The opinions expressed here are those of the author, the former head of communications at the Bank of England and a former senior editor at Reuters.

By Mike Peacock

LONDON, July 8 (Reuters) - In a conflict-ridden era where the U.S. is reluctant to act as the world’s policeman, European governments have compelling reasons to ramp up defence spending. But that doesn't mean military investment is the optimal route to achieving economic growth – and it could be a barrier if it crowds out more productive investment.

NATO leaders are meeting at a summit in Ankara, Turkey, this week, and a key agenda item will be defence spending. Last year, they agreed to boost defence spending to 5% of GDP by 2035, but the average last year was still well below 3%.

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Europe and other NATO members could previously afford to skimp on defence because they could rely on America’s enormous military for support. However, that is no longer the case, as U.S. President Donald Trump has repeatedly threatened to leave NATO, just as Russia’s invasion of Ukraine in 2022 has brought war to Europe’s doorstep.

Given that the euro area and Britain have long faced sub-par economic growth, recording average GDP growth rates of not much more than 1% over the past decade compared to almost 2.5% in the U.S., some leaders are suggesting that military spending could be the key to lifting the region out of this morass.

But that might not be the case.

Boosting growth effectively requires investing in areas that offer a positive growth multiplier – meaning every pound, dollar or euro spent adds more than that to the economy.

OECD research suggests a defence splurge can boost growth in the short term, particularly if there is a large domestic military sector poised to benefit. But it also notes that the economic multiplier is typically only a modest 0.6 to 1.0.

“Over time, competition for resources from military spending may push up prices and crowd out other private activity, potentially drawing labour and capital away from more efficient uses,” the organisation said.

European Central Bank models tally with the OECD's, suggesting the growth multiplier for defence investment in the euro zone is an estimated 0.93 over two years.

It’s true that defence spending's beneficial impact can mushroom if innovation spills over into other civilian sectors – as has happened in the U.S. But that has been possible, in large part, because America boasts the world’s biggest military-industrial complex.

On the other hand, many European nations have to import most of their defence equipment.

This was highlighted in the International Monetary Fund’s April analysis of the impact of increased military spending on Poland’s economy.

Since Russia launched its full-scale war in Ukraine, Poland has increased defence spending from 2.2% of GDP to 4.5% last year.

While this is a big increase, the IMF concluded that the wider economic impact of this spending “was likely modest” because the expenditures were “highly import intensive.”

Any boost to domestic demand likely resulted in higher interest rates than would otherwise have been the case, the IMF argued.

France and Germany, home to Europe’s biggest defence manufacturing sectors, are better placed to benefit from an increase in defence spending. Moreover, a pan-EU approach whereby all 27 member states combine and harmonise procurement and R&D activities could increase growth further throughout the bloc. But that is, at best, a work in progress.

ENERGY SECURITY IS NATIONAL SECURITY

The definition of “defence spending” may also be evolving – and budgets need to keep up. The wars in Ukraine and Iran have shown that energy security is just as important as traditional defence.

The Russian invasion set off an energy crisis in Europe, while Iran’s closure of the Strait of Hormuz this year upended the global energy system. Those countries with more resilient, flexible, diverse energy systems were best positioned to respond.

German Chancellor Friedrich Merz seems to have gotten that message. After earmarking €500 billion ($571 billion) for defence and infrastructure in a previous budget, Merz’s latest package features an expansion of the electricity distribution grid and other energy-related measures.

On the other hand, Keir Starmer, Britain’s lame-duck prime minister, has increased defence spending by a relatively modest £15 billion over four years – likely not enough to move the needle on security – and sought to pay for it in part by cutting investment elsewhere, including on transport and energy resilience. The departments of transport and energy will lose nearly £4 billion from their combined budgets by 2029/30.

This may prove to be foolish for both energy security and economic reasons. The Confederation of British Industry says the net-zero economy has become a significant driver of growth, with every £1 of value generated creating an additional £1.89 for the wider economy.

Access to sufficient energy resources is likely to become even more vital to both defence and economic prosperity as the AI revolution progresses, given the energy intensity of this critical technology. The Social Market Foundation, a UK think tank, has noted that UK data centre development is being delayed by the country’s inability to deliver the necessary electricity.

None of this means a defence scale-up is unwise in Europe and Britain. But if it comes at the expense of more productive investment elsewhere, it would be an exercise in self-harm.

(The views expressed here are those of Mike Peacock, the former head of communications at the Bank of England and a former senior editor at Reuters.)

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