Are We Sleepwalking Towards a Federal EU?

NATO recently endorsed a new 5% defense spending target, which has been presented as a crucial response to the Russian threat and years of underinvestment in European militaries. However, a closer examination of the figures reveals that most European countries may struggle to meet this ambitious goal. This new target is divided into two main components: 3.5% of GDP allocated to core defense capabilities and an additional 1.5% of GDP for broader security initiatives, both to be achieved by 2035. For context, most European NATO nations currently spend approximately 2% of their GDP on defense, with total government spending accounting for between 40% and 50% of GDP. Achieving the 5% target would necessitate an increase in defense and security spending by about 2% of GDP over the next decade, effectively raising overall government expenditure by roughly 5%.

While a 5% increase in government spending might appear minor, many European NATO members will face significant challenges in affording it. Numerous European national budgets are already under considerable strain, evident from the substantial budget deficits and large outstanding debt burdens across the continent. This fiscal reality implies that most European governments cannot simply borrow their way to the new 5% target. Some political figures and commentators optimistically suggest that increased military spending could be self-financing by stimulating research and development, leading to broader economic productivity gains. However, this outlook seems overly hopeful, given that productivity levels in most developed countries have remained stagnant since 2008.

If these optimistic scenarios do not materialize, the necessary increases in defense spending will require either higher taxes or cuts to other public expenditures. European governments already impose some of the highest tax burdens globally, which are projected to rise further due to aging populations. Furthermore, spending cuts are politically unappealing. European nations are still recovering from the austerity measures implemented during the Eurozone crisis in the 2010s, which stifled economic growth and fueled the rise of anti-establishment political parties. Even shallow spending cuts provoked strong public backlash in countries like France and the UK, and few, if any, European governments have prepared their electorates for such measures.

This is why there is a widespread suspicion that this target will not actually be met, and that it's something NATO has just signed up to, to temporarily appease Trump with the ultimate intention of giving up on it once Trump leaves office.

The widespread suspicion is that this target will not genuinely be met, and that it serves as a temporary appeasement for Donald Trump, with the ultimate intention of abandoning it once he is no longer in office. This sentiment is already gaining traction, with Spain successfully securing an exemption and Slovakia requesting a similar arrangement. However, if Europe were to adhere to this target, it could very well pave the way for a substantial increase in joint EU borrowing, which would significantly transform the financial landscape of the European Union.

If Europe commits to the new NATO defense target, it could significantly increase joint EU borrowing. This approach is seen as the only viable alternative for the EU to finance such substantial spending increases, and it is more cost-effective than national-level borrowing. The EU can secure loans at lower interest rates compared to the majority of its member states, making joint borrowing an attractive fiscal strategy for significant defense investment. This would mark a pivotal shift in how European defense spending is financed and managed, highlighting a potential move towards greater financial integration.

The European Commission has already initiated steps in this direction with the Rearm Europe program, which proposes issuing €150 billion worth of new joint debt to support Europe's defense buildup. This initiative has been advocated for some time by figures such as Emmanuel Macron and the EU’s top diplomat, though it previously faced resistance from more fiscally conservative member states. However, this resistance predates the new 5% target, when most European countries anticipated that rebuilding their national defenses would only require a modest increase to around 3% of GDP at most. The increased pressure to meet the more ambitious 5% target could sway these previously reluctant states towards accepting joint borrowing as a necessary solution.

Furthermore, the group historically known as the “Frugal Four”—comprising Denmark, Sweden, Austria, and the Netherlands, which were the staunchest opponents of joint borrowing—has largely dissipated. Danish Prime Minister Mette Frederiksen explicitly distanced herself from the group last month, declaring her support for an increase in EU borrowing to fund Europe's defense buildup. Austria is currently experiencing a severe economic crisis, entering its third year of recession, which means it will be unable to finance significant increases in defense spending without European assistance. Sweden, being one of Europe's largest defense exporters, will also likely be more receptive to joint EU borrowing if it is directed towards defense initiatives, aligning with their economic interests. This leaves only the Netherlands, and given their domestic political instability, they will likely struggle to mount a solo opposition to joint borrowing.

Senior finance ministry officials from Sweden, Denmark, and the Netherlands reportedly attended a confidential meeting in March to discuss the feasibility of establishing a supranational bank specifically dedicated to joint defense procurement. This suggests a growing openness among these nations to a fiscal union, particularly if it proves to be cost-effective for their defense needs. This potential shift indicates a pragmatic acceptance of deeper financial integration when clear economic benefits, such as lower borrowing rates for large-scale defense projects, are evident. The discussions around such a bank underscore a significant change in the fiscal attitudes of countries previously known for their conservative stance on EU-level debt.

Historical patterns suggest that increased joint borrowing by a weak central authority during a crisis can be the first step towards a deeper political union. Many of the prominent federal states known today were formed when a crisis compelled a politically weak central government to act as a borrower of last resort. The subsequent process of repaying these debts often granted the central authority greater political power, eventually paving the way for a fully federal state. This historical precedent highlights a consistent mechanism by which financial necessity can drive political integration, transforming loose confederations into more unified entities.

At America's inception in 1776, the federal government, then the Continental Congress, lacked taxation powers and, much like the EU today, relied entirely on contributions from member states. Americans were initially wary of a strong central government. However, during the War of Independence, the Continental Congress had to assume the role of borrower of last resort to finance the war effort. Subsequently, it was compelled to acquire tax-raising powers to settle these debts, which ultimately laid the groundwork for the United States' political union. This pivotal moment illustrates how fiscal exigency can lead to a fundamental restructuring of political power.

Similarly, before the First World War, Germany consisted of numerous semi-independent states, and the Reich, effectively the federal government, possessed limited tax-raising powers, primarily through tariffs. The First World War then forced the Reich to intervene as a borrower of last resort. In the inter-war years, it subsequently acquired the power of direct taxation. This historical progression demonstrates a consistent pattern: a weak central authority incurs debt during a crisis, and then, after the crisis subsides, it assumes tax-raising powers to repay those debts, a capability the EU currently lacks. This process essentially creates a new unified state, consolidating power at the center.

The present situation does not definitively predict that the EU will become a federal state. However, the critical point is that the EU's decision to act as a borrower of last resort aligns with a well-established historical pattern that typically culminates in deeper political union. To some extent, this mirrors the EU's operational history, where successive crises have consistently propelled the continent towards the “ever closer union” originally envisioned by the Treaty of Rome. This ongoing trajectory suggests that the current fiscal challenges could similarly serve as a catalyst for greater integration.

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