financial positions of any country in the western world. But that does not mean that Canada is without its risks.

The recent Bank of Canada assessment of the risks facing the Canadian economy, found that while Government and corporate wealth in Canada is comparatively strong, there is a dangerous trend of increasing personal debt among Canadian households. This increase in personal debt is growing faster than the rate of income, suggesting that the historically lower interest rates are making it more affordable and more attractive to borrow money. Much like the risks facing sovereigns, this makes Canadian individuals more susceptible to corrections in interest rates or economic downturns.

“The crisis is not over, but has merely entered a new phase,” said Mark Carney, Governor of the Bank of Canada. “In a world awash with debt, repairing the balance sheets of banks, households and countries will take years. As a consequence the pace, pattern and viability of global economic growth is changing, and Canada must adapt.”

But adapting may prove more difficult than it might seem. Canada, as a resource rich country with strong manufacturing and technology sectors, relies heavily on sustaining trade with the EU and the United States. In fact, 30% of the Canadian GDP is derived from exporting and 75% of Canadian exports end up in the United States. So, any financial trouble that the US, or indeed the EU, experiences will certainly be felt in Canada. As demand falls, so too will Canadian exports.

The Department of National Defence has seen its budget increased by about 8% per year over the past five years. As the combat mission in Afghanistan starts to draw to a close, that number is expected to drop. It is estimated that the budget will be cut by (CAN) $500 million in 2012-2013 and again in 2013-2014. So, while spending is expected to still increase, it will not be at the high levels previously seen.

Canada is still expected to follow through on its procurement of the F-35 and the $5.7 billion purchase of 28 Cyclone helicopter, scheduled to replace the Sea King fleet.

However, with regards to the F-35, it has become a symbol for the opposition, claiming it is unnecessary, especially at a time when the government continues to run a deficit. One would have to assume that with a minority government in power and a potential election at any time, the contract could be in jeopardy depending on the results of an election.

The strong fiscal position of countries like Canada and Germany are in many ways dependent upon the financial strength of their allies for trade and mutual support.

On the Road to Chapter 7: Restructuring

NATO has witnessed many events in the world, from the Cold War to the fall of communism; from humanbeings landing on the moon to a potentially weaponized space. Through all of the dangers that it has faced, it has always emerged as the victor. That is why it is continuously referred to as the most successful alliance in the history of the world.

However, past performance does not guarantee future success.

With a more long term view, the path that many NATO countries find themselves on becomes increasingly unsustainable. We have discussed the problem with metrics like debt to GDP and current account deficits to illustrate how alarming the sovereign debt crisis is becoming. Indeed, those are important metrics of the economic health of a country. However, when viewed historically, debt to GDP is not a very accurate measure of the probability of sovereign default; far more accurate is the ratio of interest payments to revenue. That is to say, as long as the percentage of revenue that is used to service debt is very low, the probability of a nation failing to meet its obligations is also quite low.

Now if we consider that in the past decade interest rates have been at the lowest levels in history, there is almost no possibility that the debt servicing costs of these nations will decrease. On the contrary, if investors in sovereign debt believe there is even a slight possibility of default, they will want to be compensated with higher yields, increasing the costs of borrowing.

The strategy of currency debasement is still available to some countries. If governments pursue a strategy of quantitative easing, as the Federal Reserve and the ECB have done with the bank and sovereign bailouts, the value of the currency will be reduced. If investors see inflation occurring, they will want to be compensated with higher bond yields, or yields that account for inflation, which offset the benefit of the quantitative easing over the longer term.

Many of the world’s most powerful nations are in a very dangerous economic position with very few avenues available to make meaningful inroads into their debt situation. This is why many countries like Britain and France are taking such drastic actions to try to avert the impending threat of economic ruin.

Yet this new threat is much different. It is a threat that is so systemic that many have no hard theory on how to defeat it. It is a threat that has been evident and growing for years, yet one that has been largely ignored for just as long.  Make no mistake about it, these deficits and debts are just as dangerous to the long term security of NATO as the Soviet Union was in the 1960s. Our reliance on credit could very well be an economic nuclear detonation.

Whether this is the winter of NATO’s discontent is still to be seen. What is clear, however, is that to remain the dominant military alliance in the world, NATO countries must bring their finances into check. Countries are starting to react now to the years of inaction, but given the gravity of the problem, in many ways they are only slowing the speed at which the ship is sinking.

NATO has indeed been the most successful alliance in the history of the world. Hopefully it can emerge from this war on the debt with that title still intact.

By Greg McBride and  Sean Palter

*Disclaimer: The opinions expressed in this article are solely the author’s, and do not represent those of The NATO Council of Canada.

About NATO Association of Canada

The NATO Association of Canada strives to educate and engage Canadians about NATO and NATO’s goal of peace, prosperity, and security. The NATO Association of Canada ensures that we have an informed citizenry able to contribute to discussions about Canada’s role on the world stage.