Will defence spending ambitions boost the European economy?

At the end of October the European Council restated its goal of producing a “credible” military deterrent in response to the Ukraine war and Washington’s equivocal attitude to European security. In a statement, the Council confirmed its “determination to deliver at pace and at scale on this objective.”

As well as upgrading its military capabilities, Brussels hopes increased defence spending will prove a shot in the arm for Europe’s struggling manufacturers. According to the Council, efforts to address capability gaps will “contribute to boosting European industrial and technological competitiveness, including for SMEs.”

Hopes like these have been expressed before. In all, EU member states aim to mobilise EUR 800 billion to boost defence spending before 2030. Germany has announced separate plans to spend a trillion euros upgrading its rusty military infrastructure. Research from the Kiel Institute estimates that Europe-wide GDP could grow by 0.9% to 1.5% if defense spending increases from 2% to 3.5% of GDP.

Is this a golden ticket for EU manufacturing? Internal German government documents seen by POLITICO are an early buyer’s list for military procurement. Around EUR 182 billion worth of tenders are already tied to domestic manufacturers.

Nevertheless, economists are urging caution over claims of a defence-related manufacturing boom. While the effects of defence spending won’t be negligible, they are unlikely to be game-changing. Evolution may be on the cards, but not revolution. We’ll explore the reasons why in the rest of this article.

The EU is acting but uncertainty abounds

What’s not in doubt is that the will to upgrade European military capability exists in a way that it hasn’t for decades. 

“Readiness 2030, Europe’s rearmament plan, reflects a significant pivot in European defence attitudes,” says Christian Bürger, Senior Editor at Atradius. “There is a recognition in Brussels, London, Berlin and elsewhere that the threat from Russia is a serious one and needs to be countered with major military expenditure.”

Readiness 2030 aims to raise funding through two key vehicles. The accelerated activation of national escape clauses (NEC - a tool to temporarily raise defence spending above usual budgetary limits) is expected to raise EUR 650 billion. The Security Action For Europe (SAFE) loan programme should add EUR 150 billion more to the pot. Both will be used to facilitate expanded government spending on defence needs. 

Over time, Readiness 2030 aims to drive a fourfold increase in current expenditure. While progress will be made, we think this is over-ambitious, for a number of reasons.

National governments are not aligned

Increases in expenditure by individual European states will be gradual and inconsistent. NATO wants its members to be spending 5% of GDP on defence by 2035, but it’s by no means certain which EU NATO members, if any, will hit this target. 

For example, Italy hopes to increase defence spending by 0.5 percentage points (ppts) over three years. We expect a similar increase in France. The UK government has said defence spending will rise from 2.3% of GDP in 2024 to 2.5% in 2027. For most European countries, spending will rise by around 0.2 ppts of GDP per year.

The exceptions are Germany, where spending is expected to rise to 3.5% of GDP by 2029 from 2.4% today, and some of the countries bordering Russia. Against that, countries like Spain and Belgium are far more reluctant to raise defence spending above current levels. It’s also true that governments in France, Italy and elsewhere may struggle to pass major defence investment packages if they come at the expense of social spending.

“Taken together, it’s not clear that every country will boost spending significantly or what the total investment will amount to,” says Bürger. “Despite greater fiscal leniency by the EU, increased borrowing costs and enlarged budget deficits - along with internal opposition - could blunt the ability of some European governments to commit to the kind of spending hikes NATO wants to see.”

European production hits bottlenecks

In addition, not all - perhaps not even most - defence spending goes on new equipment, ammunition or machinery. A lot of it goes on day-to-day operational costs. Even then, Europe’s stretched manufacturing capacity may be ill equipped to meet rising demand, at least in the short term.

“There’s a lack of capacity both in large equipment manufacturing firms and in the smaller firms along the supply chain, with many providers only equipped to handle a low volume of orders for domestic customers,” says Theo Smid, Senior Economist at Atradius. “The speed at which demand has shot up has exceeded capacity, leading to a substantial accumulation of backlogs in defence-related sectors. It will take time to scale up.”

There are a number of challenges here, from attracting and training skilled new workers to investing in the necessary R&D. In addition, defence system manufacturers require a steady stream of high-tech components like semiconductors. That supply is threatened by competition from other sectors and potential Chinese restrictions on the export of rare earth materials - critical inputs for all kinds of military kit.  

A boost to manufacturing - in the US

Until European production ramps up, a huge chunk of European investment will flow into the coffers of overseas companies, especially in the US. The International Institute for Strategic Studies (IISS) estimates that between February 2022 and September 2024, 48% of European defence procurement came from foreign suppliers, with 34% from the US. 

That pattern is likely to continue in the short-term, especially with governments wanting to curry favour with tariff-toting Washington.

“As the European defence industrial base builds up, the degree of import dependence will decline, increasing domestic economic returns,” says Smid. “But certainly initially, import leakage - spending that flows out of an economy to purchase imports - reduces the extent to which the investment will benefit European manufacturing and the wider economy.”

Sectors see positive effects

Despite misgiving around the extent of any manufacturing upturn, there will clearly be winners from Europe’s race to rearm. A concentrated subset of capital-intensive sectors will see the biggest output growth over the next five years. They include ships and military vehicles, aerospace, precision and optical instruments and telecom equipment. Compared to manufacturing, those sectors will see above average gross output growth in the coming five years in the EU and the UK. 

Additionally, investment in those sectors will rise sharply in the mid-term.

However, these sectors are not major players in Europe’s manufacturing mix. For example, aerospace accounts for around 2.1% of overall manufacturing output in the EU and UK, with optical instruments at 2.4%, ships and military vehicles at 1.6% and telecom equipment at 0.5%. Even a pronounced boost to these sectors will only result in a minor upturn for manufacturing as a whole.

Some other sectors - chemicals, automotive, wood, textiles - may be able to participate in the defence equipment supply chain, but it won’t be easy. Repurposing production is likely to require significant investment. Certification, testing and standardisation procedures can be very different in defence technology, and safety requirements considerably higher.

There will be positive spillovers too, into metal products, machinery and service sectors like computer design and engineering. But these will be modest. In the longer term, technologies developed in the military realm may benefit the civilian economy, enhancing productivity. And of course, a well defended Europe will feel like a more stable and secure place to invest.

Small steps are better than none

All in all, the impact of increased European defence spending on the wider economy will be positive but limited. A boost to eurozone GDP of a percentage point or so over the next five years isn't negligible, but it is modest. Oxford Economics expects that the GDP multiplier of European defence spending will be 0.6-0.8 on average, meaning that for every EUR 1 spent on defence, GDP is expected to increase by EUR 0.60 to EUR 0.80.

On the upside, progress is likely to be so gradual that increased defence spending shouldn't put significant pressure on core budgets. Nor should it add to inflation.

So optimistic predictions of defence-related industrial renewal appear wide of the mark. The most significant benefits will be felt by a small subset of sectors, with some modest spillovers into the wider economy. While this is clearly positive, tanks, ships and drones alone won’t turn Europe’s faltering manufacturing base around.