Return on Investment? Understanding the Rationales for Increased Military Expenditure in Europe

CSDS POLICY BRIEF • 22/2025

By Daniel Fiott

29.8.2025

Key issues

• As an academic discipline, defence economics leans towards the conclusion that military expenditure does not contribute to economic growth, and, to the extent that it does, it is in limited areas.
• Ultimately, governments cannot justify defence expenditure based solely on potential economic returns, as military and strategic justifications are just as – if not more – important.
• Instead of the contribution that defence can make to the wider economy, it is worth considering how reform of the wider economy can help support the defence sector in Europe.

Introduction

Europe is increasing its defence spending. This is long overdue. Whatever one may think of the new 5% of GDP target set by NATO, and there will be challenges in meeting it, Europeans are slowly realising that they cannot continue to rely on the United States (US) for security. In many ways, the political agreement to invest 5% of GDP in defence over the coming years is symbolic of the geopolitical shifts affecting European security – the prospect of war has returned, and state budgets must reflect this. Coupled with the additional billions of euros of investment offered within the European Union (EU) via favourable loans, regulatory shifts and (potentially) the next budget (an expected total of some €900 billion), the problem no longer appears to be finding the investment for defence in Europe. In fact, some estimates suggest that EU member states will add as much as €200 billion in additional defence investment by 2027 (from €218 billion in 2021, to €426 billion in 2027). As data from SIPRI shows, every region in the world is experiencing increased defence spending.

If more defence investment in Europe is a given, then the main challenge is how best to invest the additional money for defence. Other questions emerge, too, such as: what military capabilities should be procured? How many units should be put into service? What defence technology domains should be exploited? However, with a surge in defence spending comes other challenges. Indeed, governments are under pressure to ensure that defence expenditure provides an economic return: without this return, the logic goes, it might be difficult to pay down debt or justify increases in military expenditure while cutting back on areas such as health, education or pensions. Drawing on the relevant academic literature, this CSDS Policy Brief analyses how defence economists assess the nexus between military expenditure and economic growth. It also reflects on how European states can justify higher levels of defence expenditure over a prolonged period of time.

The imperfect science: causality, tests, models

Economists have long studied the effects of military expenditure on economies. While several economic models are used to test the relationship between military expenditure and economic growth, there is one thing that all defence economists agree on: military expenditure does affect, for better or worse, the socio-economic features of any country or countries. Where this consensus falls apart is on whether increased military expenditure benefits economic growth over the short- and longer-term. Several economic models have been used to highlight the relationship between military expenditure and economic growth, but even here, there is a dispute between economists over how best to measure the benefits of increased defence spending. And if economists cannot agree on the best measure, then governments will struggle to assess the impact of defence spending, at least in economic terms.

Several studies have relied on the familiar “Granger causality test” to analyse the relationship between military expenditure and economic growth. It is a simple test. It essentially uses past data as a clue to future trajectories and trends – so, the past (x) can help us analyse the future (y). Yet, here we need to be careful as the Granger test supposes a correlation between the x and y variables rather than causation. Dunne and Smith have already warned that the Granger test sometimes confuses correlation and causality, and they highlight how the Granger test does not provide the correct structural model to assess the past and future, as it fails to include a wider range of economic factors. Other tools, such as the “Feder-Ram model”, have also been critiqued for favouring single variables such as productivity or exports.

Economists have found ways to get around these issues. For example, the “Johansen cointegration test” analyses multiple variables over a period of time, which at least allows the economic analyst to introduce a more diverse set of economic variables. The “Solow-Swan growth model” achieves something similar as it focuses on variables such as capital accumulation, labour growth and technological progress as key drivers of economic growth. The “Augmented Solow model” goes one step further in adding human capital as a crucial variable in economic growth. As the “Barro model” also makes clear, there is a need to analyse variables such as government policies, human capital and political institutions and how they can each impact growth long-term. Such variables can be assessed in terms of their reaction to shocks over time, with the so-called “Impulse Response Function” tool allowing the economic analyst to study the effects of socio-economic shifts or shocks.

In essence, any coherent economic model needs to assess a fuller range of factors that contribute to economic growth, as only then can the importance of military expenditure be properly assessed. Yet, uncovering the variables that can give us some clue as to the relationship between military expenditure and economic growth is not easy and is open to interpretation. In fact, reading the existing literature from defence economics reveals at least two main schools of thought on how military expenditure and economic growth interact: 1) military expenditure hurts economic growth; or 2) military expenditure has a positive impact on economic growth in some cases (e.g. over the short term, but not necessarily over the long term).

Some studies note that the correlation between military expenditure and economic growth is, in the main, negative. One such study noted that there was no evidence of economic growth on the back of military expenditure in select Balkan countries from 1990-2022. Although this study focused on the benefits of military expenditure in economic transition countries (i.e. former communist states), it indicates that benefits were not accrued in real terms. Another study by Wolde-Rufael on South Korea over the period 1965 to 2011 reveals that increased defence spending contributed to income inequality. Perhaps the most comprehensive study on the subject, which looked at 106 countries over the period 1988-2010, surmised that, in general terms, the military burden has a negative effect on growth in the short and long run. A further study, focusing on investment levels rather than growth over the 1960-2014 period, stated that there was no significant link between military spending and growth.

Other studies see a positive relationship between defence spending and societal welfare. A study by Gbadegesin of the “Group of 7” nations from 1971 to 2022 revealed that military expenditure had a positive impact on health, education and consumption in the short term, even while accounting for potential growth variables such as GDP per capita rates, trade, demographics and historical events. One other study shows how Mauritius, Fiji, Seychelles and Singapore all benefited economically from increased military expenditure. Other studies are less categorical and insist that military expenditure may indeed lead to economic growth, but only in the short term. For example, one study on Greece explained how, over the period 1962-1994, there was a short-term boost to profitability because of an initial expansion in demand, but overall negative rates of profit were experienced over the longer term. One other study compared the military expenditure/economic growth nexus in NATO and non-NATO alliances, and concluded that defence spending did increase growth in NATO because of certain positive spillovers resulting from a military alliance. We do have data that shows that the economic activities of defence firms make a sizeable contribution to high-skilled jobs.

Guns, butter and Europe

As European states increase their military expenditure, governments are at pains to stress the economic benefits of these investments. Democratic societies in Europe have, at least since the end of the Cold War, benefitted from a peace dividend – albeit one provided by the American security shield and the absence of great power rivalry. This allowed European governments to invest in other public domains such as health, education and social payments. We should also note that European integration accelerated after the Cold War, so public investments at the EU-level were required to enhance the socio-economic development and integration of states that were colonised by the Soviet Union. Today, priorities are different as Russia’s invasion of Ukraine in 2014 and the rise of Sino-American great power rivalry have ended the peace dividend in Europe. Although states are never confronted with an either/or choice between “guns or butter” or “warfare or welfare” (the question should be formulated as “how many guns and how much butter” can a state afford), the low fiscal space experienced within many EU states means that making more room for defence spending is a politically challenging one. In line with the “fear hypothesis”, this is especially the case for those European states that do not feel as though they face any immediate military threat – things do feel different in Liepāja, compared to Lisbon.

Given these differing threat perceptions, an emphasis on the economic return of defence investments has emerged. In fact, the European Commission recently produced its own assessment of the economic impact of higher defence spending, in which it concluded that an increase of 1.5% of GDP among member states in defence spending up to 2028 could result in a 0.5% increase in the EU’s real GDP rate. We should be clear, however, that this assessment has been used to justify the Commission’s reform of the Stability and Growth Pact to allow for flexibility for increased defence spending up to 1.5% until 2028. We should also acknowledge that the Commission’s economic assessment is based on simplified economic assumptions that do not consider factors such as production capacity constraints, R&D spillovers, infrastructure investment, etc. What the Commission’s economic simulations do consider, however, is that more defence expenditure may lead to higher public debt in the Union, which could lead to tax increases. The Commission also points out that the EU can expect lower economic returns if structural constraints such as infrastructure, R&D, labour supply and production capacities are not addressed.

However, there are limitations to such assessments, not least because Europe is not a uniform political entity. In fact, we still need to assess individual European nations to understand the full extent of the military expenditure/growth nexus. For example, one study indicates that the smaller, newer NATO members have greater income elasticity, which enables them to more easily increase and decrease military expenditure depending on economic performance. This is not the case for many medium and large European states, where there is little income elasticity or fiscal space. We also need to consider that each EU member state has a unique economic model where investment cultures, the size of the public sector and tax rates are very different – this can enable or constrain military expenditure and economic growth. What is more, economic assessments of the benefits/costs of increased defence spending are subject to the “creative accounting” practices of several European governments. For example, under NATO’s new 5% of GDP target, public infrastructure, such as a bridge, could be counted as an investment in alliance defence, but the economic benefits of this project could not be seriously classed as a defence investment stricto sensu, even though it may contribute to overall economic growth. And what is more, it is doubtful that other budget lines, such as intelligence, which can be counted in defence budgets, will provide any economic return on investment.

We might also accept that existing economic models have the direction of correlation or causality the wrong way around: instead of military expenditure leading to economic growth (or not), it is worth considering how increased economic growth may provide the headspace to increase defence spending. On this basis, it is perhaps no coincidence that the EU has simultaneously embarked on a ramping up of its defences and a drive towards greater economic competitiveness. In fact, there are reasons to believe that without economic reform in Europe, defence investments may struggle to really contribute to developing a European defence industry and military capabilities. Europe’s competitiveness problem today revolves around several issues, but they include a lack of innovation, technological development and skills development. What is more, Europe struggles with access to critical raw materials, which limits the degree to which European firms can produce cutting-edge technologies. What is needed today is the opposite of the last time the Union decided to boost competitiveness (circa 2008), which led to a period of economic austerity – neo-liberal precepts will not help the Union boost its real economy or sovereignty.

The political economy of defence expenditure

Economists overwhelmingly frame discussions about military expenditure in terms of economic growth. In this sense, economists largely favour factors such as production, capital allocation, investment, innovation potential, etc. Yet, we know from a military-strategic perspective that economic factors are not the only positive/negative result of military expenditure, as public goods can be generated too, such as deterrence and security. In this respect, economic studies in most cases rarely consider the strategic rationales for more military expenditure, even if, as the large number of papers suggest, such expenditure does not really result in economic growth. In short, military expenditure may not always make economic sense, but such expenditure does make strategic sense. This is especially true given that all other non-defence public goods (i.e. health, welfare, pensions, etc.) will suffer during wartime. In the so-called “frontline states” of Europe, increased defence spending is overwhelmingly justified and publicly accepted based on military and strategic rationales (i.e. without increased defence spending and stronger militaries, it will be easier for Russia to invade Europe again).

Where these military and strategic justifications fall on deaf ears, however, is in states that consider themselves far removed from the threat from Russia (although it should be noted that most European states are within striking distance of Russian long-range ballistic missiles). Still, for the vast majority of European states, a military and strategic justification for increased defence spending appears to be holding for now. This is why Germany has taken the historic decision to revise its debt brake rules to finance the Bundeswehr’s transformation into ‘the strongest conventional army in the EU’. What is more, when French President Emmanuel Macron announced in July 2025 his intention to boost the Republic’s defence spending to €64 billion in 2027, he did so by stating that ‘to be free in this world, we need to be feared’. Even the Belgian Prime Minister stated that ‘there is no social welfare without economic prosperity. And no economic prosperity without security and stability’, when justifying Belgium’s long overdue increase in defence spending.

However, even military and strategic justifications for increased defence spending come with significant challenges. The first major challenge is whether Europe’s defence ministries and procurement agencies can effectively absorb and utilise the additional investment levels. In most, if not all, European states, there is simply not the managerial capacity to effectively handle the increased levels of investment. Although there appears to be a consensus in Europe for a need for more tanks, missiles and ammunition, the truth is that many European governments have favoured the acquisition of specialist military capabilities over the growth, training and equipping of armed personnel, and, in many cases, armies have been downsized. Even now, governments are announcing hikes in defence spending while also stating that they do not have the financial space to increase the size of their armies. The British Army will, for example, remain the smallest size it has been for 300 years in this Parliament, even though the British government is raising its defence investment levels. Without investment decisions in personnel, people will simply leave the armed forces or not join in the first place.

Additionally, with more money comes the temptation to “use it or lose it”, and this invariably leads to wasteful procurement decisions. Although Europe’s militaries are rushing to fill military gaps that have festered for decades, greater defence spending also leads to difficult decisions about defence acquisition. Ideally, a country would invest its increased defence investment into equipment, systems and technologies developed in that same country. This is not reality, however. In this sense, defence ministries must decide between short-term acquisition, which may mean buying from abroad, or long-term investments in domestic development and production. Only a few countries have the financial bandwidth to mediate between the short and long-term horizons by buying from abroad and ramping up domestic production. In the main, increased European investments in defence usually find their way to non-European suppliers, which is a cost that militaries and governments usually justify based on equipment availability, performance, alliance management or work shares.

In reality, any assessment must consider both the economic and military/strategic costs and benefits of increased defence spending. For example, there may be military benefits but economic losses as a consequence of Europe’s dependencies on countries such as the US. Europe’s addiction to “buying American” may give access to technologies that Europe has not itself developed, but Europe’s defence industrial base will forego the full economic benefits of developing its own materiel. It remains to be seen how long European governments can continue to invest defence budgets in non-European military equipment without the public questioning the motive. On the one hand, some will argue that paying America and others for their defence equipment is an easy way to produce military capabilities and defend Europe more rapidly. On the other hand, some will argue that habitually procuring non-European equipment is effectively a subsidy of other defence markets, and it inhibits the growth of Europe’s own defence industrial and technological base.

Conclusion

We have considered in this CSDS Policy Brief the military expenditure/economic growth nexus, and it is clear that economic modelling and rationales only take us so far in understanding the return on investment that can be achieved through higher defence spending. Depending on the methodology employed, scholars arrive at different conclusions as to whether military expenditure positively or negatively affects economic growth. Despite the grave geopolitical situation in Europe, several governments are still sensitive to counter-arguments against higher defence spending, and creative ways of accounting for higher defence spending are aplenty. Higher military expenditure is not traditionally seen as a vote-winner in Europe, especially if it is perceived to crowd out other public investment areas such as health, education and/or pensions. In this regard, European governments should be prepared for greater scrutiny of their planned defence spending increases, which will entail a need for reform of defence procurement processes and ministries of defence. In this respect, defence spending without reform may lead to waste and, above all else, inefficiencies in defending Europe.

There is, however, also strategic – rather than economic – rationales for increased defence spending, as many European nations would still seek to increase their defence spending even if there were limited economic returns based on the military threats they face. This CSDS Policy Brief has stated that, depending on an EU state’s threat perception, a government may lean into economic or strategic rationales for increased defence spending, or some mixture of the two. States closer to the Russian threat, for example, can justify their defence spending on a strategic rationale. Those further away from Russia’s land and air forces may then rely more on economic rationales for increased defence expenditure, even though, as we have shown here, there is some debate over whether economic returns can be achieved from defence investments in some countries. So, there is no perfect formula for justifying increased military expenditure in Europe. In any case, as we have also argued here, without broader economic reform in Europe, the defence sector may struggle over the medium to long term.

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