Defence Spending Under PFIre Jan 11th 2007 From The Economist print edition How Britain is managing to fight two wars on a peace-time budget. BRITAIN has asked much of its military in recent years, deploying thousands of soldiers in Iraq and Afghanistan where they have fought in some of the most intense battles since the Korean war. But it has done so on a shoestring. A decade of defence cuts (now being reversed) has trimmed defence spending to about 2.5% of GDP, its lowest level since 1930, and left commanders in the field with fewer men, helicopters and armoured vehicles than they need. Last month a coroner ruled that the first British soldier shot and killed in Iraq in 2003 had died because of âunforgivable and inexcusableâ delays in supplying bullet-proof jackets to the front line. Like any household whose budget is under pressure, Britain's defence establishment has turned to buying on credit. It has become one of the government's most enthusiastic adopters of the Private Finance Initiative (PFI). In December the Ministry of Defence (MoD) revealed that it had already signed contracts with private suppliers worth about Â£26 billion ($50 billion) over the next 30 years. Among the things it gets in return are a shiny headquarters building in Whitehall, new barracks at Aldershot and training for its ranks of newly minted helicopter pilots and submariners. Bigger deals are on the way. Civil servants and generals are currently poring over plans worth more than Â£35 billion over three decades, which is a bit more than the annual defence budget itself. Only the NHS, which is rebuilding hospitals, has a bigger pipeline of PFI deals. Until now most PFI deals have been for large capital projects such as roads, prisons and hospitals, where contractors have built a facility and then tagged on the provision of âsoftâ services such as cleaners and a maintenance man. It seems that they have been most successful with projects that provide an easily measured âhardâ outputâsuch as a school, for instance, with a roof that keeps the rain out. But the armed forces are becoming ever more daring, vastly expanding the ambit of PFI deals. Within the next few weeks the MoD plans to announce the winner of a contract worth more than Â£10 billion for taking over most of the training of soldiers, airmen and sailors. In November it selected a group of companies to train fighter pilots in a contract worth about Â£12 billion. And the ministry is negotiating the final details of a Â£13 billion aerial-refuelling contract for the private provision of airborne tankers for jet fighters and bombers on their way to the front line. The attraction is that under PFI deals the state does not have to borrow to pay capital costs at the start. Instead it gets to spread its payments over the life of the contract, in much the same way as one might lease rather than buy a car. Enthusiasm for such deals should be tempered, however. Fixed payments on PFI contracts are consuming an increasing share of defence spending. This has some advantages: one is that the generals need not worry about finding money in the budget each year to keep their new headquarters freshly painted. But the pluses must be set against a loss of flexibility and freedom to allocate resources in an organisation that can never know for sure what war it will next be called upon to fight. Moreover, defence PFI deals have also proved poor at transferring risk from the government to suppliers. The National Audit Office (NAO), a spending watchdog, found last year that the costs of a PFI contract for satellite communications had increased by Â£885m to Â£3.6 billion, partly because the price of satellite insurance had soared. Yet the contractor had agreed to provide insurance at a fixed price as part of the deal. Another NAO study found that the price of the MoD's refurbished offices in Whitehall had increased by 15% after the government had selected a final bidder because interest rates had changed and the building proved to be in worse shape than expected. Yet these were risks that ought to have been assumed by the contractor. Fans of the PFI argue that these failures do not reflect any inherent flaw in the model. They say the soldiers and civil servants who negotiate the contracts have a poor grasp of risk. Norâunlike derivatives traders, for exampleâare they motivated by the prospect of a reward if they succeed in drafting a watertight deal or a penalty if contract costs increase. This leads to a bias towards selecting the cheapest bid, even if it must subsequently be renegotiated. The Treasury has long been criticised by those who believe that the PFI is little more than a wheeze to get debt off the public balance sheet. But it has been able to argue (not always plausibly) that these deals are entered into only when they provide better value than old-style procurement (which, to be fair, also has its problems). On defence the civil servants have abandoned that fig leaf. Ministers have let slip that they could not afford to revamp their training facilities if the government had to assume the costs at the start, rather than spreading payments over decades. This leads to a disturbing conclusion. Although PFI deals may offer value, that is not the yardstick by which they are being measured. Instead, the pressure of fighting two wars on a peacetime budget seems to be driving the government to enter into hasty deals, the true costs of which will become apparent only in years to come. Hmmn..... The folk at The Economist aren't reknown for being daft.