How much will rising defense spending boost Europe’s economy?

Defense spending by European Union member states is set to increase significantly in the next two years. The shift will have a positive — but limited — impact on GDP growth, Goldman Sachs Research economists Niklas Garnadt and Filippo Taddei write in a report.

The team’s baseline assumption is that the EU will gradually increase its annual defense spending by around €80 billion ($84 billion) by 2027 — equivalent to roughly 0.5% of GDP, according to the report dated February 27. Defense expenditures in the euro area accounted for 1.8% of GDP in 2024 and Goldman Sachs Research expects them to rise to 2.4% by 2027. 

The incoming German government recently said it intends to exempt defense spending from budget control measures and to allot €500 billion to an infrastructure fund. If implemented, the policies could result in faster-than-expected GDP growth from Europe’s largest economy.

The economic impact of defense spending depends on the type of expenditure and whether it is imported or produced locally. Goldman Sachs Research estimates that additional spending on defense will have a fiscal multiplier of 0.5 over two years.

That means every €100 spent on defense would boost GDP by around €50. The forecast is based on the assumption that imports of military supplies gradually decrease (and are substituted with domestic products) and that the higher spending initially focuses on equipment and infrastructure.

What is the outlook for European defense spending?

Spending on equipment has recently increased more than other areas of defense, reaching 33% of spending by European members of NATO last year, up from 15% in 2014.

Europe bought a substantial amount of military equipment from non-EU suppliers immediately after Ukraine was invaded by Russia. However, a large portion of European defense supplies has historically been purchased from domestic companies, particularly in larger EU member states. The average domestic share of sourcing was around 90% in France, 80% in Germany, and 70% in Italy between 2005 and 2022.

Europe’s share of global arms production declined between 2008-2016, although it has since started to pick up again. EU manufacturers have joined the global surge in arms production and are now poised to expand at a faster rate than their US counterparts, according to market pricing.

As defense spending increases, there will be growing opportunity for equipment to be harmonized (made interoperable across the continent), for research and development to scale up, and for efficiency to improve. Such changes would increase the economic impact of military spending, and it would probably result in a higher fiscal multiplier after three years.

How Europe could fund higher defense spending

To meet a defense-spending target of 2.5% of GDP, the euro area needs to increase expenditures by an additional 0.6% of GDP annually, Taddei writes in a separate research report dated March 2. European leaders are discussing a common strategy for increasing defense spending, which could involve issuing more debt at the national or EU level, or setting up new lending facilities from European institutions.

Issuing more national debt could be challenging given the new European fiscal framework, which requires countries to contain their ratio of debt to GDP. European rules allow a temporary exception in the case of “major shocks to the EU,” Taddei writes, known as the “escape clause.” EU President Ursula Von der Leyen proposed this option at the Munich Security Conference in February.

Making this exception permanent for future defense spending needs (known as a “golden rule”) would require the approval of the EU Council and the EU Parliament.

Taddei writes that the EU president’s proposal has the advantage of being relatively quick. But he adds that “introducing a ‘golden rule’ would leave national defense spending exposed to sovereign market stress and reduce the likelihood of coordinated and harmonized military spending within the EU.”

How Europe could leverage supranational debt

Alternatively, the EU could turn to existing lending programs that are available for European governments — either the European Stability Mechanism (ESM) or the European Investment Bank (EIB).

“The EIB has struggled to identify projects worth funding in line with the European priorities, and the industrial reconversion needed to scale up defence spending in Europe would likely provide an ideal target,” Taddei writes.

These options have limitations however. Only euro area members would be eligible for ESM lending, for example, and the ESM would only temporarily shift issuance from domestic to supranational debt.

EU debt, meanwhile, would provide stable funding. This could come in the form of repurposing an existing Covid pandemic borrowing program (called NGEU), or as a separate program that is dedicated to defense borrowing. The latter is the only option to secure low rates for long-run funding. “However, it is also the option with the most cumbersome approval process,” Taddei writes. The team expects that setting up a new funding facility would take about a year from design to implementation.

“We continue to expect the EU to use national debt, NGEU, and a new funding facility, but in that sequence,” Taddei writes. He adds that national debt, combined with the repurposing of spare NGEU financial capacity, could fund military spending until 2026.

 

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