The Impact of Military Expenditures on Economic Growth: A New Instrumental Variables Approach

Abstract

Endogeneity problems have plagued efforts to estimate the impact of military expenditures on economic growth. This paper addresses this problem with two instruments for military expenditures: the value of arms imports during periods of peace and the number of neighboring states suffering interstate violence. While positively correlated with military expenditures, the value of arms imports is unlikely to be determined by economic growth because of the time lag which exists, which in many cases runs into several years, between the placement of purchase orders for these arms and their delivery. The number of neighboring states suffering interstate violence captures regional ‘political uncertainty’, which spurs military spending without capturing the actual scale of domestic political violence which may directly affect economic growth. Several diagnostic tests show that both these instruments are highly correlated with military expenditures and fulfill overidentification restrictions. The results from empirical analyses of panel data on 133 countries during the 1960-2012 period indicate that an increase in military expenditure/GDP of 1 percentage point reduces economic growth by 1.10 percentage points. These results are robust to the application of 2SLS, LIML, and GMM estimators.