We can have no doubt the world is more uncertain, and it is likely more dangerous. There is a perceived need for greater protection, which in many countries is reflected in the need to increase defence budgets. Take the case of NATO, where the current baseline reference for defence spending is 2% of gross domestic product (GDP). The aim is to increase this figure to 3.5%, even 5% if we include all spending linked to external security (e.g. border protection, military mobility and cybersecurity) in addition to military spending in the strictest sense.
Clearly, there is room for manoeuvre between these two values. For simplicity’s sake, let’s focus on the lower one here, which refers solely to military spending. The target is therefore 3.5% of GDP, implying an increase of 1.5 percentage points. How should we interpret these figures? A 3.5% share of GDP is more or less the ratio NATO as a whole targeted at the beginning of the 1990s. Communism had collapsed, and the Cold War was confined to the history books. Though the world remained uncertain, it seemed less dangerous. As for the increase of 1.5 percentage points, that is precisely the average rearmament effort observed across the 113 episodes recorded between 1870 and 2020, excluding two exceptional events in the 20th century: both world wars (Source: Kiel Policy Brief, February 2025). It took five years on average to achieve it.
That leaves the issue of how to finance it. We know that public accounts in the North Atlantic are not in great shape. Two series of three figures illustrate this (2024; in percentage of GDP; respectively the US, the UK and the Eurozone – source: OECD, June 2025): 7.4, 6.0 and 3.1 for budget deficits; 123, 101 and 89 for public debt. And we should bear in mind that within the Eurozone, there can be significant disparities between member states. For example, the fiscal balance stands at -2.7% of GDP in Germany and at -5.8% in France. Faced with an overriding imperative, these restrictions will need to be circumvented, both in budgetary and financial terms.
Let’s start with the budgetary question. When it comes to defence, the issue is not viewed in quite the same way on either side of the Atlantic. Military expenditure amounts to 3.4% of GDP in the US versus 2.3% in the UK and 1.9% for the European Union. The Old Continent clearly has some work to do. A fundamental rethinking of previously accepted good governance rules will be required.
Given what is at stake (security and, by extension, the future of society), spending commitments must be distinguished: civil versus military or, more broadly, managing the present versus preparing for the future.
We must accept a dual budgetary approach, with obligatory taxes or earmarked funding mechanisms.
Our view of one or the other, and their associated risks, must differ accordingly. But will we be able to develop the analytical tools necessary to design, justify and manage this distinction? And the case of the EU begs the question of where revenues or financing should be raised: in Brussels or member state capitals?
Let’s turn to the issue of financing where a threefold challenge emerges.
• Financing military spending, including upstream investment and the operations of necessary equipment producers
• Balancing tax revenues and debt in terms of public intervention, and equity versus debt financing to drive the production processes of the companies concerned
• Bank intermediation (credit) versus capital market funding, particularly through bonds but also equity, to meet companies’ capital needs.
BEYOND THIS TAXONOMY, LET’S ZOOM IN ON TWO ASPECTS.
First, past experience shows that increased defence spending does not typically come at the expense of social spending or foreign policy initiatives. Indeed, it is generally achieved through a mix of higher debt and increased taxation – with an important caveat on this second point: the greater the effort required, the larger the role played by borrowing.
Second, the necessary mobilisation of additional financial resources raises two further points. Higher bank debt may require more lenient prudential regulations and potentially greater use of securitisation to ‘make room’ on the banks’ balance sheets. Additionally, there may be value in directing savings towards military-related expenditure. For continental Europe, a surplus exists, as shown by EU’s near-structural current account surplus (2.8% of GDP in 2024). The challenge is to create investment funds attractive enough for the necessary to become possible. An initiative to create such vehicles would be welcome.
Let’s assume that all this is put in place. What macroeconomic effects should we expect?
In terms of growth, the multiplier effect of increased defence spending (i.e. the measure of its impact on growth) will depend on many factors. Downstream, the other parameters, namely employment, prices, external trade balances and interest rates (an expansion of Kaldor’s magic square), will be affected.
• Will this increase in public demand be to the detriment of private demand (crowding out effect)? This would require close attention to the labour market and price stability, as well as interest rate levels.
• What share of military procurement will be sourced domestically vs through imports? And what will be the impact on military R&D and its spillover effect into the private sector (ultimately boosting productivity)?
• The choice of financing is not without its own impact: debt versus taxation. But there are two drawbacks. First, resorting to greater debt must not trigger a Ricardian equivalence (where households and businesses anticipate future tax hikes). Second, if taxation must rise, care should be taken not to target those economic agents with a higher propensity to spend.
The range of possibilities is wide. Can we put forward some sort of quantification? In the case of the EU, the Commission conducted a simulation (The economic impact of higher defence spending, 19 May 2025).
The main assumptions made were as follows:
• The increase in military spending (1.5% of GDP) is phased in linearly up to 2028 (a rapid pace, in my opinion); it then remains above the new 3.5% of GDP benchmark for decades to come.
• The entire effort is initially financed through debt; then taxation gradually takes over; the civil spending/GDP ratio remains unchanged.
• Imports make up 20% of the increased defence spending.
• Only 10% of defence expenditure contributes to productivity gains.
Under these assumptions, the impact on key macroeconomic indicators would be as follows:
• Relative to the baseline scenario, GDP in 2028 would be 0.3 to 0.6 points higher (and 0.3 points higher in 2034); this ‘leap’ is modest because of full Ricardian equivalence effects.
• Inflation would rise by just 0.2% thanks to intervention from the ECB.
• Public debt would rise by 2 points of GDP by 2028 and would continue the moderately upward trend until 2032 before declining as fiscal pressure rises.
• Interest rates would be higher due to increases in risk premiums.
The ‘story’ told by the European Commission signals only modest macroeconomic shifts. Should we fully believe it?
Hervé Goulletquer, Senior Economic Adviser, Accuracy
Accuracy Talks Straight #13 – Economic point of view