LEC6: The finance of war & economic consequences of war II Flashcards
What is the Guns vs Butter Trade-off?
The Guns vs Butter Trade-off is a traditional economic model of a fixed budget
contraint.
The idea is that in order to increase the supply of guns, you must sacrifice butter.
Guns: Military spending
Butter: Social spending, tax relie
What is PPF/Feasible Frontier?
The Production Possibility Frontier (PPF) OR feasible frontier is a curve made of
points that defines the maximum feasible quantity of one good for a given quantity of the other.
So the maximum of guns or butter or a combination of the two that a state
may produce (red line in the graph).
Because we assume that actors are rational, we assume that actors will spend along the red line. The cannot spend above the red line, they are constrained.
What are the implications of Guns vs Butter
**Arms impose a cost on society
** Butter leads to growth, but arms rarely do. Arms could lead to innovation
though.
Butter can increase the future PPF outwards through economic growth.
The more you can spend on guns in the future.
Guns now decreases the future PPF.
Less guns later or even greater butter trade-off.
Regimes that can neglect butter might have an easier time waging war.
However, this cannot hold up in the long run.
How to avoid the guns vs. butter constraint?
States prefer to avoid the guns vs. butter constraint, so they have two
options to relax this fixed budget constraint:
- Borrowing - have guns now pay later
- Alliances - sharing military capacity with other states
What are the 3 benefits of borrowing for guns?
- More money to finance arms
- In general, states that have access to capital markets bring more money and
thus more weapons and troops to fight - Tax smoothing
Borrowing helps governments overcome gaps in taxes and revenues and helps them grow in the long run by avoiding distortionary taxes and
spending cuts
Security Implicactions
A. States that can borrow can more easily maintain military might in the long run
B. Unexpected events. like wars, restrict long run growth in states that cannot borrow.
Borrowing has political benefit
- Government can hide the cost of the current security from the public
- Purchace public and private goods to reward your supporters
- Increase popularity by borrowing to fund a war
- Maintain butter while increasing guns
- Use debt for a short term economic stimilus, before elections
Why do some state have easier access to borrowing than others.
This is caused by the
sovereign default risk, which reflects the likelihood that a government will default on its sovereign loans.
Default = miss a payment on a debt.
The higher the default risk, the larger the interest rate you have to pay and the less money creditors are willing to lend you.
What makes a nation more creditworthy than others?
- Democratic Advantage
- Central Banks
- Creditors in Government
How do Interest rates impact the probability of victory in war:
Higher interest rates lower the probability of victory.
This effect is weakest in autocracies.
Democracies are more sensitive to the costs of war.
Are states that have access to credit more hostile in their foreign policy?
Creditworthy state leaders initiate more interstate conflicts.
How to relax budget constraints to buy guns using alliances?
States can rely on other states to provide security.
By forming an allience states can:
1. Benefit from specialization
As a state you don’t have to be good at everything, but you can each
specialize in something different.
2. Exchange non-security goods for security
Alliances can mean less guns and more butter. Alliances can be a substitute when you don’t have access to credit.
What are the costs of alliances for Guns?
Collective action problem
States may free ride on others’ contributions.
Risk of abandonment
Allies may not hold agreements in a crisis.
Risk of entrapment
Alliances may embolden states to start conflicts others don’t want to fight.
How to understand war and security financing?
Understanding war and security financing starts with the Guns vs. Butter trade-off.
it gets interesting when we consider if and how states can overcome it the
trade-off.
Evidence:
States with access to credit overcome the G vs. B constraint.
They are more hostile
They spend more on military spending
They are less likely to form new alliances
What are the macroeconomic indicators?
- GDP
- Inflation AS/AD
- Budged deficit and debt (Fiscal Policy)
How do wars and conflicts impact these indicators?
What is the AS-AD model?
The
AS-AD model consists of:
1. Aggregate supply: Total quantity of output firms will produce in an economy (real
GDP).
2. Aggregate demand: The amount of total spending on domestic goods and services
in an economy (C + I + G + XN).
The impacts of war on the aggregate supply and demand are:
- Aggregate demand will increase
As government spending (G) on military goes up immensely, the increase in G
compensates for the decrease in consumer spending (C) and investements (I).
- Aggregate supply will decrease:
Production will go down
This will result in higher prices and therefore cause inflation
There will be a drop in GDP, as less is being produced.
What is Fiscal Policy?
Fiscal policy is the use of government spending (S) and taxation (T) to inflluence the economy and stimulate aggregate demand or supply.
If government spending exceeds taxes, the government creates a budget deficit
- If the budget deficit is zero (budget is balanced) → S = T
- If the budget deficit is positive (fiscal balance is negative) → S > T
- If the budget deficit is negative (fiscal balance is positive) → S < T
The stock of deficits is called
public debt.
In war the budget deficit and therefore public debt often increases, as government spending will exceed received taxes.
