The week of March 3, 2025: Funding Europe’s NATO gap, tariffs, industrial policy, the congestion tax, and much, much more.
The week of March 3, 2025: Funding Europe’s NATO gap, tariffs, industrial policy, the congestion tax, and much, much more.
In June 1991, Jacques Poos, the foreign minister of Luxembourg, was also president of the European Union’s Council. The EU, he proclaimed, was going to sort out the growing crisis in Yugoslavia: “This is the hour of Europe, not the hour of the Americans.” That hour lasted about five minutes. Years later peace returned to the Balkans, but it took the hard power of an American-led NATO to restore it.
The return of Donald Trump, a growing realization of the extent of America’s fiscal woes, and the eruption of interlinked crises over trade, NATO, and Ukraine, has forced a new “hour” upon Europe, an hour for which it will be expected to pay, but with what? Many of NATO’s European members are as financially stretched (or worse) as the U.S. But their creditors are less understanding, at least for now.
What I call Ferguson’s Law states that any great power that spends more on debt service than on defense risks ceasing to be a great power. The insight is not mine but originates with the Scottish political theorist Adam Ferguson, whose “Essay on the History of Civil Society” (1767) brilliantly identified the perils of excessive public debt…
Economists have long sought in vain a threshold that defines how much debt is too much. My own formulation of Adam Ferguson’s idea focuses our attention on the crucial historical relationship between debt service (interest plus the repayment of principal) and national security (expenditure on defense, including investment in research and development).
The crucial threshold is the point where debt service exceeds defense spending, after which the centripetal forces of the aggregate debt burden tend to pull apart the geopolitical grip of a great power, leaving it vulnerable to military challenge.
The striking thing is that, for the first time in nearly a century, the U.S. began violating Ferguson’s Law last year. Annual defense spending—to be precise, national defense consumption expenditures and gross investment—was $1.107 trillion in 2024, according to the Bureau of Economic Analysis (BEA), while federal expenditure on interest payments (the government long ago gave up on paying down principal) topped out at $1.124 trillion.
So how does Europe measure up against this standard after decades in which most of its states, made complacent by America’s security guarantee and the end-of-history belief that a major European war could be consigned to history, have neglected their own defenses?
Short answer: not well. EU members together spend 1.9 percent of their GDP on defense, only a fraction more than the roughly 1.8 percent they spend on servicing their debt.
Of course, the Ferguson benchmark is aimed at “great powers,” a status that no individual (Western) European nation claims or wants, but relevant to the collective “Europe” (or partnership of European states) that Friedrich Merz, Germany’s all-but-new chancellor, wants to see. Europe, this life-long Atlanticist insists, will have to “strengthen [itself] as quickly as possible, so that we [Europeans] achieve independence from the US.” Polish prime minister Donald Tusk framed this more positively. Speaking a week or so ago he stressed his desire for Europe to act as a “power,” but:
“It will not be an alternative to America, but its most desirable ally. President Trump wants Europe to shoulder responsibility for its own security…We have to rely on ourselves, being fully aware of our own potential and believing that we are a global power.”
But whatever form of independence they adopt Europeans cannot safely ignore the Ferguson test.
In a report dated February 21, 2025 (so before the bust-up in the Oval Office), Brussels-based thinktank Bruegel and the Kiel Institute for the World Economy looked at whether Europe could replace the current U.S. support for Ukraine. The answer, with a critical qualification, was yes:
From a macroeconomic perspective, the numbers are small enough for Europe to replace the US fully. Since February 2022, US military support to Ukraine has amounted to €64 billion, while Europe, including the United Kingdom, sent €62 billion. In 2024, US military support amounted to €20 billion out of a total of €42 billion. To replace the US, the EU would thus have to spend only another 0.12 percent of its GDP – a feasible amount.
But:
A more important question is whether Europe could do this without access to the US military-industrial base.
The way things are going, it may have to, but, even if it had to buy the necessary equipment, how much would the Americans have available to sell, given that their reserves have been run down and that they need to restore them to deal with the challenge from China?
But beyond backing Ukraine, could Europe pay for its own defense over the longer term? That topic is examined in detail in the Bruegel/Kiel report.
To give an indication:
Taking the US Army III Corps as a reference point, credible European deterrence – for instance, to prevent a rapid Russian breakthrough in the Baltics – would require a minimum of 1,400 tanks, 2,000 infantry fighting vehicles and 700 artillery pieces (155mm howitzers and multiple rocket launchers). This is more combat power than currently exists in the French, German, Italian and British land forces combined. Providing these forces with sufficient munitions will be essential, beyond the barebones stockpiles currently available. For instance, one million 155mm shells would be the minimum for a large enough stockpile for 90 days of high-intensity combat.
And that’s only a small part of it.
Military equipment spending is currently about 0.7 percent of GDP (Wolff et al, 2024); it would need to increase substantially. According to our calculations, the recent surge in military spending in Poland saw the government dedicate 70 percent of the additional funds to equipment purchases. Similarly, Germany’s Sondervermögen [off-budget] debt fund has so far gone exclusively to equipment purchases.
There would be more. Bruegel/Kiel estimate that Europe assuming primary responsibility for its defense would mean that its defense spending would have to rise to 3.5 percent of GDP, an additional €250 billion a year. That percentage is less than the 5 percent Trump has called for, which is normally associated with countries at war or in its aftermath— but is not far off the 3.6/3.7 percent given by NATO Secretary-General Marc Rutte in January, so once again before the debacle in the Oval Office.
Back then, neither Bruegel/Kiel nor Rutte were envisaging a complete divorce from the U.S. Rutte noted that “the US [was] spending over 60 percent of all the money being spent within NATO territory.” Creating “a sort of European NATO” without the U.S. would mean outlays of 8-10 percent of GDP (to cover items such as a European nuclear capability) and would take 15-20 years.
Oh.
Due to pressure from Trump in his first term and, of course, the Russian invasion of Ukraine, a large majority of Europe’s NATO members have surpassed the old target of spending 2 percent of GDP on defense. There are still prominent laggards such as Spain (1.2 percent) and Italy (1.5 percent), but’s worth taking a look how some of the alliance’s other members are faring.
The U.K. — in NATO but not the EU — spent 2.3 percent of GDP on defense in 2023-24. That’s meant to increase to 3 percent (too little) by the end of the decade (too late). Britain has long since crossed the Ferguson limit. It already spends 3.7 percent of “national income” (a figure fairly close to GDP) on servicing its debt.
The U.K.’s lenders are uneasy. A panicky spike in yields on British sovereign debt earlier this year was a sign of trouble to come. Funding future increases in defense spending will be tough going. Raiding the overseas aid budget can only go so far, and the tax burden is approaching a postwar high. The most recent tax increases have hit a stagnant economy. There is talk of spending cuts, but that’s tricky territory for any Labour government, even if, like the current one, it enjoys a large parliamentary majority.
In 2023, Turkey, another traditionally strong military power, a member of NATO, but not the EU, spent 2 percent of GDP and almost 2.6 percent on debt service (before repayment of principal). Turkey has little love for “Europe,” but it has no wish to see the Russian domination of the Black Sea that would follow a Ukrainian collapse.
Estonia, a member of NATO and one of the EU’s most fiscally disciplined countries (it has a debt/GDP ratio of 24 percent) has introduced a special defense tax intended to take its defense spending (forecast at 3.4 percent of GDP this year) to Trump’s 5 percent of GDP. A brutal history and a dangerous neighborhood will do that. Tellingly, the other two Baltic states, Lithuania and Latvia, are also targeting 5 percent.
France, the strongest military power to be a member of both the EU and NATO, spent 2.1 percent of GDP in 2024, a little more, probably, than on servicing its debt (1.8 percent in 2023). President Macron wants defense spending to increase to 3-3.5 percent of GDP, but France’s fiscal position is bleak, and tax burden heavy. So, once again, where is the money to pay for this to come from?
Poland, that emerging bulwark in the east, has undertaken to spend 4.7 percent of GDP on defense in 2025. This compares with debt servicing costs of 2.09 percent, but Warsaw’s rapid increase in its military spending is not without its financial risks. Its budget deficit is close to 6 percent.
Merz wants Germany to take a leading role in the transformation of Europe’s defense capabilities. Unlike most European countries its finances are healthy (debt to GDP stands at around 63 percent), something attributable in no small part to its constitutionally enshrined debt brake, an arrangement that Merz has (not unreasonably) previously defended, and which would need a two-thirds majority to amend.
Due to the strong showing of the populist-right AfD and hard left Die Linke, both of which are sympathetic to Russia, in the recent general election, that two-thirds majority would be out of reach in the new parliament which first meets on March 25. Merz, therefore, has agreed with the center-left SPD (his likely coalition partners) to amend the debt break in the outgoing parliament on March 18. If approved the result will be dramatic. The SPD will be rewarded for their support by the creation of a €500 billion ten-year fund it has been calling for to modernize Germany’s somewhat dilapidated infrastructure. In return, Merz will be able to borrow what is needed to upgrade the military. To get to the tally of votes he needs, Merz will also have to agree to demands of the Greens, who, in addition to some reasonable suggestions relating to defense, want more money to be wasted on (they wouldn’t put it that way) the “clean energy transition.” On a cheerier note, there is growing, if belated, European recognition that investing in defense companies is compatible with ESG.
The prospect of an additional €1 trillion in borrowing has led some analysts to predict that, if the debt brake is relaxed, GDP really could move up again as soon as this year. Possibly. Count me skeptical about how wisely the non-defense part of all this will be spent, but the skills needed to upgrade Germany’s defense sector may go some way to mitigating the crisis affecting the country’s auto sector and those who supply it.
German weapons maker Rheinmetall, whose stock has nearly doubled this year, is converting some of its own domestic car-part plants to produce military equipment. Last month Franco-German tank maker KNDS agreed to take over and convert a train-making factory from Alstom in the eastern town of Görlitz to produce parts for battle tanks and other military vehicles.
Hensoldt, a state-owned maker of sensors and radars, is in talks to hire teams of software engineers from Continental and Bosch, two of Germany’s largest automotive suppliers, which together have announced more than 10,000 job cuts in the past year.
For its part, the EU Commission is willing to support €150 billion in loans for defense spending and will also relax some of its restrictions on the amount that its member-states can borrow. Additionally, Macron has been promoting the idea that the EU should borrow in its own name to raise funds for defense spending, but that’s an idea that may come to nothing. The bloc’s more frugal member-states tend to be cautious about giving Brussels more money to play with. There are also suspicions on the part of some EU governments that the Commission plans on exploiting the current crisis to assume a greater role in defense, an obvious threat to what remains of their sovereignty.
Other European leaders would prefer a funding structure that would, Politico reports, be outside the EU. That way, countries such as the U.K. and Norway — in NATO but not the EU — could participate, and a Hungarian veto could be bypassed. Meanwhile, Norway, the Nordic region’s richest country, will be doubling its support for Ukraine this year. Up until now its contributions have lagged those of Denmark or Sweden, despite Norway having done well out of the higher oil and gas prices associated with the Ukraine war. It will also be increasing its defense spending to 3 percent from 2 percent today. So far, however, Oslo has resisted digging into Norway’s enormous (€1.7 trillion) sovereign wealth fund, which could be a useful investor in any separate financing structure for Europe’s defense.
Another potential pot of money is the roughly $200 billion in frozen Russian state assets held by European financial institutions. The interest on that is now being spent on financial assistance to Ukraine. The main argument against seizing the principal as well is that it will reduce the appeal of Europe as a place to lodge financial assets, especially for those who fear finding themselves on the wrong side of the West. There’s something to that, but at a guess it will not be enough if the need becomes sufficiently pressing.
There’s something else that could make the cost of Europe’s increased defense buildup (much) easier to bear, and that is either abandoning its race to net zero greenhouse gas emissions or extending its timetable beyond a target date (2050) that is clearly already unachievable. Bruegel/Kiel believe that the cost of getting Europeans spending to the “right” level would be €250 billion. The Economist estimates that the number is closer to €325 billion, a difference partly explained (at a guess) by Bruegel/Kiel’s expectations about economies of scale and partly, I reckon, by the fact that it is almost impossible to reach any degree of precision in this area. Either number is less than the estimated €367 billion that statistician Bjorn Lomborg, the “skeptical environmentalist,” cites as the amount that the EU is now spending annually on “climate.”
Lomborg applies a similar logic to the U.K. Britain, he suggests, should switch 90 percent of what it spends on net zero to defense, leaving the balance to be invested in climate-related R&D. This, he reckons, would have a better chance of doing something to slow climate change while freeing “precious resources to drive innovation, boost defense, and – through much lower energy prices – reinvigorate a high-growth Continent.”
There’s room to debate Lomborg’s numbers, but little to rebut his basic thesis, which is that much of the money needed to fund Europe’s defense upgrade could be found by slashing the money being spent on net zero. Moreover, removing (or suspending) the burden of net zero would increase the chance that Europe could resume the growth that would make it easier to cope with higher defense spending.
Another reason for scrapping or pausing net zero will be Europe’s need to manufacture much more of its own military equipment. As noted above, the U.S., which provided two-thirds of European NATO’s arms between 2020-24, may well not have the capacity to satisfy increased demand from Europe. Additionally, anxiety over the reliability of the Trump administration as well as revelations about “killswitches” installed in some U.S. weaponry are leading Europeans to want a reduction in their dependence on U.S. suppliers. Rebuilding European arms manufacturing will mean reindustrialization. Net zero has meant deindustrialization. Choose one.
It will be hard for Europe to pay for its own defense, and the more that the U.S. retreats from backing Europe up, the harder it will be. How far that retreat will go remains a mystery. Believing that rebuilding Europe’s defenses will be a Keynesian win-win is naïve. Any boost to its economies from higher military spending could easily be canceled out the increased spending’s effect on interest rates (already much higher than in the ZIRP decade) and inflation. And then there is the matter of the damage that a trade war could do to Europeans’ ability to pay their own way, something the president would do well to remember.
Finally, this handover will inevitably take time. For the U.S. to scale back its commitment to Europe without taking account of that is to invite disaster — and Vladimir Putin.
But Mr. Trump is not always known for his patience.
The Capital Record
We released the latest of our series of podcasts, the Capital Record. Follow the link to see how to subscribe (it’s free!). The Capital Record, which is hosted by financier David L. Bahnsen, makes use of another medium to deliver Capital Matters’ defense of free markets.
In the 216th episode, David talks about class warfare targeted at private equity firms daring to buy 0.06 percent of homes, and how counterproductive it is to the cause of a free and virtuous society to be going after the wrong people, for the wrong things, all the time.
In the 217th episode, David asks if one needs to convert their business success to charitable endeavors to create a “lasting Kingdom legacy.” Or can we say with conviction that our efforts in the marketplace are lasting, are meaningful, and, in fact, are vitally important? David goes after a well-intentioned but deeply misguided sentiment about business vs. philanthropy, and in so doing lays out a vision for economics that gets to the heart of what the Capital Record is about.
The Capital Matters week that was . . .
ESG/Stakeholder Capitalism
The apparent paradox — no, let’s put that more strongly: The perversity of shareholders voting against their own apparent interests, which is what happened at ExxonMobil, has its own well-deserved apokálypsis in Andy Puzder’s new book, A Tyranny for the Good of Its Victims: The Ugly Truth about Stakeholder Capitalism (Encounter Books, January 2025). Central to Puzder’s account of the attempt to destroy shareholder capitalism is the role of the Big Three asset managers — BlackRock, Vanguard, and State Street Global Advisors (SSGA), whose enormous size derives from the popularity of index funds among institutional investors and private investors alike…
One argument used by promoters of ESG (an investment “discipline” which includes a strong focus on environmental, social, and governance factors) to sell their snake oil was the assertion that it was a way of doing well by doing good, a claim that has required rather elastic definitions of “well” and “good.” That hasn’t worked out, thus the switch to a more defensive justification — particularly after the brief green bubble burst — that ESG was a way of reducing risk. Hmm…
The Economy
The Atlanta Fed’s GDP Now forecast model’s dramatic downward turn for the first quarter of 2025 shouldn’t be overread. As CNBC reported, the tracker is volatile and becomes more reliable toward the end of the quarter as the data come in. But the metrics fueling the contraction – declining consumer spending and confidence combined with exports coming in weaker than expected – should not be dismissed so quickly…
Economic Policy
Terrence Keeley & Jim Sorenson:
Americans are uniquely called to democratize prosperity. More than any other country in history, we have excelled at creating it. The reason for this is simple: capitalism. More than any other nation, Americans have embraced Milton Friedman’s philosophy that the purpose of business is to make money, within the constraints of law and prevailing social customs.
The results have been astounding…
Tariffs
It’s generally good practice not to worry too much about a single day’s movement in the markets. Nevertheless, the news that the administration is proceeding straightaway with 25 percent tariffs on imports from Canada and Mexico was not well received by investors, who have, more ominously, been feeling a touch morose for a little while now…
For example, Secretary of the Treasury Scott Bessent said that China will “eat any tariffs that go on.” The idea is that China’s exports to the U.S. are so valuable that Chinese companies would cut their prices to keep the after-tariff price the same as the pre-tariff price. That way, Americans would keep buying Chinese products, and the Chinese companies would effectively bear the burden of the tax.
This could be true in theory, but we know from experience this is not how the China tariffs worked last time. Nearly the entire cost of the tax was passed on to Americans. China retaliated with tariffs of its own, hurting American exporters. Both countries were made worse off…
The agricultural trade balance used to be a consistent surplus in the supposedly awful times when NAFTA was in effect and China was buying larger amounts of U.S. agricultural exports. In 2019, the year after Trump’s China tariffs took effect, the U.S. ran its first agricultural trade deficit since at least 2001.
The administration knew that the decline in exports that year was because of retaliatory tariffs, so it spent billions of taxpayer dollars bailing out farmers to make up for it. Exports increased significantly from 2020 to 2022, but so did imports, keeping the trade balance close to zero…
[P]oliticians in Washington often say they are fighting for tariffs because voters in the heartland demand them, and those of us who live on the coasts simply don’t understand how out of touch we are. As someone who grew up in Wisconsin, this has always rubbed me the wrong way. Those politicians are, in many cases, just ventriloquizing heartland voters, putting words in their mouths that they never said for the benefit of special interests in Washington.
Greg: But what could the car companies be upset about? Tariffs are great!
TP: Well, they have to move parts across borders several times during production, so they’re concerned they’d have to cut jobs and raise prices significantly if tariffs went into place.
Greg: Oh. That would be bad. So what’s the plan to prevent that from happening?
TP: That’s why we’re delaying the tariffs.
Greg: Just that?
TP: Well, no. Other businesses have been concerned as well…
Times change. It’s no longer the 1980s, but it’s not the 1890s either. Siemens was not drawn to the U.S. by the threat of tariffs, but by the promise of America.
There’s a lesson there.
Tax
Simply extending the tax provisions of the Tax Cuts and Jobs Act (TCJA) that expire this year could cost up to $4.6 trillion when factoring in additional interest payments on the debt. Moreover, some of the most pro-growth and desperately needed policies, such as bonus depreciation, would add another $322 billion to the cumulative deficit on a dynamic basis…
The Bureaucracy
In the latest example of state governments solving problems that the federal government seems incapable of solving, Judge Glock and Renu Mukherjee of the Manhattan Institute have a new paper out about civil service reform. The invincibility of the federal bureaucrat is legendary, but states have been successfully transitioning to at-will employment in the public sector for the past few decades…
Industrial Policy
In his address to the joint session of Congress, President Trump called for the repeal of the CHIPS Act, a bipartisan industrial policy law signed by Biden. “We don’t have to give them money,” he said of semiconductor companies benefiting from the law’s subsidies…
Energy
In his recent visit to the Land of Enchantment, Energy Secretary Chris Wright underscored New Mexico’s national significance in energy production, highlighting its vital role in meeting growing U.S. energy demands through oil, solar, and emerging nuclear and geothermal industries. Simultaneously, the state is enjoying more than $800 million in new tax revenue from oil and natural gas extracted from the Permian Basin in the southeast corner of the state. The oil and gas tax revenue has grown over 50 percent in the last year, is worth $2.1 billion, and represents over 20 percent of the state’s annual budget.
This government-controlled wealth has prompted an urgent and consequential question: How do we transform today’s abundance into lasting prosperity? The Southwest Public Policy Institute believes the answer lies in empowering New Mexicans directly by establishing a permanent fund dividend (NMPFD). Modeled after Alaska’s successful program, this proposal offers a path toward economic freedom, poverty alleviation, and long-term stability…
Any rinky-dink country can pull crude oil out of the ground. The U.S. is special because it can do that better than anyone while also excelling at turning that crude oil into stuff people can actually use. It has some of the best engineers and geologists financed by some of the best investors to make that happen. And it doesn’t happen without global markets.
Corporate Welfare
Republicans must cut spending to ensure that they do not increase already massive deficits. The House budget plan includes $4.8 trillion in tax cuts and new spending over a decade but only $1.5 trillion in spending cuts. The GOP should add corporate-welfare cuts of $1.8 trillion over a decade, and they should repeal $1 trillion of energy-tax loopholes passed under President Biden, which are essentially corporate welfare as well.
Congestion Tax
The MTA argues that tolls are needed on “environmental justice” grounds to fund clean-air projects for minorities. But even though low-income individuals can apply for discounts, and handicapped people are exempt, the tolls disproportionately hurt poor people and small businesses, and they punish older people and families with young children who can’t take public transport or afford taxis. It’s no justice to take away the right to personal transportation.
If local politicians desired, New York City could reduce congestion by prioritizing traffic flow on the roads. The Big Apple could get rid of some bike lanes and bike-docking stations that take up valuable road space. It could charge competitive prices for curbside parking to keep some spaces free for delivery vehicles, reducing double-parking and ensuing traffic jams…
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