Fearful of a reduced or withdrawn American security umbrella, European leaders are convening to seize the initiative on their own security. Their discussions will center around creating the fiscal flexibility necessary to invest in their defense industrial base, which is currently unable to produce the mass necessary to field a conventional deterrent. A recent Bruegel report predicts that investment must scale to an extra annual 250 billion euros in the short term, elevating euro-area defense spending from 1.9 to 3.5% of GDP. Political will is coalescing around some form of borrowing to close the gap, but the exact vehicle carries risks for Europe's debt sustainability, its political agenda, and which countries stand to benefit from increased spending.
Why Borrowing Now?
Europe is unlikely to achieve strategic parity with Russia, without drastic increases in defense spending. Since 2022, Russia has rapidly increased its productive capacity in tanks (220%), armored vehicles and artillery (150%), and long-range loitering munitions (435%). Russia is on track to produce 30% more shells than all of Europe combined in 2025. If the US were to withdraw from Europe (such as in a pivot to Asia), just matching their military presence will require the recruitment of about 300,000 additional troops.
Despite the strides Europe has made in defense spending – with two-thirds of all NATO members now reaching the 2% target – it has not moved at the speed commensurate to these vulnerabilities. Under the EU's fiscal rules established after the euro crisis, member states must rein in deficits to 3% of GDP and their debt-to-GDP ratios to 60%, lest they face penalties under the Excessive Debt Procedure. This has restricted massive allocations toward defense for indebted players, including France (111% of GDP), Italy (135%), and Greece (162%). Even healthier countries that have the capacity for debt increases, like Germany (62%), Poland (49.6%), or Finland (75.8%), are unable to rapidly increase their deficits.
European leaders, who envisage a peacekeeping role to enforce a ceasefire and fear US commitments amid its suspension of military aid and intelligence-sharing to Ukraine, have realized that business as usual will no longer cut it. The frugal countries, like Germany or the Netherlands, have recently considered an EU role in borrowing for defense.
And Borrowing How?
There are several vehicles to increase defense debt, each with different implications.
The first would be to loosen the EU's fiscal rules to allow full or partial exemptions on defense spending. EU Commission President Ursula von der Leyen proposed in a March 3 letter to governments that the national escape clause of the Stability and Growth Pact be invoked on defense, thereby treating security as an "exceptional circumstance" where normal fiscal rules do not apply. This exemption would be active temporarily and likely capped at some amount, but the terms are negotiable. Von der Leyen's letter emphasized that an average spending increase of 1.5% of GDP could unlock 650 billion euros over four years. This plan is more politically feasible because it maintains the agency of member states, but national-level decision-making risks that spending decisions, including on procurement, will remain fragmented. Potential free riding on defense spending may also continue.
The second kind of vehicle would be to allow the EU to incur common debt and borrow on bond markets—somewhat similarly to the EU's extrabudgetary COVID-19 recovery plan. In her letter, President von der Leyen proposed a 150-billion-euro special fund that would loan borrowed money to national governments, which preemptively responds to concerns about centralizing defense decision-making in Brussels and paying the debt back. Brussels would be able to borrow money at better rates than several indebted member states, but contention may arise over potential strings attached – such as joint procurement of specific defense articles, which risks disputes and delays over decisions on which national champions benefit from increased contracts. Countries with low forecasted growth may prefer grants over loans.
Third, the Europeans may seek to unlock private debt financing. This could be through increasing the European Investment Bank's prioritization of dual-use defense projects and eliminating its stringent ESG rules, thereby 'crowding-in' private finance. Another idea gaining traction is a multilateral development bank for Western defense. This Rearmament Bank seeks 100 billion British pounds in paid-in capital by shareholder nations to begin issuing bonds and making loan guarantees to private defense companies, thereby complementing national procurements a long-term demand signal to help defense manufacturers plan investments in productive capacity. A Rearmament Bank will likely need buy-in from the US to work effectively and maintain a triple-A credit rating.
The Politics Behind Each Approach
How Europe balances each approach, while not mutually exclusive, underscores a divide between fiscal hawks and fiscal doves. The Europeans will most likely agree to a form of each but likely lean on the first – a simple suspension of fiscal rules to allow for national defense spending.
If so, the bellwether of Europe's debt attitude comes from Germany, a fiscal hawk currently confronting its constitutional debt brake, which caps the German deficit at 0.35% of GDP. Incoming Chancellor Friedrich Merz seems to have settled on a solution with the Social Democrats to allow for a permanent exemption for defense spending beyond 1% of GDP (so only the first 1% is included in the formal budgetary rules). They seek to approve the idea before the entry of the next Bundestag on March 24, where constitutional changes will be blocked by the far-right and far-left. The Greens, whose votes are needed to pass the reform, would prefer an elimination of the debt brake altogether, but it is unclear if they will pose any resistance.
If EU fiscal rules and the debt brake are suspended for defense, Germany is poised to become the most effective procurer on behalf of European nations due to its buying power and lower debt-to-GDP ratio. Under the Bundesbank's conservative estimates of German growth over the next three years, increasing defense spending to 3.5% of GDP would yield roughly 350 billion euros in defense investment over the next three years, and an additional 63 billion than if Germany kept spending at 2%. If Germany sought to utilize debt only on defense until reaching a 100% debt-to-GDP ratio, it could spend up to 2.12 trillion euros, potentially procuring defense equipment on behalf of member states and then loaning it. With increased government spending, Germany may lean into defense industrial investment to pull itself out of its sluggish economic growth.
Since indebted nations like France have higher borrowing rates, they may advocate instead for increased common borrowing. The EU could spend roughly 3.76 trillion euros before reaching a collective 100% debt-to-GDP ratio. It could also make more targeted investments in Europe's defense industrial base and unlock efficiencies through larger procurement orders, at the expense of national autonomy.
The Risks
Increased European debt will rapidly strengthen the demand and value of the euro, increasing European purchasing power. This can already be seen with the preliminary rally of Eurobonds and European defense stocks this past week. Ironically, scaring Europe to undertake its security responsibility risks undermining the US' objective to balance the trade deficit. Moreover, with the frugal states now increasingly open to European strategic autonomy, American defense manufacturers risk losing out of "Buy European" contracts without establishing subsidiaries.Europe's largest defense manufacturers, most capable of surging productive capacity, stand to benefit the most from sudden debt-backed equipment orders. Politically, as formal talks begin for Europe's next seven-year budget in 2027, Europe risks losing the appetite to allocate funds for interrelated strategic challenges – such as its technological competitiveness or its energy transition from Russian gas.
A key question remains of who will incur the balance of debt – European capitals or Brussels itself? Fiscal hawks will prefer the former and the indebted economies the latter. If the EU is granted a second "Hamiltonian moment" through common borrowing, it may galvanize visions toward a fiscal union and a common foreign policy. Importantly, it remains to be seen how much debt Europeans are willing to incur. A little bit of defense-focused stimulus carries upside risks for the broader European economy, spilling over to increased consumer spending and investor confidence. Too much would reignite inflationary pressure, compelling the European Central Bank to reverse their interest rate cuts to protect non-defense sectors.
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