European financial markets have reacted positively to the fiscal stimulus from a $1 trillion defense plan, ‘ReArm Europe. But a step-up in defense expenditures is not an economic panacea.
The fiscal multiplier, which measures the effect of an extra dollar of government spending on GDP, is estimated to be around 0.5x for defense (compared to over 1x for infrastructure.) Indeed, defense spending generally creates headwinds for the private sector in both the financial and real world.
Financially, Europe's substantial defense spending risks triggering a classic ‘crowding out’ effect. By borrowing to fund military expenditure, competition for capital increases and naturally raises its cost (interest rates), as seen in Germany last week, with negative implications for all economic actors.
In the physical world, reallocating labor, land, and commodities toward defense production also diverts critical resources from economically productive sectors. Most concretely, although mandatory military conscription, back on the agenda in many countries, may foster social cohesion and help prepare for combat, it entails significant economic costs in terms of productivity losses and disruptions to civilian careers.
While this may hold true for many European nations, Germany is in a unique situation. With its automotive industry facing structural challenges, it has room to redirect labor and manufacturing capabilities toward defense. Defense spending thus represents a form of ‘military Keynesianism’ – an established fiscal policy tool in the US last used in the 00s – noting Germany’s considerable fiscal firepower.
Aside from the potential squeeze of the private sector at the European level, there are a few important considerations as the Old Continent builds its war economy.
Militarization alone will not resolve Europe's pressing external dependencies in energy (e.g., fossil fuels), pharma (e.g., antibiotics), and certain raw materials (e.g., cobalt, lithium, rare earths) as identified in a 2021 EU report. If these shortcomings are not addressed, Europe’s defense strategy risks being weakened from within. With this in mind, energy security (renewable energy, nuclear, and energy efficiency) contributes to a holistic geopolitical response.
Europe’s defense investments must prioritize dual-use technologies. Supported by a coherent industrial policy, R&D efforts in areas like drones, AI, and nanotechnology would bolster both military capability and civilian innovation throughout the broader economy and help address the previously mentioned strategic vulnerabilities. New investment themes would emerge, extending beyond defense, in fields such as advanced manufacturing, cybersecurity, or healthcare.
Finally, the recent experience of the ‘COVID economy,’ akin to a ‘war economy,’ stresses the need to prevent governments from overstepping when it comes to individual freedoms and fiscal policy.
In sum, it takes much more than buying armaments to build a strong economy ready to defend itself. Ultimately, Europe’s path to resilience lies in strengthening the assets and values it seeks to protect. That is what the financial markets can be excited about.
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