Outside the EU, the UK Economy Will Remain Structurally Disadvantaged (2024)

Since the Brexit vote in 2016, the British economy has underperformed relative to the pre-Brexit trajectory as well as relative to its peers, and it will likely to continue to underperform in the next few years, even though the political implications of weaker economic growth will be limited and will not change the political elites’ attitude towards rejoining the EU. Following World War II, the British economy used to be referred as the “sick man of Europe” characterized by low economic growth, high government debt, stop-and-go macroeconomic policies and general underperformance compared to its Western European peers. While many factors contributed to the UK’s disappointing economic performance, an important factor was the UK’s reliance on the Commonwealth and its late joining of the European Community, which would have exposed British industry to greater competition from other advanced economies and helped increase UK productivity. While France was experiencing its trente glorieueses and Germany its Wirtschaftswunder, the British economy, and especially British industry, was undergoing relative decline. Hence the moniker “sick man of Europe.” The combination of joining the European Community in 1973 and Thatcherite economic liberalization, starting in the late 1970s, helped revive the UK’s economic fortunes and put it on a more favorable economic trajectory, until 2016. Empirically, it is difficult to disentangle the relative importance of European economic integration and domestic economic liberalization. Between 1961 and 1980, French real GDP growth averaged 4.7%, compared to 2.7% in the UK. Between 1981 and 2016, the UK economy averaged real GDP growth of 2.3%, compared to 1.8% in France and 1.7% in Germany. 

The decision to leave the EU and the Common Market has had a material cost to the UK economy in terms of lost output, while the offsetting benefits have thus far disappointed, translating into a tangible UK underperformance relative to its pre-Brexit growth as well as its European peers. Long-term economic growth is a function of many factors, including demographics, savings and investment levels, technological innovation, macro-economic and regulatory policies as well as international trade integration. And there are different ways of measuring economic performance by, for example, accounting for differences in demographic changes or levels of per capita income. However, both relative to its performance pre-Brexit and its relative economic performance vis-à-vis its European peers, France, Germany and Italy, the UK economy has lost ground in recent years. The five-year real GDP growth in the UK in 2016 was 2.4%, significantly higher than in France, Germany, Italy and the US. It has since fallen to 0.8%, lower even than Germany’s five-year average real GDP growth and only half of the US’s.

The consensus among economists is that the UK is significantly worse off than it would have been if Brexit had not happened due to lower investment, lower economic confidence and higher costs of doing trade with its most important trading partner, the EU. In 2021, the UK government’s Office of Budget Responsibility (OBR) projects the economic costs to be 4% of GDP lower in the long run. In 2024, Goldman Sachs estimated that the UK economy underperformed its peers by 5% since 2016, though the actual impact may have been 4-8% of real GDP, relative to a non-Brexit scenario. The UK has also experienced higher inflation than its European peers. UK prices today are 31% higher compared to 2016, compared to 24% in Europe. In 2023, business investment, the major driver of economic and productivity growth, was only 6% higher than in 2016. In the United States, it was up 25%. Major UK trade deals remain without reach (US, China) and trade agreements reached since 2016 have had a negligible economic impact. Finally, while Britain has historically lagged its peers in terms of business investment, it has underperformed very dramatically in recent years. · 

Britain’s economy will continue to underperform, but this is unlikely to change the elites’ attitude towards EU membership, even though a Labour government will be more inclined to seek greater cooperation with the EU. The Tories’ quest for “Singapore on the Thames” has remained elusive. The UK has a competitive advantage is in high-value services, helped by geography, agglomeration effects, English law etc. While it makes sense for the UK to focus on trade services liberalization with third countries, the government has made very little progress. The EU will remain the UK’s dominant trade, followed by the United States. Much lower levels of trade with other countries mean that gains from trade liberalization will be very limited. As of 2022, 43% of UK merchandise exports went to the EU, 12% to the United States. In terms of services trade, the EU is less important, accounting for 37%, compared to 28% for the United States. For reference, unusually for a large economy, the UK is highly dependent on services exports (services: USD 490 bn vs merchandise: USD 530 bn). High-level trade agreements on services can be particularly difficult to reach given that it significantly affects non-tariff barriers. The UK has also made little progress on domestic regulatory reform in party because to retain access to the EU market makes it difficult to significantly liberalize parts of its regulatory regimes. 

The outlook for growth-boosting was always and will remain dim. A free-trade agreement with the United States is not going to happen because Washington does not do free-trade agreements anymore. A free-trade agreement with China, the world’s third-largest economy, is not on the agenda. Negotiations with protectionist-leaning India are proving difficult. There will be little economic uplift from international trade negotiations. Except for the United States and China, there are no trade deals to be had that would make a significant difference to UK’s medium- to long-term economic growth. While the Indian economy is growing quickly, its economic size in nominal GDP terms is relatively small compared to the US and China and UK trade is small and would only increase from a very low base, not to mention that the India will be reluctant to open some its services substantially to UK exports. The UK is set to join the CPTPP this year, but even here the economic benefits will remain modest given that the UK already has free-trade agreements with virtually all members (except Malaysia). The OBR estimates a GDP gain of 0.04% over the next 15 years. 

Economic reasons as well as shifting public attitudes towards cooperation with the EU/ EU membership will over time lead the UK to seek greater economic cooperation with its largest trading partner, the EU. UK public opinion has become more pro-EU membership in recent years. A November 2023 YouGov poll showed that 57% of Brits would support the single market if it allowed for a resumption of the free movement of people. Roughly 20% opposed rejoining the EU. The poll also showed that nearly ¾ of Britons want closer ties with the EU. Support for rejoining the EU is greater among Labour than Conservative voters. But this will be slow incoming and it will not compensate for the losses caused by Brexit for the foreseeable future. 

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India's Decade (2024)

A stable government and a strong medium-term economic growth outlook will make it easier for the re-elected BJP government under PM Modi to direct economic resources and diplomatic efforts towards managing India’s complex security environment during the remainder of the decade. Indian domestic politics has been dominated by the Bharatiya Janata Party (BJP) and Prime Minister Narendra Modi since first coming to power in 2014. Prime Minister Modi dominates the BJP and the BJP and its electoral coalition dominates national politics. The Indian opposition remains fragmented and the Congress party weak. The general election set to be held in April/ May will see the prime minister secure a third five-year term and high approval ratings. The BJP’s dominant position will give the government significant leeway to pursue its domestic economic and foreign policy agenda. On the flipside, Modi policies have contributed to inter-ethnic tensions between Hindu nationalism and India’s Muslim minority. The outbreak of inter-ethnic violence will remain a risk during Modi’s third term in office, which might make it complicate relations with some its Western partners.

After a decade in power, the Bharatiya Janata Party (BJP) and Prime Minister Narendra Modi remain very popular. The Congress party and other opposition parties are politically weak and very fragmented. In December 2023, PM Modi’s approval rating stood at 76%, according to Morning Consult, making him the most popular head of government in the world. In recent polls, the right-wing National Democratic Alliance (NDA), which is led by the BJP, led the Indian National Developmental Inclusive Alliance (I.N.D.I.A.), which is led by the Indian National Congress, by 8-13 percentage points. Recent polling projects the right-wing alliance between 296 and 366 out of 543 seats in the lower house, compared to 350 seats in 2019. This would continue to represent a sizable margin and allow the BJP and Modi to retain dominance of Indian national politics. In the last interim budget presented before the 2024 elections, the Modi government opted in favor of increased funding for infrastructure investment rather than more traditional pre-electoral tax cuts for the middle class and significant in increases in social spending, including subsidies for poorer households. The budget allocated the equivalent of $130 billion to fund physical infrastructure, which represented a more than 10% annual increase. A more growth-friendly macro-economic policy is made possible by the BJP’s electoral dominance.

India’s medium-term economic growth outlook is strong, which will help its double its economic size over the next decade and consolidate its position as the world’s third-largest economy. India has overtaken China as the world’s fastest-growing major economy in the world. Moreover, India will likely be able to sustain real economic growth of more than 6% annually during the remainder of the decade, flanked by broadly sensible macroeconomic policies. India will also benefit from increased foreign investment in the context of multi-national corporations’ supply chain reengineering and friend-shoring. Solid domestic investment levels and an increasing focus on much needed, productivity-enhancing infrastructure investment in the context of manageable fiscal policy and government debt levels also bode well for India’s medium-term economic growth.

India is today the world’s fifth-largest economy in nominal dollar terms and it is the third-largest economy in terms of GDP measured purchasing-power parity. India is currently ranked 121 out of 185 countries in terms of per capita income at PPP, just below Laos and just above Uzbekistan, with a per capita income of $7,100. By comparison, US and Chinese GDP per capita income was $18,700 (69) and $59,500 (11). Both the IMF and the OECD project Indian real economic growth to average more than 6% in the next few years. While this is significantly lower than the growth China registered during its heyday, it does make India the fastest-growing major economy in the world. India ’s real economic growth rate now comfortably exceeds China’s growth rate of 4-5%. On its current trajectory, India’s economy will more than double in size from less than $10 trillion in 2020 to more than $20 trillion by 2030. In non-inflation adjusted terms, this will make India’s economy three times larger than Japan’s today. India’s per capita income will exceed $10,000 by 2030.

India is benefitting from a favorable demographic momentum, but also from a major, favorable demographic transition. The country’s fertility has declined to just over 2, which is below the replacement ratio of 2.1. This is translating into an improving dependency ration (ratio of people of working age/ people of non-working age), which creates favorable conditions for increasing the national savings rate and investment, while expanding the labor supply in relative (and absolute) terms. Investment in India has averaged around 30% of GDP in the past few years. Interestingly, this is lower than at the beginning of the past decade, which suggests that India has significant room to increase both savings and investment in the next few years. Indeed, China managed to generate a savings rate of 50% and real GDP growth of 10% during its high-growth phase.

With the government not having to worry about its ability to hang on to power over the next five years and with strong economic wind in its sails, India is well-positioned to mobilize the resources and expend the diplomatic efforts necessary to pursue its foreign policy goals in a continuously complex international security environment. India’s greatest strategic challenge is to manage security and economic relations with China, including in the Indian Ocean, where Beijing’s geostrategic and commercial interests are expanding. This will force India to compete for influence in countries like Sri Lanka and the Maldives. While Pakistan, India’s traditional geopolitical rival, is currently experiencing significant domestic political and economic challenges, India also needs to manage its long-standing rivalry with Pakistan. Meanwhile, India will seek to form a closer (but not too close a) relationship with the United States without entering formal alliance commitments. The goals is to partner enough with the United States to deter China without running the risk of being drawn into a broader US-Chinese conflict. Finally, India needs to diversify its sources of foreign defense purchases after Russian sales to India have declined in the wake of the Ukraine war. Europe and the United States are the only other major suppliers. India’s rapid economic development, increasing defense expenditure and domestic political stability will make it an attractive partner for the United States and European countries. 

Pakistan and India are the greatest strategic challenges India will be continue to face. Pakistan remains a major security concern for India. India and Pakistan have fought wars in 1947, 1965, 1971 and 1999. While Pakistan is experiencing significant domestic and economic challenges, which makes it more difficult for Islamabad to compete strategically, instability does also create risks. The source of the conflict, control over Kashmir, and broader security competition will continue to require India’s attention, not least because Pakistan has nuclear weapons, which is why domestic political instability is not seen as a good thing by New Delhi. Border disputes are also an important source of Indian-Chinese security competition. India fought wars with China in 1962 and 1967. More recently, border skirmishes in disputed areas led to several deaths. China also has friendly ties with Pakistan and is a major provider of financial support to India’s rival, including infrastructure projects that New Delhi regards as threatening (e.g. Gwadar). China has also been pushing into maritime space around India to secure access to the oil-rich Gulf states. This is leading to intensifying security competition in India’s “near abroad”, including Sri Lanka and the Maldives. 

India will continue to seek closer, if selective cooperation with the United States and Europe. India joined the Quadrilateral Security Dialogue (Quad), which brings together the United States, Japan, Australia and India. Among other things, the Quad is committed to a Free and Open Indo-Pacific, and it is the sort of loose security cooperation India seeks and prefers to more formal treaty commitments to deter China. India also joined thirteen other countries under the U.S.-led Indo-Pacific Economic Framework (IPEF), which has a similar purpose in the economic realm. Meanwhile, India has refrained from joining Western sanctions targeting Russia and in fact increased its energy trade with Russia, which shows the limits to India’s alignment with Western countries. India is the world’s fifth-largest military. In 2022, it spent more than $80 billion on defense (in current dollar terms). Strong economic growth will allow the government to increase spending by 6-10% annually in nominal terms. Indian defense equipment imports from Russia have declined sharply in the context of the Ukraine war, which will lead India to seek closer cooperation with other countries able to offer advanced defense equipment. In June 2023, Germany and India signed an agreement for the possible construction of six submarines for India. In January 2024, France and India agreed to establish a defense industrial partnership for joint production of defense equipment, including helicopters and submarines.

After Three Decades of Decline and Stagnation, Global Defense Expenditure Will Increase, As a Share of GDP (2024)

Although as a share of GDP global defense spending has not changed in the decade leading up 2022, increasing security competition in Asia and Europe will lead to lead a significant acceleration of national defense spending, particularly in Europe and East Asia, though spending levels will remain well below the levels seen during the Cold War. Following the end of the Cold War, global defense expenditure declined sharply. Many of the Warsaw Pact countries, including post-Soviet Russia, faced severe financial difficulties, forcing them to sharply reduce defense spending. The end of strategic competition between NATO and the Warsaw Pact also led NATO countries and other U.S. allies to reduce defense expenditure. In the three decades following the end of the Cold war, global defense expenditure as a share of GDP fell from 4% of GDP to 2% of GDP, while in advanced economies it fell from 4% of GDP in 1970s to less than 2% of GDP in 2020. 

In aggregate defense expenditure expanded in line with nominal GDP growth over the past decade. But this masks important shifts in military spending on a country-by-country and inter-regional levels. In real terms, U.S. defense expenditure increased less than 3% in 2013-22, while Chinese, Indian and Korean spending increased 63%, 47% and 37%. Japanese defense expenditure increased a respectable 18%. U.S. defense spending increased sharply in the early 2000s, peaked at just below 5% of GDP in 2010 and has since declined to below 3.5% of GDP. The United States proved a notable exception among the world’s largest economies against the backdrop of the wars in Afghanistan and Iraq. As a share of global GDP, military spending in 2022 was virtually unchanged compared to 2013. 

Defense expenditure as a share of GDP varies significantly. Among the top-15 countries, Russia, Saud Arabia, Ukraine and Israel spend more than 4% of GDP on defense. Ukraine defense spending was estimated at a whopping than 1/3 of its GDP. In terms of GDP, Kuwait, Qatar, Oman are also major military spenders. Defense expenditure in European and East Asia is increasing rapidly. Global military spending reached $2.2 trillion in 2022. The five largest spender accounted for almost 2/3 of total spending. The world’s leading countries by military expenditure in dollar terms: United States ($877 billion), China ($292 billion), Russia ($86.4 billion), India ($81.4 billion) and Saudi Arabia ($ 75 billion). The fifteen largest spenders accounted for more than 80% of global spending.

                                                                                                

Accelerating defense spending will be driven by intensifying international security competition in Eastern European and Asia. The war in Ukraine and geopolitical competition in the East and South China Sea as well as the Indian Ocean are leading virtually all major powers to increase defense spending faster than nominal GDP growth. By comparison, expenditure in South America and Africa has not changed dramatically. The war in Ukraine has forced Russia to raise defense expenditure very significantly and it has spurred European countries, especially Eastern European countries, to raise military spending. Against the backdrop of accelerating spending, global arms exports have also increased, too. 

Among the G7 countries, Germany and Japan have announced significant increases of military spending over the next few years. Russia increased defense increased dramatically after the failed blitzkrieg against Ukraine. In 2024, Russia is set to spend 6% of GDP on defense, compared to an estimated 4% in 2022 (and 2014). By comparison, Soviet defense spending in the 1980s is estimated to have accounted for 15-17% of GDP. In 2022, the Japanese government announced a 60% of increase of defense expenditure by 2027, and Germany pledged to allocate an extra 5% of GDP to modernize its military forces and increase annual defense expenditure over the medium term. Many NATO members will increase defense expenditure above the level of economic growth in view of meeting the two-percent target they committed to in 2006. Currently, only 1/3 of NATO members meet the spending target.

Due to higher nominal growth and a larger spending base, the United States and China will account for the largest share of global spending increases with combined defense spending amounting to $2 trillion by the beginning of the next decade. Finally, global international arms transfers fell 5% in 2013-17 compared to 2018-22. However, imports increased almost 50% in Europe and East Asia, while declining in Africa, the Americas, the Middle East and Asia and Oceania as whole. Imports by South Korea (61%) and Japan (171%) were up sharply. Japan’s decision to increase defense expenditure should further raise Asian arms imports during 2023-27. 

Although defense expenditure will increase tangibly for the foreseeable future, as a share of GDP it will remain well below levels seen during Cold War, absent the outbreak of hostilities in East Asia or a further significant escalation of the war in Ukraine. The major powers today have higher government debt and larger fiscal deficits than during the Cold war. Social welfare expenditure a share of GDP is much higher, constraining government’s fiscal space more than in the past. Government debt and fiscal deficits in most advanced economies are far higher than during the Cold. Implicit government liabilities are also much higher and will constrain government’s fiscal space over the medium- to long-term. In the short term, political constraints on limiting non-defense expenditure, higher taxes to finance defense spending or increased borrowing will limit how quickly defense expenditure will increase. In the context of peacetime competition, the political constraints on defense expenditure are greater due to domestic distributional conflict. For these reasons, the increase in defense spending in Europe and East Asia will be gradual. 

However, should security competition heat up or lead to military conflict, the political constraints on spending increases would weaken quickly. While expenditure will increase faster than nominal GDP growth in any advanced economies, this may not be the case in the two countries with the world’s two largest defense budgets in dollar terms, the United States and China, which account for half of global spending. However, relative faster economic growth, particularly in China, current economic challenges notwithstanding, will nonetheless translate into significant increases in dollar terms. China has undoubtedly far greater scope to raise defense expenditure during peace time than the United States, given that Washington already spends twice as much as a share of GDP than China. Among the top-15 countries with the highest level in defense expenditure, China is best placed to increase spending in both dollar terms and as a share of GDP. 

U.S. defense spending amounted to 3.5% of GDP. Chinese defense spending was 1.7% of GDP. In dollar terms (at market exchange rates), U.S. spending is three times larger than China’s ($880 billion vs $300 billion). However, faster Chinese economic growth will allow it to increase spending faster, even without raising spending levels as a share of GDP. Under reasonable economic and financial assumption, U.S. defense expenditure could reach $1.3 trillion by 2030, up from less than $900 today (in current dollars). Chinese expenditure is set to increase from $300 billion today to $500 billion. 2030 defense expenditure would be equivalent to 3.5% of GDP in the United States and 2.2% of GDP in China.

The post-Cold War era generated the so-called peace dividend; the “post-post” Cold War era will be characterized by greater unproductivity defense expenditure, which will prove a drag on medium-to long-term, if not necessarily so in the short term. The acceleration of economic growth and global prosperity after the end of the Cold War was underpinned by globalization, the integration of China into the world economy, supply-side reforms and economic liberalization and technological innovation. Investment and economic growth also benefitted from the significant reduction of military spending made possible by the end of the Cold Car. Downsizing he armed forces and reducing relatively unproductive defense spending helped generate fiscal savings, lowered interest rates, increased non-defense investment and boost the civilian labor force. Going forward, increased military expenditure, like most deficit-financed government spending, may help boost short-term economic growth, particularly in the presence of spare capacity. But longer-term, the diminished availability of savings, higher interest rates and more limited productivity-enhancing investment will weigh on long-term growth outlook. 

To the extent that an economy benefits from excess savings, like China, the scope to raise defense spending without unduly reducing the growth potential is far greater than in more savings-constrained advanced countries characterized, additionally, by more challenging medium-term budget and debt dynamics. To the extent that China’s economic problems are related to excess domestic savings, increased defense spending, sometimes referred to as “military Keynesianism” affords it far greater financial scope than more slowly-growing, more savings-constrained advanced economies in Europe and East Asia. China is the least savings-constrained economy with savings amounting to almost 50% of GDP, compared to Japan with 23% of GDP. and the United States with 17% of GDP.

The Financial Dimension of Japan's New National Security and National Defense Strategy (20240

A modest long-term economic growth outlook rather than often-cited high government debt represents a significant constraint on long-term Japanese defense spending and provides Tokyo with enhanced incentives to strengthen its alliance with the United States and defense cooperation with regional and extra-regional partners. High Japanese government is only moderately constraining in terms of short- and medium-term defense spending. Government debt is extremely high in gross terms, but much less so in net terms, that is, after accounting for the government’s holdings of financial assets. Importantly, Japanese government is largely owned to residents and it is denominated in local currency and to residents. This sharply reduces the risk of sovereign debt distress and provides the government with greater fiscal flexibility than what high gross government debt may imply. Moreover, nominal and real interest rates of close to zero also suggest that the government retains significant room to borrow. Japan would need to see a significant widening of the real interest rates/ real GDP growth differential for public debt to move onto an irreversibly unsustainable path. Finally, if the Bank of Japan were forced to sell government bonds at a loss or if its net interest margin were to turn on negative in the face of higher interest paid on its liabilities (reserves) than it earns on its assets, this would translate into losses and reduced central bank transfers to the government budget. But a sharp increase in nominal interest rates, as opposed to a normalization of the policy rate, is becoming less likely as inflation has been steadily declining. More importantly, as long as the increase in nominal interest rates does not translate into higher real interest rates, government debt dynamics will remain unchanged. In this context, raising annual defense expenditure by one percentage point of GDP is not going to break the bank. 

Japan’s gross government debt stands at 250% of GDP. Net government debt is 160% of GDP. Net public sector debt is 120% of GDP. Only 14% of Japanese debt securities are owned by non-residents and they are denominated in Japanese yen. The IMF forecasts the fiscal deficit to fall to 3.7% of GDP this year and 3% of GDP next year in the context of a slight decline of the gross debt-to-GDP ratio. The Bank of Japan’s budget contribution to the government is only 0.3% of GDP. If the Bank of Japan were to suffer financial losses in the context of higher interest rates, the direct fiscal impact would be limited. After hitting a four-decade high in 2023, inflation fell to 2.6% in December and is set to fall to the Bank of Japan’s two-percentage inflation over the course of 2024, thus limiting the need to make major adjustment to nominal interest rates. The central bank may yet to decide to raise its policy rate from -0.1% to zero, but this will have virtually no effect on government debt service or debt dynamics.

Japan’s strong international creditor position means that it has ample scope to draw on international financing and resources to support defense spending. In addition to running a large current account surplus of 2-4% of GDP, which translates into a roughly equivalent increase of net foreign assets, Japan is the world’s largest net international creditor in dollar terms. This provides it with significant leeway to draw on foreign resources, if necessary, to support defense spending without jeopardizing its international financial position. In principle, the Japanese government could purchase 4% of GDP worth of foreign defense equipment without jeopardizing Japan’s international financial position, even though it would add to government debt unless it is funded through higher taxes or reduced expenditure.

Japan’s net international credit position is equivalent to 70% of GDP. While some smaller economies have a stronger net external position as a share of GDP, Japan is the greatest international creditor in dollar terms with net international claims exceeding $3 trillion (or 50x times annual defense spending). The Bank of Japan alone holds $1.3 trillion of high-grade foreign assets. Japan’s current account surplus has averaged more than 2.5% of GDP annually in the past four decades, and it is set to account for 3-4% of GDP this year, or more than $100 billion annually. As far as the balance-of-payments constraint is concerned, Japan has ample scope of scope to tap external resources to support defense spending increases. A strong external financial position allows the government to provide significant scope to engage in international financial diplomacy in support of its alliance and security policies. While external lending would add to the government’s gross debt burden, its net debt would remain unchanged as long as it creates a repayable loan. Moreover, if the government provides loans in Japanese yen, it can provide very attractive financing terms to borrowers, not least given the lower yen funding costs.

The more significant economic-financial constraint on medium- and long-term defense spending relates to Japan’s modest growth potential, not its external financial or fiscal position. Japan’s nominal GDP at purchasing power parity is a very rough proxy for the broader resource base from which defense spending is sourced. Japan has the world’s fourth-largest economy in terms of purchasing power after China, the United States and India. Naturally, a country’s economic resource base does not translate one-for-one into actual mobilization, let alone defense spending that is effective in military terms. Varying levels of per capita income also affect the level of “extractable” resources. Politically, a government needs to be able to raise taxes, cut non-defense expenditure or borrow, domestically and internationally. The government bureaucracy needs to spend the resource efficiently and effectively. As for Japan, it is financially well-positioned to raise medium-term defense expenditure as a share of GDP. However, Japan’s modest long-term growth outlook means that a relatively stagnant economic resource base will nevertheless limit the extent to which Japan can increase the resources allocated to security in absolute yen or dollar terms. This does not mean Tokyo would not be able to mobilize very significant resources in an emergency. But it does mean that a slowly expanding resource base does put greater limits on long-term defense spending than in other countries, including China. Not only is Japanese defense spending much lower than China’s, China’s defense spendings is also expanding at a much faster clip in dollar terms. 

China is the world’s largest economy in PPP terms at $35 trillion, followed by the United States with $28 trillion and India with $14 trillion. Japan is the world’s fourth-largest economy at $6.7 trillion. Japanese real economic growth has averaged 0.6% of GDP over the past decade. This compares to 1.8% in the United States. Chinese real economic growth averaged 10% over the past four decades, but is projected to decline to 3.5-4.0% over the medium term. But Chinese growth will continue to exceed Japan’s growth rate by a factor of four. In nominal dollar terms at market exchange rates, the United States spent $880 billion, China $290 billion and Japan$46 billion in 2022. If China grows 4% in real terms and the United States grows 2%, while Japan grows 1% and if military spending as a share of GDP remains unchanged, the financial resources directed toward defense will be 50%, 20% and 10% higher a decade from now, respectively. To match the increase in Chinese spending, Japan would need to increase defense spending as a share of GDP from 1% (roughly the current level) to 4% over the next decade. While Japan has some scope to raise defense expenditure, such a significant increase would be challenging to implement, economically, financially and politically.

In view of the deteriorating security environment and China’s increasing military prowess and assertiveness, Tokyo is fully aware of its relative resource constraints and the need to strengthen its alliances with the United States as well as other regional and extra-regional powers if it wants to balance China. In the context of increasing geopolitical tensions in East Asia and beyond, Japan is undergoing a very significant shift in defense policy and spending. China’s increasing assertiveness, North Korea’s enhanced military capabilities and more recently Russia’s war in Ukraine have accelerated Japan’s shift towards a more resource-intensive defense policy. In 2022, the Kishida government published its National Security, National Defense Strategy and Defense Buildup Program, referring to China as an “unprecedented strategic challenge”. The new national security and defense strategy involves not just higher defense spending and the acquisition and enhancement of critical weapons systems, such as counter-strike capabilities, but also inter-service integration. The Japanese government committed to a significant increase in defense spending from a baseline of 1% of GDP. While the economic constraints on a significant increase of Japanese defense spending are more than manageable, Japan will not be able to match increasing Chinese defense expenditure due Japan’s much more modest economic growth potential. This is providing Tokyo with greater incentives to strengthen its alliance with the United States in the military and economic realm as well as other countries in Asia and further afield, including Europe and Australia. 

Japan intends to spend more than $315 bn on defense in FY 2023-27. This would represent an overall increase of 60% compared to 2022. Broader national security spending (not just spending controlled by the Ministry of Defense, e.g. coast guard) is supposed to roughly double from historically 1% of GDP to 2% of GDP over the next decade. This would make Japanese defense expenditure the third- or, depending on whether Russia will sustain its increased level of defense expenditure, fourth-largest largest in the world, after the United States and China. But even at these higher level, defense expenditure in dollar terms will remain much smaller than China’s and barely keep up with projected Chinese spending increases over the next few years.

The United States remains Japan's indispensable security guarantor. Japan and the United States have been treaty allies since 1951. US-Japanese defense cooperation has intensified over the years, including significant revisions to defense guidelines in 1978, 1997, 2015, which have provided the Self-Defense Forces greater operational flexibility and have allowed for greater coordination and inter-operability with the U.S. forces in case of an attack as well as in case of U.S. forced engaging in military action near Japan. In 2017, the Abe government helped revive the Quadrilateral Security Dialogue (Quad) alongside Australia, India and the United States, which is committed to a Free and Open Indo-Pacific and is meant to counter China. In the economic realm, Japan joined the Biden administration’s Indo-Pacific Economic Framework (IPEF), which is focused on non-market access trade issues. Japan was also the driving force behind saving the Trans-Pacific Partnership (TPP), a high-quality free-trade agreement among countries in Asia and the Americas after the United States pulled out of TPP negotiations under the Trump administration and salvaged trans-Pacific trade cooperation by establishing the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTTP). 

Concerns about America’s reliability as an ally has also led Japan to pursue closer defense cooperation with other countries in Asia and beyond. Aside from the Quad, Tokyo has signed “Reciprocal Access Agreements”, which among other things provides for shared military training an cooperation, with Australia and the UK. Similar agreements are also being negotiated with the Philippines and France. Japan has also signed “Acquisition and Cross-Servicing Agreements” (or similar agreements) with Canada, France, Germany and Italy. Revealingly, Japan, the UK and Italy have also agreed to develop a next-generation fighter jet. Tokyo has also been seeking to foster closer economic and defense ties through South-East Asia, most notably with Vietnam.

 

 

 

 

Selected Writings On Geopolitics and Geoeconomics (2024)

2021

America 2021 - New President, Old Problems? (German Council on Foreign Relations, Commentary, March 3, 2021)

Germany Between a Rock and a Hard Place (German Council on Foreign Relations, Commentary, March 17, 2021)

Japan Welcomes EU and US Support (German Council on Foreign Relations, Commentary, May 19, 2021)

The Logic (and Grammar) of US Grand Strategy (German Council on Foreign Relations, Report, June 2, 2021)

Transatlantic Relations (German Council on Foreign Relations, Memo, September 16, 2021)

2022

Economic Equidistance is Not an Option (German Council on Foreign Relations, Policy Brief, January 20, 2022)

Promoting the Euro - Countering Secondary Sanctions (German Council on Foreign Relations, Policy Brief, February 8, 2022)

Defense and Deterrence Against Geo-Economic Coercion (German Council on Foreign Relations, Report, March 16, 2022)

Designing a Geo-Economic Policy for Europe (German Council on Foreign Relations, Policy Brief, March 22, 2022)

The Economics of Great Power Competition (German Council on Foreign Relations, Policy Brief, May 2, 2022)

Why China Is Stuck with the Dollar (German Council on Foreign Relations, Commentary, May 23, 2022)

Why America Won't Turn to Isolationism (German Council on Foreign Relations, Commentary, June 25, 2022)

Europe in an Age of Great Power Competition (Internationale Politik Quarterly , October 26, 2022)

US-Chinese Competition and Transatlantic Relations (German Council on Foreign Relations, Report, November 3, 2022)

Don't Get Caught in the Middle (German Council on Foreign Relations, Policy Brief, December 7, 2022)

2023

A More Strategic Approach to Foreign Direct Investment Policy (German Council on Foreign Relations, Policy Brief, February 7, 2023)

Promoting the RMB Will Limit, but not Quash , China's Vulnerability to Currency Sanctions (German Council on Foreign Relations, Memo, April 5, 2023)

Pathways to Economic Prosperity - Theoretical, Methodological and Evidential Considerations (Atlantic Council, September 18, 2023)

Restricting Technology Leakage (German Council on Foreign Relations, Policy Brief, September 25, 2023)

A Transatlantic Economic Security Alliance to Deter Geo-Economic Coercion (Bertelsmann Foundation, Policy Brief, November 28, 2023)

2024

Germany Needs an Economic Security Strategy that Prioritizes Import-Related Vulnerabilities (German Council on Foreign Relations, Memo, January 22, 2024)

The Case for an EU-US Economic Security Alliance (International Politik Quarterly, January 31, 2024)