Good morning from New Economy Brief,
It has been an eventful few weeks for geopolitics, with major knock-on impacts on European fiscal policy. With the US appearing to pull back from support not only to Ukraine but from its wider commitment to Europe, European states – including the UK – have been urgently exploring how to increase defence spending.
This week’s New Economy Brief explores the various proposals being discussed in Germany and the EU, and compares them to the policy options on offer in the UK.
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The end of the ‘peace dividend’?
Western Europe has been under the American defence umbrella since the creation of the North Atlantic Treaty Organisation (NATO) just after the Second World War. With the end of the Cold War, this extended to much of Eastern Europe too. Combined with the absence of major regional threats, this allowed countries across the continent to spend less on defence and more on public services like health, education and welfare. This has been referred to as the ‘peace dividend’.
American presidents have long argued that European NATO partners should increase their defence spending. Trump, however, has stepped this up a notch, with explicit threats that the US military might not come to the aid of other NATO members who don’t spend enough of their GDP on defence. In recent months, he has spoken of a 5% threshold – a level only nine countries worldwide reach, not including the US itself. Combined with moves away from providing military and intelligence support to Ukraine, this appears to mark a wider shift in the geopolitical positioning of the US. This has led to speculation about the end of the Transatlantic Alliance and sparked a wider debate about the future of European security. Many commentators are speculating that this geopolitical instability will cause military spending demands to grow, with a risk that this comes at the expense of other policy priorities.
How much is needed, (if any)? Bloomberg estimates that if Europe’s major powers want to protect Ukraine without US support and bolster their own defence capabilities, they could have to find over $3 trillion over the next 10 years. In short, a lot; or for comparison, more than the combined value of the current six-year EU budget and special pandemic response fund. Various critics, including Common Wealth’s Khem Rogaly, are sceptical of the benefits of or need for increased military spending. There is a risk that the focus on spending as a proportion of GDP obscures the overall size of military budgets (which have already grown significantly in real terms), what they are spent on, and who stands to benefit from this spending. Wherever you stand on the debate about defence funding, these assumptions are currently making the political weather across Europe, so the next section will dive further into how they are playing out.
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How are other governments responding to the crisis?
Lots of big numbers are floating around. The European Commission is planning to allow member states to draw upon up to €800 billion in loans to increase their defence spending without breaking the EU’s strict fiscal rules, whilst the French government has floated funding extra defence spending by taxing “those with substantial savings” while promising to protect social spending. However, developments in Germany have caused the biggest shock so far…
The German Special Defence Fund. The likely incoming German coalition government has proposed an investment package worth nearly €1 trillion, split roughly between defence and infrastructure projects like energy, transport and hospitals. To enable this, the conservatives and social democrats have jointly proposed changing Germany’s notoriously strict constitutional debt brake, i.e. loosening its fiscal rules. These rules previously limited annual government deficits to 0.35% of GDP, but if approved, the changes would exclude any extra defence spending above 1% of GDP from the calculation of national debt.. This means any amount of defence spending would be compatible with the rules. They also want to convene a commission on the debt brake’s long-term future.
…It's big.... It's important to understand the scale of this: the package could be around 10-20% of the German economy’s GDP and is “the biggest and fastest fiscal policy shift” since German reunification, in the words of a strategist at Deutsche Bank. News of the deal has been making waves in global financial markets as investors bet on German growth. Europe’s largest economy has stagnated since Covid-19, with the debt brake compounding the damage caused by long-standing fiscal conservatism to leave Germany with a legacy of underinvestment. Relaxing the rules has widespread support; all 41 economists who responded to a survey agreed with easing the debt brake, with one respondent noting that the extra borrowing could push the German economy, and Europe as a whole, towards “high-tech sectors and an effective green transition.”
…but it’s about to get even more interesting. A lot of the package still needs to be negotiated, and the clock is ticking. Economic historian Adam Tooze explains that the incoming coalition has less than two weeks to rush through a deal that can win the support of two thirds of the outgoing German parliament, before the new parliament comes in with its blocking minority of the left and the far-right. This can't be done without the support of the Green members of the Bundestag, which could give them a lot of say in the deal's eventual shape.
Could climate spending also be exempt from fiscal rules? The incoming German chancellor Friedrich Merz justified loosening fiscal rules on national security grounds, but as Tooze asks: “is Russia really a more serious threat to the security of Germans than the global climate crisis or the fact that an alarmingly large share of children in Germany grow up in poverty?” He suggests that the Greens should use their leverage to reshape the deal to put more focus on climate and social priorities. While detail is still emerging, it now looks like the Greens will take exactly this approach.
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What’s on the table in the UK?
So far, the UK government’s approach has been to trade off spending priorities against each other. Increasing the defence budget – to 2.5% of GDP – will be financed through an equivalent cut to the international aid budget. This has led to the resignation of Anneliese Dodds and growing backbench dissent about the government’s approach. Welfare spending looks next in line to be cut, with widely trailed cuts to disability benefits also provoking internal opposition. Climate spending, via GB Energy or the National Wealth Fund, could be at risk too as the government looks ahead to its goal of spending 3% of GDP on defence.
The road ahead looks bumpy. In her resignation letter, Dodds noted: “I also expected we would collectively discuss our fiscal rules and approach to taxation, as other nations are doing. Even 3% [of GDP on defence spending] may only be the start, and it will be impossible to raise the substantial resources needed just through tactical cuts to public spending.” IFS boss Paul Johnson agreed that she was “unequivocally right”, noting that “we are not going to fund higher defence spending through piecemeal cuts elsewhere”. As the government plans departmental spending for the coming years through its first Comprehensive Spending Review, meeting its commitments on defence and public services without increasing tax or revisiting the fiscal framework itself looks increasingly difficult.
Security for the long term. The OBR has warned that spending demands will keep growing throughout this parliament and beyond, whether on defence or on climate change and health. And just as in Germany, these issues cannot really be separated in the UK, with recent IPPR research showing why climate change presents a major security risk – and still-high energy bills an ever-present reminder that “energy security is national security”. If the government wants to claim the mantle of being “the security party”, then it may need to look to Europe for inspiration, taking the kind of bold steps on either tax or the overall fiscal framework that are being considered in France and Germany. As Sam Freedman put it: “The current crisis contains many dangers but at least it creates scope to do things that seemed impossible before.”
Tax more to stop the far right. Labour can reduce the threat from the “populist right” by raising taxes to fund better public services, argues Simon Wren-Lewis. He says that although tax cuts can be politically tempting, they ultimately lead to underfunded, decaying public services and an emboldened right-wing that can blame this on immigration.
The consequences of social security cuts. With cuts to health-related benefits very likely, new analysis from the New Economics Foundation and the Joseph Rowntree Foundation reveals the social cost of such an approach. 50% of people receiving the health-related element of Universal Credit (UC) either cannot heat their home, are behind on bills, or have low or very low food security, compared to 11% of households not receiving any UC or Personal Independence Payments (PIP). The research also finds that almost a quarter (24%) of working-age adults in a family receiving health-related UC have had to use a food bank in the last year, compared to 3% of all working-age adults.
Work-related ill health. The number of days lost due to work-related ill-health has rocketed by a third since 2010 and reduced economic output by £22 billion in 2023 alone, according to the latest figures from the TUC. The analysis notes that this trend coincides with a “huge boom in insecure work”.
Piloting basic income. People leaving care in Wales who took part in a pilot for a basic income scheme have reported improvements to financial literacy, mental health and autonomy, according to a briefing by the Autonomy Institute and Basic Income Conversation. They also said that receiving the basic income allowed them to pursue career goals or study without the immediate pressure of earning a living.
Local government finances. It's likely that 6% of councils will effectively go bankrupt in the next year and 35% in the next five years, with fewer than 1 in 10 senior council officials confident in the sustainability of local government finances according to a new report by the Local Government Information Unit (LGIU). The report also finds that 63% of councils are planning to reduce spending on services.
Thames Water and failed privatisation. “Thames Water is the poster child for failed privatisation” argues Cat Hobbs from We Own It, pointing out that the company is seeking approval for a £3 billion crisis loan while increasing customer bills by 53%. Hobbs highlights that publicly run water in Scotland saves consumers £113 a year.
Energy security and national security. With the pressure on to increase defence spending, the Treasury is rumoured to be considering cuts to GB Energy: the state-owned company set up to invest in renewables and decarbonisation of the grid. However, cutting the programme would both be unpopular and leave the UK less secure, argues Common Wealth.
