Borrowed time: How defence spending can bridge the EU’s fiscal divide

At the World Economic Forum in Davos, US president Donald Trump once again turned up the heat on NATO members, demanding they spend 5% of their GDP on defence. But even as European governments scramble to assess the president’s good faith, the reality is that investment and spending are emerging as central to realising Europe’s foreign policy ambitions. The Draghi report, for example, argues that to remain competitive, the European Union must invest an additional €800bn annually using joint borrowing. If it does not meet this goal, the bloc risks paying a steeper price: its geopolitical clout. The strength of European foreign policy now seems tied not only to the persuasiveness of its values but to its ability to pragmatically mobilise resources.

This hits a sore point. First, the EU lacks a centralised fiscal authority. Twenty-seven national fiscal policies are coordinated by the Stability and Growth Pact, which sets limits for government deficit and debt. Unlike monetary policy, that falls entirely in the hands of the European Central Bank, fiscal policy is largely still a matter of national politics. The lack of a European coordinating body can fragment investment and delay and impair the bloc’s reaction to crises which need ad-hoc solutions (like the NextGenerationEU fund in case of the covid-19 pandemic). Second, the EU’s fiscal rules have long been contentious ground between the bloc’s two major players, Germany and France. The two countries have frequently embodied the divide between the “frugals” and the “spenders” of the bloc, a fault line that became salient during the eurozone crisis. Such division has often obstructed meaningful collective action at the European level.

Down and out in Paris and Berlin

However, both Berlin and Paris have recently been defeated by their own economic philosophies—and by their budgets. Rules-oriented and liability-focused Germany is battling a stagnating economy that needs more investments. Ahead of the snap federal election this month, calls to reform or even abolish the debt brake enshrined in the German constitution—which limits the country’s structural deficit to 0.35% of GDP—have become mainstream. But even if this ceiling were to be raised or removed, the European Commission’s initial review of the member states’ 2025 budgets late last year showed that Germany and other frugal states could find it difficult to meet the requirements of the strict rules they advocated for.

Meanwhile, France’s budget drama reached its apex last December, when Paris’s borrowing costs briefly surpassed Athens’s—an inconsequential yet highly symbolic moment for market watchers. Shortly after, the government led by prime minister Michel Barnier collapsed over its budget aimed at addressing the country’s overspending, which reached double the level permitted by EU rules. Although investors reacted with surprising calm, France’s political and financial crisis continues to unfold. If this trend persists, markets could react with increasing volatility: undermined investor confidence could drive up borrowing costs and create broader economic instability.

In short, Berlin and Paris seem to have proven each other’s concerns right. Ultimately, the ideological division between the frugals and spenders has failed to capture that stability and growth are both needed. To keep their edge, Europeans must invest, albeit in a responsible and future-oriented manner. But the diminished strength of Germany and France leaves a void in Europe just as leadership is desperately needed. Moreover, the complex dance of the next EU budget negotiation—expected to start later this year—could lose its rhythm as their coalition-building power wanes.

A good defence

The EU needs a new, pragmatic consensus on how to save and invest that moves past ideological barriers and can foster collective action

Europeans are thus confronted with three facts: first, mobilising more resources is essential for their long-term survival and prosperity; second, the EU’s budgetary model has shown its limits in both size and scope; third, the magnitude of the effort required makes it impossible for a country to go it alone. It follows that the bloc needs a new, pragmatic consensus on how to save and invest that moves past ideological barriers and can foster collective action. This will require time and bold policy experimentation, but it is achievable, and it could start in the defence sector.

This may sound counterintuitive: there’s no single policy area that sits closer to the national interest than defence, where EU action has been limited to specific areas due to the institution’s civilian mandate. For example, the EU budget has restrictions when it comes to funding military expenditures, and the European Defence Fund, despite supporting research and development of defence technologies, cannot be used for weapons purchases. But it is exactly this area that has been moulding the beginnings of a more lenient frugal position in the recent past, due to a very real incentive: geography.

Most of the traditionally frugal states—like Sweden, Finland and Denmark—and those who also followed a more responsible fiscal approach in the past—like Poland or the Baltics—lie close to Russia, and this has somewhat proportionally inflated their defence spending. Last December, Denmark, Finland and even the geographically sheltered Netherlands showed support for a plan to fund defence via joint borrowing, albeit with countries guaranteeing the money rather than the EU itself. Moreover, 19 European countries recently co-signed a letter to the president of the European Council and the head the European Investment Bank, urging them to relax restrictions on financing excluded activities—such as the production of ammunition, weapons, and military equipment—and to explore the possibility of issuing defence bonds. And finally, after former German finance minister Christian Lindner harshly refused Draghi’s joint borrowing argument, even Friedrich Merz, German’s likely next chancellor, did not rule out the use of EU defence bonds to finance Europe’s toolkit. Considering that the Christian Democratic Union, Merz’s party, is traditionally fiscally conservative, this newfound openness could be an encouraging sign of a broader shift. To propel this new momentum for investment, the Nordic-Baltic countries could further leverage their inroads into the frugal coalition to rally Berlin and Amsterdam behind bold policy solutions. But that’s not all: by emphasising the need for shared research and development and for streamlined procurement, they can show that their efforts do not support a “free-for-all” approach to defence spending, but a strategic one.

In this endeavour, the northern countries shake hands with an unlikely ally in the south. Greek prime minister Kyriakos Mitsotakis has been exceptionally vocal on the matter and pitched a €100bn European defence fund to EU partners, much to France’s approval—another country who has always paid special interest to the bloc’s security (Paris’s defence spending, as shown in the map above, seems to be less affected by geographical considerations). Together, the two could help bring onboard more reluctant southern countries like Italy, who are distant from Russia and face opposition at home.

Before the covid-19 pandemic hit in 2020, the prospect of EU joint borrowing seemed distant, if not impossible, but exceptional times brought exceptional measures. This time around, Europe finds itself once again in crisis-management mode, squeezed between Trump’s grievances and Putin’s threats, urgently needing to mobilise resources for its defence. One can hope that this time Europeans move past reacting, start to test ways to mobilise the bloc’s collective fiscal power—starting with defence spending—and institutionalise the successful approaches. If they succeed, they could boost the bloc’s geopolitical influence, strengthen its security, and sharpen its economic and technological edge. As Danish prime minister Mette Frederiksen put it in her new year’s address, “We will always pursue responsible economic policies. But responsibility isn’t just about the bottom line”.