# ‘Military Keynesianism’? Reeves faces British defence dilemma after EU spending surge

by Richard Partington, Economics correspondent

Even Berlin and Brussels are bending fiscal rules in the face of Russia’s threat. Will the chancellor still stick to hers?

As the Nobel laureate Robert Lucas quipped during the 2008 financial crisis: “” Donald Trump’s upending of the postwar security consensus has underlined the enduring wisdom of Lucas’s observation. But now, instead of bank bailouts and emergency bond buying, European firepower is being directed at bombs, tanks, and drones in the desperate fight to secure the continent’s border with Russia.

Berlin and Brussels – typically capitals of financial orthodoxy – have been convinced that this approach is required once again. Under the plan put forward by Germany’s chancellor-in-waiting, Friedrich Merz, Berlin is on the brink of  to pave the way for spending on defence and infrastructure worth an additional €1tn (£840bn) over the coming decade.

The EU, too, is at a “watershed moment”, having  allowing member states to ramp up borrowing for their defence spending, under an “escape clause” from its stability and growth pact debt rules. It is being chalked up as one of the most remarkable shifts in European economic policy in decades.

But for Britain, a more old-fashioned approach still prevails, with the chancellor, Rachel Reeves, insisting that her self-imposed fiscal rules remain “non-negotiable”. Rather than allow for a rise in borrowing, Labour’s plan to increase defence expenditure from 2.3% of GDP to 2.5% by 2027 involved a .

Pushing spending higher still would require further “difficult decisions”, Reeves has suggested.

> Britain and Germany are at different starting points. Berlin, unlike London, has a recent history of recording budget surpluses

The Treasury accepts the world has changed and that higher defence spending is a necessity, but with a tight fiscal position in advance of an already tough spring statement for the chancellor, paying for it will involve difficult decisions to find savings elsewhere.

There are hopes in Labour circles that Britain will follow Germany’s “military Keynesianism”, but the Treasury view has not shifted that much. Reeves still believes in it enough to stick to fiscal rules that, after all, were only announced less than six months ago.

That is, in part, understandable. Fresh in Reeves’s mind will be the , in which the British government was in the eye of a global storm. Mostly that was driven by investor fears over Trump’s inflationary policies. But there was also a UK-specific overlay.

Reeves could point to the sharp rise in German yields last week. On Wednesday, the yield – in effect, the interest rate – on Germany’s 10-year bonds rose by the largest amount in a single day since March 1990. She could also point to France, where even with newfound EU political cover, Emmanuel Macron could find he is still restricted by a . In a divided Bundestag,  to overcome.

Britain and Germany are at different starting points. Despite its deep economic troubles, Berlin, unlike London, has a recent history of recording budget surpluses before the onset of the Covid pandemic. Its debt-to-GDP ratio is close to 63%, compared with almost 100% for Britain. Even though German borrowing costs have risen sharply, yields remain significantly below those of the US and the UK, at about 2.8% for 10-year borrowing, compared with 4.6% for the UK.

That said, Reeves is being held back by politics more than economics. The government could make the case that higher borrowing today can be a down payment on stronger economic growth. Across the Channel, that is exactly what investors anticipate.

Before this month’s spring statement, it is widely thought higher government borrowing costs will break Reeves’s fiscal rules, fuelling speculation about cuts to the welfare budget.

But the Institute for Fiscal Studies reckons a small breach could be overlooked: “There is no meaningful economic difference between a forecast for a small current budget surplus in 2029-30 and a forecast for a small current budget deficit,” the thinktank suggests.

> EU chief unveils €800bn plan to ‘rearm’ Europe
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Still, the chancellor is hamstrung after promising before the election not to increase taxes, and having signalled the virtue of balancing the books to draw a neat dividing line with the Tories’ Liz Truss experiment.

That position may not be tenable for much longer. Whittling away at government spending threatens to undermine Labour’s other promises: of fixing public services, avoiding a return to austerity, and growing the economy.

It is a point made clearer by ­growing disquiet within Labour ranks, and by the government’s sliding opinion poll rating. So watch this space: it may not be wise to burrow much further into a fiscal foxhole.
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