Using Tariffs to Strengthen U.S. Military Alliances
by Dora L. Costa and Matthew E. Kahn
For decades, many U.S allies have under-invested in their military. This weakens alliances such as NATO and emboldens our enemies. During his first term in office, President Trump raised tariffs on China, the European Union, Canada and Mexico. Given that the President will use the tariff tool, he should raise tariffs on allied nations who fail to increase their military expenditures.
Allies always face a collective action challenge. Each recognizes the mantra of peace through strength but each has an incentive to free-ride and hope that other members of the coalition contribute. If a leading nation does not step up, the allies are faced with an ugly Nash Equilibrium, named after the Nobel Laureate John Nash (played by Russell Crowe in the movie A Beautiful Mind), as each under-invests in the alliance and are collectively more vulnerable.
For decades, NATO members have relied on the United States to finance their military defense. These nations have used their cost savings to finance their generous social safety net and to finance their retirement programs. Twenty-three out of 32 NATO members will reach the 2 percent of GDP target this year but eight are below, including Italy, Canada and Spain. Under-investment in the past has left armed forces ill-prepared and discussions are underway to increase the NATO target to 3%, a percentage met only by 5 countries. President Trump has suggested that these nations contribute 5%.
The reliance on the United States to provide a large share of expenditure is unlikely to be sustainable. The U.S. budget deficit is growing. U.S isolationists are questioning why the U.S is spending so much on the protection of Europe. Progressives in both Europe and the United States prioritize domestic social programs and decarbonization efforts over increased military expenditure. Countries far from Russia are under-spending. Low economic growth rates among some of our allies make defense expenditures politically difficult. Defense spending in every country is subject to electoral cycles and politicians’ whims.
Suppose the United States commits to raise tariffs on ally nations that fail to reach the target military expenditure promise. Such a tariff increase would provide an incentive for our allies to increase their expenditure. This commitment device would help to create a permanent institutional arrangement (the “military club”) that outlasts the term of any one leader. The members of the club benefit from remaining in the club and avoiding the penalties for being “outsiders”. The size and clout of the United States gives it unique powers to enforce an international club that helps to overcome the significant collective action problem.
The Trump Administration could start with a 10% across the board tariff on allies who do not meet a given military allocation target and see if this pressure changes budget allocations in ally nations. Such tariffs would impose costs on U.S consumers and our allies might respond by raising their own tariffs. In such a “tit for tat” game, the Trump Administration would have to navigate avoiding a trade war with our allies while nudging them to increase their investments for strengthening the military alliance.
If our allies increase their military expenditure, this would impose short run costs on them. The leaders of our allies would need to convince their domestic constituents to engage in fiscal reforms such as reducing entitlement expenditures for their aging populations and pruning down their generous social net. These nations are already running large deficits and under “business as usual”, rising military expenditures would translate into even larger fiscal deficits.
By setting up a system which triggers automatic enforcement, future Presidents will benefit from the introduction of institutions that strengthen our alliances and deter our foes. Allies need a member nation with the economic importance and the political will to act as an enforcer. The United States stands out among our allies for the size of our overall economy and our willingness to lead such a coalition.
While economists typically oppose the use of tariffs for achieving unilateral goals, this is a case where a group of allies could actually collectively benefit from such a high stakes “game of chicken”. Each ally nation has sought the free lunch of pursuing its own domestic interests while relying on the American shield. The Trump Administration could contribute to world peace by introducing new “rules of the game” that foster ally cooperation in an increasingly risky world.
Dora L. Costa is the Sokoloff Professor of Economic History at UCLA. Matthew E. Kahn is the Provost Professor of Economics at USC and a Visiting Fellow at the Hoover Institution.
