The Germans are funding increased defence spending through debt so why can’t we? The Chancellor needs to start telling a better story about the future direction of our economy, says Paul Ormerod
President Trump wants European countries to spend five per cent of GDP on defence. Kier Starmer plans to increase UK spending from 2.3 to 2.5 per cent.
The proposal of the Prime Minister involves what is, in the context of the overall state budget, a trivial amount of money. Public spending is around £1,200bn a year, and the extra defence monies are under £6bn, more or less a rounding error.
A commitment to the five per cent Trump target involves serious money. An additional £70bn a year spent on defence is necessary in order to achieve it.
Last week, German political parties struck a deal to allow an extra €100bn a year to be spent on defence and infrastructure over the next decade. Crucially, given the restrictions on debt embodied in the German constitution, defence spending above one per cent of GDP will be exempt from them.
If the Germans can fund the increase through debt, why can’t we do the same?
The answer is quite simple. The Chancellor, Rachel Reeves, fears the bond markets. At the start of this month, the yield on 10 year German government bonds was around half that of the UK, at some 2.4 per cent. The agreement on the extra expenditure has pushed it up to 2.9 per cent.
Already under Labour the interest on government bonds has risen by the best part of a percentage point, from some four per cent around the time of the election in July last year. The Chancellor cannot risk a substantial further increase without scuppering her own fiscal rules.
A relentlessly negative picture
A key reason why the interest rate on British bonds is so much higher than on Germany’s is of course the catastrophic impact on the public finances of the policy of lockdown.
But another has been the relentlessly negative picture of the British economy painted by Labour.
In particular, the phrase repeated at every opportunity by members of the Cabinet from the Prime Minister downwards – the “£22bn black hole in the public finances” – is extremely unhelpful. If there is a black hole, why should the bond markets countenance any further increase in borrowing?
Yet the massive shift in the international situation demands that defence spending be increased very substantially.
The massive shift in the international situation demands that defence spending be increased very substantially
The Poles have a quite different historical experience than the countries of Western Europe. Invaded by both Germany and the Soviet Union in 1939, overrun completely by Germany in 1941, taken over by the Soviets in 1944, and spending the past four decades sitting next to a heavily armed Russia, they understand the importance of defence.
This is why Poland already spends four per cent of its GDP on defence. Poland’s worldview is no longer the exception in Europe, it is the new normal.
The UK government needs to commit to the same four per cent of GDP target for defence.
But to do this needs a convincing narrative. The Chancellor is right to worry about the impact on interest rates of an announcement to increase defence spending by some £40bn a year unaccompanied by other measures.
Yes, senior ministers can make statements about efficiency savings and the introduction of AI throughout the public sector. They may even do something about it. But this is all rather vague and uncertain.
In contrast, the welfare bill represents a clear, quantitative target. Total expenditure on welfare this year is £300bn, of which £165bn is on pensions.
As is well known, since the pandemic welfare spending has ballooned. It is inconceivable that £30bn of cuts could not be made in this budget.
As Keynes memorably said; “when the facts change, I change my mind”. The international facts have changed dramatically and government policy needs to change accordingly.
Paul Ormerod is an Honorary Professor at the Alliance Business School at the University of Manchester, an economist at Volterra Partners LLP, and author of Against the Grain: Insights of an Economic Contrarian, published by the IEA in conjunction with City AM