The debate on using common debt for European defense is intensifying, particularly in Central and Eastern Europe, where governments fear they will bear an outsized share of military costs. The proliferation of threats has already led Europeans to increase their defense budgets substantially in recent years. Some European Union member states, Poland in particular, are rapidly ramping up their defense spending. However, underinvestment over the past three decades mean that it will take many years to fill the capability gaps that Europeans face in a range of areas from ammunition to precision-strike weapons.
At the same time, there is a growing emphasis on spending in a more coordinated way, to improve the interoperability of military equipment and to address the fragmentation of Europe’s defense industrial base, which remains largely organized nationally and therefore hinders economies of scale. European defense innovation is also lacking: As the recent report by former Italian Prime Minister and European Central Bank President Mario Draghi highlights, EU member states spent only 4.5 percent of their defense budgets on R&D in 2023, totaling $11.8 billion, while the United States spent $138.9 billion the same year, amounting to 16 percent of its $847 billion budget.
A Poor Image
Funding European defense is a major challenge. Private financing is scarce in a sector that has long suffered from a poor image amongst investors, although the tide may be turning. Valuations of publicly traded European defense companies, as measured by an index of aerospace and defense stocks, have approximately doubled since February 2022, far outstripping the performance of the broader European market. But these valuations, and the availability of private credit for defense more generally, will be contingent on demand for defense capabilities, which will always remain driven by governments.
Public financing is therefore essential to boost the EU’s defense capabilities. But some EU member states already carry a high public debt burden. And in many member states, it is unclear whether political consensus for raising defense budgets in inflation-adjusted terms will be sustained in the future. Voters are unlikely to support higher defense expenditures if these are perceived to cause higher taxes or come at the expense of lower spending on other priorities.
Borrow and Spend
There are good reasons to borrow to swiftly increase European defense spending. US President Donald Trump has been threatening to withdraw America’s NATO security guarantee unless European countries spend 3 or even 5 percent of GDP on defense—a tall order, as only 23 out of the 32 NATO member states met or exceeded the 2-percent spending goal in 2024, according to the alliance’s estimates. Meanwhile, the EU and the United Kingdom are scrambling to support Ukraine as it loses ground against Russia. Rapid tax hikes would be a way to generate funds, but taking on greater public debt could actually make the burden more manageable.
There are also advantages to borrowing jointly. The EU’s aggregate debt levels are lower than that of the US, as are its borrowing costs. Europe’s supranational issuers—the EU, the European Stability Mechanism (or ESM, the eurozone’s bailout fund), and the European Investment Bank—are all triple-A rated. The EU’s pandemic recovery fund first made large-scale common EU borrowing a reality. To follow this up with a significant EU bond issuance for defense seems feasible. A €500 billion fund issued at around 3 percent would imply an annual interest rate burden of €15 billion.
Common debt could offer other benefits. If access to the funds is part of a quid pro quo that forces Europeans to coordinate their expenditures, it could improve efficiency in military spending by reducing duplication of military equipment, enabling pooled investments, and generating economies of scale. Since everyone would be on the hook to repay the debt, it could also reduce countries free-riding on the defense capabilities of rapidly ramping-up peers like Poland.
Facing Trade-Offs
However, the Europeans must face up to the real trade-offs involved. First, defense spending will have to be financed by taxes, sooner or later. Whether done by underwriting joint debt or issuing nationally, the money will ultimately come from the same tax base as other government expenditures.
Europe can ease, but not escape, the “guns or butter” dilemma. Also, if the EU wants to issue additional bonds for defense, member states will have to provide new national guarantees. Alternatively, they will have to amend the EU’s own resource decision by unanimity—essentially committing more resources to the EU to guarantee the issuance of additional EU debt.
Re-directing existing EU spending programs is not a solution. The EU’s budget is nearly impossible to overhaul politically. Funds in other programs, such as the pandemic recovery fund, are not intended for this purpose. Moreover, the new EU budget will not take effect until 2027, the same year the Chinese military is expected to be ready to invade Taiwan.
Second, member states underwriting the EU with more guarantees to enable it to provide loans offers an alternative that does not require tax revenues, but will ultimately prove ineffective. Spending will expand the stock of military hardware and personnel that, ideally, Europe will never need to deploy. So, no productive asset is created to generate returns for repaying debt. That mostly excludes using loans, let alone leveraging private capital.
One exception is providing cheap EU loans to high-debt countries that may underinvest in defense due to the higher borrowing costs they face. But this only has modest upsides. For example, the €300 billion loan portion of the EU’s recovery fund lowered borrowing costs for member states that used it by just €6 billion.
Similarly, providing public guarantees to EU defense firms may help derisk their investments in new production capabilities, but will only marginally improve their balance sheets. Defense firms’ main customers are governments. Without demand, funded by actual government expenditures, they will not scale up production. The EU, a cash-strapped superpower, has a history of pretending that a handful of public guarantees can trigger implausibly high levels of investment. The continent would be even more poorly served with an army of imaginary tanks and planes based on a false promise of crowding-in private investment.
Third, Europe cannot escape a third trade-off between “coalitions of the willing” and relying on already existing mechanisms. One seemingly appealing option is to forge ahead on defense bonds with a coalition of willing European military powers. This should ideally include the UK, but exclude certain EU member states, like Hungary, that may choose to side with the Kremlin rather than defend states bordering Russia. That could work for coordinating their national spending, but not for issuing joint bonds.
The reason is that only existing federalized institutions such as the EU or the ESM can issue debt in their own name, and using them to launch a batch of defense bonds requires unanimous approval from member states. A new ad hoc special-purpose fund from a select coalition of countries could bypass a veto by Viktor Orbán, Hungary’s pro-Russia prime minister, but would not necessarily secure a triple-A rating.
The guarantees to capitalize the fund could also be taken into account by statistical authorities when calculating the debt levels of participating countries, as was the case with the ESM’s predecessor, the European Financial and Stability Facility. This means that if a participating country taps the fund, it would be counted to its debt level twice: first, for the loan it owes to the fund, and second, for (its share of) the guarantees to capitalize the special purpose vehicle.
A Hard-Nosed Debate
Most importantly, Europe’s leaders need to have a hard-nosed debate about what they want to spend any new defense money on, and how to spend it well. If Europe does more joint defense procurement, it should avoid giving handouts to poorer regions and focus on purchasing critical military kit, which will benefit wealthier western member states, because that is where most of the industry is. The governance to manage the spending also needs to be built first. France alone has 10,500 military procurers, and the European Defense Agency currently works with 200.
The growing emphasis on coordinating EU defense spending, combined with constraints on national budgets, has sparked a search for other forms of funding. Defense bonds can accelerate the remilitarization of Europe, improve co-ordination, and create more bang-for-your-buck in military spending. But they are not a magic wand. What Europe needs is an honest debate about the trade-offs involved.
Sander Tordoir is chief economist at the Centre for European Reform (CER).
