From Peace to Preparedness: Analysing Europe's Expanding Defense Expenditures
Ethan Ilzetzki and Suryaansh Jain
Tuesday, July 23, 2024
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Summary
The July 2024 CfM survey asked the members of its EU panel to choose the best way to fund EU increases in military spending to meet members’ increases in defence expenditures. The panel was also how this expansion in military spending would affect the EU economy over a 5 year horizon. Most panellists believe that borrowing money at the EU level would be the best way to fund increases in military spending. The majority of the panel also believes that increases in defence spending will boost economic growth in the medium-term in the EU.
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Background
The July 2024 CfM-CEPR survey asked the members of its EU panel to choose the best method to fund EU increases in military spending and how this spending increase would affect medium-term economic growth.
Fortifying Europe
Since Russia’s invasion of Ukraine in 2022, the EU has made available close to $110 billion in financial, military, humanitarian, and refugee assistance. This figure is expected to continue to increase over the upcoming months as the war continues with no end in sight. Aside from supporting Ukraine, however, the Russian threat has compelled many member states to push for increased military spending to strengthen Europe’s defensive capabilities, yet there is no clear consensus on the issue (Kandrík, 2024).
Several EU member states are also a part of NATO, and as such, are bound by its guidelines to spend at least 2% of their GDP on defence expenditures. While NATO members in Europe have steadily increased their defence spending since the target was set in 2006, many countries did not follow this guideline, with non-US NATO members failing to meet the target on average over the last decade (McKinsey, 2022; Lau, 2024). This year marks the first time that NATO allies in Europe will invest 2% of their combined GDP in defence, with Germany, the Netherlands, Norway and Turkey are among those that reached the 2 percent figure for the first time.
Beyond NATO commitments, the EU also proposed the European Defence Industrial Strategy (EDIS) and the European Defence Industry Programme (EDIP) in March, which tackle 3 key issues: 1) increasing joint defence procurement within EU structures; 2) strengthening and making the EU defence industrial and technological base more autonomous and 3) solving the capacity issues in times of crisis (Walker, 2024). However, the proposed funding for EDIP – which aims to boost weapons procurement and production – is only €1.5 billion, which is significantly short of the €100 billion fund called for by EU Commissioner for the Internal Market Thierry Breton (Walker, 2024).
With military spending ramping up, European leaders will need to make tough budgetary decisions on how to allocate sufficient funds for military expenditures without compromising on social services and how to raise these funds – through taxes or debt. As the Managing Director of the IMF summarised, the “peace dividend” – the era when security took a back seat to trade and economic growth – ended with Russia’s invasion of Ukraine.
Since the end of the Cold War, the EU’s defence spending stagnated while welfare costs surged. For instance, Denmark doubled the money it directed to health care between 1994 and 2022, while Poland more than doubled funding for culture and recreation programs over the same period (Cohen and Alderman, 2023). In particular, many expanded their social welfare systems. After adjusting for inflation, social spending has grown by a factor of 2.4, 60 percentage points more than GDP has grown since 1990 (Dorn, Potrafke and Schlepper, 2024).
With an aging population and high dependency on social security, EU member states already have significant budgetary commitments. Additionally, with ambitious climate transition plans, EU member states have already committed substantial budgetary increases. Achieving carbon neutrality by 2050 alone is estimated to cost between $175 billion and $250 billion each year for the next 27 years (Cohen and Alderman, 2023). Changing national priorities towards a more military-oriented economy would require shifting resources away from these services and objectives and could hamper long-term growth.
More importantly, this shift arrives at a particularly bad time, with households still reeling from skyrocketing energy prices and stinging inflation and countries trying to tighten their fiscal plans. The EU has 3 ways of raising funds for its increased military expenditures – raising taxes, cutting spending, or accumulating more national or EU-wide debt, or. Raising taxes, while politically unpopular, also seems challenging due to Europe’s pre-existing high tax rates and tax burden and may hamper competitiveness and growth in the long run (Dorn, Potrafke and Schlepper, 2024). Issuing debt also seems to be only a temporary solution due to the limited fiscal headroom available to most EU countries. Notably, 7 of 25 European NATO countries currently pay more on interest than on defence, illustrating the constraints behind issuing more debt. Some member states have called for issuing Eurobonds (bonds issued by the ECB as a form of common eurozone debt, not to be confused with a eurobond more generally, meaning international bonds denominated in foreign currencies), but the idea is opposed by Germany and the “frugal” Nordic countries (Colombatto, 2024). Consolidating finances seems to be the only way to permanently raise the level of military spending, but it comes at the risk that voters may not support such consolidation (Dorn, Potrafke and Schlepper, 2024).
Increasing military spending could yield some positive economic effects as well. Beetsma and Nicoli (2024) argue that military procurement can be used as a response to industrial policies adopted in the United States and China but will prove more effective if coordinated at the EU level. EU-level procurement is also sensible because collective defence is a quintessential public good (Beetsma, Buti and Nicoli, 2024). There is also a growing body of evidence that defence contracts and procurement projects create employment opportunities, stimulate innovation, facilitate learning by doing, and foster the development of high-tech industries. Howell et al. (2021) find that procuring military innovation through “open” competitions (where firms suggest ideas) lead to more adoption of new technologies and more commercial innovation, in terms of venture capital funding and patenting. Ilzetzki (2024) shows that increased demand for military equipment may enhance plant productivity as it forces them to adapt via active investments in new production methods, improving working conditions, and experimenting with different supply chain management techniques. Gross and Sampat (2023) cite American public investment in military R&D during WWII as an example of how military R&D can lead to the generation of technology clusters that enhance competitiveness, and in turn economic performance, in an economy. Public R&D spending by NASA contractors had a similar impact and led to increased manufacturing value added, employment, and capital accumulation in space related sectors (Kantor and Whalley, 2023). A review of R&D literature suggests that public R&D spending generally has the potential to crowd in private innovation, rather than crowding out private R&D, leading to long-lasting positive local effects (Juhász, Lane and Rodrik, 2023). Furthermore, public support for increased military spending remains high, with as much as 80% of respondents on the July 2023 Eurobarometer survey supporting increased defence cooperation and 77% supporting a coordinated purchase of military equipment. Yet, it may be the case that the painful budgetary trade-offs or tax increases that will be required have not yet trickled down to daily life, which could significantly swing public opinion.
In this survey, you will be asked how the increase in EU military spending should be financed and what its economic implications will be. The first question asks you about the best way to finance defence expenditures. The best way to finance the expenditures may differ from country to country. Please choose the response that would best suit the average EU country, i.e. imagine that you had to choose a policy that all EU countries would uniformly adopt. You can use the comment section to discuss any heterogeneity in optimal policy for any specific member states. The second question asks you for the economic implications of the increase in defence spending. You should respond to this question under the assumption that countries finance the increase in defence spending using the policy you chose in your response to question 1.
Question 1: What is the best way to fund EU increases in military spending to meet members’ increases in defence expenditures?
Twenty-nine panel members responded to this question. There are 2 schools of thought on the best way to fund EU increases in military spending, with the panel equally divided between raising money via borrowing and financing these increases by adjusting current budgets. Most of those who opted for borrowing (45% of the entire panel) believe that borrowing at the EU level is the best way to fund EU military expansion, with only 3% of the panel choosing increased borrowing by individual member states. Amongst those who opted for budget readjustments, most panellists (21%) believe increased taxation is the solution, with the remainder split between public spending cuts (14%) and raising the retirement age (7%). Overall, there appears to be a view, consistent with economic theory, that the EU should borrow if the increase in defence spending is transient, but the taxes or spending should adjust if the change is permanent. This suggests more consensus amongst the panel than implied by the results.
Several panel members characterise this issue as a classic case of ‘public goods’ and hence believe that EU level borrowing is the best way to fund increases in defence expenditures in the EU. Evi Pappa (Universidad Carlos III de Madrid) summarises this: “Defence in this case is a public good and given the difficulties of the different economies in the zone, borrowing at the EU level is the best policy choice.” Ugo Panizza (Geneva Graduate Institute) echoes these thoughts, but adds that “at some point, it will be necessary to either increase taxes or cut spending,” with the latter being a better option.
Some panellists believe EU level borrowing may be impossible to implement in the real world. Marcel Fratzscher (Humboldt University) suggests that “joint EU borrowing via a fiscal capacity for defence” while “desirable”, is simply “politically not feasible” and suggests increased taxation as a better alternative. Ricardo Reis (LSE) also proposes an alternative in the form of raising the retirement age, arguing that “if it is the case that, with a higher probability, younger Europeans will have to go to war, it is appealing to balance that by asking older Europeans to work a few more years to pay for the expenses.” Jürgen von Hagen (University of Bonn) argues in favour of public spending cuts and European self-reliance, stating that “European governments have outsourced the defence of their own countries to the US for too long”.
Many panel members suggest using a combination of different mechanisms to fund the EU’s military expansion. Charles Bean (LSE) suggests that “permanent increases” in defence spending should be funded by “a combination of higher taxes and a reduction in other public spending”, while “temporary increases” should be funded by “temporarily higher borrowing.” Philip Jung (University of Bonn) summarises this viewpoint: “From an economic point of view, the best, one might say, is that national governments likely have to use a convex combination of all the instruments to minimize distortions along the transition [to higher defence spending]. Picking one instrument therefore seems costly.”
Question 2: What impact will an increase in defence spending have on the EU economy over a 5 year horizon?
