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Europe faces an unprecedented fiscal squeeze as NATO allies commit to spending 3.5% of GDP on defense by 2035, with discussions of a 5% target formalized at The Hague summit in June 2025. An IMF working paper published in March 2026 warns that debt-financed, synchronized defense spending may crowd out €375–526 billion annually in green investment and social spending while producing lower-than-expected economic multipliers. As sovereign debt ratios rise across the EU and the OECD Global Debt Report 2026 flags record borrowing levels, the continent must navigate a trilemma of military readiness, climate commitments, and fiscal sustainability.
The NATO 5% Pledge and Its Fiscal Implications
At The Hague summit in June 2025, NATO allies committed to invest 5% of GDP annually on defense by 2035, including at least 3.5% for core defense requirements and up to 1.5% for critical infrastructure protection, cyber defense, and resilience. This represents a dramatic escalation from the previous 2% guideline. According to the Hague Summit Declaration, the pledge responds to the long-term threat from Russia and persistent terrorism. However, Spain has indicated it is opting out, signaling divisions within the alliance over the financial burden.
The NATO defense spending targets come at a time when European economies are already stretched. The OECD Global Debt Report 2026 reveals that combined sovereign and corporate bond markets have reached a record USD 109 trillion, with OECD central government borrowing surging to USD 17 trillion in 2025. Outstanding sovereign debt hit USD 61 trillion, and gross borrowing is projected at USD 29 trillion in 2026 — 17% higher than 2024. The debt-to-GDP ratio for OECD central governments reached 83% in 2025 and is projected at 85% in 2026, while interest expenditures climbed to 3.3% of GDP, approaching decade highs.
IMF Warning: Crowding Out and Lower Multipliers
The Crowding-Out Effect on Green and Social Spending
The IMF working paper (No. 2026/053), authored by Furceri, Juarros, Mishra, Nguyen, Pessoa, and Sollaci, estimates that debt-financed defense spending could crowd out €375–526 billion annually in green investment and social spending across the EU. This is particularly concerning given the EU's Green Deal commitments and the need for social cohesion. The EU Green Deal investment needs are already substantial, and diverting funds to defense could delay the transition to net-zero emissions.
Lower-Than-Expected Economic Multipliers
The IMF study uses two complementary approaches: an annual panel dataset covering 27 EU countries from 1989–2023 and a novel high-frequency dataset of monthly defense procurement contracts from Opentender (2009–2023). It finds that past defense spending stimulated short-term economic activity with sizable cross-border spillovers, but multipliers varied considerably. They were larger when import intensity was low, fiscal space was ample, and public investment efficiency was high. Equipment procurement had the strongest relative impact on output.
However, the larger and more synchronized nature of the current European defense buildup may produce multipliers below historical estimates, especially if monetary policy is not accommodative. This is a critical finding: the simultaneous ramp-up across multiple countries could dilute the economic benefits while amplifying fiscal strains.
The Sovereign Debt Dimension
The OECD Global Debt Report 2026 highlights several vulnerabilities. A critical trend is the shift toward treasury bills, which now account for 48% of total borrowing, reducing immediate costs but increasing refinancing risk. The investor base is also changing, with central banks shrinking their holdings and price-sensitive investors like hedge funds growing, which could amplify volatility. Emerging market sovereign borrowing hit USD 4 trillion in 2025, the highest debt-to-GDP ratio since 2007.
For Europe, rising debt-servicing costs and the need to finance both defense and climate goals create a classic trilemma. As OECD Secretary-General Mathias Cormann warned, rising debt-servicing costs and growing AI financing needs demand sound fiscal policies and growth-oriented reforms before markets force the issue. The European sovereign debt crisis risks are not imminent, but the trajectory is concerning.
Expert Perspectives
Economists are divided on the path forward. Some argue that defense spending can be structured to boost innovation and industrial capacity, particularly in high-tech sectors. The IMF paper notes that equipment procurement has the strongest relative impact on output, suggesting that investment in advanced defense technologies could yield dual-use benefits for civilian economies.
Others warn that the sheer scale of the required spending — potentially 5% of GDP for some countries — is unsustainable without significant tax increases or cuts to other programs. "The math simply doesn't add up without either raising taxes to levels that would stifle growth or slashing social and green spending," said one EU fiscal policy analyst. The IMF paper itself cautions that debt-financed spending could lead to higher borrowing costs and reduced private investment.
FAQ
What is the NATO 5% defense spending pledge?
At The Hague summit in June 2025, NATO allies committed to invest 5% of GDP annually on defense by 2035, with at least 3.5% for core defense and up to 1.5% for infrastructure, cyber, and resilience. This is a significant increase from the previous 2% guideline.
How much could defense spending crowd out green investment?
The IMF March 2026 working paper estimates that debt-financed, synchronized defense spending could crowd out €375–526 billion annually in green investment and social spending across the EU.
What does the OECD Global Debt Report 2026 say?
The report reveals record sovereign borrowing of USD 17 trillion in 2025, outstanding debt of USD 61 trillion, and a debt-to-GDP ratio of 83% for OECD central governments, projected to rise to 85% in 2026. It warns of rising refinancing risk and a shift toward price-sensitive investors.
Why might defense spending multipliers be lower than expected?
The IMF paper finds that the larger and more synchronized nature of the current European defense buildup, combined with tight monetary policy, may produce multipliers below historical estimates. Multipliers are higher when import intensity is low and fiscal space is ample.
Can Europe afford both defense and climate goals?
This is the central trilemma. Without significant fiscal reforms or growth acceleration, Europe may struggle to meet both NATO defense targets and EU Green Deal commitments while maintaining debt sustainability. The EU fiscal rules reform will be critical in determining the outcome.
Conclusion and Future Outlook
Europe's rearmament dilemma is not merely a security question but a fundamental economic challenge. The IMF's analysis suggests that the path to 5% defense spending is fraught with risks, including crowding out of green investment, lower economic multipliers, and rising sovereign debt costs. The OECD's debt report underscores the fragility of global bond markets, which could amplify any fiscal missteps.
Policymakers must therefore pursue a balanced approach: prioritizing high-multiplier defense investments (such as equipment procurement), improving public investment efficiency, and coordinating fiscal and monetary policies to avoid exacerbating inflation. The European Central Bank monetary policy stance will play a crucial role. Ultimately, the success of Europe's rearmament will depend on its ability to integrate defense spending with broader economic and climate strategies, ensuring that security does not come at the expense of sustainability.
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