Editor's Foreword

NATO EUROPE – DEfENCE ECONOMICs
Economic activity in much of developed Europe had
already begun to contract before the catastrophic
September 2008 financial blowout, and despite
initial perceptions that relatively healthy household
balance sheets would enable European economies to
escape a full-blown recession it was not long before
the consequences of the shock to the world’s financial
systems led to a severe downturn. Regional GDP,
which grew by an anaemic 0.5% in 2008, contracted
by a massive 4.8% in 2009 as consumer and business
confidence plunged. Countries particularly badly
hit included Iceland (which had to seek IMF support
following the total collapse of its overextended
financial sector), Spain and the United Kingdom,
which suffered the combined effects of the end of
twin bubbles in real estate and financial-services.
Initially it had seemed that problems in Europe
would be limited to a few banks, and therefore the
macroeconomic implications were not considered
great. As such, immediate fiscal- and monetarypolicy
responses were limited. Once it became clear,
however, that the close links between Europe’s
major financial institutions, together with their high
leverage, were having a severe impact on regional
economic activity, remedial policies were introduced.
The European Economic Recovery Plan called for
discretionary fiscal measures to be taken mostly at
the national level to provide a stimulus of 1.5% of EU
GDP. A number of countries, including Germany,
Spain and the UK, introduced even larger discretionary
rescue packages. As a result of these initiatives,
public finances have deteriorated sharply, with
the OECD calculating that combined EU budget deficits
in 2009 would reach 5.6% of GDP, rising to 7% of
GDP in 2010, compared with a deficit limit of 3% of
GDP that is a cornerstone of the Stability and Growth
Pact governing membership of the single European
currency.
In its October 2009 World Economic Outlook
report, the IMF suggested that during the second
half of the year the pace of decline in economic
activity in Europe was moderating due to rising
exports, a turn in the inventory cycle and continued
support from stimulus programmes, and that the
region had emerged from recession. While noting
that upside potential had appeared in several economies,
it warned that the recovery could be more
sluggish than expected if conditions in the financial
and corporate sectors were to worsen or unemploy-
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ment were to rise faster than anticipated. The report
also stressed the importance of a suitable fiscal exit
strategy: withdrawal of support too early could forestall
a fledgling recovery, whereas leaving policy
loose for too long could usher in a rise in inflation as
output gaps diminished.
The parlous condition of government spending
across Europe quickly had a negative impact on
defence spending, and that trend looks set to
continue, at least over the medium term. Of the
24 European members of NATO for which 2010
budgets were available, only Norway and Denmark
proposed higher real terms budgets compared
to the previous year. The biggest cuts were in the
Czech Republic (down 12%) and Romania (down
17.4%). The fact that most countries held spending
at broadly the same nominal level in 2010 is probably
misleading as many will likely be forced to trim
discretionary spending over the coming years in
order to deal with deficits.
As the worst-hit of the advanced European economies
the United Kingdom will have a particularly
difficult task reconciling its defence ambitions with
available financial resources. The recession in the UK
has been particularly severe because of the country’s
large financial sector, high household indebtedness
and strong cross-border links. Economic growth has
turned sharply negative; house prices have fallen
by more than 20% from their peak; and unemployment
has increased as banks have concentrated on
reducing leverage, causing credit availability to fall
dramatically. The government reacted to the crisis
with a wide range of measures to both stabilise
the financial system and support demand, but as
a consequence will run up fiscal deficits of around
13% of GDP in 2009 and 2010. National debt is set
to double over the next five years to nearly 100% of
GDP.
Even before the implications of the financial crisis
on the UK’s public finances became clear, tensions
between military activity and the defence budget
were apparent. The cost of running two overseas
operations in Iraq and Afghanistan, coupled with
a comprehensive equipment plan that suffers from
repeated delays and cost overruns, was putting
increasing strain on a budget that was rising by
only a point or two above inflation each year.
In March 2008, the House of Commons Defence
Committee acknowledged the situation, warning
that the Ministry of Defence (MoD) would need to
take ‘difficult decisions’ in order to compile a real-
Europe