Europe’s defense billions will only boost the wider economy if policy is designed for it

The EU aims to mobilize as much as EUR 800 billion to rebuild its military-industrial capacity. In Germany alone, the 2027 defense budget will reach EUR 140 billion, by far, the largest genuinely discretionary item in the federal budget. The question now is how to design this spending to foster innovation and strengthen industrial capacity across the economy. The Kiel Report "Defense Promotion and Industrial Development" reviews international evidence on R&D tax credits, grants, and public procurement, including defense programs in the US and Europe.

"We cannot assume spillovers from defense are inevitable; they must be engineered by tilting policy toward high-spillover activities," says Nathan Lane, economist at the London School of Economics and author of the Kiel Report.

Public support crowds private investment in, but returns are concentrated

The evidence is consistent: public innovation support generally triggers additional private investment in research and capital rather than replacing it. Effects on patents, productivity and new firms are positive but vary more. Returns are concentrated among small and medium-sized enterprises, new entrants, and financially constrained firms. Defense R&D, however, is dominated by a small number of large prime contractors.

Whether defense spending benefits the civilian economy is contested. Secrecy, export controls and highly specialized military technology limit transfer to civilian uses. At the same time, mission-oriented wartime research and modern dual-use programs have produced lasting benefits for the wider economy.

"Europe is set to spend billions on defense. This presents a historic opportunity to use defense spending as a tool of industrial policy. But spending alone will not determine the outcome. What matters crucially is how these policies are designed. Nathan Lane reminds us of what research tells us about effective industrial policy: Effective industrial policy should target specific binding constraints rather than apply broad interventions, address institutional and informational barriers alongside financial ones, leverage well-designed public procurement, prioritize activities with high spillover benefits, and be supported by strong administrative capacity," says Katharina Erhardt, Head of the Industrial Policy Lab at the Kiel Institute.

Procurement matters most, and is understood least

According to Lane, the evidence does not match what is at stake. "The instruments we understand best are not the ones that now matter most, especially for the EU," he says. "As defense budgets expand, the demand for design evidence will outrun its supply where spending is heaviest, and decisions of enormous scale will rest on the thinnest evidentiary base."

Procurement can create future demand, stimulate R&D, and build production capacity. Complex rules and uncertain follow-on contracts, however, tend to exclude SMEs and favor incumbents. More open tenders, in which firms propose their own technological solutions, and reliable pathways from development contracts to production orders make a measurable difference.

Five lessons for Europe's defense industrial policy

The report recommends that policymakers:

1. Target support to where constraints actually bind, rather than spreading it across all firms.
2. Address informational and institutional barriers, not only financial ones, for example through innovation organizations such as NATO's DIANA or the Bundeswehr Innovation Center.
3. Use procurement deliberately as a tool for industrial development.
4. Prioritize technologies with civilian applications and high spillover potential.
5. Invest in the administrative capacity needed to design, steer, and evaluate procurement.

"The rearmament now underway will reshape Europe's industrial base for a generation, regardless of how it is conducted; whether it also leaves behind a stronger, more innovative economy hinges on the arduous task of designing a truly developmental industrial policy," says Lane.

Nathan Lane will present the Kiel Report today, 22 October, at 12:30 pm in a small-group setting at the Kiel Institute’s Berlin office (Chausseestraße 111). The event will be held under the Chatham House Rule. If you are interested in attending, please register in advance at industrialpolicylab@kielinstitut.de. More information about the event.