Why Markets Do Not React to Europe's Defense Spending Surge
Financial discipline, growth potential, and deeper EU integration reassure investors amid rising defense budgets. A commentary by Lorenzo Bini Smaghi
Europe’s commitment to significantly increase defense spending in response to the new geopolitical scenario has raised concerns about the ability of European countries to finance such expenses without jeopardizing their public finances.
Politically, the main worries focus on the potential impacts on other budgetary items, notably social spending, and the prospect of new taxes, especially in highly indebted countries.
Interestingly, financial markets appear considerably less anxious. The prospect that part of these expenses might be financed by issuing new public debt seems not to have rattled markets—not just in Germany but across Europe.
Indeed, despite rising long-term interest rates following Germany's announcement of a more expansive fiscal policy, sovereign bond spreads within the eurozone have continued to narrow.
Even amid market volatility driven by geopolitical uncertainty, the spread between Italian and German government bonds has fallen by over 20 basis points since last November. Spreads in France, Spain, and Greece have similarly declined by around 10 basis points. Meanwhile, the euro has appreciated, reflecting increased capital flows into Europe.
This trend suggests that financial markets are not overly concerned about rising European public debt, which is used to finance defence expenditures. Three factors may explain this market confidence.
First, the commitment to boost defense spending remains framed within Europe's recently revised rules-based fiscal framework.
The updated rules include specific provisions for defense expenditure without undermining medium-term debt sustainability commitments.
This reassures international investors, who increasingly worry about the continuous rise in US public debt, exacerbated by the absence of disciplined mechanisms and procedures that prevent government shutdowns.
Thus, seeking further modifications to the European Stability Pact at this stage would be dangerously counterproductive, particularly for highly indebted countries.
Second, defense spending typically generates stronger economic growth than current expenditures. Academic research consistently demonstrates that defense investments stimulate economic activity across sectors, notably through research and development and technological innovation, especially when directed at European-made products.
While American defense equipment and services often come with restrictive contractual obligations and ongoing software updates exclusively managed by US firms, fostering an integrated and efficient European defense industry capable of replacing imported products could significantly boost economic growth and job creation in Europe.
This impact is even more pronounced if the new infrastructure aligns with Europe's specific security needs, not just military, but also regarding counterterrorism and migration control.
Third, building an effective European defense system will require substantial investments—such as satellite surveillance and missile defense—that can realistically only be financed and implemented at the European level.
Initiatives like Rearm Europe suggest an increasing degree of European financial integration, comparable in some respects to the Next Generation EU programme, including joint debt issuance.
This development strengthens investor perceptions of greater financial solidarity among EU member states, reducing sovereign debt risks collectively.
In short, from an investor's perspective, a unified European defense framework decreases financial risks for all member countries.
Of course, these expectations must be confirmed over time through concrete decisions and actions by European institutions.
A first version of this article was published in the Italian daily Il Foglio
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
