Defense Primer. Guns, Butter, and Balance Sheets: The European Defense Funding Conundrum

Money, Markets, and Militaries: How Europe's Fiscal Future Will Shape Its Strategic Present

Welcome to another installment of "Fiscal Fiascos and Geopolitical Gambits," where today we're diving into the thrilling world of European defense spending. I know what you're thinking: "Defense spending? Thrilling? Has he lost his mind?" But bear with me—this is where the fiscal meets the physical, where budget lines determine battle lines, and where the question of who pays for what might determine who's still standing when the music stops.

I. The Peace Dividend Hangover: A Three-Decade History

For decades, Europe enjoyed what defense wonks call the "peace dividend"—the absolutely lovely practice of spending less on tanks and missiles and more on things voters actually want, like healthcare, education, and not being taxed into oblivion. According to the research, European countries extracted a cozy €1.8tr "peace dividend" since 1991 by underspending relative to NATO's 2% GDP target. Germany alone accounts for about one-third of this discount defense shopping spree.

It's a bit like canceling your home security system because the neighborhood's been quiet for a few years, then waking up to find your unfriendly neighbor Vladimir has kicked down the fence and is eyeing your garden shed with unseemly interest. "What a shame," he says, stroking his tank. "These things fall apart so easily these days."

The historical spending trend tells the story in vivid data:

• 1989-2000: US defense spending dropped from around 5.5% to 3%, while European countries plummeted to well below 2%

• 2001-2010: US wars in Afghanistan and Iraq briefly pushed US spending back above 4%, while Europe continued its holiday from history

• 2011-2016: Defense spending got further squeezed during austerity, with some countries like Germany bottoming out at 1.1% of GDP

• 2017-2020: Trump frantically waves arms, demands NATO partners spend more (while muttering "Montenegro is a very aggressive people")

• 2022 onwards: Russia invades Ukraine, and suddenly defense spending curves start looking like hockey sticks. Coincidence? I think not.

Looking at the data country by country reveals the dramatic shift. Poland has been the most aggressive, increasing spending from 2.2% of GDP in 2021 to 4% in 2024, with plans to hit 4.7% in 2025—practically Soviet-level militarization. Even Germany, long the sleeping giant of European defense, is finally awakening from its pacifistic slumber, hitting the 2% target in 2024 after decades of underspending. As the German defense minister might say, "Panzers don't grow on trees, you know."

By 2024, most European countries were finally approaching or hitting the 2% target, with 24 of NATO's 32 members expected to reach it. That's up from just 4 members in 2021. Nothing motivates fiscal discipline quite like the sound of artillery a few hundred miles east.

II. The Three-Percent Question: The €200bn Annual Gap

But here's where things get spicy: defense planners are now whispering about potentially increasing the NATO target from 2% to 3% of GDP. European Commission President von der Leyen has suggested that collective spending should move "from just below 2% to above 3%"—a seemingly innocuous statement that would casually add about €200bn in annual spending requirements.

Individual countries are already getting ahead of this curve. France's Macron wants to hit 3-3.5% of GDP, while the UK's Starmer is committing to 2.5% by 2027 with "ambition" (that wonderfully non-committal word beloved by politicians everywhere) to reach 3%. In politician-speak, "ambition" is what you call a promise you have no intention of keeping, but would like credit for anyway.

Let's put this in perspective using concrete figures:

• Current EU defense spending: approximately €330bn (2024)

• At 3% target: would need to reach €530bn annually

• Draghi's catch-up investment: €500bn over next decade

• Total additional funding needed (per annum): €250-300bn

Let's be honest: those are big, scary numbers. And they hit different countries disproportionately. Using 2024 GDP forecasts, a 3% target would require:

• Germany: €120bn annually (vs. €70bn now)

• France: €85bn annually (vs. €55bn now)

• Italy: €60bn annually (vs. €30bn now)

• Spain: €45bn annually (vs. €20bn now)

It's like discovering that your "modest home renovation" requires not just new countertops but also replacing the foundation, electrical system, and roof—all while your income hasn't changed. "Sorry sir," says the contractor, "but it turns out your security system was actually a garden gnome with a stern expression."

III. The Fiscal Reality: Cold War vs. 2025

Here's where historical context truly matters. During the Cold War (1980-1989 average), European countries spent around 3% of GDP on defense but only 15-20% on social expenditures. Fast forward to 2025, and the script has flipped: defense spending is around 2% while social expenditures consume 25-35% of GDP.

The data visualized on a scatter plot makes this shift painfully obvious. Take France as an example:

• Cold War period: 3.5% defense spending, 20% social spending

• 2022 projection: 2.3% defense spending, 31% social spending

This inverse relationship between guns and butter plays out across virtually every European country. Add in demographic projections showing the "additional cost of aging" in GDP percentage points, and the fiscal picture gets even darker. Germany faces an additional 1.7% of GDP cost from aging by 2034, Italy around 1%, and the EU average about 0.6%. Turns out, pensions and tanks both cost money. Who knew?

This creates a political dilemma that would make Machiavelli wince: either cut popular social programs (electoral suicide) or increase deficits and debt (fiscal suicide, especially for countries already under Excessive Deficit Procedures). As one anonymous European finance minister put it: "I'd rather face Russian tanks than angry pensioners. At least the tanks won't vote."

The fiscal space varies dramatically by country:

• Germany: €75bn fiscal room (3.5% of GDP)

• Denmark: €15bn (5.1% of GDP)

• Portugal: €10bn (3.8% of GDP)

• Ireland: €25bn (5.0% of GDP)

• France: -€70bn fiscal deficit (-2.5% of GDP)

• Italy: -€25bn fiscal deficit (-1.2% of GDP)

Seven member states are currently under Excessive Deficit Procedures, including major economies France and Italy, who must improve their structural budget balance by 0.5 percentage points of GDP until their nominal deficits fall below 3%. In plain English: they're already maxed out on their credit cards and the bank is calling.

This is what makes the analysis so interesting: the countries that feel most threatened by Russia and have increased defense spending the most (Poland, Baltic states) often lack the fiscal capacity for further increases, while some countries with more fiscal capacity (Germany, Netherlands) have historically been more hesitant on defense. It's like a geopolitical version of that old saying: "The pessimist complains about the wind, the optimist expects it to change, and the realist adjusts the sails." Except in this case, the realist also needs parliamentary approval and doesn't want to trigger a debt crisis.

IV. The EU Funding Options: A Comprehensive Taxonomy

Given these national fiscal constraints, attention has turned to EU-level funding solutions. Let me present the complete taxonomy of options, from least to most ambitious:

Option 1: Reprioritization of Cohesion Funds (€60bn potential)

• Only 4% of the 2021-2027 cohesion funds (€368bn total) have been spent so far

• Commission working on guidelines to allow defense industrial projects

• Poland has €75bn in open cohesion funds, Italy €41bn, Romania €30bn

• Implementation timeline: Short-term (2025-2026)

• Political feasibility: High (adjustment to Commission guidelines)

• Limitations: Cannot fund military equipment, only infrastructure

Think of this as finding money in your coat pocket that you forgot was there. Pleasant surprise, but not a long-term solution.

Option 2: Repurposing RRF/NGEU Funds (€95bn unused loans)

• €95bn in unused RRF loans plus €344bn allocated but not yet disbursed

• Window for applying has closed (August 2023)

• Would require unanimous agreement to reopen

• Implementation timeline: Short-term (by 2026)

• Political feasibility: Medium (requires Council agreement)

• Limitations: Cannot fund military equipment

This is tantamount to saying, "Remember that money we were going to use to build bike lanes? Let's use it for tank lanes instead."

Option 3: Next EU Budget 2028-2034 (€100bn over 7 years proposed)

• Negotiations start 2025, implementation from 2028

• Defense Commissioner Kubilius proposing €100bn defense allocation

• Commission plans to bundle budget into three pillars, with defense in second pillar

• Implementation timeline: Long-term (first payments by 2030)

• Political feasibility: High (part of normal budget process)

• Limitations: Limited in scale, late implementation

By which time, as one wag put it, "We'll either not need it at all, or need it way more than this amount would cover."

Option 4: SURE 2.0 Mechanism (€100bn potential)

• Based on pandemic-era SURE facility

• EU loan scheme backed by member state guarantees (€25bn)

• Requires unanimous agreement on guarantee structure

• Implementation timeline: Short-term (2025-2026)

• Political feasibility: Medium (requires unanimous approval)

• Limitations: Loan-based, not attractive to all member states

When you name your emergency finance mechanism "SURE," you're just asking for trouble. "Are we SURE about this?" Yes, that's literally the name!

Option 5: ESM Credit Line for Defense (€240bn potential)

• Proposed by former Italian PM Letta

• Similar to unused €240bn ESM pandemic credit line

• ESM has €427bn current lending capacity

• Implementation timeline: Short-term (2025-2026)

• Political feasibility: Medium-low (eurozone only, stigma issues)

• Limitations: Eurozone only, loan-based, political stigma

ESM is the European Stability Mechanism, which sounds reassuring until you remember it was created to bail out failing countries during the eurozone crisis. "Hey, Italy, want to use the Embarrassing Failure Fund to buy some tanks?"

Option 6: New Intergovernmental Fund/SPV (€500bn potential)

• New special purpose vehicle issuing bonds

• Backed by national guarantees

• Potentially administered by EIB

• Could include non-EU NATO members

• Implementation timeline: Short-term (2025-2026)

• Political feasibility: Low-medium (requires treaty, but voluntary participation)

• Limitations: Political will for common defense fund uncertain

SPVs are like the financial equivalent of those shell corporations in spy movies. Technically legal, but you wouldn't want to explain them to your mother.

Option 7: New EU Joint Borrowing/RRF 2.0 (€650bn proposed)

• Similar to NextGenEU/RRF structure

• Would require amendment to EU Own Resources Decision

• Ratification by all member states in accordance with constitutional requirements

• Implementation timeline: Long-term (2026-2027)

• Political feasibility: Very low (Germany, Netherlands opposed)

• Limitations: Politically divisive, requires unanimity

As likely as finding a German who thinks Berlin's new airport was well-managed. (For non-European readers: this is what we call "statistically improbable.")

The critical insight here is the trade-off between political feasibility and scale/scope. The easiest options (repurposing existing funds) are limited in scale and restricted in what they can fund, while the more ambitious options face significant political hurdles.

V. The German Question: Europe's Critical Fiscal Fulcrum

No discussion of European defense would be complete without focusing on Germany, the continent's economic powerhouse and traditional defense spending laggard.

Germany's position in Europe's defense funding debate is unique for several reasons:

1. Largest fiscal space: €75bn room for maneuver under EU rules

2. Constitutional debt brake: Caps federal deficit at 0.35% of GDP

3. Special defense fund: €100bn Sondervermögen created in 2022

4. Political complexity: February 23, 2025 snap elections approaching

Germany has been operating under its special €100bn "Sondervermögen" (special fund) for defense established in 2022 after Russia's invasion of Ukraine. This fund, enshrined in the constitution alongside the debt brake, allows Germany to meet NATO's 2% target—for now. But the fund will likely be depleted by 2027, creating a funding cliff.

The data tells an interesting story about Germany's defense equipment procurement:

• 2014: €5bn on equipment (core budget only)

• 2020: €8bn on equipment (core budget only)

• 2023: €15bn on equipment (core budget + special fund)

• 2024: €23bn on equipment (core budget + special fund, planned)

This spending pattern has created a hockey-stick curve that will be hard to sustain once the special fund expires. According to Deutsche Bank's analysis, potential coalition negotiations after Germany's upcoming elections may determine if the debt brake exceptions will be expanded for defense spending. Conservative parties traditionally favor fiscal discipline, but might consider defense an area meriting special treatment given the "very exceptional circumstances" of the current security environment.

As one German politician put it: "The debt brake is sacred, just like our commitment to defense, and our refusal to choose between sacred principles." Which is the sort of logic that has made German defense policy so... interesting.

It's a classic case of immovable object meets unstoppable force: German fiscal conservatism colliding with new security imperatives.

VI. Defense as a European Public Good: The Economic Theory

This brings us to the philosophical and economic core of the debate: is defense a European public good that merits common funding solutions?

In economic theory, public goods have two characteristics:

1. Non-rivalrous: One person's consumption doesn't diminish others' ability to consume

2. Non-excludable: Difficult to prevent non-payers from benefiting

Defense, particularly air defense, is a textbook example of a public good—if Poland has a robust air defense system, its neighbors automatically benefit from the deterrence it provides and the early warning it might generate. No individual nation can comprehensively provide air defense alone, but all benefit from a coordinated system.

The poster child for this concept is a European missile shield, with an estimated price tag of €500bn. A missile shield provides classic positive externalities—benefits that extend beyond the direct funder. Projects of this scale almost certainly require common funding mechanisms—the question is whether political will exists to create them.

Or as one Brussels wag put it: "Everyone wants the umbrella, but no one wants to pay for it until it starts raining missiles."

This economic logic suggests EU-level funding solutions, but political realities often trump economic theory. The more the perceived security threat remains concentrated on Europe's eastern flank, the more national resources combined with limited EU fund repurposing might suffice. But if the threat perception grows and spreads across the continent, the need for new, common funding solutions becomes more pressing.

VII. The Growth Case: Defense as Economic Strategy

One argument gaining traction is that increased defense spending could boost European economic growth—particularly if directed toward domestic defense production rather than imports.

% of NATO Total Defense Expenditure on Equipment

The data supporting this "growth-through-defense" thesis includes:

• Defense equipment spending as share of total budget increasing from <15% to >30% from 2014-2024

• European Commission target: 50% of equipment spending on European products by 2030 (vs. 35% now)

• US currently captures 50% of European defense equipment spending

• If targets met, expenditure on European equipment could increase by 137% from current levels

European defense companies are already showing impressive growth projections:

• Rheinmetall (Germany): 26% revenue CAGR 2025-27, 33% EBITDA CAGR

• SAAB (Sweden): 16% revenue CAGR 2025-27, 22% EBITDA CAGR

• Dassault Aviation (France): 18% revenue CAGR 2025-27, 20% EBITDA CAGR

• Hensoldt (Germany): 12% revenue CAGR 2025-27, 17% EBITDA CAGR

Apparently, the invisible hand of the market gets quite enthusiastic when it's holding a missile launcher.

European Commission President von der Leyen recently announced a package totaling €800bn, of which €650bn would come from loosening EU deficit rules. The Commission is also focusing on ensuring increased spending goes to European equipment—targeting 50% of procurement from European sources by 2030, up from 35% currently, reducing dependence on US equipment.

This "Buy European" approach serves multiple policy objectives: strengthening defense capabilities, industrial policy, and potentially defusing trade tensions with the US (by showing Europe is shouldering more security burden).

The optimism about defense-led growth is reflected in European equity indices:

• Eurostoxx: +12% YTD

• S&P 500: -4.5% YTD

• Dow Jones: -2.3% YTD

As the saying goes in defense industry circles: "Peace is good for humanity, but war is good for business." (Disclaimer: I just made that up, please don't quote me.)

VIII. Investment Implications: Following the Money

For those looking to position portfolios in line with these tectonic shifts in European defense policy, several investment themes emerge:

1. European Defense Pure Plays

• Rheinmetall (Germany): Leading land systems manufacturer, trading at 18.2x EV/EBITDA

• SAAB (Sweden): Aircraft and missile systems, trading at 17.9x EV/EBITDA

• Hensoldt (Germany): Electronics and sensors specialist, trading at 14.2x EV/EBITDA

• Leonardo (Italy): Broad defense exposure, trading at 11.2x EV/EBITDA

2. Multi-Domain Integrators

• Thales (France): Defense electronics, cybersecurity, space, trading at 12.1x EV/EBITDA

• BAE Systems (UK): Broad defense portfolio, trading at 11.3x EV/EBITDA

• Airbus (Pan-European): Aviation and defense, trading at 12.9x EV/EBITDA

3. Supply Chain Beneficiaries

• MTU Aero Engines (Germany): Aircraft engine components, trading at 12.7x EV/EBITDA

• Safran (France): Aerospace propulsion and equipment, trading at 16.5x EV/EBITDA

• Renk (Germany): Specialized transmission systems, trading at 13.3x EV/EBITDA

4. Eastern European Defense Pure Plays

• Korea Aerospace (Korea): Aircraft manufacturer with strong Eastern European presence, trading at 14.6x EV/EBITDA

• Hanwha Aerospace (Korea): Land systems supplier to Poland, trading at 5.3x EV/EBITDA

5. Sovereign Debt Considerations

• Countries with fiscal discipline and manageable debt levels may see relatively better sovereign bond performance

• Countries with high defense commitments but limited fiscal space may face sovereign risk premiums

• Watch for spread widening on Italian (BTP), French (OAT), and Spanish (Bonos) government bonds

6. Defense ETFs with European Exposure

• iShares U.S. Aerospace & Defense ETF (ITA)

• SPDR S&P Aerospace & Defense ETF (XAR)

• Invesco Aerospace & Defense ETF (PPA)

• All have meaningful European defense exposure through US companies with European subsidiaries

The relative valuation point is important here—European defense companies trade at an average EV/EBITDA multiple of 13.2x, compared to 20.4x for US defense companies. This valuation gap may narrow as European defense budgets increase and growth accelerates.

And for those looking to really go long on European defense: Invest in Ukrainian language lessons, bulletproof vests, and canned goods. (This is a joke. Please don't actually do this. I mean, learn Ukrainian if you want, it's a lovely language.)

IX. Timeline of Catalysts to Watch

Several critical events over the coming months will shape the trajectory of European defense funding:

• February 3, 2025: EU leaders retreat to discuss defense capabilities

• February 23, 2025: German snap elections

• March 11, 2025: EU "white paper" on defense integration expected

• Mid-April 2025: EU finance ministers discuss defense funding options

• June 2025: NATO summit, potential decision on 3% spending target

• July 1, 2025: European Commission presents draft 2028-34 budget

Each of these events represents a potential catalyst for both policy advancement and market repricing of defense-related assets.

The real question is whether European defense integration will move at the traditional EU pace (glacier impersonating molasses) or the new, post-Ukraine invasion pace (slightly melted molasses).

X. The Bottom Line: Deterrence Has a Financial Dimension

The fundamental conclusion from all this analysis is that deterrence isn't just about military capabilities—it's also about financial sustainability.

The more credible European defense finance appears, the stronger the deterrent effect. Making the most of national fiscal space and unused EU resources is the minimum expectation. Moving toward more ambitious funding solutions—reforming the ESM or creating new intergovernmental funds—would signal greater urgency and commitment.

As the February 3rd summit of EU leaders approaches, with defense high on the agenda, the decisions made about funding will send important signals about European resolve. The challenge is formidable: finding a path between fiscal prudence and security imperatives that's politically sustainable and militarily credible.

In other words, Europe needs to square the circle of wanting guns without sacrificing butter, all while keeping its balance sheets in order. It's a task that would make Houdini sweat.

But hey, that's what makes fiscal and defense policy so endlessly fascinating—the intersection of cold hard cash with even colder hard power realities. In the end, as the old saying goes, "Defense is expensive, but not as expensive as being conquered." Europe is rediscovering this ancient wisdom, one budget line at a time.

And if all else fails, Europe can always try the time-honored tradition of writing a strongly worded letter. After all, the pen is mightier than the sword, especially when the sword budget has been redirected to pension payments.

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DISCLAIMER: This analysis is for informational purposes only and does not constitute investment advice. The views expressed here are solely those of the author and do not represent the views of any financial institution. The author may have positions in securities mentioned. Past performance is not indicative of future results. Defense spending policies and fiscal frameworks are subject to change without notice. Readers should conduct their own research and consult with a qualified financial advisor before making investment decisions. All investments involve risk, including the potential loss of principal. If you actually read this far, congratulations—you now know more about European defense funding than 99.9% of the population, which may or may not be something to brag about at parties.