A new hope for Europe’s ailing economies: the military

Countries from the U.K. to Germany and Denmark have announced vast increases in military spending to counter Russia’s threats as the U.S. warns Europe not to take America’s protection for granted.

For some economists, this could be just what the region needs to support an under-pressure manufacturing sector and unlock new engines for growth and exports. There are numerous hurdles along the way, including a skills shortage, and the rewards might be unevenly distributed, they warn.

Rearmament could mean sacrifices in some areas as the peace dividend Europe has enjoyed since the end of the Cold War is unwound. Yet recent economic research suggests the benefits of the dividend, which was used primarily to fund a steady expansion in the welfare state, might have been exaggerated.

The European Commission, the European Union’s executive arm, this month unveiled a “ReArm Europe" initiative aimed at mobilizing around €800 billion, equivalent to about $868 billion, for military spending. In Germany, likely future Chancellor Friedrich Merz has floated plans to exempt such spending from the country’s strict self-imposed debt limits. Denmark said last month it would increase its defense budget to more than 3% of gross domestic product over the next two years, while the U.K. unveiled plans to boost military spending to 2.5% of GDP by 2027.

The investments, European Commission President Ursula von der Leyen said Sunday, could “trigger a powerful tailwind for important industries." Artificial intelligence, quantum computing, secure communication, satellite networks, autonomous vehicles and robotics all stand to benefit, she said.

Military spending affects the economy in multiple, sometimes contradictory ways. In the short term, it can employ idle workers and capital, and encourage private companies and households to spend and invest. It can also divert state money from potentially more productive uses, push up borrowing costs and crowd out some private investment.

Longer term, research suggests that military expenditure can increase the efficiency of the broader economy. Government defense contracts can foster economies of scale and spur innovations in civilian industries, economists say. The internet was built on protocols used in the U.S. Defense Department.

“The consensus is really clear that [gross domestic product] does expand in order to accommodate defense buildups. It’s not a fixed pie," said Ethan Ilzetzki, associate economics professor at the London School of Economics.

To be sure, producing munitions and warheads doesn’t have the same economic benefit as investing in factory machinery or infrastructure. Weapons are intended to be stored or destroyed, rather than used to speed production or shorten journey times.

Yet Ilzetzki estimates that increasing European military spending from 2% to 3.5% of GDP could increase the continent’s economic output by 0.9% to 1.5%, based on his broad survey of the economic literature published last month for the Kiel Institute for the World Economy.

Conversely, falling military spending can coincide with slower growth. Annual GDP growth in the U.S. declined from around 4% in the 1960s to less than 3% recently as military spending slumped from 8% of GDP to less than 4%, Ilzetzki noted. In the EU, economic growth has halved since the 1960s as military spending declined by two-thirds.

One reason is that public investment in cutting-edge research during wartime or military buildups is lost in peacetime. A temporary increase in military spending of 1% of GDP could increase long-term productivity by 0.25%, Ilzetzki found. A 10% increase in government-funded military research and development can bolster private R&D by more than 4%, according to a 2019 study by economists Enrico Moretti, Claudia Steinwender and John Van Reenen.

“Perhaps we can find ways [to support cutting-edge research] that don’t necessitate military expenditure, but so far there are few examples of that," Ilzetzki said. “It is difficult to imagine nuclear power emerging so early without World War II R&D or space exploration technologies in the 1960s without NASA."

America’s military R&D spending is currently 12 times as large as Europe’s, according to a 2024 report on Europe’s economic competitiveness by former European Central Bank President Mario Draghi. Increasing the share of government defense R&D to GDP in the eurozone to U.S. levels would result in a 350% to 420% boost to defense industry R&D, according to an estimate by Barclays.

Military spending can also offer jobs for idled workers with the right skills. German carmakers, for instance, have cut tens of thousands of jobs as global demand for the country’s cars has softened.

“The types of jobs created are exactly those jobs hollowed out in the middle of the income distribution…higher-paid jobs that don’t require large amounts of education," Ilzetzki said.

On both sides of the Atlantic, war has spurred industrial development. The American Civil War appeared to promote industrialization of the North, by stimulating infrastructure investments such as the first transcontinental telegraph line and railroad expansions.

In Europe, the Franco-Prussian War of 1870 may have supported the nascent industrial base of newly unified Germany, boosting industrial giants including Krupp, BASF and Siemens. Last century, President Richard Nixon’s threat to withdraw U.S. troops from the Korean Peninsula motivated government support for military-relevant industries in South Korea, which caused them to nearly double from the late 1960s to the mid-1980s, according to research by Nathan Lane, an economist at the University of Oxford.

Yet there is a caveat: To maximize the benefits of higher military spending, Europe needs to build more equipment domestically rather than buying it overseas.

This isn’t what’s happening: Arms imports to European North Atlantic Treaty Organization members more than doubled from 2020 to 2024 compared with the previous five years, and the U.S. supplied 64% of those weapons, according to the Stockholm International Peace Research Institute.

Historically, a much larger portion of European defense supplies have been purchased domestically—around 90% in France and 80% in Germany between 2005 and 2022, according to Goldman Sachs.

There are other hurdles, too. Finding enough skilled workers will be challenging in aging Europe. There is also a limit to how much highly indebted nations like France or Italy can borrow to finance their buildups.

These and other reasons mean Germany could benefit more than most given its large and currently underused industrial base and its comparatively low public debt.

European defense stocks such as Rheinmetall of Germany and Leonardo of Italy have soared this year, while bigger American counterparts such as Lockheed Martin have sagged as investors anticipated more aggressive European competition.

“Europe is going to be a formidable military exporter," said Jacob Kirkegaard, senior fellow at the Peterson Institute for International Economics.