The Commission’s plan to ‘rearm’ Europe and to unlock extra defence spending largely hinges on invoking the national escape clause of the Stability and Growth Pact again. According to the plan, this could potentially unlock €650 billion if countries allocate an extra 1.5% of GDP to defence, raising average EU defence spending to 3.5% of GDP. This approach would enable countries to exceed the 3% of GDP deficit threshold without triggering the Excessive Deficit Procedure.
The proposal includes creating a €150 billion fund from which countries can borrow specifically for defense purposes. This would be particularly beneficial for countries that face higher interest rates, as it would provide them with more favorable borrowing conditions compared to borrowing independently. However, borrowing from this fund would not be considered additional defence spending because it is intended to help countries meet the target of increasing defence spending by 1.5% of GDP.
The plan also allows cohesion funds to be used for defence spending but it falls short of creating a shared fund for joint spending. The fact that the plan does not involve a hard target for spending, but more an estimate of what would happen if Europe used the escape clause to increase spending by 1.5% of GDP, makes it uncertain whether the €800bn mentioned by the Commission will be reached.
There is uncertainty about the market response
While the Commission’s plans so far focus mainly on unlocking extra national spending and do not result in talk of a “Hamiltonian moment” like the NextGen EU announcement did, markets do remain very relaxed on the matter. Spreads have remained benign so far, which means that while interest rates are up, markets don’t seem concerned about more indebted countries, at least not yet. To us, this implies that investors are still banking on more European unity in the face of geopolitical developments.
With spreads under control for the moment, that is a positive sign for extra spending. Then again, national governments will have to live with uncertainty about the market response to much higher defence spending without cuts elsewhere. For the high debt countries, in particular, this will add further to debt levels and could result in a lack of market trust at some point, which could curb defence spending or trigger budget cuts elsewhere even though the Commission is allowing it.