Making Europe’s defence spending great again

Another day, another withdrawal of US support for Ukraine’s and, therefore, Europe’s security. While President Donald Trump pushes for a surrender deal with Russia, Europeans are hurrying to equip Europe to defend itself without American help. Europe is a rich continent, and the signs are that its leaders can move fast when they have a knife against the throat. That Friedrich Merz, who is on course to be Germany’s chancellor, has brokered a political agreement to exempt defence spending from the country’s paralysing debt brake is nothing short of stunning.

There is also a lot of discussion about funding models. So below I go through the questions that need to be asked about the financials of Europe’s defence challenge, and offer some tentative answers. What do Free Lunch readers think? Send us your opinions at freelunch@ft.com.

To untangle my own confusions, I have found it useful to divide the questions into three. How much money needs to be raised and spent? Where from? And by whom? Let’s start with the first.

How much must Europe spend?

Europeans need to spend more on defence. But how much more? That depends on what you think it needs to be able to defend against. But any plausible answer to that entails a very large increase from current (let alone pre-2022) levels, plausibly several percentage points of annual GDP for many countries. This could amount to as much as a doubling from current levels, which for most of Europe are a little above, and sometimes well below, 2 per cent of GDP.

As a good yardstick, take Poland, the standout pupil. In just three years it has gone from an average of about 2 per cent of GDP to nearly 5 per cent. Poland is, of course, particularly exposed to a potential Russian invasion and highly aware of it. So what about the rest of Europe?

A recent report by Alexandr Burilkov and Guntram Wolff gives a succinct but informed answer. If the US cannot be counted on, they argue, Europe would need 300,000 more troops and at least €250bn more defence spending a year — a near-doubling from 2 to 3.5 per cent of GDP — to compensate for the loss in capability. Not that far off Poland’s additional effort, then.

Where should the money be found?

Such a defence build-up means reallocating several percentage points of European economies’ real resources away from current uses towards defence equipment, personnel, logistics and research and development. That economic reality is the fundamental point about “financing” and needs to be kept firmly in mind in any discussions of how accounting numbers get on to budgets.

There are only three ways to do this in economies that are not leaving significant resources idle by producing less than their potential. (There may, in fact, be some slack in European economies — in which case more defence spending can, macroeconomically, pay for itself by boosting total economic activity. But for the sake of this discussion, let’s put that possibility aside.) You take away resources from consumption and private investment through taxes; government borrowing can coax the private sector into saving more resources, with the freed-up resources channelled to defence budgets; or the government can cut other budget expenditures.

Johannes Marzian and Christoph Trebesch at the Kiel Institute have studied how military build-ups have historically been financed. They find that on average, and in important case studies, military expansions are not generally paid for by reallocating existing government expenditures. Instead, they are financed through a mix of taxes and debt — and the steeper the rearmament, the more debt in the mix. That also fits the current Polish case, which is largely debt-financed.

History can be a poor guide, of course, but Marzian and Trebesch point out that economic principles recommend precisely this. Any permanent increase in defence spending should be paid for by taxes or cuts in other spending. But in a fast ramp-up, it is good to smooth the tax rises out over time, so it makes sense to borrow for the initial burst. In addition, when the build-up involves a permanent increase in the stock of materiel, the short-to-medium term spending needs will be somewhat higher than the permanent level. That bump, too, should be debt-financed to avoid a bump in the tax level as well. (And in a case of economic slack, debt-funded deficit spending is warranted for standard Keynesian reasons.)

Who should do the borrowing and spending?

So we are set (or we should be) for an imminent burst of borrowing to spend on defence, to be partly replaced by a rise in tax levels over time. A critical question in Europe is whether the borrowing should be done nationally or at the European level. This is often a confused debate that, fortunately, has recently benefited from some greater enlightenment.

One source of confusion is that a lot of countries are coming up against domestic and/or European rules on deficit spending. This is one reason why there are calls for pan-European common borrowing or new institutions such as a “defence fund” (modelled on the EU’s pandemic recovery fund, for example) or a “defence bank” (modelled on existing multilateral development banks). But it’s a bad reason. If the rules lead to bad economic policy (indeed, bad security and defence policy), it’s the rules that should change.

That’s precisely what happened this week. In a bold decision, Germany’s two traditional governing parties agreed to permanently exempt increases in defence spending from the country’s constitutional debt brake. Meanwhile, the European Commission proposed suspending EU budget rules for defence spending. (How exactly this will be done is not entirely clear, since the “escape clause” that will be invoked is not sector-specific but suspends constraints across entire government budgets. But the political decision is clear.) For Germany, then, neither domestic nor European rules now put any limit on a bigger deficit to fund defence.

There are other good arguments for joint borrowing and new facilities, however. One is that joint borrowing would help with joint spending, or at least spending that’s co-ordinated and standardised between countries. As many observers point out, different national specifications are a big burden on Europe’s military procurement efficiency (because economies of scale are not exploited) and on its military fighting efficacy (because countries’ equipment is not sufficiently interoperable or interchangeable).

Another reason is that joint procurement and interoperability should naturally include non-EU members such as the UK and Norway. But there are all sorts of legal and political constraints on these countries’ participation in existing EU policy and financing structures. (A working paper from Stiftung Wissenschaft und Politik explains the complications well.) What is more, not all EU members — some are neutral, some are friendly with Russian President Vladimir Putin — may want to join the needed defence build-up. So some new constructs could be necessary for joint financing and procurement by a “coalition of the willing” that includes non-EU states.

Even so, no one should think a defence bank somehow sidesteps the political choices involved in reallocating real resources. Unlike in other big initiatives, such as the green transition, it is not possible to “leverage” small amounts of public funding to get private finance to do the rest. Only governments buy tanks (and thank goodness for that). Lending by a defence bank does not overcome the need for a government to put money on the line for an order, if the tank is to be built. European leaders must categorically avoid the temptation to think that a detour of setting up a new institution will somehow change that basic fact. Too much financial engineering will send an unmistakable signal of weakness — of still not wanting to muster the resources that are needed.

If that is kept in mind, there is a case for common borrowing (Sander Tordoir usefully sets out how to think about common defence bonds), if this is designed to encourage streamlining specifications and joint procurement across Europe. Burilkov and Wolff suggest that half of the additional €250bn needed a year could be done at the European level, half at the national level. Over a seven-year period of the multiyear EU budget, that would match the size of the recovery fund: bold but doable.

This week the European Commission president proposed an €800bn spending burst on defence by the EU and its member states — of which €650bn would be spent by national capitals over four years, enabled by suspending the fiscal rules. That is about the right amount. But capitals would still have to do the political work to decide to spend more. Poland has done this; Germany has put itself in a position to do it, but not yet actually committed the spending. And the spending commitments must be sustained over the long term to give weapons manufacturers confidence to build up capacity. Merz is therefore right when he says the EU budget rule suspension for defence must be reliably in place over time.

As for common borrowing, the mooted €150bn is far too little, and probably defined less by needs than by what could be repurposed from unused borrowing capacity without too much fuss. So while there have been some excellent steps in the right direction this week, a lot more financial and political footwork remains.

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