By Victoria Castro Garcia
Mario Draghi had warned the European Union of its impending challenges in his report on The Future of European Competitiveness. The structural integrity of the defence industry was crumbling as Draghi addressed member states. Geopolitical threats surround the EU: there are conflicts on its Eastern border (namely, Russia’s affront to Ukraine) and security concerns in Africa, the Mediterranean, and the Middle East. Still, its reliance on foreign assistance and products is undeniable; Europe has doubled its dependence on US armament in the last decade. Draghi highlighted that ramping up defence was a priority to ensure the independence and competitiveness of the EU.
However, it is only now – under the threat of tariffs imposed by the Trump administration, armed conflict all across the union’s borders, and regional tension – that finding a solution or viable system of protection has changed from being a desire to a goal. The global security landscape is shifting, and the EU is countering it with a plan to increase defence expenditure over the next two years.
Historically, the ‘peace dividend’ led to a reduction in defence spending, such that its magnitude since 1992 was lower than any period in the past. European arms exports experienced stark cuts in the 1990s and again in 2018, and military funds were gradually diverted towards social programs ever since the end of the Cold War. The last decade, however, has seen this trust in peace waver, with the annual real change of major equipment expenditure by Canada and the European members of NATO growing from -2.9% in 2014 to 36.9% in 2024.
From the timing of this rearmament, we can extract the drivers of the EU’s increased spending. The annexation of Crimea in 2014 heralded the conflicts that would soon shadow the union and led to the promise of allocating a minimum of 2% of their GDP to spending on defence. Of the 32 NATO countries that agreed to this in 2014, only three had fulfilled the minimum that same year and fewer than ten had done so by 2022. By 2024, 22 European countries fulfilled their quota.
Hence, one of the greatest concerns of the EU is maintaining (and increasing) this level of defence now that the geopolitical crisis is only worsening. Financial strategies to achieve this are varied, although the focus is placed on fiscal flexibility and debt financing. Countries such as Germany support adjustments to fiscal constraints, which would include easing debt brakes. Thus, a higher military expenditure would not entail breaching financial limits. Alternatively, the European Commission’s ReArm Europe Plan would mobilise up to €800 billion over four years to improve defence infrastructure through initiatives such as defence loans, budget repurposing, and leveraging private capital.
All of this must be considered through the variations in defence spending seen throughout the EU. This is most clearly understood under the lens of geographical disparities: while Polish spending increased from 1.88% of its GDP in 2014 to 4.12% in 2024, making it the country with the highest defence expenditure, Spain on the opposite corner of the continent spends the least (only 1.24% of its GDP in 2024). Four of the five countries with which Russia shares a border are in the top five greatest EU spenders. These variations are even seen in what member states consider defence spending exemptions and aids must include. Baltic countries advocate for a strict focus on rearming, while those in the Mediterranean hope that this spending will also be directed towards cybersecurity and the protection of borders. Nevertheless, it may be possible to establish a system of coordinated procurement and standardisation that leads to cost savings, improved interoperability, and an integrated defence posture while adopting a broad definition of defence that would cater for the interests of all EU nations.
There are many economic implications of such stark spending and budgetary changes. Most clearly, this enhanced expenditure constitutes economic stimulus. Studies suggest that elevating defence spending from 2% to 3.5% of GDP could enhance GDP by 0.9% to 1.5% annually; alternatively, defence spending will have a fiscal multiplier of 0.5 over the next two years. This is the measure of the effect that increases in fiscal spending will have on economic output – in other words, an increase in government spending will lead to an increase of half that magnitude in GDP. However, it must be noted that the impact of increased military spending on the economy, albeit positive, will be limited. While €800 billion is roughly equivalent to 0.5% of the EU’s GDP, matching this spending would have required an additional €375 billion to be allocated to defence yearly between 1995 and 2023. In addition, if this enhanced spending is financed with higher taxes, GDP growth will be lower or negative.
The consensus, nevertheless, is hopeful in the long term. Research purports that there is the possibility of the fiscal multiplier increasing further: interoperable equipment and the use of economies of scale will allow the EU to increase its efficiency exponentially. In increasing efficiency, government spending can target areas that will generate higher returns, thus leading to increasingly productive economic activity; economic inefficiencies will be reduced, ensuring a greater proportion of the stimulus directly boosts economic output; and, improved resource allocation will decrease wastage and improve the government’s reaction times. Similarly, now that European stock markets have outperformed their US counterparts by over 17% after the announcement of Germany and the EU’s spending plans, there is hope for a bull market to be established, and for it to last a decade.
This economic impact will vary depending on whether defence products will be imported or produced locally. A focus on prioritising domestic production will simultaneously increase defence capabilities and invigorate the economy: an increase in national spending will galvanise the European industry, fostering innovation and potentially leading to the emergence of new industries, subsequently increasing economic diversification. EU arms manufacturers are expected to grow at a faster rate than their counterparts according to the market.
Similarly, the impact on the labour market will likely be positive. The revitalisation of the industry may lead to a shortage in the workforce; hence, the EU will likely require more workers and an improved system of training to support the defence projects. The French Minister of Economics and Finance, Èric Lombard, states that this must be a priority. In order for the social model to be unaffected, filling vacancies and invigorating the labour market is a necessity.
Therefore, the challenges to this rearmament mostly concern financial constraints. Most importantly, the great question European leaders must answer is where they will source the financing needed. In order to match a defence spending of 2.5% of GDP, the EU would experience an increase of 0.6% in their own expenditure. The two options are clear: the EU must find new income to cover this increased spending or must cut spending elsewhere. The former, finding new sources of income, could involve issuing more debt (at the national or the EU level), setting up new lending facilities, or increasing taxes; the latter, cutting spending elsewhere, would most likely be achieved through cuts in welfare programmes. Lombard asserts that the social model can be maintained while supporting increased defence spending. Whether this entails placing a larger tax burden on taxpayers or expanding government borrowing is still unknown.
The EU is also considering how to achieve this without relying on the US. The current Euro budgets could cope with substituting the US’ support in the Ukrainian war: of the allocated €42 billion, only €20 billion have been spent; taking over American aid would only entail an increase in expenditure of 0.12% of GDP. As far as the current situation goes, that the planned changes in defence spending will be enough seems to be the EU’s greatest source of relief. However, if the US were to exit NATO – or, in the words of Trump, go their “own way” – these numbers would be much different. Amongst others, Germany would most likely have to supply 100,000 additional soldiers (to put this number into perspective, they currently supply 40,000), and the EU would have to increase its defence expenditure to 3,5% of its GDP in the short term.
EU President Ursula Von der Leyen advocates for the use of the “escape clause”, which would allow defence spending to be excluded from the fixed debt-to-GDP ratio measures placed by the EU’s fiscal framework. This would generate a fiscal margin of roughly €650 billion over four years. Germany’s incoming coalition essentially intends to do this at a national scale, exempting defence spending from debt break. While this would boost the ReArm Europe Plan and lead to greater GDP growth than the one experienced recently for the largest European economy, it would also expose the European defence industry to sovereign market stress and difficult harmonisation. It is incompatible with the EU deficit, debt limits, and debt sustainability, and could raise doubts about the EU’s financial health in the long term, subsequently leading to a downgrade in credit rating, increases in borrowing costs, and, eventually, default risk.
Another alternative would be to appeal to or reform existing lending programmes through the European Stability Mechanism (ESM) or the European Investment Bank (EIB). The latter has already announced that it will issue €60 billion over the next year – less than a tenth part of the €800 billion originally planned, but still enough to allow flexibility. Although this would secure low long-term funding rates, it would only be a temporary shift of domestic to supranational debt; moreover, repurposing existing programmes (such as the borrowing scheme set up during COVID, NGEU) or creating new programmes constitutes the most difficult of the possible financing schemes. Based on this, it is likely that defence spending will be financed through sovereign debt and a temporary exclusion from the EU’s debt framework, in accordance with the plans already set in motion.
This balancing of social and defence trade-offs depends on an intricate system of debt, arguably unsustainable by those nations in the EU already highly entrenched. Italy has seen its public debt-to-GDP ratio increase from 31% in the 1960s to 137% in 2024; the debt of France has also exceeded the size of its economy, drawing the ire of financial markets and heightening political instability. France’s benchmark bond yields have, for the first time in history, matched Greece’s, and the difference between the bond yields on French and German 10-year government bonds rose in November close to 90 basis points. In and of itself, that Germany is dealing with a quasi-recession is concerning, taking into account it was once a reliable European benchmark; that the second biggest European economy, France, is also struggling is alarming. It begs the question of whether this increase in spending is fiscally sustainable. Financing defence at a national level risks plunging weaker European economies into a crisis, and even if fiscal rules are eased, EU credit profiles are expected to worsen.
The financial challenges plaguing the EU are many, trapped in a geopolitical standoff that requires fast and implacable action. Whether this can be achieved without obstacles is yet to be proved, but what cannot be questioned is that disquieted times await us.
The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.
Photo by Guillaume Périgois on Unsplash