We’ve grown fat on the butter – but we need guns too

Among the vast range of futile economic constructs, one of the worst still drummed into students and recycled unthinkingly in the media is the "Guns and Butter" theory. This essentially states that an economy must choose between defence (guns) or consumption (butter), but you can't have ample amounts of both.

You would be forgiven for thinking that a theory largely attributed to two leading Nazi ministers Hermann Gring and Joseph Goebbels might invite scepticism, but it became enshrined dogma from 1948 due to articles and models by the American Paul Samuelson, who went on to win a Nobel prize in economic sciences (a term beyond irony).

Since 1950, somewhere in the world there have been at least three armed conflicts involving at least two advanced countries every year. Concurrently the improvement in our standard of living has been both spectacular and faster than at any time in history. Developed countries have enjoyed ample butter along with sufficient guns to defend themselves and wage war overseas.

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This huge improvement in wealth, health and longevity has many causes (of which the explosion of the availability and quantity of credit must rank top), yet it took place even as euphemistically named "defence budgets" were absorbing great chunks of government expenditure (until 1964 the Ministry of Defence was called the War Office). In the UK in 1953, for example, defence absorbed 12% of GDP, or about a quarter of all government expenditure; the Cold War was heating up and the country was embroiled in the Korean War and other colonial conflicts.

The truth about the 'peace dividend'

The benefits of military expenditureare feeble in economic terms relativeto, say, building infrastructure, so countries that spend a very high percentage of their GDP on armaments tend to suffer from sub-par growth. As we all threw our pennies at Bob Geldof during the 1985 Band Aid concert to alleviate an extreme famine in Ethiopia, more than half of that country's foreign debt, and about the same amount of its government spending, was supporting the largest army in sub-Saharan Africa.

Pakistan's conspicuous economic failure is the direct result of Pakistan spending great chunks of its budget on its armed forces, which in turn plays up the existential threat of an invasion by India.

The best example of all is the USSR, where military expenditure ended up consuming the entire economy. Its break-up since 1989 resulted in the much-lauded 'peace dividend' abelief that military spending across the world could be slashed as the biggest threat to the West had all but disappeared. As a percentage of GDP, defence expenditure declined in all advanced countries.

But what's less well known, and with hindsight is peculiar in the circumstances, is that defence expenditure had actually been falling steadily for the previous 35 years. From the 1953 post-World War II peak in the UK, it had already more than halved to 4.1%, and today hovers around 2% (although in inflation-adjusted terms, the real fall in expenditure was much less).

It has long been believed that thesteady fall in military costs massively benefited welfare, pensions and education. In 1950, welfare and pensions consumed a mere 5% of Britain's GDP as opposed to 15% today, a 300% increase; the increase in real education spend has been less dramatic at 50%. Yet these increases were due far less to lower spending on guns and more on butter, than to the considerable escalation in tax and government borrowing.

This pattern was repeated in most countries. Thus lower military spending was a marginal benefit at best. The real and gigantic peace dividend was the release of three billion consumers from previously moribund, state-controlled economies.

The rise of universal love

Since the 1990s, the expectation has been that ever-lower military spending could continue; occasional warnings of too little defence capability became associated with far-right cults, such as America's Tea Party. In most countries, universal love has been in the ascendant, with some even espousing total disarmament as introduced by Costa Rica in 1948.

In the vanguard of the minimal defence camp are some unexpected nations. In 2001, New Zealand's government announced that it was scrapping its Air Force, thus effectively relying on its isolation and US/Australian air cover. Many European Union countries, such as Hungary, Austria and Ireland, are spending so little of their GDP on defence (well below 1%), and their equipment and training are so poor, that in reality their armed forces would be pushed to round up a drunken troop of Girl Guides. These countries too have opted to rely on their larger, friendly neighbours, who in turn have also been reluctant to spend.

While the current UK government has been making Churchillian-like noises about defence, it shows many happy-clappy aspects. Britain has around 220 battle tanks by comparison, tiny, neutral Switzerland has nearly 400. If the Ministry of Defence (MoD) wants to know if there is a Russian or Chinese submarine ten miles away from London or Edinburgh, they have to call Paris to ask: since the grounding of the last Nimrod surveillance aircraft, we now rely on French cover.

The UK has no working aircraft carriers and for the first (of two) under construction there are no plans toinstall aeroplanes, making them white elephants. The Labour Party's newleader, Jeremy Corbyn, has been excoriated for many of his more extreme policies, but his stance against nuclear deterrence, especially a new Trident submarine, has wide resonance. Scotland's ruling party regularly rehashes the argument that the cost of a Trident is 30,000 new primary schools (guns versus butter, again), even though both can be funded and Scotland's school-age population is shrinking.

Understandably, America sees its Nato and non-Nato allies as spineless backsliders who rely on the generosity of its taxpayers which perhaps explains the decision two years ago to pull all US armour out of Europe (now being brought back). Anyway, America's priority is Asia.

Yet even in America, there is much debate over whether the military should be pared back; it has been so pampered that in most years since 1990, Congress has actually voted more funds to the military than have been requested. Moreover, losing two long wars back-to-back (Iraq and Afghanistan) has lessened the desire for further adventure, hence the policy vacuum over dethroning President Assad in Syria, with no thought of ground troops to stop the march of Isis.

Return of the Bear

Domestic events always dominate politics, so changes overseas tend to come as a 'surprise'. Russian threats and incursions into its former colonies, from Estonia to Georgia, were dismissed as exceptional. The penny only dropped with the annexation of Crimea. President Vladimir Putin was notbluffing when in 2005 he stated that "the collapse of the Soviet Union was the greatest geopolitical disaster of the century", and he has been trying to re-establish it ever since.

Meanwhile, China has claimed most of the East and South China Sea since 1947, and has shown a clear long-term intention to turn the Western Pacificinto its own boating lake, so as tocoerce and control its neighbours.This has escalated in the last ten years through the construction of military outposts on distant rocks and reefs. Neither in the case of Russia nor China have negotiations had any effect.And only with the arrival of hundredsof refugees per day has Europe realisedthat with the overlapping religious, sectarian and national wars in the Middle East, its defence forces are incapable of protecting its own frontiers, let alone coercing tiny countries, such as Syria.

In theory, Uncle Sam and the Good Guys such as Nato and Japan are impregnable, with more than 75% of the world's firepower between them but they are unable or unwilling to use it. Voters abhor casualties on their own side, or even the enemy's, so ground action is off all agendas. This makes expensive battle fleets and missiles redundant for much modern warfare, which in turn has changed in character.

Often it lacks clear battle lines, or even a knowledge of who is on your side, as dozens of irregular armies conduct hit-and-run raids and urban terrorism. The less squeamish 'bad guys' have embraced this new approach where ruthlessness talks more than money. In short, Russia, China, Iran, Saudi Arabia and Isis have continued their empire building in sufficiently small steps to prevent the 'good guys' from taking meaningful action they remain sidelined as horrified observers.

There are signs that the need to adapt, develop and invest in new strategies and resources is growing, albeit slowly. An example was the largest joint Nato exercise for 25 years that took place in the Baltic Sea in June; but it was only 6,500 troops and an old-fashioned sea-borne assault. Then the British government noisily announced the dispatch of 100 troops to support the Baltic countries (better to have hired300 Spartans and get the film rights), while, more realistically, eastern European countries are rushing to train more troops. Although little sleep will be lost in the Kremlin, a turning point appears to have been reached.

An unpleasant awakening

I am no fan of military adventure, and, like all of us, have for years watched the UK and Western governments wasting billions on bad planning, worse procurement and overseas adventures that often lacked any clear aim or benefit, either at home or for the people we sought to assist. Yet, the most important event of the second half of the 20th century the destruction of the USSR was achieved through the combination of the right military strength for the circumstances, a willingness to act if pushed and, crucially, the offer of a superior alternative in terms of wealth, justice and tolerance.

Western governments are struggling with the unpleasant realisation that their countries have become vulnerable. The time has come to invest more in defence. For the last 50 years, we have become far wealthier despite large military expenditure, but the populations were younger, the demographics favourable and demands on government less. Now the economic rune-sticks suggest a prolonged period of slower growth for the economy. Even without greater defence expenditure, it is inevitable that expenditure on government services and welfare will slacken. This will reignite the guns versus butter argument. We can still have both, but not quite as lavishly as before.

This 'militarism' isn't what I wish for, but it is an unpleasant reality. Just as prudent people take out house and medical insurance hoping never to call on either, so it makes sense for investors to protect themselves financially by switching some of their butter investments into a range of beneficiaries of a more bellicose era.

Six of the best defence stocks

Ethical investment is a laudable, but often nave idea, and the yardsticks by which they're judged perverse toxic mining companies are often awarded high marks for ethical behaviour, for example. Giant ethical managers such as the smug California Public Employees' Retirement fund equivocate about their investments in armaments, but to me self-defence is the first duty of any government, which therefore requires a well-armed military.

In July last year, I wrote on China's bellicosity in the Pacific and recommended five defence-related stocks: in the UK BAE Systems (LSE: BA) and Babcock (LSE: BAB), and overseas Raytheon (NYSE: RTN), Mitsubishi Heavy Industries (Tokyo: 7011), and Singapore Technologies Engineering (Singapore: STE). After dividends I reckon, if equally weighted, the basket is down 4% versus the FTSE World index at 6%. You can't eat relative performance and it's not the best result, but OK, and I wouldstill hold the first three especially.

BAE ranks in the top five armaments makers globally and makes armoured vehicles and systems for navies and air forces. On a forward price/earnings (p/e) multiple of 13 times, a 4%-plus dividend yield, and sporting a good order backlog, it is the safest bet in the UK. On the logistics and support side, Babcock is a major provider of services to the Ministry of Defence, but the share price has been hurt by other exposure to oil and gas services.

American giant Raytheon has performed well, but is still cheap on 15 times forward earnings, given its lead position in a range of defensive missile systems, cybersecurity and special electronic mission networks. All three are significant players in the all-important American market.

Three further UK defence companies are worth a look. Cobham (LSE: COB) looks good value at 13 times forward earnings, with earnings per share growth of about 12% a year. It specialises in electronics, such as contracts to upgrade Hercules transport planes, or a recent contract for microelectronics in the AmericanF-35 Lightning fighter. The share price suffered over the summer because of investors' concerns over a major American acquisition, but the deal fits the business. Around 40% of revenue is directly defence-related in electronics and aviation systems. It has weathered shrinking defence budgets well.

Chemring (LSE: CHG) is a world leader in military manufacturing. Its shares collapsed this week on poor results and an emergency rights issue to reduce debt. This weakness makes a great entry point my bet is that it will also become a takeover target.

My final pick is Ultra Electronics Holdings (LSE: ULE), a supplier of software and electronics to defence and security markets. It too has been a poor long-term performer because of uncertainty over major orders, such as Trident. It is the riskiest pick, but the most interesting of the niche players.

Jonathan Compton spent 30 years in senior positions in fund management and stockbroking.