Breaking the Austerity Taboo: Innovative Defense Financing Through Military Bonds

Europe’s Aversion to Debt vs. Defense Needs: The same European bias against debt-financed stimulus that marked the euro crisis has, in recent years, hampered Europe’s ability to respond to new challenges – notably the need to significantly increase defense spending in the face of Russian aggression. Most European countries have for decades kept defense budgets low (often under 2% of GDP) and relied on the U.S. security umbrella. Now, with geopolitical tensions high, there is broad agreement that Europe must “re-arm” and build a self-sufficient defense.

However, many EU nations – especially in the Eurozone – face fiscal constraints and political reluctance to boost spending. Highly indebted countries like Italy or Spain worry that borrowing for tanks and missiles will violate EU deficit rules or alarm bond markets. Even fiscally sound Germany, after announcing a big defense fund post-Ukraine invasion, ran into its own debt-brake limits and bureaucratic slowdowns.

In aggregate, the European Commission estimates €500 billion in additional defense investment is needed over the next decade reuters.com. Meeting this with normal budgets would push several countries over the EU’s 3%-of-GDP deficit cap. European fiscal rules historically have not prioritized military spending – unlike, say, Cold War U.S. policy, where defense was often treated as off-budget emergency spending (or financed by war bonds). Thus Europe’s aversion to debt financing isn’t just an economic issue; it directly impacts security preparedness.

Why Conventional Solutions Fall Short: European leaders are actively discussing ways to square this circle. One idea is simply to exempt defense spending from EU fiscal rules, effectively ignoring those costs when calculating deficits​ reuters.com. Indeed, in 2023 the Commission has signaled it may allow such exclusions for defense. However, not all member states agree – some hawks fear this opens the door to creative accounting.

Another approach is to use the EU’s budget or joint funds: for example, channeling unspent EU Recovery Fund loans (on the order of €90 billion) into defense projects ​reuters.com, or beefing up the next multi-year EU budget to include defense outlays​ reuters.com. Yet the EU budget is small (around 1% of EU GDP) and notoriously difficult to increase due to unanimous approval requirements.

A more ambitious proposal, backed by countries like Italy and Poland, is to engage in common borrowing for defense – essentially Eurobonds for military investment ​reuters.com. This could mean a dedicated “European Defense Fund” that raises money with EU-backed bonds and distributes it for joint capabilities. Such joint debt would spread the burden and not immediately show up as national debt. Investors, in fact, might welcome more EU issuance; EU bonds from the 2021 Recovery Fund were highly demanded and seen as safe assets ​reuters.com.

However, as noted earlier, Germany and some northern states remain wary. Germany’s Constitutional Court would likely scrutinize any new joint borrowing; it already insisted the pandemic Recovery Fund be one-time and not a template for permanent debt union​ reuters.com. So politically, Eurobonds for defense are a “hard sell” in Berlin​ reuters.com.

The Case for ECB-“Backed” Military Bonds: This is where unconventional thinking comes in – borrowing a page from the euro crisis playbook (quantitative easing, etc.) and extending it to defense. Some economists and officials have floated the idea that the European Central Bank could indirectly support defense spending by purchasing “military bonds.” The notion is that the EU or member states would issue special bonds to fund defense investments, and the ECB would buy these bonds in secondary markets (as it did for government bonds under QE programs). If needed, the ECB could hold these bonds indefinitely or even write them off eventually, effectively monetizing the defense effort.

Canceling or perpetually rolling over the debt would mean that European governments get the defense equipment without ever having to fully repay the cost – the burden would be absorbed by the central bank. This sounds radical, but in economic substance it’s not far from what already happened under QE: the ECB amassed trillions in government bonds, rebating interest back to governments. As analyst Paul De Grauwe notes, once government bonds are on a central bank’s balance sheet, they “do not exist anymore from an economic point of view” – the interest payments circulate back to the treasury, and if the bonds are simply rolled over, the government effectively never has to repay in real terms​ blogs.lse.ac.uk​blogs.lse.ac.uk. Whether the ECB records them at face value or zero makes little practical difference as long as inflation is under control​blogs.lse.ac.uk​blogs.lse.ac.uk. In other words, monetary financing of one-time expenditures can be achieved without immediate ill effects, provided it’s done in a controlled manner.

In the context of defense, this approach offers a way to bypass the Eurozone’s fiscal rigidity. Instead of each country trying to squeeze tanks out of tight budgets, a European-level bond (guaranteed by the ECB’s willingness to buy) could finance a rapid buildup. If the ECB later “forgave” those bonds or kept rolling them over at 0% interest, the cost would effectively never hit national ledgers. This is analogous to how major wars have often been financed by central banks. For instance, during WWII, the U.S. Federal Reserve capped interest rates and implicitly monetized much of the war debt; after the war, debt-to-GDP was very high (over 100%), but inflation and growth gradually reduced the burden without any default or crisis. There was inflation post-war, but not runaway hyperinflation – and the extraordinary circumstances justified the temporary monetary expansion.

Inflation Concerns: The immediate objection to any form of “printing money” for spending is inflation. However, there are arguments why defense spending financed by the ECB need not trigger an inflationary spiral, especially if designed carefully.

First, the scale – while €300–500 billion is large, it would be spent over, say, 5-10 years. Spread across a €14 trillion euro-area economy, that’s on the order of 0.5%–1% of GDP per year – significant but not enormous. During the pandemic, the ECB created far more money in a short time without lasting inflation (the recent inflation spike was driven mostly by supply shocks like energy, not demand overheating from fiscal stimulus).

Second, defense procurement is a more controlled form of spending. Unlike handing out cash to consumers (who might then go bid up prices of goods), defense budgets go into specific capital projects, salaries for military personnel, and R&D. Much of the equipment will be produced over multiple years by a few contractors – this can be scaled without immediately hitting supply bottlenecks in the broader consumer economy. In fact, if European defense production has slack or can be expanded (new factories for ammunition, etc.), the spending increases supply capacity (jobs, output in the defense sector) alongside demand.

Moreover, some defense spending may effectively leak outside the consumer economy – for example, if countries import some weapons from the U.S., that portion doesn’t create Eurozone inflation pressure (though it does not stimulate the local economy either).

Another key point: Defense spending is investment-like, not recurring consumption. It adds to public capital (military hardware, infrastructure) and doesn’t directly put money in households’ pockets to chase everyday goods. And importantly, the ECB can calibrate its involvement – it need not announce “we will buy and cancel all military debt” upfront. It could simply start by ensuring bond markets remain liquid and interest rates low for defense-related issuance. If inflation did start to rise too fast, the ECB could slow or stop purchases to cool demand (just as it would with any economy-wide QE).

Essentially, as long as the ECB remains committed to its 2% inflation target in the medium term, financing defense should be manageable. Even De Grauwe’s analysis of debt cancellation concludes that if the ECB sticks to an inflation target, canceling debt per se makes no difference to inflation outcomes​ blogs.lse.ac.uk​blogs.lse.ac.uk – what matters is how much money is in circulation relative to output. The ECB can always sterilize excess liquidity if needed by issuing its own bills or raising reserve requirements (tools it has used in the past).

Finally, historical precedents show that debt-funded military buildups don’t inevitably cause runaway inflation. The United States during the Cold War ran persistent deficits to finance arms races (Korea, Vietnam, Reagan-era defense surge), and while inflation did rise in the 1960s, it was largely due to policy missteps (keeping rates too low, oil shocks, etc.) rather than the mere fact of defense spending. In the 1980s, the U.S. sharply increased military spending while the Fed kept monetary policy tight – result: large deficits but inflation actually fell. The lesson is that fiscal expansion can be offset by monetary control to keep inflation stable.

In Europe’s case, ironically, defense outlays could be increased while other demand (e.g. some consumer spending) is cooling due to higher interest rates currently aimed at fighting inflation. This means there is room to redirect some economic resources from private consumption to defense without causing overall overheating. Indeed, one could argue Europe is facing a form of supply-side constraint (security) that justifies public investment even if private consumption is curtailed a bit by interest rates. In economic terms, spending on defense in the current environment – where growth is sluggish and investment needs are high – could be a form of productive stimulus that also addresses an existential external threat.

“Military Bonds” and European Unity: Beyond pure economics, having the ECB back a “military bond” program could signal political unity and resolve. It would show that Europe is willing to break old taboos for a common cause. Legal hurdles would of course be significant; the ECB’s mandate does not explicitly include defense. But one could envision a scenario where EU governments declare defense a common European priority and adjust the legal framework (or interpret existing clauses) to allow central support.

In fact, ECB officials like Greece’s Yannis Stournaras have hinted that “if the EU has a common objective to boost defense spending, the ECB can discuss what it can do to support that goal”, noting that the ECB’s treaty mandate allows it to assist EU policies as long as its primary price-stability goal is met​ politico.eu​politico.eu. This suggests some openness, at least conceptually, to aligning monetary policy with critical fiscal imperatives such as defense in extraordinary times. During the pandemic, the ECB showed flexibility by launching the PEPP bond-buying program with relaxed country limits, explicitly to support the fiscal response to COVID. A parallel could be drawn for a defense emergency.

Toward a New Paradigm: The Eurozone’s experience over the past decade highlights the dangers of one-sided, austerity-focused policy and the importance of demand-side management in a integrated economy. Austerity as a route to competitiveness proved largely a fallacy – it crippled growth and ended up worsening debt ratios in the short term, revealing the paradox of thrift on a grand scale. A more symmetric and pragmatic approach, with surplus countries stimulating their economies, would have likely produced a faster and more balanced recovery. Germany’s structural fear of inflation and legal strictures prevented that, at great cost to the periphery and ultimately to Germany too (which lost export markets and now faces a legacy of political resentment).

Looking forward, Europe can learn from these mistakes. Policy flexibility and balance are key. In the realm of defense, this means recognizing that fiscal rigidity must not trump existential security needs. If ever there was a case for bending the rules or innovating, a military threat on Europe’s border is it. Proposals for ECB-backed “military bonds” or EU-wide defense funds should be evaluated not with the old austerity mindset, but with a pragmatic eye to economic capacity and stability. The evidence suggests that with slack in the economy and prudent oversight, Europe can significantly increase spending on defense (or other public priorities like green investment) without unleashing harmful inflation, particularly if that spending is coordinated and focused. Just as importantly, doing so through common European mechanisms (like joint bonds) would prevent fragmenting the Eurozone along financial lines – no country should be forced to choose between fiscal orthodoxy and national security.

Policy Recommendations:
- Going forward, Eurozone leaders should consider a more balanced macroeconomic strategy. This includes allowing higher inflation in surplus economies in a controlled way when needed to facilitate adjustment, and using EU-level fiscal tools to support weaker members during downturns (so that austerity is not the default).
- The ECB, for its part, should maintain its inflation target but be willing to get creative in exceptional circumstances – much as it did to save the euro, it may need to do to safeguard Europe’s security and future. For example, an ECB-facilitated European Defense Fund could finance critical investments with minimal impact on national debts or inflation, especially if paired with supply-side measures (increasing defense production capacity).
Europe’s challenge is to overcome the “ghosts of inflation past” and the politics of moral hazard, and realize that sometimes the bigger risk is doing too little, not doing too much.

The euro crisis showed that insistence on belt-tightening by all led to a deeper hole. By contrast, a bit more boldness – a willingness to mutualize burdens and boost demand when needed – can make the whole Eurozone stronger, whether in economics or in defense.