Analysis-Defence surge could help jumpstart Europe's flat economy

By Yoruk Bahceli

LONDON (Reuters) - A defence spending surge could boost Europe's sluggish economy as long as it provides a springboard for a broader industrial revival and if governments convince the sector that the funding is there for the long haul.

Amid growing concerns the continent can no longer rely on U.S. protection, European leaders meet in Brussels on Thursday to approve new ways to increase defence spending and pledge continued support for Ukraine.

While questions remain over whether Europe will match words with action, this week's deal between Germany's likely next coalition partners to remove fiscal caps from defence spending has boosted hopes of a wider military push that could also kickstart the region's ailing industry and technological base.

"(It) will support growth, and in particular, will support European manufacturers at a time when they are particularly struggling," said Goldman Sachs senior European economist Filippo Taddei, while stressing: "It's very important that this extra spending is deployed consistently over time."

EU leaders are seen broadly welcoming European Commission proposals to mobilise up to 800 billion euros ($863 billion) for European defence, including a plan to borrow up to 150 billion euros to lend to national governments.

Estimates vary greatly on how much defence spending can raise wider growth in the economy. But many economists think the initial benefit is limited, with each euro of extra funding generally seen providing less than one euro of extra output.

There are several reasons defence spending is typically not seen having the same spillover effect into wider growth as spending on civilian infrastructure.

One is that complex military projects take time to plan and execute. Citi, for example, doesn't expect a meaningful growth impact before 2027.

With only three of the world's top 15 arms producers, Europe is heavily reliant on defence imports, meaning a lot of the benefit will flow out of its economy. Since Russia's 2022 invasion of Ukraine, 78% of EU procurement has gone outside the bloc, with 63% to the U.S., European Commission data show.

A further hurdle is the fragmentation of Europe's defence industries along national lines, meaning they do not have the scale needed to maximize the benefits of spending.

The question, then, is how this surge can be managed and how much of it can be achieved with domestic production.

BETTER PROCUREMENT

Some economists say the capital-intensive nature of defence projects mean they do not have the same job-creating benefits initially as more labour-intensive sectors.

But Jacob Funk Kirkegaard, senior fellow at EU think tank Bruegel, argued that could be an advantage given Europe's shortage of skilled labour.

And if, further down the line, the rise of the EV sector leads to job losses in Europe's typically more labour-intensive traditional auto sectors, then rearmament would open up a new destination for those workers with manufacturing skills.

"So the timing of this is quite beneficial," he said.

Analysts say that to make its money go further, Europe must invest more in defence research and innovation, where it spends less than one-tenth of the U.S. level, a 2024 report by former European Central Bank chief Mario Draghi found.

Kirkegaard cited Israeli tech start-ups benefiting from innovations emerging from decades of high defence spending, while Germany's Kiel Institute concluded in a February report that in Europe, defence R&D spillovers into the private sector could lead to wider long-term productivity gains.

On that basis and assuming a greater focus on domestic production, it estimated that an annual increase in defence spending to 3.5% of output from around 2% would raise overall output by 0.9%-1.5% per year - not insignificant given the euro zone's current potential growth rate estimated around 1%.

While European defence firms are confident they can ramp up production, analysts say steady funding is needed to show that governments are in it for the long haul.

The current European Commission proposal - a four-year exemption of defence spending from its rules limiting fiscal deficits - plus a small portion of EU lending, may not suffice.

"You're not building a long-term fiscal framework conducive to long-term stability," said Sander Tordoir, chief economist at Centre for European Reform.

"There's a bit of a risk here that... you don't see much progress on what matters most, which is having a much better-coordinated procurement system across the EU."

An as-yet unanswered question is what ramping up defence means for other spending, from welfare provision through to other infrastructure and the green transition.

"If part of defence spending is funded via cuts elsewhere, we might even see a situation in which at least in the short run, higher defence spending will have a negative multiplier," said ING's head of global macro Carsten Brzeski of the possible lagging effect on growth.

Germany's coalition hopefuls, in addition to removing spending caps on defence, are also planning a 500 billion euro infrastructure fund.

But French President Emmanuel Macron, facing a high deficit, has warned of tough budget choices ahead, and other EU leaders will also face the question of how a defence surge will impinge on other priorities.

They may conclude, suggested Bruegel's Kirkegaard, that "none of that matters if you are not physically safe."

(Reporting by Yoruk Bahceli; Additional reporting and editing by Mark John and Hugh Lawson)