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UK defence spending is going up and the best way to pay for it would be to grow the economy rather than cut other public expenditure (or borrow or raise taxes for individuals and businesses).
To achieve the level of growth required, there is only one option economically: a major reset of the UK’s trading relationship with Europe.
The Trump administration’s declarations on Ukraine, tariffs and NATO have focused European minds. Keir Starmer has decisively reaffirmed UK support to Ukraine and committed to raising defence spending from 2.3% to 2.5% of GDP by 2027 (implying an increase of about £6 billion).
In simple terms, the 0.2% GDP increase in defence needs an extra 0.5% of GDP to fund it (aggregate UK tax revenues are about 40% of GDP). Extra GDP would enable the Government to avoid unpopular cuts to public services and maintain the international aid budget, which Starmer has previously acknowledged supports UK security.
A new trading relationship would boost both the UK and EU economies. This matters because EU economic performance is already a critical issue. Even without Trump tariffs, the EU economic model is spluttering with growth in France, Germany and Italy just as weak or weaker than that in the UK.
On top of that, the EU is now facing the challenge of significantly increasing its defence spending from a lower proportion of GDP than the UK.
In 2024, the comprehensive Draghi report on the future of EU competitiveness proposed a suite of actions to improve economic performance. These include reducing internal trade barriers, which may come as a surprise to those who assume that trade in the EU is frictionless.
The reality is that although the EU has very successfully lowered trade barriers for intra-EU trade, they are still relatively high compared to the barriers for intra-US trade. In January, the European Commission responded with its “Competitiveness Compass”, a road map for change whose aims include reducing trade barriers by simplifying EU regulation and strengthening coordination between member states.
The pressing need for European defence collaboration has already pushed the EU and the UK much closer politically. The UK’s relatively strong defence capabilities now give it a unique opportunity to seek reduced UK-EU trade barriers to facilitate cross-border procurement and free up supply chains.
For example, a customs union between the UK and the EU would cut through customs red tape. It would take time to implement but would be very valuable and increase UK GDP by at least 1%. But, it would also have consequences.
In a customs union, the UK would have to levy the same tariffs on US imports as the rest of the EU but these should be a small cost compared to the benefits of freer UK-EU goods trade.
The US is an important UK trading partner (15% of UK goods exports worth £60 billion in 2023) but a much smaller partner than the EU (49% of goods exports). Note that tariffs do not apply to services trade and the UK exported £126 billion of services to the US.
The UK would also have to renegotiate the trade agreements that were not rollovers of previous EU agreements: Australia, New Zealand and membership of the Comprehensive and Progressive Agreement for Trans-Pacific Partnerships (CPTPP). Again, the economic cost would be small.
The Government estimated the long-run value of each of these at less than 0.1%, principally because these involve small economies that are a long way away and we have already agreements with nine of the 11 CPTPP members.
Similarly, The previous Government estimated the value of a trade deal with the US at just under 0.2% of GDP after 15 years. However, Trump’s willingness to renege on trade deals makes the potential benefits very uncertain.
Aside from a customs union, which, for political reasons may need to be deferred, there could be other big mutual economic gains. A recent report from Frontier Economics found that deep regulatory alignment, even while staying within Labour’s ‘red lines’, could increase UK GDP by 2.2% (about £60 billion a year, that could fund defence spending of £24 billion).
It would also deliver significant economic benefits to the EU — the estimated first-year increase in EU exports would be USD 30 billion. Frontier have told me that they estimate the long-term benefits to the EU economy would be in the range of 0.2% to 0.3% of EU GDP (in round figures, USD 40 to 60 billion).
The UK’s national economic interest lies with Europe rather than the US, but it also depends on maintaining a good relationship with the US, which Starmer seems to be doing well.
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To head off domestic political opposition to a closer EU relationship, Labour should rightly argue that a Government’s first responsibility is to protect its citizens and strengthen defence. This patriotic duty eclipses concerns about following certain EU rules or accepting the European Court of Justice as the final arbiter.
As EU ramps up defence manufacturing and reduces internal trade barriers, this moment in history presents the UK with a unique chance to redefine its priorities, relax its red lines and push for a parallel step change in its EU trading relationship.