Stability and Growth Pact

Stringent rules on fiscal policy have been hardwired into the policy architecture of the common currency area, the eurozone, which consists of twenty EU member economies (see table below). The currency union has from the outset been a neoliberal political project intended to free up Europe’s markets for private business and finance while restricting space for public policy and regulation.

Its structures rest upon a hierarchy of policymaking actors, in which monetary policy by the supranational European Central Bank (ECB) serves only to maintain price stability. Member states are to pursue policies promoting employment and economic growth at the national level by means of deregulated, flexible markets (first and foremost, the labor market), while rigid rules strictly circumscribe the scope for states to use fiscal policy in support of those objectives.

Encoded in the SGP, these rules force eurozone governments to maintain balanced budgets (over the business cycle), limit a (temporary) budget deficit to a maximum of 3 percent of GDP, and restrict their country’s public-debt trajectory to a maximum of 60 percent of GDP. The avowed purpose of these fiscal rules is to avoid potentially unsustainable public-debt trajectories that would result from “irresponsible” fiscal policy at the national level, because of their implications for the financial and monetary stability of the eurozone as a whole.

In reality, these one-size-fits-all rules have not prevented such unsustainable trajectories from developing, as illustrated by the cases of France, Spain, and Belgium. But they have ingrained austerity into the hearts and minds of policymakers in economies as diverse as Italy and Germany and led to grindingly slow growth, crumbling public infrastructure, and weakened social protection. Due to the SGP, the eurozone has become trapped in a deliberately depoliticized austerity mode and a corresponding democratic deficit.

The rigid fiscal rules became untenable in the wake of the COVID-19 pandemic and the subsequent energy crisis, as public spending was essential to navigate the recession caused by the breakdown of global supply chains, the lockdowns, and the Ukraine war. In effect, the SGP was suspended from 2020 until the end of 2023.

The pact was reinstated in April 2024, after a modest reform of the rules that offered eurozone countries some flexibility and respite to deal with “exceptional” emergencies in the form of “escape clauses.” Under these (general or national) escape clauses, eurozone countries subject to the excessive deficit procedure (EDP) may obtain permission to deviate temporarily from the standard fiscal rules and agreed-upon medium-term fiscal adjustment plans, in case of a severe economic downturn in the EU and/or a negative, temporary exogenous shock.

In 2024, twelve eurozone member countries have public debts in excess of 60 percent of GDP. Five countries (Belgium, France, Greece, Italy, and Spain) have a public-debt-to-GDP ratio higher than 100 percent; in Portugal, public debt is equal to 95 percent of GDP. Even Germany is breaking the rule with a debt-to-GDP ratio of 63 percent.

Governments in six countries have a fiscal deficit higher than 3 percent of GDP. Belgium and Italy have deficits in excess of 4 percent of GDP, while Macron’s government in France is struggling, in a tense political situation, to rein in a fiscal deficit of 6.2 percent of GDP.

Guns and Butter

France and the other countries cannot borrow more without paying much higher interest rates; their governments are significantly exposed to an increase in sovereign interest spreads and volatility or a reduction in growth. None of these countries has leeway for the kind of massive expenditure increase on remilitarization that is believed to be necessary today. For them, the SGP rules are close to irrelevant, as bond markets decide.

In Europe, defense spending falls short of the NATO norm (2 percent of GDP or higher) in all eurozone member states, with the exception of Greece and the Baltic nations. If defense expenditures are to increase, and assuming that Trump’s tariffs will cause a global recession, most eurozone countries will have to cut other items of public expenditure — on social security, pensions, education, climate change, and health care — if they have to adhere to the letter of the SGP. The “guns versus butter” trade-off is raising its ugly head again in Europe’s macroeconomic regime built on a dogged adherence to fiscal austerity.

Enter President Trump, whose confrontational retributive approach gave Europe an “electroshock,” in Macron’s words. The French president insists that Europe needs to boost its defense industries in the face of a reconfigured geopolitical world order:

We must also develop a fully integrated European defense, industrial, and technological base. This goes far beyond a simple debate about spending figures. If all we do is become even bigger clients of the US, then in twenty years, we still won’t have solved the question of European sovereignty.

For once, the European Commission concurs, declaring that the security emergency facing Europe in the wake of Russia’s war against Ukraine constitutes a set of “exceptional circumstances” that justify proclaiming a “state of exception.” At the Munich Security Conference in February 2025, European Commission president Ursula von der Leyen announced that she wants “to activate the escape clause for defence investments.”

In fact, no such specific escape clause exists. Hence the European Commission proposed instead to activate the temporary national escape clause available for individual countries under the SGP to accommodate defense spending without triggering the excessive deficit procedure. The national escape clause can be activated for a period of maximum of four years, starting in 2025, and is limited to an increase in only defense expenditure — up to a maximum of 1.5 percent of GDP.

It is for national governments to decide whether or not to use the extra room for budgetary maneuver. The four-year period seems rather short, however, given that defense expenditure now has to be ramped up for a long time, and contracts in this area stretch out over many years.

Deferring Responsibility

In effect, the European Commission is deferring responsibility (and funding) to national governments. This is where the trouble starts. Eurozone countries such as the Netherlands, Estonia, and Lithuania, which meet the SGP conditions, do not need to activate the national escape clause, since they have the policy space for higher military spending.

The escape clause is therefore relevant mainly for fiscally constrained countries with high public debts and/or high fiscal deficits. However, for Belgium, France, Italy, and Spain in particular, the availability of the national escape clause may not be enough.

These high-debt countries may fear that using the extra fiscal space created by the escape clause could result in negative reactions from bond-market investors who are already shaken to the bone because of Trump’s tariffs. In other words, these countries may hesitate to incur the extra risk associated with additional borrowing, however limited, for the sake of rearmament.

This particular fear is probably exaggerated, because the ECB will protect the face value of these bonds by duly making “secondary market purchases of securities issued in jurisdictions experiencing a deterioration in financing conditions not warranted by country-specific fundamentals, to counter risks to the transmission mechanism to the extent necessary.”

The backstop provided by the ECB, in turn, raises serious concerns that the use of national escape clauses will hollow out the credibility of the SGP and lead to problems of moral hazard. It will become more difficult to hold countries to the rules, once the exception becomes the rule and a bailout is all but guaranteed.

Europe’s high-debt countries may nonetheless prefer the safer option of common EU borrowing to finance extra defense spending. In lieu of euro bonds, the European Commission proposed to set up the Security Action for Europe (SAFE) financial instrument, worth €150 billion, from which member states can borrow (until the end of 2030) to fund additional defense expenditure, according to common criteria — most important, joint procurement and exclusive sourcing from European producers.

The proposed facility will be attractive only for those countries that cannot access the financial markets on more favorable terms than the commission. The proposed facility is surprisingly limited in size relative to the challenge posed by rearmament. However, a larger facility would likely have increased opposition from the (fiscally less constrained) EU countries that do not expect to benefit from it.

The German Debt Brake

The commission’s fiscal proposals have been overshadowed by the overhaul of Germany’s constitutional fiscal rule, known as the “debt brake,” in March 2025. In particular, Germany’s reform will do away with the borrowing constraint on defense-related spending (and includes a one-off spending package on infrastructure, climate protection, and the green transformation of the economy on the order of 10 percent of GDP).

The German reform does not rely on activating an escape clause, which by definition entails a merely temporary suspension of the normal functioning of the existing rules. Instead, it replaces the existing rules, specifically, by modifying permanently the upper limit on Germany’s deficit. The new limit would be essentially determined by the amount of defense expenditure (in excess of 1 percent of GDP). The interest rate on German bonds rose sharply in response to the debt-brake reform.

Germany’s debt-brake reform breaches the rules of the SGP: having a public-debt-to-GDP ratio in excess of 60 percent (in 2024), Germany should credibly adjust its fiscal policy to ensure that its debt is put on a “plausible downward path” in the medium term. Removing the borrowing constraint on defense expenditure will do the opposite.

Germany’s public-debt-to-GDP ratio is projected to rise to 90 or 100 percent in 2035 by economists including Lars Feld and Jeromin Zettelmeyer who assume that the higher public spending will not lead to a faster rate of (nominal) GDP growth. In contrast, according to Peter Bofinger, the debt ratio would increase to just 73 percent in 2035 if the reform generates additional economic momentum. Even in the latter case, however, since the overhaul of the debt brake is meant to apply permanently, the inconsistency between Germany’s new rules and the rules of the SGP will be hard to ignore.

Other member states, including those with less fiscal space, may follow suit and break the deficit and debt norms. Hence one way or the other, the conflict between the revamped German fiscal rules and the rule-based system that underpins fiscal policy coordination in the eurozone will have to be resolved in order to sustain the currency union.

One option would be to restore the ECB as the arbiter imposing a robust no-bailout rule, which would generate a strong incentive for fiscal discipline at the national level. However, pressure on the ECB to intervene in bond markets on behalf of countries facing difficulties in refinancing their debts will inevitably mount. This is especially likely once the larger, systemically vital eurozone member states — such as France, which is already in trouble —  end up in distress. Another option would involve a further reform of the SGP along the lines of Germany’s reconstituted debt brake, permanently exempting defense expenditures from the fiscal rules.

Fiscal Futures

What is likely to happen next? Does the permanent reform of Germany’s constitutional debt brake and the temporary exemption of defense spending from Europe’s deflationary fiscal rules augur a fundamental reform of the policy architecture of the eurozone? Does the turn to military Keynesianism portend a more sensible fiscal policy approach that will contribute to a renaissance of European growth instead of causing self-harm as was the case with the SGP?

It is difficult to make predictions, especially about the future. But the following inferences can be safely drawn. First, while the neoliberal logic underlying the policy framework of the eurozone can accommodate a temporary suspension of its fiscal rules (as a “state of emergency”), especially at times of critical threat to the system, it cannot cope with a permanent abandonment of these rules.

The dominance (or autonomy) of fiscal policy vis-à-vis monetary policy will only be possible in a political union that has monetary sovereignty — and even then, it will not have the blessing of establishment macroeconomics, which dogmatically mistrusts the fisc and worships the technocratic paternalism of “politically independent” central bankers. Hence at some point, we will see the reactivation of fiscal rules, probably somewhat modified, obliging eurozone countries to cut other items of public expenditure — assuming that the defense outlays will continue to remain elevated for a long time to come.

Austerity will not go away for as long as state finances remain structurally dependent upon bond markets. As a result, the capacity of the state to adequately and progressively tax incomes, corporate profits, and wealth remains constrained by neoliberal ideology (and political money) that legitimates the existing huge inequalities in income, wealth, and political power.

Second, it is difficult to consider the reform of the fiscal policy straitjacket to allow for higher military spending as a sensible macroeconomic strategy. The higher military spending will without doubt raise demand, create jobs, and generate additional growth in Europe, although the exact impacts will depend on how much of the equipment, software, and armaments will have to be imported.

Things are not looking bright in this respect. Of the approximately €75 billion in European aid pledged to Ukraine, around 80 percent had to be sourced from outside Europe — of which about 80 percent came from the United States. The economic benefits of European remilitarization are further constrained by the fragmented nature of public defense procurement in the European Union, as national interests continue to dominate decision-making and domestic defense industries are fiercely protected, with a lack of standardization of weapon types as the obvious result.

European defense companies are relatively small, leading to costly duplication of research and development and a lack of economies of scale. They are also far behind their American, Israeli, and Chinese competitors on AI-enhanced weaponry, cybersecurity, satellite and missile technology, and advanced armor technology. The €150 billion allocated to SAFE looks pathetic in light of the strategic military investments required.

However, the revival of military Keynesianism will lead to “crowding out” of the fiscal policy space for critical, forward-looking public investments in the renewable energy transition, (social) housing, education, health care, and climate mitigation and adaptation. The relative ease and speed with which the European Commission and member states have responded to Trump’s electroshock is remarkable — but equally remarkable is the deafening silence on the Green Deal and on Europe’s mounting socioeconomic problems.

The renewed military Keynesianism will do nothing to remove the democratic deficit at the heart of EU decision-making. However, it will twist technological progress toward defense, AI, and surveillance, all in the name of national security interests, which in combination with the prevailing income and wealth inequalities will have corrosive societal effects.

In a worst-case scenario, the EU may manage to build up sufficient military capabilities to ward off (real or perceived) foreign threats but will fail to resolve the real economic insecurities, financial difficulties, societal corrosion, and inequalities that distress large sections of its population. All this will further fertilize the breeding ground for far-right populism that has already been prepared by means of funding from billionaires. In the end, the “enemy within” could prove to be more dangerous than any external adversaries.