Guns and Oil: An Analysis of Conventional Weapons Trade in the Post-Cold War Era

Khanna, Neha, Chapman, Duane, Economic Inquiry

I. INTRODUCTION

The end of the Cold War saw a dramatic reduction in the international trade in conventional weapons. From an all-time peak of 86.7 billion 19995 in 1987, world arms imports fell to 51.6 billion 19995 in 1999 (Bureau of Verification and Compliance 2002). But some important trends emerged during the decade of the 1990s that warrant analysis. First, a vast majority of conventional weapons went to the Persian Gulf countries, with Saudi Arabia emerging as the world's single largest weapons importer (though by the end of the 1990s, Taiwan was a significant importer as well). On the export side, the singular dominance of the United States was notable: in 1999, its share in world arms exports was 64%, an all-time record (Bureau of Verification and Compliance 2002).

Second, the motivations underlying the trade in weapons seem to have changed fundamentally. During the Cold War, much of the arms trade was driven by geopolitical factors associated with the arms race and the action-reaction type behavior of the two superpowers. However, Matelly (2003) shows that while the arms race between the United States and the former Soviet Union can explain U.S. military expenditures between 1952 and 1989, it fails to predict these expenditures in the post-Cold War period. Anderton (1995, 532) argues that there has been a shift from political to economic motives for arms transfers.

Our goal in this article was to determine, both analytically and empirically, the main drivers of international arms transfers in the immediate post-Cold War period (1989-1999). We postulate that the key reasons for the huge transfer of weapons to the Persian Gulf region are the enormous value of the oil wealth there and the dependence of Western economies, especially the United States and its allies, on access to the reasonably priced and steady supply of crude oil from this region. (1) For most of the years between 1989 and 1999, world oil prices remained remarkably stable and between about $15-20 per barrel (the notable exceptions being the Iraq-Kuwait war year of 1990 and 1998; Chapman and Khanna 2006). This was the result of an explicit Organization of Petroleum Exporting Countries (OPEC) price policy under which production was expanded or contracted to maintain prices within the target range. Military security in the Persian Gulf region, including the export of weapons from the United States and its allies to the Persian Gulf countries, was an integral part of the institutional framework that supported the oil price arrangement (Chapman and Khanna 2001, 2006).

We employ a traditional demand and supply framework, which includes economic factors such as production costs on the supply side and income and prices on the demand side, but also incorporate the political-economic factors represented by the trade in crude oil. We find that the association between arms trade and crude oil trade is robust, regardless of the empirical specification or data sources: there is a strong and positive association between arms exports and crude oil import, on the one hand, and between arms imports and crude oil exports, on the other.

The link between arms trade and crude oil trade is not new. After the decline of military aid programs, such as the U.S. Military Assistance Program, weapons transactions became more commercial. Historically, unprecedented OPEC oil revenues in the 1970s and 1980s provided an alternative source of finance and much of these petrodollars were spent on importing weapons. Conversely, weapons-exporting countries found a means to offset the balance of payments discrepancy that resulted from the higher oil prices (Levine, Sen, and Smith 1994, 3; Smith, Humm, and Fontanel 1985, 240-241). But the period considered in this study, 1989-1999, was an era of relatively low and stable oil prices, and this argument is not very satisfactory. (2)

The outline of the article is as follows. In Section II, we describe the analytical framework for trade in conventional weapons. The data are described in Section III and the results of the empirical analysis are reported in Section IV. Section V contains additional sensitivity analyses and Section VI concludes.

II. ANALYTICAL FRAMEWORK

Determining prices and quantities in the weapons market with any degree of accuracy is complex. This holds true both at the analytical level and at the empirical level (we defer the discussion of the empirical difficulties until Section III). Weapons are often traded as part of a larger package that may include related aspects such as access to technology and spare parts and seemingly unrelated aspects such as offset agreements (Levine, Sen, and Smith 1994, 4; Levine and Smith 1997, 346). In one example from the 1980s, Smith, Humm, and Fontanel (1985, 241) note that the Belgian purchase of military vehicles from Bombardier of Canada was tied to landing rights in Toronto for the Belgian commercial airline, Sabena. Furthermore, the close relationship between arms firms and national governments means that the production and trade of the weapons, not to mention research and development and marketing efforts, are often heavily subsidized by governments and that major international trades are more in line with national priorities than with the profit maximization goals of the private firms (Levine, Sen, and Smith 1994, 4; Smith, Humm, and Fontanel 1985, 242). In addition, the price at which weapons are traded need not be closely correlated with the cost of production, and different recipients may pay vastly different prices for identical products (Levine, Sen, and Smith 1994, 4; Levine and Smith 1997, 345-347).

Despite these complications, economists have addressed the international exchange of weapons using the standard economic model of welfare maximization, with its attendant demand and supply functions (e.g., Levine, Sen, and Smith 1994; Smith 1995). In the context of the arms trade, these models assume that the relevant economic agents are national governments, with full information and well-defined welfare and security functions (Levine and Smith 1997, 339). While this approach remains somewhat unsatisfactory, it ensures a logical consistency and provides a useful benchmark for empirical analyses (Smith 1995, 76) and it forms the starting point for our analysis as well.

A. The Supply Side. Arms Exports

On the supply side, the export of weapons can be derived by maximizing a supplier's welfare function, where welfare depends on the profit from as well as the security repercussions of the sale (Levine, Sen, and Smith 1994). Supply is thus determined by economic as well as strategic and political factors (Smith, Humm, and Fontanel 1985, 242-44). In the post-Cold War era, we hypothesize that the supplier's welfare, [V.sup.S.sub.i], is determined as follows:

(1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII],

where [[PI].sub.it], is the profit from the sale of weapons; P([Q.sub.t]) is the demand function facing the supplier; [q.sup.S.sub.it] is the quantity of weapons supplied by supplier i at time t; [Q.sub.t] is the total weapons supply at time t; C([q.sup.S.sub.it]) is the supplier's cost function; [S.sup.S.sub.it] is the supplier's national security that depends on [W.sub.t], the global stock of weapons at time t; and [X.sup.S.sub.it] is a vector of other factors that relate to political and economic security issues.

In the post-Cold War period, national security issues are just as likely to relate to concerns of economic security as to military security. With more than 75% of the world's identified crude oil reserves and more than 50% of remaining global oil resources located in the Persian Gulf countries (United States Geological Survey 2000), stable access to the crude oil of this region has become a major economic concern for the key oil-consuming countries of the Organization for Economic Co-operation and Development (OECD). (3,4) Given the concentration of oil resources in the Persian Gulf, it is conceivable that the countries of this region, and more broadly OPEC, could exert monopoly power and set prices to extract monopoly rents. On the other hand, at about $5 per barrel, the Persian Gulf countries have some of the lowest extraction costs in the world that gives them the power to undercut competition from the lower 48 United States, Alaska, and the North Sea. (5) Yet, production in high-cost regions of the world coexists with Persian Gulf production and world oil prices in the 1990s were not nearly as high as they might be under a pure monopoly (for a comparison of global oil prices under perfect competition and pure monopoly, see Chapman 1993).

Consider the following statement made by the OPEC President in April 2000, "If prices fall below $22, we will cut production to push prices back up. When prices are above $28, we will increase production" (Rohter 2000). Following then U.S. Vice-President George H. Bush's visit to Saudi Arabia in 1986, OPEC established a price-band arrangement wherein crude oil production was increased or decreased to maintain world crude prices within the target range. This mutually acceptable price-band arrangement had joint payoffs for the Persian Gulf producers and for their key importers in the West, many of whom were also high-cost producers of oil (Chapman and Khanna 2001, 2006). For example, when the price is low, crude oil production outside the Persian Gulf declines as high-cost facilities are shut down and drilling plummets. In contrast, very high oil prices constitute a break on the importing economies and make higher cost production outside the Persian Gulf, for example, in the Arctic National Wildlife Refuge, economically feasible.

Thus, it is in the economic interest of major oil-consuming countries to enable the Persian Gulf countries to maintain the target price range. As the invasion of Iraq has made clear, the ability of Persian Gulf producers to maintain prices within a target band is critically dependent on military and institutional security in this region. Military support from the United States and its European allies was crucial in turning back the 1990 Iraqi invasion of Kuwait, and we see this military support as the bulwark of the Persian Gulf countries' ability to maintain crude oil prices within the target range. Major oil-consuming countries provided the Persian Gulf countries with the requisite weaponry, maintained military bases in the region, and enforced the no-fly zones.

Furthermore, due to the public good nature of military security, there is an asymmetry in the distribution of its benefits (Sandler 2003, 211). Major oil-consuming countries and countries that are otherwise critically dependent on crude oil imports from the Persian Gulf have a disproportionately large stake in the security of this region and would be expected to supply a disproportionately large share of the security there. Thus, it is not surprising that the United States and the United Kingdom have been actively engaged in military operations in the Persian Gulf. Note also the correlation between increasing Chinese dependence on Persian Gulf oil and its recently increasing military engagement in the region.

To summarize, we expect the supply of weapons to be a function of standard economic factors like production cost but also factors like the volume and share of crude oil imports.

B. The Demand Side: Arms Imports

The demand for weapons can be derived analogously to the demand for military expenditure using the standard economic model of welfare maximization (see Smith 1989, 1995, for models of military expenditure). National welfare, [V.sup.D.sub.it], is determined by national security, [S.sup.D.sub.it], and nondefense consumption, [c.sub.it], and it is maximized subject to a national budget constraint as well as a security production function. This can be represented formally as:

(2) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where [c.sub.it] represents nondefense consumption, [q.sup.D.sub.it] is the quantity of (conventional) weapons consumed, [p.sub.it] is the relative price of conventional weapons, [Y.sub.it] is national income, and [X.sup.D.sub.it] is a vector of other factors that determine national security. This maximization yields a weapons demand function whose arguments include relative prices and income as well as factors that are related to national strategic and political factors.

Levine and Smith (2003, 2) state that the biggest driver of the demand for weapons is war or fear of war. The countries of the Persian Gulf are in a unique situation in this context. With approximately 1.5 trillion barrels of remaining oil reserves, the oil in the Persian Gulf region is worth on the order of $10-75 trillion (Chapman and Khanna 2004, 2006). The precise value of this oil wealth is, of course, debatable, but we believe that its undoubtedly enormous magnitude poses a serious problem for the Persian Gulf countries insofar as it creates an incentive for military action such as the Iraqi invasions of Iran and Kuwait. If Iraq had succeeded in its attempt to invade Kuwait and subsequently to gain access to the oil fields of Saudi Arabia as it had apparently planned, it would have had control of more than 40% of identified (known) global oil reserves and 75% of known Persian Gulf reserves. By the same token, the economies of these countries are critically dependent on revenues from the exports of crude oil and they are likely to have a greater demand for military security and weapons, ceteris paribus.

It is not surprising, then, that Persian Gulf governments undertook major military expansion in the 1990s. Between 1994 and 1999, three Gulf countries--Kuwait, Saudi Arabia, and the United Arab Emirates--purchased a quarter of the global supply of conventional weapons, spending nearly $67 billion on conventional weaponry (Chapman and Khanna 2006; Table 2), and the Persian Gulf emerged as the single largest regional importer of weapons.

In addition to external threats, a country may fear internal threats as well and this will also impact its demand for weapons (Anderton 1995, 536; Smith, Humm, and Fontanel 1985, 240). We hypothesize that internal strife is likely to be correlated with greater income and social inequality and the presence of relatively autocratic rather than democratic political institutions.

III. EMPIRICAL SPECIFICATION: VARIABLES, DATA, AND SUMMARY STATISTICS

Based on the above discussion, we posit the following empirical relationships, where the signs in parentheses indicate the direction of the relationship we expect to obtain, and constitute empirically testable hypotheses:

(3) Arms exports

= f {unit production cost(-), military security (global weapons stock( +/-)), economic security(crude oil imports(+), share of crude oil imports in petroleum consumption(+)), other factors( +/-)}

(4) Arms imports

= g{income(+), weapons prices(-), war, fear of war(economic value of oil reserves(+), share of oil export revenues in total GNP(+), economic and social inequality(+), political freedom (-), conflict (+))}

The weapons industry is characterized by high fixed costs and economies of scale and exports constitute an important way of expanding the market and lowering unit costs (Anderton 1995, 534; Garcia-Alonso and Hartley 2003, 40; Smith, Humm, and Fontanel 1985, 242). Thus, we expect to see higher exports associated with lower unit costs. International data on production costs for the defense industry are notoriously hard to obtain. The United States publishes an annual producer price index (PPI) for the domestic defense and space industry and this is probably the best available estimate of the year-to-year variation in the average cost of production. To capture any international variation in the cost of weapons production, we use total military expenditure as a proxy for the scale of production following Smith, Humm, and Fontanel (1985) and we expect it to be positively correlated with arms exports.

We expect that the variation in the global stock of conventional weapons is highly correlated with the global delivery of such weapons and we include the total real value of conventional weapons delivered in each year as an explanatory variable to reflect exporting countries' concern for military security. As argued earlier, economic security in the post-Cold War era is correlated with the dependence on imported crude oil, much of which originates in the Persian Gulf, and the successful operation of the target price system. Thus, we expect a positive association between crude oil imports and conventional weapons exports. We also expect a positive association between the share of crude oil imports in total petroleum consumption and the exports of conventional weapons due to the fact that countries that are more dependent on imported oil have a vested interest in a stable world oil market and, therefore, the maintenance of security in the Persian Gulf, ceteris paribus.

To the extent that arms production and sale are typically subsidized by national governments, we hypothesize that larger and richer countries are likely to have higher weapons exports and we include gross national product (GNP) and GNP per capita as additional explanatory factors. Among "other factors," we also include a binary variable to indicate whether a country was engaged in, or likely to be engaged in, internal or external conflict between 1989 and 1999 as the fact of or potential for war may result in a country developing its domestic weapons industry and a binary variable for North Atlantic Treaty Organization (NATO) membership. (6)

On the demand side, we use total military expenditure to reflect the relevant national income constraining weapons purchases. We measure the economic value of a country's oil wealth by the value of its crude oil exports and its economic importance by the share of crude oil export revenues in GNP. We also include GNP and GNP per capita to capture the effect of any other missing variables that might explain variation in arms imports.

It is impossible to find data on the sale price of conventional weapons, whether for individual weapons categories, or in more aggregate terms. (7) Smith and Tasiran (2005) use the ratio of the value of arms imports published by the Bureau of Verification, Compliance, and Implementation (BVCI), U.S. Department of State, to the volume of arms imports published by the Stockholm International Peace Research Institute (SIPRI). While innovative, this approach is problematic for two reasons. First, because many countries do not import conventional weapons at all, or import very small quantities, the volume of imports is often reported as zero or unavailable and the ratio is undefined in many cases. Smith and Tasiran's (2005) analysis is based on data for only 52 countries. A second, more serious problem is that the ratio as defined above, rather than being a proxy for weapons prices, may simply reflect differences in the methodologies employed by the two agencies in calculating their respective series. (8) At the same time, omitting prices from the arms import estimation is equivalent to assuming either that the demand for weapons is perfectly price inelastic or that the relative prices of defense and nondefense consumption are constant across nations and time. Both assumptions are untenable and the most likely situation in an analysis sans prices is that the estimated equation is misspecified and not a true demand function (Smith 1995, 78).

To avoid these problems, we define weapons prices as the ratio of the annual U.S. PPI for the defense and space industry to each country's 2006 corruption index value developed by Transparency International. The corruption index ranges from 1 to 10 with larger index values indicating lower corruption. Our justification is that as the world's leading producer of conventional weapons, the U.S. production cost is likely to be correlated with the average sales price of weapons, while at the same time, the political and secretive nature of arms deals is likely to result in higher final sales price for more corrupt nations. We acknowledge that this is a noisy measure of weapons prices and that there is likely to be measurement error. To test the robustness of our results, we also use the Smith-Tasiran price measure in our analysis of weapons imports, albeit with a smaller sample of countries.

We use the Polity2 index developed under the Polity IV Project (http://www.systemicpeace.org/ polity/polity4.htm) to measure international and intertemporal variations in political freedom. This index reflects the structure of governance (e.g., the degree to which all citizens are guaranteed civil liberties) and the openness of a country's political institutions (Marshall and Jaggers 2002). It ranges from--10 (very autocratic) to + 10 (very democratic).

The Polity IV Project also provides information on the occurrence of an armed conflict. We used the individual country reports available on the Web site for the Polity IV Project to construct a binary conflict variable that equals 1 if a country was involved in a significant internal or external armed conflict between 1989 and 1999. This includes wars for independence, ethnic warfare, revolutionary warfare, and genocide/politicide. (9) For our analysis, not only is the fact of war relevant, the fear of war is important as well because countries may engage in an arms buildup either by importing weapons or by developing the domestic weapons industry in response to this fear. For example, Taiwan emerged as a significant …

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Publication information: Article title: Guns and Oil: An Analysis of Conventional Weapons Trade in the Post-Cold War Era. Contributors: Khanna, Neha - Author, Chapman, Duane - Author. Journal title: Economic Inquiry. Volume: 48. Issue: 2 Publication date: April 2010. Page number: 434+. © 2003 Western Economic Association International. COPYRIGHT 2010 Gale Group.

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