Europeans are building a war economy Can they master it?

When Russia invaded Ukraine two years ago, French President Emmanuel Macron quickly proclaimed Europe needed an “économie de guerre” — a war economy — to underwrite its security.

Since then, governments here have rushed to assess how rapidly they can purchase weapons. Most were sobered by the lack of production capacity in an arms industry focused on the promise of expensive, advanced technology rather than mass output, Defense News reports.

As Russia’s war in Ukraine enters its third year, there’s a movement afoot to remake the European defense-industrial complex into a muscular deterrent in its own right. The effort is playing out in national capitals as well as at the European Union. Officials in Brussels are expected to unveil a defense industry strategy soon that will test the bloc’s ability to unleash and simultaneously tame a market that went from obscure to omnipresent in two short years.

“Russia’s invasion has been a wake-up call for Europe,” European Commission President Ursula von der Leyen said last month. “We have to rethink our own defense and defense-industrial base.”

The ability to produce more weapons faster has become the singular yardstick for progress. In Germany, politicians have begun debating ways to front money to arms makers for the production of critical equipment, coupled with long-term purchase guarantees. And companies are building new production facilities and introducing new work shifts to keep up with making weapons needed both by Ukraine and national forces.

But amid the frenzy, there has been little discussion about anchoring the business of defense among a set of political rules that reflect an expectation production will only take place on terms acceptable to governments.

In an interview with Defense News during a recent visit to Washington, Lt. Gen. Michael Claesson, the chief of the Swedish defense staff, described a new model for the interplay between governments and the arms industry as “public-private partnership 2.0.″

“I don’t believe in increasing necessarily government ownership” he said. “What I’m asking for is government engagement.”

Private companies can still deliver the best results, he added, “but there needs to be interaction in a different way than before.”

In Germany, politicians have long seen the defense market as one like any other, said Torben Schütz, an analyst at the Berlin-based German Council of Foreign Relations. “That is no longer up to date,” he added, arguing vendor incentives alone “probably won’t get you anywhere” in finding the equilibrium between government control and laissez-faire economics.

Growing prices

Key weapons, needed by European nations and Ukraine alike, have seen major price increases. Citing NATO officials, The Wall Street Journal reported last month the price of a 155mm artillery shell has risen from $2,100 apiece to $8,400 since the war began in February 2022.

In Germany, there is an entire cohort of weapon systems whose cost projections are expected to rise because of contract provisions with vendors that allow prices to remain flexible in line with market conditions. The increases are now showing up on the books because stipulations in the German government’s €100 billion (U.S. $108 billion) military plus-up fund prescribed that all programs financed through it must fully account for any expected cost escalation.

Affected programs include the Eurodrone, for which officials last month reported a 35% jump, or €1.3 billion, since last summer, according to the Defence Ministry’s most recent report on the status of major weapon systems, dated January. The document downplays the increase as academic, noting the terms of the contract had remained the same while future cost hikes during the performance period through 2035 were now baked in.

The types of contractually agreed price adjustments taking effect in the Eurodrone program are “generally” unlimited in both directions — less expensive or pricier over time, a ministry spokesman told Defense News in an email. But it’s possible to restrict the degree of volatility in negotiations with contractors, the spokesman added.

In addition, the cost for a new short-range air defense system to counter drones for the German military has increased from €240 million at the program’s inception in 2018 to almost €1.3 billion now, as first reported by Der Spiegel in December.

According to the defense spokesman, higher demand for counter-drone capabilities on the global arms market has led to manufacturers increasing their prices.

“Demand goes up, supply remains relatively constant,” Schütz said. “We all have enough economics knowledge to know what happens as a result.”

But there are more factors wrapped up in cost increases than simply higher demand. As the war in Ukraine rages, companies have complained about the growing price of everything from labor to raw materials, raising the key question: Are vendors charging more now because they must, or because they can?

Government reach

The question of how to arrange the relationship between the European defense market and governments buying from it has taken on an almost existential dimension. That is because defense analysts believe Russia could one day attack the continent if it succeeds in Ukraine.

Daniel Fiott, the head of a defense and statecraft program at the Brussels School of Governance, said governments generally agree there’s a need for them to interfere in the defense market, but it’s a tricky concept to apply at the EU level.

“Defense markets across the world experience state intervention, and for good reasons,” Fiott told Defense News. “Without control, governments would experience job and skills losses, and even lose manufacturing capacity to rivals.”

“In this sense, price volatility for equipment could pose a national security risk if it means governments become priced out of a market to which they urgently need access,” he said.

While the United States has the Defense Production Act, which allows the government to prioritize the production of goods needed for national security, there is no such tool available to the European Union.

There is also limited understanding in Brussels about the intricacies of the European defense market as a whole, its supply chains and its pricing mechanics. The lack of knowledge became more apparent in past years as EU officials, for example, tried to identify vital suppliers needing protection from potentially nefarious investors outside the bloc.

Still, officials believe they can translate lessons learned from collective COVID-19 vaccine or natural gas purchases into the defense market to refill national armories. For now, equipment levels remain low until manufacturers can catch up following their donations to Ukraine. But there are exceptions, thanks to early government action, according to Minna Ålander, an analyst on Nordic defense matters at the Helsinki-based Finnish Institute of International Affairs.

“The Finnish Defense Forces (FDF) received extra funding for procurement and immediately issued new contracts in the spring of 2022, not long after Russia’s full-scale invasion and before other countries woke up to the issue,” she wrote in an article for the Center for European Policy Analysis earlier this month. “As a result, the country’s stockpiles have been filling to such an extent that more warehouse capacity is needed.”

Meanwhile, in Germany, the lack of experience in using defense-industrial policy as a deliberate planning tool of governing — often decried by industry executives — is now coming back to haunt Berlin, and officials are now forced to wise up in a hurry, according to analysts here.

German officials never had to think about industrial mobilization because the assumption was the Cold War front-line nation would immediately lose its manufacturing base in a major war anyway, according to Schütz.

“The discussion about the particulars of a war economy are off to a slow start here,” he said. “Hopefully not too late.”

The upcoming EU defense industry strategy won’t solve all of the dilemmas facing the bloc’s defense market, according to Fiott. At the same time, he added, it’s the first of its kind and could provide European industry with greater certainty about demand over the coming years.

“Alongside the strategy should also be the European Defence Investment Programme, which seeks to invest in defense technologies and systems beyond the prototyping phase, where the EU’s European Defence Fund currently ends, to production and commercialization,” Fiott said. “Clearly, then, if the strategy and the EDIP emerge in public together, and if the EDIP comes with a hefty investment tag — some have called for €100 billion over a seven-year period — then the demand signals sought after in the strategy may become a reality.”