By focusing on defence, European leaders appear to be downplaying the need to address other key fiscal policy challenges: climate change, an ageing population and upgrading infrastructure
Given Russia’s ongoing invasion of Ukraine and the broader threat that President Putin’s regime poses to Europe and the prospect that Ukraine and America’s Nato allies may not be able to rely on continued US military support, European leaders hastily convened meetings where many brave words were spoken. They vowed to go it alone and boost substantially Europe’s military capabilities and arrange financing for greatly increased defence spending.
A key question is how Europe would finance the required increase in military investment at a time when their economies are sluggish, public finances are strained, and many voters are reluctant to accept cuts in other government spending and an increased tax burden.
Europe’s major economies, Germany, France and the United Kingdom, have struggled to meet Nato’s agreed peacetime target of spending at least 2 per cent of GDP on defence, a level which “experts” have argued is grossly inadequate for Europe to defend alone its continent in time of war.
And against the background of President Trump wanting Nato’s European members to increase their defence spending to 5 per cent of GDP, and Nato secretary-general Mark Rutte acknowledging the need for such expenditure of “considerably more than 3 per cent of GDP”, EU leaders agreed that member countries should each raise their defence expenditure by 1.5 per cent of GDP over four years.
However, it was generally agreed among European leaders that even if welfare expenditures could be slashed, as was the want of Rutte, and taxes increased there would be far from sufficient funds for financing much higher defence spending over the coming years and that Europe would have to engage in very large amounts of borrowing.
In fact, European Commission president Ursula Van der Leyen at a recent meeting proposed to activate the Stability and Growth Pact’s escape clause (which allows higher borrowing during crises) to permit increased spending on defence. Furthermore, it was agreed that the EU would need to borrow collectively at least €150 billion through bond issues in order to extend loans to member countries to support higher defence output. Van der Leyen stated that such loans should be spent in Europe by EU members and like-minded European nations such as the United Kingdom, Norway and Switzerland on weapons produced in Europe.
And for Germany, Friedrich Merz, head of the Christian Democrats party, and his likely coalition partner in the next government, the Social Democrats, unveiled plans to raise defence spending and boost the country’s creaking infrastructure. They have proposed a €500 billion infrastructure fund and plan to change radically the debt borrowing rules, the “debt brake”, to fund defence spending. In fact, economists polled by the Financial Times anticipated that such a planned fiscal stimulus could lead to an additional one trillion euro in public borrowing by Germany over the next decade and opined that future growth would not be jeopardised.
In prioritising the need to substantially raise defence spending most European leaders appeared to be downplaying the need to address other key fiscal policy challenges facing Europe, including climate change, an ageing population and the need to invest substantially in upgrading infrastructure and in enhancing the competitiveness of European industry. But, more recently, Spanish Prime Minister Pedro Sanchez, at least, called for “a broader definition of defence spending to include cyber security, anti-terrorism and efforts to combat climate change” for exemption from calculations in assessing whether nations are meeting EU fiscal rules.
The “Green Party” of Germany is objecting to the plans of Merz arguing that too much the government’s fiscal space would be pre-empted by very large amounts to defence spending and that funding for climate protection and the green transition would be adversely affected.
Most importantly, Europe is experiencing demographic ageing presenting challenges for the government finances. With its number of elderly citizens increasing relative to the working age population, pay-as-you-go pension systems face mounting financial pressures. Furthermore, ageing populations typically require more extensive healthcare services and long-term care. Indeed, reports by the United Nations indicate that ageing-related costs could add over 1.5 percentage points of GDP on average to government spending in EU countries over the longer-term.
Substantial investments in upgrading deteriorating and outdated infrastructure and in innovation and improved technologies are also required to raise the potential growth of the EU. The well-received “Draghi Report”, which was commissioned by the EU, calls for massive increases in investment to enhance the competitiveness of European industry. Indeed, the report recommends that the EU would need to spend €800 billion in annual investments in research, innovation, leading-edge technologies and supporting infrastructure, of which around €400 billion or over two per cent of GDP would be covered by the public sector. And in this connection Italian Prime Minister, Giorgia Meloni, has recommended that a broader range of expenses to cover not just defence, but also competitiveness to be exempted in judging compliance with EU fiscal rules.
While economists have contended that the EU and countries, such as Germany with government debt around the 60 per cent of GDP, would have the fiscal space to finance large increases in defence spending, without impeding economic growth, they seem to neglect the requisite expenditure on the aforementioned other key fiscal policy challenges that most likely would seriously limit fiscal space over the medium to longer-term. Indeed, approximate calculations by this author, based partly on an earlier study by Edmund Moshammer of the ECB on the euro area, estimate that the challenges of higher defence spending, an ageing population, climate change, and required non-defence investments could add at least five percentage points of GDP to the spending of EU member states over the next ten years, especially if Europe continues to engage in an endless war.
Given such a curtailment in the room for financing these key fiscal policy challenges, EU nations or the EU as a whole would have to choose assigning much less priority to achieving certain of these challenges. Currently, with most European leaders giving overwhelming priority to raising substantially Europe’s military capabilities to combat the threat of an endless war there is the danger that social and productive investment expenditures could be curbed substantially. Already, as in 2024, EU nations are spending less on longer-term investments outside of the property sector with the implementation of the green and digital transitions lagging significantly in southern European countries.
Fiscal space in Europe could be enhanced through raising government revenue by increasing the taxation on wealthier individuals and companies and the taking of more serious and effective measures to combat tax evasion and avoidance. But, given the weakness of many European leaders and their domination by the rich and powerful, the raising of taxes to provide greater fiscal space would appear to be a non-starter.
The defence burden on Europe could be lessened by Turkey joining the “coalition of the willing” with its military forces, resulting in somewhat offsetting the problem arising from the withdrawal of American security guarantees for Europe. However, such a move by Turkey would increase its bargaining power with the EU and powerful European nations, that could not only improve its trade and other relations with the EU, but affect political relations with its smaller neighbours in the EU such as Greece and Cyprus.
Finally, the reactions of European leaders to the Russian-Ukraine war and the perceived prospect of Russian incursions into Europe are premised on military solutions to the war and on the guarding of Europe against further Russian advances. Surely, in contrast to preparing Europe for an endless war and engaging in military Keynesianism, as termed by Ioannis Varoufakis, with its unproductive spending, it would be preferable for European leaders to devise a peace plan to end the war and guarantee European security, rather than just waiting for the Americans to do deals with the Russians and the Ukrainians.
Indeed, achieving peace in Europe would end the prospective serious disruptions and harm to European economies and society that would come inevitably with the continued placement of the continent on a war footing.
Les Manison is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus
