Nato members have today endorsed a significant increase in defence spending at the 2025 summit in The Hague, Netherlands. This is a long-overdue and necessary step in reinforcing collective security and prosperity.
The case for higher European defence spending is made overwhelmingly on negative grounds – to counter the supposed imperialistic ambitions of Russian President Vladimir Putin, or to prevent a break-up of Nato.
Mark Rutte, Nato secretary-general, has warned Europeans to either boost defence capabilities or learn to speak Russian. Germany’s chief of defence has cautioned that Europe needs to prepare for a possible attack from Russia within the next four years. The threat is not limited to conventional wars. Defence ministers have increasingly denounced intensifying industrial espionage. Cyberattacks have become ever more perilous for civil and military systems.
Safeguarding European prosperity
Establishing a credible deterrent against aggression can entail fiscal and political costs. Populist parties could benefit from misrepresenting the path forward as a choice between popular options – health and pensions – versus investment in defence. If such political groups rise in prominence, as currently appears to be the case in several European nations, forces can gain ground that undermine European unity, sympathise with Russia and promote unsustainable fiscal policies.
To prevent such an outcome, policy-makers need to pursue a two-pronged strategy. First, they need to define more clearly the enormous costs of failing to address mounting external threats. Second, they need to introduce a complementary narrative – which is currently almost entirely absent – explaining the benefits of defence spending.
Europe is not facing a routine allocation of public resources. A debate on ‘how to slice the cake’ is misplaced. Investing in defence is indispensable to safeguarding European prosperity, in other words, the cake itself. The prevention of conflicts yields substantial benefits. Therefore, stepping up efforts in armaments, as well as in key technical areas such as cybersecurity countermeasures, is a crucial ingredient in the recipe for making the cake bigger.
A recent study by the Kiel Institute spanning 150 years and 60 countries found that wars typically lead to an output decline of 30% and a 15% increase in inflation. Output in neighbouring countries tends to decline by more than 10% over five years.
Similarly, cyberattacks and industrial espionage pose major impediments. The European Commission has estimated that annual global costs from cybersecurity incidents are equivalent to 7% of world gross domestic product. So, taking countermeasures to stop that happening provides a massive economic bonus.
Complementing the narrative with a positive message
As Europe ramped up weapons purchases to support Ukraine, insufficient domestic production capacity resulted in a transfer of wealth to foreign suppliers. Deutsche Bank has estimated that, of about €200bn spent since 2022, only about a fifth went to European Union defence providers. Governments that allow taxpayer money to seep abroad generally lose popularity. Conversely, strengthening the domestic high-tech defence sector can deliver both economic benefits and electoral dividends.
European policy-makers cannot rely solely on a strategy based on promulgating fear. The case for ‘more money on defence’ needs to be interwoven into a positive economic message, illustrating the widespread economic benefits of higher investment in defence.
Plentiful academic studies show that defence spending has historically spurred innovation. European military activity from the 19th century acted as a boost to technological development. Growth in US research and development during the second world war had long-lasting effects on innovation and the creation of technology clusters. The multiplier effects are considerable. A 10% increase in government-financed R&D boosted private R&D by 4% according to a 2019 report spanning 26 Organisation for Economic Co-operation and Development member countries over 23 years.
A more credible deterrent would reduce uncertainty. Helping to lower the excessively high euro-area household saving rate would thereby boost GDP. A household survey by the European Central Bank confirmed that geopolitical concerns can inhibit consumption even when real incomes are rising.
Overcoming European fragmentation
Nato members have agreed to elevate spending on defence to 3.5% of GDP, plus 1.5% for broader security capabilities. Friedrich Merz, German chancellor, has deviated from decades of German fiscal restraint and Germany is preparing to double its defence budget compared to what it spent on average over the past five years.
However, for Europe to prosper, defence spending at the national level must be complemented by European funds. Such federal funding would reduce the fragmentation of the European defence industry and gain economies of scale. It would incentivise co-operation, improve standardisation and increase the interoperability of equipment as argued by Mario Draghi, former ECB president, in his 2024 report on the state of European competitiveness.
And, if properly designed, a federal dimension can reduce free-riding behaviour – the tendency of a significant proportion of Nato countries failing to reach the defence spending targets – while fostering the respect of the EU fiscal rules. Only countries who comply with the EU fiscal framework and meet Nato defence spending targets would benefit from federal funding.
Although the EU Treaty imposes limits on federal military funding, these could be overcome. And there would be wider benefits from funding higher defence spending at the federal level. ECB President Christine Lagarde argued that increasing the euro’s international role could lower borrowing costs and insulate the bloc from exchange rate volatility. A liquid, European federal safe asset would boost the international status of the euro.
Europe cannot afford to wait for the next crisis. It needs to respond pre-emptively and cohesively. Investing in Europe’s security today is the surest path to protecting and bolstering tomorrow’s prosperity. Europeans need to wake up to this reality – not because US President Donald Trump is instructing them to do so – but because this policy is overwhelmingly in Europe’s own self-interest.
Marco Stringa is Chief European Economist at Element Capital Partners. The views expressed here are the author’s own and do not necessarily reflect those of Element Capital Partners.
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