Chart of the Month - March 2025

A lot has happened in President Trump’s first 100 days. For many of its allies, America no longer seems like a steadfast partner. Trust has given way to disbelief and uncertainty. Trump cajoled NATO members to increase military spending in his first term. Europe is now hearing the call.

Australia too feels less certain. Comments by Elbridge Colby, Trump’s nominee for head of policy at the Pentagon, has Canberra scrambling.

"The main concern the United States should press with Australia, consistent with the president's approach, is higher defence spending,  … Australia is currently well below the 3 per cent level advocated for NATO … and Canberra faces a far more powerful challenge in China." Elbridge Colby.

While Australia spends more on defence than many other American allies as a percentage of GDP (see chart below), it is currently spending less than 2% of GDP. Increasing defence spending to 3% will not be easy but it is a strategic imperative.

Will Australia increase defence spending?

Australia has not spent more than 3% of GDP on defence since its involvement in the Vietnam War. Spending did increase during the 1980s during the Reagan administration in the US but after that it continued to fall until stabilising after the 2012 Defence Strategic Review (see chart below).

The 1987 Defense whitepaper made self-reliance a goal but at that point in time, Australia only saw itself fighting low-level threats. The paper did recognise that Australia could face conflict against a major power in the future but it noted that Australia would have enough warning-time to increase defence spending and build up its forces.

While China has rapidly built up its strike capacity over the last 35 years, with a notable increase since the 2010s and more recently, Australia’s defense spending has not ramped up. As a result Australia’s earlier goal of self-reliance has given way to a higher degree of reliance on the US military than was envisioned. The creation of the AUKUS trilateral security arrangement in 2021 and the Australian commitment to build nuclear powered submarines in collaboration with the UK and US reflects this.          

So, at the current crossroads, it appears that Australia has no choice but to increase defence spending. Australia needs to upgrade  its military capability to meet current and future geopolitical realities and it must demonstrate that it is a committed ally to the US. At the moment, the latter is more important - any significant reduction in US support (current or promised) would likely trigger an existential crisis in Australia not seen since the fall of Singapore.   

The Australian government had already committed to increase defence spending to 2.3% by 2033-34 in response to the 2023 Defence Strategic Review, but now a lot more spending is needed.  

How will Australia pay for it?

Thankfully, Australia has both the capacity to increase taxes and to take on more government debt. Despite its high level of social welfare, Australia earns less tax revenue than Norway and Sweden as a percentage of GDP but has less central government debt than Germany (see chart below).

The impact on the Australian economy

Increased defence spending would of course boost Australian demand which is timely as Australia, a small open economy, is likely to be negatively impacted by the US instigated  trade war.

Given that the increased defence spending would be focused on highly specific sectors, its impact on CPI should be negligible. However, given Australia’s tight labour market, an increase in defence spending could put upward pressure on wages which could then flow into prices.

Final thoughts

The world is entering a new strategic era and Australia has no choice but to keep up. Australia’ plight  is not unique, however, compared to many other countries, including the UK, Australia can lean on its considerable economic health. The Australian economy will also benefit from the boost to demand.