How to Finance European Defence?

Europe must balance rising defence needs with social spending, or risk political turmoil and far-right gains.

How to finance European defence? This is a million – or perhaps a billion – dollar question. If it remains unanswered for much longer, it risks toppling governments, deepening social tensions, and giving further momentum to the far-right.

In Europe, the fault lines are unmistakable. Member states further to the west are reluctant to increase military budgets, given that their public finances are already under strain and sluggish economic growth in recent years has further narrowed their fiscal room for manoeuvre. In Western Europe, the war in Ukraine is, quite literally, a more distant reality, making it far more difficult for politicians to generate electoral support for higher defence spending.

Meanwhile, in north-eastern European member states from Finland to Poland, the political case for increased military expenditure – even up to five percent of gross domestic product – meets little resistance. Societies there require no convincing of the very real threat posed by Russia, even if or when a ceasefire is reached in Ukraine. For these countries, the new political reality is clear: Russia represents a long-term security risk, and societies must arm themselves accordingly.

The political challenge is to mobilise resources for this goal without compromising the need to invest in social infrastructure and protection. Financing defence is not merely a matter of choosing between increased borrowing, faster growth, or tax hikes. It is about ensuring a sustainable balance between social and military investment. If defence spending comes at the expense of society’s most vulnerable, governments will face a paradox: while military security becomes the political priority, people’s everyday lives will feel increasingly precarious.

It is regrettable that the new economic governance framework agreed by the European Union last year effectively forces this dilemma. It was a singularly missed opportunity to create a fiscal architecture suited to the demands of our age. The political crises in France and Germany serve as clear evidence of the shortsightedness of this framework – balancing the competing economic interests within society now appears nearly impossible. The Covid-19 pandemic, coupled with war-induced inflation, has destabilised the financial position of every major economic actor. Restoring equilibrium requires flexibility, yet flexibility is precisely what the new fiscal rules lack.

This year, Latvia will allocate about three and a half percent of its gross domestic product to defence. It is already among the top spenders in both the European Union and NATO. Latvia managed to increase its military budget even as the new fiscal framework forced governments back into budgetary discipline. Not only did military spending rise – income taxes for most low- and middle-income earners were reduced. This was made possible through a windfall tax on the financial sector, a measure effectively borrowed from neighbouring Lithuania. The result was a budget that successfully reconciled the competing imperatives of the moment – increased military expenditure alongside additional financial support for households.

A fresh approach is now needed. Military spending requirements are continuing to grow, and the presidency of Donald Trump in the United States is amplifying geopolitical uncertainty. Yet general tax increases – whether on income or Value-Added Tax (VAT) – would not only aggravate social tensions but also dampen growth, which is currently reliant to a large extent on private consumption. Estonia, having opted to raise both income tax and VAT, is soon to reveal the consequences of this approach. This should not serve as a model for socially responsible governments.

A universally acceptable solution would be stronger economic growth. However, the European Union is simultaneously confronting a crisis in its growth model. Germany’s export-led strategy no longer functions in an era of escalating trade tensions and China’s technological ascendancy. It is not only time to reorient growth towards the domestic market, but also to foster continent-wide industries through public investment. The defence industry is an obvious candidate.

Developing such capacity, however, requires greater fiscal flexibility. It is therefore noteworthy – and encouraging – that European leaders are discussing exemptions to fiscal rules. At this juncture, this is the only viable path forward if the goal is to craft a political solution that meets both military and social needs. For progressive and left-leaning forces, this also presents an opportunity to question the fiscal rules themselves. If these rules prove ill-suited to addressing existential challenges such as war – as they did during the pandemic – it is entirely reasonable to ask: what purpose do they truly serve?

Defence financing is not a subject with which the political left is familiar, nor is it one it finds comfortable. Historically, the expansion of military industries has been viewed as a danger and an undesirable development for society. However, the geopolitical landscape is shifting. Russia poses a genuine security threat to the entire European Union. As a result, progressives must take the lead in resolving the question of defence spending – otherwise, the far-right will fill the void, doing so with little regard for social concerns.

Progressives must resist the zero-sum politics of the centre-right, which forces societies to choose between social welfare and defence. It can achieve this by advocating a common European approach to shared defence expenditure. Exemptions from fiscal rules for defence spending would be a step in the right direction. Precedent already exists: such exceptions were introduced during the Covid-19 pandemic, and national legislation reflects this. Ultimately, however, a sustainable long-term solution points to common European debt. Only by pooling risks and capital can the European Union emerge from its current crisis stronger.

Should this prove politically unattainable, regional alliances might offer a smaller, yet more realistic, first step. Europe needs pioneers to drive it forward. If such alliances are being considered for projects like capital markets union, there is no reason they could not be applied to defence spending. This is a challenge that could bring down governments – and progressives must ensure they are ahead of the curve.