Economically and financially, Germany is well-positioned to increase defense expenditure and provide support to Ukraine. Over the short- to medium-term, a declining debt-to-GDP ratio allows Germany to increase expenditure without jeopardizing debt sustainability and without having to increase taxes or cut non-defense expenditure. The government should consider reforming, but not abandoning the constitutionally mandated debt brake to allow for structurally higher medium-term defense spending. Given its economic size and financial strength, Germany is pivotal in terms of strengthening European defense and deterrence.
Increasing Defense Expenditure Is Strategically Necessary
Maintaining the conventional military balance in Europe and denying Russia victory in Ukraine are both critical to European security. Strategically, a credible NATO, European and German commitment to match Russian defense expenditure offers the best prospect of maintaining the military balance of power in Europe as well as ending hostilities in Ukraine. Russia’s best policy is to weaken the West’s economic-financial resolve and thereby undermine its support for Ukraine. If NATO or European NATO members managed to credibly commit to matching any Russian defense spending increases and providing support to Ukraine to make a Russian victory impossible, Moscow’s political and military objectives in Ukraine would be thwarted and its incentive to continue the war would diminish, if not under the current leadership, then under the next one.
Economically Possible
In terms of potential economic resources, if not necessarily resource mobilizability, Russia is at a significant disadvantage vis-à-vis NATO and European NATO members. Economically, Russia is far smaller than NATO and smaller even than the big-4 European NATO members, France, Germany, Italy and the UK.
Economic size is of course only a rough proxy for the ability to “buy” security and prevail in long-term strategic competition. Available economic resources need to be mobilized politically and they need to be converted efficiently and efficaciously into security. [1] A sufficiently large economic resource base does not guarantee strategic success. It also requires an effective security strategy. But any credible and effective security strategy needs to be supported by adequate resources.
But Politically Difficult
Although NATO and European NATO members produce collectively far more economic output than Russia, high debt levels in countries like France, Italy and the UK, and even the United States, constrain the degree to which these countries are politically willing to increase defense expenditure and provide support to Ukraine. But this constraint is political, not economic or financial in the sense that Western countries are weary of raising taxes or cutting non-defense expenditure to free up financial resources. They sit on a far larger economic resource base than Russia. Meanwhile, Russia is being forced to divert more and more resources to defense spending, resources that will not be available to finance investment to support future economic growth, and will sooner or later force difficult economic and financial choices on the Russian government.
European countries do face fiscal and debt sustainability challenges. The European Central Bank[2] estimates that for euro area economies to cope with higher spending related to demographic change, climate change and defense by 2070 (!), governments would need to raise an additional 3% of GDP (or reduce spending by the same amount) starting 2024. But this would, according to the projection, only prevent debt levels from increasing from today’s high levels. It would require an additional 2% of GDP to bring euro are government debt levels to the 60% of GDP target.
Distributional conflict and difficult choices over defense expenditure and Ukraine aid are real. But it does not mean that the economic resources are not in principle available to support tangibly higher defense spending or Ukraine. For some countries, the near-term constraints and ensuing trade-offs are more immediate due to high debt levels and limited fiscal space (France, Italy, UK), than for others, the challenges are more long-term (German), meaning that politically difficult choices can be pushed further into the future. Countries that face greater near-term choices would need to reduce non-defense expenditure or raise additional revenue to support substantially higher defense expenditure. Nevertheless, raising the level of defense expenditure from currently low levels is first and foremost a political issue. However, Russia’s economic resources are not unlimited, either, even if in the short run its low level of government debt and continued export revenues give it more short-term financial flexibility than its Western opponents, while a lesser need for political responsiveness give it more political room for maneuver, at least in the short- to medium-term. The fact remains that Russia’s economic resource is insufficient to compete with NATO or even European NATO member, provided the latter are politically willing to mobilize the necessary resources.
Why Germany Can and Should Raise Defense Expenditure
Germany, the second-largest economy in NATO. It is also the most populous country in Europe (other than Russia). It has the largest economy and the largest and most advanced technological-industrial base. It benefits from far greater fiscal space and fewer economic-financial constraints than its European allies. Germany has therefore has a crucial role to play in terms of European defense.
Fact #1: NATO and European NATO member economies are far larger than Russia’s economy
The combined, purchasing-power-parity-adjusted gross domestic product (GDP) of NATO is about ten times larger than Russia’s. The combined GDP of France, Germany, Italy and the UK (or E-4) is three times larger. Germany’s economy alone is slightly larger than Russia’s. In addition, the per capita income of the E-4 is higher than in Russia, which, economically, if not necessarily politically speaking, translates into larger resources mobilizable for national security. E-4 per capita income ranges from $57,000 to $67,000, compared to only $38,000 in Russia.
This economic balance in favor of European NATO countries will not change meaningfully if at all in the next few years. The IMF projects Russian economic growth to average 1.7% annually in 2024-29, compared to 0.9% in Germany. However, unless Russia makes a much more intensive use of its existing capital and labor, it is not likely to grow twice as fast as Germany or the other larger European economies, not least given the medium-term effects of sanctions, the increasing share of national resources Russia is dedicating to “unproductive” defense economy and the war’s negative effect on labor supply. But even if Russia’s were to grow at twice the rate of Germany over the next five years, it would have a very negligible effect on the two countries’ relative economic size over the medium-term and would not change the E-4/ Russia economic balance meaningfully.
On the assumption that all countries have access to comparable military technology and that PPP conversion rates roughly reflect the price differential of military goods and services, the E-4 have a substantial edge over Russia as far as the mobilizable economic resources are concerned. The resource advantage is particularly salient in case of long-term security competition, like the Cold War, and wars of attrition, like World War I and II, where the side with the greater resources prevails over the long term, provided it is politically able to mobilize the necessary resources for defense purposes in time. [3] In short, the large European countries’ economic resource base is sufficiently large to compete with Russia and prevail. The obstacle to higher spending is domestic distributional conflict, not economics
Fact #2: Russia is currently outspending the E-4 , but only because it allocates a far greater share of GDP to defense
The Stockholm International Peace Research Institute (SIPRI) estimates that Russia spent $100 billion on defense in 2023, measured in current dollar terms at market exchange rates, compared to a combined $200 billion in France, Germany and the UK. Adjusted for PPP, however, Russia spent $250-300 billion, or roughly as much as Germany, France, Italy, the UK, and Poland combined. To be able to do so, however, Russia needed to mobilize nearly 6% of GDP, compared to a GDP-weighted average of less than 2% of GDP in the E-4. If the major European NATO countries doubled their defense spending, Russia would be forced to raise defense spending to 12% of GDP to match it. This would represent a massive increase and force Russia to curtail private consumption or investment, or both. Over the medium term, the former risks causing political discontent, while the latter will lead to economic problems, including declining productivity and growth.
Fact #3: German defense expenditure Is low by historical standards and on a comparative basis
German defense spending peaked in the early 1960s at just over 4% of GDP. In 2023, it stood at 1.5% of GDP, up from an all-time low of 1.1% of GDP in 2016. German defense spending has not exceeded 2% of GDP since 1991. In terms of defense spending as a share of GDP, Germany currently ranks 21st out of 30 NATO countries. Germany also spends tangibly less than France, Italy and the UK where defense expenditure was 2.1%, 1.6% and 2.3% of GDP, respectively. By comparison, Poland spent almost 4% of GDP and the United States spent 3.5% of GDP last year. The NATO defense spending target is 2% of GDP, which was supposed to be reached this year.[4]
Fact #4: Germany can afford to increase defense expenditure in the medium-term without having to cut social expenditure or raise taxes
German government debt is comparatively low and the debt-to-GDP ratio is set to fall by more than one percentage point a year until the end of the decade. A more sophisticated financial is unnecessary to understand that Germany has ample financial room to increase defense expenditure. A one-percentage point increase in spending would help keep the debt-to-GDP ratio roughly unchanged. In the short run, a larger fiscal deficit would boost domestic demand and economic growth. Germany is therefore well-positioned to raise defense expenditure “on the cheap” without having raise additional taxes or cut non-defense, including social expenditure. In other words, a permanently larger fiscal deficit would not undermine the outlook for debt sustainability, certainly not in the near or medium-term.
Fact #5: Germany has far greater fiscal flexibility than its major European allies
In 2023, German defense expenditure was 1.5% of GDP, making Germany one of the lowest spenders while being one of the countries with the greatest fiscal space. Government debt in the next four largest European NATO countries, France, Italy, Spain and the UK, is much higher, nearly (more than) twice as high in some instances (see chart). Even if projected long-term pension and healthcare spending are added to the debt stock (and suitably discounted) German debt, while high, is far lower than in the other large NATO countries. Finally, German debt is less costly in terms of both nominal and real interest rates. Naturally, larger fiscal deficits and less favorable debt dynamics could help raise interest rates and hence medium-term and long-term debt servicing costs, and thus limit the fiscal space in t future. But thanks to a relatively favorable maturity structure, this would take time.
Fact #6: Constraints on higher German defense expenditure are legal and political in nature, not economic or financial
If Germany does face short- and medium-term constraints on defense spending, they are legal and political, far less financial or economic. The constitutionally mandated debt brake forces the government to limit the federal budget deficit to 0.35% of GDP. This acts as a check on substantial defense expenditure increases, unless government revenue is increased or spending reductions in other areas are implemented, neither of which would be politically popular. Nonetheless, some poll suggest that the public supports higher defense expenditure. A recent poll has shown that the majority of Germans or 68% supports higher defense spending and 29% oppose it. Support for higher spending was highest among Conservatives (90%) and Liberals (88%) followed by Green voters (75%) and Social Democrats (72% of Social Democrats).[5] It is likely that popular support would be lower if it had to be financed by higher individual income taxes or lower pension and health expenditure, both of which would negatively affect private consumption. This suggests that the constraints in higher German defense spending are legal (debt brake) and political, due to a lack of political leadership, including a willingness or ability to reform the debt brake, less so due to a lack of popular support or outright opposition.
Recommendations
> Explain to voters the economic costs and benefits as well as the strategic rationale of higher defense spending and the provision of aid to Ukraine. Higher defense spending enhances national and alliance security as well as deterrence. Economically, higher government spending on defense helps support the rebuilding of the defense-industrial base, provided military aid comes out of German/ European production rather than imports from the United States (and procurement accounts for a significant share of the spending increases) as well as domestic demand and domestic employment. But increased defense expenditure, unless financed by non-defense expenditure reductions or revenue increases, translates into higher debt levels (relative to the baseline forecast). Importantly, savings-constrained economies also suffer if savings are reduced to support the consumption of defense goods (and services). However, Germany’s large current account surpluses suggest that it is not a savings-constrained economy; if anything, it suffers from excess savings and insufficient domestic demand. This should limit the negative effects of higher defense expenditure on non-defense investment, and if increased defense expenditure is deficit-financed boost short- and medium-term economic growth.
> Reform the constitutionally mandated debt brake to make room for moderately larger fiscal deficits while remaining committed to long-term debt sustainability. The new rules need to strike a better balance between greater short- and medium-term budgetary flexibility and long-term debt sustainability in order to allow for a reasonable increase in defense expenditure. How this can be done is a highly technically issue. But the rules should allow for a higher defense expenditure and a slightly larger deficit as long as long-term debt sustainability is not jeopardized. This may require a commitment to cut expenditure or, more likely, raise revenue in the future.
> In conjunction with European NATO allies, make a credible and sustainable commitment to matching future increases of Russian defense expenditure beyond the two-percent NATO expenditure goals. Such a commitment should seek to match any Russian defense expenditure to the extent that the existing NATO commitment to spend 2% of GDP on defense fall short of this goal. [6] Germany and the European NATO members should commit to matching increased Russian military expenditure to the extent that Russian spending increases exceed NATO-related increase, including channeling a share of the increase to Ukraine. Strategically, this should help diminish Russian incentives to continue the war. Economically, it would help incentivize industry to invest in defense production by providing a longer planning and investment horizon, thereby helping to rebuild Germany’s defense-industrial base. (Admittedly, it will be difficult to get all European NATO members to commit to such an automatic increase, but even a non-binding political commitment do doing so would be a signal, if perhaps not a very credibly one, of European resolve. Commitments should be made more credible by other European countries committing to raise additional defense-related taxes or, politically even more challenging, cutting non-defense expenditure).
> Ensure efficiency and efficacy of defense spending, including greater European defense industry integration. The amount of spending share of resources allocated to defense is a proxy and does capture how efficiently it is spent nor how efficaciously economic resources are converted into military power, security and deterrence. Germany should learn from other countries’ best practices as far as procurement is concerned. European defense integration would allow for greater economic efficiency and help military inter-operability.
[1] Markus Jaeger, The Economics of Great Power Competition, DGAP Policy Brief, 2022
[2] European Central Bank, Longer-term challenges for fiscal policy in the euro area, ECB Economic Bulletin 4, 2024
[3] Similarly, Paul Kennedy, The rise and fall of the great powers, New York: Random House, 1987
[4] National defense as well as collective defense are public goods, economically speaking, prone to free riding. Mancur Olson & Richard Zeckhauer, An economic theory of alliances, The Review of Economics and Statistics, 48(3) 1966
[5] Internationale Politik (Forsa), April 2024
[6] NATO, Defence Expenditure of NATO Countries (2014-23), Press Release, July 7, 2023