Oil and Guns: Why New Military Spending Won't Boost Europe's Economy

Alexander Lubnevsky

Mar 10, 2025

Last week, Germany and the EU announced the creation of funds amounting to hundreds of billions of euros, which will largely be directed towards military spending. We explain the current state of public finances in European countries and whether militarization can give a significant boost to the economy.

Why European bonds fell sharply

Last week, the EU bond market experienced a highly sensitive sell-off: on March 5 and 6, 2025, the yields on 10-year government bonds of Germany, France, and Italy, the largest economies in Europe, soared by about 40 basis points in two days. On Wednesday, German government debt experienced its worst day since the fall of the Berlin Wall: long-term bond yields rose by 30 basis points to 2.85%.

Such a sharp decline in bond prices showed a nervous reaction from investors to Germany's decision to ease strict budget rules and exempt military and infrastructure spending from the 'debt brake.' Also, to the new ambitious plan for the rearmament of the European Union, ReArm Europe, presented on March 4 by European Commission President Ursula von der Leyen.

According to the program, it is proposed to direct up to €800 billion to strengthen the EU's defense potential and urgently support Ukraine, left without American aid. 'If EU countries increase defense spending by an average of 1.5% of GDP, this will create an additional budget of €650 billion over four years,' said the head of the European Commission. Another €150 billion was proposed to be allocated in the form of EU loans and directed to the purchase of air defense systems, artillery, ammunition, and drones.

The need to increase military spending in the EU is also related to the fact that the US, and especially Donald Trump, have long criticized the European Union for not fulfilling its NATO obligation to spend at least 2% of GDP on defense for years. Back in 2024, Trump, addressing EU leaders, stated: 'No, I would not protect you. Moreover, I would encourage them (the Russians) to do whatever they want. You have to pay. You have to pay your bills.' In January 2025, the US president even threatened to raise the defense spending requirement for NATO members to 5% of GDP.

European leaders voted to adopt the plan to increase defense spending at the EU summit on March 6 in Brussels. 'Whatever happens in Ukraine, we need to build autonomous defense capabilities in Europe,' emphasized French President Emmanuel Macron following the summit.

How EU countries live on credit

The reaction of debt markets to the announcement of new spending is related to investors' fears of rising budget deficits in European countries. According to the Maastricht Treaty signed in 1992, public debt in EU countries should not exceed 60% of GDP, and the budget deficit should not exceed 3% of GDP. In practice, these rules have been constantly violated as a result of periodically adopted political decisions, including to counteract the consequences of global crises, pandemics, etc.

Faced with a series of crises (first the pandemic, then the energy crisis, and the need to increase military supplies), the EU significantly relaxed budgetary constraints. In March 2020, the general escape clause was activated, allowing temporary non-compliance with deficit and debt limits. This measure remained in force until the end of 2023, giving countries the freedom to increase borrowing to support the economy.

As a result, budget deficits soared: the average deficit in the eurozone reached 7% of GDP in the pandemic year 2020, and in 2021–2022 it remained above 3–4% of GDP. For comparison: in pre-crisis years, the budget deficit in eurozone countries usually did not exceed 1% of GDP, and some countries, such as Germany, had a surplus. A number of countries ended 2023 with deficits significantly above 3%. For example, in Italy, it was 7.2% of GDP, in France — 4.7–4.9%, Spain — 4%, Hungary — 6.7%, Romania — 6.5%.

The growth of deficits is related to the fact that government spending has increased significantly. According to Eurostat, total government spending in the eurozone in 2022–2023 remained at the level of 49–50% of GDP, whereas in the pre-pandemic period (2013–2019), this indicator gradually decreased to 46% of GDP. Thus, the government is now 'redistributing' almost half of the entire GDP — this is above the long-term trend. The reason is large-scale anti-crisis measures: in 2020–2021, authorities financed support programs for businesses and the population (lockdowns, medicine, vaccines), and in 2022 — compensations due to the spike in energy prices as a result of reduced supplies from Russia.

In addition, an unprecedented at that time pan-European recovery fund, NextGenerationEU, amounting to €750 billion, was launched, allowing countries to attract additional resources for investments equivalent to 5–6% of EU GDP. All this temporarily expanded budgetary constraints — debts that were previously considered threatening became permissible. For example, Germany in 2022 attracted €200 billion of new debt, half of which was for the defense special fund and war-related expenses. This effectively doubled the initially planned borrowing volume for the year. This jump was an exception to the German 'debt brake' and showed that even the most fiscally conservative countries are willing to temporarily exceed previous limits for emergency spending.

It is not surprising that as a result of all the stimulus measures, by the end of the third quarter of 2024, the public debt of EU countries reached 81.5% of GDP, significantly exceeding the 60% threshold of the Maastricht agreements and remaining above the pre-pandemic level (about 79% of GDP in 2019). However, the situation varies significantly among member countries: traditionally disciplined Germany maintains debt at 62% of GDP, while France (112%), Italy (135%), and Spain (108%) have much higher debt burdens. Greece stands out in particular, with its debt at 158% of GDP remaining the highest in the EU, although this is significantly lower than the peak value of 207% reached in 2020. After the 2011 restructuring, Greece's borrowing conditions are much more lenient than Italy's, which is forced to constantly refinance its loans on market terms. The key question remains how the largest EU economies plan to reduce public debt levels in the future amid new defense spending without provoking further deficit growth and increased servicing costs.

Why military spending is ineffective for the economy

The easing of the 'debt brake' in Germany was linked to the main hopes of investors for the country's economic growth ahead of the new parliament's work. Indeed, the growth of government defense spending has a stimulating effect on the economy in the short term. Government purchases of weapons, military infrastructure, and salaries of defense complex workers directly increase aggregate demand. Thus, additional defense spending contributes to GDP growth in the short term due to the multiplicative effect of government spending. Economists estimate the military spending multiplier at about 0.5–0.7, meaning an increase in defense spending by 1% of GDP can add about 0.5–0.7% to GDP over several years. However, this impulse is mostly one-time and is likely to weaken once spending stabilizes at a new level.

In the medium and long term, increased military budgets pose risks to sustainable growth. The main difference with defense spending is the lack of direct returns in the form of increased economic productivity unless there is a huge surplus of labor and free production capacity, as in the US before World War II. Funds spent on tanks, planes, and ammunition do not create new income or infrastructure that would increase GDP growth potential. Unlike investments in education, transport, or technology, military purchases do not generate future economic benefits (their 'benefit' is security, which is difficult to measure in GDP).

According to some studies, an increase in military spending by 1% of GDP can lead to a slowdown in growth rates by up to 9 percentage points cumulatively over 20 years. The reason is the crowding-out effect: resources (capital, labor) engaged in defense are withdrawn from the most productive sectors. The government either has to raise taxes or increase borrowing to finance the military. Raising taxes reduces private investment, and increasing debt raises servicing costs and risk premiums for investments. Moreover, all else being equal, a high military burden leads to a decrease in the accumulation of fixed capital in the economy — long-term assets that form the basis of the economy. These are production capacities, transport and energy infrastructure, high-tech equipment, as well as intellectual capital, including investments in science and education. A RAND study shows: prioritizing defense spending at the expense of reducing infrastructure investments 'undermines economic growth, and therefore the resources available for defense in the future.' Thus, excessively high militarization of the economy can weaken its fundamental foundations — technology and capital, including human.