Uncertainty Over Pace and Scale of Extra European Defense Spending

Figure 1: European Security Scenarios   

Source: Continuum Economics.  A 4 scenario is that Putin (72) dies of old age in the next few years and is replaced by a weak leader that is less regionally aggressive.

Uncertainty exists of the prospective pick-up in European defense spending over the next 1 to 10 years for a number of reasons, which needs to be monitored in the coming months.

·       Reliance on the U.S.  European political leaders know that defense of their own countries is currently reliant on the U.S.  U.S. command and control systems and hardware dominate the NATO military set-up in Europe, which is not easily replaced in the next few years.  Europe also does not have enough troops and has depended on U.S. troops and military spending, that will now likely be cut back (Figure 1).  Military experts have estimated that Europe really needs to exceed 3.5% of GDP to make up for shortfall since the end of cold war. Europe also needs to coordinate procurement more and build up defense industries, which can take years (here). Additionally, the U.S. ultimate deterrent is the tactical to strategic nuclear weapons, include those based in Germany and Italy.  UK nuclear weapons are partially dependent on U.S. support, while French nuclear weapons could be shared but would take some major decisions and neither includes the tactical options that Russia may resort to in any attack on the west.  Overall, European leaders need to keep good relations with the U.S. for the next few years at least, and more efforts will be made in this direction.

·       Distrust of the Trump administration. European political leaders privately do not fully trust the Trump administration, given the U.S. defense secretary signaling a multi-year scale down in U.S. troops in Europe and President Trump’s variable support for NATO.  Europeans are also fearful that the next U.S. president in 2029 could also hold the same isolationist views.  Additionally, Trump could ask European countries to pay for protection later in H1 as part of a trade war, with Trump having already pressured Japan and South Korea for extra payment for U.S. military support. Meanwhile, the temporary cut off on U.S. intelligence and support for equipment has also alarmed European politicians and defense leaders, that are now uncertain whether the U.S. could allow equipment to be used in any future conflict and/or may withhold vital maintenance and software updates needed repeatedly.  This has caused a big political push in the last 2 weeks to buy European rather U.S. defense equipment. Overall, this has driven a twin track strategy of trying to keep the U.S. on board in European NATO countries defense but also building up domestic defense in the next 1 to 10 years.  This is still our baseline scenario (Figure 1), but we have increased the main alternative from 20 to 40%, where triggering article 5 would not be guaranteed to bring the Trump administration into a future military conflict between Russia and a large country e.g. Poland – U.S. direct military support for Baltic states looks unlikely even in our baseline under the Trump administration if an attack is seen by Russia.  Fear of this moderate probability scenario is driving some European leaders to take aggressive steps to increase defense spending e.g. Germany.       

·       Ukraine war.  The negotiations about a ceasefire and peace deal are entering a crucial period.  President Putin has maintained his maximist demand for peace, as preconditions for accepting the U.S. idea of 30 day ceasefire. U.S./Russia negotiations will now start in earnest and while the most likely outcome is eventually a Russia-friendly peace deal (here), it could also result in the Ukraine war continuing but with the U.S. not providing new military and aid funding from the summer.  If war continues, Ukraine will likely lose more ground without U.S. intel and military support, and Russia will increase control over Ukraine and pressurize Europe more. Either outcome is bad for European politicians.  Though Europe could at a stretch financially fill the EUR46bln supplied by the U.S. in 2024 according to Kiel institute (military and aid), carrying on without U.S. support from a military standpoint would be more difficult for Ukraine.

Budget constraints.  Germany has the fiscal space and focus to substantively increase defense spending on a multi-year basis from 2.0% to 3.5% of GDP, which could add an extra Eur75bln to defense spending per annum.  However, other major European countries are constrained by long-term budget trajectories e.g. France, Italy and to a degree UK and now face possibly protracted additional debt servicing costs due to the German-induced rise in bond yields.  Though the EU Commission re arm idea has up to EUR650bln of extra fiscal space (which needs to be clarified in the March and June EU heads of state summits).  Notably, Germany is crucially now willing to back a relaxation of EU budget rules, while rating agencies and bond markets would look at the total deficit and debt picture.   Thus actual individual countries spending could be constrained to well below the EU Commission’s estimate. In addition, the EUR 150 bln in loans to countries that the EU Commission says is can provide under Article 122 of the Treaty is controversial as a) the Article stipulates such lending is more short-term crisis related and b) could still be considered as ‘joint borrowing’ as the fund is guaranteed by the EU budget and would still have to be borrowed in the capital markets. 

·       Political constraints. Politics is also a major restraint on France credibly committing extra funds to defense, which may not be resolved before the 2027 presidential election.  Additionally, internal European/EU politics restrains some countries from going at the same speed as says Germany.  Spain reluctance to build up the military extends back to the Franco years, while distance from Russia also produces less urgency from some countries.  The struggle to get a coalition of countries to serve as a potential peacekeeping force in Ukraine show the limits of cooperation – this remains unlikely to be implemented given strong Russian opposition and lack of U.S. backstop.  Finally, European politicians need to convince electorate that more defense spending is required and that could take years.   

Overall, we see this meaning that a multi-track approach will likely be evident.  Some countries will likely move quicker than others to build up defense spending and fill gaps, but Europe as a whole acknowledging that other countries will be slower but still committed.  Europe will also try to work between EU and non-EU countries (e.g. UK/Norway/Turkey) in coordinating defense procurement and having the capability to fight alongside each other with or without U.S. military capability. 

While some focus exists on the March 21 EU heads of state summit, the crucial date for more clarity is the June 24-26 NATO summit.  Donald Trump might attend but will ask for more.  NATO head Rutte desire is for above 3% of GDP for NATO countries, but the politics and budget suggest that a 2.5% minimum may only be agreed with Germany and UK target likely to be 3.0% and eastern European countries still higher.