Re-Arming Europe: “Whatever It Takes” 2.0?

In a new Citi Research note, a team of economists and analysts led by Head of European Equity Strategy Beata Manthey looks at the unprecedented urgency among European policymakers to scale up defense spending. Our Super-Sector Analysis explores what policymakers’ plans are, how they might be accomplished, and the potential implications of these plans.

Action from von der Leyen, Merz

The urgency has come from growing tensions within the transatlantic alliance with the United States. EU Commission President Ursula von der Leyen has pledged €150 billion in EU loans for the 27 EU member states (EU27) for defense spending, and proposed excluding new defense spending from EU fiscal rules, which would allow the 27 to use their national budgets to spend up to €650 billion without triggering budgetary penalties. The total package of €800 billion implies ~1.1 percentage point (pp) of EU GDP extra spending per year through 2028, de facto targeting spending/GDP at 3%, up from 1.9% in 2024.

Friedrich Merz, Germany’s chancellor-elect, has also announced bold and unexpected plans to overhaul the country’s debt brake to exclude defense and security spending above 1% of GDP from the domestic fiscal rule’s calculations. This would mean his government would no longer be constrained in raising arms procurement and investment and could also expand military recruitment, incentivize domestic arms production and finance military operations and partnerships.

Scaling up European defense spending isn’t new — NATO estimates EU27 defense spending has already increased 44% to $360 billion last year from $110 billion in 2022, with the largest shift Germany’s increase of $36 billion. As a percentage of GDP, EU27 spending has risen to 1.9% in 2024 from 1.5% in 2022. Still, reaching 3% would be a significant acceleration compared with the recent pace.

National budgets and their drawbacks

Financing is a question. The main takeaway from von der Leyen’s announcement is that the bulk of additional spending will likely come from national budgets and not from EU joint debt. The traditionally “frugal” countries (such as Germany, the Baltics and the Nordics) seem the most determined to use the domestic fiscal lever to finance re-armament. The “escape clause” for defense spending, meanwhile, could also be a significant incentive for spending by higher-deficit countries constrained by EU fiscal limits, such as France, Italy and to some extent Spain. As things stand, EU direct financing looks like more of a complement to national budgets, with a new EU-wide funding tool similar to the 2020 Next Generation EU recovery plan pretty unlikely for now.

We see two drawbacks to using national budgets instead of an EU joint tool. The first is that defense spending always reflects the perceived geopolitical risk, so if the pressure fades spending will most likely slow. The second drawback is that adding 1% to 1.5% of GDP to annual budget deficits may not be sustainable for long, even if allowed by EU rules. Overall, we see financial commitments via national budgets as less reliable and less supportive than an EU-funded defense plan.

The growth impact of increased defense spending will mostly depend on three factors: the speed of spending, the fiscal multipliers for it, and the potential offset from fiscal consolidation and crowding out.

Questions about spending speed

On speed of spending, direct public spending usually takes time even when the money is freely available. Over the past six decades, German public investment jumped by 1 pp of GDP over a year’s period only once, during German reunification in the early 1990s. However, deployment may prove somewhat faster if public money is mobilized to incentivize public investment, such as through grants or tax breaks.

On fiscal multipliers for defense spending, the economic literature suggests they’re generally below unity (meaning for each €1 spent, GDP grows by less than €1) and tend to be small in the first year or two.

With regard to potential offsetting factors, we don’t see funding defense efforts with spending cuts and/or tax cuts as high on European policymakers’ agenda, meaning at least in the short term, extra defense spending will be largely unfunded. Given the already challenging fiscal positions of some member states, fiscal consolidation would clearly be a medium-term risk for growth. At the same time, unfunded spending may be associated with higher bond yields and generally tighter financial conditions.

Given the above, we tentatively estimate that if the planned additional spending goes ahead, the growth impact on euro-zone growth may be very small in 2025, rising to +0.2 pp in 2026 and to the range of +0.5 pp to +0.7 pp in 2028–2029. On balance, we’d view the risks around these estimates as skewed to the downside.

A profound shift for the UK

We see this European strategic shift as profound for the UK, though the economic ramifications may prove more limited, at least at first. That reflects the tight constraints on the UK’s fiscal position; we expect additional defense spending to contribute a modest +0.1 pp to GDP over the coming years.
 

We see the main aim of the current UK administration as the effective replacement of U.S. deterrence on Europe’s eastern flank. What would that entail? According to RAND Corporation, existing U.S. plans call for a fighting force of 300,000 U.S. soldiers, some 2,000 battle tanks, various additional armored vehicles, air defense and infrastructure support. We think the €500 billion to €800 billion package suggested by the euro area should be largely sufficient. For the UK, we think that leaves the current administration free to scale up defense spending to around 3% of GDP, in line with current euro area proposals. 

How this would be delivered will determine how additional spending feeds through into growth. The UK’s public finances are already stretched, and we think only a portion of additional spending will be debt financed. We expect a further £16 billion a year to be spent on defense by 2028, with £5 billion in additional borrowing. While precise figures are hard to come by in considering the boost to domestic demand, we think it would be effectively neutral, perhaps adding 0.1 pp at most to GDP.

Ultimately, potential growth benefits depend on the UK’s capacity to use additional military investment to generate broader productivity improvements. This is by no means implausible, but the benefits would likely require further increases in defense spending and a convincing industrial strategy to see them effectively utilized.

What will the money be spent on?

While the shape of future warfare is changing rapidly, there are certain capabilities we believe European militaries would consider vital in the near term. With the rise of hypersonic missile development, missile defense spending has become a major priority. European nations currently lack the kind of sophisticated, multi-layered air defense required to defend against a peer adversary.

The Russia–Ukraine conflict has seen a vast quantity of artillery shells expended, leaving European stockpiles depleted and in urgent need of renewal. Rockets (and their munitions) such as the Multiple Launch Rocket System are also in very high demand, having proved devastatingly effective in Ukraine by targeting key operational assets.

Man-portable munitions have been used to great effect by Ukraine’s infantry, most notably neutralizing enemy armor in the conflict’s early phases. Man-portable air defenses, such as Starstreak, have also helped prevent Russia from dominating the air.

Conflicts in both Ukraine and the Middle East have demonstrated the effectiveness of inexpensive unmanned aerial vehicles (UAVs), with Ukraine having demonstrated that UAVs are a critical capability on the modern battlefield.
Armored vehicles are a vital asset for seizing ground and remain crucial for opposing enemy armored assets, and we assume they now need urgent replacement in Ukraine.

Mid-term considerations

Looking to the mid-term, we note that the U.S. provides a very significant portion of capability enablers within NATO. Such capabilities encompass logistics/sustainment, Intelligence Surveillance and Reconnaissance assets, C4 assets (Command, Control, Communications and Computers), cyber/electronic warfare, space-based assets and AI. These are ultimately capabilities in which Europe will need to invest more money. 

Beyond procurement, we’re likely to see an increase in personnel and potentially some increase in defense infrastructure spending as well. We’d expect that procurement will be the fastest-growing category, adding further tailwinds to growth beyond the headline budget increases.