Britain’s New Defense Spending Quest Faces Fiscal Constraints

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He said steps should include taking more equity stakes in promising defense or dual-use start-ups, which offer positive returns, draw in private investment and can help prevent firms relocating to the US. 

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The Ministry of Defence has been looking to do this and the British Business Bank is showing more interest in defense or defense-linked technology firms, taking equity stakes in Kraken Technology, Hadean and SatVu in recent months. But government investment in the three firms amounts to less than £35 million of around £600 million in total across more than 50 UK firms. Although a much bigger economy, America’s Defense Advanced Research Projects Agency has a budget of $4.9 billion this year alone. “The scale is just too small,” said Surico. 

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The constraint is that the financial transaction model is mainly limited to start-ups, and most PuFins are expected to achieve a return on their investments.

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It’s harder to make a case for using them for more traditional capabilities like tanks, jets and warships, which tend to be manufactured by defense primes with the government often the primary or only customer.

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“If you try to do it that way, that would just be a mirage and would not genuinely be an alternative way of financing this that didn’t ultimately rely on government borrowing,” said Thomas Pope, chief economist at the Institute for Government.

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The fiscal rules also cannot be bent for everyday spending such as military salaries, training and exercises, which military chiefs have said face the biggest pressures. That’s unless the government follows the advice of former chancellor and prime minister Gordon Brown, who last year called for “exceptional” defense spending to be exempted from the fiscal rules. Brown is now advising the government on using international finance partnerships to boost national security.

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As Defense Secretary Healey pushed Starmer to look for creative funding options, including pointing to how almost 20 European Union nations activated an escape clause to temporarily deviate from budgetary requirements to fund defense. Economists and markets are wary though.

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“It makes sense to borrow in the short term for something you expect to be temporary,” for example if the UK was at war, said Pope. “But everything around the defence investment plan and the Strategic Defence Review is saying that we need to permanently have this different posture.”

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Savings through welfare reform is a more viable option, he said, but the government is yet to publish its plans and Starmer proved how difficult it was to push through policies involving cuts after many of his own Labour lawmakers rebelled. “Even if that ends up funding some of the gap, I’d be very surprised if it found close to all of it,” said Pope.

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Burnham’s government has indicated it would like to join Canada’s defense bank, allowing the UK to provide capital for the defense industry alongside allies. That’s alongside a multilateral mechanism Healey’s predecessor Rachel Reeves set up to stockpile and procure off-balance sheet, which she said would save the UK as much as 20% on procurement. 

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Economists say these offer promising ways to lower costs and reassure markets with the fire-power of multiple nations, but both are yet to be operationalized, little economic research has been done so far and it’s not clear if funding through these mechanisms would be counted as government spending.

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“Most likely you will need a combination of the three and it would be strange not to,” said Surico, pointing to the prospect of tax rises, increased borrowing and spending cuts. 

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—With assistance from Tom Rees.

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