A New Era in European Defense Spending?

In a significant shift in defense policy, the European Commission has launched the "ReArm Europe" initiative, a comprehensive plan aimed at mobilizing approximately up to EUR 800 bn to enhance the security and resilience of Europe. This comes in response to the evolving geopolitical landscape, particularly following the end of American military support in Ukraine, which has prompted European nations to accelerate their efforts towards military independence.

Announced on March 4, 2025, the ReArm Europe initiative is structured into five key components designed to bolster defense capabilities across the continent. The initiative proposes activating the national escape clause of the Stability and Growth Pact, allowing member states to significantly increase defense expenditures without triggering the Excessive Deficit Procedure. This could potentially create fiscal space of up to EUR 650 bn over the next four years.

Additionally, a new loan instrument will provide EUR 150 bn in loans to member states for defense investments, encouraging collective procurement in critical areas such as air defense, artillery systems, and cybersecurity. The initiative also aims to redirect more funds from the EU budget towards defense-related investments, alongside incentives for member states to enhance their defense spending through cohesion policy programs.

The final two components focus on mobilizing private capital and leveraging the European Investment Bank (EIB) to support the defense industry. The EIB is expected to drop limits on lending to defense firms, facilitating access to capital for companies involved in defense production.

Germany is at the forefront of this defense spending revolution. The future Chancellor, Friedrich Merz, announced a legislative package on the same day as the ReArm Europe initiative, aimed at significantly increasing defense spending and investing heavily in infrastructure. This package includes an exemption from the debt brake for all defense expenditures exceeding 1% of GDP, which is estimated at approximately EUR 45 bn.

Further, a special fund of EUR 500 bn is set to be created over the next decade to renovate outdated infrastructure, also exempt from Germany’s public debt brake. This legislative package is expected to increase the German deficit by around 1 percentage point this year, with further increases projected for 2026 and 2027, depending on how the funds are utilized.

The German government is seeking to accelerate planning and permitting for new defense projects to ensure rapid deployment of the new defense funds. Merz has been largely praised by analyst and defense experts regarding his quick and assertive decision making on the topic.

If the plan receives approval, it could lead to a steeper yield curve and a significant rise in the term premium, with the 10-year Bund potentially testing the 3% mark. The market's reassessment of European growth prospects is evident in rising real rates and equity markets. However, uncertainties remain regarding the implementation of these ambitious fiscal plans, particularly in light of potential political resistance and the need for broader support within the Bundestag.

To finance this ambitious defense effort, several options are being considered. National borrowing is the first and most straightforward option, particularly for countries with low defense spending as a share of GDP. However, many EU countries face limitations due to high levels of public deficit and debt. Germany, with a public debt close to 60% of GDP and defense spending at 2.1%, has the highest fiscal space among EU nations.

Another option is borrowing from existing EU institutions, such as the European Stability Mechanism (ESM) and the European Investment Bank (EIB). The ESM could establish a specific lending facility similar to the Pandemic Crisis Support, while the EIB has already indicated its intention to expand eligibility rules for financing defense projects.

A more ambitious approach involves repurposing funds from the Next Generation EU (NGEU) program or creating a new NGEU-like program specifically for defense spending. However, this would require unanimous approval from the EU Council and ratification by all national parliaments, making it a more complex and uncertain option.

The defense effort is estimated to require an annual increase in spending of 1 to 1.5 percentage points of GDP to meet NATO's commitment of 2% of GDP on defense expenditures across all member states. This increase is expected to have a positive impact on GDP growth, potentially rising from 0.5 percentage points to over 1 percentage point in the medium term, subject to sustained investment and domestic production benefits.

Increased defense spending can stimulate demand through equipment purchases, leading to job creation and increased consumption. However, the positive effects on GDP growth may be tempered by potential crowding-out effects between civil and military investments, as well as the risk of inflationary pressures in labor markets and supply chains.

The ReArm Europe initiative represents a pivotal moment for European defense policy, signaling a shift towards greater military independence and increased investment in defense capabilities. As European nations take bold steps to enhance their defense spending, the implications for the European economy and geopolitical landscape will be profound. The success of this initiative will depend on effective implementation, cooperation among member states, and the ability to navigate the complexities of financing and political dynamics within the EU.

As Europe embarks on this new chapter, the commitment to building a safer and more resilient continent is clearer now more than ever.