Demographic change and prosperity (2025)

Demographic change is a slow-moving force whose causal impact often remains imperceptible in analyses focused on shorter time horizons due to its limited variability. Over the longer term, however, demographic change is often a critical variable shaping developments, including economic growth, capital accumulation, government budgets, technology adaptation, prosperity, and even politics.

Global demographic trends differ greatly with some countries experiencing population stagnation or decline, while the populations in other countries are expanding rapidly. Some commentators have voiced fears that current levels of prosperity in advanced economies cannot be maintained due to demographic decline. For this to happen, however, the decline of the economically active population would need to more than offset the increase in labor productivity. This is possible, but not necessarily likely. But demographic aging will bring about changes to the pattern of consumption, including its distribution across generations and its type (e.g. consumption of health care services vs. automobiles).

None of this is to say that an economy that is stagnating in terms of size because of a declining working-age population does not create economic and financial challenges. Economically, the combination of low growth and increasing government social spending can create financial problems. Politically, demographic aging creates so-called “grey majorities” which can make it difficult for governments, particularly democratic ones, to force through the reform necessary to maintain financial stability. To the extent that voters view health and pension expenditure as “acquired rights”, political opposition to reform tends to be significant. Similarly, countries with a large share of young people may be more prone to political instability, particularly in the context of uneven economic growth and limited employment opportunities.

Countries and governments are not powerless to deal with demographic change. But both mitigating the effects of demographic decline in advanced economies and leveraging demographic expansion in developing economies requires far-sighted public policies.

This comment is divided into three parts. First, it provides an overview of demographic trends in advanced, emerging and developing economies. Second, it discusses the various economic, financial and political challenges faced by the three types of countries. Finally, it will offer recommendations about what can do to cope with the economic challenges brought about by demographic change.

Demographic change in advanced, emerging and developing economies

When discussing the impact of demographic change on prosperity, it is helpful to divide countries into three categories: advanced economies (or high-income countries), emerging economies (or middle-income countries), and developing economies (or low-income countries). [1] Demographic trends in advanced, emerging and developing economies differ markedly, leading to different sets of economic (and political) challenges. For a start, the median age of high-, middle- and low-income countries is 40, 30 and 20 years, respectively.

Advanced economies are characterized by high per capita incomes, low economic growth and a rapidly increasing old-age population. In some cases, the population is even declining due to decades of below-replacement fertility rates. Where the population continues to increase, it is generally due to net immigration. In either case, the so-called old-age dependency ratio, defined as the share of people over 65 years relative to the population of working age, averages 30 in advanced economies, meaning that that for every person of retirement age, there are roughly three people of working age. In Japan, for example, the ratio is currently 50 and will reach 80 by 2050.

Emerging economies, characterized by middling per capita incomes but generally rapid economic growth, are also aging, in some cases very rapidly (e.g. China). But their old-age dependency ratio remains substantially lower than in advanced economies. Emerging economies are (or were until recently) in a demographic sweet spot as they experienced declining overall dependency ratios. China’s economic takeoff, for example, in the 1980s was demographically flanked by the effects of the one-child policy introduced in the late 1970s. Today, fertility rates have fallen to near or even below replacement levels in many upper middle-income countries, setting them up for rapid demographic aging over the next few decades. In today’s advanced economies, this transition was comparatively gradual. In many emerging economies it will be much more abrupt, meaning that related economic challenges will affect these countries more precipitously, if more predictably.

Developing economies have low levels of per capita income and are characterized by young, growing. The variability of economic growth is significant within this group. Similar to old-age dependency in advanced economies, a high youth dependency ratio in developing economies translates into a large share of economically inactive youth relative to the working-age population. 

How demographic change affects prosperity

The economic and financial outlook for the three groups of countries differs markedly. First, advanced economies have a significantly lower growth potential than emerging and developing economies. Advanced economies grow less fast because they operate near the so-called technological frontier. Low economic growth in advanced economies makes distributional conflict more intense, exacerbating challenges related to high debt and significant old-related expenditure commitments (see below). Emerging and developing economies find it easier to generate productivity gains due to physical capital accumulation and the adaptation of advanced-economy technologies. In principle, developing economies are even more favorably positioned, but they not infrequently fail to fully exploit their potential catch-up growth due to political and economic instability, among other things.

Second, advanced economies are faced with adverse labor supply dynamics, compared to emerging and developing economies. According to the standard economic growth model, labor, in addition to capital and technology, contributes to economic output. Expanding working-age populations, provided they are fully employed, will add to economic output, while a declining working-age population will subtract from it, all other things equal.

Third, advanced economies’ demographic aging can affect the level of savings (and hence investment and economic growth). As the share of economically inactive people, namely retirees, who do not produce but consume, increases, consumption will tend to increase and savings to decrease (relative to the baseline scenario where the old-age dependency ratio remains constant). This is akin to the life-cycle hypothesis which posits that savings peak in middle age. Indeed, the savings ratio in “middle-aged” emerging economies is significantly higher than in advanced and developing economies. Of course, many other factors affect savings and investment in an economy, but an increasing dependency ratio should, all other things equal, reduce or at least weigh on savings.

Fourth, advanced economies are, on average, characterized by high debt-to-GDP ratios and are faced with large age-related government spending increases. Social transfers and old-age related spending typically constitute the largest spending category in advanced economies. Moreover, advanced economies, but also some emerging economies, face large increases in age0-related expenditure, as represented by the net present value of future pension and health care spending. By contrast, the government debt burden (measured as a share of GDP) in developing economies is much lower, as is age-related spending. This does not mean that advanced economies are at lower risk of short-term financial instability. Although advanced and emerging economies have higher debt, they also benefit from a broader tax base, a more captive investor base, superior governance and higher per capita incomes, compared to developing economies. Nonetheless, the medium- and long-term financial challenges in the face of demographic change are significant in advanced economies, somewhat less so in emerging economies, and virtually absent in developing economies.

Finally, distributional conflict is easier to manage in rapidly growing emerging economies than in slow-growing advanced economies, particularly over age-related “acquired rights.” It is more challenging to rein in spending and/ or increase revenue in slow-growing economies, as a less rapidly growing “pie” makes distributional conflict more intense. In advanced economies, especially, an expanding grey majority keen on defending acquired rights also becomes electorally more influential given its growing share of the voting population. By contrast, a rapidly expanding youth population can lead to instability (‘youth bulge”). This also can make it harder to pursue a forward-looking policy consistent with long-term financial stability. Compared to advanced economies, emerging economies may find it easier to deal with distributional conflict given generally high economic growth rates as well as more limited pressure to rein in old-age spending.

RECOMMENDATIONS

Demographic change will have a major impact on the economic outlook and government finances, particularly in advanced economies, but also in many emerging economies. Developing economies also face demographics-related economic challenges. Here are recommendations what countries should do.

Advanced Economies

Advanced economies faced with slowly growing/ declining working-age populations, low trend growth, and increasing government debt should do the following:

> Devise policies to prevent further decline in economic growth by, for example, creating incentives for older workers to remain in the workforce, if only part-time, for longer and supporting the development and integration of productivity-enhancing technologies (e.g. AI).

> Increase fertility rates from below-replacement levels. However, few, if any countries have thus far proven successful at increasing fertility. Even countries with significant social policies (e.g. Scandinavia) have seen their fertility rates decline significantly. But it is worth experimenting with policies that can at least stabilize fertility rates at current levels.

> Reduce upward pressure on old-age-related government spending by adjusting benefits and making old age spending more targeted and efficient as well as by increasing contributions to the various regimes to adjust for increased longevity.

> Increase smart immigration by facilitating immigration and supporting immigrants by offering training and education to accelerate their economic integration, particularly in sectors experiencing labor shortages. Politically, this may be a delicate task given the prominent role played by anti-immigrant parties in many advanced countries. However, by explaining the benefits of immigration and facilitating economic integration and, if necessary, by offering temporary work permits only, governments can maintain greater control in view of political headwinds in many advanced countries.

Emerging Economies

Emerging economies faced with a rapidly slowing demographic momentum, a fair economic growth outlook and middling debt levels, should seek to avoid replicating the mistakes of advanced economies and should:

> Devise policies to support continued high economic growth. Individual policies will vary by country, as different economies face different challenges (e.g. high-saving China versus low-saving Brazil).

> Convert high levels of savings into productive, growth-enhancing domestic investment and/ or generate government savings to be invested in a sovereign wealth fund/ public pension to support future increases in old-age expenditure (e.g. Singapore).

> Limit future government old-age-related spending in view of rapid demographic aging. Avoid making expenditure commitments that will put stress on government finances in view of rapid aging by, for example, tying contributions and expenditure to projected demographic developments.

> Increase immigration (see advanced economies).

Developing Economies

Unlike advanced and emerging economies, developing economies have low savings rates due to a high youth dependency ratio, but significant catch-up growth potential, while a rapidly expanding young population creates economic and political challenges. They should:

> Maintain/ increase political and economic stability to exploit considerable economic catch-up potential and reduce the incentives for emigration of the most skilled individuals to high-wage economies where there is strong demand.

> Mobilize greater fiscal and financial resources to invest in education (among other things, including infrastructure) to make young people entering the workforce employable, particularly in view of AI and robotics.

> Pursue policies aimed at lowering the youth dependency ratio to enhance the economy’s savings potential. This should not be done in terms of incentives, ideally by way of educating women, strengthening their political rights and offering targeted, affordable old-age-related policies to reduce the incentives to have large numbers of children, particularly in poor, rural areas.

> Create attractive conditions to lure back emigrants through incentives, such as economically efficient tax benefits, before or after retirement.

American Budgetary Politics and Policies (2025)

The Republican majority in Congress is slowly but surely moving towards the approval of a large budget reconciliation bill, which would increase fiscal deficits, accelerate the increase in government debt and may weaken, but is unlikely to significantly undermine investor confidence. In recent days, the House of Representatives has made some progress toward agreeing on the details of a party-line budget reconciliation bill. Once approved, it will need to be modified by the Senate through reconciliation. The budget reconciliation process allows Congress to pass tax and expenditure legislation while circumventing the sixty-vote, super-majority requirement in the Senate (filibuster). The budget bill has made only slow progress due to the Republican’s narrow House majority and intra-party disagreement. Conservative House Republicans are keen to reduce the deficit and demand greater spending cuts. The House leadership is keen to implement the president’s mostly and costly tax-cutting-focused priorities, and centrist Republican House members in electorally vulnerable, purple districts generally oppose significant spending cuts and favor increased tax expenditure in the form of higher state and local government deductions. Increased pressure from the White House has helped advance the legislation, which moved out of committee last week, and the House leadership is pushing for a vote before Memorial Day. Although Republicans have only small majorities in both chambers, they are likely to pass the budget reconciliation in the few months, following successful reconciliation, which means that the final, final precise provisions and details will not be know for sure for a little longer.

> Republicans have only narrow majorities in both houses. They control 53 out of 100 seats in the Senate and 220 seats out of 425 seats in the House. This means they can only afford to lose three votes in the Senate as well as the House, where Democrats currently control 213 seats. (Two formerly Democrat-controlled seats are currently vacant. By threatening to withhold support, individual Republican House members have a significant degree of influence to shape legislation, making it difficult to reach agreement.

The budget reconciliation bill, if passed roughly in its current form, will help avoid a sharp increase in taxation next year when the 2017 Tax Cuts and Jobs Act (TCJA) tax cuts are set to expire, thus avoiding a significant shock to domestic demand and economic growth. Budget reconciliation addresses the expiration of several provisions of the (TCJA), originally enacted in 2017. The bill would avoid a sudden increase in taxes (so-called fiscal cliff), but it would do nothing, in fact in its current form it would significantly add to the government debt burden in the coming years. The budget reconciliation bill calls for $1.5 trillion in spending cuts and $4 trillion in tax cuts (scored against the current law scenario) The bill would extend Trump 2017 individual income tax cuts, increased standard deduction and childcare tax credit, cut taxes on tips and overtime pay as well as as boosting military and border security spending. The final bill will likely seek to rein in Medicaid spending (through stricter work requirements), reduce Biden-era green tech tax credits and increase the ceiling for state and local deductions.

> The Byrd Rule sets a budget window of ten years to limit the increase in government that can be enacted through budget reconciliation. The Byrd rule does not allow for extraneous provision to be included in legislation. Legislation is considered extraneous if it does not have a budgetary effect, if the budgetary effect is merely incidental, the effect is outside the jurisdiction of the committee recommending it, the effect is not what the original provision calls for, the measures affect social security spending and, importantly, it increases the deficit beyond ten years.

> The baseline budget deficit projection is based on federal spending and revenues under current budgetary practices. The current policy scenario assumes that all policies are extended, even if certain provision are set to expire, such as many TCJA cuts. The costs of the bill are calculated based on current law policies. According to the Congressional Budget office, extending the TCJA provisions, compared to current law, is projected to reduce revenues and increase deficits by nearly $4 trillion from 2025 to 2034. That is critical because a current-law baseline counts the extension of TCJA provision as a cost that, due to the Byrd rule (see below), would need to be offset with an equivalent of cuts to remain deficit neutral during the ten-year budget window.


If the budget reconciliation passes in roughly its current form, it will further accelerate the increase in federal government debt and is likely to put upward pressure on bond yields and government borrowing costs, while it may also be marginally dollar-negative. The government argues that the tax cuts, combined with economic deregulation, will pay for themselves. But tax cuts have never fully paid for themselves, and non-partisan agencies and think tanks project the federal debt-to-GDP to be roughly ten percentage points higher by 2035 than otherwise. This is likely to increase market concerns about the longer-term fiscal trajectory and lead to higher yields, but it is not likely to lead to significant financing challenges. The U.S. federal government has significant financing flexibility due to the breadth and depth of its financial, including treasury market and the international role of the dollar. But a significant sudden spike in yields may yet force the U.S. government to become fiscally more disciplined following the approval the budget reconciliation bill. Analysts and markets will become more concerned about the medium- to long-term fiscal trajectory if the bill passes in roughly its current form.

> Federal government debt held by the public amounted to 98% of GDP last year, compared to just 73% of GDP a decade ago, according to the Congressional Budget Office (CBO). The CBO projects federal debt to reach 116% of GDP in 2035 and 156% of GDP by 2055. This is before adding in the likely costs of the budget reconciliation bill.

> The non-partisan Committee for a Responsible Federal Budget estimates the legislation in its current form would $ 3.3. trillion to the federal debt burden (or roughly 10% of GDP,) or increase the debt ratio to 125% of GDP instead of 117% of GDP from its current level of around 100% of GDP.

> On Mary 16, Moody’s was the last international credit rating agency to strip the United States of its AAA sovereign credit rating. Standard & Poor’s had done so in 2011 and Fitch in 2013. Moody’s also forecast that the federal deficit would increase from 6.4% of GDP in 2024 today to almost 9% of GDP in 2035. The International Monetary Fund has called on the United States to reduce its deficits.


The short- to medium-term implication of the approval of a profligate budget reconciliation bill will be limited in terms of the international role of the dollar and the continued centrality of US treasury markets, provided the U.S. administration does not pursue other destabilizing policies. The U.S. treasury market is the largest, most liquid and most developed financial market in the world. A sudden breakdown of the market is unlikely, though increased volatility is possible. International investors have very limited alternatives. A worsening budget outlook may lead them to diversify further, but they will not aggressively dump the dollar and U.S. assets, as the deteriorating fiscal dynamics will lead to only a gradual, if persistent increase in U.S. government debt. Meanwhile, countries like China will continue to diversify their holdings, including through gold purchases and by moving into non-US-treasury assets. This will at the margin contribute to higher yields, and maybe a weaker dollar. But the degree to which investors and country can diversify their foreign assets away from the treasury market is somewhat limited. Alternative markets for safe assets are very small (Australia, Canada) or too fragmented (euro area) or even potentially more fraught with political and economic risk, in addition to being difficult to access (renminbi). Similarly, aggressive diversification out of the dollar by a country like China is also not likely. In addition to the above reasons, aggressive as opposed to gradual diversification would jeopardize trade negotiations, and if it were to lead to more serious market dislocation, lead to capital losses, a stronger renminbi, and it would risk a severe economic and political reaction from Washington. The most likely scenario is one of higher or high-ish yields on long-dated U.S. treasuries and possibly a weaker dollar, but no significant market dislocation, at least nothing worse than what U.S. treasury markets witnessed in 2019 and 2020 increase pressure on yields.

> in its April World Economic Outlook, the International Monetary Fund lowered its growth forecast for real GDP growth for 2025 nearly a full percentage point to 1.8% on the back of heightened uncertainty about U.S. trade policy.

> The yield on 30-year bonds temporarily exceeded 5% on Friday, following the Moody’s downgrade. According to the IMF, 59% of global foreign-exchange reserves are held in dollars and only 20% are held in euros. Renminbi holdings amount to only 2%.

Germany Reforms Constitutionally-Mandated Debt Brake (2025)

The impending approval of a historic reform to Germany's debt rules will allow for increased investment and higher defense spending, which will help raise medium-term economic growth in both Germany and the euro area. On March 18, the lower house of Germany's parliament, the Bundestag, approved a constitutional amendment to reform the country's so-called ''debt brake,'' a constitutional rule introduced in 2009 that restricts government borrowing, limits the structural deficit to 0.35% of GDP and requires states to run a balanced budget. The reform exempts defense expenditures exceeding 1% of GDP from the debt brake, thereby removing legal limits to German military spending. It also allows the next parliament to establish a EUR 500 billion special purpose fund to finance spending for civil protection, intelligence services and military aid for Ukraine, as well as infrastructure and climate-related investments. Additionally, the reform allows German states to run a deficit of 0.35% of GDP (up from the current zero deficit cap), but many states would need to reform their own legislation to take advantage of the loosened borrowing limits. The constitutional amendment will now go to a vote in the Bundesrat (the upper house of parliament) on March 21, where it is widely expected to pass. 

> The debt brake reform passed in the Bundestag with 512 votes to 206, thanks to the backing of incoming Chancellor Fredrich Merz's conservative Christian Democratic Union (CDU) and its prospective coalition partner, the center-left Social Democratic Party, along with the environmentalist Greens. In the Bundesrat, these parties only control 41 of the chamber's 69 seats, leaving them six votes shy of the two-thirds majority needed to pass constitutional amendments. However, the CDU's Bavarian sister party, the Christian Social Union (CSU), which controls six votes in the Bundesrat, has signaled its firm intent to support the debt brake reform when it goes to a vote in the upper house, despite the fact that the CSU's coalition partner in Bavaria, the Free Voters, remain skeptical about the reform.

> The debt brake has significantly constrained German government borrowing over the past 16 years, which has, in turn, prevented necessary infrastructure investment and a more proactive fiscal policy to support Germany's economic growth. Through its proposed reform, Merz's incoming government is also seeking to increase defense spending in response to U.S. President Donald Trump's March 4 decision to suspend all military aid to Ukraine and the broader uncertainty regarding future U.S. support for German (and European) security. 

A sharp increase in government spending will help boost Germany's medium-term economic growth, upgrade its defense-industrial base, lift asset prices and support the rotation out of the U.S. into European stocks in the context of an increasingly uncertain U.S. economic outlook and unpredictable U.S. policymaking. Germany's economic performance has been very disappointing following the energy price shock in the wake of the 2022 Russian-Ukrainian war and in the context of chronic underinvestment. A large-scale, investment-focused fiscal stimulus could boost economic growth over the medium term, though the precise growth effect will hinge on how well the money is spent and on what. That said, even if the money is spent poorly, it will help boost economic growth and revive economic confidence. Higher German economic growth will also help support eurozone growth, particularly in countries that supply the German market (like France and Poland) or are deeply integrated into German supply chains (like the Czech Republic, Hungary and Slovakia). Additionally, a stronger German economy will make Europe a more attractive investment location, continued regulatory impediments notwithstanding. 

> The International Monetary Fund has repeatedly highlighted the need for Germany to raise public and infrastructure investment. German real GDP growth is estimated to have averaged a mere 0.2% annually in 2020-24. High energy prices and increasing competition have hit Germany's chemicals and auto sectors particularly hard.

> Since the beginning of the year, European and German asset prices have increased as markets became convinced the debt brake reform will happen. Over the medium term, European asset prices and especially German and European defense sector stocks will continue to benefit from a successful reform of the debt brake. Banking stocks will also benefit from higher growth and higher interest rates. This will support a rotation of investors from the United States into European equities, not least due to U.S. political and economic uncertainty under the Trump administration.

Due to significantly higher German borrowing, euro-area interest rates will increase over the medium term, which will increase nominal debt servicing costs for all euro-area sovereigns, even as other economies stand to benefit from higher German economic growth. German debt is set to increase significantly from around 62% to 90% of GDP over the next ten years, according to some private-sector estimates, though any projections depend on how rapidly defense expenditure can and will be ramped up following the debt brake reform. This will not represent a financial problem for Germany due to its history of fiscal discipline, which has characterized policymaking since the establishment of the Federal Republic in 1949. However, higher European interest rates, combined with a larger fiscal deficit in other eurozone countries, will still further increase German debt levels. These developments could also renew concerns about fiscal sustainability in some of the more highly indebted euro area countries in the coming years, particularly those planning to increase defense spending in the context of more accommodating euro area fiscal rules.

Political Economy of Fiscal Reform in Brazil (2025)

Brazil’s economic growth has outperformed expectations post-COVID-19, but this improved economic performance is unlikely to be sustained over the medium term due to continued low savings and investment After years of economic underperformance following the car wash scandal, economic growth has outperformed market economists’ expectations. Brazil’s economic fundamentals are relatively sound in terms of its international financial position, commitment to a floating exchange rate regime and the government’s net foreign currency creditor position, all of which mitigate the risks of a balance-of-payments or sovereign external debt crisis. However, domestic government debt is high and fiscal deficits are high, raising concerns about the medium- and long-term outlook for debt sustainability, and hence economic growth.

> According to the IMF, real GDP grew by 3% annually in 2022 and 2023, and it is expected to expand another 3% in 2024, supported by strong domestic consumption, increased agricultural and hydrocarbon output and a less than anti-cyclical fiscal policy. Real GDP growth averaged 0.5% a year over the past decade. According to the World Bank, real GDP per capita growth averaged a negative 1.6% annually.

> The Brazilian public sector is net foreign-currency creditor. Less than 5% of Brazilian public debt is foreign-currency-linked. Brazil’s international financing requirements are low and the central bank sits on $350 billion of foreign-currency reserves, while the current account deficit is more than fully financed by net foreign direct investment flows.

> Compared to the other two large Latin American economies, Argentina and Mexico, Brazil compares favorably in terms of long-term economic growth. In the past thirty years, both Argentina and Mexico registered real GDP growth of 2%, compared to Brazil 2.4%. Over the past decade, Brazil grew 0.5% annually, compared to Mexico’s 1.5%, while Argentinian real GDP did not grow at all.

While Brazil’s international financial position is very manageable, a modest medium-term growth outlook and adverse fiscal dynamics represent will sooner or later force the government to pursue a much more restrictive fiscal policy. While such an adjustment is necessary to ensure medium- to long-term debt sustainability, if would also, if implemented forcefully, help free up resources to be invested in the economy to raise medium-term growth. But this is unlikely to happen on a meaningful scale, as the Lula government is struggling to implement more decisive short- and medium-term fiscal adjustment, particularly in view of the 2026 presidential elections. The government has reformed the fiscal framework, but is struggling to take more decisive actions aimed at a fiscal adjustment in the short term to help stabilize the debt-to-GDP ratio. The government has also failed to address longer-term fiscal concerns related to high levels of education, health and pension spending, which will sooner or later prove unsustainable. Significant reform remains unlikely in the next two years.

> In 2023, congress approved a constitutional amendment replacing the zero cap on growth in real federal spending, which had been in force since 2016, with a corridor for real spending growth tied to both revenues and the difference between projected and targeted primary fiscal balances. The amendment re-established floors for mandatory education and health as well as investment spending. While the reform committed the government to improving the primary balance from -0.5% of GDP in 2023 to 1% of GDP by 2026, these are indicative targets only and can be changed with a simple majority vote in congress. Mandatory spending increases mean that the government is constantly struggling to mobilize greater revenues, while it limits the amount of money that can be spent on investment.

> Absent reform, public pension spending is projected to increase from 12% of GDP in 2016t to 16% in 2025 to 26% in 2050. This is not sustainable. Pension reform in 1998, 2003 and 2012 were insufficient to significantly impact the path of future spending. Adjusted for age, Brazil has the largest pension expenditure in the world, according to the IMF.

> The IMF projects gross government debt to increase from 85% of GDP in 2023 to 95% of GDP by 2027, which represents a substantial increase. The IMF also forecasts the structural primary balance to improve by 0.5 percentage points of GDP annually, which will likely prove way too optimistic. It also forecast real economic growth of 2.4% annually, which is way above the ten- and twenty year average of 0.5% and 2.3%.

Structural economic reform necessary to accelerate medium- to long-term economic growth is always difficult, particularly so in Brazil. Brazilian presidents typically face an unwieldly congress in several ways. First, the president’s own party generally controls an often miniscule share of seats in the chamber and the senate, forcing the formation of often disparate “presidential coalitions”. Second, the number of congressional political parties and hence congressional fragmentation is high, which further weakens the cohesion of presidential coalitions. Third, party discipline in Brazil is very low, largely due to an electoral regime that weaken party-political control of candidates and favor personalistic policies. More recently, changes to the way budget policy is implemented further has further weakened the president’s ability to win congressional support for a cohesive, long-term economic reform agenda. Finally, many important economic reforms require amendments to the constitution and this require super-majorities to pass them. This is not impossible, but does make it more difficult to pass reform legislation than in other countries. If Brazil fails to implement major spending reform, particularly pension and social spending, it will sooner or later fail to comply with its new fiscal framework and government debt will inevitably become unsustainable. It also means that the government will fail to mobilize the fiscal space required to increase investment and support medium- to -long-term economic growth.

> Consisting of 82 members, the Senate has 11 different political parties and groups. The high degree of fragmentation tends to limit the size of presidential coalitions. The government coalition consists of 42 senators. Consisting of 513 member, the chamber of deputies has 16 different parties and political groups. The government coalition consists of 225 deputies, falling short of an absolute majority, hence requiring wide-ranging compromise with independents or the opposition to pass legislation.

> Members of the chamber of deputies are elected on the basis of open list proportional representation, which gives voters extensive influence over who they elect and weakens party political control over candidates, leading to personalistic and clientelist politics. The centrao, the broadly centrist group of members of congress that lack ideological conviction or cohesion and engage in clientelist politics, is a reflection of the open list proportional representation. Senators are elected on the basis of a plurality regime, but due to weak national political parties and the senatorial candidates’ need to maintain close ties with and rely on state governments and governors (and their political machines) to be elected, they are similarly independent from the parties they represent.

> The Brazilian constitution established extensive social and economic rights, which require constitutional majorities to be amended. This is possible, particularly as far as it concerns minor issues, but it is generally politically challenging due to 4/5 super-majorities in both chambers.

Despite a surprisingly strong growth performance, the medium-term outlook remains challenging, not least because sooner or later Brazil will need to overhaul public finances. Over the medium term, the government will need to implement a more forceful fiscal adjustment to prevent a further increase in government debt, not least given the large social and pension obligations. A future government will implement reform only gradually in terms of the politics and economics. Politically, radical reform is politically very unpopular as it affected “acquired rights”, which often are grandfathered in. Economically and financially, the effects of reform are limited in the sense that they typically seek to prevent a further rise of pension spending rather than a decline in a context where spending is set to increase due demographic dynamics. This will also mean that Brazil will continue to be characterized by a low, perhaps even falling savings rate, which will constrain domestic investment, particularly in public infrastructure, and future economic growth. Other structural reform, such as greater trade integration, may support higher medium-term growth, but progress will be slow, while the international trade environment is set to worsen in the next few years in the context of the U.S. presidential elections. With major structural reform unlikely before the 2026 elections, Brazil’s economic performance is likely peaking and will deteriorate as 2026 approaches and beyond.

> According to IBGE, Brazil’s population currently at 216 million is projected to peak at 220 million in 2041 in the context of a rapidly falling fertility rate (falling from 2.3 in 2000 to 1.6 in 2023, and projected to reach 1.4 by 2040). The old-age dependence ratio increased from 10 in 2010 to 15 in 2023 and is projected to 36% by 2050. Brazil’s working-age population is estimated to have peaked in 2021 as share of the total population.

> Trade integration, defined as exports and imports of goods and services, Brazil ranks 184 out of 195 countries. Agricultural product and fuels and mining account for 75% of total exports, only 25% manufacturing. China accounts for 26% of exports, followed by 15% for the EU and 11% for the U.S. China accounts for 23% of all imports, followed by the U.S. with 19% and the EU with 16%.

> Federal capital expenditure typically amounts to less than 1% of GDP and the public sector is net dis-saver, meaning most public sector net borrowing finances non-investment expenditure. Public sector dissaving is the major cause of a low domestic savings ratio of less than 15% of GDP, and hence low investment.

 

Why Europe Has Made Little Progress on Banking Union (2024)

Europe’s banking union remains incomplete and the prospect of significant progress toward closer integration, particularly with respect to a common deposit insurance scheme, remains unlikely, as creditor countries are unwilling to indirectly backstop debtor countries’ sovereigns. The euro area sovereign and financial crisis which started almost exactly fifteen years ago led European policymakers to the realization that Europe’s fragmented banking supervision regime, largely under the purview of national authorities, required significant strengthening. Economic and Monetary Union (EMU) had been intentionally designed in such a way as to force members to take responsibility for their own financial stability by prohibiting individual members from assuming the financial liabilities of others. In the face of the financial crisis late noughties, however, the absence of an overarching financial architecture capable of pre-empting a systemic financial crisis due to the so-called sovereign-bank nexus. In some instances, sovereign distress and default caused banking sector instability (Greece, Italy, Portugal). In others banking sector weakness led to sovereign financial distress (Cyprus, Ireland, Spain). Without the ability to intervene and backstop sovereigns and national banking sectors, this nexus risked turning into a self-reinforcing financial doom loop. In response to the Greek financial crisis, the euro area created financial instruments and a financial architecture to deal with financial instability by providing distressed countries with financial support in the form of loans issued to government. In the face of the Spanish banking crisis, Europeans then proceeded to consider the public, joint and direct recapitalisation of banks through the European Stability Mechanism, which originally was meant to provide loans to governments only. With a fiscal union not on the agenda due to creditor country opposition and a desire to sever the sovereign-bank nexus, banking sector union represented a second-best solution. The reform of the euro financial architecture, including the move towards banking union, allowed ECB President Mario Draghi to give his “whatever it takes pledge” in the summer of 2012, which effectively saved the euro area from a financial meltdown and potential breakup. 

> Pre-crisis, there existed only limited harmonisation of banking regulation, but only in the form of directives rather than regulations, such as the Banking Directive (2000) and the Capital Requirements Directive (2006). National authorities remained in charge of supervision. The EU also created a Committee of European Banking Supervisors (CEBS) in 2004.

> The Maastricht Treaty contains an enabling clause that allowed the ECB to take on prudential supervision of credit institutions and other financial institution, subject to Council approval and EU Parliament assent. This article formed the legal for the euro area members to establish a banking union and delegate supervision to the ECB.

> In 2012, the Van Rompuy proposed the establishment of a banking union, a fiscal union, an economic union and a political union to strengthen EMU and the EU. Banking union presented the path of least political resistance.

Banking union, as originally envisioned, was to consist of three pillars – supervision, resolution and common bank deposit insurance – but euro area governments only succeeded in establishing the first two. Rather than a politically impossible to achieve fiscal union to sever the bank-sovereign nexus, euro area governments agreed to move towards a banking union by establishing euro area level banking supervision and a resolution authority (including a resolution fund) to reduce the risk of destabilizing financial spill-overs by preventing bank failures from triggering sovereign distress and preventing sovereign distress from destabilizing the national and European banking sectors. The Single Supervisory Mechanism (SSM) entered into force in 2014 and transferred the supervision of larger euro area banks from the national supervisory authorities to the European Central Bank. Smaller and mid-sized remained under the supervision of the national authorities, but the ECB was given authority to intervene in them in case of a risk to systemic financial stability. The Single Resolution Mechanism (SRM), consisting of a Single Resolution Board (SRB) and Single Resolution Fund (SRF), transferred the authority to intervene in and, if necessary, resolve in an orderly fashion euro area banks to the body. But euro area governments failed to create a common European deposit insurance regime and a common backstop supporting the SRF. Instead, they issued a political declaration that a common backstop would be created to strengthen SRF within the next ten years. Meanwhile, member states would ensure that national deposit insurance schemes would accumulate sufficient funds to cover 1% of their deposits by end-2023, which would then be fully mutualized to support the SRF. 

> All twenty euro area members are members of the SSM. Non-euro area members have the option to participate in the regime.

> The SRF is financed by contributions from banks. A reform was meant to create a common public, if limited financial backstop to the SRF in the guise of a ESM revolving credit line of nearly EUR 70 billion in case SRF resources are insufficient to finance a resolution. This reform has been stalled due to Rome’s unwillingness to ratify ESM treaty change.

> The SRF is not meant to be used to absorb financial losses incurred by a distressed bank or to recapitalize it. Under certain circumstances, the SRF can provide substantial support to a bank under resolution, but only if at least 8% of the bank’s total liabilities have been bailed in and contribution must not exceed 5% of the bank’s total liabilities.

Efforts to establish a common European Deposit Insurance Scheme (EDIS) to guarantee euro banking sector deposits has not made any substantial progress, largely due to opposition from creditor countries like Germany, while the creation of common ESM-backed backstop to SRF has been blocked by the Italian government. As it stands, the SFR has only limited funds to deal with a systemic banking crisis. But creditor countries not willing to make a pledge to guarantee banking sector deposits in the guise of EDIS for fear of indirectly underwriting debtor countries banking sectors and sovereigns. Instead, Germany has pushed for higher capital charges on bank holdings of sovereign debt to reflect their inherent risk. Such concentration charges would reduce the risks to (debtor) countries’ banking sectors. This however is unacceptable to debtor countries, as they rely on their banking sector to provide financing, particularly during a crisis, and if necessary through moral suasion. The so-called regulatory treatment of sovereign exposures (RTSE) is a non-starter for debtor countries, while it is the starting point for creditor countries if they are ever to agree EDIS. Without progress on RTSE, creditor countries are not going to back a European deposit insurance regime, as they are concerned about indirectly risk insuring other countries’ sovereign risk. Meanwhile, the establishment of a (limited) common backstop to the SRF failed due to Italy’s failure to ratify the necessary ESM treaty change. Making further strides toward a more complete banking union will require euro area governments to find a compromise on how to deal with sovereign exposures and how to share the financial risks related to EDIS. The present relative stability of euro area banking sectors, which have managed to make it through the global monetary tightening relatively unscathed compared to some of its American peers, sharply limits the incentives to reach an agreement. It will require another major crisis for substantial progress to occur. 

> The SRF common backstop was meant to replace the so-called (unwieldly) Direct Bank Recapitalization Instrument. Italy continues to block changes to the ESM and has prevented the common backstop from entering into force. We need to send somebody to Rome to find out why the government opposes ratification. The we did not like the way we were treated a decade ago explanation does not strike one as a plausible explanation.

> The von der Leyen EU Commission failed to establish, or make progress toward a European deposit insurance scheme and create a common backstop to the SRF, despite its pledge to do so when it came to office in 2019. This shows just far apart creditors and debtors are on the issue of completing banking union.

 

How a “Defense Tax” Can Finance Europe’s Higher Defense Expenditure (2024)

See also: https://ip-quarterly.com/en/how-defense-tax-can-finance-europes-higher-defense-expenditure

Highly indebted European NATO countries should levy a “defense tax” to make their long-term commitment to higher defense spending politically credible and financially sustainable.

This year, 23 out of 32 NATO members are expected to meet the 2 percent of gross domestic product (GDP) defense spending target that the allies agreed to in 2014. While this is an improvement, the failure of nearly one third of NATO members to meet the relatively modest two-percent spending target speaks for itself. To strengthen its political-strategic and deterrence effect, defense spending needs to be made politically credible and financially sustainable. A long-term commitment to higher defense spending would also incentivize Europe’s private sector to make the investments necessary to rebuild Europe’s indigenous defense-industrial base.

European NATO countries have a sufficiently large economic resource base to balance Russia militarily. In terms of economic size, measured in purchasing power parity (PPP) terms to adjust for differences in prices, NATO GDP exceeds Russian GDP by a factor of 12, European NATO GDP exceeds Russia’s by a factor of six, and the combined GDP of Germany, the United Kingdom, and France exceed Russia’s by a factor of two and half. (Measured at market exchange rates, European NATO member GDP is more than 20 times larger than Russia’s.) 

The challenge European governments face is how to mobilize the necessary resources in the face of domestic distributional conflict. To the extent that greater resources are allocated to defense, fewer resources will be available for private consumption or non-defense investment (or both), unless they are borrowed from abroad. If the increase in defense spending comes primarily at the expense of private consumption, the population will be economically worse off. If it comes primarily at the expense of non-defense investment, longer-term growth will suffer. Allocating greater resources to defense implies economic tradeoffs and gives rise to domestic distributional conflict.

High Government Debt Constrains Larger European NATO Members

The five economically largest Western European NATO members (Germany, the United Kingdom, France, Italy, and Spain) account for 60 percent of European NATO GDP. Their ability to mobilize resources will have an outsized impact on European defense capabilities. But with the exception of Germany, government debt in these countries exceeds 100 percent of GDP and the International Monetary Fund (IMF) projects debt ratios to continue to exceed this level by the end of the decade. Financing substantial increases in defense spending through larger fiscal deficits therefore would seem at best financially imprudent. (All the other 25 European NATO members have more manageable debt levels of 80 percent of GDP or less, except for Belgium, Greece, and Portugal.)

Admittedly, France and the United Kingdom already spend 2 percent of GDP or more on defense, compared to 1.5 percent of GDP in Italy and Spain as well as Germany (if one discounts the contribution from its €100 billion special defense fund). However, should it become necessary to raise defense spending to 3 percent of GDP, as recently suggested by Poland, they would be faced with financial challenges. All of them are already faced with significant spending pressures as a result of higher spending related to demographic change, climate change, and defense. The European Central Bank (ECB) estimates that eurozone governments would need to raise an additional 3 percent of GDP – and substantially more than that in France, Italy and Spain – to cope with these increasing spending pressures and stabilize their debt-to-GDP ratios at current levels. But this would, according to the ECB’s projection, only prevent debt levels from increasing from today’s already high levels. It would require an additional 2 percent of GDP to bring government debt levels to the eurozone target of 60 percent of GDP. 

How to Finance Increased Defense Expenditure

So how should they go about financing higher defense expenditure? First, governments can increase defense expenditure by simply running larger deficits and accumulating additional debt. Germany has some fiscal space to do so in the short- to medium term. The other large European NATO members, as suggested, do not have that option. At the very least, it would be financially imprudent to do so, as it might undermine financial sustainability and therefore also political credibility. In terms of distributional politics, however, it would be the least challenging option, as it largely sidesteps distributional conflict by pushing the costs into the future and leaving it uncertain who will end up having to pay for higher spending.

Second, governments can cut non-defense spending (or, if no major immediate increase is necessary, reduce its increase relative to economic growth over time), thus freeing up resources to be spent on defense. According to the OECD, public social spending, by far the largest single expenditure category in the five countries, exceeds 30 percent of GDP in France and Italy. It is also high in Germany and Spain. 

Economically, reducing non-defense spending would be the preferred option, as the concomitant reduction in transfers to households for consumption purposes would help finance higher defense expenditure without reducing national savings. But politically it would be the most challenging option, as reducing social welfare spending or “acquired rights” typically mobilizes significant opposition, not least because who will incur economic losses, even if the materialize in the future, will be far less uncertain than in the case of issuing additional debt. Governments can also reduce public investment or other types of expenditure, like subsidies. But the former is costly in terms of foregone future economic growth, and the latter can just easily lead to significant political opposition if it affects well-organized or highly mobilized interests, such as farmers.

Third, governments can increase revenues, primarily income taxes, social security contributions, and taxes on goods and services. Higher taxes are hardly politically popular, and they, too, can trigger distributional conflict, particularly if they are perceived to exempt or favor one group over another. And increasing social security contributions to finance defense expenditure would be a difficult sell, even if higher contributions simply helped plug existing social security deficits and thereby allow the government to redirect resources to defense. But unlike spending cuts, higher taxes, if properly designed, can help spread the costs more evenly and more widely, thus limiting domestic political opposition.

Economic Effects of Higher Defense Spending Will Vary 

The macroeconomic effects of increased defense spending will depend on how they are financed, but also on how the additional funds are spent. If financed by additional debt in the absence of binding financial constraints, higher defense spending would provide a demand stimulus, at least in the short term. In debt-constrained economies, however, higher debt would increase the level of interest to be repaid, thus offsetting some or even all of the fiscal stimulus. In a worst-case scenario, it might undermine economic confidence altogether and force the government into a strategically disastrous fiscal retrenchment.

If financed by higher taxes or lower non-defense expenditure, the impact on short-term economic growth would likely be limited. Much would depend on where higher defense expenditure is directed. Increased spending on personnel, maintenance, and infrastructure would support domestic demand, while spending on overseas operations and equipment, much of which is currently being bought from abroad, would lead to what economists call fiscal leakage. But with spending on equipment typically accounting for about one third of defense spending, the broader macroeconomic drag—all other things being equal—would be limited. Over time, the build-up of intra-EU defense production capacity would also lead equipment spending to be redirected to the EU economy and support domestic and growth in the future. 

However, without a complete offset from a reduction of domestic consumption, allocating greater resources to defense would weigh on longer-term economic growth, at least in savings-constrained economies. Here again, Germany’s very large current account surpluses, which reflect “excess savings,” would provide it with much greater leeway to increase defense spending without jeopardizing non-defense investment than France, Italy, Spain, and the United Kingdom, whose current account positions are far less favorable.

European Governments Should Consider a “Defense Tax” 

In view of the need to raise defense spending in a financially sustainable and politically credible manner, fiscally constrained EU governments should consider introducing a “defense tax” at the national level. The related recurrent revenues should be earmarked for defense spending and finance the gap between current defense spending levels and current (and future) expenditure goals. If properly designed, such a tax would spread the financial burden broadly across society. 

This should help make it politically more palatable, compared to the alternative of financing increased defense expenditure through cuts to welfare spending. After all, the defense of the realm is a public good. So, everybody should contribute to it. Naturally, such a tax would not help governments avoid tackling broader, politically painful budgetary reform to address current and future spending pressures related to demographic change and the green transition. But by earmarking the revenue raised with the new tax for defense, it would go quite some way toward credibly and sustainably committing European governments to higher long-term defense spending, thus bolstering its strategic and deterrence effect.

Why Germany Can and Should Increase Defense Spending (2024)

See also: https://ip-quarterly.com/en/why-germany-can-and-should-increase-defense-spending

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