How Will Increased Defence Spending Impact the UK Economy? Finn Watson fwatson@arlingclose.com

Readiness at a Cost: Defence Spending and the UK Economic Outlook

From Eastern Europe and the Middle East to the South China Sea and beyond, rising geopolitical tensions have prompted the UK and its NATO allies to allocate greater resources toward achieving heightened military readiness. The Hague Summit Declaration, issued by NATO on June 25th, calls on all member states to allocate at least 5% of GDP to defence by 2035, with a minimum of 3.5% directed toward ‘core’ defence expenditures such as procurement and personnel, and the remaining 1.5% allocated to areas including cybersecurity and civilian defence. Given that the previous spending requirement for member states was 2% of GDP, this resolution represents a significant change. Prime Minister Kier Starmer reaffirmed the UK’s commitment to the pledge, adding that the plan will “create jobs, growth, and wages for working people.” However, given that the UK spent only 2.3% of GDP on defence in 2024, and that Starmer’s February defence goals outlined a target of 2.5% by April 2027 with only the ‘ambition’ to spend 3% of GDP by 2034 if economic conditions allow, such aims may prove more difficult to realise than to declare. In addition to higher defence spending, rising global tensions or the outbreak of war may give rise to a range of tail risks and broader shifts in the global economic order, including potential disruptions to trade, bond markets, supply chains, and commodity flows, as well as elevated inflation and reduced investment and social spending.

Raising defence spending from 2.3% to 5% of GDP within a decade poses a significant challenge and requires substantial restructuring of government priorities. To illustrate the scale of this commitment, the United States currently spends 3.4% of its GDP on defence, while Russia is spending approximately 6.1% in pursuit of its full-scale war against Ukraine.  Particularly challenging is the prospect of increasing military spending within the constraints of the Treasury’s self-imposed fiscal rules. In her October Budget, Chancellor Rachel Reeves introduced fiscal rules committing the government to balance the current budget for day-to-day spending and reducing net debt relative to GDP by 2029-30. As part of this strategy, Reeves set aside a £9.9 bn buffer, which was effectively wiped out by lower-than-expected tax receipts ahead of the Spring Statement. Confronted with the choice of cutting spending, raising taxes, or breaching the fiscal rules, she opted for the first, proposing approximately £14 bn in welfare and departmental cuts to restore fiscal headroom. However, this strategy has since partially unravelled. Dissent from Labour Backbenchers forced the government to drop most of the controversial welfare cuts, eliminating much of the planned savings. The OBR confirmed that the reversal will wipe out the £4.8 billion in savings originally expected from welfare reforms by 2029–30, leaving the revised package with no net fiscal benefit. This significantly narrows the Treasury’s headroom and makes future tax rises considerably more probable if the government is to meet its fiscal rules.

Additionally, the Spring Statement included an extra £2.9 bn in defence spending, bringing military expenditure to 2.36% of national income as part of the government’s plan to reach 2.5% by 2027. Given that adhering to the fiscal rules was already proving challenging, the ambitious military spending targets set out in the Hague Summit Declaration will continue to force the Treasury to make difficult choices. To comply with the borrowing rules, the Treasury faces two politically difficult options: raise taxes, despite the government’s manifesto pledge not to increase headline rates of income tax, National Insurance, or VAT; or implement politically unpopular cuts to social spending, risking internal fracturing within the Labour Party. Of course, expanded defence spending could also be financed through additional borrowing, breaching the fiscal rules in doing so. However, such a move could unsettle bond markets by signalling a lack of fiscal discipline, potentially raising risk premia and yields on government debt and pushing up borrowing costs across the economy.

Furthermore, ongoing geopolitical tensions may continue to affect the economy in various ways, with specific impacts depending on the nature and scope of the conflict. Specifically, the UK is particularly vulnerable to the impact of conflict on its energy security, as demonstrated by the outbreak of the Russo-Ukrainian War – a period which, when combined with increased post-pandemic energy demand, saw the Ofgem price cap rise by 54%. Further risks to the UK’s energy security were highlighted by the recent 12-Day War between Iran and Israel, during which Iran’s parliament approved the closure of the Strait of Hormuz. Although the measure was ultimately not implemented, its impact would likely have been even more disruptive than that of Russia’s invasion, given that one-fifth of the global oil supply passes through the strait, whereas Russian oil accounted for 13% of global production prior to the war. Conflict-related oil shocks would have numerous second-order effects beyond higher energy prices. Most notably, it would likely increase inflation, as energy is integral to both production and transportation, thereby placing additional pressure on monetary authorities to pursue a tighter policy. Furthermore, depending on the scope of the conflict, war can contribute to inflation even in the absence of an energy shock. In an energy-rich country like Russia, the shift toward a war economy, characterised by increased military spending, labour shortages, and sanctions, has led to the highest inflation since the turmoil of the post-Soviet era. In a less extreme Western example, US inflation rose following the commencement of the Iraq War in 2003, driven by deficit-financed military spending, elevated energy prices, a weakened dollar, and the crowding out of productive investment. For several consecutive years, inflation remained elevated while opportunity costs – such as investment in domestic infrastructure, education, and healthcare – were largely overlooked.

In terms of its impact on bond yields and monetary policy, sustained medium-term inflation could prompt central banks to tighten monetary conditions. However, this interpretation risks oversimplifying the complex array of factors that influence policy decisions and market responses. For example, during World War II, both the UK and US central banks maintained low interest rates to facilitate government borrowing on favourable terms, despite high inflation. Reinhart and Sbrancia (2011) show that in the post-war period until the 1970s, financial repression was widely employed across the West to support the liquidation of public debt. In this context, financial repression refers to a policy framework in which governments engineered below-market real interest rates through a combination of capital controls, regulatory mandates on domestic investors, accommodative monetary policy, and moderate, sustained inflation. This approach reduced debt not through overt austerity or default, but through the gradual erosion of its real value. In this way, the policy response of monetary institutions – and interest rates and yields by extension – can be influenced or distorted by concerns over fiscal sustainability. While such long-term dynamics shape the broader policy regime, short-term market reactions to conflict may follow a different trajectory. Corallo (2005) examines market movements on ‘war days’ – defined as days marked by sharp increases in volatility linked to war-related news – and finds that during the 2003 Iraq War, bond yields fell across all maturities, equity prices declined, and the US dollar depreciated. This suggests that, in the immediate term, geopolitical shocks can trigger a flight to safety that compresses yields, even in the context of inflationary or fiscally expansive conditions. While the conflicts above (WW2 and the Iraq War) may not be fully representative of the current environment or future conflicts, they illustrate that, despite inflationary pressures, interest rates and yields may not rise as much as conventional expectations would suggest.

For more information on our macroeconomic forecasting, borrowing cost projections, and analysis, please contact us at treasury@arlingclose.com or call 08448 808 200.

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